Track That Trade 110411. MT Covered Call

Taking the suggestion of member Chris, I opened a covered call position (or a Buy-Write) on MT, ArcelorMittal, a steelmaker headquartered in Luxembourg. I don’t believe in writing calls on stocks that I don’t want to own. However, there is no reason not to accommodate a member’s trade selection,when possible.

The Trade

Buy 1,000 shares MT @ $36.88
Sell 10 MT Jun 35 calls @ $3.05

Net Debit: $33.83
Trading Platform: Interactive Brokers Paper-Trading account

Maximum profit occurs when stock is above strike price at expiration. (Note: A closing price of $34.99 or $35.00 would result in a larger overall profit if your broker charges a fee when an option is assigned to your account). That profit is $1.17 per share, or $1,170 for the 1,000 share position.

That represents a return on the investment of 3.4%. Very conservative for most option traders. However, the purpose of this trade is to get some experience managing risk, and not to earn a big profit.

I’d like to hear from Chris: You proposed the stock, but neither an expiration date nor a strike price. What did you have in mind when suggesting this stock as a CCW candidate?

Rationale

When writing covered calls, choosing the strike price is always a serious consideration.
As a reminder to experienced traders: Writing a covered call is equivalent so selling the cash-secured put.

    Thus, this position is equivalent to selling 10 MT Jun 35 puts

If you are unfamiliar with the concept of equivalent positions, please take a look at two of my blog posts this and that. Feel free to raise any questions on that topic: Either below or in the forum.

Most traders who write naked puts write OTM puts. That’s the main rationale for selling ITM call options. I know that most buyers of stock tend to be bullish, and prefer to sell OTM (out of the money) call options. That style of covered call writing (CCW) is more bullish, allows for larger profits, and as Dmitry would say – what’s the point of trying to find a good stock to buy if you plan to sell so quickly – and especially for such a small profit.

That is a legitimate argument and the right attitude for bullish investors who are more concerned with profit potential than with the idea of owning a less risky trade.

This time I chose the less risky trade – and the trade with a much reduced potential profit. Note that I always refer to profits as potential. After all, stocks can move in the wrong direction, and there may be no profits when all is said and done.

Trade and Risk Details

The position is long 343 delta, and although upside profits are limited, this is a bullish trade. Delta is one of the greeks that measures ‘share equivalency. That means the position is expected to increase in value by $343 if the stock rises by one point, and to decline by $343 when the stock moves one point lower.

Please understand that this is an approximation. Other greeks come into play and delta does not hold steady

Despite the shortcomings delta is a reasonable number for measuring risk when the stock undergoes a price change.

Gamma is -70. Translation: When the stock moves one point, delta will change by ~70 units. Because gamma is negative, a higher stock price makes the position long fewer delta and a lower strike price makes the position long more delta. Gamma also changes as the stock price changes.

Note that negative gamma is not position friendly. As the market moves higher the position loses some of it’s delta. Translation: When you have negative gamma, any market move is unfavorable to the delta position. The position gets shorter (or less long) on market rallies and gets longer (or less short) as the market falls.

It’s this negative gamma that makes option selling riskier than it appears and why option buyers can occasionally generate large profits when the stock moves



The green line represents P/L if implied volatility declines by 15%
The purple line is for a 15% increase.
We sold calls, so for this trade we have negative vega.

Vega represents the sensitivity of the option price (premium) to a one point change in the implied volatility. Being short 59 vega tells us that the whole position gains (loses) $59 per point that IV declines (rises).

Trade Plan

Profit Target

When selling an ITM call option, I hope to collect the entire $1,170 available to us. However, being greedy is a losing strategy and I’ll look to exit, if possible. By that I mean: If the bid/ask spread is not too wide, then we can enter an order to buy the call and sell back the stock. We’ll need two things to happen for that idea to be worthwhile. Lots of time to pass and a price in crease for MT.

Protecting our assets

There is a point at which this position can be risky to hold. Unlike the iron condor (110404) traded earlier, this time there may be a reason to hold the trade when risk becomes too high.

