A few weeks ago I wrote an article entitled, Selecting the Best Strike Price. Since then I have received several emails asking for more information as to why I sell I-T-M strikes and the rationale behind my thoughts. I fully understand your concern about this issue since historically Out-Of-The-Money strikes have been the most popular.
Before I address this matter, let’s review the pros and cons of each type of strike price:
Out-Of-The-Money:
This gives us upside potential in addition to the option return but no downside protection. If we buy a stock @ $28 and sell the $30 call, we have the possibility to earn an additional $2 per share if the equity appreciates from $28 to $30 or beyond. If the stock goes down in value during the 1-month contract period, the profit will be decreased or lost (unless we invoke an exit strategy).
At-The-Money Strike:
This type of strike will normally give us the highest option return but offers no upside potential or downside protection. If we purchase a stock @ $30 and sell the $30 call, our option return will be impressive but we will not participate in any share appreciation nor will we have have any insurance if the stock declines in value.
In-The-Money Strike:
Here we receive option profit plus downside protection but no upside potential. If we buy a stock @ $32 and sell the $30 call, we receive an option profit plus protection down to $30. In other words, if our shares depreciate in value from $32 to $30, our option profit is protected. Let’s examine this in more detail.
Option Value as it relates to Strike price:
In my book, Cashing in on Covered Calls, this matter is discussed on pages 25 to 27. An option premium is broken down into two components:
1- Intrinsic Value- The value of an option if it were to expire immediately with the underlying stock at its current price; the amount by which the stock is in-the-money. For these call options, it is the positive difference between the stock price and the strike price. In the above example, it would be $2 (32 – 30). Only in-the-money strikes create intrinsic value.
2- Time Value- The portion of the option premium that is attributable to the amount of time remaing until expiration Friday. Time value = Option premium – Intrinsic value. All strikes have time value but at-the-money and out-of-the-money strikes have ONLY time value.
What makes the I-T-M strike so special ?
This is the only strike that offers intrinsic value as a component of its option premium. In the above example, if we sell a $30 call on a stock trading @ $32, we receive $2 of intrinsic value to start and then time value on top of that. The time value is our actual profit because if our shares are assigned and sold @ $30 (a strong likelihood), we lose $2 per share on the sale of the stock. Therefore, we do not include the intrinsic value in our profit. However, this money is protecting us from $32 to $30. For my computations, I use this $2 to “buy down” the purchase price of my stock. Instead of saying that I bought a $32 stock and received an option premium of $3.50, I enter it as if I purchased a stock for $30 and received an option premium of $1.50. If we receive an option premium of $3.50 per share when selling the $30 call, there is $2 in intrinsic value and $1.50 in time value. The profit is time value divided by the “bought down” purchase price. It would look like this:
ROO = 150/3000 = 5% 1-month return or 60% annualized.
Downside protection = 200/3200 = 6.3%
Therefore, we are guaranteed a 5% 1-month return as long as our shares do not depreciate by more than 6.3% in that month.
The principles behind selling the in-the-money strike:
Successful covered call writing is not about selecting the only obvious choice using some magical formula that can be employed in every situation. There are many facors to incorporate into our investment decisions and no two scenarios are precisely the same. We can, however, use the Blue Collar mission statement of incorporating sound fundamental and technical principles along with our common sense to come to intelligent and informed conclusions. Think of yourself as the artist who incorporates his well-thought-out strokes into an eventual masterpiece. How many Picassos are created with a paint-by-the-numbers kit?
I view an I-T-M strike as an option with an insurance policy. Now this policy is free but it does eliminate an opportunity. It’s free because the option buyer is paying for it when we sell the call. The opportunity lost is any potential for share appreciation. So when would the odds favor us to opt for the I-T-M strike versus the O-T-M strike? Here are the situations when I am most likely to sell an I-T-M strike:
1- An extremely volatile or declining market (hello!).
2- Technical analysis of the stock demonstrates mixed indicators.
3- An uptrending chart pattern but in a volatile manner (the Scouter Rating will eliminate many of these).
4- Part of my laddering of strikes procedure: even in normal markets I will incorporate some I-T-M strikes as a way to diversifiy strikes.
