Now let’s bring this information into our world of covered call writing. We sell call options which implies that someone is buying them (we’re the “casino” …they’re the players). Let’s say we buy a stock for $69 and sell the $70 call. The holder of that call option bought the call with the strike $1 higher than the market value of the stock. If a $1 cash dividend is distributed prior to expiration causing the stock price to be adjusted down by $1 his position would be dramatically compromised. To make this situation fair and the option buyer “whole” the strike price is decreased by the dividend amount or $1 in this scenario. So a $70 call becomes a $69 call. All other factors being equal, the market value and strike drops an equal amount and so the strike is still $1 from the market value.

Where to get information on special cash dividends

www.cboe.com

www.optionsclearing.com

Real life example

On August 11, 2011, HollyFrontier announced a special, 1-time cash dividend of $1. Here is what that information looked like on the second site listed above:

HFC- Special cash dividend

Here is a chart taken from the CBOE site reflecting the change in the strike prices:

HFC- Change in strike prices

How to calculate our covered call returns

If we bought a stock for $69 and sold the $70 call for $3, our initial calculation would be:

ROO= $3/$69 = 4.3%

When we receive a cash dividend of $1, in essence our cost basis is reduced by $1 or $69 becomes $68:

ROO = $3/$68 = 4.4%

Our long stock position is decreased by $1 and that is why I don’t like to calculate the extra $1 as additional option premium. It would skew the results and not account for the reduced share value:

$4/$69 = 5.8%

These calculations are NOT for tax purposes. They are used to assess the best covered call decisions at that specific point in time.

Strike prices if the dividend were not an even number

The OCC Security Committee evaluates each situation on a case-by-case basis but generally speaking if a dividend if greater than 12 1/2 cents the strike price can be adjusted by the amount of the dividend. If HFC had declared a 1-time cash dividend of $1.25, the $70 strike would become $68.75. As new series of options are published, the standard strike prices will return.

Special dividends in the form of shares instead of cash

Once again contract adjustments are done on a case-by-case basis but generally speaking if a 5% stock dividend was declared on a $30 stock:

• Share value is determined by the following equation: $30/1.05 = $28.57
• The new strike price will be $28.57
• Each contract will now deliver 105 shares instead of the original 100

Conclusion

Special cash dividends will frequently impact our strike prices due to the decrease in share value after the distribution. Because these are handled on a case-by-case basis it is important to understand how your position has changed due to the unexpected cash or stock distribution. The websites I referenced above are great resources for locating this information as are specialists who work at your brokerage.

My 4th book:

Editing has been completed and just needs my final approval. This is a general stock and mutual fund investment book geared to high school and college age students. It is the book I’ve always wanted to write. I anticipate publication this summer and I will make the book available to our members at an early discounted price before it is available on Amazon.com.

My next live seminar:

Despite my plans to take the summer off from live events, I did accept an invitation from The Money Show to host two presentations at one of their great events, The San Francisco Money Show Expo on August 16th:

http://www.moneyshow.com/tradeshow/san_francisco/moneyshow/speakers/speaker_details/?speakerid=891071A

Money Show interview:

I was interviewed several times at the recent Las Vegas Money Show Stock Traders Expo. Here is a link to one of those interviews:

http://www.moneyshow.com/video/video.asp?wid=9305&t=3&scode=031070

Market tone:

It’s been a challenging few weeks as the VIX (CBOE Volatility Index) has moved between 12 and 17 but remained under the 20 level during this time frame. It was a lean week for economic reports:

• Retail sales (a report of the dollar value of sales of a broad range of goods, from cars and gasoline to furniture, food services, and clothing. Retail sales are a major indicator of consumer spending trends, accounting for a substantial portion of total consumer spending and aggregate economic activity) rose by 0.6%, more than the 0.4% expected mainly due to a strong demand for cars
• Producer prices increased by 0.5% in May, more than the 0.1% anticipated due to an increase in gas and food prices
• The Producer Price Index or PPI (a measure of the average change over time in the selling prices of a fixed basket of goods by stage of production, industry, and commodity. It is considered a leading indicator for consumer inflation. The “core” PPI excludes food and energy prices—which account for roughly one-quarter of the broad PPI and tend to fluctuate widely—providing a truer reflection of inflationary trends) saw a rise of 0.1%
• Industrial production ( a measure of the changes in quantity of physical materials and items produced in the manufacturing, mining, and utilities industries) was unchanged in May
• Business inventories rose by 0.3% in April as analysts predicted
• Initial jobless claims for the week ending June 8th came in at 334,000, below the 345,000 expected
• Low market volume muted cause for excessive concern

For the week, the S&P 500 declined by 0.1% for a year-to-date return of 16%, including dividends.

Summary:

IBD: Confirmed uptrend

BCI: Cautiously bullish using an equal number of in-the-money and out-of-the-money strikes

My best to all,

Alan (alan@thebluecollarinvestor.com)

www.thebluecollarinvestor.com

__________________________________________________________________________________________________

In 2011,  a BCI member sent me an email describing a series of trades he made with GMCR. After responding to his inquiries I realized that there was a great learning lesson here that could benefit many others as well. With his permission I presented the key parts of his email. The example is such a valuable tool that I decided to re-publish it as a review to all our members:

_______________________________________________________________________________

Hi Alan,

I have a few questions regarding the Ellman Calculator.  Let me give you a recent trade as an example first.  On 6/01/2011, I bought 100 shares of GMCR at $80.24 and sold 1 GMCR Jun11 80 Call at $2.90.  A week later the price had dropped and I was able to buy back the Jun11 80 Call at $0.27 and sell a Jul11 77.50 Call at $2.77. By the first week of July the price had shot up in the high $80s and I wanted to participate in the gain, so I bought back the Jul11 77.50 call for $14.60 and sold a Jul11 92.50 Call at $1.95. The July 92.50 call expired with the price around $91.00.  I then sold an Aug11 95 Call at $4.25 on 7/19/2011.  On 7/28/2011, GMCR shot up over 18%, so I bought back the Aug11 95 Call at $11.50 and sold 100 shares of GMCR at $106.06.

Here’s the trade in table form:

• 6-1-11: Buy 100 x GMCR @ $80.24
• 6-2-11: Sell 1 x June $80 call @ $2.90
• 6-10-11: B-T-C 1 x June $80 call @ $0.27
• 6-10-11: S-T-O 1 x July $77.50 call @ $2.77
• 7-6-11: B-T-C 1 x July $77.50 call @ $14.60
• 7-6-11: S-T-O 1 July $92.50 call @ 1.95
• 7-15-11: July $92.50 call expires worthless; stock value $91
• 7-19-11: Sell 1 x August $95 call @ $4.25
• 7-28-11: B-T-C 1 x August $95 call @ $11.50
• 7-28-11: Sell 100 x GMCR @ $106.06

_______________________________________________________________________________

For someone new to covered call writing this investor has many of the principles of this strategy mastered. He also has the motivation and determination to put them to use. VERY IMPRESSIVE! For all of us (including me), the learning process never stops and there oftentimes are ways to enhance our bottom line returns. So let’s sit back, relax and evaluate the various stages of these trades:

6-1-11: Buy 100 x GMCR @ $80.24 and

6-2-11: Sell 1 x June $80 call @ $2.90

Initial profit is $2.90 – $0.24/$80.24 – $0.24 = 3.3%. Here we deduct the intrinsic value of the premium and divide it by the initial cost minus the intrinsic value. Good job!

6-10-11: B-T-C 1 x June $80 call @ $0.27

Buy back the option @ $0.27 which meets our 10% guideline. Nice work!

6-10-11: S-T-O 1 x July $77.50 call @ $2.77

You rolled down (to the $77.50 call) and out (to the July call), a strategy I never use. You are assuming more obligation on a declining equity (we did not know at that time it would appreciate the way it did but you shut the door on benefiting if it did). Since you were early in the June contract, consider waiting to hit a double you would have! (See pages 259-261 of Encyclopedia for Covered Call Writing). If the share price does not rebound, consider rolling down in the same month or closing the position if the stock continues to decline. Before the lower strike was sold your cost basis is $80. When you buy-to-close (BTC) @ .27 and sell-to-open (STO) @ $2.77 there is a net credit of $2.50. Since the $77.50 call is 2.50 in-the-money, the ROO is 0. Again, I never roll out and down. At this point in time, your cost basis (for purposes of making the best investment decisions, not for tax purposes) is $77.50. You made no money and lost no money on the last trade.

7-6-11: BTC 1 x July $77.50 call @ $14.60

Here you rolled up in the same month also a strategy I rarely use  for fear of a decline due to profit-taking (after a stock price has risen sharply in a short period of time) and it usually does not put a lot of cash in our pockets. The net debit is (-) 12.65 and the unrealized credit is the current market value – 77.50, probably a wash, again a no-profit trade (but a great learning experience…I’ve been there!). Take a look at this link for the  mid-contract unwind, a strategy I developed after I wrote Exit Strategies….This may have been a better approach. It is used when a strike moves DEEP in-the-money and the time value of the premium approaches zero.

7-15-11: July $92.50 call expires worthless; stock value $91

As we move to the next month make sure the stock still meets our system criteria INCLUDING NO EARNINGS REPORT …uh oh).

7-19-11: Sell 1 x August $95 call @ $4.25

Now for my most important comment: You sold the August 95 call with an upcoming 7-28 earnings report. Avoid doing this at all costs. Either sell the stock prior to the 28^th or own the stock through the report but do not cap it by selling the call. This way you can participate if the report is positive (evidently it was). After the report and the price settles, feel free to sell the call if the stock meets your requirements. You could have sold the stock for $106 without paying the $11.50 to buy back an option you probably won’t sell in the future.

7-28-11: B-T-C 1 x August $95 call @ $11.50 and

Sell 100 x GMCR @ $106.06:

Ouch, we had to buy back a call we never should have sold. Many years ago when I first started educating myself on this strategy I did this very thing many more times than I care to think about before I made this rule for myself and now share with you: never sell a covered call option on a stock about to report earnings.

