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The Out-Of-The-Money Strike- Pros and Cons

Whenever a study is performed on covered call writing a stock is selected and the nearest out-of-the-money (O-T-M) strike is sold. This is repeated over and over and then the results are compared to the overall market performance. The usual conclusion is that covered call writing slightly outperforms the overall market but with much less volatility. What too many analysts overlook is the fact that the O-T-M strike has its advantages and disadvantages and to use it to our greatest advantage we must explore and understand the circumstances as to when to use this strike and when to avoid it.

An out-of-the-money strike is one where the option’s agreed upon sales price (of the equity) is HIGHER than the current market value of the stock. If we buy a stock for $28 and sell the $30 call option, that strike price is out-of-the-money.

When to use O-T-M Strikes:

Consider this strike the most bullish of our covered call positions. The greatest benefit will come if the stock appreciates in value from the time of purchase to expiration Friday. The closer it comes to the strike price (or surpasses it), the more money we realize and the returns can be eye-popping! So let’s take a common-sense look at some of the factors that would encourage us to favor this strike price:

  • A bullish overall market with low volatility
  • The stock chart is technically sound
  • The positive technical indicators are all on high volume
  • The positive momentum is continuous and not the result of a quick spike which could snap back
  • The stock’s industry is also technically strong

Advantages of the O-T-M Strike:

  • We can benefit from both the option premium AND the stock appreciation. 1-month returns can easily end up between 10-20% if the strike price is reached.
  • Less chance of assignment (your stock is sold at the agreed upon strike price) if we prefer to hold the stock
  • Time decay works in our favor since the premium consists only of time value. This means that as we approach expiration Friday, if the strike is still O-T-M, the time value will approach zero.

Disadvantages of the O-T-M Strike:

  • This strike offers the least amount of downside protection of the overall position and no protection of the option premium
  • May be a poor choice for those with low risk tolerance
  • The initial option premium is low, so the 1-month return may not be impressive if the stock does not appreciate in value
  • This strike has a low delta (amount an option value changes in relation to a $1 change in stock price). If the stock drops in value, the corresponding option will not change as much, thereby making it more expensive to buy back the option for an exit strategy. I-T-M strikes have the highest deltas.

O-T-M strikes and the Ellman Calculator (multiple tab):

  • Ellman Calculator Multiple Tab

  • The yellow highlighted rows show O-T-M strikes 
  • The second row down shows NFLX purchased @ $75 and the O-T-M $80 call sold for $2.60
  • This represents a 3.5%, 1-month return
  • If the stock appreciates to or beyond the $80 strike, an additional 6.7% will be realized
  • Total possible 1-month return is 10.2% 

Conclusion:

O-T-M strikes have an important place in our portfolios. Those with greater risk tolerance will tend to use them more than those with less. No matter who is writing these calls, they must be used to our greatest advantage. Select the strongest stocks in the strongest industries that have been uptrending with low implied volatility (avoid violent whipsaws on the charts). When constructing your portfolio for the month you can mix or ladder your strikes using a higher percentage of these O-T-M strikes the more bullish you are on the market and decreasing that percentage if you turn bearish. By doing so we are not guaranteeing success but dramatically throwing the odds in our favor of winning more frequently than losing. Some investors will do a combination of covered call writes and long stock ownership in a strong bull market. For example, if you own 300 shares of company XYZ you may sell two O-T-M strikes and allow the remaining 100 shares to appreciate without the restriction of a call option obligation.

Don’t miss out:

Monday December 20th is the last day of our DVD holiday sale. All orders finalized by 12PM EST will be shipped for FREE via priority mail (within the US) so that they will arrive on time for Christmas. Thanks to one and all for the amazing response we received for our new DVD program. Here is the link to our store:

/store.shtml

Premium members please enter the store via the premium site for an additional discount:

/member/login.php

Market tone:

I have been receiving dozens of emails asking why I have been so bullish on the economy over the past several months (I use the term “moderately bullish”). I am far from an economist and base my decisions on the same information available to other Blue Collar Investors. The economic reports and general market technicals along with the market volatility have simply been positive for a long time. Could it better? Sure. But it’s still favorable for our covered call environment. This week’s reports were no exception:

  • On Friday, the Conference Board reported that the index of leading economic indicators rose 1.1% in November and accelerated to an annual rate of 8.6% the past 3 months.
  • Industrial production rose 0.4% from October to November
  • The FOMC confirmed that it will continue to purchase $600 billion in Treasuries by the 2nd quarter of 2011 to help prevent deflation and assist with the economic recovery.
  • Retail sales rose for the 5th consecutive month in November at a better-than-expected rate.
  • New home construction starts rose 3.9% in November, higher than anticipated and the October rate was revised upward.

Let’s view a 6-month chart of the S&P 500 with its 50-d simple moving average:

S&P 500- 6-month chart as of 12-17-10

  • Since the beginning of September (green column) the price of the index has appreciated in value remaining above the 50-d sma (blue arrows) moving average
  • The 50-d sma served as support in early December (red arrow)

Summary:

IBD: Uptrend under pressure.

BCI: Moderately bullish but taking a slightly more defensive posture due to the market appreciation noted above. Currently selling an equal number of O-T-M and I-T-M strikes.

Happy holidays to you and your families.

Alan and Linda and the BCI team

alan@thebluecollarinvestor.com

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About Alan Ellman

Alan Ellman loves options trading so much he has written four top selling books on the topic of selling covered calls, one about put-selling and a sixth book about long-term investing. Alan is a national speaker for The Money Show, The Stock Traders Expo and the American Association of Individual Investors. He also writes financial columns for both US and International publications along with his own award-winning blog.. He is a retired dentist, a personal fitness trainer, successful real estate investor, but he is known mostly for his practical and successful stock option strategies.

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35 Responses to “The Out-Of-The-Money Strike- Pros and Cons”

  1. Dave D December 18, 2010 5:55 am #

    YGE

    Yes, I will be looking at this stock for december trading… Here is why…

    Fundamentally its doing ok. Earns a EPS rating of 99. MSN rating of 5. IBD rating suggest this stock is strong,

    Technically this stock impresses me. Maybe others here would think im absolutelycrazy. But, seriously, pull up an 18 month chart. There is super strong support at 10 dollars with 10 points of validation (note the stocks current price is $10.21). Stochastics are turning up . MACD is trending sideways, but still slowly heading north. In addition, last friday this stock completed a bullish engulfing pattern

    Now if we bought this stock now ($10.21) and sold the ITM call (10 dollar strike) for 65 cents we would have a ROO OF 4.4% and downside protection of 2.1%…

    Happy Trading everyone!

    Dave

  2. Barbara December 18, 2010 2:08 pm #

    I noticed that on the premium list rvbd has a higher beta number than many of the other stocks. This helps explain the higher option return I’ve been getting with this stock. It’s all coming together and making more sense. More volatile stocks give higher returns but could be riskier investments. I never paid much attention to the beta column before but will from now on.

    Barbara

  3. Barry B December 18, 2010 5:17 pm #

    DaveD (#43),

    Dave…
    I took a look at YGE with a fresh set of eyes. Here are some of my thoughts…
    – Support around the $10 area
    – A down trend line beginning with the Oct 14 swing high (5 touches). The downtrend line combined with support at $10 displays a descending triangle. Historically, this is a down trending pattern.
    – The Bollinger Bands are constricting meaning that there will be a breakout in the near term. That, combined with the descending triangle would indicate a breakdown is likely.
    – The price chart is stacked down, meaning that the price is below the 5EMA, 20EMA, 50SMA, 100EMA, and 200SMA.
    – IBD’s Smart Select Ratings are not all green per the BCI system (3 red, 2 green, and 1 yellow).
    – IBD’s Industry Ranking is 170 out of 197.
    – The MACD is slightly above the signal line and the Slow Stochastics is slightly below it’s signal line.

    So, if you are following a “pure” BCI methodology, it doesn’t meet the systems requirements. The descending triangle chart pattern combined with the constricting Boll Bands would cause me personal worry because I tend to be VERY conservative.

    I wanted to give you another point of view so you can make a better decision.

    Best,

    Barry

  4. DaveD December 18, 2010 5:57 pm #

    Thanks Barry for your insight…

    I do appreciate it…

    One thing I really like about the BCI method is that we can lower our risk using the sale of the options…

    I might be wrong in the analysis of YGE. If I am wrong this is how I will look at it…

    My breakeven point is $9.56 (10.21-0.65)…

    If the stock closes below 10 dollars at expiration I am free to sell another call (provided there is no earnings the next month. This will once again lower the cost basis.

    Heres an example with FUQI which I incorrectly bought at 7.40.
    Sold a strike 7 call for 90c (Cost basis 6.50)
    Sold a strike 7 call for 45c (cost basis 6.05c)

    Fuqi is now trading at 6.37.

    If I now sold the 7.50 strike call I would recieve 30c (cost basis 5.75). Or if I sold the 6 strike call I would recieve 0.85c (cost basis 5.20)…

    Based on the currest status of the FUQI example, even though I was wrong I have though selling calls lowered my cost basis. If I sold now I would have a profit of 3%…

    Last month i made 16 trades on different companies. I do follow Alans rule of diversification. Also, this month I will make a few trades that strictly follow Alans system…

    Happy Trading

    Dave

  5. Don_B December 18, 2010 6:03 pm #

    Musings (only) on Market Tone. Alan, you add a breath of fresh air to what is being written these days by economists.

    But the big, and I mean huge, concern in our country, IMHO, is the massive printing of dollars – evidenced by the QE (quantative easing, they call it) which makes investing troublesome. Inflation is coming. However, in spite of these factors and others, to NOT invest these days is probably unthinkable. With all this in mind, I have done quite well in the precious metals mining shares combined with cc writing. So far I can say I do not recall a loss ever in this vein. My losses have been in the general market, non-metals.

    I learned years ago that the Congressmen & Senators of the USA were said to be large owners of gold mining shares during the time that gold was declared illegal by FDR during the great depression of the 1930s. This is also part of my thinking. As an investment tool, asking ones-self WHAT IF is valid in many ways.

    Alan, your system for doing due diligence (ddd) has been a serious learning experience for me.
    Many thanx.

    Don B

  6. Duane December 19, 2010 11:35 am #

    Hi Alan, interesting upcoming change in the IBD 100, will be the IBD 50 on January 3rd. Look forward to see what impact it has on the BCI screening for CC’s, in coming weeks.

    Merry Christmas to you, Linda and the BCI team!!!

  7. Amy December 20, 2010 6:47 am #

    My shares of tibx were assigned this weekend as I made a nice 4.2% profit. It reports tomorrow and I plan to buy it back later this week if the earnings report is positive.

    Happy holidays!

    Amy

  8. Bill December 20, 2010 8:35 am #

    A question about the weekly stock screen list. The column that has seqment rank (ie tibx, software, A/A) Shouldn’t all stocks in the software industry segment have A/A for segment rank? For example, Rovi is in the same industry segment (software) as tibx but has C/C for segment rank. What am I missing? There are other examples of this throughout.
    Regards,

    Bill P

  9. Dirk December 20, 2010 9:58 am #

    Did anybody see the IV of CCE ???
    I have never seen something like that.
    For the Jan 17.50 strike a IV of 607

    Cheers
    Dirk

  10. Barry B December 20, 2010 4:06 pm #

    Bill (Post # 8).

    We use the IBD100 industry rank system. There are 197 individual industry segments represented in that metric. What we’re tried to do is simplify the process by ranking the segments into A through E.

    A = 1-40
    B = 41-80
    C = 81-120
    D = 121-160
    E = >161

    Within each industry there are can be multiple segments with the same description. In the case of software, there can be enterprise software, design software, consumer software, etc.

    The key idea that we’re trying to present is the relative direction of the movement of the segment week over week. This is a good proxy for sector rotation. While there may be multiple industries represented by “software”, we attempt to simplify the process so the average subscriber can easily do the proper diversification. The specific segment differences are less important than broad diversification.

    Best,

    Barry

  11. admin December 20, 2010 4:33 pm #

    Duane (#6),

    At some point in the near future the IBD 100 will become the IBD 50 so the paper and website will publish only the elite stocks from this screen. We are currently analyzing how this will impact the number of stocks on our premium watch list and have plans in place to give our members an adequate list of covered call candidates each and every week. We will keep you updated as our analysis continues.

    Alan

  12. admin December 20, 2010 4:42 pm #

    Dirk (#9),

    When a stat appears too good to be true or unrealistic it usually is. CCE recently distributed a one-time special dividend of $10 per share. The $17.50 strike should be viewed as a $7.50 strike. Evidently your resource calculated the IV of CCE based on a $17.50 strike. The original $17.50 strikes are now $7.50 strikes due to this special dividend distribution.

    Alan

  13. Dirk December 20, 2010 5:03 pm #

    Thanks Alan, that explains it!
    I looked at the option symbol and it did not follow the standard procedure.
    It should have read: CCE110122C17.5
    Instead it read: CCE11101C17.5
    There was one 1 too many.
    And the unrealistically high strike price was puzzling me.
    And don’t worry, I didn’t trade it. . . :>)

    This was then the same deal we had last week with GES

    One more issue.
    PZI, one of our top performing ETFs does not show any options.
    Cheers
    Dirk

  14. admin December 20, 2010 5:17 pm #

    Dirk,

    PZI: You are correct. No options available. Thanks. I will have my team remove this security from next week’s report. As the kids say….”my bad”!

    CCE: Yes same deal as GES from last week.

    Alan

  15. DaveD December 20, 2010 11:19 pm #

    RVBD

    This stock meets all the BCI criteria (i think)…

    *All the smart select are green.
    *There is no up coming ER release in this month.
    *MSN rating is green.
    *The price bars are above an uptrending EMA 20.

    The only negatives that I can see are the following.
    * The MACD and slow stachastics are both down trending.
    *There have been 3 bearish engulfing patterns in the last month, including the last 2 days.

    Even so, im considering selling an ITM call.

    *If we sold the 35 call we would have a ROO of 5.1% with downside protection of 0.9%.
    *If we sold the 34 call we would have a ROO of 3.9% with downside protection of 3.8%.
    *If we sold the 32.50 call we would have a ROO of 2.7% with downside protection of 8%.

    Those who went out of the money and sold the 36 call would have a ROO of 4.5% with upside potential of 1.9%.

    In my opinion, based on the overall technical picture at this current time, the best deal would be to sell the 34 call.

    Happy Trading

    Dave

  16. DaveD December 20, 2010 11:23 pm #

    MSN rating is green (LOL)…

    Blame that one on silly season!

    Make that a 6…

  17. Fred December 21, 2010 1:24 pm #

    I own 1000 shares of ibm that I’m willing to let go for 150. I just sold 10 contracts of the 150 call for 1.05 making nearly 1000. If it goes off I’m okay with that. If not, I’ll keep selling the options.

    Happy holidays and good luck trading.

    Fred

  18. admin December 21, 2010 1:59 pm #

    TIF:

    On November 24th this company reported a positve earnings surprise of 43%. Net sales were up 12% year-over-year. Income from continuing operations rose 46%. As a result, management significantly raised guidance as did many analysts. TIF also rewards it s shareholders with a 1.6% dividend.

    To show its confidence in its business, this company spent $25M to repurchase 588,000 shares. It trades at a reasonable PEG ratio of 1.5. Check to see if this equity deserves a place on your watch list.

    Alan

  19. Don_B December 21, 2010 4:03 pm #

    Alan –
    What is a good strategic approach to the following? I own 200 shares of FCX, bot at 114.77. At the moment I have no options on the shares. Forthcoming events are: 2 for 1 split announce 12/9, record 1/15. Happening, I believe, 2/1. A one-time dividend of 1.00 went Ex on 12/16, with Record 12/20, and pay 12/30. Its ER takes place on 1/20.

    Unsure of whether or not to write Calls on it, and if so, just when! I am quite bullish the stock (copper mainly) so thinking in terms of OTM.

