Recently, a BCI member sent me an email describing a series of trades he made with GMCR. After responding to his inquiries I realized that there was a great learning lesson here that could benefit many others as well. With his permission I present the key parts of this email:
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Hi Alan ,
I have a few questions regarding the Ellman Calculator. Let me give you a recent trade as an example first. On 6/01/2011, I bought 100 shares of GMCR at $80.24 and sold 1 GMCR Jun11 80 Call at $2.90. A week later the price had dropped and I was able to buy back the Jun11 80 Call at $0.27 and sell a Jul11 77.50 Call at $2.77. By the first week of July the price had shot up in the high $80s and I wanted to participate in the gain, so I bought back the Jul11 77.50 call for $14.60 and sold a Jul11 92.50 Call at $1.95. The July 92.50 call expired with the price around $91.00. I then sold an Aug11 95 Call at $4.25 on 7/19/2011. On 7/28/2011, GMCR shot up over 18%, so I bought back the Aug11 95 Call at $11.50 and sold 100 shares of GMCR at $106.06.
Here’s the trade in table form:
- 6-1-11: Buy 100 x GMCR @ $80.24
- 6-2-11: Sell 1 x June $80 call @ $2.90
- 6-10-11: B-T-C 1 x June $80 call @ $0.27
- 6-10-11: S-T-O 1 x July $77.50 call @ $2.77
- 7-6-11: B-T-C 1 x July $77.50 call @ $14.60
- 7-6-11: S-T-O 1 July $92.50 call @ 1.95
- 7-15-11: July $92.50 call expires worthless; stock value $91
- 7-19-11: Sell 1 x August $95 call @ $4.25
- 7-28-11: B-T-C 1 x August $95 call @ $11.50
- 7-28-11: Sell 100 x GMCR @ $106.06
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For someone new to covered call writing this investor has many of the principles of this strategy mastered. He also has the motivation and determination to put them to use. VERY IMPRESSIVE! For all of us (including me), the learning process never stops and there oftentimes are ways to enhance our bottom line returns. So let’s sit back, relax and evaluate the various stages of these trades:
6-1-11: Buy 100 x GMCR @ $80.24 and
6-2-11: Sell 1 x June $80 call @ $2.90
Initial profit is $2.90 – $0.24/$80.24 – $0.24 = 3.3%. Here we deduct the intrinsic value of the premium and divide it by the initial cost minus the intrinsic value. Good job!
6-10-11: B-T-C 1 x June $80 call @ $0.27
Buy back the option @ $0.27 which meets our 10% guideline. Nice work!
6-10-11: S-T-O 1 x July $77.50 call @ $2.77
You rolled down (to the $77.50 call) and out (to the July call), a strategy I never use. You are assuming more obligation on a declining equity (we did not know at that time it would appreciate the way it did but you shut the door on benefiting if it did). Since you were early in the June contract, consider waiting to “hit a double”…you would have! If the share price does not rebound, consider rolling down in the same month or closing the position if the stock continues to decline. Before the lower strike was sold your cost basis is $80. When you B-T-C @ .27 and S-T-O @ $2.77 there is a net credit of $2.50. Since the $77.50 call is 2.50 in-the-money, the ROO is 0. Again, I never roll out and down. See the middle of page 121 of Cashing in on Covered Calls. At this point in time, your cost basis (for purposes of making the best investment decisions, not for tax purposes) is $77.50. You made no money and lost no money on the last trade.
7-6-11: B-T-C 1 x July $77.50 call @ $14.60
Here you rolled up in the same month also a strategy I rarely use for fear of a decline due to profit-taking (after a stock price has risen sharply in a short period of time) and it usually does not put a lot of cash in our pockets. The net debit is (-) 12.65 and the unrealized credit is the current market value – 77.50, probably a wash, again a no-profit trade (but a great learning experience…I’ve been there!). Take a look at the blog page in the left column and look for “mid-contract unwind”, a strategy I developed after I wrote exit strategies….This may have been a better approach. It is used when a strike moves DEEP in-the-money and the time value of the premium approaches zero.
7-15-11: July $92.50 call expires worthless; stock value $91
As we move to the next month make sure the stock still meets our system criteria INCLUDING NO EARNINGS REPORT …uh oh).
