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Achieving The Highest Covered Call Writing Returns Using The Blackjack Analogy

Covered call writers and all investors using stock options strategies have one thing in common: we all want to achieve the highest possible returns within the framework of our own personal risk tolerance. The focus of this site and The Blue Collar Investor is to provide the education and to share ideas that will help achieve these goals. Education is power and that is our starting point but where do we go from there? In this article, I will focus on the thought process that can be used to become an elite covered call writer and how it reminds me of the casino game of blackjack.

Recently, Mark T. wrote to me with a valid question: If I achieve a 2% return on the sale of my option and one of my trades turns against me, I will end up with less than a 2% return…should my goal be higher than 2% to end up with that goal? So the question becomes how can we generate an initial return and protect and manage our positions such that it will coincide with our final returns or at least as close as possible. The answer lies in throwing the odds in our favor in ways that few covered call writers ever think of. Let’s turn to blackjack first just for the fun of it. I am no expert in this card game but when I do play, I have all the charts memorized. That tells me that given my 2 cards and dealers one up card, what the computers say is the best play…take a card, stand pat, split, double down. If we have a 2-card total of 11 and the dealer is sitting with a 6, we double down (double our bet) and take advantage of a situation where we can increase our returns. If we are sitting with a 6 against a dealer’s ace, we take a card hoping to improve a losing situation. Each situation is handled on its own merit as we strive to move the odds in our favor and much like covered call writing, it all starts with education. The major difference between these two strategies is that covered call writers will make money in the long run and most blackjack players will lose money. The main point here is that Blue Collar Investors must take advantage of all aspects of our BCI methodology to throw the odds in our favor and that is what will make us elite covered call writers.

The 3 aspects of the strategy that will give us opportunities to generate the highest possible returns are:

  • Stock selection
  • Option selection
  • Position management

By selecting the best performing underlying securities from fundamental, technical and common sense perspectives, we begin the process of throwing the odds in our favor. Option selection is based on overall market assessment, personal risk tolerance and chart technicals. Let’s look at a real-life example for KORS, a stock on our Premium Stock List at the time I am penning this article. With KORS trading @ $95.56, here is the options chain for March, 2014, a 5-week return:

Covered call writing and strike price selection

KORS options chain 2-14

We will evaluate the in-the-money $92.50 and $95 strikes as well as the out-of-the-money $97.50 and $100 strikes as we feed these stats into the “multiple tab” of the Ellman Calculator (free in the “free resources” link @ the top black bar on this site):

Calculating covered call writing returns

The Ellman Calculator

Now it’s time to throw the odds in our favor. In a bull market environment with chart technicals favorable, we are sitting with an 11 against the dealer’s 6. Time for an out-of-the-money strike. These will generate excellent initial returns (2.9% and 2% in yellow field) but also give us the opportunity for additional income streams from share appreciation (2% and 4.6% more in pink field). This is like doubling down in blackjack or taking advantage of a favorable situation to elevate our returns.

In a bear market environment or with chart technicals mixed, we need an insurance policy to protect our capital. We are sitting with a 6 against the dealer’s ace. We throw the odds in our favor by selling an in-the-money strike, both of which return decent initial option profits (2.5% and 3.6% in yellow field) and one (the $92.50 strike in brown field) offers decent protection of that option profit. So what we have accomplished here is to generate some protection against a potential losing trade and to enhance profit potential for winning trades and this will allow us to achieve our goals in normal market conditions.

We are not finished yet because we haven’t started to execute our exit strategy opportunities. Some (“hitting a double”, the “mid-contract unwind”) will allow us to generate a 2nd income stream in the same month with the same cash) and others (like rolling down or closing the entire position) will allow us to mitigate losses. These strategies are discussed in detail with examples in my books and DVD Programs.

Throwing the odds in our favor and taking advantage of opportunities are factors that distinguish Blue Collar Investors from all the others. When we’re sitting with a 16 against the dealer’s ace we do not sit there like a deer in headlights with sweat pouring down our foreheads…we take a card. There may not be a great play all the time but there is always a best play and it’s all about throwing the odds in our favor like nobody’s business (an expression my mother uses).