I created a chart from June 1st to July 28th, the first and last trades made by this investor highlighting BCI strategies to consider:

Covered call writing trade

Trading GMCR: 6-1-11 to 7-28-11

Note the following:

• The chart shows the June and July expirations
• We initially buy GMCR @ $80.24 and sell the June $80 @ $2.90 for a $266 initial profit (3.3%, 1-month return)
• In June we  BTC the short options position and STO the same $80 strike for (let’s say one third the original premium) for $1 generating another $73 in profit ($1 – $0.27). This is called “hitting a double”. Total profit so far = $266 + $73 = 339 = 4.2%, 1-month return
• The June contracts close right about $80 so we can roll out to the July $80 strike or roll out and up to the July $85. As it turns out the latter would have returned the most but let’s err on the conservative side and say we went with the $80 call and generated another $266 per contract for a final total of $339 + $266 = $605 = 7.6%, 2-month return or 45% annualized.
• When the July contracts expire, the price is well above the $80 strike or even the $85 strike for that matter. We can allow share assignment and move on to another equity or buy back the option at parity (almost all intrinsic value) and await the earnings results.

Conclusion: There are so many ways to enter, manage and close our stock and option positions. By analyzing these different approaches and having a complete understanding of the advantages and disadvantages of each, we will all become better investors and ultimately financially independent.

My grandson just turned  1:

The youngest Blue Collar Investor

Next live seminar:

June 8th: Baltimore, Maryland

http://www.aaii.com/chapters/meeting?mtg=2440&ChapterID=79

New seminar just added:

Phoenix, AZ: April, 2014

Date and venue to follow

***I will not be presenting live seminars over the summer but will get back into the action in September in Philadelphia. I really enjoy meeting our BCI members as I travel throughout the US.

Market tone:

U.S. stock markets hiccupped this week, but still finished the month with healthy gains. The Dow Jones Industrial Average fell 208.96 points or 1.4% to close on Friday at 15,115.57. For the week the index is down 1.2%. The Nasdaq Composite Index dropped 35.38 points or 1% to close at 3,455.91, while notching a 0.1% loss for the week. Meanwhile the benchmark S&P 500 Index fell 23.67 or 1.4% on Friday to close at 1,630.74. For the week the benchmark index lost 1.1%. This week’s reports:

• Real GDP (after-inflation comprehensive scorecard of the country’s economic health. GDP represents the total value of the country’s production and consists of purchases of domestically produced goods and services by individuals, businesses, foreigners, and the government) grew at an annual rate of 2.4% for the 1st quarter compared to 0.4% in the 4th quarter, according to the Commerce Department. This was slightly below expectations mainly due to a decline in government spending
• Personal income (a report of the income that households receive from all sources, such as wages and salaries, employer contributions to pension plans, rental properties, and
  dividends and interest. It also includes data on personal spending for durable goods (products with an expected life of more than one year) and nondurable goods and services, as well as information on the percentage of their income that households are saving. Since income is the major determinant of spending, the report is an indicator of future consumer spending patterns) was flat in April after a 0.3% increase in March
• The Conference Board’s index of consumer confidence jumped to 76.2 in May from 69.0 in April, the highest reading since February, 2008 and its second straight monthly increase. This was well ahead of analyst’s expectations and most likely related to a healthier outlook for the labor market and the economy in general
• The S&P/Case-Shiller Home Price Indicies, the leading measure of US home prices, posted double-digit gains for all 3 of its indexes for the 12 months ending March 31st. All 20 cities showed advances with Phoenix, San Francisco and Las Vegas being the strongest while NY, Cleveland and Boston being the weakest but still showing gains
•  Initial jobless claims for the week ending May 25th came in @ 354,000, slightly higher than the 340,000 expected

For the week, the S&P 500 fell by 1.4% for a year-to-date return of 15.5%, including dividends.

Summary:

IBD: Uptrend under pressure

BCI: Moderately bullish, favoring out-of-the-money strikes

My best to all,

Alan (alan@thebluecollarinvestor.com)

www.thebluecollarinvestor.com

Covered call trade with SODA

Our member generated a nice 1-month return with downside protection of that profit. However, on expiration Friday the price of the stock has accelerated all the way up to $65.16 and the $50 call was very deep in-the-money. The question is “to roll or not to roll” let’s look at the options chain on this expiration Friday (May 17, 2013):

SODA options chain

To buy back the $50 call (BTC) will cost $15.30. Let’s look at the trade if we roll out to the June $50 call:

Rolling out generates no option profit

What if we roll out and up to the $60, $62.50 or $65 strike choices? These scenarios will normally result in a net debit on the options side, but a net credit on the share price side as our $50 obligation to sell is eliminated and share value is enhanced to the new strike or current market value whichever is lower. Let’s look at the trade if we rolled out and up to the $62.50 strike:

SODA: rolling out and up-

The trade results in the following scenario:

We are guaranteed a 1-month return of 4.2% as long as share value does not depreciate by more than 4.1% by expiration Friday because we rolled out and up to an in-the-money strike. In my books and DVDs I give examples of rolling out an up to at-the-money and out-of-the-money strikes as well.

Conclusion:

When a stock price moves up dramatically it usually does NOT pay to roll out as the option credit is negligible or non-existent. Rolling out-and-up may make sense because appreciation of current share value may surpass the option debit.

