As covered call writers, we have all looked at option chains. That’s where we determine how much cash will be generated into our accounts when we sell our options. It’s fun! We first inspect the current price of the underlying security (stock or ETF). Then we check out the closest strike prices (I-T-M, A-T-M and O-T-M) and take note of the bid and ask prices. For I-T-M strikes, we will also look at the amount of intrinsic value that the option premium consists of. If we are interested in a particular option, we will make note of the option symbol, usually found to the left. Let’s look at a typical options chain for a stock (MELI) that is in my portfolio at the time this article was written (November, 2009).
Current market price: $48.59
Options Chain for MELI 11-29-09
I have highlighted two columns that tend to be overlooked, Vol (ume) and Open Interest. Although many investors assume these stats are similar, they are, in fact, quite different. The purpose of this article is to discuss that distinction and the significance of each figure.
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:
_________________________________________________________________________
| TRADING ACTIVITY | CURRENT OPEN INTEREST | VOLUME | |||||
| Trader A: B-T-O 6 contracts | 6 | 6 | |||||
| Trader B: B-T-C 2 contracts | 4 | 8 | |||||
| Trader C: S-T-O 8 contracts | 12 | 16 | |||||
| Trader D: S-T-C 3 contracts | 9 | 19 | |||||
__________________________________________________________________________________
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:
Wishing you a happy and healthy holiday season,
Alan and Linda
alan@thebluecollarinvestor.com
30 responses so far ↓
1 Mark // Dec 13, 2009 at 2:56 am
Alan,
Your books are excellent. I had 2 questions re. p. 142-144 (Chapter 13 Mathematics) in Cashing In on CC:
1) The examples show 8 positions with $100k, and 5 positions with $65k. Assuming reasonable diversification, would you say, in general, that an optimal position size is $10k to $12k ?
2) Are you opposed to buy-writes on $10 to $20 stocks, given the comment on p. 173 re. look only at stocks valued at $20 or more ? These days, there are still a few big names like GE, BAC, and AA trading in the mid teens after last year’s drop.
Thanks for your help!
2 admin // Dec 13, 2009 at 2:57 am
Mark,
I appreciate your comment about my books, thank you. My responses:
1- $10k to $12k is reasonable for portfolios of those sizes. Those who have portfolios of $200k and higher (there are several investors in our group who invest $1M and up in this strategy) would have more equities with larger positions per stock. By paper trading for a few months you will be able to determine your comfort level in the # of stocks you can manage. The more diversification, the better. The minimum is 5 stocks in different groups (industries or sectors). As time goes on, you will be enhancing the value of your portfolio and expand the number of stocks and contracts you manage and this becomes easier with more experience.
2- EXCELLENT POINT! 2008 did knock down the value of many quality companies. I still find the “sweet spot” to be between $30 and $70 for most of my watchlist stocks but there ARE quality companies less than $20 per share. KIRK is (currently) one such company that I recently alluded to in my comments.
Alan
3 Jerry Smutek // Dec 13, 2009 at 1:39 pm
Can you comment on a study that I once read about that shows that there was no significant difference in returns between owning the stock outright and owning & selling covered calls against the stock?
4 admin // Dec 13, 2009 at 1:58 pm
Jerry,
I would love to!!!!!! The study you are alluding to uses all stocks in the S&P 500, sells 1-month, near O-T-M strikes. The results showed that writing covered calls in this manner only beat the benchmark by a negligible amount. Those who use the CC strategy IN THIS MANNER will probably experience the same disappointing results. Here is why the study is flawed and does NOT apply to us:
1- It uses ALL stocks in the S&P 500, the good, the bad and the ugly. There is no process for stock selection…flaw #1.
2- It utilizes ONLY O-T-M strikes. The I-T-M strike is an immensly valuable tool that the study ignores…..flaw #2.
3- There are no provisions for exit strategies. If a stock is tanking, it stays in, no matter what….flaw #3.
4- Calls are sold on stocks that are reporting earnings. This is a major negative for CC writers and ignored by this study….flaw #4.
There are many CC writers that do invest in this manner, however, that is not relevant to us.
Alan
5 Don B // Dec 13, 2009 at 2:09 pm
Re postings #3 and #4, Jerry & Alan.
Wonderful question, and wonderful answer. There is another part to this, I think. Attitude has a lot to do with profit and loss. It is sometimes more difficult to sell a winner than some may think, but CC writing can make the decision for us. Also, an analysis based on something as wide as the S&P leaves any decision-making out altogether. Further, the thought that we cap our profits can be resigned easily by understanding that we take profits consistently, month after month. FWIW. Don
6 Don B // Dec 13, 2009 at 2:18 pm
PS The ugly elements of Fear, and Greed, are also part of the equation – once again part of the decision making process. Totally absent in any study such as that S&P.
7 Barry Bergman // Dec 13, 2009 at 8:39 pm
Alan,
the name of the figure in the MED chart is called a “rectoval”.
Barry
8 admin // Dec 13, 2009 at 8:59 pm
Don,
Thanks for your astute comments.
Barry,
I never heard that term before and I’ve taken every conceivable math course in college. Thanks.