  • If you want to own this stock
  • If you believe that a price decline represents a buying opportunity rather than a danger

Then there is no need to exit on a decline.

However, if you are interested in this as a trade and not as an investment, then we must have an exit plan in place. Our break-even point [I dislike using this concept], but I know it makes things easier to discuss, is our cost basis, or $33.83. Thus, if the stock price approaches (a relative term) or moves through that level, risk reduction is suggested.

Because I have no special attachment to this stock, I would love to take some protective action if and when the stock breaks through the strike price ($35). It would not be an emergency. It’s okay to give a little leeway, but I’m setting $34.50 as the limit of my risk taking, and perhaps I’ll jump at $35. It will depend on which adjustments are available and how much I can collect for the one I prefer.

Reasonable Adjustments

  • Buy to close our Jun 35 calls and sell to open a lower strike price in July, Aug, or Sep
  • It’s difficult to choose the strike, but I’d hope to be able to choose 33 or 34. It will depend on the risk graph and how risky the position looks moving into the future

This is not an exact plan, but it does tell us when to cut losses and offers a couple of ideas for rolling the position. ‘Rolling’ is not something I prefer, but with a covered call, the investor often wants to hold the shares, making the adjustment possibilities less numerous than with other spreads.

There are no contingency plans for a rally. For me, the potential profit is satisfactory and there is no reason to take more risk in an effort to eke out a larger profit.

Next trade will be more aggressive than the first two – fairly conservative trades.

  • If you want to own this stock
  • If you believe that a price decline represents a buying opportunity rather than a danger

Then there is no need to exit on a decline.

However, if you are interested in this as a trade and not as an investment, then we must have an exit plan in place. Our break-even point [I dislike using this concept], but I know it makes things easier to discuss, is our cost basis, or $33.83. Thus, if the stock price approaches (a relative term) or moves through that level, risk reduction is suggested.

Because I have no special attachment to this stock, I would love to take some protective action if and when the stock breaks through the strike price ($35). It would not be an emergency. It’s okay to give a little leeway, but I’m setting $34.50 as the limit of my risk taking, and perhaps I’ll jump at $35. It will depend on which adjustments are available and how much I can collect for the one I prefer.

Reasonable Adjustments

  • Buy to close our Jun 35 calls and sell to open a lower strike price in July, Aug, or Sep
  • It’s difficult to choose the strike, but I’d hope to be able to choose 33 or 34. It will depend on the risk graph and how risky the position looks moving into the future

This is not an exact plan, but it does tell us when to cut losses and offers a couple of ideas for rolling the position. ‘Rolling’ is not something I prefer, but with a covered call, the investor often wants to hold the shares, making the adjustment possibilities less numerous than with other spreads.

There are no contingency plans for a rally. For me, the potential profit is satisfactory and there is no reason to take more risk in an effort to eke out a larger profit.

Next trade will be more aggressive than the first two – fairly conservative trades.

Update 110413. April 13, 2011

With MT trading below $35.50, this is a time for more conservative traders to be highly concerned with risk and want to make some sort of adjustment. We did decide to make this trade more conservative to begin by writing ITM, rather than OTM calls.

When managing risk, it is up to each of us to have a game plan, and understand our limits for requiring an adjustment.

    ***Important: This is NOT a game to see who can be more daring or more MACHO. Our money is at stake – not our pride.***

    For now, nothing done to adjust because our plan called for holding until $35 is reached – before acting. Note that the plan is not written in stone, but for today, I see no valid reason to change. Tomorrow may be a different story.


April 15, 2011. Adjustment Made

Work in progress. Frequent updates.

Our trade plan called for risk reduction if the underlying stock were to trade below $35, with the possibility of waiting until the stock reached a limit of $34.50.

Today the stock gapped lower and opened at a price below our intended adjustment point. The is one of those disturbing events that can happen. The opening price was $34.76. Not panicking, and giving the market a few minutes to settle down, I looked at possible trades and made a decision to cover the Jun 35 call and sell a new call that expired in September.