Next live seminar:

Thursday May 23rd Plainview, NY:

http://www.thebluecollarinvestor.com/event/long-island-stock-traders-meetup/

***A special thanks to BCI members who attended my presentation in Las Vegas for The Money Show. I can’t tell you how great a speaker feels when you’re given a double room and there is still standing room only.

Market tone:

This week’s economic reports put economists at ease regarding the fact that inflation does NOT appear to be rearing its ugly head:

• According to the Labor Department, the Consumer Price Index (CPI-A widely followed indicator of inflation. The CPI is a measure of the average
  change over time in the prices paid by urban consumers for a fixed market basket of consumer goods and services. The “core” CPI excludes food and energy prices, which account for roughly one-quarter of the broad CPI and tend to fluctuate widely, providing a truer reflection of inflationary trends) declined by 0.4% compared to the previous month. A decline of 0.2% was expected
• Core CPI was up 0.1% half the amount anticipated
• The Producer Price Index (PPI) declined by 0.7% in April more than the 0.5% projected
• Core PPI was up 0.1% in April, half the amount anticipated
• Housing starts in April dropped by 16.5%
• Single and multi-family housing starts in April rose by 13.1% compared to a year earlier
• Building permits form privately-owned homes rose 14.3% in April compared to March and up 35.8% compared to April, 2012
• The Conference Board’s index of economic indicators rose by 0.6% in April following a 0.2% decrease in March
• Business inventories were flat in March while economists were expecting a 0.3% increase
• Industrial production fell 0.5% in April more than then 0.2% decline economists were anticipating
• Initial jobless claims for the week ending May 11th came in at 360,000 more than the 330,000 projected
• April retail sales rose by 0.1% much better than the 0.3% decline economists had projected

For the week, the S&P 500 rose by 2% for a year-to-date return of 18%, including dividends.

Summary:

IBD: Confirmed uptrend

BCI: Moderately bullish favoring out-of-the-money strikes 2-to-1

Wishing you the best in investing,

Alan (alan@thebluecollarinvestor.com)

www.thebluecollarinvestor.com

The strategy:

• Buy a high-dividend yield stock
• Sell a long term (LEAPS- more than 9 months) deep in-the-money call option to reduce cost basis
• Increase the dividend yield and create downside protection

Stock requirements:

• Must be a candidate for a long-term holding
• Must have options
• Must have LEAPS
• Must provide a dividend yield that meets our goals. Many stocks on our premium report will have not have dividends or yields high enough for this strategy. We must therefore use stocks that require less stringent screening procedures. Since we have huge downside protection with deep in-the-money calls our risk is still limited.

Once we have located a stock that has met our requirements, we must look for the dividend and yield information. A good FREE site for this is:

www.finance.yahoo.com

Past example: Dividends and yields

For GSK the dividend is $2.03 per year and a yield of 5.3% based on current market price of $38.07. Dividend yield information for stocks passing the BCI screens can be accessed from the premium report:

Dividend yield and the Premium report

The column highlighted in green shows dividend yield for a running list in a premium report. As stated above, there will NOT be many stocks from this list that would be great candidates for this strategy. A list of outstanding candidates for this strategy is provided to our premium members and will be discussed later in this article.

Once we have decided on an equity we need to access an options chain and check the premiums for long-term deep in-the-money calls:

Options chain for deep I-T-M calls

This example was archived from February, 2011 and the January 2012 $25 call option is highlighted. We can generate $12.90 per share or $1290 per contract by selling this option.

Calculations before covered call writing:

$2.03/$38.07 = 5.3%

Calculations after covered call writing:

By generating $12.90 per share we are reducing our cost basis to $25.17. Our new equation is:

$2.03/$25.17 = 8.07% (slightly lower if the option is exercised and we sell for $25. Our plan, however, is to continually roll the option to later expiration dates).

Increase in returns:

8.07% – 5.3% = 2.77%

2.77%/ 5.3% = 52% increase

Advantages of this strategy:

• Superior yields (+2.77% or 52%)
• Downside protection (from $38.07 to $25.17)
• Immediate cash flow + dividends
• You know maximum profit and breakeven
• Can implement exit strategies if needed
• Deep I-T-M strikes have high deltas. If we want to close our position it will be less costly to do so because option value will decline dollar-for-dollar with the stock price decline
• Less time required to monitor positions

Disadvantages of this strategy:

• No upside potential if price accelerates
• You can lose money if the stock drops more than the premium and dividends collected
• May be taxed at the unqualified rate. Check with your tax advisor
• Assignment risk because of deep I-T-M calls
• Must own securities through earnings reports
• Lower yields than selling 1-month options
• If the time value of the option is less than the dividend, your option may be exercised prior to the ex-dividend date and the shares sold. In this case you will not lose any money but you will not generate any additional income from this position. The cash will then be used to enter a new position. Let’s explore the possibility of early assignment in more detail:

Early Exercise of Calls for Dividends 

When is it likely that the option holder will exercise the call option (we sold) early to capture a dividend? This is the primary risk with this strategy. First let’s recall the equation for the value of a call option:

Call value = intrinsic value + time value 

This can be redefined as follows:

Call value = intrinsic value + interest rate value + volatility value – dividend value 

Considerations just prior to the ex-dividend date: 

Let’s assume a stock is trading @ $50 and will go ex-dividend by $2 the next day. There is a $40 call about to expire in 10 days. The $40 call has a theoretical value of $10 and a delta of 1. Therefore, the stock and the option have similar characteristics. Here are the three choices as the option holder:

1- Hold the option and take no action: The stock will open $2 lower because of the dividend deduction. The option will open @ $8 since the delta is 1 and this is the new parity price. This approach will guarantee a loss of $2, not really a good choice.

