One of the common flaws found in many of the studies of the covered call strategy is that they select only slightly out-of-the-money strike prices. Needless to say, a majority of covered call writers are also guilty of the same mistake. It is certainly understandable why one would lean to this strike as we ultimately will garner the very highest of returns if the stock does appreciate up to and beyond the strike. This is a strike that should be favored when both market and individual equity fundamentals and technicals are positive.
What if the market or equity technicals are volatile or slightly bearish? Should we not consider the protection afforded by in-the-money strikes? The risk is that the stock will head north and we will miss out on the appreciation. The benefit is that the option buyer is purchasing insurance for us in the amount of intrinsic value of the option premium. This generosity should be given consideration when market or stock indicators dictate. Furthermore, in-the-money strikes have deltas approaching “1″. This means that as the stock moves up or down, the option value will move up or down in a similar amount. If the stock starts declining in value, so will the option premium and it will be less costly for us to buy back (B-T-C) the option to execute an exit strategy.
Once we have selected a stock for our portfolio, we can run the calculation for the different strike prices using the “single tab” page of the Ellman Calculator (ESOC). This tab allows you to view up to four different strike prices for the same equity.
Procedure:
Simply input the information required into the blue cells on the left side of the single tab page as shown in the figure below. All of these figures are gleaned from the option chain:
Ellman Calculator- Single Tab- enter info
SNDK is currently trading at $46.62 with three weeks remaining until expiration Friday. We will look at the in-the-money $45 strike, the near-the-money $47 strike and the out-of-the-money $50 strike.
Information Generated:
For each strike price submitted, the calculator specifies ROO (return on option), upside potential, downside protection, share buy down (I-T-M strikes), proceeds, cost basis and annualized returns. All of this information appears in a split second and can be printed to facilitate the best possible investment decisions. The chart below shows these results for SNDK:
Ellman Calculator- Single- Final calculations
- Only the I-T-M strike ($45) offers downside protection as seen in the cell highlighted in yellow.
- The cells highlighted in green show the actual return on the option when initially sold.
- The cells highlighted in blue show upside potential if shares appreciate in value.
- The cells highlighted in red show maximum possible profit percentage for each strike price.
Depending on your market outlook, risk tolerance and stock technicals, you can use this information to select the strike price that best meets your needs.
The Elite Calculator:
For the past several months, the BCI Team has been working hard developing an enhancement to the basic Ellman Calculator. It now complete as I am in the process of writing a user guide and my webmaster is adding the tool to the website store. The Elite Calculator will have two additional sections. One is the “unwind tab” which allows you to calculate returns mid-contract and a Schedule D which will shows long term and short term capital gains (losses). Those trading outside sheltered accounts will greatly benefit from this added link. Below is a “sneak preview” of the information page of the Schedule D where I highlighted (in yellow) the six different investment choices this tool offers:
Schedule D- Information page
Currently premium members have access to the “unwind now” tab in the resource/download section of the premium site. The completed Elite Calculator will be uploaded once I have completed the user guide and will be FREE to all premium members.
Event update:
1- I will be hosting, along with Barry Bergman, a BCI team member, a seminar on Long Island on August 12th titled “A Practical Approach to Covered Call Writing”. We will be using real life examples to set up a covered call portfolio. More information will follow.
2- I have completed the first rough draft of my third book. It incorporates information from my first two books, new updated information and material from three years worth of journal articles I have written. I will go through the book at least ten more times before handing it over to my publisher. My goal is to have it published by the end of the year.
Market tone:
The news this week was more negative than positive. For the first time this year, the number of employed workers fell as did consumer confidence, construction spending, manufacturing growth and factory orders. On a positive note, the unemployment rate fell slightly to 9.5% and personal income, savings and spending rose. For the week, the S&P 500 fell 5% (ouch!) for a year-to-date return of (-) 7.4%. Below is a comparison chart of the S&P 500 and the VIX (CBOE Volatility Index):
S&P 500 vs. the VIXD 7-3-10
The red arrow shows a declining S&P 500 and the green arrow shows a declining VIX after a major advance. The S&P 500 did beak through support (about 1045) this week but on unimpressive volume. This is still a technical negative.
Summary:
IBD: Market in correction.
