Application of the 20%/10% Guidelines for ITM & OTM Strikes + Registration Form for Thursday’s Webinar – May 08, 2023
One of the key methods to partially automate our covered call writing exit strategy arsenal is to place buy-to-close (BTC), good until cancelled (GTC) limit orders to close our short calls based on our BCI 20%/10% guidelines. We instruct our broker to buy back the short call if the value reaches 20% (in the 1st half of a monthly contract) of its original sale value or 10% in the last 2 weeks of a monthly contract. Option value will decline as share value declines (Delta) and as time passes during that contract (Theta). For example, if we sold a covered call option for $2.00, we’d place a BTC GTC limit order to buy back that option if value decreased to $0.40 in the 1st half of a monthly contract and $0.20 in the last 2 weeks of that contract.
I am frequently asked if those guidelines are based on the time-value component of the premiums only or if intrinsic-value (IV) should be included in the calculations for in-the-money (ITM) strikes. This article will detail a real-life example with XLE which will demonstrate why the 20%/10% guidelines apply to the entire premium of ITM strikes.
Real-life example with Energy Select Sector SPDR Fund (NYSE: XLE – an exchange-traded fund or ETF)
- 11/25/2022: XLE trading at $92.21
- 11/25/2022: The $89.00 ITM strike has a bid-price of $4.95
- The time-value component of the $89.00 strike is $1.74
- Do we base our 20%/10% guidelines on $4.95 or $1.74?
- 11/25/2022: The $95.00 OTM strike has a bid price of $1.77
- The $95.00 strike is all time-value and therefore will be the basis of our 20%/10% guidelines
XLE option-chain on 11/25/2022
- Brown cells: The $89.00 (ITM) strike has a bid price of $4.95 and a Delta (amount a premium price will change for every $1.00 change in share price) of 0.68
- Yellow cells: The $95.00 (OTM) strike has a bid price of $1.77 and a Delta of 0.38
Initial trade calculations using the BCI Trade Management Calculator
- 22-day and annualized returns are practically identical (bottom left of screenshot)
- Yellow cells: Breakeven price points
- Brown cell: The $95.00 OTM strike offers 3.03% of upside potential (share appreciation up to the OTM strike price)
- Purple cell: The $89.00 ITM strike offers 3.48% downside protection of the initial time-value profit
What is breakeven?
This is the price point at which there is no gain or loss. It is the price of the underlying security at the time of the trade minus the entire option premium.
Delta calculations to the 20% guidelines
We take the difference between the original premium and the 20% amount and then divide by the Delta. This will provide an approximation of how much share value must decline to trigger the breach of the 20% guideline. Below is a spreadsheet I created to reflect these calculations for the $89.00 strike using both time-value only and the entire premium as well as calculations for the $95.00 strike.
20%/10% guidelines as they relate to breakeven (IV = intrinsic-value)
- Typically, the 20% guideline will be breached when share price dips slightly below the breakeven price, giving us opportunities to mitigate the small losses or even turn losses into gains
- By using the entire premium (time-value + intrinsic-value) for ITM strikes and not just time-value, we will close the short call at a higher share price
Discussion
The 20%/10% guidelines will assist in automating our exit strategy implementation when share price declines. The 20% guidelines are changed to 10% prior to the final 2 weeks of a monthly contract. When using ITM call strikes, we base our 20%/10% guidelines on the entire option premium.
Author: Alan Ellman