2- Exercise the option: We will buy the stock for $40, then lose $2 when the stock goes ex-dividend but also receive the dividend because of our share ownership. This is clearly better than choice 1 as we break even rather than lose $2. This is why sophisticated option holders will exercise prior to the ex-dividend date.

3- Sell the option and buy the stock: If the option is trading at parity (equal to the intrinsic value) this is the same as choice #2. If the option is trading for more than parity, let’s say $10.25, the option holder will generate an additional $0.25 per share making the third choice the best one.

Conditions for early exercise: 

1- The option must be trading at parity: If the option is trading at more than parity, the holder should sell the option and purchase the stock at market. Most deep-in-the-money calls will be trading at parity near expiration Friday.

2- The option must have a delta close to 1: This will ensure that the option and the stock have the same characteristics so that the holder is not losing out on any time value. In our example, if the call holder feels that there is a chance that the stock value can drop below $40 prior to expiration he would prefer to hold the call as the potential loss would be limited to the call premium. Holding a long underlying (the stock), on the other hand, can result in a much greater potential loss. If there is a delta close to 1, there is almost no market expectation of the stock going through the exercise price. Here is a breakdown of parameters to consider:

• A delta of 1 will almost definitely be exercised 
• A delta above .95 has a high probability of exercise 
• A delta below .95 is unlikely to be exercised.

3- Volatility considerations: Options in low-volatility markets are exercised more frequently than those in high-volatility markets.

4- Time to expiration considerations: With all other factors being equal, the delta will rise as we approach the expiration date. This will increase the chance of early exercise. Those selling deep-in-the-money LEAPS to increase dividend yield may want to roll the call option as the delta approaches .95.

Strategy objective:

Try to sell an option that will bring the cost basis down to as close to the strike price as possible. For example if a stock trades at $38 and you can sell the $25 call for $13, we have an ideal scenario.

Stocks to consider (as of May, 2013):

Here are a few stocks that have dividend yields between 4% – 8% and also trade more than 250,000 shares per day. They also have LEAPS options associated with them:

• AZN
• CPNO
• DUK
• VZ

Premium dividend yield stock list (produced quarterly):

As a result of the tremendous interest our membership has expressed in this strategy I have asked our BCI team to screen our huge database of stocks to locate outstanding candidates for this strategy. We are using stocks with LEAPS that trade 250,000 shares per day or more, have a dividend yield of 4% – 8%, priced lower than $200/share and a RS rating of 50% or higher. This list will be updated quarterly and can be found in the “resources/downloads” section of your premium site. Look for the file titled High dividend yield stocks. Also check the “resources/downloads” section of the premium site where we have archived an expanded version of this article which also explains how to monitor the stocks on the premium dividend yield stock list. This file is titled High Dividend Yield Strategy.

Conclusion:

Selling deep in-the-money call options will enhance the dividend yield and provide downside protection. Our risk of early assignment can be mitigated by monitoring the delta of the option and rolling out should the delta reach or exceed .95. Please note that this is not a strategy I use myself but one which I researched and wrote about in response to the interest of many of our members. It is a strategy most appropriate for ultra-conservative investors.

New seminars (just added):

Delray, Florida: March 18, 2014

Fort Lauderdale, Florida: March 19, 2014

May seminars:

Las Vegas: May 14th

http://www.thebluecollarinvestor.com/event/las-vegas-moneyshow-at-caesars-palace/

Plainview, NY: May 23rd:

http://www.meetup.com/LISTMG/events/70350492/

Market tone:

A positive jobs report boosted a week of mixed economic signals:

• 165,000 jobs were added in March (150,000 expected) causing the unemployment rate to drop to 7.5%, a 4-year low
• January and February jobs stats were revised upward, adding an additional 114,000 jobs
• The Conference Board’s index of consumer confidence (gauge of consumers’ attitudes about the present economic situation as well as their expectations regarding future conditions. Consumer confidence tends to have a strong correlation with consumer spending patterns) rebounded to 68.1 well above the 60.8 anticipated
• Personal spending rose by 0.2% in March above the 0.1% expected
• Personal income rose by 0.2% in March less than the 0.4% expected
• Nonfarm business productivity ( measure of the growth of labor efficiency in producing the economy’s goods and services) rose by 0.7% in the first quarter, less than the 1.5% anticipated
• The trade balance narrowed to $38.8 billion, much better than expected
• Construction spending dropped by 1.7% in March perhaps a reflection of the “sequester” squeezing state and local government spending
• The ISM manufacturing index fell to 50.7, below expectations
• The ISM service-sector survey also dipped below expectations

For the week, the S&P 500 rose by 1.1% for a year-to-date return of 14%, including dividends.

