Prior to 2007, most options traded with minimum price variations (MPVs) of $.05 for premiums below $3.00 and $.10 for premiums above $3.00. Beginning in January of 20007, the SEC initiated an industry wide (on six option exchanges) pilot program entitled thePenny Pilot Program, in which MPVs were reduced for certain equities. The “Pilot” reduced the MPVs to .01for premiums below $3.00 and to .05 for premiums above $3.00. An exception to this was the ETF, QQQQ, which already traded in .01 increments.

This six-month program which started with 13 option classes (equities) has been renewed and expanded several times. Here is a list of the stocks currently participating in the program:

These securities will trade in .01 and .05 increments while all others (except ETFs) continue to trade in .05 and .10 increments. The reason this program was initiated by the SEC was to reduce trading costs for investors by reducing the potential for market makers to earn a larger spread between option prices thereby allowing investors to trade options at better prices.

How to use this information when playing the bid-ask spread:

For those of you who haven’t read my article on how to play the bid-ask spread, I encourage you to do so by hitting the link in the first paragraph of this article. When the spread is small, I simply sell at the current bid. For example, if the bid-ask is $1.35- $1.40, I will sell @ $1.35. For higher priced premiums, we move to the higher increments. So if the spread is $6.60 – $6.70 , I put in $6.60 because of the tight spread. If however, there is a larger spread, we may be able to put some additional cash in our pockets. As I say in my article, we don’t want to insult the market makers but rather want to be “mild pests”. Let’s say the spread is $1.10 – $1.40. I compute the mid-way point which in this case is $1.25. Then I will place a figure slightly below that point. If we are trading in .05 increments that figure will be $1.20. No insult to the market maker, and he very well may pay us just to get rid of us. That’s $10 per contract in our pockets, perhaps a few hundred per month, a few thousand per year and tens of thousands over an investment lifetime. If the options are part of the pilot program, the limit order can be placed between $1.20 and $1.24. I like to look at returns in terms of percentages rather than dollar amounts (see chapter 9 in Cashing in on Covered Calls to review my calculation equations). By understanding the Penny Pilot Program and playing the bid-ask spread, if we generate $1.20 per contract rather than $1.10, we have increased our returns by 9% (10/110)!

Conclusion:

Market tone and the S&P 500:

The technicals of the general market are showing some signs of breaking down. This is not a call to flee the market or even to be overly concerned but rather to be vigilent and monitor the situation carefully. When technicians view the long term market, many use the 50- and 200-d SIMPLE moving averages. Covered call writers who sell predominently 1-month options opt for the 20- and 100-d EXPONENTIAL moving averages.. The former shows the S&P 500 trading above its short-term 50-d sma but with the confirming indicators negative:

S&P 500 50 and 200-d SMA

However, if we use the shorter term, exponential moving averages, we see that the overall price of the S&P 500 has just dipped below the 20-d ema along with negative confirming indicators (MACD histogram and Stochastic oscillator):

S&P 500 20 and 100-d EMAs

We will continue to monitor this situation.

Last Weeks Economic News:

The economy is improving but “economic growth is likely to remain weak for a time.” So said the Fed this past week. The Conference Board’s index of leading economic indicators was up 0.6% in August, the fifth consecutive gain for this critical index pointing to an end of the recession. The Fed announced that target rates would remain at historic lows (0% – 0.25%) “for an extended period.” Exisitng home sales were down 2.7% in August but up 3.4% compared to this time last year. Sales of new homes rose 0.7% for the fifth straight increase. On a negative note, durable goods orders declined 2.4% in August while economists were expecting an increase of 0.5%. For the week, the S&P 500 was down2.2%, for a year-to-date increase of 17.8%

______________________________________________________________________

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Exit Strategies for Covered Call Writing

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Alan (alan@thebluecollarinvestor.com

Definition of an options chain:

It is a list of option prices of a particular underlying security (stock, ETF etc.) for various strike prices, expiration dates, and option types (calls and puts). Here is what a typical options chain looks like (for call options only):

The components of the option chain (from left to right):

1- Strike price- Also called the exercise price. For call options, this is the price at which the option holder (buyer) can purchase the underlying security. They usually trade in $2.50 increments under $25, $5 increments above $25, and $10 increments above $200. There are exceptions as in the case here.

