LULU- Chart as of 7-16-10

• The red circle highlights a recently ascending price pattern but still slightly below the 20-d ema, a negative.
• The red arrow shows the MACD histogram just turning positive, a bullish signal.
• The blue arrow highlights the stochastic oscillator moving above the 20% and ascending, also a bullish signal.

Since this is a mixed technical picture, (should I decide to keep this equity) I would lean to the rolling out strategy wherein we start the contract cycle with an I-T-M strike and downside protection. I will, however, also compute the rolling out and slightly up strike as well. We must first ensure that this equity is NOT reporting earnings in the August cycle. NOTE TO PREMIUM MEMBERS: The ER dates we provide in our reports should be rechecked prior to trade execution because corporations may change a date last mminute in rare circumstances. Here is the projection from www.earningswhispers.com:

LULU- Earnings report

The scheduled report date is 9/9/10 (highlighted in yellow) well after the end of the August expiration which is 8/20/10.

Next we will run our calculations with information obtained from the July and August option chains. We first check the July chain to see what it would cost to buy back the short option position we originally sold (B-T-C). Please note that this article was written mid-day on Friday:

LULU: B-T-C July contracts

I have highlighted the July contract in yellow and circled (in red) the cost to B-T-C, $1.05. It is possible we could have reduced this price by playing the bid-ask spread. Next we look at the August chain to see the cash amount that will be generated from selling the August $38 or $39 contracts:

LULU: S-T-O August contracts

We will receive $2.60 to roll out to the $38 call and $2.25 to roll out and slightly up to the $39 call. Once again, the large bid-ask spreads may allow us to generate even more cash. Because of the mixed technical picture, I will generally lean to the I-T-M strikes. This information is then fed into the “What Now” tab of the Ellman Calculator as seen below:

Ellman calculator- enter info

Note the entries of $1.05 (red arrow), $2.60 (blue arrow), and $2.25 (green arrow). Once entered, the calculations will appear on the right page of this tab:

LULU- Rolling calculations

• Highlighted in yellow is the 4.08%, 1-month return for rolling out.
• The red arrow shows a downside protection of $88 per contract
• The green highlighted area shows rolling out and up returns both with (5.79%) and without (5.47%) upside appreciation.

Conclusion:

When considering expiration Friday exit strategies we must first check the stock’s fundamentals and technicals. If technicals are mixed we may want to garner the extra protection of an I-T-M strike by rolling out and NOT out and up. Consideration should also be given to general market tone. We must also make sure that there is no earnings report due in the upcoming cycle. Finally, the calculations must meet our goals which for me are 2%-4% per month. Once these positions are established, they must be monitored as any other covered call position.

Market influence on mid-contract exit strategies:

Most covered call writers are conservative investors who do not appreciate market volatility. We can still generate fabulous returns in normal market conditions. When we have dramatic whipsaws in the market, opportunities are created to enhance our returns or at least minimize losses. This month many of us hit several doubles or perhaps rolled down. The 1-month chart pattern of the market benchmark for the past cycle highlights the type of market pattern that offers these opportunities:

Exit strategies and the S&P 500

The past contract cycle opened and closed at the red lines. The green arrow shows a severe dip when we have a chance to buy back our options (using the 20%/10% guidelines) at a greatly reduced price. We then are prepared to resell our options should the market recover which it did as shown by the blue arrow. Whether we rolled down or “hit a double” this is cash we would have not generated had we not been prepared to execute an exit strategy. THIS IS NOT LUCK; but rather the intersection of preparation and opportunity.

Market tone:

The economic reports this week leaned more to the negative which may account for the dramatic dip in stock prices on Friday. Consumer spending declined by 0.5% in June, the U.S. trade gap rose in May to the highest level in a year and a half, factory orders rose at a slower rate than expected and the Federal Open Market Committee (FOMC) downgraded its expectations to a slower recovery than previously anticipated. For the week, the S&P 500 declined by 3.5% (including dividends). A 3-month chart shows a downward trend:

3-month chart of S&P 500 7-16-10

This is confirmed by a 6-month chart which displays a series of lower highs (red arrows) and lower lows (green arrows):

Market trend 7-16-10

Summary:  

IBD: Market in confirmed uptrend (this is a longer term outlook).

BCI: Cautiously bullish, favoring I-T-M strikes as this site is anticipating encouraging earnings reports over the next several weeks.

My best to all,

Alan (alan@thebluecollarinvestor.com)

Next hand…two eights again. The dealer now shows a five and probably has fifteen and will go “bust” (over 21) on his next hit. So you split eights hoping to benefit from the dealers lousy hand.