Real life example- PZZA:
Papa John’s International, Inc. (NASDAQ:PZZA) is a stock on my watchlist with no upcoming earnings report. The technical indicators recently turned positive after a positive earnings report (see recent volume spike on the chart below). Here is the current chart:
PZZA as of 3-6-09
The current market value is $21.95 between the I-T-M $20 strike and the O-T-M $22.50 strike. The stock technicals are positive but the market tone is __________(you can fill in the blank!). Those with low risk-tolerance (I’m guilty as charged) may opt for the $20 call. Let’s work out the calulations. Since there are only two weeks remaining until the March options expire, let’s look at the April calls:
Out-of-the-money strike:
- Buy 100 x PZZA @ $21.95
- Sell 1 x $$22.50 call @ $1.25
- ROO = 5% 6-week return (125/2195) or 49% annualized
- Upside potential is 2.5% (55/2195)
- There is no downside protection
In-the-money strike:
- Buy 100 x PZZA @ $21.95
- Sell 1 x $20 call @ $2.60
- ROO = 3.3% 6-week return (260 – 195/2000) or 28% annualized
- Downside protection = 8.9% (195/2195). This is our insurance policy.
As an informed Blue Collar Investor we must decide between the two choices. The more bullish approach would be to sell the O-T-M strike and receive a neat 5.7% 6-week return, with the possibility of another 2.5% if the stock appreciates beyond the $22.50 strike price.
The safer, more conservative investment would be the I-T-M strike wherein we generate a lower 3.3% 6-week return but have a huge 8.9% downside protection insurance policy. In other words, our 3.3% return is protected as long as our stock does not depreciate in value by more than 8.9% in the next 6 weeks.
Many of our readers have asked why I have been highlighting mainly I-T-M strikes of late. The reason has to do with the extreme market volatility and the fact that I am a conservative investor with low risk tolerance. More aggressive investors might opt for the O-T-M strike. There is no right or wrong as long as you are making an informed decision factoring in and understanding all available information. Remember that all these calculations are done for you automatically using the ESOC (Ellman System Options Calculator).
Market Tone:
With the market in steady decline over the past several weeks, there is no surprise that the charts in most sectors are trending down. The S&P 500 is no exception. However, the chart of the CBOE Volatility Index is showing a trading range pattern which to many technicians is indicative of a possible bottoming of the market. Here are the charts:
S&P 500 as of 3-6-09
Volatility Index as of 3-6-09
Last Weeks Economic News:
The Federal Reserve’s Beige Book survey reported “weaker conditions in economic activity ” from January to late February in 10 of its 12 districts although Philadelphia and Chicago reported no change in “weak” economic conditions. The unemployment rate rose to 8.1% the highest since December 1983.
There is some good news. The Institute of Supply Management (ISM) reported stronger than expected manufacturing activity for February. This suggests that economic contraction may be stabilizing. Also, the service sector which represents the bulk of our economy appears to be stabilizing also indicating an economic upturn.
For the week, the S&P 500 was down 7% for a year-to-date return of – 23.9%.
Alan’s radio interview:
Last week, I was interviewed by Danielle Hampson of WNB Radio Network on her Mind Your BIZness Show. To listen to that program use the following link and then click on Cashing in on Covered Calls:
http://www.wnbnetworkwest.com/WnbMybShow.html
My best to all,
Alan (alan@thebluecollarinvestor.com)
Alan:
Another great article. You make an arcane science both easy to understand and incorporate into sound investment planning. Thank you ! !
Mark
Below are a list of stocks on my watch list I have run through the IBD check up list and the MSN scouter. All appear to have potential for covered call trades. Hope someone may benefit from these.
Mark Green
NTES – PZZA – STAR – DLTR – LFT
Thanks to Mark for sharing his admirable research with the rest of us.
Let’s say we wanted to set up a paper-trade (practice) account utilizing these 5 equities on Mark’s watchlist. Let’s also make the assumption that we have $25,000 in cash to invest. Here’s how I would proceed:
1- Make sure these stocks are in 5 different industries so that no one equity represents more than 20% of our potrtfolio. They are.
2- Next we want to also diversify financially:
5 stocks/25k = 5k per stock. This is an approximation. I will now use the market value of these stocks at the time of this post. We divide the share price into 5k and then round off to the nearest hundred (1contract = 100 shares):
NTES: 5000/21 = 238 = 200 shares
PZZA: 5000/20.91 =238 = 200 shares
STAR: 5000/15.85 = 315 = 300 shares
DLTR: 5000/39.99 = 125 = 100 shares
LFT: 5000/17.60 = 284 = 300 shares
3- Now we check the cash needed for these transactions, making sure we have money left in our account for exit strategies:
NTES: 200 x 21 = $4200
PZZA: 200 x 20.91 = $4182
STAR: 300 x 15.85 = $4755
DLTR: 100 x 39.99 = $3999
LFT: 300 x 17.60 = $5280
Total investment is $22,416 (plus commisssions) leaving us $2584 for exit strategies.
