Understanding option calculations is a necessary skill to become an elite covered call writer. The Ellman Calculator will do all the legwork but accurate and meaningful results are dependent on appropriate inputs. To highlight this point, let’s look at a real-life trade sent to me by Catherine who trades on the Toronto Stock Exchange:
Catherine’s trade
- Stock price at purchase of BNS (Bank of Nova Scotia) at $61.75
- Sell the $58.00 call at $2.10 (8 months to expiration)
- Current stock price $62.00
- Cost-to-close (buy back option) is $5.75
Why these stats make no sense
Let’s start with our basic premium equation:
Total premium = Intrinsic value + time value
Now, if the above stats are accurate, the $58.00 call generated $2.10 while BNS traded at $61.75 This cannot be because there is $3.75 intrinsic value + a time value component (with 8 months remaining to expiration) so a premium of $2.10 is impossible. I would expect a premium well over $5.00 depending on the implied volatility of BNS. I’ll bet most of you have figured this out.
I checked back with Catherine and sure enough the shares were purchased at a $61.95 but the covered call was sold after share depreciation to $58.00. Let’s say Catherine bought BNS 10 years ago for $5.00 per share which has now appreciated to $58.00 and then the $58.00 call was sold for $2.10. Does that mean her return for the 8-months remaining is 42% using a $5.00 cost basis (hint: rhetorical question)?
What is our cost basis when we write a covered call?
Tax issues aside, our cost basis is the price of the shares at the time the call is sold. Although Catherine paid $61.95 for the shares initially, the day the call was written the shares were worth $58.00. Had she paid $30.00 initially, the shares would still be worth $58.00 for purposes of covered call calculations. We cannot cloud our calculations by using irrelevant figures that have nothing to do with current positions.
Initial returns using current cost basis
The Ellman Calculator shows an initial 8-month return of 3.6% and a breakeven of $55.90. This annualizes to 5.4% which doesn’t get me very excited. It does, however, demonstrate the value of accurate calculations which will guide us in making the best covered call writing decisions in a given point in time.
Buying back the option when share price is at $62.00
The cost-to-close (buy back the option) is $5.75 which will move share price from the original $58.00 strike ceiling to current market value of $62.00. We have a share price credit of $4.00 and an option debit of $5.75 resulting in a net loss of $1.75 or 3% of our real current cost basis. This may be something to consider to get out of this “deal” and start using the cash for more productive investment trades. Lesson learned.
Discussion
Although the Ellman Calculators (and others) do the heavy mathematical lifting for us, inputting accurate statistics will result in meaningful calculations which will go a long way in guiding us to appropriate trades that give us the greatest chance of achieving high levels of success.
Market tone
Global declined this week on growing concerns that the accommodative monetary policy has reached the limit of its effectiveness and interest rates will be increasing in the near-term. The Chicago Board Options Exchange Volatility Index (VIX) rose to 17.5 from 12.11 last week, most of the increase occurring on Friday. Crude oil prices advanced on the week, with West Texas Intermediate crude rising to $46.50 per barrel from $44.00. This week’s reports and international news of importance:
- The European Central Bank made no changes to its policy mix, defying market expectations that the ECB Governing Council would extend its bond buying program beyond its scheduled end date in March 2017
- The Reserve Bank of Australia and the Bank of Canada left policy unchanged, though the BOC warned that economic risks are tilted to the downside, suggesting that a cut in policy rates is possible later this year
- Despite market skepticism, several members of the US Federal Reserve Board members this week reiterated calls to hike rates gradually in the coming months
- The United Kingdom’s service sector purchasing managers’ index surged by the most on record in August, rising to 52.9 from 47.4 in July
- Last week, the UK’s manufacturing PMI rebounded sharply as well, suggesting that the UK economy will weather the Brexit event
- The US service sector performed less well in August, with the Institute for Supply Management’s nonmanufacturing index slumping to 51.4 from 55.5 in July. The August reading is the lowest since February 2010 but still reflecting expansion
- Retail sales in the eurozone jumped 1.1% in July and 2.9% on an annual basis. The solid showing in July pushed retail sales volumes above their prior 2008 top
- Chinese imports rose unexpectedly for the first time in nearly two years in August and exports fell less than feared, suggesting to some analysts that the worst of the Chinese economic slowdown may be behind us
- South Korean markets fell on Friday after North Korea conducted its fifth nuclear test. The KOSPI benchmark fell 1.1
THE WEEK AHEAD
- EU finance ministers meet on Saturday, September 10th
- China reports retail sales and industrial production data for August on Tuesday, September 13th
- ECB president Mario Draghi speaks in Italy on Tuesday, September 13th
- The Swiss National Bank holds its quarterly rate setting meeting on Thursday, September 15th
- The Bank of England Monetary Policy Committee meets on Thursday, September 15th
- US retail sales data are reported on Thursday, September 15th
For the week, the S&P 500 declined by 2.39% for a year-to-date return of +4.10%.
Summary
IBD: Uptrend under pressure
GMI: 6/6- Buy signal since market close of July 1, 2016 (prior to Friday’s decline)
BCI: Friday’s 2+% market decline does not imply a trend and it is important not to react emotionally. It may turn out to be a smaller version of the Brexit decline and rapid recover. I am managing my September positions and will decide on a ratio for the October contracts as next week’s action dictates.
WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US
The charts continue to point to a neutral outlook. In the past six months the S&P 500 rose by 7% while the VIX declined by 5%, stats that have been muted by Friday’s price action.