Summary:

IBD: Confirmed uptrend

BCI: Cautiously bullish selling an equal number of in-the-money and out-of-the-money strikes

Wishing you the best in investing,

Alan (alan@thebluecollarinvestor.com)

www.thebluecollarinvestor.com

LEAPS- Long-Term Equity Anticipation Securities. These are option contracts with expiration dates longer than one year. Not all stocks and ETFs have these type of options associated with them.

Calendar Spread-  Simultaneously establishing  long and short options positions on the same underlying stock with different expiration dates. For example, you buy the December, 2010 $20 call and sell the April, 2010 $20 call on the same equity.

Horizontal Spread- A  spread where both options have the same strike price as in the above example but different expiration dates. The terms calendar and horizontal spreads are interchangeable.

Diagonal Spread- A long and short options position with different expirations AND strikes. For example, you buy the December $20, 2010 call and sell the April, 2010 $25 call.

Concept behind this strategy:

The investor establishes the long option position by purchasing (usually) I-T-M LEAPS and then selling a near-term, slightly O-T-M call, the short position. Trades are constructed such that, if assigned, the difference between the spread ($5 in the above case where the $20 call was bought and the $25 call was sold) + the short premium collected, exceeds the cost of the long option. If unassigned, where the price of the stock does not exceed the strike price of the short call, we then continue to write calls and generate a monthly cash flow. The problem in this second scenario is that if the stock price falls, the premiums generated from the short call drops unless we write for a lower strike, which may result in a loss for this long-term strategy as the spread (difference between the two strikes) declines.

Let’s take a look at the options chain for a highly traded equity, INTC:

INTC currently priced @ $20.43

LEAPS for covered call writing

INTC- Deep I-T-M Calls

The January, 2012 $10 strike is purchased for $10.60, $10.43 of which is intrinsic value and only $0.17 is time value. Minimal time value is a characteristic of deep I-T-M LEAPS options.

Next let’s check the near-term, slightly O-T-M strikes:

INTC- Near-Term, O-T-M Options

The next month, $21, slightly O-T-M strike can be sold for $0.43.

Let’s do the math, if assigned:

We collect the difference in the spread ($21 – $10 = $11) + the short option premium = $0.43 for a total of $11.43. We deduct the cost of the long call ($10.60) for a profit of $0.83 per share or $83 per contract. The percentage return is $83/$1060 or 7.8%. All calendar spreads are constructed such that there is a profit if assigned.

If the shares are not assigned (price of stock NOT greater than the strike of the short call ($21), our profit is $43/$1060 = 4.1% and we’re free to sell another option. As noted above, this works well as long as the share price does not dramatically decline thereby reducing the returns on the short options. We also must bear in mind that the long call (LEAPS) is a decaying asset and there will become a time when we no longer own the right to purchase INTC at the $10 strike (when the option period expires). If we continue to generate monthly returns of $43, how long will it take us to retrieve the $1060, if never assigned? Here’s the math:

$1060/$43 = 24 months, not counting any difference in the spread.

Our option is good for about 22 months, so if the option ultimately expires worthless and the spread has decreased, we lose! Diagonal spreads work best for rising stocks where we can take advantage of the difference in the original strike prices.

Advantages of using LEAPS:

• Less costly than purchasing stock; remaining cash can be used to generate additional cash
• A declining stock will have time to recover
• Low time value of deep I-T-M LEAPS make option ownership similar to stock ownership where intrinsic value changes dollar-for-dollar.

Disadvantages of using LEAPS:

•  You do NOT capture stock dividends
• To stay active, you must sell options in cycles that report earnings, taking on additional risk
• LEAPS have a delta of approximately .50 to .60 making it difficult to close a position at a profit for A-T-M and O-T-M strikes (option value has not moved up in step with share value). This is less of a factor for I-T-M LEAPS.
• A higher level of approval will be required by most brokerages to allow this type of trading
• The long calls will ultimately expire, stocks will not
• Forced assignment may not allow for a profitable trade

Conclusion:

Purchasing LEAPS and selling a call option on that position is NOT a true covered call write. It is an alternate strategy that has its pros and cons. For most Blue Collar Investors, covered call writing is the better path to take. But to some investors who fully understand the nuances of diagonal spreads, this may be a viable alternative.

California seminar:

I’ve been invited to host a presentation for the Los Angeles Chapter of the American Association of Individual Investors.

• Date: Saturday October 19, 2013
• Time: 9AM to 12PM
• Venue: Skirball Center, 2701 N. Sepulueda Blvd

I will post the link to register on this site once the group leadership sends it to me.

