Over the past two years, with the market volatility so intense, I have been stressing the benefits of the In-the-Money strike. Many of you felt that I had little or no use for its counterpart, the Out-of-the-Money strike. That is simply not the case. The key point is to understand the advantages and disadvantages of each and to know when best to apply them. When a football team has a rookie quarterback, they will use short passes and running plays for their in-the-money offensive strikes. When the quarterback is more experienced and the defense is expecting a handoff to the the halfback, we break out the out-of-the-money bomb down the sidelines. In other words, there is a time and place for each, and we, as Blue Collar Investors, need to master this information, so that we can make the best investment decisions.
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
44 responses so far ↓
1 Don B // Jan 30, 2010 at 3:12 pm
Alan & All,
On the options symbology changes – INTERESTING!! You used AAPL at Schwab for the May 20 as AAPL0522201020.00C. You showed USAA as using AAPL 05/22/2010 C 20.000. Fidelity shows the Apple option as -APV100717C95 for July. (No May, or 20, to compare to). Yahoo then shows the July 95 as -QAA100717C00095.000! Wow, what a moniker! I can understand each, separately, but how on earth do the market makers work with the differences in these four companies, much less those of the myriad of other brokerages? Thus far, I have had no problems, but what…..??
And welcome home! Hope you had a ball!!
Don B
2 Dave D // Jan 30, 2010 at 7:49 pm
Hi Alan, weclcome back! Hello to all…
Recently, (today in fact), I thought of a stratrgy to limit financial loss during these down times in the market.
On a daily basis, IBD (Investors.com) states one of the below 3 things…
1) Market in confirmed uptrend
2) Uptrend under preasure
3) Market in correction
The first is definetly the kind of conditions us BCI’s want to be working in. Obviously, the 3rd (Market in correction) might be a problem, depending what your risk tolerence is. For me, id rather avoid this as id say im generally a conservative investor who likes to follow the rules.
On the 22nd of January, IBD stated on their website (investors.com) that the ‘market was in a correction’. I figure that if this happens, it would make sense to immediatly go over ALL our stocks we own and check the technical analysis of each stock. If ANY stock we own is showing weakness, then perhaps it might be time to perform the most conservative exit stratergy of all, SELL… Yes, we may sell at a loss, but wouldnt it make sense to cut our losses small (especially if the market is in a correction)?!
In the long run, I figure this would save allot of money $$$ from being lost. I say this because 3 out of 4 stocks follow the market trend.
Note: The reason why I thought of this was to come up with a very specific rule that I could easily follow when the market went into a correction!
I would like to hear anyones feedback. Perhaps Ive missed something or someone may want to improve this idea for me (or you)…
Thanks
Dave D
3 Eric R // Jan 30, 2010 at 9:19 pm
Dave –
Very good point. IBD is usually a good source for gauging the market tone with the Big Picture section. I would also say another option in a correction is to switch to inverse ETF’s and sell ITM on those. Of course, this is not really a conservative strategy.
Eric
4 Rob // Jan 31, 2010 at 8:45 am
I have found myself willing to buy ETFs and hold them for longer. By doing this, I am more willing to take a unrealized loss on my underlying stock while still gaining premiums from options. Since I stick to ETFs that follow uptrend (no inverse ETFs), I can be reasonably assured that my ETF will rebound in the future allowing me to sell either for what I bought it or at a profit all while collecting good premiums in the meantime.
5 Eric R // Jan 31, 2010 at 10:57 am
Rob –
I’ve tried this before, but every now and then I run into the issue where I’ve trapped myself in a lower strike than my cost basis. For example I buy an ETF for 45 and sell the 45 for $2 which makes my breakeven 43, ETF proceeds to fall to 38 by expiration. So overall I’m down 5 on the trade. Next month I sell the 40 for 1.00. This lowers my cost to 42. If the ETF runs up to 42 I’m stuck selling at 40 or having to buy back my call for $2 intrinsic at expiry. If I buy back for $2 my net loss is $1 and my cost is back up to $43. I’m curious how you would handle this.
