(I am writing this article because I have had feedback in the past from investors who reject covered call writing based solely on the theoretical risk-rewrad profile.)
A risk reward profile is a chart of the theoretical maximum profit or loss a particular investment can have in your portfolios. For example, let’s look at the risk-reward profile of stock ownership:
Risk-reward profile for stock ownership
This graph demonstrates that, in theory, profit is unlimited; it can go to the moon! You can also lose your entire investment. For savvy investors, will either of these events ever occur? No. Even, the most solid of companies will hit bumps in the road and give us reason to sell some or all of our shares. Furthermore, which educated, prepared investor will allow his stock price to drop to zero?
Theoretical Risk-Reward Profile for Covered Calls:
Let’s analyze this next graph:
R-R profile for unmonitored covered calls
Risk-Reward for an Unmonitored Covered Call:
When selling a covered call option, we are placing a ceiling on the share appreciation; our profit is limited to the option premium plus any stock appreciation up to the strike had we sold an O-T-M strike. The downside is dramatic as we can lose all our equity value and retain only the cash from the sale of the option. If we were to base our decision regarding the efficacy of covered call writing solely on this profile, we would reject it immediately. It appears that the odds are against our success. Fortunately, there is a major difference between theoretical and practical applications of risk-reward profiles. Enter the wonderful world of exit strategies.
Practical Risk-Reward Profile for Covered Calls:
Let’s now analyze an enhanced graph that has application in the world of the informed and prepared investor:
R-R Profile for a Monitored Covered Call Position
The actual profit potential can actually be elevated in some instances by instituting one of our exit strategies. Certainly the potential losses can be minimized by utilizing any of these strategies. Some investors buy puts to limit losses. This is called a collar strategy and will be discussed in future articles and perhaps a future book. Here is the key point uneducated investors miss: This horizontal line that represents potential loss can be elevated closer to the zero line by instituting appropriate exit strategies, selecting the best strike prices, factoring in market tone and equity technicals. These are the marks of true Blue Collar Investors and are what set us apart from all the others.
Conclusion:
When evaluating information to make an intelligent investment decision, we must know the limitations of that tool, in this case the risk-reward profile, so we can apply it in the proper manner. Viewing the last graph as compared to the one before it demonstrates the significance of this point.
IBD 50:
In last week’s blog I mentioned that the IBD 100 list was being enhanced to the IBD 50. That change became effective in this week’s edition of the IBD. I checked the criteria used and found it to be exactly the same as the IBD 100. I cannot attest to the percentages used but the parameters are the same. When I spoke with tech support at IBD I was told that the list basically will be the top 50 of the former top 100. Here is what IBD is publishing regarding the enhanced list:
- Less is more
- Focus on variables that separated the great from the good
- List that is faster and easier to study
- Higher success rate
- Eliminate more volatile stocks
One of the things that attracted me to IBD was the fact that they are always working towards improving the quality of their already stellar products. This, initially, appears to be such an upgrade. We at the BCI will continue to evaluate, monitor and report back to you on this screen and its impact on our covered call positions. We are expecting 2011 to be a great year for the BCI community!
Market tone:
This was an extremely light week for economic reports. The Conference Board’s index of consumer confidence unexpectedly fell in December as economists were anticipating an increase due to the extension of the Bush-era tax cuts. This decline was a result of concerns regarding the state of the job market. Consumer confidence, however, is still on par with the confidence levels of a year ago. For the week, the S&P 500 rose 0.1% for a year-to-date return of 15% (including dividends).
Summary:
IBD: Market in confirmed uptrend
BCI: Moderately bullish. My outlook for 2011 is positive. Economic reports, corporate earnings and government tactics have been favorable to the market. The two major hang-ups continue to be unemployment and real estate. When these turn around expect the ride of your lives as there is still trillions of dollars on the sidelines waiting to enter the equity markets. Of the two, I am more concerned about unemployment as I feel the bottom of the real estate downturn could happen later in 2011. Many of you know that I am heavily invested in real estate as I own both commercial and residential properties in four states. I am seeing property values starting to stabilize, renting much easier in both the commercial and residential arenas and banks just starting to make cash available. We have a long way to go but the early signs are encouraging. My hope is that once real estate bottoms and turns around, it will impact the jobs market in a big way. Construction will pick up, basic materials will be in demand, home furnishings will be needed and a trickle down effect will mean happy days for the stock market. As a rule, the stock market precedes the economy as it is forward looking and 2010 was a decent year for the market and the BCI community. As educated investors we know that there are no guarantees but the signs are generally positive and that is why we continue to remain bullish on the stock market. Let us know how you feel.