My next live seminar will be on Tuesday May 14th @ Caesar’s Palace in Las Vegas:

http://www.thebluecollarinvestor.com/event/las-vegas-moneyshow-at-caesars-palace/

Market tone:

The first quarter, 2013 showed accelerated growth compared to the 4th quarter, 2012 but below expectations. Here is our mixed bag of economic reports that still supports a slowly-recovering economy:

• The annualized growth rate of GDP as reflected in the 1st quarter, 2013 came in @ 2.5%, below the 3.0% expected but well above the annualized 0.4% rate from the 4th quarter, 2012 according to the Commerce Department
• Consumer spending and inventory replenishment accounted for a large portion of the expansion
• Existing home sales declined in march by 0.6% BUT sales are up a whopping 10.3% compared to march, 2012
• Existing home sales have beat year-ago stats for 21 consecutive months and prices have also beat for 13 straight months
• Prices for existing homes rose by 6.4% from February to March with the median price reaching $184,300
• Existing home inventories in March came in @ 4.7 months, 17% below a year ago
• New home sales rose 1.5% in March and are up 18.5% from a year-ago
• The median price of new homes rose 3% to $247,000 in March from $239,800 a year-ago
• Durable goods orders (a measure of the number of orders for a broad range of products—from computers and furniture to autos and defense aircraft—with an expected life of at least three years. Durable-goods orders are a leading indicator of industrial production and capital spending.) fell by 5.7% in March more than the 2.8% decline expected
• Orders for core capital goods (a measure of business investment spending) rose by 0.2% in March
• Initial jobless claims for the week ending 4-20-13 came in @ 339,000 better than the 351,000 anticipated

For the week, the S&P 500 rose by 1.7% for a year-to-date return of 11.6%, including dividends.

 Summary:

IBD: Market in correction

BCI: Cautiously bullish favoring in-the-money strikes 3-to-2

My best to all,

Alan (alan@thebluecollarinvestor.com)

www.thebluecollarinvestor.com

One of our members, Ashwin from India, has been generous enough to share this information with me and now me with you. Ashwin trades Indian stocks on the Indian stock exchange and is a proponent of covered call writing. I found the differences between US and Indian covered call writing fascinating and decided to share this information with you.

Rules for covered call writing in India

• Indian options are 100% cash-settled meaning they can never be exercised (we can never lose the stock)
• If the option ends up in-the-money, the option seller (the covered call writer) must pay the holder in cash. If we sold a $30 call and the price of the stock was $40 at expiration, the seller would have to pay $10 per share to the buyer of the option
• All Indian options are European style as opposed to the American style options we are familiar with. This means that the holder can only receive cash settlement after expiration
• The option contract size of the underlying will vary from stock to stock and not (almost) always be 100 shares. Each year the Indian stock exchange reviews the share prices of all equities traded on the exchange and adjusts the number of shares per contract such that the cost of ownership of the underlying remains affordable. More expensive securities will require less shares per contract. The US exchanges recently addressed this concept with the institution of the “Mini options“
• Because of the cash-settlement requirement, Indian brokerages require investors to set aside 10-20% of the contract size (# shares x stock price) in cash. The amount the brokerage will require depends on the volaility of the underlying, with the most volatile stocks requiring the highest percentages. If the investor has a substantial portfolio, this requirement may be waived as do brokerages in the US

Percentage returns in India

The example Ashwin was kind enough to send me information for Infosys which was trading @ $44.20. The exchange requirement per contract = 125 shares or $5530.00. The near-the-money $44.20 call was generating $1.24. Let’s do the math:

125 x $1.24/ $5530 = 2.8%, 2-week initial return

Let me add this one caveat: INFY has earnings due out prior to expiration so the implied volatility on the option is high but if we extrapolate the returns seem fairly similar to US exchanges and that is also the information provided to me.

Is this a popular strategy in India?

NO!!! Based on feedback Ashwin has received from investors from Indian trading forums the high capital requirements (buying the shares and margin requirement for settlement) discourages many traders.

Advantages (as I see them)

• No one stock will be too expensive to enter a covered call position
• There are no tax concerns relating to selling shares with a low cost basis or impacting holding periods for short versus long-term capital gains
• The covered call writer will never be exercised early causing the holder to capture a dividend instead of the call writer
• A call writer can simply sell a few shares to cover cash settlement and retain the bulk of the shares if so desired
• Options can be rolled to avoid or delay settlement

Disadvantages (as I see them)

• We must be diligent to keep track of the number of underlying securities since this will vary from stock to stock
• Calculations will also require more diligence since the number of underlying varies
• A significant percentage of cash available cannot be put to work since we must make 10-20% available for settlement

Conclusion

Covered call writing is a great strategy for conservative retail investors. Much like baseball, if the rules change, the approach to the strategy must also fluctuate as we have seen in this article. Rules can also change impacting how we approach our investments. It is critical to understand all the parameters that apply so we can take advantage of them and maximize our returns to the highest possible levels.