Eric
6 Rob // Jan 31, 2010 at 11:43 am
Eric R,
It definitely takes some watching. Trying to find that balance between a strike price I can accept and the premium receieved.
This week, I had an experience similar to yours. I rolled down to an OTM strike that gave me a good premium but would result in a loss were it called. I took the chance based on the market downturn and the time left in the month ( I figured the strike would not be reached as it was just high enough to give me cushion from an upswing). As it turned out, my play was correct and I was able to buy that option back for less than i sold it, making a small profit on a downturn. Now I am free again to see how the market does.
As you can see, I don’t have a solid plan on this; I am still new to covered calls.
I am just doing a lot of experimenting.
7 Don B // Jan 31, 2010 at 12:30 pm
All –
Re Eric R in post #3 on Inverse ETFs. Sounded like a great idea, so I did some calculations just now. Using DXD, Ultra Short the Dow (said to be double the inverse), and using the Fri. 1/29 closing numbers, I came up with the following example: Buy @ 31.42. Write Feb 29 C @2.55. If mkt continues down or stays same, stock goes up or stays same. You get called. 3.142 – 29.00 = 2.42. 2.55 premium minus 2.42 loss on stock = .13/31.42 = .004%. But if mkt goes up stock will retreat. If below 29 you do not get called, so 2.55/31.42 – .08%!!!
SO – this short position ETF essentially becomes a BULLISH strategy, a belief in a newly ascending Dow, therefore in this market a somewhat aggressive view.
Looks to me like no loss is possible either way, tho the likely gain is quite small relative to the investment numbers.
COMMENTS welcome and hoped for. Good Luck.
Don B
8 Rob // Jan 31, 2010 at 12:52 pm
Don B,
Don’t forget that, if the market increases, and this stock goes down and is not called, you have an unrealized loss on your stock. And then you can get into loss strike price situations like Eric R mentioned.
I have this situation with my ETFs but I feel more confident that the market will rebound than I do that it will continue to drop forever. Especially since I have already made good premiums for this month; I have time to wait it out.
9 Doug // Jan 31, 2010 at 1:13 pm
Hi Alan & All,
I’d like to second Dave’s approach and question about how seriously to take the IBD market prognosis. We take IBD very seriously in other regards, and IBD takes market direction very seriously, encouraging readers to “raise cash”, to put it mildly, and go entirely to cash if a solid correction takes hold. I learned my “big lesson” on this back in 2000, selling all after stunning losses, but in time to still preserve about 80% of my account. But that’s another story.
It looks to me like this correction could have real legs and has been overdue. Now I wish I could take more credit, but due to just being busy, I found myself almost entirely in cash and just had to decide to stay there. But I’d be pretty sore if I was fully invested and having to figure out how to unwind. These are definitely the times that try CC investors souls. Yes, I’ve read the “Exit Strategies” book, and it is great. But while “Hitting Doubles” works great for small pullbacks only to upward continuing trendlines, a serious correction or bear market will incure losses that could wipe out a year’s worth of premiums and require a year to earn back, assuming the chosen stocks ever recover.
So I’m at a loss (npi) at how best to deal with real corrections. I’ve never rolled down, without disappointment. Rolling down does two things. It locks in a loss even if the stock recovers. And more seriously, it prevents you from setting a stop should the stock continue to fall. So my strategy is pretty much the opposite. If IBD calls for a correction and a stock is down (which it usually is by that time), I buy back the option (at a profit) and then set a hard stop below the next support. Sometimes the stop takes it, and sometimes happily the stock recovers.
Is there a better way in a general correction?
- Doug
10 Don B // Jan 31, 2010 at 1:45 pm
Rob – post #8 – good input. I should have carried this out that one step further. My error. Thanx.
On this business of using IBD online, I cannot seem to get on that website. Perhaps because I took the freebie when I started with BCI, and did not follow up by paying for it. Ideas anyone?
Don B
11 Rob // Jan 31, 2010 at 3:46 pm
Doug,
Short of getting out entirely, I think the best way to handle downturns (for my tolerance at least), it watching my stock closely and determining if the premium I am getting for a rolldown is good enough to outweigh the chance of the stock rising over a strike that could lose me money.