Wishing you the best in investing,
Alan ([email protected])
Those who reject covered call writing I find irritating. I lump them in the “coulda, woulda, shoulda” investors, and they deserve what they get, or don’t get.
First, options, in all their forms, are a tool for generating some income. Is it “additional” income? Sometimes, but not always.
Second, can you make more without capping your gains? Yes. Can you lose more without selling a covered call? Yes.
If you look at a covered call position as capping your possible gain you are putting the cart before the horse, and you are assuming that the stock will climb above your basis plus the option premium.
The BCI start with a thorough screening process which provides a list of stocks with the “best chance” of performing as expected in the next thirty days. Years ago I lost thousands holding GM and XRX, all the time selling covered calls, on the idiotic belief that these were a couple of the monsters of the NYSE. The can’t drop 90%, or 100%.
I had thirty years of experience trading options, sometimes successfully, sometimes not, when I took Alan’s seminar. Ha taught me to PICK THE RIGHT STOCK to sell options on.
As for the risk/reward curve? Who cares. Look, you can put your money in the bank and earn a guaranteed 1/2 of 1%, PER YEAR. You can up that to around 2% for US Treasuries, 5% for municipals, 12% for California, etc. Each time you increase the risk to increase the reward.
If you let yourself sit there looking the best return with the least risk you will make nothing. If you can get 5% on a muni bond today, maybe you should wait until next week to see if you can get 5.1%.
The BCI scout the stocks. We calculate the returns for various option choices and then we ACCEPT a 1% or 2% return for the next month. We have the ability to jump out if it goes wrong. We take the same risk as the stock buyer who buys the stock and waits for it to double. If you bought NFLX last year at $75, you beat us. If you bought it at $209, you probably won’t. But many of us have pecked off (remember my crow analogy on the last blog entry) bits and pieces here and there. We took our 1% or 2% and smiled the smile of a successful investor. We could have taken less risk, and perhaps made more, but the point is we knew ahead of time how much we would make under certain circumstances. I would venture to say there are many NFLX investors who bought at $160, rode it to $209, and, waiting for $210, are still holding it at $173.
I don’t use the risk/reward graph. I use the good stock/bad stock selection process and then sell an option. If I don’t make a million by the end of the year, I’ll live. I will still make a decent return. If covered call writing isn’t for you, then so be it. Good luck. We’ll take our chances and reap our rewards, you take your chances and reap your rewards. I do own some stocks which I don’t sell covered calls on. I have a 65% gain on DuPont. Tell me, when should I sell that?
Before I started selling CCs, I was concerned about the criticisms that I read regarding the strategy (the main one being that you’re capping your gains but still have unlimited losses). A couple of things convinced me the strategy was sound:
– The BXM index (http://www.cboe.com/micro/bxm/), which simulates writing CCs on the S&P 500, has achieved long-term returns similar to the S&P but with less volatility.
– I simulated the outcomes of Alan’s trading strategy (including exit strategies) for stocks on the premium watchlist (using a volatility model based on the stock’s historical volatility for the past year), and found that the strategy generated positive returns for many stocks. This means that even if a stock just bounces around randomly, odds are I will still make money. Of course, other factors further improve the odds (gauging market direction, fundamental & technical analysis, etc.), but even without that, I believe that writing CCs is a sound strategy.
The fact that you can “dial-in” your risk-reward threshold with strike price selection is also a huge plus for me. I’m fairly new to managing my own money so I want to start off conservatively, and Alan’s strategy lets me do just that.
You don’t need to “preach to the choir” to those of us who read the blog, we’re believers! You only need to follow Alan’s system and it will make a believer out of you in short order.
Good Luck in 2011 to fellow members.
Mark
In normal market conditions we can expect to achieve 2-4% a month. True.
So this works out to be 24-48% annualized…
Should one expect to achieve a goal of 24-48% a year? If not, what should one expect?
Ive spoken to one person who has traded covered calls for the last 20 years and he says he has averaged 20-25% a year…
Another person I have spoken to thinks this is obsurd and that 10% would be great.
I occasionally hear figures such as 40, 50 60% thrown around…
Alan and co. what are your thoughts on this topic? Should we set a goal over the year? Or, should it be a month to month approach? Or, is goal setting something we should avoid in trading in order to maintain an eotional detatchment from the trades?…
Also, here in Australia there has been talk about a double dip recession in 2011. I cant help but chuckle when I hear this. Call me a skeptic, but hasnt the market just been gong up the last 6 months. Where do people draw such conclusions?
One of the reasons I decided to trade the US market is the amount of optionable stocks available. I just love the fact that I have thousands of stocks to choose from. Also, in Australia you have to own 1000 stocks to sell 1 contract.
Dave
JP (#2),
Your careful approach to managing your own money is quite impressive. It’s great to have you part of the BCI community.
I’m glad you brought up the BXM because I get inquiries about this index frequently. The BXM tracks the performance of a hypothetical buy-write strategy on the S&P 500 Index. Here’s how it works:
1- Buy S&P 500 Index portfolio
2- Sell 1-month, slightly O-T-M call options
3- Hold until expiration and cash settled
4- Write new near term, O-T-M calls
I support the use of 1-month options, a subject I have written about frequently over the years and stress in my books and DVDs. Here are the reasons why the BCI system will “blow away” the results of BXM: The BCI system……
1- Selects the greatest performing stocks in the greatest performing industries ONLY. BXM takes the good, the bad and the ugly.
2- Uses all strike choices (A-T-M, I-T-M and O-T-M) depending on market conditions, stock technicals and risk tolerance; BXM uses only slightly O-T-M strikes.
3- Uses exit strategies when a stock unexpectedly declines. BXM holds until expiration under all circumstances.
4- Avoids stocks that will report earnings in that cycle. BXM totally ignores this risky approach. The same holds true for stocks that report same store monthly retail sales.
What BXM does demonstrate is that if you buy the benchmark index and then hibernate you can achieve slightly higher returns than the S&P 500 over time with much less volatility.
Thanks for bringing this issue to our blog. It’s an important point to evaluate.
Alan
DaveD,
I don’t set a goal for the year unless I can tell where a particular stock will go during the year. If you set a goal you tend to take chances to you shouldn’t just to keep up. If the market gets bad, and you take a month off, you will have to make double next month to keep to your goal.
I take what I can get each month. 10% per year is a decent return. That works out to less than 1% per month. If I want to double my money in one stroke, I’ll put in red on a roulette wheel, but only if I want to risk losing 100% of my bet in one stroke.
My only goal for the year is to make more money than I lose. As for the question of a double dip recession in 2011, we will just have to wait and see what the 600+ dips in Washington DC do for (to?) us. Since you have chosen to hitch your cart to a US horse, they will be important to your financial future, too.
Hope you don’t live anywhere near the new Queensland ocean.
I do covered calls but most of my trades are married puts or collars. Covered calls alone ignore 3 very important factors:
Emotions. Changing behavior is difficult. Tell someone to exercise to reduce heart disease and 10 % might be disciplined and many use the treadmill to hang their clothes.
Alan, how many of your patients continued to floss everyday?
How many people loved to invest when the market was going up in early 2000 and 2008. I am certain that 10-20% of you were disciplined to get out but many of you went through the 5 stages of death, with the first
stage being DENIAL That was me.
I suspect most of you will have a bard time admitting your losses in 2000 and in 2008 as well as the emotional upheaval. Fortunately a few of you were disciplined and stocks improved.
Ok, let’s say you are disciplined, diversified,analytical and logical. Such an approach puts you in an elite class of investors. You will do better than most but you cannot avoid the second disadvantage of covered calls.
Stocks go down faster than they go up and your gains for the year can be nullified in 1 month.
Tax law changes, excessive greed,terrorism,European defaults,a war in Korea/Iran and even another flash crash which still remains unexplained.
The third reason that covered calls are not as protective as you think relates to market tone. Do what everybody else does and you will lose. The professionals get in early and then tulipmania sets in.You get in too late.
When the market goes down you get out and now sentiment is low. The market starts to
come back but sentiment is low and you can’t get yourself back into the game.
I like your system, Alan, but human behavior, world events and even investor sentiment can get in the way. I’d rather buy my insurance prior to being in a burning building waiting for the fireman to put out the fire.
Best Regards,
Evan
Dave (#4),
Since we write predominantly 1-month options in the BCI system, I set my goals monthly mainly to make sure my technique and due-diligence are maintained at the highest levels possible. If I fall short of my goals, I will go back and check to see where I could have improved. It is by maintaining this discipline over a long period of time that led me to many of the rules and guidelines that is now inherant in the BCI system. For example, when I lost money after an earnings report (for the 100th time!) I finally added the rule to avoid these ERs when selling cc options. So setting 1-month goals will keep you sharp and allow you to focus on any posssible shortcomings you may have using this great strategy. It will also give you confidence knowing that it will be unlikely that you will make the same mistake repeatedly.
As far as others promising much higher returns, common sense tells us that to get returns of 5-10% per month (as I have read on other sites) you must use underlying securities with extremely high implied volaility options. This simply is not my style and in my view way too risky. By using the conservative rules and guidelines and the BCI system your expectations need to be more realistic and therefore your risk dramatically muted.
Alan
Evan (#7),
The use of protective puts is not only a valid strategy but one that is actually the right strategy for some investors. As a matter of fact, one of my goals for 2011 is to start writing a book describing the various ways that put options can be incorporated into the covered call strategy.
One of the mission statements of The Blue Collar Investor is to achieve financial independence and become CEO of your own money. There are many ways to accomplish this. Any expert/author/speaker who professes that his (her) way is the ONLY way should be looked at with suspicious eyes. The BCI system does not use protective puts but a myriad of other measures that minimizes risk. I share with our BCI community the approach that works best for me and explain why. It is right for me and many others but not for everyone. We respect and encourage other approaches and value your input as it will make us all think and as a result become better investors.
You make some excellent points relating to emotions, world and political events and market tone. For the BCI community and our educated investors I would respectfully have a slightly different take on these matters. Rather than assume that these factors are ignored and forgotten, I feel that they are understood and delt with in a different manner. There is no right or wrong here because what is right or comfortable for one investor may or may not be for another. We have a mutual respect for each other.
Finally, I must tell you that a surprising number of my patient floss on a regular basis. They are easy to identify: they are highly motivated, do their due-diligence and have strong desire to keep their hard-earned money.
Thanks for sharing your point of view. Once again, I consider it so important that I am planning a book that will include how to utilize protective puts in a covered call strategy.
Alan
Alan, Evan, & All –
The viewpoints expressed by Evan in #7 could not easily be expressed any better. Adding to that, many of the risks he mentions are those which nobody can possibly anticipate, such as wars. We face today war in possibly several zones, as well as another severe matter, that of the potential destruction of the dollar.
But since one cannot anticipate these things, in a way it becomes necessary to ignore them. If one sat in fear of them, one would do no investing at all.
Re losses – I have had my share of them, but as a percentage of my overall CC experience, even those chokers become small comparatively.
About the statement that stocks go down faster than they go up?? That is only part of the story, as it is also obvious that upmoving stocks can tend to go up faster than expected, and downmoving stocks can go down faster than expected.
I dearly LOVE the expression of investment attitudes as well as that of investment techniques that is expressed on this blog. Continue please to bring it on!!!
Don B
The best time to invest is when everyone is scared and is speaking doom and gloom…
I remember in 08 here in Australia, there were people I know, grown men, who were saying the world is going down the sink. If you even mentioned “investing” or “stocks” people would run the other way. They were scared. As a result I just stayed on the sidelines cause I didnt know much anyway at the time-novice.
Yep, that was the best time to get in… When everyone was scared…
Listen to the charts, not to people. People lie, charts dont…
Dave
DaveD,
I love your comment about the charts!
Barry
And speaking of the use of charts, I have been trying to learn to use what is called the CCI, Commodity Channel Index. Seems that when it breaks above that 100 plus line that is a bullish signal, and when it breaks below that 100 minus line that is a bearish signal. Anyone who can enlighten me of the accuracy on that will be appreciated, and who can give me more perspective on using it will be appreciated. Thanx much.
Don B
I have read that one of the best ways to avoid the emotional issue to set a predetermined sell point and stick to it. You can either use a stop loss order, or you can set a loss percentage that you will not adjust. If the position loses 4%, or 6% you close it. Period. No re-evaluating the original concept. Dump it. The theory is, if you cut your losses, and let your winners go, you will make money.
You already do this with other things. Your bank tells you they are raising fees, you switch banks. Your car repair will be $800 and the car is only worth $600, dump the car. Your wife just came home with her third mink coat, well, sometimes you have to be flexible.
Selling a covered call is already setting one price we will sell at. Set the second one on the downside when you make the trade. Write it on a piede of paper next to the computer. NFLX hits $198, SELL. Do not hope it will come back. And, if it does, it does not matter. It is a BUSINESS decision. Your stocks are not family. They are soldiers. If they can’t get the job done, replace them.
Alan –
A learning opportunity for me exists here & now. NOG, on our weekly chart, shows in red because of the MACD line & the STO. The MACD shows as 1.5, today, while the bar itself is barely negative. I for one could use a better understanding of those two. And Yes, the volume is quite low today. Hoping for your commentary. Thanx much.
Don B.
PS – Meant to comment that the STO line appears to be fairly good. Perhaps I am reading it wrong.
Don B
Don,
Our premium report is red-flagging a possible turnaround of this fabulous upward trend for this stock. The red arrow below shows a long and consistent uptrend with a bullish moving average trend identification.
However, our momentum indicators are turning negative. The red circle in the chart below shows the histogram just dropping below the centerline and the stochastic oscillator with a double-dip below the 80% (green circles) a bearish signal as well. We recognize that this can change but the reason we update the report weekly is to give our members the most recent information when making their investment decisions. If I owned this stock I would keep it but watch for possible exit strategy executions should the price start to drop. If I were entering a new position I would select a different equity until the confirming indicators turned around. If I was determined to buy this equity I would sell an I-T-M strike to get additional protection.
Here is the chart I just constructed:
Alan
What criteria do you use to decide when to buy back an option if the stock has gone way past the strike price. For example, I sold the $35 option for RVBD and the stock is now at $37.29. If I buy back the option for $3.10 and sell the stock I will lose $0.81 per share. Common sense tells me that this is too much (2%) but was wondering what guideline you use.
Thanks.
Alex
Alex,
I think we are missing a piece of your RVBD positions. I have the same position. I bought RVBD at $35.46 and sold the JAN $35 call for $2.42. The stock is now $37.28 and the call is $3.14.
If I close both positions I make $1.82 on the stock and lose $0.72 on the call. I will have a net gain of $1.10 per share.
If you prefer to not post your cost basis here, please email me what you paid for the stock and what you sold the option for: [email protected]
Owen,
I wasn’t counting the cash I made from the first option sale. If I bought back the option for $3.10 and sold the stock for $37.29. I would lose $0.81 (adding $2.29 to my stock value). That’s a little more than a 2% loss (.81/35). Like you, I made a 5% profit from the initial option trade.
Alex
Thank you. Be careful about the calculations. You don’t want to make an incorrect move because of incorrect numbers. Your initial option sale is not a completed transaction, so you should not consider it to be “income”, until the option expires, it is exercised or you buy it back to close it out. You have a net profit if the stock gets called. That is the target you should be keeping an eye on.
In my trade, I sold an In The Money call. The first thing I need to do is subtract the intrinsic value (the amount that is in the money). So, my call becomes a “profit” potential of $1.96 ($2.42 – $0.46). The $0.46 is the amount of intrinsic value since I am selling a $35 call and bought the stock for $35.46.
So, my calculation is a potential profit of $1.96 for a $35 investment, or 5.6%. Now, what I have done for the last two weeks is to watch the net profits on the two positions. Currently, I can take this trade off the table for a net of $1.10. Why would I give up the remaining $0.86 left in the deal? Well, if I am concerned that RVBD is going to tank, the general market is going to tank and perhaps take RVBD below $35, or I found something that will make me more than the $$0.86 I am giving up, with the same money, in the same period.
Right now, none of these choices interest me, so, I will continue to watch it. If I think the stock will stay above $35 and get called I will hang on. If I become concerned, I will unwind it.
Owen thanks. That clears it up.
Alex,
When I unwind a position mid-contract due to price appreciation I look for the TIME VALUE of the option premium to approach zero. As the strike moves deeper and deeper in-the-money (the share price appreciates), the time value will decline and the bulk of the option premiuim will be intrinsic value. We will retrieve the bulk of this intrinsc value with the share appreciation by lifting the option obligation ceiling (your shares are now worth $37.29 not $35). In the scenario you addressed above the time value is $0.81 or 2.3%. If you unwind, your 5% initial option return will be reduced to 3%. As Owen suggested you can hold as is and the 5% is now protected by $2.29. If time value was much less and you could sell the shares and enter a new position to generate additional income, that would be a reason to unwind mid-contract.
Alan
ARMH:
Here’s a real life example of a potential mid-contract unwind:
Those who sold the $20 call can repurchase it for $1.95 and sell the stock today for $21.85. This is a net debit of $10 per contract (0.5%). It should be easy to use the cash from the stock sale to generate a much higher return than 0.5% for the 13 trading days remaining in the January cycle.
Alan
Alex, applying Alan’s analysis to our Riverbed stock, this is what we get right now.
The $35 call is priced at $3.20. That values the position at $38.20 if you bought the call and immediately exercised it. Since the stock is currently trading at $37.48, we get a time premium remaining on the option of $0.72. Assuming the stock stays above $35 until January 22, this means that you will earn a maximum of $0.72 more than you have already earned on the position if you close it now.
So, what you do is look at your watch list. Determine if there are any trades where you may potentially earn more than the the $0.72 you will give up to close the RVBD now. Compare apples to apples. Look at the January calls. February is not a choice for RVBD because their next earnings report is due on January 27.
My personal choice is to let this run and get called. It gives me time to watch some other stocks and get ready to invest the $3,500 on the 24th.
Also, keep a sharp eye on it. Just because the earnings report isn’t due until the 27th doesn’t mean that somebody out there knows something and the stock could begin to move before the report comes out.
Considering jumping aboard INFA or MRVL…
Opinions/ insights anyone…
Dave
DaveD (#26),
My Opinion…
INFA
-Passes SmartSelect – 6 green “lights”
– ER on 1/27, OK for this month
– Stock Scouter – 7
– Chart
> Strong upward trend
> Price above all MAs
>All MAs “stacked up” (5EMA, 20EMA, 50SMA, 100EMA, 200SMA)
– Indicators
> MACD below signal line but moving up
> Stochastics – Above signal line, moving up but not yet in overbought territory
– As of close tonight, you can do an ATM cov call and get approx 1.8+% for the rest of the month.- Anecdotally – I’m in the software sales business and I compete with them. They are in EVERY deal, installed everywhere.
Net/Net – my PERSONAL opinion…I like the trade.
MRVL
– Did not pass SmartSelect…immediate disqualification
– Closed below 5 EMA…immediate disqualification
Net/Net – my PERSONAL opinion…INFA is the better trade
I hope this helps,
Barry
DaveD (#26),
One other point on INFA…Bollinger Bands just coming out of a constriction and the stock did not close above the upper band while remaining above the 20 MA…a nice pattern.
Barry
Barry,
Thanks for your insight…
Yes, I might very well decide to make the trade with INFA…
You definetly make a strong case for the stock!
Dave
Have any of you guys heard of a stock market ‘guru’ called Chuck Mellon…
I just had a phone call from a guy asking me if I wanted to become a member of his private recomendation service…
How much does it cost?
$3,500……………….Per month!!!
Thats $42,000 A YEAR!
Uh, I might pass on that one for now…
Dave
JBL:
On December 20th announced a positive 1st quarter earnings surprise. Revenues were up 32% and earnings per share beat consesnsus estimates by $0.05. It gave guidance for a record year in 2011. Analysts started jumping aboard this stock driving the price up. The stock still is trading at a reasonable forward PE of 11x and a PEG ratio of 0.9.
Check to see if this equity deserves a spot on your watch list.
Alan
Dave,
Chuck Mellon’s website says he is one of the world’s best investors, so it must be true.
http://www.chuckmellon.com/
Ok, I’m trying something new in the spreads. I sold the FFIV Jan 150 call for $1.87 with the stock at $138.38. I bought the Jan $160 for $0.51. Hopefully the stock will stay under $150. I will keep $136 for putting up $1,000 for 16 days. Hmmmm……….
Owen – #33 –
Egads……….let us know how it works out please!! Sounds fabulous on paper. But unclear on the risk and what the possibilities are, in practice. If the stock rose above $150, say, you would be called away for your STO obviously. I presume you do not have any stock to be exercised on.
What happens if A) the stock closes under $150, B) Between 150 & 160, and C) Above $160? And is early exercise on your short much of a potential problem? TIA.
Don B
I tried to put Owen’s spread on a spread sheet. . .:>)
Please advise, if there are mistakes or wrong conclusions.
Cheers
Dirk
Food for thought:
What type of ER is Owen hoping for on January 19th? It is the increased implied volatility caused by the upcoming ER that is giving value to strikes so DEEP out-of-the-money.
