Definition:

A change in the number of shares outstanding (in circulation). The number of shares are adjusted by the split ratio, e.g. 3 to 1. In this case, 100 shares splits to 300 shares but the price is cut in third. Thus the cost and current value of the investment remains the same while increasing the number of shares and decreasing the per share price. This facilitates retail investors to own shares in round lots. To view a real life example of a 3-for-1 split, see pages 178-79 of Cashing in on Covered Calls.

Is the split an asset or a liability? :

There are those who feel that a stock split will automatically result in a share price increase. Research seems to disprove this theory. However, a split will oftentimes occur after a significant run up in price and continuation of this trend is likely. I give credence to a stock split that occurs after such a price increase and look at the company’s chart to evaluate the momentum associated with this appreciation. When the technicals confirm the split as legitimate, I consider the event as another plus in that stock’s column of assets.

On the other hand, if the chart paints an ugly picture and a split is announced, it is likely that the Board of Directors is desperate and looking to garner interest in a deteriorating asset. Now the split is viewed as a liability.

SHOO- A real life example:

One of the companies on our premium report, SHOO, recently announced a 3-for-2 stock split. This means that for every 2 shares owned, 1 additional share will be distributed. The value of the shares will be worth 2/3 of the current value at the time of distribution so the capitalization (price x number of shares) remains the same. Let’s look at the chart to evaluate whether this split represents an asset or a liability:

SHOO as of 4-17-=10

A beautiful chart, uptrending with confirming indicators,  describes an authentic split and an asset in the column of parameters for this equity.

Next, let’s view the current options chain, assume we purchase 200 shares (that rounds off nicely!) and sell the May $55 calls as the stock is trading @ $53 per share:

Stock Split- SHOO Options Chain 4-17-10

The $55 call generates $165 per contract or a 3.1%, 1-month return with an upside potential of 3.8%. Let’s next view the impact this split will have on our covered call position both pre- and post-split:

SHOO- Pre- and Post-Split Option Info

The major difference is that prior to the split, each contract delivers the conventional 100 shares while post-split, each contrcat will deliver 150 shares. This is known as a non-standard contract. If the split had been by an even number, like 2-for1,  the number of contracts would simply double and would deliver the standard 100 shares. For example, if a $50 stock splits 2-for-1 and we sold 1 x $50 call, after the split we would have sold 2 x $25 calls and our cost basis would be $25 with each contract delivering 100 shares.

Conclusion:

With the economy on the upswing and the stock market showing a bullish trend, stock splits are likely to become part of our covered call lives. It is important to recognize quality splits from imposters and to learn how the splits impact our option contracts.

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Introducing Barry Bergman:

Barry has been a friend of this site since its inception. He has been a frequent contributor to our blog commentary and his insight and due-diligence has greatly enhanced the quality of our web site. About a year ago Barry sent me the first generation copy of our premium report. For the past year we have been working together refining and elevating the level of this product. The success of the premium site has been both gratifying and humbling. We thank all our members, both general and premium, for your incredible support.

One of the challenging offshoots of the popularity of the premium site has been the exponential increase in on and off-site email questions and comments sent to the BCI team. In order to respond to these emails in a timely manner, Barry has generously agreed to assist me, particularly in the area of the premium site. The BCI misssion statement remains to assist average Blue Collar Investors to become CEO of their own money. We are here for each other and no matter how fast we grow, we will never forget you, the folks who put us on the map.

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Event Update:

1- The Learning Annex asked me to change the venue of my presenation from a live event to a teleseminar so as to reach a wider audience. It will be aired on a Tuesday evening in the near future. The particulars will be posted on this site as soon as I get the information.

2- I will be hosting an “Advanced Seminar” in Plainview NY on May 13th at the Plainview-Old Bethpage Library. I will post the time and directions as we approach the event. It was wonderful seeing so many of you at the basic presentation on April 9th. For those planning to attend and would like a sneak preview, send me an email and I’ll send you an outline of the presentation.