For instance, if I think that a stock will not rise to a price by expiration and is in fact going to continue falling, I may decide that I can safely sell a lower call, get the premium and then buy that call back later at a cheaper price. This allows me to continually lower my cost basis, making more strike prices become attractive.
This is not without risk; it gets called, I lose. But the way I look at it is that I can either lose 10% because the stock dropped or I can grab premiums and cut that loss down quite a bit. And I watch closely, maybe even come out even.
In any case, it is a tough situation and requires some will to risk. I certainly don’t try this will my whole portfolio. But if I get “stuck” with a stock, I might at well try to cover my loss and maybe even come out ahead.
12 Eric R // Jan 31, 2010 at 3:55 pm
Doug – Great post! I agree with you on how it can be touchy trying to hit the double and then deciding to throw in the towel to roll down or even turn dead money to cash profits. Another thing to point out here is many times these stocks in IBD will be leaders in the current market, but once a correction does hit the next bull market may have entirely new leaders. This means if you hold on to a stock to recover you may be holding on for a long long time. Not to mention that as the stock falls the premiums obtained from writing CC may not even be worth the trouble. I’m thinking another way to deal with this is to switch to a collar strategy once the distribution days start racking up in IBD. This way you are covered to the downside if your stock suddenly plummets. The problem is if you wait until your stock is down to start buying protective puts then your paying out the nose in premiums for them.
Eric
13 Marty // Jan 31, 2010 at 5:55 pm
Doug-
I like your approach the best as you have firm rules. The other posts use “…if I think…” or other such subjective language that always gets me in trouble. Trying to outthink the market has served me badly.
Thanks for sharing…
Marty
14 admin // Feb 1, 2010 at 4:40 am
Last week I received this off-site email question:
Hi Alan,
I have read both your books and watched most of your DVDs. The only question I have is that couldn’t you sell puts instead
of a covered call using your strategy? The risk is the same for both strategies but the margin requirement is much less for a short put.
My response:
Although CC writing and naked put selling have many similarities, there are some differences that give the former an advantage. As I list these, bear in mind also that this site has been constructed and geared to the average retail investor, hence the name “Blue Collar Investor.”
My reasons:
1- Your point about margin requirement is an excellent one. However, most brokers will require investors who are new to options trading to be fully cash-secured when shorting puts.
2- The CC writer captures corporate dividends, the put seller does not.
3- Put premiums usually are SLIGHTLY smaller than call premiums.
4- The CC writer has an opportunity to garner greater returns when selling O-T-M strikes whereas the put seller’s max return is the time value of the option.
5- Some brokers will not allow put selling in a self-directed IRA.
6- Many brokers will require a higher level of options approval which many in our group will not be able to obtain.
7- Management issues: If a stock is dropping precipitously near the end of a trading day as we approach expiration Friday, a put seller may want to unwind the position and sell the stock (about to be put to us) before it drops even more. Without the equity physically in our account, it would behoove us to sell the stock short, a level of approval most of our group cannot achieve.
That being said, I am considering highlighting an advanced strategy ( in the future) that would use a combination of calls and puts that would make CC writing even safer and more conservative…stay tuned and thanks for this great question.
Alan
15 admin // Feb 1, 2010 at 6:42 am
Thanks to all for participating in our site dialogue during these last few very trying weeks. We all benefit from these insightful comments and questions. I just finished unpacking from a wonderful cruise through the eastern Carribean. The itinerary we had kept Linda and me busy full time so my participation was impossible. I took a peak in my mailbox and see triple digit # of comments and questions. I will address one in this comment and the remainder over the course of the week, some on this blog and others offsite.
First some business:
1- Many of you have inquired about the premium site and weekly spreadsheet- I will update the progress on this site early in the week after I speak with my web tech.
2- All DVDs and CDs ordered in the past week will be shipped TODAY…thanks for your patience and understanding in this matter.