BCI: Neutral and taking a defensive posture. Market fundamentals remain predominantly positive showing a slow but continuing recovery. My expectation is that earnings next month will be favorable. However, the market volatility and technical breakdown will lead me to favor I-T-M strikes. I bought back 30 contracts on Thursday and Friday and will roll down or unwind if there is no turnaround on Tuesday or Wednesday.
Where’s Alan?
My son Jared is getting married this coming weekend and I will fall behind in my email responses to you. I will publish next week’s article early and catch up the following week. Premium members will see NO DELAY in publication of the ETF and premium reports.
Best regards,
Premium members:
This week’s stock screen and watch list as well as the ETF List has been uploaded to your premium site.
Have a wonderful holiday weekend.
Alan
SXCI:
I noticed that this (non-IBD 100) stock was up in value on Friday on higher than average volume. It has great fundamentals, is trading above an uptrending moving average but with mixed technicals. It is one of the better performers in this recent market downturn.
Alan
Happy holiday weekend to you Alan and congrats to your son and entire family!
Alan,
Best wishes to you and your family.
Amy
Hello Alan & all,
Just FWIW- on the natural gas ETF on this week’s report. Just a reminder that UNG is indeed a Limited Partnership. This involves a K – 1 Tax Form. Some advisers want investors to be sure to keep LPs out of tax advantaged accounts, such as IRAs and 401-Ks. The IRS has something called Unrelated Business Income in these LPs, which gets treated differently. Hence a problem in those accounts.
Anyway, seems worth looking into as part of the usual Due Diligence. Don B.
John, Amy and all those who sent direct emails:
Thanks so much for your well wishes regarding my son’s wedding. I’ll pass them on to him and his future wife.
Alan
THS:
As with many equities the technicals have been hit hard the past few weeks BUT are recovering. The stochastic oscillator just broke through the 20%, a bullish signal. This company has impressive fundamentals and in May, had its 4th consecutive positive earnings surprise (beat estimates by 16%). Revenues were up 12%, projections increased by 13% in the Q1 report. It may be worth keeping an eye on this one as technicals improve.
Alan
Best to you and your family on the upcoming event!!!! Exciting……..
jody & bruce
Well Humph, Harrumph, and a Holy Hannah –
I noticed just now that GDX has two expirations for July. One set expiring July 9, and one set expiring July 17!!! This from my Option price pages. Following that is August and September, both with the normal expirations. Any ideas why? Thanx.
Don B.
Don B,
There are a number of stocks, ETFs, etc. that have weekly and quarterly options…in addition to the normal monthly options.
Barry
Don,
Following up on Barry’s response, here is a link that offers more info on weekly expirations:
http://www.cboe.com/micro/weeklys/introduction.aspx
You will note that GDX is NOT listed here and that’s because it doesn’t trade on the CBOE.
Alan
Re Don B’s comment #5, he is absolutely correct. A limited partnership interest, even a publicly traded one that looks, smells and acts like a corporate stock, is not a corporate stock. The K-1 will list the income, distributions, capital balance, etc. It will also probably have a little code and an amount (for 2009 it’s line 20, code “V”) that is UBTI. If you have any retirement accounts with that sort of income, and it exceeds $1,000, you must file Form 990-T. The tax rate runs from 15% for the first dollar over $1,000 to 35% for all dollars over $12,150.
I have filed the form for several clients. Their view was that the tax was worth the investment income. For many people it’s not. Also, there can be penalties and interest involved, the cost of paying someone like me to prepare the return, etc. That is why most people will avoid these partnerships for their IRA accounts.
Alan,
I am new to your site, but appreciate all the great info. One possible refinement to your premium screens is eliminate stocks with very little options volume. Today I was looking at SLH and the options volume was minimal. Thanks for your service.
Alan,
A second question for you. I had sold calls on FDO and today the options dropped below 10% of my selling price. (I know I violated your rule of selling calls during an earnings call period, but I hadn’t started your service yet). Today the price of FDO dropped significantly due to change in earnings forecast. I did a rollout/rolldown to August calls as I believe fundamentals of stock are still good. Is this what you would do or would you have closed the position?
Patty…posts # 13 and 14…
Hello Patty…my name is Barry Bergman and i work with Alan on the Premium Report, so I would like to answer your two questions.