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Market Tone:

I constructed a shorter-term, 3-month chart of the S&P 500 versus the VIX (CBOE Volatility Index). An uptrending S&P 500 with a descending or calming VIX is favorable to shareholders. This chart shows a continuing and favorable divergence of these indicators:

 

S&P 500 vs. The VIX 4-24-10

To show its resilience, the S&P 500 rose by 2.1% this past week despite the possibility of loan defaults in Greece and the Goldman news regarding SEC charges of impropriety. Leading economic indicators and home sales continued to improve although durable goods orders declined.

Summary:

IBD: Market in a continued uptrend

BCI: Mildly bullish selling a higher percentage of O-T-M strikes.

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The best in investing to all,

Alan (alan@thebluecollarinvestor.com)

What are non-standard (NS) options? :

These are options that don’t have the standard terms of an options contract, namely 100 shares as the underlying asset. They are normally created as a result of a specific event such as a merger, acquisition, spin-off, extraordinary dividend or stock split. As a result of the changing circumstances, the contract is adjusted to be equitable to both the option buyer and seller by equating the new underlying asset(s) of equal value as the owner of 100 shares. The Depository Trust Company (DTC) determines how the shares will trade pre-event while the Options Clearing Corp. (OCC) decides how these changes will be reflected in the options. Each situation is unique and therefore non-standard. This makes them difficult to understand and therefore risky to most investors. In the above hypothetical, one contract was a standard options contract, the other non-standard. The standard contract represents 100 shares of the underlying, while the NS contract does not. As an example, when BAC took over Merill Lynch, the owner of 100 shares of Merill received 85 shares of BAC stock plus $13.71 in cash. NS contracts of BAC now would deliver 85 shares of BAC + the cash as opposed to the standard contracts which represented 100 shares. The obvious rule is avoid all non-standard options. Let me add another: if an option value seems too good to be true, it is. These contracts will also show odd strike prices and different root symbols.

Real life options chain for BAC showing standard and NS options:

Options Chain with NS Options

I have highlighted the two $5 strike options. BYO DE is the standard option which represents 100 shares of BAC while JLW DA is the non-standard reprersenting 85 shares of BAC + cash. An uninformed investor looking to buy an option would think the NS option is a much better deal, costing $179 per contract as opposed to $254 per contract. The caveat is that the former will deliver only 85 shares (+ cash), not 100 shares.

Liquidity of NS Options:

These contracts are often illiquid and difficult to trade. In this chart, we can see the volume of the standard contract is 3990 compared to the 209 for the NS contract. When evaluating the liquidity based on open interest, one can easily be deceived as many of those option holders had their contracts since prior to the merger. Most likely there has been little activity in them since.

Timing of contract adjustments:

When contract adjustment is needed as a result of the aforementioned events, the standard (“plain vanilla”) options are adjusted accordingly. When a new option comes into existence after the event, it will appear as a standard option. ****Check with your brokerage company to make sure that you will be notified, prior to execution, if attempting to trade a NS option.

Free information on contract adjustments:

http://www.cboe.com/tradtool/contracts.aspx

Conclusion:

Non-standard options result from an asset-changing event like a merger or spin-off. They are difficult to understand because each is unique to its particular situation. When we see a premium that makes no sense and there are two similar strikes, avoid the NS option and stick to the one we know and understand.

Chart of the Week- WIT:

WIT as of 12-31-09

The following points should be noted:

• This stock passes our system screens as described in my first book, Cashing in on Covered Calls
• The blue arrow shows the price bars at or above an uptrending 20-d ema
• The red arrow shows the 100-d ema below the shorter-term ema, also uptrending
• The green oval shows the MACD positive as is the histogram below it
• The orange oval shows the stochastic oscillator in the overbought, but holding position
• Note that volume declined during the holidays as it dropped below the average volume (yellow line)

Economic News of the Week:

Consumer confidence rose for the second consecutive month demonstrating a more positive outlook for the future. The index, however, is still historically low. For the week, the S&P 500 declined by 1.0% for a total year return of 27%.

Next Week’s Economic Reports:

• Monday: Latest survey of the manufacturing sector, construction spending
• Tuesday: Factory orders
• Wednesday: FOMC minutes, latest survey of the service sector
• Friday: Consumer credit, payroll jobs, unemployment rate

Video currently playing on the homepage:

Exit Strategies for Covered Call Writing

Wishing you all a happy, healthy and wealthy 2010,

Alan (alan@thebluecollarinvestor.com)