With the market reminiscent of 2008 these last few weeks, there have been a myriad of comments and questions regarding how to assess the general market and possibly go into cash when we are in the midst of a correction. Bear in mind that timing the market is a science that no investor has perfected….even Warren Buffett lost money in 2008. We can use knowledge and common sense to throw the odds in our favor. I closely watch the S&P 500 (50-d and 200-d moving averages) and the VIX (CBOE volatility index). Currently, both are looking bleak. All technical indicators are negative for the S&P 500 and the VIX has moved up (a negative) from 17 to 24 recently. This means that a bearish stance must be taken wherein we role down or convert dead money to cash profits. Certainly all options that have been hit hard should have been bought back. Those who have closed the option positions but still own the stocks may want to wait a day or two as most stocks are “on sale” and the institutional investors may step in to start buying. This may boost the value of your shares over the next few days. As of this post, the futures are looking good.
Dave made an excellent suggestion, to use the IBD website to check on the overall market outlook. They use a service that focuses on this aspect of investing and can be used in conjunction to the two I mentioned above. Those not familiar with this aspect of the site, here’s how it works:
1- Go to http://www.investors.com
2- Click on “Big Picture”
3- Look for box headlined by “market pulse”
The categories of market uptrend, under pressure or correction should confirm what the S&P technicals and VIX has guided us to.
You may also want to look for “leaders in up volume”. It currently lists VPRT and PRGO. This could be a source for locating a candidate for our watchlists as it represents equities with institutional support.
For newbies, this is a fee-based site. You need only to sign up for the “Monday Special” which gives you 55 weeks of the Monday paper (delivered to you on Saturday) and 24/7 access to the website.
Although nobody likes to see their stocks pulled down due to an overall market downturn, it can be a great learning experience as we are forced to institute exit strategies to minimize losses.
Alan
16 admin // Feb 1, 2010 at 12:41 pm
Rolling out and up:
Last week there were several posts discussing the mathematics behind this exit strategy. Great points were made as were good questions asked regarding the profits generated from such a trade. Let’s use the example shown on page 106 of “Exit Strategies….”:
Buy 100 x CPO @ $23
Sell the $22.50 option
Stock trading @ $24.58
B-T-C the $22.50 call for $2.45
S-T-O the next month $25 call for $2.10
Option loss is $.35
Stock value now $24.58, not the $22.50 we were previously obligated to sell at.
Increase in share value is $2.08
Profit (at the time of the trade) is $2.08 – $0.35 or $173 per contract. Cost basis is $2250 per contract. Profit is 208/2250 = 7.7%
The discusssion centered around calling the $2.08 profit. Some brought out the point that this is potential profit as opposed to realized profit….certainly a valid viewpoint. When I wrote the equations for my calculator I DID include this amount in the calculations. Here’s why:
1- When we B-T-C the current option, we are paying both time and intrinsic value. If we count the intrinsic value of the new option premium as a debit, why not include the enhanced share value as a credit, thereby leaving the time value as profit, something covered call writers do all the time.
2- Even when we write a CC, the original profit generated is not a realized profit until the position is unwound in some form, yet to many this IS a realized profit. On our brokerage account statement the premium is listed as a “-” because it is possible we may have to buy back the option. By definition, a covered call position is not truly realized until the position is closed and that’s why management is such a big part of our system.
My viewpoint is all about generating profits and managing the position to maintain, increase or minimize deterioration of that position. Others may come from different vantage points and they are not necessarily wrong as long as there is a thorough understanding of the mathematics.
One thing we can all agree on is that we have developed quite an impressive group of investors on this site.
Alan
17 Don B // Feb 1, 2010 at 4:35 pm
Hi Alan –
Welcome home.
Sir, I cannot figure out, either in the book or on your post #16 how much you received for the first sale, the 10/24 sale – tho the bid shows at 2.05. Somehow I do not see that in the calculation. What am I missing? TIA.
Don B
18 admin // Feb 1, 2010 at 5:43 pm
Hi Don,
The premium received from the original option sale is deliberately left out as it is irrelevant when calculating an expiration Friday exit strategy. The cash generated from the first option sale is money in the bank and now we are deciding:
Are we going to allow assignment and take the cash (strike x number of shares) to invest in another stock OR….