2- Symbol- These are the ticker symbols for options. They identify the underlying equity, the strike price and the month of expiration (the specific date is always the third Friday of that month). The etiology of these symbols is explained in Chapter 5 of Cashing in on Covered Calls.

3- Last- This is the price at which the last trade of that particular option was executed at. For example, the $20 strike was last traded @ .85.

4- Change- This column describes for the trader how much that option has risen or fallen since the previous market close. In this example, the $15 strike has increased in price by .60.

5- Bid- The price at which the market makers are willing to buy your option. It is the price when you sell an option (sell at the bid, the lower price).

6- Ask- The price at which market makers are willing to sell the option. It is the price when you buy an option (buy at the ask, the higher price).

7- Volume (Vol)- The number of contracts traded for that option during the trading day. The higher this daily volume, the more liquid this option contract becomes as compared to options with a lower daily volume. However, because each day brings a new daily volume, it is not the most accurate measure of option liquidity. Furthermore, getting information on past daily volume is much more difficult to obtain than the vast information available on stocks. 

8- Open interest- The open interest of an option contract is the number of outstanding options of that type which currently have not been closed out or exercised. So if the open interest was 1,000, this means that there are currently 1,000 options that are still active to be exercised or sold. Because an option is simply a contract, more can be created every day, but the current open interest gives investors an idea of the interest that investors are showing in that contract type. The higher the open interest, the more liquid the option contract is thought to be.

An example using the above options chain:

First, let’s make up a name for this company….okay, I got it: BCI Corp.

• We buy 100 x BCI @ $20
• We then sell the at-the-money $20 strike @ .84 sell at the bid, the lower price
• Our 1- month option return (ROO) is 84/2000 = 4.2% = 50% annualized

Analysis of this example:

The options chain tells us the symbol for the $20 strike (MQF-FD)  and the fact that it is up in price by .26 for the trading day. We also see that this strike, along with the $21 strike have the highest liquidity of the available options. Also note that on the top of the chain, we are told that these are call options and that the expiration date is June 19, 2009.

The bid-ask spread:

The amount by which the ask price exceeds the bid. This is essentially the difference in price between the highest price that a buyer is willing to pay for an asset and the lowest price for which a seller is willing to sell it. In the above options chain, for the $20 strike the spread is only .01 (.85 – .84). In many cases, the spread will be much larger presenting us with an opportunity to sell at a slightly higher price than the bid or buy at a slightly lower price than the ask. Earlier this year, I published an article on how to play the bid-ask spread. Here is a link to that column:

http://www.thebluecollarinvestor.com/blog/how-to-play-the-bid-ask-spread-when-selling-covered-call-options/

To those of you new to options, I assure you that by studying and viewing options chains, in a relatively short period of time, they will become second nature to you. Organic chemistry (my nemesis…never could get that A!) is another story.

Exit Strategies for Covered Call Writing- The Book (not the movie):

Earlier this week, I sent an email to all those on my mailing list announcing the publication and availability of my latest book. The response has been overwhelming and I deeply appreciate your support and confidence. This book was written because of the many requests that I received asking for more information on exit strategies for cc writing. I thank you for your feedback as it allowed me to enhance this aspect of our system and clarify to you many of the maneuvers that I make automatically after years and years of trial and error. I decided to package the book with an Expiration Friday DVD I previously produced, since these end of the contract exit strategies can be big money-makers for us. In keeping with my Blue Collar philosophy of holding prices down, the book and DVD are priced @ $24.95 for both. The DVD can only be accessed from this website. For a short time, I have put up a pre-order form (shipment will begin next week based on dates orders are received) which will give you a discount of $5 per book/DVD package. Here is a link to that form:

http://www.thebluecollarinvestor.com/store.shtml

I STRONGLY URGE YOU TO VIEW THE VIDEO ON THE HOMEPAGE…see below.

