Strike price selection is a critical concept needed to master covered call writing. Selling in-the-money strikes is the most conservative approach to this strategy and selling out-of-the-money strikes is the most bullish. We use the latter when the overall market is bullish and chart technicals are bullish and confirming. Once we have decided that a bullish approach is indicated the next decision is how far out-of-the-money should we go when writing our calls.
Let’s first review the pros and cons of a deep OTM call vs. an OTM with a lower strike price:
- More room for share appreciation
- Less likely to be assigned
- The net effective sale price (NESP- call strike price + call premium) is higher
- Lower call premiums
- Lower final returns if share price remains static
If we decide to sell deep OTM strikes we must be bullish on the overall market and the stock itself. The way to determine how far OTM to go we must first set our investment goals for the month. In the BCI methodology our goal for a 1-month initial return is 2-4% for stocks and 1-2% for exchange-traded funds. Of course, each investor can tweak these guidelines based on their personal risk tolerance. The deeper OTM we go, the closer to the 2% figure we get (and then below) and the further from the 4% stat. Let’s take a look at a real-life example using one of the stocks on our current Premium Stock List: YNDX:
Please note the following:
- On 9-10-13 YNDX was trading @ $35.17
- We will look at the October 18th expiration, 5 weeks away
- We will evaluate 4 OTM strikes: $36, $37, $38 and $39
- Bid prices range from $1.30 down t0 $0.35
Next we will enter the options chain information into the “multiple tab” of the Ellman Calculator:
The 2 strikes that meet our criteria of a 2-4% initial return (ROO) are the $36 (3.7%) and $37 (2.4%) strikes. The $38 strike just misses at 1.6% but can be used at the investor’s discretion. Same holds for the $39 (1%) strike. The maximum returns for the 2 strikes that do meet our initial criteria are 6.1% for the $36 strike and 7.6% for the $37 strike. The ultimate decision rests with the individual investor. For me, I would opt for the $37 strike and be happy with a 2.4%, 5-week return and thrilled with a 7.6% 5-week return. As always, we must follow our exit strategy guidelines once these positions are entered.
Deep OTM strikes can be used in a bull market environment with strong chart technicals. The higher the strike selected, the lower the initial return but the higher the maximum return possibility. Strike selection should be based on sound fundamental, technical and common sense principles along with your personal risk tolerance comfort level.
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September 24, 2013
Philadelphia Chapter of the American Association of Individual Investors
6:30 PM Registration and 7 PM start.
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Details are available on the above website.
The market reacted favorably to the surprise Federal Reserve’s announcement that it will maintain its aggressive bond-buying program (QE) to stimulate the economy by keeping interest rates low. This week’s mixed reports:
- The Fed expressed concern regarding weak employment and fiscal fighting in Washington. The committee does not expect a raise in Fed funds rate until 2015
- The Fed decreased its outlook for 2013 real GDP to the 2.0 – 2.3% range, down from the 2.3% – 2.6% range
- US housing starts were up 0.9% in August compared to a 5.7% increase in July
- Housing permits were down 3.8% in August although housing starts were up 19% from a year ago
- Single-family housing permits are at the highest levels since 2008
- Sales 0f existing homes in August were up 1.7% to an annualized $5.48 million units, the highest level in 6 years and above analyst expectations
- Single family and condo sales were up 13% and 16% year-over-year
- Housing inventory in August came in @ 4.9 months, less than the 6.0% from a year ago
- Industrial production increased by 0.4% in August better than the 0.3% predicted
- Fed officials project unemployment to drop to between 6.4% and 6.8% by the end of 2014 (7.3% last month)
- Consumer Price Index (CPI) rose by 0.1% in August, below the 0.2% expected mainly due to a decline in energy prices
- Core CPI (excludes food and energy) rose by 0.1% in August less than the 0.2% anticipated
- Year-to-year inflation rose by 1.8%, below the Fed’s 2.5% threshold for lessening stimulus programs
- The Conference Board’s index of leading indicators rose by 0.7% in August better than the 0.6% analysts expected
- Initial jobless claims for the week ending September 14th came in @ 309,000, lower than the 330.000 expected
For the week, the S&P 500 rose by 1.3% for a year-to-date return of 22%.
IBD: Confirmed uptrend
BCI: Moderately bullish but taking a slightly defensive posture due to concerns over a possible government shut-down (here we go again). Selling an equal number of in-the-money and out-of-the-money strikes
Wishing you all successful trading,