In other words, I am willing to own a September covered call position for MT. It’s not easy to make that decision because I am truly unfamiliar with this stock. However, let’s look at the position this way: We are following the Chris O advisory newsletter and that newsletter publisher is bullish on this stock. When following the advice of another person, it’s an awkward situation. We cannot quiz the newsletter writer and ask for a detailed explanation of his/her opinion – so we tend to follow (or at least I assume that one does).

In a situation such as this, the first thought that comes to mind is exiting the trade. It’s essential to know whether to maintain a holding in this stock or to exit and take the loss. I looked at various alternatives and decided that by writing Sep 31 calls, we would have a chance to earn some money (from today going forward. I do not look at our original cost for the position) and chose Sep 31 as the call to write. It’s a decent compromise between having adequate downside protection – the call is $5.00 and that represents 5 point of protection for a stock priced at $34.68. The time premium in that option is $1.32 (Intrinsic value is $3.68 and time value is the remaining $1.32 of the option price. I usually want a greater profit potential with covered call, but decided to stick with this stock. This is one of the problems of running a team (think investment club) operation. When it’s time to trade, there is no time to have a meeting and take a vote. Action is needed.

I did consider using June calls but wanted to collect a higher cash credit by moving to September. This is not the place for a discussion on why I believe thinking about the original trade price and the break-even point is a complete waste of time, energy, and money. But, that is my true belief.

This stock is not behaving well and I am uncomfortable holding it.

The trade: Bought 10 Jun 35 calls @ $1.60 and sold 10 Sep 31 calls $ 5.00. Net cash to us: $3.40.

Because I know it’s probably important to each of you, I’ll mention that the break-even point has been reduced from $33.83 to $30.43. Yes, I recognize that leaves very little opportunity to earn a profit on this ‘whole’ trade.

Does that make anyone uncomfortable? Do you dislike rolling all the way down to the 31 level? Would you have done something very different? I’d be happy to discuss this, if there is interest in doing so.

The Adjustment


Note that I was forced to pay the offer ($1.67) after my bid of $1.65 did not get filled.
I was also forced to sell the bid ($5.00).

Based on the natural bid ask spread of $3.33 to $3.60, I thought a reasonable fill would be $3.40. If this were a real money account, I’d have asked $3.45 for the spread and would have expected to be filled at that price.

Current Position

Revised Trade Plan

For today, I’m allowing for a loss of another $1,000 and would look to adjust (or exit) if the stock dips below #32.


Addendum: This question from Paul is as valid as they get:

By rolling down to the 31 level in SEPT doesn’t this lock up $33000 of capital with the maximum profit opportunity af $1 or so. This doesn’t seem to be very profitable. Am I missing something?

Paul,

Writing covered calls ties up a lot of cash. And this specific trade ties it up through September.

The stock was trading about $34.70 and the Sep 31 call was $5.
That’s a premium of only $1.30 and a potential return of 4.38% for 5 months.
I agree that is too low, considering the volatility of this stock.

Please keep in mind that the main purpose of tracking this trade is to run into adjustment situations that lead to discussions – such as this. The purpose was not so seek an especially profitable trade.

Nevertheless your point is well taken and when making trade decisions, the profit potential is a crucial part of the process and I now believe that I was too interested is keeping an MT covered call alive than in selecting a trade that was worth making. Thus, I violated my own first rule for any adjustment: Only open a new position when happy to own it.

Thanks for the wake-up call.


Update May 20, 2011

Stock trading near 32.61.
It is not that far away from our Sep 31 short strike. The risk graph is not pretty.

MT Covered Call Writing



Update Jun 3, 2011

MT was trading under 32 this morning. That is certainly not a comfortable price for this position. Yet there is no urgency to do anything.

This position does require that some attention be paid to it.

Update June 23, 2011

There is nothing to be learned from this trade. At some point we would exit or extend the expiration date of our covered call.

Trade exited for convenience so we can spend time on trades that are more valuable as learning experiences.

Sols stock @ $31.83; bought the call @ $2.61.
Net credit $29.17.

Position closed.

14 Responses to “Track That Trade 110411. MT Covered Call”


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