After entering our covered call writing trades, we immediately enter our 20%/10% BTC (buy-to-close), GTC (good-until-cancelled) limit orders. If and when these thresholds are reached (resulting from share price decline) are short calls will be closed (bought back). At that point, we can plan our next steps to mitigate losses or turn losses into gains. This article will highlight a hitting a double trade I executed with XLP where the short call was bought back in the morning and the same option was re-sold later that afternoon. This result could not have been achieved without our 20% guideline.
What are the 20%/10% guidelines for covered call writing?
After entering our covered call trades, we immediately enter BTC GTC limit orders based on the premium received from the initial trade. We instruct our broker to close the short call if option value declines to 20% or less of the original premium in the first half of a monthly contract or 10% or less in the last 2 weeks of a monthly contract. These trades will be executed automatically if the stated thresholds are reached.
Initial trade with XLP
- 4/18/2022: Buy 300 shares of XLP at $78.59
- 4/18/2022: STO 3 x 5/20/2022 $80.00 calls at$0.84
- 4/18/2022: Place 3 x BTC GTC limit orders at $0.17 (20% guideline)
- 5/4/2022: BTC 3 x 5/20/2022 $80.00 calls at $0.17
- 5/4/2022: STO 3 x 5/20/2022 $80.00 calls at $0.46
- 5/4/2022: Place 3 x BTC GTC limit orders at $0.05 (10% guideline)
May 4, 2022
The market had been reeling from inflation and interest rate concerns as well as the Russian invasion of Ukraine. The Fed was to make an announcement at 2 PM ET regarding an interest rate hike and many investors were expecting a 50-basis point increase but feared a 75-basis point rise. The Fed announced a 50-basis point increase and stated that there was no consideration for a 75-point increase. The market loved the statement and rose by nearly 3%.
Price chart of XLP on 5/4/2022
XLP: “Hitting a Double” on 5-4-2022
Broker transactions on 5-4-2022
XLP: Broker Transactions
Discussion
By having the 20% guideline in place, along with the market volatility created by the Fed announcement, an additional $87.00 of premium was added to our account [($46.00 – $17.00) x 3]. Since we were approaching the final 2 weeks of the May contracts, I used the 10% guideline for the new $0.46 premium. Generating additional time-value premium in our option-selling trades is not luck. It is the intersection of preparation and opportunity.
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Over the years, the BCI community has been incredibly gracious by sending our BCI team email testimonials sharing stories as to what our educational content has meant to their families. Moving forward, we have decided to share some of these testimonials in our blog articles. We will never use a last name unless given permission:
Alan,
I’ve been a premium member for nearly 2 years now. Your simple way of explaining things gave me the confidence to try options. Thus far, the videos cover almost everything. The purpose of this note is to thank you for the information, and great support.
Thanks!
Bob
Upcoming events
To request a private webinar for your investment club, hosted by Alan & Barry: info@thebluecollarinvestor.com
1. Mad Hedge Traders and Investors Summit
Thursday December 8th at 12 Pm ET (topic to follow)
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Analyzing a 1-Month Covered call Writing Portfolio from Start to Finish
Thursday February 16,2023
7:30 PM ET- 9 PM ET
A real-life example with a $100k ETF Select Sector SPDR portfolio
Covered call writing is a low-risk option-selling strategy that generates weekly or
monthly cash flow. This presentation will demonstrate how to implement this
strategy using a database of only 11 exchange-traded funds for a 1-month option
contract cycle. These are real-life trades taken directly from one of Dr. Ellman’s
portfolios with screenshots verifying each trade. A final monthly contract result
compared to the performance of the S&P 500 will be calculated.
Topics included in this webinar:
What are the Select Sector SPDRs?
How to establish a covered call writing portfolio
What is the role of diversification?
What is the role of cash allocation?
Calculating initial returns
Analyzing each trade in the monthly contract
Final results
Next steps
***********************************************************************************************************************
Market tone data is now located on page 1 of our premium member stock reports and page 1 of our mid-week ETF reports.
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Alan,
In your new book on exit strategies, you discuss the 3% guideline for puts. I sell mostly weekly options. Should I use 3% or another percentage?
Thank you,
Eileen
Eileen,
The 3% guideline is based on monthly options that generate 2% – 4% as our initial time-value return goal range. Another way to view this and make the formula more universally applied to different time-frames and expirations is to close the short put when the underlying’s price drops below the breakeven price point.
Let’s use an example with NKE from an option chain as of market close on 11/11/2022.
-NKE trading at $105.71
-Annualized initial time-value return goal 26%
-For weekly options, the goal is 1/2% per week
-Premium goal for NKE is about $0.53 (1/2% of $105.71)
-This is a guideline premium as initial results will be higher than 26% since the cash required to secure the put will be lower than the OTM strike
The screenshot below shows the following based on current market value of $105.71:
Red arrow: BE price point of 97.46. This is a reasonable price point threshold to close the short weekly put and use the freed- up cash to secure a different put trade with a new underlying to mitigate the loss from this first trade.
Blue arrows: An initial weekly time-value return of 0.55%, 28.89% annualized.
Green arrow: If the put is exercised, we will have purchased NKE at a 7.80% discount from the price when the put sale was initiated.
CLICK ON IMAGE TO ENLARGE & USE THE BACK ARROW TO RETURN TO BLOG.
Alan
Hello Alan,
Curious question; we have conversed earlier regarding ex-divi dates and stocks called away.
Following are details:
Own 300 shares XOM; price as of yesterday’s close 113.95
sold (3) 106 CC expiration date 11/25, option price as of yesterday’s close 7.75 bid, 8.1 ask
Ex divi date of 11/14
.91 dividend/share
Wondering why with another 2 weeks to expire it was called.
Can you educate me please?
Much appreciated as always.
Bob
Bob,
This is an interesting scenario.
Let’s start with this: Most of the time, when a call option is exercised to capture a dividend, it is the result of investor error.
The investor would be better off, selling the option and buying the stock to capture the dividend and enjoy the additional benefit of the time-value component of that sold option.
That said, let’s look at the published bid-ask stats that you accurately quoted, specifically the bid price of $7.75, the amount the option could have been sold for if the holder went in that direction rather than exercise.
With XOM trading at $113.95, the $106.00 call is in-the-money by $7.95. We would anticipate the bid price to be $7.95 of intrinsic-value + 2 weeks of time-value. In this case, the published bid ($7.75) is lower than the intrinsic-value and no time-value component. I believe the option-chain data was different at the time of the exercise.
I am confident that the option holder could have sold the option for a price closer to the “ask” of $8.10. The “last” price listed is $8.08. Let’s use that. The time-value would be $0.13 per-share. If the option buyer sold the option at $8.08 and bought the stock for $113.95 prior to the ex-date (Monday), an additional $13.00 per-contract could have been generated (commissions should balance out).
From your perspective, you maximized your option trade but won’t capture the dividend. That’s okay because on Monday, share price will decline by the dividend amount (other factors will ultimately determine the final price but -$0.91 will be part of the equation). You did just fine and now you have the cash from the sold shares to start another covered call trade and a second income stream. It’s all good.
Bottom line: The early exercise of the option was, most likely, the result of investor error.
Alan
lan,
Thanks for the detailed response. I thought it was an error as well.
This sudden “up” market is keeping me very busy. I have many call options that are itm and must analyze roll ups vs letting the stocks get taken. Losing a bit of capital gains in the process.
Bob
Bob,
Another way to view this situation (“losing capital”) is to say that we’ve maximized our returns as the trade was initially established and have downside protection of that max profit down to the (now) ITM strike.
Champagne or Kleenex? I vote for champagne.
Keep up the good work.
Alan
Alan,
I’ve been tending to have the strike price lower than the market price, i.e. ITM, but I see that I miss out if the stock goes up and I let it expire. (Because the broker sells the item at the strike price on expiry).
But the trouble with setting the strike price OTM is that the premium you can get on selling is low. And then if I want to buy it out, the amount I have to pay can exceed the premium I have received !! Is there a happy in-between ?!!
Thanks very much for your help. Much appreciated.
Malcolm
Malcolm,
When measuring our actual profit returns, use the time-value component of the premium only.
ATM and OTM strikes are 100% time-value. ITM strikes consist of intrinsic-value (not profit) + time-value.
When we establish our covered call writing trades, we have a stated initial time-value return goal range. Let’s say 2% – 4% per-month. We must adhere to this range whether we use ITM or OTM strikes. We will favor ITM strikes in bear and volatile markets and OTM strikes in normal to bull markets.
Let’s set up a hypothetical example:
BCI trading at $48.00
The 1-month OTM $50.00 call has a bid price of $1.50
The 1-month ITM $45.00 strike has a bid price of $4.50
We enter this information into the BCI Trade Management Calculator (see screenshot below):
The brown cells show similar time-value returns. The calculator will deduct the intrinsic-value component from the total premium to generate an accurate initial time-value return.
The yellow cells show the BE price points noting that ITM strikes provide the greatest protection to the downside (this is why we favor ITM in bear and volatile markets).
The purple cell shows the additional upside potential provided by OTM strikes (this is why we favor OTM in normal to bull markets).
The pink cell reflects the downside protection provided by ITM strikes. With the $45.00 ITM strike, we are guaranteed a 3.13% 36-day return as long as share price does not decline by more than 6.25% by expiration Friday.
Understanding time-value versus intrinsic-value will assist us in crafting our trades. The TMC spreadsheet will do all the mathematical legwork for us.
CLICK ON IMAGE TO ENLARGE & USE THE BACK ARROW TO RETURN TO BLOG.
Alan
Premium members,
Just a reminder that this week’s stock report is slightly delayed as Barry returns from a cruise.
My expectation is that the report will be posted on the member site Sunday evening.
Alan
Premium Members,
This week’s Weekly Stock Screen And Watch List has been uploaded to The Blue Collar Investor Premium Member site and is available for download in the “Reports” section. Look for the report dated 11/11/22…our 700th consecutive report!
Also, be sure to check out the latest BCI Training Videos and “Ask Alan” segments. You can view them on The Blue Collar YouTube Channel. For your convenience, the link to the BCI YouTube Channel is:
http://www.youtube.com/user/BlueCollarInvestor
Reminder: Premium members are grandfathered into your current rate and will never see a rate increase as long as the membership remains active.
Best,
Barry and The Blue Collar Investor Team
barry@thebluecollarinvestor.com
Hello Alan –
With respect to your 20%-10% guidelines involving XLP, I noticed XLP continued to decline after hitting a double. Therefore, my understanding is you made money on the options you sold but didn’t the decline in stock value more than offset any option premium making this a losing trade? Thanks.
Jim
Jim,
Your question and comment are valid and also gives me the opportunity to state an important fact.
Our BCI exit strategy arsenal covers all possible scenarios regarding managing our trades if and when those opportunities present.
In May of this year (as well as much of 2022), the market was volatile due to inflation and interest rate concerns. This article highlighted 1 of our go-to strategies … “Hitting a double” I found it particularly interesting because I was able to use it in the same day, fairly rare.
As you accurately pointed out, the market volatility continued, and the entire market headed south. On May 12th, the 10% BTC limit order was breached at $0.05 and I rolled-down 3 contracts. Once we execute an exit strategy, our commitment to the strategy does not end. We must be ready to execute another, as I did in this case.
Exit strategies have multiple purposes: They can mitigate losses (as in this case), enhance gains and, in some scenarios, turn losses into gains.
Not all our trades will be winners. However, if we take advantage of our entire exit strategy arsenal, we will achieve the highest results possible and become elite-covered call writers and sellers of cash-secured puts.
Alan
Portfolio Overwriting Presentation Part II:
For those who missed my Money Show webinar last week, the Money Show will highlight the recording this Thursday at 2:10 PM ET at The Accredited Investors Virtual Expo.
Here’s the link to register:
https://online.moneyshow.com/2022/november/accredited-virtual-expo/speakers/e413c9dea90047bcba9fded15d808435/alan-ellman/?scode=058464
Alan
Thursday’s Money Show event image below.
CLICK ON IMAGE TO ENLARGE & USE THE BACK ARROW TO RETURN TO BLOG.
Alan,
For underlyings we do not want to get called away…..
If the way OTM call becomes way ITM, is their utility in rolling up and out prior to expiration Friday? Or would you recommend always waiting until expiration Friday?
Thanks,
Graham
Graham,
If we roll out-and-up, the cost-to-close the current month strike is the intrinsic-value component of the premium (amount the strike is lower than current market value) + a time-value component.
That time-value amount is subject to Theta or time-value erosion. This means the lowest amount of time-value we will pay is as close to 4 PM ET on expiration Friday as possible.
If we wait, we may end up paying more in intrinsic-value, but that will be negated by share appreciation. We could also end up paying less in intrinsic-value, if share price declines but not below the original strike.
I start rolling my options on expiration Friday between 1 PM and 2 PM ET. If I’m traveling on Friday, I execute these trade adjustments on Thursday afternoon.
Alan
Hi Alan,
Attached your PMCC calc, with an in my opinion a normal trade. But it gives a ’No’. Why?
Groeten,
Sjoerd
CLICK ON IMAGE TO ENLARGE & USE THE BACK ARROW TO RETURN TO BLOG.
Sjoerd,
The glaring error is that the short call strike is entered incorrectly. It should be higher than the current market value of AAPL.
Let me give you a general answer to this issue:
The spreadsheet tells us “NO” because the trade does not meet our required trade initialization formula:
[(Difference between the 2 strikes) + short call premium] > Cost of LEAPS
This will allow us to conclude a PMCC trade with a profit if we are forced to close both legs of the trade due to significant share price acceleration after entering the trade. The above formula is inherent in the spreadsheet.
For more information on this topic, see our online PMCC course:
https://thebluecollarinvestor.com/minimembership/video-poor-man-covered-call-program/
Also, see Chapter 16 in my book, “Covered Call Writing Alternative Strategies”, pages 117 – 133:
https://thebluecollarinvestor.com/minimembership/covered-call-writing-alernative-strategies/
Now, here are suggestions on how to convert this trade to an acceptable entry:
1- Use deeper ITM LEAPS strikes
2- Use 1-month options with a greater time-value component.
By doing so, you will find several “YES” opportunities.
Alan
Premium members:
This week’s 5-page report of top-performing ETFs and analysis of ALL Select Sector Components has been uploaded to your premium site. The report also lists Top-performing ETFs with Weekly options, mid-week market tone as well as the implied volatility of all eligible candidates.
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Alan and the BCI team
New Blue Chip Report:
Premium members,
The latest Blue Chip Report of the best-performing Dow 30 stocks for the December 2022 contracts has been uploaded to your member site.
Look on the right side in the “resources/downloads” section and scroll down to “B”
Alan & the BCI team
Money.net interview:
https://youtu.be/npScQT8CBOE