Analyzing the Cost-To-Close a Covered Call Trade Mid-Contract: A Real-Life Example with NVDIA Corp. (Nasdaq: NVDA) – April 25, 2022
Breaking down the components of a deep ITM strike
As the strike moves deeper in-the-money as share price rises, the time-value component of that option premium approaches zero. However, the intrinsic-value component will rise. The actual cost-to-close (CTC) will be substantial but the time-value cost-to-close will be minimal. We use the unwind now tab of the Trade Management Calculator, Elite and Elite-Plus Calculators to perform these calculations which assists us in evaluating these potential exit strategy opportunities.
Why is the intrinsic-value component of a deep ITM strike negated when we sell the shares?
When the short call is in place, our shares are worth the strike price due to our contract commitment to sell at that price. When we buy back (buy-to-close or BTC) that call option, the shares are now worth current market value. This bought-up value of our shares negates the intrinsic-value facet of the cost-to-close.
A real-life example with NVDA (per-share trades)
- 10/20/2021: Buy NVDA at $221.47
- 10/20/2021: Sell-to-open (STO) the 11/19/2021 $225.00 call at $7.25
- 11/5/2021: NVDA trading at $311.91
- 11/5/2021: Close the 11/19/2021 $225.00 call at $87.35
Initial trade structuring
The initial 1-month time-value return is 3.3% if the trade lasts through contract expiration (11/19/2021- yellow cell). There is an additional upside potential of 1.6% (brown cell) if share price rises past the $225.00 strike (and it certainly did). The trade was setup for a maximum potential 4.9% 1-month return.
Calculating the time-value only cost-to-close using the unwind now tab
Although the actual CTC is $87.35, the actual time-value component is only $0.44 per-share as the intrinsic-value aspect is $86.91 (the amount the strike is lower than current market value).
Discussion
If we close this trade mid-contract, the initial trade structuring maximum return is lowered from a 1-month 4.9% return to a 16-day 4.7% return. The cash freed up when the shares are sold can be used for a second income stream in the same contract month.