7-19-11: Sell 1 x August $95 call @ $4.25
Now for my most important comment: You sold the August 95 call with an upcoming 7-28 earnings report. Avoid doing this at all costs. Either sell the stock prior to the 28th or own the stock through the report but do not cap it by selling the call. This way you can participate if the report is positive (evidently it was). After the report and the price settles, feel free to sell the call if the stock meets your requirements. You could have sold the stock for $106 without paying the $11.50 to buy back an option you probably won’t sell in the future.
7-28-11: B-T-C 1 x August $95 call @ $11.50 and
Sell 100 x GMCR @ $106.06:
Ouch, we had to buy back a call we never should have sold. Many years ago when I first started educating myself on this strategy I did this very thing many more times than I care to think about before I made this rule for myself and now share with you: never sell a covered call option on a stock about to report earnings.
I created a chart from June 1st to July 28th, the first and last trades made by this investor highlighting BCI strategies to consider:
Trading GMCR: 6-1-11 to 7-28-11
Note the following:
- The chart shows the June and July expirations
- We intially buy GMCR @ $80.24 and sell the June $80 @ $2.90 for a $266 initial profit (3.3%, 1-month return)
- In June we B-T-C the short options position and S-T-O the same $80 strike for (let’s say one third the original premium) for $1 generating another $73 in profit ($1 – $0.27). This is called “hitting a double”. Total profit so far = $266 + $73 = 339 = 4.2%, 1-month return
- The June contracts close right about $80 so we can roll out to the July $80 strike or roll out and up to the July $85. As it turns out the latter would have returned the most but let’s err on the conservative side and say we went with the $80 call and generated another $266 per contract for a final total of $339 + $266 = $605 = 7.6%, 2-month return or 45% annualized.
- When the July contracts expire, the price is well above the $80 strike or even the $85 strike for that matter. We can allow share assignment and move on to another equity or buy back the option at parity (almost all intrinsic value) and await the earnings results.
Conclusion: There are so many ways to enter, manage and close our stock and option positions. By analyzing these different approaches and having a complete understanding of the advantages and disadvantages of each, we will all become better investors and ultimately financially independent.
Market tone:
There is little doubt that market psychology has taken hold of our markets. I’m talking fear and panic. Now there are good reasons for concern. We have seen tragedies in Japan, European debt issues, our credit rating issues, unemployment, a sluggish recovery of our economy and a host of politicians who make Beavis and Butt-Head look like Mount Rushmore candidates:
Heading for Mount Rushmore?
This emotional response to these extreme circumstances has led to increased volatility as reflected in the CBOE Volatility (investor fear) Index. This index normally has an inverse relationship to the market benchmark (S&P 500). Let’s look back at the VIX for the years 2008, 2009, 2010, and 2011 to date. Specifically let’s hone in on spikes in the VIX and see how it relates to the behavior of the market:
VIX- 2008
VIX- 2009
VIX- 2010
VIX- 2011 through August 12th
Note spikes in the VIX:
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2008- October and November
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2009: January through March
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2010: May and June
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2011: Recent weeks highlighted in yellow
Next let’s view a chart of the S&P 500 which incorporates this 3 1/2 year time frame:
S&P 500 reacts to the VIX
I have highlighted in green the corresponding areas of market decline in response to the rising VIX. I believe that this panic buying and selling will pass and here are my reasons:
- Corporate fundamentals have not changed
- Interest rates are low and favorable for corporations
- The PE ratio of the S&P 500 is @ 12, below longer term average
- Corporate cash balances are at all-time highs
- US government bonds remain the standard as the safest place to put our money
- Corporate earnings continue to positively surprise
- Profit margins are at all-time highs
- US Banks have stronger balance sheets than a few years ago and most are trading below their book values
- Oil prices have declined
- Stocks are a better investment than bonds by virtue of an earnings-to-price yield (inverse of PE ratio) of 8.3% compared to bond yields of less than 2.5%
For the week, the S&P 500 declined by 1.7% for a year-to-date return of (-)5.1%.
Summary:
IBD: Market in correction
BCI: I am short-term extremely defensive using the strategies I presented in the Premium Emergency Management Report last week (in-the-money strikes, protective puts etc.). I remain bullish longer term and look for technical confirmation before taking more aggressive positions.
Wishing you the best in investing,
Alan,
I love these real-life trading articles. They are great learning tools. When the June contracts are expiring and you consider rolling to the 80 call or up to the 85 call would it be fair to say that in the current market conditions you would opt for the 80 most of the time?
Thanks for all your work.
By the way- its the first time I saw Beavis and Butthead in a financial article!!! South Park next?
Tim
Tim,
As a conmservative investor I would opt for the $80 strike in the current market environment. More aggressive investors may opt for the $85. At the time this trade was considered the market was not going through the turmoil it has been subjected to recently so the $85 strike was a viable choice even for conservative investors.
South Park?….not bad.
Thanks for the kind remarks.
Alan
Premium Members,
The Weekly Report for 8/12/11 has been uploaded to the Premium Members Website.
Best,
Barry
Alan,
One more question: If you held the stock through the earnings report would you have sold it after the big price increase or sold another option?
Thanks again.
Tim
Alan,
In your DVDs you talk about using low beta stocks in volatile markets. Can you give an example of how this could be used from this week’s watch list?
Thanks a lot.
Joel
Premium Members,
The Weekly Report has been revised and uploaded to the Premium Member’s site. Minor change…does not impact selections. Look for Weekly Stock Screen And Watch List 08/12/11 REVA.
Best,
Barry
Alan, I also agree with Tim above that these real life examples are very, very useful. Even though the principles are simple and straight forward, the complexities of analysis trades on multiple month position gets higher and higher with each trade. I “lost” myself in a series of trades very much like this example. I learned a lot from it, and like the confirmation of your comments. From your site, I’ve also started using IBD, but find O’Neill’s strategy much more difficult to execute. I would like to know how much of IBD’s stock analysis you take advantage of.
As a follow-up to using charts to help predict the market, I suggest one look at the work of Ron Walker at: http://www.thechartpatterntrader.blogspot.com. The site is free although he does request a donation.
He goes into great detail regarding the market each day and is bold enough to consider up and/or down possibilities. He is an excellent teacher and provides an important foundation for those who wish to hone their skills on reading and using stock charts.
His work is also on U-Tube and Stockcharts.
The action has begun on the world stage. Looks like lots of volatility during the remainder of August-September-October. As I mentioned last week, in this crisis there are opportunities for great profits as well as great losses.
Tim (#4),
Each situation is evaluated on its own merit. I look at market tone and chart technicals. After a substantial price run-up following a positive earnings surprise there is always the risk of profit-taking and a slight pull- back. Therefore, in neutral market conditions I am likely to sell an in-the-money strike. If I have traded multiple contracts (usually the case) I will “ladder” the strikes with some out-of-the-money and most in-the-money. If the market is smoking-hot bullish I will favor out-of-the-money strikes even in this scenario when the stock price appreciated so dramatically.
Alan
Joel (#5),
I discuss the fact that low beta stocks tend to outperform in bear or volatile markets and high beta stocks tend to outperform in bull markets. Beta is only one of the criteria we use in our investment decisions. It relates to the historical or statistical volatility of an equity as it relates to the market benchmark (S&P 500). Stocks with greater volatility will generate higher option premiums but also expose us to more risk.
Looking at the just released premium watch list we see two stocks in bold (met ALL system criteria) in the middle of the first page of this list:
RES has a beta of 1.42
ABX has a beta of 0.34
All other factors being equal I would opt for ABX in bear or volatile markets and RES in bull markets. We would expect the returns of RES to be greater. Checking the current options chains of these two stocks as of market close this past Friday, here are the returns for the slightly out-of-the-money strikes for the September contracts:
ABX: 3.9%
RES: 7.6%
RES is tempting but your decision is also based on market assessment and your personal risk tolerance.
Alan
Warren (#7),
The IBD paper and site are wonderful resources. I use them precisely as I describe in my books and DVDs as some of the tools in the screening process. I also use the site and paper to follow the economic news of the day (along with other resources like CNBC, Reuters and many others) and publish some of these findings at the end of my weekly blog articles. So IBD is one of the tools in my arsenal that allows me to make my own decisions based on the sytem I share with my fellow Blue Collar Investors.
Thanks for your generous comments about this week’s article.
Alan
Alan,
In your response to Tim in comment 9 do you ever use delta in your decision to sell an option on a stock that has appreciated so much and if so how?
Thanks as always.
Amy
Amy,
It is not necessary to look up the precise delta of each option premium. It is useful, however, to understand the concept of delta and how it relates to the different strike prices. For new members: delta is the amount of price movement in an option premium for every $1 change in the underlying stock or ETF price. Selling options with higher deltas is a more conservative approach than selling options with lower deltas. Here is a summary:
Summary regarding delta:
Delta measures the probability of an option expiring I-T-M, or stated differently, the probability the option will expire with intrinsic value:
• I-T-M strikes- highest deltas
• A-T-M strikes- deltas near 50% or .5
• O-T-M strikes- low deltas
Strike selection based on delta:
• I-T-M strikes- if bearish or conservative, because option premiums decline faster with decreasing share price making it easier to B-T-C (buy-to-close).
• A-T-M strikes- for maximum premium return.
• O-T-M strikes- if bullish so option premium AND share appreciation can be realized.
If you roll out to an I-T-M strike, the delta will be higher than if you roll out and up to an O-T-M strike.
Alan
Alan (#10),
I agree that the September contract for RES (7.6%) entails a fair amount of risk in this market. However, I believe the August contract entails substantially less risk for a significant return.
Today (9/15) I bought RES at $25.13 per share and sold the August contract with a $25 I-T-M strike price for $0.97. That’s a potential return of 3.34% for one week.
Next week, that still leaves me the potential to sell September contracts on RES, if the market provides the appropriate level of risk.
Richard
Richard,
You achieved an excellent initial return, no doubt. What a 3.3%, 1-week return tells us is that not only is RES a high beta stock but that particular option has a high implied volatility. So the market is anticipating a significant price movement by expiration but does not specifiy a trend or direction. This is an appropriate trade for a more aggressive investor with a higher risk tolerance. More conservative traders might lean to a low-beta stock with an option displaying lower IVs. There is no right or wrong here as long as decisions are made based on mastering all available information.
Best of luck and keep up the good work.
Alan
HANS:
This stock has been on our premium watch list for 7 weeks. Recently it reported a positive 2nd quarter earnings report with revenue up 27% from last year and earnings 8% ahead of estimates. It boasts a cash reserve of $699M with no long-term debt and a 17% earnings growth projection. It is a bit pricey with a PEG of 1.59. Our premium report shows an industry segment rank of “A” and a beta of 0.97. Check to see if this equity deserves a spot on your watch list.
Alan
If a company declares a special dividend in the form of additional stock shares (but not a split) how are our option contracts affected?
Thanks.
Pat
Pat,
Every special dividend is evaluated individually resulting in “non-standard options”. These can be complicated and hard to understand
and we should exercise caution when dealing with them.
Here is an example as to one way such a situation could occur:
Let’s assume that company XYZ trades @ $30 and a $30 call was sold. A special 1-time 5% dividend in the form of additional shares is announced. When that dividend is distributed the corresponding price of the stock will decrease to account for this dividend. Here is a typical formula to establish a new price:
$30/1.05 = $28.57
Our option contract now will need to be adjusted as well: each contract will now deliver 105, not 100, shares.
Before special dividend:
$30 x 100 = $3000
After special dividend:
$28.57 x 105 = $3000
I will write a more detailed blog article in the near future on this topic.
Alan
Anyone have any opinions on PRGO. Reported earnings on Tuesday and the price is holding. It’s been one of my favorites over the years and is on Alan’s stock list.
Eddie
Eddie,
This is one of my favorites also. According to the conference call revenues were up 21% and earnings 32%. They project sales and earnings growth at 15% or better for 2012. But down today along with everything else.
Best of luck.
Tony
Premium members:
This week’s 6-page report of top-performing ETFs and analysis of ALL Select Sector Components has been uploaded to your premium site.
For your convenience, here is the link to login to the premium site:
http://www.thebluecollarinvestor.com/member/login.php
Not a premium member? Check out this link:
http://www.thebluecollarinvestor.com/membership.shtml
Alan and the BCI team
Alan,
I noticed the ETFs in your weekly reports are holding up pretty well in this crazy market. What do you think about favoring these over stocks until things quiet down?
Thanks.
Barbara
Alan,
In your article on LEAPS you state that all LEAP options expire in January. Does this mean that we will see 2 January options available for stocks with LEAPS?
Thank you.
Fred
Barbara (#22),
The Premium ETF Report is designed to locate the best-performing ETFs over the most recent 3 months that have options, a minimum trading volume and RS rating. Because they represent a basket of stocks they are less volatile than individual equities ETFs return a lower option premium. In the current market environment these securities do make sense for conservative investors who want to remain active in the market.
Alan
Fred (#23),
There will NOT be 2 January expirations relating to the LEAPS options. As we approach the current January LEAPS expiration that option will be “converted” to a conventional January expiration options after the May, June or July expirations depending on the cycle the underlying has been assigned to. I will be publishing an article and producing a video on this topic in the near future.
Alan