A few years ago I read an article authored by an options broker working for one of the larger brokerage houses. He did a study of the returns gleaned from covered call writing versus those from stock index funds. An index fund is a mutual fund that mirrors a particular segment of the market. For example, the Vanguard 0040 fund mirrors the S&P 500. In his investigation, he sold only out-of-the-money (O-T-M) strikes on all the optionable stocks in the S&P 500 over a 1-year period. He compared these results to the returns garnered from investing an equal amount of money in an S&P 500 index fund. At the end of the 1-year period, the ROI (returns on investment) were nearly the same. His conclusion was: why sell covered call options when you can get the same returns by investing in a stock index fund.
I remember smiling to myself but also being shocked that an expert would write about and execute such an obviously flawed study. Here are some of the major concepts ignored in his research (or lack thereof):
- There was no stock selection process; poorly performing stocks were allowed to be part of his study….why?
- There were no exit strategies employed. This is a key element to all investment strategies….why not?
- Long term options were sold, requiring that stocks be held through earnings reports. Way too risky. Why take the chance?
- Only O-T-M strikes were sold, a common rookie mistake in selling covered call options. This is what I want to discuss in this weeks article.
Out-Of-The-Money-Strike Prices:
There is a reason why these are popular strikes for many investors. When an option is sold, we generate an option premium that is ours to keep no matter what happens to the stock or whether that option is ultimately exercised. In the case of an O-T-M strike, we have an opportunity to make additional profit on stock appreciation. For example, if we buy 100 x XYZ @ $28 and sell the $30 call, we can generate an additional $200 on the sale of the stock (28 to 30 times 100). When we sell at-the-money or in-the-money strikes, there is NO CHANCE of such additional profits (additional capital can be made via exit strategies but that’s an article for another day). So from a profit perspective, O-T-M strikes are more attractive. Blue Collar Investors love profit but understand that it is only part of the big picture. Not factoring in risk is a major error that many cc sellers make and in my view is what separates the men (women) from the boys (girls).
In-The-Money Strike Prices:
An example would be if we buy a stock for $32 and sell the $30 call. We are obligated to sell our shares for $30 per share. If the equity goes from $32 to $40, we make no additional income due to our obligation to sell @ $30. The option premium we receive from the sale of this option has an intrinsic value of $2 (32 – 30). The remaining option premium is time value and our true profit (ROO). However, the $2 additional premium we receive from this I-T-M strike will give us downside protection. For example, if we sell the $30 call for $3.50, we deduct the $2 of intrinsic value for an option profit of $150 per contract. This represents a 5% return. This profit is fully protected as long as our shares do not decline below $30. This $200 per contract represents a 6.3% downside protection. In other words, we are guaranteed a 5% 1-month return as long as our stock price does not decline by more than 6.3%.
Factors that determine which strike to sell:
1- Your risk tolerance: If you can’t sleep at night when your portfolio value declines, opt for the I-T-M strikes that offer more downside protection. Be sure not to complain if your shares appreciate!
2- Market Tone: In an uptrending and stable market environment, O-T-M strikes make sense to take advantage of share appreciation. In a market like we have had for the past year, I-T-M strikes make more sense.
3- Technical Analysis: The stronger the chart pattern of a stock, the more likely I am to sell an O-T-M strike. This would involve an uptrending ma with all confirming indicators.
Laddering of Strike Prices:
Laddering is an investment technique whereby investors purchase multiple financial products with different maturity dates. For example, when I purchase bonds (boring!!!!), I may buy 1,2,3,4 and 5 year maturations. This will protect me from interest rate risk. I have borrowed this term and applied it to strike prices. Each month, I will try to have a mix of I-T-M, A-T-M and O-T-M strikes. In a favorable market environment, I will lean towards more O-T-M. In a volatile or declining market, more I-T-M strikes. This is just another way of throwing the odds in our favor. It’s not a guarantee but rather a smart sophisticated approach to cc writing that few others even think about, never mind actually employ.
Conclusion:
When determining which is the best strike price to utilize for cc writing we must factor in several parameters. By doing so, we will increase our chances to maximize the profits that this wonderful strategy will provide for us. If someone brazenly confronts you with a statement the cc writing cannot outperform index funds, ask him about technical analysis of great performing stocks; ask him about market tone; ask him about risk tolerance; ask him about laddering of strikes; ask him about exit strategy utilization; ask him about earnings report avoidance. Then watch him walk quietly away!