Next hand, two eights again. I guess it’s time to head to the buffet!  Dealer shows a two, not great, not bad. You decide to stand pat, not take a card, not double and hope the dealer goes “bust”.

Three exact situations for you dictate three different decisions because of dissimilar circumstances. In much the same way, selecting a strike price based on surrounding conditions is an art and a science that must be mastered to elevate profits to the highest possible levels. In this article, we will look at an options chain and the in-the-money (I-T-M), at-the-money (A-T-M) and out-of-the-money (O-T-M) strikes. We will discuss the pros and cons of each;  the role delta plays in our decisions along with the rationale for each approach. First let’s look at the options chain for HITK, with three days remaining in the February contracts:

Strike Selection for HITK

Here is the information we glean from the chain:

• HITK is trading at $22.34- red circle @ top
• March strikes to consider are $20, $22.50 and $25- highlighted in yellow
• The I-T-M $20 strike returns $3.10- Red arrow
• The A-T-M (near) strike returns $$1.70- Blue arrow
• The O-T-M $25 strike returns $.80- Green arrow
• The only strike with intrinsic value is the $20 strike- Green circle and arrow to left

Next, let’s feed this information into the “single tab” of the ESOC (Ellman Calculator):

HITK- Info fed into Ellman Calculator

 After the blue fields are filled in with information gleaned from the options chain, the results will appear:

HITK- Calculation results for 3 Strikes

Let’s review the information for each strike:

$20 I-T-M Strike- in RED:

• The only strike with intrinsic value- $2.34 or 10.5% downside protection of the option profit
• There is NO upside potential
• The return on the option (ROO) is 3.8% or 44.7% annualized

The $22.50 A-T-M (near the money) Strike- in Green:

• Minimal upside potential and NO downside protection of the option premium
• The ROO = 7.6%  and 8.3% with the upside added in
• Annualized return is 97.7%

The $25 O-T-M Strike- in Blue:

• 11.9% upside potential with NO downside protection of the premium
• The ROO = 3.6% and a possible 15.5% if the upside is realized
• A possible 182.5% annualized return if upside is realized

What these calculations tell us:

• The time value or option profit for I-T-M strikes offer lower returns than the near-the-money call but the greatest protection for the option premium
• A-T-M (near) calls provide the highest ROO but little or no upside potential or downside protection of the premium
• O-T-M calls offer less option profit than the A-T-M calls but the greatest total profit potential should the upside be realized or almost realized.

The role of delta in our decisions:

Delta is the amount an option value will change for every $1 change in the price of a stock. The greater the chance of the strike ending up in-the-money, the higher the delta will be. Delta values for calls run from 0 to 1. I-T-M strikes have deltas of 0.75 to 1.00. This means that if a stock drops in value, it will cause the option to drop close to dollar for dollar and make a re-purchase of that option cheaper. A-T-M strikes have deltas near 0.50% and O-T-M strikes in the neighborhood of 0.25%. For these O-T-M strikes, if a stock drops in value, the corresponding option will not drop in step with that equity, making it more expensive to unwind the position.

When to use each strike:

• I-T-M strikes are the most conservative and easiest to unwind because of the high delta. Use these when technicals are mixed and/or the market is bearish or volatile.
• A-T-M strikes can be used when technicals are good and market conditions are positive.
• O-T-M strikes are used when extremely bullish on the stock and general market conditions are favorable 

Laddering the strikes:

There is no law that says you must use the same strike when you have multiple contracts. You can use some of each, favoring a particular strike based on the overall environment.

Conclusion:

Whether you’re sitting with a sixteen in blackjack or selling a call on an equity, one size DOESN’T fit all! Evaluate the stock and market parameters and then make a Blue Collar decision that has the best chance to maximize your returns.

Premium members:

1- This week’s list and charts of the top-performing ETFs has been uploaded to the download/resource area of your premium site.

2- We have recently added price data for the stocks listed in the weekly stock screen. Although the prices will change when the market opens the following week, this information will give you a general idea as to the cost when considering which equities to include in your portfolios. This addition was included as a result of the suggestions of some of our premium members.

Event update:

1- I will be hosting another seminar on Long Island, NY on August 12th. BCI team member, Barry Bergman will be sharing the podium with me. More information will follow.

2- A few weeks ago I started writing my third book. It will include information found in books 1 and 2, plus updated information as well as information found in the journal articles I have written over the past three years. I have become more skilled at creating charts and graphs which I hope adds to the quality of the finished product. This is by far the most extensive project I have undertaken and have set a goal for completion by the end of the year.