Roll out or roll out and up.
The previous month’s option profit plays no role in this decision and may even confuse matters. My only concern is how to make the most money at that point in time. I do show original option profits when considering mid-contract exit strategies because they are part of the same cycle.
Alan
19 GaryM // Feb 2, 2010 at 5:39 am
David D (post 2). I also use the IBD Market Pulse as my guide. I either sit on the sidelines like I have been since December or look for high Beta stocks to purchase puts. I know that is not part of the BCI teaching. I also don’t trade CC just to say I am trading. I am in it to make money and I don’t like fighting the trend. So I will patiently wait. On the other hand if the market is neutral or in an uptrend I love CC trading. Everyone has their own trading methods. Saying all of that Alan does an outstanding job with this site as well as his books and I am looking everyday to dip my toe back in the water again.
20 admin // Feb 2, 2010 at 10:48 am
TPX and GMCR:
These are 2 stocks that have weathered the recent market downturn.
TPX recent ER showed sales up 29% year to year, gross profit margin up to 48% and EPS doubling over the previous year.
GMCR has hit a new 52-week high with sales up 77% year-to-year after a recent positive ER.
We have had some really intelligent suggestions on this site regarding how to protect from a severe market downturn as we had recently (although some recovery of late). Eric suggested protective puts or a collar strategy where we sell a call and buy a put. This will protect against a massive loss although limit gains due to the cost of the put. Doug suggested buying back the call and setting a stop to protect against a further price decline but at the same time allowing for a posssible price recovery. These are both viable approaches especially for those who cannot monitor their positions on a regular basis.
Another approach would be to sell a put before entering a long stock position. If exercised, we have purchased the stock at a lower price point. This is a strategy that would be used in a bearish environment or for extremely conservative investors.
I plan to write a journal article covering some of these topics. Many thanks to our BCI community whose contributions have significantly added to the quality of our site.
Alan
21 Eric R. // Feb 2, 2010 at 11:04 am
Hi Alan –
Glad you had a great time on your cruise. Always good to take some R&R now and then.
Per your #16 post I am having a difficult time understanding the cost basis part. I always think of cost basis as my breakeven. Simple example: I buy a stock at 30 (not counting commissions) this is my breakeven. If stock falls below 30 I’m down on the trade. If stock goes above 30 I’m ahead on the trade. If I sell the stock at 30 I breakeven and make zero.
Following this to the CC example. I buy a stock at 30 and sell the 30 call for 1.50. My breakeven is 28.50 (As long as I let the option expire and do not BTC). Below 28.50 I’m in loss on the trade. Above 28.50 I’m in profit.
If I go to the example given in #16. I buy CPO at 23 and sell the 22.50 for 2.05 (using Don’s bid from post #17). My breakeven or cost basis is 20.95 (23 – 2.05). Now expiry comes along and I BTC for 2.45. Just this trade will raise my breakeven to 23.40 (if I did not STO a new option this is the point where this trade starts to lose for me). Now I STO the 25 for 2.10. This lowers my cost down to 21.30 (23.40 – 2.10). So 21.30 is actually where I would start to lose money on this trade not the 22.50 cost you point out above. Am I missing something?
Thanks
Eric
22 admin // Feb 2, 2010 at 4:28 pm
Eric,
My mathematical philosophy, calculations and calculator are based on two assumptions:
1- CC writers make the most money selling 1-month options. This is indisputable.
2- CC writers will maximize their success by having the ability to calculate which of their investment choices will garner the greatest returns AT THAT SPECIFIC POINT IN TIME. This is my strong opinion based on years of investing with CCs.
When an option is sold that cash can be viewed as profit which we must manage until expiration (my viewpoint) or as a means of lowering your cost basis (but NOT both) and then computing the profit at expiration. So far the different perspectives are not really dissimilar. In the above example, the conventional perspective is (as you state) a cost basis of $20.95 and your shares are worth $22.50 because of the option obligation, for a profit of $1.55. The Ellman Calculator breaks it down as follows:
The $2.05 premium contains $0.50 in intrinsic value which I use to “buy down” (or lower my cost basis) to the strike of $22.50. That leaves $1.55 (time value) left as profit the same as above.