Alan
@ Alan
If he wants to be on the safe side, he hopes for a bad earnings report. :>)
Cheers
Dirk
Don_B,
The whole purpose of a spread is to act as a pseudo covered transaction. First, the reason for this particular transaction is that I think FFIV will not reach $150. It has been screaming north for weeks and is currently trading around $138, its 52 week high.
Since I believe it won’t hit $150 i decided to sell the $150. I can’t sell it naked, so I bought the $160 call. If the stock runs through to $200, I get called at $150, I turn around and call in the $160, and I lose $1,000.
If the stock lands between $150 and $160, I buy the stock at market to deliver at $150 and lose the difference. Let’s say it hits $154. I lose $4o0 on the deal (less my net of $136 on the calls).
If the stock stays below $150, both options expire worthless, and I keep a net profit of $136.
There will not be an early exercise as long as the stock stays below $150. Nobody is going to call in stock at $150 he can buy on the market for $138 or $141. Even if there is an early exercise, I simply buy the stock and deliver it, or exercise my $160, if it’s above, and deliver those shares.
What I am doing here is taking the position that FFIV has done very well, but it can’t keep it up, or it can’t hit $150 before Jan 22. I may be wrong, but that’s the chance I am willing to take.
In order to make money on the upside, the stock really has to go above 160, which is very unlikely.
Even 150 is very unrealistic, but possible.
Cheers
Dirk
Oh, our posts crossed each other Owen.
Cheers
Dirk
Eiweih, my Scenario # 1 is wrong. . .
Sure, Owen, you buy it at market for $15400 and deliver it for $15000. You loose only $400
Geez, how could I get this so wrong? :>)
Cheers
Dirk
Again, folks, spreads are not for everyone. I have been doing this for years, I don’t have a family to look out for, and I am not betting the farm on any one trade. Covered calls very good and I use them. There are times when I think I can make some money on a stock that I think is going to go down, or is not going to rise enough to make a covered call trade worthwhile.
A spread can also be used where you can’t afford the stock. If you want to do a covered call on Google you have to come up with $61,000. Using a spread you can buy the $560 or $570 call for $5400 or $4400, and then sell the $600, or $610 call. I have made a great deal of money recently on Apple option spreads, and I haven’t bought the stock in two years.
Spreads are not for everyone. You should be comfortable with covered calls and have been trading them for a while. Spreads give up a few dollars that you don’t with a covered call, but you are still protecting yourself from complete disaster. I cannot lose more than $1,000 on the FFIV spread. I can make $136. Those are my two outside limits.
Please don’t trade spreads unless you are very comfortable with the concept. I don’t want to feel I gave someone too much information here and they went off and lost a bundle. Some of you are a bit more able to deal with the spreads, so I think if you see some actual trades you will begin to understand their uses.
O.K. here is my revised spread sheet.
I hope I got it right this time.
Shame on me for the first one. . . ;<)
Cheers
Dirk
@ Owen,
how does your exit strategy look like if the stock moves closer to your 150 strike?
Cheers
Dirk
Dirk,
The stock has to climb 8.7% from $138 to just reach $150, not clear it. It has already risen 251% in the last year. 9% in the next two weeks seems a bit extreme, to me. And I stress TO ME.
The short interest is only 4.25 million shares, 5.25% of the outstanding. This means that there will not be a lot of upward pressure from short covering.
The last earnings report was October 26. I am not sure if the next is just before expiration Friday, or just after, but I will unwind before the earnings come out.
Its 52 week high is $143.75. That is still 5% below the $150 I have bet on.
Last, but certainly not least, I am hoping to take advantage of the time premium erosion. The closer we get to expiration Friday, the faster the premium will erode.
This is not a trade I am going to go on vacation and hope for the best. I will watch it carefully. This roulette wheel allows you take your bet off the table while the ball is still in motion.
I admit, I lost on the Netflix put spread I had. I sold the $185 put and bought the $175 put. When Cramer and that CNN short seller dumped on the stock, I closed the position for a loss, when the stock was around $184. The stock is now $178. I didn’t lose the maximum I could have, but I did come out on the short (excuse the pun) end on that trade.
Thanks Owen,
Earnings whispers has a confirmed ER date for FFIV for the 19th after close.
So I am assuming, there will be some movement because of this and because of the expiration 2 days later.
I’ll do a paper trade on this one and will watch it like an eagle.
The theta is 14 cents per day for the 150 call, so there will definitively be some good time erosion on it, which makes it cheap for you to BTC.
Let’s see how much money we make.
You for real and I on paper. :>)
Cheers
Dirk
With 2 weeks im trying to find some nice deals…
AGP looks ok…
So does DSX..
Both these would give us 2%…
Anyone wanna share any $tock$…
Dave
If I can’t find anything worthwhile for the next two weeks, I would seriously consider going for six weeks to the Feb calls.
Here is another thought on using spreads. Let’s look at my Riverbed trade. I bought the stock on 12/17/10 for $35.46. I sold the Jan $35 call for $2.42, for a potential profit of $1.96.
Instead of buying the stock for $3,546, I could have bought the Jan $25 call for $10.50, or $1,050. What is my risk? Exactly the same (except for an extra $4 from the call premium). What is my reward? Well, I have $2,500 more to invest in other things, or, if I really believe in this trade I could have bought 3 $25 calls and sold 3 $35 calls.
Again, you must be very careful with spreads. You have to be sure you buy the correct call. Had I gone with the $25 call instead of the stock, I would have had a $192 potential profit, instead of $196, but it would have been on an investment of $1,050, instead of $3,546. The return % would have been 18.3% ($192 / $1,050) instead of 5.5% ($196 / $3,546). Don’t let the percentage figures cloud your judgment. I will still make almost the same amount of total return in dollars, but I will have freed up $2,500 to, perhaps, help diversify my trades.
Owen,
Going back to your FFIV call spread. I have this fear of another flash crash or of a market correction. This trade works as long as the underlying doesn’t go up too far too fast and works if the market drops. I already have a covered call position in FFIV with a 140 strike. I think this might complement that. Maybe I’m just doing a collar or straddle or strangle? I’ve got to think about this some!
Mark
Mark,
I didn’t sell the $140 call because it was too close to the $138 price at the time, and I thought it might make that. I wish you luck with your trade. Don’t let my opinion worry you. My opinion and $1 will get you a latte at McDonalds. You could be correct, I could be correct and we will both make money. Someone may offer to take over FFIV next week for $200/share. You will make your profit and I will lose $1,000.
The only person who was correct in the stock market 100% of the time was Ivan Boesky, and he got 10 years in the federal pen when the government figured out how he did it.
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Somebody has a high opinion of Riverbed Tech. The stock is now $37.82 and the ask on the Jan $35 is $3.50, a $0.68 time premium. Somebody thinks this is worth $38.50 within the next two weeks. I would have liked a bit more time premium erosion to give me the choice of closing it early, but, I guess, Alex and I will just to have to wait two more weeks to lock in our profits.
Is this a great country, or what? Happy trading everyone.
Usually I hate high priced stocks.
At least I did in the past.
Then I discovered the option of the spread, thanks to Owen and others and I am playing with it. . . on paper.
Covering your call position with another one is a great way to deal with high priced stocks we can’t afford. . ,.if done very carefully and right.
I found another love.
Weeklies.
I had some money left and did not know what to do with it :>) and bought 100 shares of NFLX at the end of December for $179.9 a piece.
That was just enough for one contract.
I sold the weekly Dec 31 180 call for $1.40.
That would be 140 bucks in my pocket for just one day remaining. Oh, I like that.
The next day, Dec. 31, the expiration of the 180 weekly, the 180 call was down and I bought it back for 4 cents because I did not want to get assigned.
I sold immediately the next weeks 180 call for $2.45
Another 245 bucks in my pocket. Huhh, huu!!
And hopefully it will remain there. . .
Yes, it did. The stock closed on Friday at 179.25, meaning I have not been assigned and the money stayed in my pocket.
Today I was eager to continue this steady money stream and sold the next weekly for $5.85
Another 585 bucks in my pocket.
I could have waited a little bit, because the 180 Jan14 call is now at $ 6, but I was eager to cash in.
I know, this week’s deal is not finished, but lets just count the numbers to have some fun.
$ 1.40 STO for on day in Dec
$ 0.04 BTC on the 31st
$ 2.45 STO for the first Jan week
$ 5.85 STO for the second Jan week
Makes summa summarum $9.66 for 15 days on an investment of $17,900
Thats 5.37% or 128% annualized.
Did I say I hate high priced and volatile stocks?
:>):>):>)
Cheers
Dirk