SLH Volume:
The guideline that is used in screening for liquidity (volume0 is average volume over the last three months. We get that from a number of sources. Our guideline states that there has to be a minimum average volume of 250,000 shares per day over the last 90 days. For Solera, today’s IBD shows that SLH has had an average volume of over 953K shares per day…so it does meet the system criteria for volume.
As for FDO, this is one of Alan’s “banned stocks”…meaning that it reports monthly same store sales. Here we have two problems…a banned stock and a stock that reports earnings during the option month…so you were hurt on both accounts. The important thing is that you recognized the errors.
Please post any other questions that you may have. I’ll be responding for Alan while he is enjoying his son’s wedding…he’ll be back next week.
Best,
Barry
Patty,
The question I ask myself is “would I buy that stock today with the current fundamentals and technicals at the current price?” Also, “Is my best chance of a successful investment with this equity or another?”
Here is a link to an article I recently wrote regarding stocks that have gapped down:
http://www.thebluecollarinvestor.com/blog/managing-stocks-that-have-gapped-down-3/
Alan
Exit Strategies:
Those of us who bought back options last week put ourselves in a position to generate additional income into our accounts should the market bounce back. There was no way to predict the significant bullish move in the past two days but it cost us very little to place ourselves in a favorable position.
Some may call it “luck” but I prefer “preparation, motivation and education”.
Alan
Post #15
Barry,
Thank you for your very thorough answers. I didn’t realize FDO was a banned stock! Thank you. I had read the rules on retail stocks, but forgot to apply that to FDO. Today would be a good example for your educational examples!
A follow up question on volume. I had noticed that the stock SLH has good amount of daily stock volume but is any distinction made for average option volume or number of option contracts etc? Thanks again for your input.
Post #16
Alan,
Thanks for the article link. Excellent points on how to deal with a gap down. Lots to think about.
IMF Report:
BEIJING -”The global economy is recovering faster than expected but Europe’s debt crisis might stall the rebound and governments need to shore up shaky public confidence, the International Monetary Fund said Thursday.
The IMF raised its 2010 world growth forecast to 4.6 percent from 4.1 percent in April and boosted estimates for the United States and China. But its quarterly World Economic Outlook warned that “risks have risen sharply” and Europe has to quickly resolve debt problems and restore confidence in its banks”.
Alan
Hitting several doubles:
Before leaving for my son’s wedding this weekend, I hit a few doubles. Here is one example for RVBD:
- Sold the July $30 call (10 contracts) for $1.53
- The initial profit was $1524.
- I closed the short options position @ $0.12 for a debit of $126
- Today I resold the same July $30 call for $0.65 for an additional profit of $643
- Total profit = $1524 + $643 – $126 = $2041
- 1-month return (to date) = $2041/ $30,000 = 6.8%.
The final results will not be in until a week from Friday but the extra $643 – $126 = $517 would NOT have been in my pocket had I not prepared for an exit strategy.
Alan
Alan,
Re Post #21
Wishing you the best for this weekend’s exciting event in your family.
I have a question about your post. (Don’t worry if you don’t get to this till next week).
In your setup, you bought to close the July 30 calls at .12 and later resold the same calls at .65. How long do you generally wait to find this type of profit? Do you just watch and wait for this type of price? I have been rolling out or down on the same trade to save on commissions, but do you think it is generally better to unwind and then wait to find a better deal? Do you generally find the stocks will bounce back to give you an opportunity to make your double on the same option?
I do have your book Exit Strategies which I have already read twice, but I am still learning the strategy.
Patty, your questions in #22 are best answered by the fallback: “How do you FEEL about the market, the sector, and the stock.” BP blows up an oil well. How do you feel about investing in oil companies in general? Dell has a bad quarter, but Apple has a great one. Are Dell options worse than Apple options?
What Alan has indicated is that SOMETIMES you just look at the stock and say, “Still enough time and likelihood for a bounce back”, and sometimes you say “Don’t look for a bounceback, but a roll out or roll down may be a good choice.
There is no hard and fast answer. It comes with experience, fear, greed, arrogance, ego, etc. There really isn’t a “generally better” answer until the expiration date has passed.
Study the books, do some paper trading, make sure you have a good selection of various industries represented and, if you want a little unbiased comfort, run a question by the current discussion. Soemone will probably have an “I did this” or an “I would….” suggestion.