4- If I were starting today, I would sell the April calls since there are 9 days until March expiration. Make sure there are no earnings reports interfering with your option sales.
5- When paper-trading factor in exit strategies the same way you would when you are investing real cash.
As you paper-trade your skills will get sharper and sharper and then when the market normalizes you’ll be ready to hit the ground running!
Thanks again to Mark.
Alan
Hi Alan,
I have a question about exit strategies and I’m hoping you can help. In late February I bought 200 shares of BWLD for 30 dollars. Then I sold the 30 dollar strike price (March) for 2.25 which is a 7.5% one month retrun. Today the stock is trading at 32.41 and I’m not sure if I should be doing any exit strategy. I would appreciate any help you can give.
Jeff
Jeff,
First of all, congratulations on a deal that’s looking quite sweet right now.
Now the answer to your question is NOT YET. You sold an A-T-M strike understanding that you will not benefit in share appreciation but will receive a high option premium. Look at the $2.41 above the strike as insurance. BWLD is a volatile stock and you have significant downside protection at this point in time.
If the stock is still trading above the $30 strike on or near expiration Friday, check to see if you want to roll out or rollout and up. Of course, make sure that there is no upcoming ER to interfere with such a maneuver.
Alan
Some good news to brighten our day:
Yesterdays rally was due in large part to positive news from Citibank and hints of enhanced market monitoring with such maneuvers as re-instatement of the uptick rule.
In addition to this, there are some overall market conditions that normally bode well for a strengthening stock market:
1- Low P/E multiples…stocks are cheap.
2- S&P 500 provides a 4% dividend yield
3- The VIX (volatility index) has dropped to 42, less than half of its November highs. This demonstrates calmer market conditions.
4- Low interest rates
5- Tremendous liquidity…trillions of dollars sitting on the sidelines waiting to come in and boost the market.
One positive day does not mean that we are headed north permanently but the fact that we are seeing multiple positives is a breadth of fresh air and a sign that the recession is nearing an end. That would make good historical sense since recessions last a little over a year, on average, and this one started in December of 2007.
Alan
Alan,
Any update when IBD goes live with the new formatted website?
Barry
Barry,
The folks at the technical department of IBD are still working out the glitches in the enhanced website. They estimate a few more weeks before going live but that could be extended if more bugs are found.
Once the change is made, I will send out a FREE packet of information to everyone on my mailing list explaining the change and how to best screen our stocks. The process will be easier and just as effective as the previous screen.
To those who are not on my mailing list but would like to join, you can use the following link:
http://www.thebluecollarinvestor.com/joinlist.shtml
If I hear any new information, I’ll pass it along in these comments of my journal articles.
Alan
BWLD Calculations:
Let’s take a look at Jeff’s current position with BWLD (see comment #4 above).
His investment is still looking great. He generated a 7.5% 1-month return and still has $335 of downside protection as the stock is trading @ $33.35 at the time of this post. As we get closer to expiration Friday ( a week away), Jeff may want to consider a rolling out strategy. If he did it today, here are the numbers after confirming no interference from an earnings report:
1- Buy to close (2) March $30 calls @ $3.60
2- Sell (2) April $30 calls @ $4.60
3- ROO = 100/3000 = 3.3% 1-month return or 40% annualized.
4- Downside protection = 335/3000 = 11.1%
This means that Jeff is guaranteed a 1-month return of 3.3% as long as his shares do not depreciate in value by more than 11.1% by April 17th. He has between now and next Friday to decide if he wants to utilize this exit strategy.
Alan
I came upon your website today while seeking information relating to tax treatment of options transactions (selling CC) for use in calculating my estimated income tax payments due for 1Q2009. I retired from corporate employment in 2008 and this is the first time ever I have had to deal with estimated tax payments. I am not certain whether I need to include these premiums in my estimates of my AGI for each quarter or not. I prefer not to “loan” my money to the government through overpayment of income taxes prior to their due dates.
Would you please go into further detail regarding the above March 13 post using BWLD, and rolling into an April 30 call? It appears to me that the investor is giving up (or letting ride) 7.5% return in March and actually putting in more money in exchange for the opportunity to collect $460 at close in April on an investment of $3135 ($3000 + 225 – 360 + 460).
Thank you for sharing your many insights and strategies.
Dave R.