Next live seminar:

NEW YORK

Long Island Stock Traders Investment Group

Monday, March 10th

6:45 PM – 9:30 PM

Plainview Old Bethpage Library 

999 Old Country Rd, Plainview, NY

 

Date change:

My seminar in Orange County California has been moved from June 7th to June 14th. Details and link to register to follow

 

 Market t0ne:

New Fed Chairwoman, Janet Yellen, re-affirmed her commitment to continue the course to slowly decrease the government’s bond-buying program as the economy improves. This week there were only a few economic reports and they were rather unimpressive perhaps due to extreme weather conditions throughout the country:

  • The second estimate for Real Gross Domestic Product for the 4th quarter, 2013 is projected to be 2.4% annualized, lower than expected (2.5%). This is well below the 4.1% reading for the 3rd quarter
  • This revised data now puts GDP growth @ 1.9% for 2013, less than the 2.8% for 2012 and slightly higher than the 1.8% reading for 2011
  • New orders for durable goods (a measure of the number of orders for a broad range of products—from computers and furniture to autos and defense aircraft—with an expected life of at least three years. Durable-goods orders are a leading indicator of industrial production and capital spending. Data fluctuate widely from month to month and are often subject to significant revision) fell by 1.0% in January, less than the 1.7% projected by analysts
  • The Conference Board’s Consumer Confidence Index (a gauge of consumers’ attitudes about the present economic situation as well as their expectations regarding future conditions. Consumer confidence tends to have a strong correlation with consumer spending patterns) dropped to 78.1, below the 80.3 expected
  • Sales of new single-family homes surprisingly rose by 9.6% in January to an annualized post-recession high of 468,000 units while analysts were anticipating 400,000 units. This was increase of 2.2% year-to-year
  • The median price of new single-family homes was 3.4% higher, also year-to-year

For the week, the S&P 500 rose by 1.0%

Summary:

IBD: Confirmed uptrend

BCI: Cautiously bullish favoring out-of-the-money strikes 3-to-2

My best to all,

Alan (alan@thebluecollarinvestor.com)

www.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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18 Responses to “Achieving The Highest Covered Call Writing Returns Using The Blackjack Analogy”

  1. Marty March 1, 2014 10:50 am #

    Alan,

    Great article and I love the analogy (I’ve had much more success with covered calls than in casinos). I noticed that the 92.50 and 97.50 strike prices have open interest under 100. Would you avoid these?

    Thanks,
    Marty

    • Alan Ellman March 1, 2014 12:07 pm #

      Marty,

      Excellent observation. The BCI guideline is:

      “An open interest of > 100 contracts and/or a bid-ask spread of $0.30 or less”

      In the cases of the $92.50 and $97.50 strikes. both do have b-a spreads of $0.30 or less so I would not be discouraged by option liquidity. Remember also to ‘negotiate” the bid prices as detailed in my books/DVDs.

      Alan

  2. Adrian March 1, 2014 8:13 pm #

    Hi Alan, I emailed you some questions twice from over a week ago but still haven’t had a reply back. I will have to post these again below if you could please answer to them.

    1. First if a share is declining and I have been rolling-down the strike prices, and then price turns and goes up past all strike prices, and buy price, then to institute a MidCU strategy from this(if this was in the first 2 weeks) does the shares Capital gain now be taken from the lowest rolled-down strike price up to where the share price is now sitting at?
    2. Is that percentage return for just the “11th November” of your roll-down example of p.119 of exit strategies book :- $2.65/ $30 = 8.83%? (but not 8.52%)
    3. If a stock is declining in price and you have been rolling-down, then after how many weeks/months do you then convert ‘dead money to C.P’s’?
    4. Also if at expiration of a contract I have been trading, any of the stocks I used are now listed in the pink squares of running list or not on the running list at all(in last contract week), then should I consider selling them for other ones?

    Like I said to you in my email I may soon need to give you a ‘Rolldown to MidCU’ trade example, it first just depends on how I feel about your answer to my No.1 above.
    I appreciate it if you can help me here. Thanks

    • Alan Ellman March 2, 2014 4:49 pm #

      Adrain, Your Qs followed by my responses:

      1. First if a share is declining and I have been rolling-down the strike prices, and then price turns and goes up past all strike prices, and buy price, then to institute a MidCU strategy from this(if this was in the first 2 weeks) does the shares Capital gain now be taken from the lowest rolled-down strike price up to where the share price is now sitting at?

      There are 2 answers:

      -When evaluating if you should employ the mid-contract unwind exit strategy, it is based on the current position you hold…the last strike sold. You will determine the time value cost to close and whether the cash generated from the sale of the stock can generate significantly more time value.

      -The 2nd answer is from a tax perspective which I suggest you consult your tax advisor. Generally speaking, in the US, each option trade (once closed) is a short-term capital gain (loss) as a separate entity, so you will have a series of tax events…again consult you advisor if this was the thrust of your question…it was probably the first.

      2. Is that percentage return for just the “11th November” of your roll-down example of p.119 of exit strategies book :- $2.65/ $30 = 8.83%? (but not 8.52%)

      When rolling down you are generating additional time value ($2.65 in this case) but losing on share value ($30 to $25 in this case). When calculating results for these trades, add up the option credits and share value debit or credit at the end of the contract and divide by your original cost basis ($30 in this case after deducting intrinsic value from the cost of the shares). Looking at one step of this multi-leg trade will not produce any meaningful statistical results. Final results can be calculated using the Schedule D of the Elite version of the Ellman Calculator.

      3. If a stock is declining in price and you have been rolling-down, then after how many weeks/months do you then convert ‘dead money to C.P’s’?

      Every 3rd month I am out of a stock due to earnings reports. My decision to roll down or sell the stock depends on:

      • Any egregious stock news? (www.finviz.com is a great site)
      • Performance compared to overall market
      • Calculations meet our goals?

      4. Also if at expiration of a contract I have been trading, any of the stocks I used are now listed in the pink squares of running list or not on the running list at all(in last contract week), then should I consider selling them for other ones?

      If a stock has had a complete technical breakdown and is underperforming the market, I move my cash into a better-performing security. If it’s borderline, I may keep it in my portfolio until the next earnings month. If I am already in a position and the stock is removed from our “eligible” list, I manage as detailed in my books/DVDs with our exit strategy opportunities if indicated but we do NOT sell automatically if moved off the eligible list.

      Alan

  3. Barry B March 2, 2014 2:09 am #

    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 02-28-14.

    Also, be sure to check out the latest BCI Training Videos and “Ask Alan” segments. You can view them at The Blue Collar YouTube Channel. For your convenience, the link to the BCI YouTube Channel is:

    http://www.youtube.com/user/BlueCollarInvestor

    Best,
    Barry and The BCI Team

  4. Barry B March 2, 2014 10:04 am #

    Premium Members,

    You will notice a small but useful change to the Weekly Report this week. Following the suggestion of Ron M, one of our Premium Members, we have carried over the color coding of the Running List to this section. The “Gold” highlighted stocks…stocks that are reporting earnings during the current options month…are now identified.

    This will save time by eliminating the need to check to see if a particular stock will be reporting earnings in the current month (for those subscribers that cut and paste the Running List stocks to their own purpose built spreadsheets). Many of the improvements to the Weekly Report have come from the suggestions of our subscribers.

    Thank you Ron.

    Best,

    Barry and The Blue Collar Investor team

  5. Barry B March 2, 2014 10:10 am #

    Premium Members,

    Per the suggestion from Premium Member Jim K, you can now enter your own comments (or strike through notation) directly on to the Weekly Report.

    Thank you Jim.

    Best,

    Barry and The Blue Collar Investor team

  6. Adrian March 3, 2014 4:10 am #

    Hi, and thank you for all those answers given.
    For my first question above, after I read of you saying that the MCU strategy is to be based from the last(lowest) strike price up to current share price, to then calculate T.V and returns, I have now decided to give you an example trade of this.(it will hopefully make me understand this better)
    An example I have here is:-
    Buy shares @ $75.
    STO $74 calls(ITM) @$2.50.
    Buyback $74C’s @0.50.
    Rolldown to $70 strike C’s @$2.
    Price rockets way up to say $78.
    Buyback $70C’s @ $8.20. (all prices here I made up!)

    – Now what I want to know is that if I am correct here in knowing that the I.V is $8, and T.V is at 0.20(for the $8.20 option), then am I to also take the MCU share gain as $8?(from $70 to $78?)
    – It can’t surely be from $75 up to $78 can it, as T.V would be too large?(or am I wrong?)
    – Is my calculation correct for a -$4.20 total options loss, and +$8 for price gain to = +$3.80 profit?
    – Also if this is right, then the return that I have calculated must be at 5.43%($3.80/$70), – can you confirm on this too?

    This is the type of situation I had in January while papertrading, and which happened to appear on 2 shares I was using.
    I didn’t know if a MCU exit plan was useful, and so because of that I had to just watch them go deeper ITM.
    Maybe with some new knowledge from you I will be able to implement this exit plan earlier! Thanks

    • Alan Ellman March 4, 2014 7:29 am #

      Adrian,

      I admire your determination to master the calculations and I’m happy to help.

      Based on your example I believe I see your confusion. There are 2 sets of calculations that should be viewed individually but you are combining and that may be clouding the situation. The 1st calculation relates to whether to pull the trigger on the MCU strategy or not. The 2nd is your overall profit (loss) results. Let’s address the MCU 1st:

      1- We base our decision whether to completely close our short option and long stock positions based on the current market value of our shares which you rolled down to $70. We do not base it on some value in the past ($74). The time value component to accomplish this is $0.20 because we can sell our shares for $78 and gain $8 in share value at this point in time. If we can generate more than $20/$7000 or .28% (a fraction of 1%) by re-investing that newly-acquired cash, we should pull the trigger on the MCU strategy.

      2- Final results: we don’t know yet because you haven’t re-invested the cash generated from the MCU strategy so the final chapter hasn’t been written. However, to date you have an options debit of:

      $2.50 + ($2.00 – $0.50) – $8.20 = (-) 4.20

      You have a share credit of $78 – $74 = + $4

      Total loss to date = $0.20

      Now Adrian, it’s up to you to write the final chapter that month and re-invest the $7800/contract to turn that small loss into a gain.

      This example you set up is a great example of how being active can, in many cases, allow us to manage our positions to mitigate losses, turn losses into gains and enhance gains.

      Keep up the good work.

      Alan

  7. Alan Ellman March 3, 2014 6:43 am #

    Russia/Ukraine/Stock markets:

    Market futures are reflecting concern over the situation in the Ukraine. Should this result in a sharp decline in stock prices my plan is to buy back options sold @ 20% or less. Since there are still 3 weeks remaining until expiration, I plan to wait at least a few days before taking a bearish stance on exit strategy management.

    In the UNLIKELY event that the situation continues to deteriorate I suggest our premium members re-read our Emergency Management Report located in the “resources/downloads” section of our premium site. In the past, these geopolitical events have had only temporary impact on our markets.

    Alan

  8. Alan Ellman March 3, 2014 6:57 am #

    Running list stocks in the news: AYI:

    Acuity Brands, the world’s largest lighting fixture manufacturer, has seen 10 analysts raise estimates in the last 2 months. The company has positively surprised with its earnings reports in the last 3 quarters. Our Premium Stock Report shows an industry rank of “A”, a beta of 1.30, a % dividend yield of 0.40, adequate open interest option liquidity and a last ex-dividend date of 1-16-14. CLICK ON THE CHART BELOW AND USE THE BACK ARROW TO RETURN TO BLOG.

    Alan

  9. Alan Ellman March 3, 2014 2:52 pm #

    Recent Q&A with Carlos:

    Hi Alan,

    I just finished studying your Exit Strategies book (and I mean deeply studying it: I have even made a summary in Spanish with all the details of every Exit Strategy). With this and with the ESOC and the material on your web I am pretty confident that I am learning so much about options. Paper trading is also looking pretty good, since I achieved a 3.2% last month, and this month is also looking great.

    I have a few questions I would like to ask you if it’s not too much trouble:

    1-I don’t understand the advantage of using the Rolling Out (forward) strategy. It seems to me that the cost of a Buy To Close does not make it profitable compared with getting your option executed and buying another great stock and selling the option the following Monday. What am I missing?? For instance, in one of the examples you use in your Exit Strategy book:

    Even more: Since this is an on or near expiration Friday strategy, why don’t you just wait to be exercised on Friday and then buy the same stock again on Monday and sell the $72.50 option?? I get that the stock might have changed its price a little, but you would be saving 180 $ from the Buy To Close, isn’t that right??

    2-When you perform an Expiration Friday Exit Strategy, do you have any advice on weather it is important to wait to the end of the trading session to do that Exit Strategy, or is it irrelevant and we should make it at any time during the session? (I’m thinking the later the better because we will know with more precision the closing value of the contract period, which we need for our calculations for rolling out and rolling out and up)

    3-One of your lessons about ETFs is that your goal is 1-2%, but the great performing ETFs you send us every week show approximately the same returns as stocks (2-4%). Is this because they are more volatile than average stocks? Should we be more careful with these ETFs, or is it just a temporal situation of the market?