Alan
9 Allan // Dec 14, 2009 at 5:56 am
Alan, are you having any workshops in the NYC or Philadelphia area anytime soon?
10 Aaron // Dec 14, 2009 at 7:38 am
Just to add another context to study mentioned on post #3.
I am sure the test didn’t take into account those of us that write covered calls or naked puts to ‘walk down’ the cost basis.
I got a couple of stocks that I deliberately did OTM writes & naked puts that in one to two months time, my cost basis is below current price, so now, I can sell juicy ITM calls and gain great premium, but also great equity gain.
The more I walk the cost basis down, the sweeter the premium I can get, and also a nice equity pop!
11 Dave // Dec 14, 2009 at 12:02 pm
Hi Alan,
Regarding post #2, do you increase your position in stocks that have better technicals?
12 admin // Dec 14, 2009 at 1:29 pm
Allan (comment #9),
I’ve been hosting seminars for private groups of investors the last few months but plan on a general seminar in NY early in 2010. I am also writing a new seminar based on my “exit strategy” book. I will announce the dates and times to all those on my mailing list plus on my blog articles. Thanks for your interest.
Alan
13 admin // Dec 14, 2009 at 1:38 pm
Dave (comment # 11),
No. I try to allocate equal funds to each position. The technicals do dictate the type of strikes I sell. A perfect chart is more likely to cause me to select an O-T-M strike, whereas mixed would lead me to favor I-T-M strikes. If I sell 6 contracts of a stock with mixed technicals, I may sell two O-T-M and four I-T-M even in a strong market. I call this “laddering my strikes”.
I avoid putting myself (portfolio) in a position where any one stock or group (industry or sector) can damage my overall situation.
Alan
14 Don B // Dec 14, 2009 at 6:47 pm
Alan –
Re your marvelous article on Volume & Open Interest, a much-needed treatise, I do not understand the meaning of the 2nd column to the left, that of Intrinsic Value – i.e., where those numbers came from.
Thanx. Don B
15 admin // Dec 14, 2009 at 7:14 pm
Don,
An option premium consists of intrinsic value + time value. Only I-T-M strikes have intrinsic value. This is the amount the strike price is LOWER than the current market value. For example, look at the $45 strike in the above options chain. You see the intrinsic value is $3.59. Since the current market value is $48.59 (stated above the chain), the intrinsic value is computed as follows:
$48.59 – $45.00 = $3.59
If we were to sell the $45 call @ bid or $4.40, our true option profit would be $0.81 ($4.40 – $3.59), since we would lose $3.59 if our shares were sold @ strike, a very likely possibility. The ESOC (Ellman calculator) will breakdown all the calculations for you.
Alan
16 admin // Dec 15, 2009 at 10:46 am
JCG:
I love smooth, uptrending charts and this stock (J Crew) currently has one. It recently hit a new 52-week high and posted it’s 4th straight positive ER. Sales are up 14% year-to-year and it sports a (little pricey but not a deterrent) PE ratio of 25x forward earnings. Option returns are within our objectives (2-4% per month). Check to see if this equity has a place on your watchlist.
Alan
17 admin // Dec 16, 2009 at 7:21 am
Brokerage statement:
I have had several offsite inquiries (the latest from Todd and Eric) regarding the cash value of our accounts after selling CCs. Some confusion arises from the fact that we are selling short the call option (S-T-O). Brokerage nomenclature requires these trades to be shown as debits (negatives). If we sell 2 contracts, it will be shown as (-) 2 contracts. The cash generated WILL be added to the cash portion of your account and available to use for compounding purposes. This amount is also shown as a debit. For example, if your 2 contracts generated $500, it will be displayed as (-) $500 and deducted (offset) from the value of your STOCK. If your stock is currently worth $5000, it will show as $4500, with the debit factored in. Once the options expire or the position is closed by buying them back, this debit will disappear and the account value will increase accordingly.
Alan
18 Phil // Dec 16, 2009 at 9:53 am
Alan,
As far as your CC strategy goes, do you treat the December month differently due to the low volume and activites at the year end or you just treat it as a regular month.
We love your books and your website.
Regards,
Phil,
19 admin // Dec 16, 2009 at 12:08 pm
Phil,
I’m a very tough boss to my cash. No holidays. No vacations. No sick days. The only exception is when there is an overall market aberration as there was in 2008. A key to wealth is to compound your profits on a consistent basis. If you are concerned at any point in time (I curently am not), you can use low-beta, low implied volatility stocks and sell I-T-M strikes.
Thank you for your generous comments.
Alan
20 Don B // Dec 16, 2009 at 12:26 pm
Alan:
I Came across a puzzler: Looking at AUY option prices. December run (to mention just a few) 11 – 12 – 13- 14 – 15 strikes. Yet January has 10 – 11 – 12.50 – 14 – 15. What gives?
On another but related matter, it looks more rational to use ITM strikes that are not so far beneath the current price of the underlying than those which are, say, half way between. Do you see an issue there? TIA.