Market tone:

Market volatility continues to be an issue negatively impacting our markets despite more positive economic reports here in the U.S. Although the 1st quarter growth rate was reised downward, home sales, durable goods orders and consumer confidence rose. Fiscal problems in Europe is superceding the good news here.For the week, the S&P 500 rose 0.2% for a year-to-date return of of (-) 1.5%.

Although I am presenting to you a combination 3-month chart of an elevating VIX and declining S&P 500, I do feel that the technicals are less reliable in an environment where market psychology is the major factor in dictating the market direction. As a result, this site remains short term bearish and longer term bullish. Here is ther 3-month chart of our two indicators:

S&P 500 vs. The VIX as of 5-28-10

The red oval highlights the VIX up 50% in the last 3 months while the S&P 500 has declined about 10% in that same time frame (green oval).

Summary:

IBD- Market in correction

BCI- Short term bearish; predominently in cash and dollar cost averaging into broad market ETFs. 

Wishing our entire BCI community a happy and healthy holiday.

Alan, Linda and the BCI Team (alan@thebluecollarinvestor.com)

Current market price: $48.59

Options Chain for MELI 11-29-09

Vol(ume):

This is a measure of the number of transactions that transpired for a particular options contract for that day. It signifies how many times a day a particular contract has been bought or sold. The higher the volume, the greater the liquidity. A contract with zero volume should NOT be considered illiquid because it takes time to build up volume during the day. Also, an exchange specialist or market maker will step in to take the other side of the transaction. On the above options chain, the volume for the O-T-M $50 call is 202 contracts bought or sold thus far that day.

Open Interest:

This is the number of options contracts that are open or outstanding on a particular day. Options with large open interest have a secondary market of buyers and sellers. This will allow that option to be traded at a reasonable bid-ask spread. The open interest for the $50 strike on the above chart is 2282 contracts.

The Mathematics of open Interest:

There are four types of options trades that can be executed. Two will increase open interest and two will decrease it:

• Buy to Open (BTO)- Increases open interest by creating a new long position
• Sell to Open (STO)- Increases open interest by creating a new short position
• Buy to Close (BTC)- Decreases open interest by closing an exisiting short position
• Sell to Close (STC)- Decreases open interest by closing an exisiting long position

Trading Activity and Open Interest:

_________________________________________________________________________

__________________________________________________________________________________

As you can see, open interest is not the same as volume. With volume, both entries and exits cause volume to increase but in the case of open interest, entries will cause an increase and exits a decrease in open interest.

Significance of Open Interest:

Increasing open interest shows strength in the current price movement of an option in much the same way as a volume spike will enhance the significance of a change in a technical indicator like the MACD. Decreasing open interest shows a weakening of the current price movement. If the price is increasing on increasing open interest, the likelihood of continued price increases is greater. If open interest starts decreasing, that upward price movement is starting to weaken. Also, as mentioned earlier in this article, the greater the open interest, the more favorable the bid-ask spread is likely to be. Open interest of 20 contracts or less (2000 shares) is thought to have relatively thin liquidity.

Chart of the week- MED:

MED- Chart of the Week

 This stock has been a terrific cash-producer for many of us over the past few months. Note the technicals:

• Price bars are at or above the uptrending 20-d ema (blue arrow)
• Uptrending 100-d ema is below the shorter-term ema (red arrow)
• MACD is positive (green oval)
• Histogram is positive (red oval)
• Slow stochastic oscillator is in the overbought range but holding (purple recatngle)
• Volume is significant with all positive indicators (orange recangle with rounded corners- anyone know what this shape is called?) 

Last Week’s Economic News:

A light but positive week of reports sums up the last few days. Retail sales increased by 1.3% from October, much higher than anticipated. Business inventories rose for the first time in over a year signifying a boost to the economy and the U.S. trade deficit narrowed in October as the economy continues to show signs of recovery. For the week, the S&P 500 rose slightly for a year-to-date return of 25%.

This Week’s Economic Reports:

• Tuesday: Producer Price Index and Industrial Production
• Wednesday: Consumer Price Index, New Residential Construction and info on the last FOMC meeting
• Thursday: The Conference Board’s leading economic indicators

Video currently playing on the homepage (NEW!):

I hope you find this helpful as we approach expiration Friday:

Calculating Expiration Friday Exit Strategies using the Ellman Calculator

Cashing in on Covered Calls is now in KINDLE format:

http://www.amazon.com/s/ref=nb_ss?url=search-alias%3Dstripbooks&field-keywords=alan+ellman%2Fkindle&x=13&y=20

Wishing you a happy and healthy holiday season,

Alan and Linda

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): 

 http://www.thebluecollarinvestor.com/

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)