So now that brings us to expiration Friday as we make our decision: Do we permit assignment or roll out or roll out and up? If we allow assignment, we will have $2250 per contract in our account to use to purchase another stock for the next month’s contract. If we roll out or out and up what cost basis makes the most sense to use so that we can compare apples to apples? For me, it’s $22.50 because using a lowered cost basis will skew the figures and NOT allow us to make the best choice AT THAT POINT IN TIME. The $1.55 profit was last months gain and now we are looking at our next investment.
Using conventional calculations, in my view, works well for many investment strategies but not for CC writing because of its uniqueness. We are not buying a 1-year bond or buying a stock, mutual fund or ETF for a long term hold. Instead we are making a series of 1-month investments each one unique and independent of the previous one. Common sense (I hope you agree) dictated that I create a calculator that reflected this specialized strategy.
To summarize: On or near expiration Friday (in the above example) your shares are worth $22.50. When deciding to allow assignment or roll out should the cost basis be $21.30, $20.95 or $22.50 when computing what to do for your NEXT, UNIQUE investment? Whether you calculate this way or another, the important point is that you have a clear understanding of the mathematics of an option premium and are comfortable and successful with that perspective.
Alan
23 Eric R. // Feb 2, 2010 at 5:26 pm
Alan –
I get it now. It makes sense to treat each month as a unique trading situation. I can see why you have the disclaimer on the calculator about not using the figures for tax purposes.
I see above where you mention strategies for handling declining stocks and you say one method is to sell a put to enter the long stock position. I’m not sure if my broker would allow this in my IRA, but it is an interesting idea.
Another question for you – we had brought up a lot of ideas about how to handle a declining stock while that decline is in progress. How do you handle a stock once it has already taken a hit such as MED did recently. I know you said you only wanted to risk half of your position, but have you done anything with the other half such as sell calls to bring in more premium on those shares as you wait for it to come back? Just wondering.
Thanks
Eric
24 Don B // Feb 2, 2010 at 7:50 pm
Re post #21 and #22, I just caught up too. See, I have always had taxation in mind when calculating returns, basis, etc. And I find it easier to also do so even when dealing with IRA trades – simply to avoid confusion. For me, I also keep paper work on stock results quite separate from that of the option. If I buy a stock and sell the call ATM, and get called away, that shows a small loss, for tax purposes, due to the small commission, while I show the option as a separate gain.
Thanx for listening.
Don B.
25 Don B // Feb 2, 2010 at 7:54 pm
PS – In my last sentence on post #24, I meant to say EXACTLY at the money. I.E., buy stock at $30, sell call at $30, show loss due to the small commission on both sides of that trade.
Don B.
26 admin // Feb 3, 2010 at 4:29 pm
Email question from Gary:
Alan,
In your CC and Exit Strategies books you provide a lot of information on exit strategies and pre-stock-purchase analysis. One thing I’d like a bit more input from you on is timing as it relates to purchasing a stock on which to write covered calls. Specifically, do you have a “deadline” relative to expiration Friday after which you simply will not purchase a stock no matter how good the fundamentals and technicals are? (e.g. No stocks should be purchased 2 weeks or less prior to expiration Friday.) It certainly seems to me that at some point the time value of any option in the current “30 day period” will have erroded so much as to make the value proposition of any trade negligible. I’d appreciate your thoughts on this.
My response:
I have no hard guideline in this regard because even with only 1 or 2 weeks remaining until expiration there may be opportunities to generate cash. I also feel that it is important to keep your money hard at work at all times unless the market is plummeting (or you’re away on a cruise as I was last week).
You do bring out an excellent point about time value eroding significantly the last two weeks of a contract period so the percentage returns will decline. However, if you ask me if am I willing to earn 1-2 % in 2 weeks, my answer is YES. How long will it take to earn that 1% with a CD? It’s a “single” nstead of a “double” but I still got on base!