Don
21 admin // Dec 16, 2009 at 4:46 pm
Don,
1- AUY is one of over 300 stocks that is part of the “One Point Strike Program”. Here is how it works:
The options exchanges received SEC approval to expand and make permanent the ability to list strike prices in $1.00 increments. Initially, the program allowed the exchanges to list dollar strike prices on equity options for up to five individual stocks provided that the strike prices are $20.00 or less, but greater than or equal to $3.00. Under the recently approved program, each exchange can elect to list dollar strike prices on equity options for up to fifty-five individual securities provided that the strike prices are $50.00 or less, but greater than or equal to $1.00. Additionally, no $1 strike may be listed that is greater than $5 from the underlying stocks closing price in its primary market on the previous day. The options exchanges are also restricted from listing any series that would result in strike prices being $0.50 apart.
2- Regarding how far I-T-M a strike should be needs to be evaluated for each situation. A slightly I-T-M strike will deliver a greater option return with less protection whereas a deeper I-T-M strike will return a lesser profit with more protection. Generally speaking, you bring out a good point. Low beta, low volatility stocks half way between 2 strikes, usually return a lower percentage profit on the option. An extremely conservative investor who would be satisfied with a 1 to 1 1/2%, 1-month return may opt for such an option.
Alan
22 Nancy // Dec 17, 2009 at 5:24 am
Alan,
I have several stocks that are priced higher than the strike prices I sold and I’m considering rolling out. Should I be using the price I paid, the current price or the strike price as my cost basis? Thanks for your help.
Nancy
23 Don B // Dec 17, 2009 at 9:18 am
Alan –
This morning, AUY took an 8% downward path, after an announcement by the company that showed less gold output & more cost than had been anticipated. Far as I could see, there was NO scheduled ER. Yet they made this announcement, plus offered an invitation to a meeting for today in Canada. Is it common for companies to simply have an unexpected or unscheduled meeting or ER? Comment will be appreciated. TIA.
Don B
24 admin // Dec 17, 2009 at 12:34 pm
Nancy (comment # 22),
The strike price. That’s what your shares are currently worth to your portfolio, not the purchase price and not the current market value. When deciding on whether to institute an expiration friday exit strategy or ALLOW assignment, we need to compare “apples to apples”. If we allow assignment, we will generate the strike price x the # of shares owned as cash into our account. We can then use this cash to purchase another stock and sell that corresponding call. If we roll out (or out and up) we use this same cost basis to determine our returns. We can then compare the two choices and make an informed decision. The Ellman calculator (ESOC) will compute this for you.
Congrats on selecting so many great stocks this cycle.
Alan
25 admin // Dec 17, 2009 at 12:44 pm
Don (comment # 23),
Companies will, from time to time, UNEXPECTEDLY, issue a press release, pre-announce earnings information or generate some sort of news event that could positively or negatively impact our share price. Since we have no control over these events, I give them no thought and deal with them if and when they come.
ERs and same store retail sales reports are events we can deal with by avoiding them and both have become integral parts of my system.
Whenever this happens (and it’s rare) I take a look at the stock and ask myself if the fundamentals and technicals, the factors that motivated me to buy the stock in the first place, are still sound. That will guide you in the right direction.
Alan
26 Barbara // Dec 17, 2009 at 4:09 pm
Alan,
Since tomorrow is options expiration and it looks like I will be called out of some of my stock picks, how do I determine which stocks to buy and sell calls on for January 2010 expiration. I know I need to do my homework this weekend to prepare for next Monday.
Barbara
27 admin // Dec 17, 2009 at 5:15 pm
Barbara,
PLEASE view the video on the homepage as you may want to hold on to some of your stocks by rolling out or rolling out and up. For example, if you had sold the November $50 calls for BUCY and roll out to the December $50 calls (these are the after hour figures on Thursday evening), the calculations would look like this:
BUCY currently trading @ $52.26
B-T-C @ $2.40
S-T-O @ $3.90
ROO = 390 – 240/5000 = 3%, 1-month return
Downside protection = 226/5226 = 4.3%
This means that your 3%, 1-month profit is protected as long as the shares do not depreciate by more than 4.3%. If you still like the fundamentals and technicals and there is no upcoming ER, these type of expiration Friday exit strategies can be quite lucrative and should be given consideration.
Alan
28 admin // Dec 18, 2009 at 7:10 am
GES:
Recently reported a 3rd quarter ER that far outpaced analysts’ expectations. The company also projected bullish prospects for the 4th quarter and declared a 12.5 cents dividend, for an industry-leading yield of 1.14%. The ROE is a hefty 25%, compared to the industry-average of 9%. The net profit margin is far ahead of the industry average of 2%. Check to see if this equity has a place on your watchlist.
Alan
29 admin // Dec 19, 2009 at 9:47 am
Stop-Loss Orders: Are they appropriate for covered call writing? Check out my upcoming blog article. Also, I produced a new video discussing earnings reports that is being shown on this site’s homepage. To be updated on all new articles, news, products and seminars, join my mailing list:
http://www.thebluecollarinvestor.com/joinfrnds.shtml
Alan
30 Early Exercise and Assignment of Options // Feb 13, 2010 at 2:40 pm
[...] High Open Interest- When you see thousands of open contracts we know that the institutional players are involved. [...]
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