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August 16, 2003
It's Expiration Day... Now What?
by John Brasher, CallWriter Publisher
| Let's take a look at an
actual covered call trade in USG Corp.
(USG). The stock cost $15.11 and the AUG
15 Call was written for $1.03 (a 6.08%
return for a 17-day holding period). Now
it's expiration day and USG is down slightly to
$14.87. Now what? |
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We will not
be called out of USG, apparently, unless it floats back up overf
$15 right before the close. Had we been called out of the stock
at $15, our return would have been $0.92. We got $1.03 in
premium, sure, but this call was slightly in the money (ITM)...
we paid $15.11 for USG and if called would have had to sell at $15,
losing $0.11 per share. There is no formula here, really, just simple
arithmetic:
Total
Premium |
- |
Loss
on Stock |
= |
Return
before Costs |
|
|
1.03 |
- |
0.11 |
= |
0.92 |
But it took
two commissions to enter this trade, one each for
the stock and call legs (one to buy stock, one to sell the calls).
Let's assume the trade cost to close is $15 per leg, for a total
of $30. If only one contract was opened, the cost to close would
be $0.30 per share ($30 ÷ 100 shares) , and if two contracts
were opened, half that - $0.15 per share ($30 ÷
200 shares). Let's assume we opened two contracts, so our realistic
return if called out at the $15 strike - after deducting trade costs
- would not be $0.92 but $0.77 (0.92 - 0.15). I just think
of it as having really received $0.77 in net premium.
TIP:
CallWriter members using our Trade Management Calculator™
can easily take trading costs into account by subtracting the
commission cost per share from the premium received. See the Money
Management II article for more of my views relating to covered
calls and trade commissions,
Should we
buy back the call and sell USG to close the position, or take another
course of action, also discussed below? The stock is down as I write
from $15.11 to $14.87, so closing immediately would take the return
down from the $0.77 in net premium received to $0.52, lopping
$0.25 off the return. But wait,
in order to close, we first must buy back the calls, and there are
trading comissions to pay, also.
Let's assume
it would cost $0.20 (the asked price) to buy back the calls.
The cost of buying them back never goes to zero, even on expiration
day. We also have to pay trading commissions on the transactions
to close the covered call trade, another two legs (buy back
calls and sell stock). Since we're assuming we've run two USG contracts,
closing will cost us $0.15 per share, as explained above. require
two commissions, one each for the stock and call legs. Let's assume
the trade cost to close is $15 per leg, for a total of $30. If only
one contract was opened, the cost to close would be $0.30 per share,
and if two contracts were opened, half that - $0.15 per share.
Here is how closing looks in table form, assuming we opened two
contracts in USG:
| Cost
to Close Trade - Stock is Now $14.87 |
| Bought
stock |
-15.11 |
| Wrote
AUG 15 Call |
1.03 |
| Trading
costs |
-0.15 |
| Net
Trade Debit
(cost basis) |
$
14.23 |
| |
|
| Buy back
calls |
-0.20 |
| Sell
stock |
14.87 |
| Trading
costs |
-0.15 |
| Net
Return on Closing |
$
0.29 |
The original
trade set up a potential return of $0.77 per share if called out
at $15. But the $0.20 per share cost to buy back the calls and the
$0.15 per share commission cost really ate up the return. Closing
early will therefore take the expected return on the USG trade from
0.77 down to 0.29. Ouch! Closing is not a good idea, unless
you feared a selloff in USG. Letting the AUG calls expire worthless
is free if the stock is not dropping.
TIP:
Notice how important trading costs are in this position? Trading
3 contracts would lower the entry and exit commissions from 0.15
to 0.10 per share. Trading 5 contracts would lower them to 0.06
per share, which would make closing a different analysis. In my
opinion, traders should always write 3 or more contracts per covered
call trade.
Instead of
closing the position out before expiration, we could simply do nothing
and let the calls expire, then sell the stock next week after expiration.
Assuming we would still get today's $14.87 per share, the profit
picture improves slightly, as shown below:
| Let
Calls Expire and Sell Stock at $14.87 |
| Bought
stock |
-15.11
|
| Wrote
AUG 15 Call |
1.03
|
| Trading
costs |
-0.15
|
| Net
Trade Debit
(cost basis) |
$
14.23 |
| |
|
| Sell
stock |
14.87
|
| Trading
costs |
-0.075 |
| Net
Return on Closing |
$
0.565 |
By waiting
a few days, we saved the cost of buying back the calls (0.20) and
the commission to close the calls (0.075), which increased profit
on the trade from $0.29 to $0.565, almost doubling it. Unless
the stock seems to be in danger of selling off, the choice is clear
to me - wait.
Should we
keep USG and write another call? If it still looks safe to write
and the premium is acceptable, why not re-up USG by writing a September
call? So let's now assume the AUG 15 Call has expired worthless.
A stock option is said to expire worthless when it is not exercised.
In the above example, you finished at expiration having collected
$1.03 in premium with the stock slightly down. USG went into a trading
range back in mid-July 2003. It is now slightly below the 50-day
moving average (MA), testing it. It's not showing particular strength
or weakness, but remains significantly above the $12.50 - $13 support
level.
Assuming we
write USG again, which month should we write? I personally would
write September, since I don't like getting too far out in time;
I like to maximize the use of time decay in the last 30 days of
a call's life. Moreover, the longer we're in the trade, the longer
things have to go wrong. So September is the choice if we rewrite,
but which September call? The Sept. 15 is paying about $1.20
now, the in-the-money Sept. 12.50 is paying $2.70
(fat premium, but remember you'll have to sell the stock at $12.50
if you write this one).
The decision
whether to rewrite or not should depend on a new evaluation and
assessment of USG next week on Monday or Tuesday after AUG expiration.
If USG then seems strong, there is no technical reason not to write
the 15 Call. Here is a table showing how the two SEP strikes compare
economically right now, assuming that each strike is in the money
at SEP expiration and we're called out of USG:
| |
Sept.
12.50 Call |
Breakeven |
Sept.
15 Call |
Breakeven |
| Bought
Stock |
-$15.11 |
-$15.11 |
-$15.11 |
-$15.11 |
| August
Premium (net)* |
+$
0.87 |
+$
0.87 |
+$
0.87 |
+$
0.87 |
| Sept.
Call Premium |
+$
2.70 |
+$ 2.70 |
+$ 1.20 |
+$ 1.20 |
| Trade
cost (calls) |
-$
0.075 |
|
-$
0.075 |
|
| Sale
of Stock at strike |
+$12.50 |
|
+$15.00 |
|
| Trade
cost (calls) |
-$
0.075 |
|
-$
0.075 |
|
| |
|
|
|
|
| Net
Return (overall) |
$
0.97 |
|
$ 1.97 |
|
|
Basis (breakeven) |
|
$11.53 |
|
$13.03 |
*Even though
we got a total of $1.03 for the AUG calls, trade costs
to open the position lowered the net premium to $0.87
(1.03 - 0.15).
If we are called
out of both strikes (meaning USG is over $15 at SEP expiration),
there is far more money in writing the SEP 15C, nearly double the
return; but it only lowers our breakeven in the trade from $14.23
to $13.03, slightly above major support. On the other hand, the
SEP 12.5C would lower our cost basis from the current $14.23 to
$11.53, which is well below a strong support level in USG; not a
bad place to be. However, the SEP 12.5C does not offer a particularly
enticing return. Our return if we sell the stock at $14.87 - see
the second example above - is $0.565, and writing the SEP 12.5C
adds less than 0.40 to the overall return.
So is the 15
Call the best strike to write? Only if you believe USG will hold
its price. A market downtrend could easily carry USG down to
its support level around $12.50, or through it.
The 12.50 Call
yields a much lower profit, since the net premium is $1.12 for both
months, about a 7.4% return for a 52-day trade. This annualizes
to a return of more than 100%, without compounding, so it isn't
bad. However, the 12.50 call gives downside protection all the way
to $11.38, meaning USG would have to drop below $11.38 to deal a
loss. But clearly, the money is in the Sept. 15 Call. This analysis
illustrates the dilemma always facing the trader: take the safer
but lower return (12.50) or the higher but riskier return (15)?
Ultimately,
the decision will be based on what you think the market and USG
will do prior to Sept. 19th expiration. The above chart illustrates
how you compare different strike options in deciding where the money
is. Our proprietary Trade Management Calculator available
to CallWriter members also is invaluable
in making these calculations, since it allows you to instantly compare
two different strikes in writing another call at expiration.
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