Last Weeks Economic News:

The only negative news was housing, which needs a boost of demand. Sales of exisiting homes was up 2.9% in April, no change from back in October. Median home prices were about 15% lower than a year earlier. On a more positive note, the overall economy is contracting at a slower pace than initially expected. In the 1st quarter the GDP fell by 5.7% versus an estimate of 6.1%. Consumer sentiment increased for the second straight month. This is important as perception is critical when it comes to the strength of the stock market. Also positive, was the fact that durable goods orders increased by 1.9%, much more than expected. For the week, the S&P 500 rose 3.6% for a year-to-date return of 3%.

Video now playing on the homepage: Multiple Exit Strategies in the Same Contract Period (just created): 

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Hope to hear from you. Your feedback is essential to the quality of this site.

Best regards,

Alan

Blue Collar Investors throughout the world are always looking for ways to generate additional profits into our portfolios. This includes the use of some of the more esoteric maneuvers that may produce small returns of $40, $50 or more. One of the main philosophical approaches to Blue collar Investing is that by generating small but consistent, low risk returns and then compounding those profits, we can become financially independent. 

In my book and DVD series, the following phrase appears on numerous occasions:

Sell at the “bid”, the lower price; buy at the “ask”, the higher price. This references the price lists found in the options chains.  Before we discuss some common sense applications to maximizing profits by playing the bid-ask spread, let’s review some definitions (stay awake now, this can make you some cash!).

Definitions:

BID: An offer made by an investor, a dealer or a trader to buy an option. It will usually stipulate the price the buyer is willing to purchase the option and the quantity to be purchased.

ASK: The price a seller is willing to accept for an option, also called the offer price. The ask will always be higher than the bid.

BID/ASK SPREAD: The difference in price between the highest price that a buyer is willing to pay for the option and the lowest price a seller is willing to sell it. If the bid is $2.80 and the ask is $3.00, the the bid-ask spead is .20.

Theoretical Value: The hypothetical value of an option as calculated by a mathematical model such as the Black-Scholes Option Pricing Model. 

Black-Scholes Option Pricing Model: A model used to calculate the value of an option, by factoring in stock price, strike price and expiration date, risk-free return, and the standard deviation of the stock’s return.

How the bid-ask spread is set:

There may be several bid prices and several ask prices at any point in time. However, only the highest bid and lowest ask are used to calculate the spread. These are the figures you see when accessing the options chains. Utilizing an estimate of the volatility of the underlying stock, a theoretical option value is calulated using an option pricing model, such as the Black-Scholes model. A market maker will then set the bid below this theoretical value and the ask above this theoretical price. This is the spread and is determined mainly by liquidity. For example, the highly liquid ETF, QQQQ, have bid/ask spreads as low as .01. This is one of the reasons I require all stocks owned in our portfoilios and on our watchlist trade at least 250,000 shares per day. Market makers derrive their profit from bid/ask spreads. The greater the spread, the more money they make. Playing the spread will decrease their profits and increase ours.

Market order vs. limit order:

If you use a market order when executing a trade, you will sell at the published bid price and buy at the published ask price (this is called “lifting” the offer or “hitting” the bid). This may be okay for the purchase and sale of stocks where the spread is tight (small), but for options, which have a wider bid/ask spread,  a limit order is more appropriate and beneficial.

The Limit Order Display Rule (Show or Fill Rule):

Officially known as the “Exchange Act Rule 11 Ac1-4″, this is the slingshot Blue Collar Inverstors can use to fight off Wall Street’s Goliaths. It behooves us to know and understand this rule so we can generate those $50 returns in 50 seconds. Market makers will never mention this rule so I will !