    Your comments will be very much appreciated. Thanx much.

    Don_B

  20. Don_B December 21, 2010 4:25 pm #

    Alan –

    Of course I intended to mention that I have not forgotten the ER date importance here. This next one comes two days before Jan. expiration.

    Don B.

  21. admin December 21, 2010 4:43 pm #

    Don,

    Although I cannot give specific advice about a trade (my legal team will lock me up and throw away the key!), it looks like you figured it out in comment # 20. In the BCI system we NEVER write a call when there is an upcoming ER. There have been occasions when I have been bullish on a stock (AAPL many times, RVBD more recently) and decided to own the equity through the ER and then sell a call after the report passes (if all system criteria are still met).

    FCX was one of my favorite stocks a few years ago and generated tremendous returns until the recession of 2008. Check the chart and note the stock drop from $120 to $20 in a few months. Of course I got out (and many other BCIs) as soon as the stock no longer met our system criteria. I can understand your bullish posture on this equity as the chart looks great and the dividend and split demonstrate the bullish posture of the management team.

    One other thought: Some investors will buy a put to protect on the downside if owning a stock through an ER. This is NOT part of the BCI system but a technique utilized by many conservative investors.

    Alan

  22. owen December 21, 2010 5:48 pm #

    We did mention a trade called a “collar” at one point. The concept of the collar is that I sell a covered call and use the call proceeds to buy a put. If the stock drops, I can sell the put for a profit, or use it to sell the stock for the strike price price. If the stock rises, I will get called away and lose the put premium, but the call premium paid for it.

    It might be a reasonable choice for a position with a large gain you want to protect, but not take and pay taxes on. Generally this won’t apply to a stock you bought last week.

  23. Fred December 23, 2010 8:07 am #

    From my family to yours….happy holidays to Alan, the BCI team and all my fellow investors. here’s to a lucrative 2011.

    Fred

  24. Barbara December 23, 2010 2:51 pm #

    Holiday wishes to all.

    Barbara

  25. Dirk December 23, 2010 5:08 pm #

    Happy Holidays to you Alan and the whole BCI family.
    You all helped me a lot.
    I wish everybody a healthy 2011 and a lot of successful trades.

    Cordially
    Dirk

  26. Phil December 23, 2010 5:35 pm #

    I want to second Dirk’s comments. This has been a great group to learn and earn.

    Merry Christmas.

    Phil

  27. DaveD December 23, 2010 9:53 pm #

    Merry Christmas everyone…

    Thanks Alan, all the BCI team and fellow investors for a great environment to learn from…

    Dave

  28. admin December 23, 2010 10:10 pm #

    Many thanks for all the holiday well wishes both on and off site. Although I don’t know you personally, I consider this group my extended family and want you to know how much your support and contributions mean to our team.

    In 2011 we will continue to work hard to achieve our mission statement of achieving financial independence through education and due-diligence. Thank you for the role YOU have played in this total team effort.

    Happy holidays to one and all,

    Alan, Linda, Barry and the BCI team

  29. admin December 24, 2010 6:10 am #

    Premium members:

    This week’s report of top-performing ETFs has been uploaded to your premium site. All premium members should have received a direct email to that effect. If you are a premium member and did not receive an email, please let me know (alan@thebluecollarinvestor.com) and I will add your name to our premium mailing list.

    Alan

  30. Don B December 25, 2010 1:58 pm #

    MERRY CHRISTMAS TO ALL – And a Happy New Year. I have grown to feel a powerful kinship with our group – folks who come to the point and are always respectful. A well-run and nicely participated blog. Very best –

    Don B

  31. Jim L December 25, 2010 7:49 pm #

    Merry Christmas to all BCI Family. Alan, I havn’t
    heard how the new book is coming along. Will it be
    published soon?

    JIM

  32. admin December 25, 2010 9:20 pm #

    Jim,

    The book is complete and currently being edited. My understanding is that it will take a few months before becoming available. I will send out an email to all those on my mailing list as well as publish information on my blogs when more information becomes available.

    Thanks for asking.

    Alan

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