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Thursday, October 11, 2007

Keep or Sell?

Expiration Friday for October is now exactly one week away. Let’s consider the following question: How should we decide which stocks currently owned in our covered calls portfolio should be kept and which ones should be sold? This article describes the decision-making process used by the Covered Calls Advisor to answer this question.

While the decision to sell an existing underlying stock can of course be made at any time, the overwhelming majority of the keep or sell decisions made by us covered call investors are normally made near the monthly options expiration dates. The easiest approach to the keep or sell decision faced by us covered call investors as an expiration Friday approaches is to simply do nothing. And unfortunately, since it is the easiest approach, it is too often the approach used by many covered call investors. With this approach, the following will automatically occur:
1. Almost all in-the-money (ITM) positions will be called away (a.k.a. ‘assigned’ or ‘exercised’) and the underlying stock will be sold for the strike price value; and
2. For all out-of-the-money (OTM) positions, the options will expire worthless and the underlying stock is retained in the portfolio.

This do-nothing approach is absolutely NOT the technique recommended by this advisor. It definitely flies in the face of good common sense when you think about it, since the end result of this do-nothing approach is that those stocks are sold which have actually been the strongest performers in the portfolio (the winners if you will); and those stocks that have been the weakest performers (i.e. the losers) are the ones that are retained. This is exactly the opposite of what we would normally be inclined to do if we simply owned the stocks and were not facing an imminent options expiration date.

Since the result of this do-nothing approach is inherently counterintuitive and clearly undesirable, then what does constitute a desirable approach? First, plan to evaluate each and every stock in the portfolio to make an assessment of whether to keep or sell that stock, based on an objective set of pre-defined criteria. For the Covered Calls Advisor, the keep or sell decision-making process is as follows:
1. During the week prior to expiration each month, make a list of all covered call stocks that have options written against them for that particular month.
2. Plan to sell (either on expiration Friday or early the following Monday) those stocks for which any one of the following criteria is met:
· The stock rating as provided by either of the two stock advisory services you follow has been reduced below a ‘buy’ rating; or
· The consensus analysts’ future earnings estimates (see Reuters Research) for the company have been reduced since the stock was initially purchased; or
· There is an earnings release scheduled between this month’s expiration date and prior to next month’s options expiration date; or
· The annualized return if unchanged % (ARIU) for establishing next month’s covered call position does not meet or exceed a 25%+ threshold.
3. Process any transactions necessary in order to: (a) keep those stocks for writing additional covered calls for the next month that meet all criteria listed in #2 above; and (b) sell those stocks that fail to meet any one of the criteria listed in #2 above.

The requirements listed in #2 above are very restrictive – so much so that it has been this advisor’s experience that it is not uncommon for only 20% to 25% of stocks to be retained from one expiration month to the next. But don’t be concerned about the relatively high turnover – over a period of time you’ll see that it is actually quite preferable to other alternatives.

So how does this approach apply to the eleven positions currently in the Covered Calls Advisor Portfolio? As of right now, only two of these stocks (BMC and TRV) have earnings releases scheduled for the period between October expiration (10/22/07) and November expiration (11/17/07) and so they will definitely be eliminated from the ongoing CCAP. However, all eleven positions will be re-evaluated next Friday (on the expiration date itself) to make the final keep or sell decision based on using all four of the analysis criteria for each stock owned.

Regards and Godspeed

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