I am more cautious in these situations because there are limited exit strategy opportunities if the stock declines. I usually look to slightly I-T-M strikes in the last 2 weeks as you can get decent returns with some protection. I do insist on great technicals and at least neutral market conditions.
Alan
27 admin // Feb 3, 2010 at 4:43 pm
TUNE IN THIS FRIDAY:
I will be doing another live radio interview this Friday @ 8:30 AM:
http://www.stockgoodies.com
The host will give a phone # for those who want to call in specific questions.
Alan
28 admin // Feb 4, 2010 at 5:25 am
ATHR:
As with most equities, ATHR dos NOT meet our system’s technical requirements due to the recent market selloff. However, this company caught my eye after the January 25th ER when sales were up 89% year-to-year and cash reserves were up fourfold. With a PE ratio of 15 and a PEG (PE/Growth) of 0.85, this stock has a sound fundamental backing.
Consider adding this stock to your watchlist once the technicals turn positive.
Alan
29 Don B // Feb 4, 2010 at 10:14 am
Alan:
The ATHR looks just wonderful, fundamentally. But would you please expand on your thoughts on what constitutes a positive turn in the technicals?
A turning up in price would of course be a positive, but you must be thinking of something else to watch for. ?? Many thanks.
Don B
30 admin // Feb 4, 2010 at 12:40 pm
Don,
In NORMAL martket conditions, I would suggest you set up a chart as described in figure 28, page 85 of “Cashing in on Covered Calls”. You will notice that this stock is trading under its 20-d ema, the MACD and histogram are below zero. Only the stochastic oscillator has a positive tone. In an ideal world, we want the equity to be trading at or above the 20-d ema with the other indicators confirming with strong volume.
However, there are currently few charts that would pass our screens due to the GLOBAL selloff. Overall market now takes presidence over individual stock analysis. The VIX has taken off and the S&P 500 has lost 10% in a short time frame. These last few weeks are reminiscent of 2008.
We are also hearing a new term….”sovereign debt” where our market is impacted by high debt levels in places like Greece and Portugal. Even the strongest stocks fundamentally, like ATHR, and others can’t fight the trend of a declining market. For me, I will not enter a new position until I see a calming of the VIX and a bottoming of the S&P 500 decline. This can happen as early as tomorrow when the unemployment stats come out and reasonable decisions overcome panic maneuvers. One thing
I have learned over the past two decades: Things are never as bad as they appear on days like this and never as good as they seem on days when the market is heading for the moon. When things are really bad, they’ll get better. When they are too good to be true, look out below.
In any case, despite the market craziness, when I come across a stock that catches my eye, I’m happy to share it with you just as many of you have done for us.
Alan
31 admin // Feb 4, 2010 at 2:39 pm
http://www.stockgoodies.com//page/radio
This is the link to my live radio interview, tomorrow February 5th from 8:30 -9:30 AM EST
The host will also provide a phone # to call in questions.
Hope you can make it.
Alan
32 DaveP // Feb 5, 2010 at 10:28 am
I decided to exit out of a position today as the option price was below 20% of what I paid. The Bid was 0.05 and the Ask was 0.20, so I put my buy order in at 0.15. The Bid immediately went up to 0.15. I rechecked a few times and it was still the same so I changed my buy price to 0.20 and it was immediately executed. But the funny part is that when I checked the price I paid it was 0.15.
33 DaveP // Feb 5, 2010 at 11:31 am
Sorry, previous post should have started out with “option price was below 20% of what I sold it for”.
34 GaryM // Feb 5, 2010 at 2:38 pm
Alan,
I know trading the Q’s are somewhat boring, but for an anchor ETF to trade this seems to be a conservative ETF to write CC’s. I know you mentioned either in your books or on here that you trade the Q’s for your mom’s account. I plan on trading individual stocks, but want a portion of my investment in something like the Q’s. Your thoughts? I have been on the sidelines in cash since mid December, but looking for opportunities for the March expiration. Thanks.
35 admin // Feb 5, 2010 at 6:26 pm
Dave,
I commend you for playing the bid-ask spread. It is not unusual to get a better execution seconds before agreeing to a higher offer. Weel done.