Let’s assume the bid for an option is $1 and the ask is $1.25 (.25 spread). If we put in a market order to sell at the bid, we will get $1, case closed. If we put in a limit order to sell @ $1.10, the market maker has 2 choices according to the Show or Fill Rule:

1- Fill the order- you get a favorable trade execution above the bid.

2- Show the order- bid is now $1.10 and ask remains @ $1.25 (.15 spread).

The market maker is required to fill or show even if your order is for just 1 contract. Score one for the little guys! In the past, security dealers did not have to show our offers and we could not compete with them. This was not fair and damaged the market efficiency. Now higher bids and lower offers decrease the spreads, attract more buyers and sellers and enhances the world of the Blue Collar Investor.

How to Play the Spread:

If the spread is tight (.05 under $3, and .10 over $3), there is no playing the spread. Just accept the bid or ask with a limit order. For example, if the bid is $2 and the ask is $2.05, place a limit order for $2 if selling a covered call option. Many option investors accept spreads up to .20 before playing the spread. 

Let’s go back to our above example wherein the bid was $1 and the ask, $1.25. Why settle for $1 for our option sale. Let’s play the spread and  put in a bid for $1.10. Now some of you are probably thinking: Hey Alan, why not $1.20, don’t be a whimp! Here’s my thinking: If you had your home on the market for  $200,000 and someone came along and offered you $190,000, there very well could be a negotiation and a symbiotic agreement. If, however, you were offered $150,000, there would be several 4-letter words out of your mouth and the conversation would be permantly over. So let’s not insult the market maker, let’s play the spread so we can all be satisifed investors. But let’s not be taken advantage of!

I like to place my limit orders short of the halfway point of the spread favoring the market maker as we have in this case. Because of the Show or Fill rule, the dealer must give us the additional .10 or show the higher bid of $1.10. Once displayed, most exchange rules require the market maker to provide at least 20 contracts at that price. Our 5 contracts then represent an annoyance to the market maker, another reason not to insult him with our offer. Many times, our offer will be accepted so that the $1.10 will not have to be displayed. Remember, the wider the spread, the more profit for the dealer. In this case, we are happy with the favorable execution (if we get the $1.10 bid price), the dealer still has his favorable spread and we have just generated an additional $50 ($10 per contract) in 50 seconds by playing the spread.

 

All or None Orders:

Here’s another point you’ll never hear from the dealers: Market makers are NOT required to show your order if it is marked all-or-none (AON). DO NOT CHECK THE AON BOX ON YOUR EXECUTION SCREEN WHEN PLAYING THE SPREAD. If your order is for 20 contracts or less, the quote size must be good for at least 20, so it is redundant to mark it with the AON retsriction. By NOT requesting AON, you will allow your limit order to be shown.

Conclusion:

Playing the spread is another tool that Blue Collar Investors can use to level the playing field with Wall Street insiders. These $10, $20 and $50 profits will become hundreds, then thousands and then tens of thousands over the years. As with all other aspects of our system, education and common sense is what will elevate us to levels that will result in our financial freedom.

 

Last Weeks Economic News:

Let’s get through this quickly and hope next week will be better.

The Commerce Department revised GDP growth downward for the 4th quarter, 2008 to – 6.3%, the largest quarterly drop in 27 years. New-home sales declined more than 10% in January compared to December 2008 results. Consumer confidence dropped to a record low and the manufacturing sector continued to shrink as durable-goods orders had their 6th consecutive monthly decline. For the week, The S&P 500 decreased by 4.5% for a year-to-date return of – 18.2%.

Note:

This article was written in response a great email question I received from a fellow Blue Collar Investor. Although I have a myriad of ideas for future publications, I welcome your suggestions for future topics. Many times your ideas will allow me to respond to the important issues that concern you the most.

Wishing you the best in investing,

Alan (alan@thebluecollarinvestor.com)