Monday, October 5, 2009

Investigation of an Over-Write

Last Thursday's post reviewed the current status of a GLD strangle. Let's follow that up by reviewing the current status of a trade mentioned way back in the Aug 31st post on Over-Writing.

At the time, National Oilwell Varco was trading around $36.50 and I mentioned selling the Oct. 40 call for $1.50. The risk-reward characteristics of the trade are listed below.

NOV Over-Write
Cost Basis: $36.50 - $1.50 = $35.00
Max Risk/Breakeven: $35.00
Max Reward: $40- $35.00 = $5.00
ROI (if assigned) = (5/35) 14% return
ROI (if stock unchanged) = (1.50/35) 4% return

Risk Graph @ Trade Inception (click image to enlarge)
[Source: EduTrader]

Current Risk Graph (click image to enlarge)
[Source: EduTrader]

NOV is currently trading at $41.90. The Oct. 40 call is currently trading around $2.70. Remember, the $2.70 is comprised of both intrinsic and extrinsic value. Given that the current price of NOV is $41.90, the 40 strike call possesses $1.90 of intrinsic value and $.80 of extrinsic value.

With NOV residing above 40 and inside of our max profit zone, the trade has worked out fairly well thus far. What are the potential actions worth taking (if any) at this point?

1. Do Nothing. If we anticipate NOV staying above $40, we could merely sit on our hands and ride the trade to expiration in an effort to realize the maximum profit. Remember, because we're obligated to sell NOV at $40 a share, the stock will be taken away over expiration weekend if it resides above $40. Although we've already accumulated a $420 unrealized gain of the possible $500 gain, there is still another $80 of potential profit. That $80 represents the amount of extrinsic or time value remaining in the call option.

2. Exit Trade to Lock in Unrealized Gains. Given that we've already accumulated the majority of the potential profit, we could choose to fore go the last $80 by exiting the trade now. This would eliminate any chance of giving back our gains due to a significant drop in NOV price between now and expiration.

3. Roll Forward. If we like the prospects of NOV going forward and wanted to enter another covered call for November, we could buyback the Oct. 40 call and sell a Nov call option, such as the 42 or 43 strike.

Like any trade, there isn't one right way to manage the position. It comes down to risk tolerance, personal preference, market outlook, etc...

For other posts on Over-Writes, check out:

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