Alan
36 admin // Feb 5, 2010 at 6:30 pm
Gary,
It’s no secret that I have been trading the Qs in my Mom’s account for years. The disadvantage is lower returns than individual equities. The advantage is instant industry diversification and lower risk. You can also get involved in CC writing with less cash when trading ETFs. For more info, check out this recent article I published:
http://www.thebluecollarinvestor.com/blog/etfs-how-they-operate-and-the-pros-and-cons/
Alan
37 Dave D // Feb 5, 2010 at 7:20 pm
Hi Alan,
One of the stocks I currently own is HEAT. I purchased this stock for $16.30 and currently the stock is at $11.07… This is a loss of 5.23… BUT, with the option profits I have made (.80c + 1.35) its only 3.13…
If I sell now, I incur a loss of around $3.00.
On the other hand, if I hold the stock and continue to sell options on it, perhaps I will lessen the loss and eventually arrive at a profitable position… What are your thoughts of doing this? In your experience, is this a wise thing to do?
Thanks Alan
Dave
38 Barry Bergman // Feb 6, 2010 at 7:39 am
Alan,
I am interested in DaveD’s question …(#37)…having the same problem with other positions. Perhaps you could devote an entire column to the topic.
The best,
Barry
39 admin // Feb 6, 2010 at 9:27 am
Dave and Barry,
I will add a section to this weekends journal artcle (putting the finishing touches on it today)to address this issue and write a more complete article in the near future.
Alan
40 Don B // Feb 6, 2010 at 10:04 am
Alan –
Re post#37 and 38, and your response, FWIW, I experienced that situation heavily last year with Calls on DXD. (It is double inverse the DOW). Seemed to be a good system at the time, but eventually I simply lost heavily – the worst loss I ever experienced. I called it “chasing it down” – and were I able to do it again I would simply take my lumps earlier, and would probably be smaller. Of course being double-inverse is heavy leverage, so I will never use an Ultra or an Ultra short ETF again – too agressive – this is a separate matter. Will look fwd to your commentary.
Don B
41 admin // Feb 6, 2010 at 11:56 am
Don,
Amen to avoiding leveraged ETFs. Great advice for our conservative readers.
Alan
42 Eric R. // Feb 6, 2010 at 12:08 pm
All –
I’d like to chime in here because this is an interesting discussion. I also have a couple positions that are way below my cost and I’ve tried to roll-down to bring in more premium, but it seems like I keep getting further and further behind. I feel like this is a great learning experience for all with the recent downturn. Someone mentioned in an earlier post that if you do not take action on your positions in a market like this it can wipe out a years worth of profits which was a great point and obviously if we do not learn from history we are doomed to repeat it. For me I know a few things I am going to add into my trading regimen are:
1. Using IBD Big Picture more religiously – Dave D had a great point in post 2 about using the IBD big picture to determine if we should hang on to our positions or sell. This can also guide us to ITM or OTM money strikes for our options. After we get into a confirmed uptrend such as in March 2009 OTM strikes might be preferable. As we hit 3 – 4 distribution days then switch to ITM strikes. Keep in mind that in addition to intrinsic value ITM strikes will have a higher delta than OTM strikes so they will lose money quicker. This allows you more ability to sell your option for some kind of return and you can then decide to sell or try to hit the double.
2. Set up a trading plan before I enter the trade – I have multiple positions in many accounts I am trading and it can be a real struggle to analyze things on the fly while the market is moving. The questions enter my mind – should I buy back my option, has the stock broken support, what is the volume telling me. I know I would have benefitted from a trading plan that was thought out before I entered the trade. It could state things such as support/resistance points, stop-loss levels, when to buy back the option or look to unwind my trade. Obviously this may change midway through the option contract, but at least I have something I can refer to in the heat of the moment.
Just my two cents FWIW. Looking forward to your article discussion on this topic Alan.
Thanks all for your input
Eric
43 Donna Doran // Feb 14, 2010 at 12:07 pm
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44 The Ellman Calculator- Single Tab: Selecting the Best Strike Price // Jul 3, 2010 at 2:42 pm
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