Market Tone:
Most economists agree that the economic dilemma we find ourselves in today started with the collapse of the housing industry. When building is booming, people are working and spending money, banks are lending and taxes are collected. A turnaround could be initiated by this very same industry. Looking at the chart of the building/construction industry, we see a consolidating chart pattern which is up 50% from its November lows. The MACD and stochastic oscillator are confirming positive as well. For the calendar year 2008, construction spending fell a record 5.1%, the largest decline since 1993 when records began to be published. Here is the (not so bad) chart pattern of the building/construction industry:
Housing/Construction Industry 2-6-09
Last Weeks Economic News:
Unemployment rate rose to 7.6%, a 17-year high. Personal household income dropped 0.2% from November, the third straight monthly decline. New factory orders decreased by 3.9% from November to December, the fifth consecutive monthly decline. The nation awaits approval of the stimilous package to restart the economic growth we so desperately need. For the week, the S&P 500 rose 5.2% for a year-to-date return of – 3.6%.
Updates:
1- As I’ve mentioned in the past, the IBD website enhancement will take place in the near future. I have been in touch with the IBD education and technical departments. The enhanced site will make stock screening quicker, easier while just as accurate. Those of you on my mailing list will receive a FREE package of information as to how to utilize the upgraded site. If you are not on my mailing list you can join by using the following link:
http://www.thebluecollarinvestor.com/joinlist.shtml
2- Thanks to you, it has now been a year that my book, Cashing in on Covered Calls, has been rated # 1 on Amazon.com for the category of covered call writing. I have been receiving dozens of emails every week asking about availability of my upcoming book entitled Exit Strategies for Covered Call Writing . The manuscript is currently with the publisher and I am told that it should be available to the public in 2-3 months. I am at their mercy and will keep you informed as I get more information.
Thanks to one and all for the incredible support you have provided to this Blue Collar Investor,
Alan
One has to remember why options are being purchased. Some buyers are just taking a shot at a 20%, 40% or 100% gain on their “investment” in months, rather than years. I once made $2500% over a weekend. How?
I bought an option on a Thursday for $0.25 per share. On Friday, AFTER the market closed, someone announced they were buying the company and the option opened on Monday morning at $6.25 per share.
Okay, so why is this story so important? That’s a rare example. Well, suppose someone out there sold 10,000 XYZ company shares short at $28 per share. He receive $280,000. What happens if someone announces a takeover at $38? He instantly loses $100,000.
Now suppose he buys a March 30 call for $0.80. He will pay $8,000 for the INSURANCE that the most he can lose is the $2.00 difference in share price, even if the buyout is for $200 per share.
Instead of a buyout announcement, the stock drops to $21. The short seller will make $7 per share, less the $0.80 per share insurance he bought with the option premium.
The moral of the story is that losing money on an option premium is a hopeful outcome for some of the call option buyers out there. You just don’t want to be the person holding the stock that dropped from $28 to $21 and got to keep the $0.80.
Hi Alan – I’m so excited to hear you are writing a book on exit strategies. It will certainly be one that I will add to my collection as soon as it comes out.
Thanks!
Best Performing Industries:
Last week, four industries stood out for me as far as increased stock prices as well as noticeable increases of institutional money moving in. Three have been poor performers of late but potential turnarounds and the other is smoking hot! Here they are with a few stocks that have made us some Blue Collar money in the past:
Potential turnarounds:
METALS: CLF, RIO, BHP, PCU
STEEL: STLD, NUE, SID
COAL: BTU, FSLR
Smoking HOT!:
SCHOOLS: ESI, APOL, DV, APEI
The turnarounds are not ready for purchase in my view, but worthy of a careful eye. The School Industry is one we have been discussing for the past month and has appreciated significantly since that time. It is still performing beautifully but a short-term consolidation (profit taking) is possible.
Alan
LADDERING OF STRIKES AND CALCULATIONS:
The laddering of strikes that I discuss in this article can be utilized with the same stock. Let’s say we have 200 shares of MYGN (one of the few stocks on my watch list that went up in price today). The stock price closed the day @ $86.47. Since we are only 8 trading days from expiration Friday, let’s look at the March expiration. We can sell the I-T-M $85 call or the O-T-M $90 call. Since we have 200 shares, let’s sell one of each, thereby laddering our strikes:
3/85 call:
- Sell 1 x $85 call @ $6
- Option profit (ROO) is $4.53 (6 – 1.47)
- $1.47 intrinsic value buys down the cost of the stock to $85 (see chapter 9 in Cashing in on Covered Calls).
- ROO = 453/8500 = 5.3% = 45% annualized. Since this is a 6-week return, we multiply by 8.5 to annualize.
- Downside protection is 147/8647 = 1.7%.
We are guaranteed a 6-week profit of 5.3% as long as our shares do not depreciate in value by more than 1.7%. There is no upside potential.
3/90 call:
- Sell 1 x $90 call @ $3.50
- ROO = 350/8647 = 4% = 34%
-Upside potential is $3.53 (90 – 86.47):
353/8647 = 4% = 35% annualized
We generate a 6-week return of 4% and have an opportunity to garner another 4% if our shares appreciate past the $90 strike price. There is no downside protection.
Laddering can also be accomplished by using different strikes for different stocks in your portfolio.