***Many thanks to Ashwin for sharing this information.

Market forces:

This week we saw several triple digit movements in the markets causing stock prices to move dramatically. This is in line with the belief that over 70% of a stock’s price movement is based on overall market conditions. In the BCI methodology we study the price charts of the S&P 500, the CBOE VIX and weekly economic reports to help craft our covered call writing positions. Below is a price chart for AMGN, one of the stroger equities on our current Premium Stock List. Note how the chart remains strong but has defintely been impacted by the recent market volatility. The chart was taken after market close on Wednesday:

Market forces impacting stock price

Market tone:

In a week of emotional domestic and political events, the economic reports seem almost second nature. However, as news of the second terrorists’ capture is being announced, I present this week’s summary:

• The cost of consumer goods declined by 0.2% in March
• Core CPI (excludes food and energy) was up 1.9% in March. The Fed’s monetary policy appears NOT to be causing inflationary concerns
• Construction of multi-family homes caused housing starts to increase by 7% in March, the highest level since June, 2008
• The number of new building permits fell by 4% in March however home-related spending has added to economic growth for 7 straight quarters
• Industrial output rose by 0.4% in March, the largest monthly increase since early 2007
• The Federal Reserve Beige Book showed that new home construction and auto manufacturing has assisted the US economy to grow moderately through early April
• The Conference Board’s index of leading economic indicators dropped by 0.1% in March, down from an average 0.5% increase over the past 3 months

For the week, the S&P 500 fell by 2.1% for a year-to-date return of 9.7%

Summary:

IBD: Market in correction

BCI: Cautiously bullish favoring in-the-money strikes 3-to-2

With special thoughts to our friends and family in Boston and West, Texas,

Alan and the BCI team (alan@thebluecollarinvestor.com)

www.thebluecollarinvestor.com

• March 18th: Buy FSLR @ $27.25 and sell the April $28 call for a 3.5% initial, 1-month profit
• April 9th: Price of FSLR gaps up to $39 and the $28 call option to $11.10
• The additional share appreciation brings the trade profit to > 6% and is maxed out no matter how high the price goes
• There is an upcoming earnings report prior to the May expiration

Let’s take a look at the price chart of the stock showing the gap up:

FSLR price gaps up

Next, let’s look at the price chart of the April $28 call option demonstrating the corresponding gap up:

FSLR April $28 call option gap up

The question posed to me was which of the following actions should we consider?

• Buy back the $28 call and roll up to a higher strike to benefit from additional share appreciation
• Since the earnings report negates the choice of rolling out, just allow assignment after expiration Friday
• Another choice?

Let’s review these choices:

Rolling up in the same month

I generally don’t take this approach because a stock that has gapped up may decline in price due to profit-taking (which it did as of this writing). In addition, we will be incurring an option net debit and thereby depending on further share appreciation to make this approach profitable. Let’s reject rolling up in the same month.

Allow assignment after expiration Friday

An astute observation by this member to avoid the next month earnings report. This is a viable choice if there is none better. A > 6%, 1-month return with protection all the way down to $28 is not a bad deal!

Another choice (notice how I’m avoiding the word “option”)

You know how I love to squeeze every ounce of profit from our trades and we may be able to do so here. Because of our option obligation, our shares are worth $28, not $39. If we close our short options position and buy back the $28 call for $11.10, our shares are now worth market value or $39. Let’s do the math:

$11.10 debit (buying back the option) + $11 credit (share appreciation from $28 to $39) = net debit of $0.10 = $10 per contract.

Since we no longer have an option obligation we can sell our shares for $3900 per contract and put this cash right to work. If we can institute a NEW covered call position in the last 9 trading days of the April cycle which generates more than $10 or four tenths of 1% then we have successfully instituted an exit strategy and created a second income stream in the SAME month with the SAME cash. I call this the mid-contract unwind exit strategy.

Link to sign up for my April 2oth seminar in Atlanta:

http://www.meetup.com/Atlanta-Option-Investors-Club/events/113533742/

Market tone:

This past week’s economic reports leaned to the negative but the stock market remained strong. The Fed policy makers expressed concern over the impact the sequester may have on our recovery:

• The Producer Price Index (PPI- a measure of the average change over time in the selling prices of a fixed basket of goods by stage of production, industry, and commodity. It is
  considered a leading indicator for consumer inflation. The “core” PPI excludes food and energy prices—which account for roughly one-quarter of the broad PPI and tend to fluctuate widely—providing a truer reflection of inflationary trends) dropped 0.6% in March (-0.1% expected), the largest 1-month drop since May, 2012. A big component of this decline was due to the 6.8% drop in gasoline prices
• Initial jobless claims for the week ending April 6th came in at 346,000, less than the 365,000 projected
• According to the Labor Department retail sales (a report of the dollar value of sales of a broad range of goods, from cars and gasoline to furniture, food services, and clothing. Retail sales are a major indicator of consumer spending trends, accounting for a substantial portion of total consumer spending and aggregate economic activity) in March fell by 0.4% after rising 1% in February
• The minutes from the March 19-21 FOMC meeting revealed that some policy-makers were concerned over the impact the sequester might have on current monetary policy of quantitative easing where the Fed is buying $85 billion a month in US Treasuries and mortgage-backed securities. The concern relates to possible increases in interest rates and inflation
• Business inventories increased by 0.1% in February, less than the 0.4% anticipated

For the week, the S&P 500 rose by 2.3%, for a year-to-date return of 12%, including dividends.

Summary:

IBD: Confirmed uptrend

BCI: Moderately bullish but favoring in-the-money strikes until the impact of the sequester is quantified or resolved.

The entire BCI team thanks you for your amazing support.

My best to all,

Alan (alan@thebluecollarinvestor.com)

www.thebluecollarinvestor.com