beginners corner

Arbitrage: Part I

Understanding stock and option pricing requires an awareness of arbitrage and market efficiency. Although most retail investors do not have the tools to take advantage of arbitrage opportunities, a comprehensive understanding of how it works adds to our financial literacy and so I am sharing this 2-part series with our readers.

 

What is arbitrage?

Arbitrage is the simultaneous purchase and sale of an asset to profit from a difference in the price. It is a trade that profits by exploiting the price differences of identical or similar financial instruments in different markets or in different forms. Arbitrage exists because of market inefficiencies.

 

Arbitrage is a necessary force in the financial marketplace

Arbitrage provides a mechanism to ensure prices do not deviate substantially from fair value for long periods of time. With advancements in technology, it has become nearly impossible to profit from pricing errors in the market. Sophisticated traders have computerized software programs used to monitor fluctuations in similar financial instruments Any inefficient pricing combinations are acted upon quickly, and the opportunity is often eliminated in a matter of seconds. Arbitrage is a necessary force in the financial marketplace.

 

An arbitrage example

  • Stock BCI is trading at $30.00 on exchange ABC
  • Stock BCI is trading at $30.05 on exchange XYZ
  • Buy the stock on ABC and immediately sell the same shares on XYZ earning a no-risk profit of 5 cents per share
  • A trader can continue to exploit this arbitrage until the specialists on ABC run out of inventory of BCI stock, or until the specialists on ABC or XYX adjust their prices to eliminate the opportunity

Arbitrage for the call buyer

An arbitrage opportunity exists when in-the-money options (ITM) are trading less than parity (below intrinsic value). Here we exercise the call (buy the shares) and short the stock:

  • XYX is trading at $50.00
  • $40.00 call (ITM)is trading at $9.75 (below parity of $10.00)
  • Exercise the call 9that cost $9.75) and buy shares at $40.00
  • Short the stock (sell) at $50.00
  • Arbitrage profit = (+ $10.00 – $9.75) = $0.25

 

Arbitrage for the put buyer

An arbitrage opportunity exists when in-the-money options are trading less than parity (below intrinsic value). Here we buy the stock and exercise the put (sell stock):

XYZ is trading at $30.00

$40.00 put (ITM) is trading at $9.75 (below parity of $10.00)

Buy stock at $30.00

Exercise put and sell stock at $40.00

Arbitrage profit = (+ $10.00 – $9.75) = + $0.25

 

Discussion

In this day and age of computerized trading and efficient markets, arbitrage opportunities are few and far between and generally not available to retail investors. When these opportunities do appear, they are quickly erased by institutional investors with sophisticated software programs that find and eliminate these inefficiencies. From our perspective, it is instructive to understand the operation of the markets we invest in. In Part II of this series, we will add dividends into these arbitrage equations.

Related article: Put-Call Parity

 

HOLIDAY DISCOUNT COUPON: PROMO CODE “HOLIDAY10”: Holiday gifts at a discount

The BCI team is thanking our members with a 10% discount off all items in the Blue Collar store for all orders placed from now through December 24th. Use promo code holiday10 to receive the 10% discount at checkout. Premium members, enter the store from the premium site to receive your additional member discount.

 

Coming soon

1- BCI Video membership (premium members do not need this subscription as you are already receiving these benefits)

  • Over 140 Ask Alan videos + 1 new video added each month
  • Blue Hour webinars + 4-6 new webinars added per calendar year
  • Beginners Corner for Covered Call Writing added to this site
  • Beginners Corner for Selling Cash-Secured Puts added to this site
  • 5% discount on all items in BCI store
  • Bonus streaming DVDs
  • $20-per-month or $200 for 12 months (2 months free)

2- New book, Covered Call Writing Alternative Strategies (coming early 2018)

  • Portfolio Overwriting
  • The Collar Strategy
  • The Poor Man’s Covered Call

New Book Coming Early 2018

3- Three new calculators for strategies detailed in the new book

 

Upcoming speaking event

Orlando Money Show

February 8th –  11th, 2018

Click for information

I will also be part of the event opening All Stars of Options Presentations.

 

Market tone

 This week’s economic news of importance:

  • Producer price index for November: 0.4% (expected)
  • Consumer price index for Nov3ember: 0.4% (expected)
  • Core CPI: 0.1% (0.2% expected)
  • FOMC announcement: 1.25 – 1.50% (expected)
  • Weekly jobless claims: 225,000 (235,000 expected)
  • Retail sales: 0.8% (0.4% expected)
  • Manufacturing PMI: 55.0 (expansion)
  • Services PMI: 52.4 (expansion)
  • Industrial production: 0.2% (0.4% expected) 

 

THE WEEK AHEAD

Mon Dec 18th

  • NAHB home builders index for Nov.

Tue Dec 19th

  • Housing starts for Nov
  • Building permits Nov

Wed Dec 20th

  • Existing home sales Nov

Thu Dec 21st

  • Weekly jobless claims
  • GDP revision
  • Leading indicators

Fri Dec 22nd

  • Durable goods orders
  • Personal income
  • Consumer spending
  • Core inflation 
  • New home sales
  • Consumer sentiment

 

For the week, the S&P 500 rose by 0.91% for a year-to-date return of 19.52%

Summary

IBD: Market in confirmed uptrend

GMI: 5/6- Buy signal since market close of August 31, 2017

BCI: My portfolio makeup remains in a neutral bias, selling an equal number of out-of-the-money and in-the-money calls. Let’s see the final tax bill.

WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US

The 6-month charts point to a slightly bullish outlook. In the past six months, the S&P 500 was up 10% while the VIX (9.42) moved down by 14%.

Much success to all,

Alan and the BCI team

 

 

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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.

55 Responses to “Arbitrage: Part I”

  1. Paul December 16, 2017 3:26 am #

    Alan:

    At the market close on Thur., 12/14/17, I held 800 shares of the ETF SPY together with their Jan 19 256 calls (8 contracts). SPY closed that day at 266.39, with an option price of 10.65 & .26 of time value. