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?

Should We Close Early?

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:

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:

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.

Should We Just Let the Calls Expire and Sell the Stock?

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:

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 Write the Stock Again?

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:

*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.

Good luck and good trading!