Mastering stock and strike price selection are key components in successful covered call writing. There is no one factor that will dictate our choices but rather a mosaic of bits of information which will lead us to the best selections. In this article, I will discuss two of those critical components: technical analysis of the underlying security and overall market assessment. Let’s start with viewing the chart of an elite performer on our Premium Watch List dated 4-4-14 (Continental Res, Inc. or CLR):
At this point, we have an elite performer both fundamentally and technically and one would be leaning to selling one of the bullish out-of-the-money strikes. However, let’s have a look at the chart of the S&P 500 and VIX (CBOE Volatility Index or investor fear gauge) to evaluate our overall market assessment:
S&P 500 versus the VIX
Note that in the past one month, the market volatility has increased significantly (15%) while the value of the S&P 500 has declined by 2.5%. For many investors, this red flag guides us from bullish out-of-the-money strikes to the more conservative in-the-money strikes giving us a bit of a cushion when it comes to capital preservation. Next, let’s view the options chain for CLR at the time I produced the above screenshots:
With CLR trading @ $128.02, we will evaluate the in-the-money $125 strike and out-of-the-money $130 and $135 strikes feeding the stats into the multiple tab of the Ellman Calculator:
The out-of-the-money $130 and $135 strikes create the potential for returns of 4.9% and 7.6%, respectively. Neither offers downside protection of the time value. The in-the-money $125 strike generates a nice 3.3%, 5-week return (time value only) with downside protection of 2.4%. This means that we are guaranteed a 3.3%, 5-week return as long as our shares do not depreciate in value by more than 2.4% by expiration. I call this downside protection (very different from breakeven) an insurance policy that is paid for by the option buyer, not by us.
Many factors are considered when selecting underlying securities and strike prices for covered call writing. Taking the most bullish positions (out-of-the-money strikes) are most appropriate when both chart technicals are bullish and confirming as well as overall market assessment also bullish. If either component is compromised, selling in-the-money strikes will afford us downside protection and provide a cushion for capital preservation.
Next live seminar:
Saturday, June 14th
8:30 – 11 AM
Costa Mesa, California (Orange County)
BCI members who will be attending may want to get to the venue a bit early. I’m told by the chapter President that they are expecting a much larger attendance than normal based on the number of recent inquiries from non-chapter members.
As some “talking heads” continue to forecast doom and gloom the economic reports continue to retort: “But what about this?”
- Total construction spending increased by 0.2% in April, below the 0.6% expected, and advanced for the 3rd straight month
- Construction spending is 8.6% above stats from a year ago
- The US trade deficit widened to $47.2 billion in April from $44.2 billion in March, the largest margin since July, 2012. The silver lining was the healthy import statistics
- According to the Federal Reserve Board, the Beige Book report noted expansion in all 12 of its regional districts
- Initial jobless claims for the week ending May 31st came in @ 312,000, below the 318,000 expected by analysts
- According to the Labor department, 217,000 jobs were added in May, meaning that the US Labor Market has now returned to pre-recession levels
- Unemployment remained @ 6.3% and the number of unemployed remained @ 9.8 million
- Compared to a year ago, unemployment is down 1.2% and the number of unemployed decreased by 1.9 million
- The ISM Manufacturing Index increased in May to 55.4 from 54.9 in April. Economists had projected a figure of 55.2
- All but one of the manufacturing industries showed growth in May
- The ISM Non-Manufacturing Index (measures service-sector trends) rose to 56.3 in April from 55.2 in March, the 4th straight monthly rise. The index is now at its highest point since August, 2013. Any reading above 50 signals expansion
- Both business activity and new orders indexes reached their highest levels since 2011, as 17 of the 18 nonmanufacturing industries showed growth (only the mining industry contracted)
- According to the Labor Department, nonfarm business productivity fell by 3.2% in the 1st quarter, worse than the decline of 1.0% expected. Severe weather conditions in January and February was largely responsible. Compared to a year ago, productivity is actually up 1%
- According to the Commerce Department new orders for manufactured goods rose by 0.7% in April, the 3rd straight monthly gain and well ahead of the 0.2% predicted by economists. March’s stats was revised higher by 1.5%
For the week, the S&P 500 rose by 1.3%, for a year-to-date return of 6.4%, including dividends.
IBD: Confirmed uptrend
BCI: Moderately bullish favoring out-of-the-money strikes 2-to-1.
Wishing our members much success,