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)

Out-of-the Money Strike:

This is where the option’s agreed upon sales price (of the equity)  is HIGHER than the current market value of the stock. If we buy a stock for $28 and sell the $30 call option, that strike price is out-of-the-money.

When to use O-T-M Strikes:

Consider this the most bullish of your covered call positions. The greatest benefit will come if the stock appreciates in value from the time of purchase to expiration Friday. The closer it comes to the strike price (or surpasses it), the more money we make and the returns can be eye-popping! So let’s take a common-sense look at some of the factors that would encourage us to favor this strike price:

• A bullish overall market with low volatility
• The stock chart to be technically sound
• The positive technical indicators are all on high volume
• The positive momentum is continuous and not the result of a quick spike which could snap back
• The stocks industry is also strong both fundamentally and technically

Advantages of the O-T-M Strike:

• We can participate in both the option premium AND the stock appreciation. 1-month returns can easily end up between 10-20% if the strike price is reached.
• Less chance of assignment if we plan to hold the stock
• Time decay works in our favor since the premium consists only of time value. This means that as we approach expiration Friday, if the strike is still O-T-M, the time value will approach zero.

Disadvantages of the O-T-M Strike:

• This strike offers the least amount of downside protection
• May be a poor choice for those with low risk tolerance
• The initial option premium is low, so the 1-month return may not be impressive if the stock does not appreciate in value
• This strike has a low delta (amount an option value changes in relation to a $1 change in stock price). If the stock drops in value, the corrersponding option will not change as much, thereby making it more expensive to buy back the option for an exit strategy.

Conclusion:

O-T-M strikes have an important place in our portfolios. Those with greater risk tolerance will tend to use them more than those with less. No matter who is writing these calls, they must be used to our greatest advantage. Select the strongest stocks in the strongest industries that have been uptrending with low implied volatility (avoid violent whipsaws on the charts). When constructing your portfolio for the month you can mix or ladder your strikes using a higher percentage of these O-T-M strikes the more bullsih you are on the market and decreasing that percentage if you turn bearish. By doing so we are not guaranteeing success but dramatically throwing the odds in our favor of winning much more than losing.

Options Symbology will be changing- VERY IMPORTANT:

The Options Clearing Corporation has announced that as of this month, February, 2010 option symbols (tickers) will change. This information is just getting out and we will be hearing more about it over the next few weeks. Here is an example as to how the changes will look: I will use Apple Computer as my example:

This example was taken from the Charles Schwab website. The brokerage I use, USAA differs slightly:

AAPL  05/22/2010   C  20.000

All brokerages must make these changes by February 12, 2010.

Home Sweet Home:

Linda and I have been out of the country for the past week and returned on January 31st. I will catch up on all your emails during the course of the week. Economic news and reports will re-appear in my next article.

My best to all,

Alan

alan@thebluecollarinvestor.com