    4-Is it possible to achieve similar returns with Inverse ETFs in a clearly bearish market as the ones we are getting now with stocks or “normal” ETFs?

    5-In one of your videos you talk about PROTECTIVE PUTS, and SELL CASH SECURED PUTS, but I haven’t been able to find more information about this in your wonderful website. Do you go in depth about this in a book that I could purchase or anywhere else?

    As always, thanks for everything Alan!

    My responses:

    1- The Apple trade was executed 2 days prior to expiration. The $180 in time value was recouped almost in it’s entirety in the sale of the next month same strike, ultimately resulting in a 3.6%, 1-month return. We spend the extra cash to close and get it back on the next month’s sale. The advantages of rolling rather than allowing assignment and re-purchasing the shares the following week are:

    • Known pricing and cost: our cost basis is the strike sold and should the price increase by Monday we may be forced to spend more money to buy the new shares
    • Known options credit and % return: if 3.6% 1-month return meet your goals, take the “deal” while you have it
    • One less trading commission (buy and sell option compared to sell stock, buy stock and sell option)

    2- There is a slight advantage to waiting close to 4PM…very slight. Time value of the near-month option will erode faster than that of the next month option so you will pick up a few more pennies by waiting.

    3- Some of the ETFs have high implied volatility and therefore higher option returns. Once we noticed this new pattern, we started including IV into our reports. Now the member can select the most appropriate ETFs for his (her) own risk tolerance.

    4- Yes, but it’s very rare that these securities would be appropriate…2008 was an example where we could have flourished using inverse ETFs. Historically, the stock market goes up in value and should continue to do so.

    5- I am currently writing a book about puts. This will take some time as my speaking schedule along with writing articles and producing videos (as well as answering emails!) takes up a good part of my week (but I love every minute of it). In the interim, you can use the google search tool at the top of our web pages to locate articles I have published on the topic.

    Alan

    • Carlos March 4, 2014 7:02 am #

      Thanks so much! As always, every question was explained in a way that it is very easy to understand!

  10. Adrian March 3, 2014 11:07 pm #

    Alan, I am going to be away on Holiday for a few days soon, and wonder if you can quickly reply to my 3rd March questions I asked. I just need confirmation so I can work out some calculations.
    Also I think I made a mistake in my trade example.
    Shouldn’t the new answers be :- ” – $4.20 total options loss, and a +$3 for price gain(-$5 + $8) to then = – $1.20 loss” ?
    Is the return a loss of -1.71%? (- $1.20 / $70)?

    Confirmations to these two questions along with the other two in my 3rd march reply will definitely help me a lot.
    Hope you can reply to my four questions again. Thanks

    • Alan Ellman March 4, 2014 7:30 am #

      See above for the calculations

  11. Alan Ellman March 5, 2014 6:55 pm #

    Premium members:

    This week’s 8-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 as well as the implied volatility of all eligible candidates.

    For your convenience, here is the link to login to the premium site:

    https://www.thebluecollarinvestor.com/member/login.php

    NOT A PREMIUM MEMBER? Check out this link:

    https://www.thebluecollarinvestor.com/membership.shtml

    Alan and the BCI team

  12. Adrian March 6, 2014 2:14 am #

    Alan, I think I now know where my calculation went wrong. (with my question at bottom to consider.)

    The options profit/loss and the percentage of T.V was what I already had, but I calculated the share credit, along with the total a different way.
    From this I now don’t think there was any point in my example to deduct the share loss of $74 to $70, to then add on the gain of $8 from the $70, – when all I should have done was take the share credit from the $74 price.
    This of course would result in a small total loss for a MCU strategy, but also poses a question for you.

    – Which is, would it be feasible to even consider applying the MCU plan at this time, where you can now see there is a small 0.20c debit?
    Thanks for giving me the correct maths to work that out!

    • Alan Ellman March 6, 2014 7:47 am #

      Adrian,

      The decision as to whether to pull the trigger on the MCU strategy is based on your situation AT THAT POINT IN TIME. In my previous response, I calculated that your cost to close would be .28% or a fraction of 1%. If the cash generated from the sale of the stock would be significantly greater than .28%, say 2%, then, in my view, it does pay. These 1.5% profits add up over time. In addition, it would result in an overall credit rather than the $0.20 per share loss prior to the MCU execution. If executed, the position still must continue to be managed.

      Alan

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