Alan
Exit Strategy Opportunity:
On Tuesday the stock market plummeted in response to Treasury Secretary Timothy Geithner’s remarks. News driven market volatility occurs in all market conditions but has been much more prevalent during this unprecedented economic downturn.
These dramatic declines may represent exit strategy opportunities. If the market decline causes corresponding decreases in your stock and option values, it may pay to buy back the option and then look to either “hit a double” or roll down to a lower strike. For example, if you generated a profit of $2.50 per share when you sold the option initially, and the current value of that option is .25, buying back the option will put you in a position to generate more cash into your account to minimize losses. I will be giving specific guidelines in my new biook, “Exit Strategies for Covered Call Writing”, coming out this spring.
After a precipitous decline in the market, I always carefully check for exit strategy opportunities.
Alan
Hi Alan,
I noticed that when doing the calculations you show annual percentages. What is the purpose of this? Also, I’m almost finished watching the last of the DVDs and they are really great in tying all this information together.
Thanks for your help.
Mark
Mark,
I show annualized returns to demonstrate that small but consistent monthly returns can add up to substantial profits. Factoring in compounding makes the numbers even more impressive. It also allows you to compare these percentages to those of CDs, treasuries and other investment choices. It is important to realize that there is some risk in this strategy. The risk is in the stock, not in the option sold. As an informed investor, it is important to weigh the pros and cons of all choices before making your informed decisions.
Thanks for your feedback on the DVDs….you made my day!
Alan
Email question from Bob B:
” HI ALAN, IN BROWSING THRU SEVERAL STOCKS AND ETF”S ON MY TELECHART 2000, I CAME ACROSS AN ETF THAT LOOKS INTERESTING. THE ETF IS UWM. IT IS THE ULTRA RUSSELL 2000. IT CLOSED ON NOV 20 AT 12.58 AND THE HIGH SINCE THEN HAS BEEN 21.61. AS OF 2/11/2009 IT IS AT $16.00 AND THE MARCH 16 CALL IS $2.00 FOR A 12%RETURN IN 5 WEEKS OR 120% ANNUALIZED. LONG TERM THE STOCK MARKET IS BULLISH AND THE VOLATILITY OF THIS ETF TRADES AT A NARROW RANGE IT LOOKS LIKE A CONSERVATIVE RISK. IF IT DOES EXPIRE AT UNDER $14.00 (THE BREAK EVEN PRICE) THEN ANOTHER CALL CAN BE SOLD FOR THE FOLLOWING MONTH. WHAT IS YOUR OPINION ON THIS ETF. THANKS FOR ANY INPUT”.
BOB
My response:
Bob,
I truly respect the fact that you are always looking for new and innovative ways to cash in on covered calls. I agree with you that from November 20,2008 until present we have a consolidated chart pattern with an acceptable low-risk trading range. I would respectfully ask you to take a step back and consider the following before making a final decision on this ETF:
1- Two months prior to the Nov. 20th low, the fund was trading @ $55. This may influence one’s risk evaluation.
2- One of the main advantages of an ETF is diversification. This ETF consists predominently of financials and in my view is a non-diversified fund.
3- It’s group rank (financials) currently ranks in the lowest third of all other industries in terms of new institutional money flowing in.
4- It’s price ranking is in the 20th percentile (lower fifth of all groups).
When investing with a stock or ETF in an industry that is currently out of favor, you are riding your bicycle uphill. Your decision is whether your hard-earned money has a better chance to produce profit for you with UWM or with another investment vehicle.
Many experts feel that financials are due for a turnaround, so this may turn out to be a great investment. Factoring in all the information and making an informed decision based on financial and technical parameters along with common sense is what Blue Collar Investing is all about.
Thanks for sharing your ideas.
Alan
Know when rolling down no longer makes sense:
Last week I posted a rolling down exit strategy I used for DLTR eventually selling the 2/35 call and generating $516 profit in my account using this strategy.
The stock has since dropped to $33.96 so I checked to see if rolling down another strike would make sense. Since this stock recently split, there is a $32.50 strike price. here’s the math:
- buy-to-close 2/35 @ $.50
- Sell 2/32.50 @ $1.75
- Net gain on option trade is $125 per contract (175 – 50).
- Now, if the stock closes the contract period at the current $33.96, we would lose $146 per contract on the exercised sale (33.96 – 32.50) for a further loss of $146.
It doesn’t make sense to lose $146 in order to gain $125. At this point a rolling down strategy does not make sense. If you feel the stock must be sold before it suffers further losses, buy back the option, sell the stock and purchase a new one to then sell a cc option. This what I call converting dead money to cash profits. At this point, I am standing pat.
Alan
You may have covered this question in your book or blog, but… is there a minimum volume of option trading that you look for in a stock before making a decision to buy/write the stock/call option? (I do note your reference to reviewing the option chain for a security as part of your overall selection process.) Thanks. Roy