When in doubt, close it out. You can’t lose money if it’s not on the line. Good luck with your trading.
Hi Owen,
Your comments are very useful. I know I am asking a lot of questions as I am new to Alan’s system. I have actually been trading stocks for about 20 years though but just started options about 6 months and have done the CBOE options courses. So I will chime in like you say to run by ideas. I like Alan’s system as it provides a framework on how to trade options. I also am trying to use the Elite Calculator and so far find it very helpful. Thanks again for your very thoughtful message.
Patty (Post # 18),
I’m sorry for not responding more quickly, but I had a family medical emergency. Now, on to your question…
If I’m interpreting your question, you want to better understand the differences between share volume vs.option volume and open interest. Share volume is the number of shares traded and the BCI system requires a minimum of 250K shares traded per day.
Option volume is the total number of options contracts traded that day at the specific strike price that you are interested in….both bought and sold. To get a more detailed look at how many contracts bought or sold, you can go to the CBOE website.
Open interest is more important…it is an important indicator of activity in an option contract. Open interest is the total number of contracts at a given strike that are open…that is the number of contracts that have been traded but not closed or liquidated by an offsetting transaction…exercise, assignment, etc.
Open interest can give you insight into the liquidity of the option. The greater open interest, the better liquidity, and better bid/ask spreads…hence better fills and more money in your account. While there are no hard rules surrounding a recommended level of open interest in selecting a strike price…but the higher the better.
I hope this answered your question. If not, let me know and I’ll try again.
Best,
Barry
Premium members:
This week’s list of top-performing ETFs has been uploaded to your premium site. Look for the list dated 7-8-10.
The BCI Team
To add to Barry’s commet #25, you might watch the open interest in the coming months, including the puts. Every once in a while you will see 4,000, 5000, 15,000 contracts change hands in one day. That ussually means several things…someone is trading on inside information, and the SEC is going to looking for the people making the trade.
Seriously, this can be an important indicator. If you sold the July $50 call and suddenly someone is selling 4,000 July $50 puts, it might be an indication that holding that stock might be a bad choice. Of course, it might also mean that someone wants to own the stock, he just doesn’t want to pay the current price, but is willing to pay $50, less the option premium. I did that once.
So keep an eye on the open interest of a given option. The premiums and open interest are directly related to the volatility and volume of the underlying stock, current or expected.
#25 and #27
Thanks Barry and Owen. Great information on the open interests.
Types of orders
I have been using limit day orders to place my option trades. Do any of you use GTC orders to sell a call? For example, let’s say you want to get a certain price for a call option and due to low volume and not many open interests, your trade isn’t getting placed. I was thinking a GTC order might increase the chance of filling the order at your price. On the other hand, the volatility of option prices might mean this isn’t a good idea? I have been having trouble getting some of my day orders to fill. Strategies anyone?
If a limit order doesn’t fill in ten minutes you should consider changing the price. A GTC order may not execute and you may miss out on a profit. For instance: you buy the stock at $28 and try to sell the $30. The stock drops to $27.50 and stays there for a week. The option order may not get executed because you were trying to squeeze an extra 5 cents per share out of the deal. Now, instead of getting $1.28, instead of $1.23, you got nothing and you are waiting for the stock to go back up to get that $1.28 on the option.
If the call is $1.25, enter $1.28 and wait for about 10 minuts. If it doesn’t execute consider changing it back to $1.25. The problem with a market order (which I use often just to get the trade done) is that a market order with the price at $1.25, may get executed at $1.20. You know what, if I lose $5 on a 100 share option contract I am not going to go broke. I spend more than that on Coca Cola in one day. I’ll drink water for a day.
#30
Owen,
Thanks, I will try your suggestions. I actually wasn’t worried about capturing a few pennies on the order price but just trying to get it filled where option volume is low. But I will try some of your ideas.
Patty & Owen (Post # 31),
I agree with Owen. I’ve been caught trying to squeeze a few pennies out of a trade and lost the opportunity of my original thesis in the trade. I generally enter the order below the mid-point of the bid/asked spread and, as Owen suggests, wait a few minutes…if I don’t get filled I change the order to the bid price.
A previous system that I learned suggested that only limit orders be placed…no variation…and it cost me money in lost opportunity.
Barry