As covered call writers, we have all looked at options chains. That’s where we determine how much cash will be generated into our accounts when we sell our options. It’s fun! We first inspect the current price of the underlying security (stock or ETF). Then we check out the closest strike prices (I-T-M, A-T-M and O-T-M) and take note of the bid and ask prices. For I-T-M strikes, we will also look at the amount of intrinsic value that the option premium consists of. If we are interested in a particular option, we will make note of the option symbol, usually found to the left. Let’s look at a typical options chain for a stock (MELI – figure below) an equity that was in my portfolio at one time (note the original option symbology):
Current market price: $48.59
I have highlighted two columns that tend to be overlooked, Vol(ume) and Open Interest. Although many investors assume these stats are similar, they are, in fact, quite different. The purpose of this segment is to discuss that distinction and the significance of each figure.
This is a measure of the number of transactions that transpired for a particular options contract for that day. It signifies how many times a day a particular contract has been bought or sold. The higher the volume, the greater the liquidity. A contract with zero volume should NOT be considered illiquid because it takes time to build up volume during the day. Also, an exchange specialist or market maker will step in to take the other side of the transaction. On the above options chain, the volume for the O-T-M $50 call is 202 contracts bought or sold thus far that day.
This is the number of option contracts that are open or outstanding on a particular day. This number is cumulative. Options with large open interest have a secondary market of buyers and sellers. This will allow that option to be traded at a reasonable bid-ask spread. The open interest for the $50 strike on the above chart is 2282 contracts.
The Mathematics of open Interest:
There are four types of options trades that can be executed (see the chart below):
Two will increase open interest and two will decrease it:
Buy to Open (BTO)- Increases open interest by creating a new long position
- Sell to Open (STO)- Increases open interest by creating a new short position
- Buy to Close (BTC)- Decreases open interest by closing an existing short position
- Sell to Close (STC)- Decreases open interest by closing an existing long position
Trading Activity and Open Interest:
|TRADING ACTIVITY||CURRENT OPEN INTEREST||VOLUME|
|Trader A: B-T-O 6 contracts||6||6|
|Trader B: B-T-C 2 contracts||4||8|
|Trader C: S-T-O 8 contracts||12||16|
|Trader D: S-T-C 3 contracts||9||19|
Mathematics of open interest
As you can see, open interest is not the same as volume. With volume, both entries and exits cause volume to increase but in the case of open interest, entries will cause an increase and exits a decrease in open interest. Open interest is generally a higher number than Volume because it is cumulative whereas volume is reset to zero at the beginning of each trading day.
Significance of Open Interest:
Increasing open interest shows strength in the current price movement of an option in much the same way as a volume spike will enhance the significance of a change in a technical indicator like the MACD. Decreasing open interest shows a weakening of the current price movement. If the price is increasing on increasing open interest, the likelihood of continued price increases is greater. If open interest starts decreasing, that upward price movement is starting to weaken. Also, as mentioned earlier in this chapter, the greater the open interest, the more favorable the bid-ask spread is likely to be. Open interest of 100 contracts or less is thought to have relatively thin liquidity. I like to see an OI of at least 100 contracts and/or a reasonable bid-ask spread ($.30 or less). Keep in mind that a bid-ask spread of greater than $.10 can oftentimes be negotiated down by “playing the bid-ask spread”.
One time cash dividends and adjusted strike prices: From time to time, we will notice options chains with oddball (non-standard) strike prices resulting from one-time cash dividend distribution. For a strike price to be changed as a result of a dividend two criteria must be met:
- It must be a one-time only distribution
- The dividend must be for more than 12 1/2 cents.
Last year, GES declared such a dividend, this one for $2. It went ex-dividend on December 6th and that is when we saw the option strike prices reflect this dividend. Here is a chart showing the strikes before and after:
GES- Strike price adjustments
A free site where you can access information on contract adjustments is:
LAST CHANCE TO SAVE $100:
The introductory pricing for our new DVD Program with Companion Workbook ends June 30th. The current special price of $295 returns to the original $395 and the package of the DVD Program with our latest book (“Encyclopedia…”) returns to $419 from the current discounted price of $319. We are proud to provide our members with the most comprehensive amount of information on the subject of covered call writing for the lowest prices. Premium members be sure to enter the Blue Collar Store from your premium site to benefit from your 10% discount. Here is a link to an informational video:
1- This coming Tuesday June 12th: I will be the keynote speaker for the New York City Private Investors Group at the ING Direct Cafe:
To sign up (seating is limited):
Time: 6PM to 7:30 PM
Admission is FREE and non-members are welcome.
2- September, 2012- Las Vegas: I’ve been invited to speak at an options trading event at the Paris Hotel in Las Vegas. Details to follow.
3- Financial Survival Network Radio Interview: On Friday, I was interviewed by Kerry Lutz of The Financial Survival Network about using covered call writing in a volatile and bearish market environment:
This week’s reports were mixed but the market reacted positively:
- The US trade deficit declined to $50.1 billion but concerns over China’s handling of the impact of the European crisis remains a major concern
- The Beige Book showed modest expansion between early April and late May with continued strength in the manufacturing sector
- Nonfarm business productivity fell in the 1st quarter by 0.9% more than the 0.6% expected
- Consumer credit grew by $6.5 billion in April for the 8th straight month, but less than the $13.2 billion anticipated
- Growth in the service sector grew to 53.7 in May but less than the 53.9 expected
- Factory orders fell by 0.6% in April while a positive figure of + 0.4% was predicted
For the week, the S&P 500 rose by 3.7% for a year-to-date return of 6.4%, including dividends.
The past 3 months have been challenging for investors but June is off to a positive start:
IBD: Market in correction
BCI: Cautiously bullish on the US economy but hedging our covered call positions with low-beta securities and selling in-the-money strikes. ETFs are also considered good underlying choices in this environment.
My best to all,