For the benefit of all option traders, Alan Ellman of thebluecollarinvestor.com, highlights an exit strategy that is useful for both covered call writing and put-selling.
Rolling up is a useful exit strategy for both covered call writing and put-selling. However, in my humble opinion, it rarely benefits us to roll up in the same contract month. The main reason for this conclusion is that we are dealing with a stock that has substantially appreciated in value in a relatively short time frame. The success of the rolling up strategy in the same contract month is dependent on that stock maintaining that share value or even accelerating even higher. In other words, we are asking a lot of this security while risking our unrealized gains from the initial option sale. In this article we will evaluate a trade shared with me by Preacher John of Mexico (they call him Preacher in Cancun where he teaches the BCI methodology):
The initial trade in one-contract format
3/22/2015: Buy 100 x PAYC at $51.10
3/22/2015: Sell 1 x $50.00 call at $2.10
3/22/2015: Initial returns are 2% with downside protection (of that profit) of 2.2% as shown in the screenshot below using the multiple tab of the Ellman Calculator:
Position evaluation six days later
- PAYC price moves up to $56.69
- Value of the $60.00 call (“ask”) is $7.10
- Bid price of the $55.00 call (should we decide to roll up in the same month) is $2.55
Situation if we do not roll up in the same contract month
We are guaranteed a 2%, 1-month return as long as share value does not decline by more than 12% by expiration (move from $56.69 to under $50.00). This represents a safe scenario where our initial investment has been maximized.
Situation if we do roll up in the same contract month
Our maximum share appreciation is now up to the $55.00 strike which represents a credit of $3.90 from the initial purchase price of $51.10. We also have an option debit of $2.45 [($2.10 + $2.55) – $7.10]. Since we used the intrinsic value of the $7.10 buy-to-close option to enhance the value of our shares, our cost basis is now $55.00. Let’s calculate:
($3.90 – $2.45)/ $55.00 = 2.6% with downside protection of that profit of 3%
Chart summary of two approaches
This chart gives clarity to the two positions. Rolling up will generate an additional 0.6% profit and lose 9% of our position protection. The question we must ask ourselves is whether that amount of additional profit potential is worth the loss of a majority of our protection at that point in time. I’ll leave that for you to answer but also present it to you as to the reason why I rarely roll up in the same contract month.
Is there any other way to take advantage of a situation like this?
As Blue Collar Investors, this is the question we must ask ourselves and the answer is you bet. Frequently, we can implement the mid-contract unwind exit strategy when share price has accelerated significantly in a short time frame. This is a topic I have written about in detail on pages 264 – 271 of the classic version of the Complete Encyclopedia and pages 105 – 111 and pages 243 – 252 of Volume 2 of The Complete Encyclopedia.
Before implementing an exit strategy, we must weigh its pros and cons as well as alternate approaches that may better meet our needs. For those of us who are conservative investors with capital preservation as a key focus, the mid-contract unwind exit strategy may be more appropriate than rolling up in the same contract month when share value has accelerated significantly early in the contract.
By Alan Ellman of TheBlueCollarInvestor.com
Tickers Mentioned: Tickers: PAYC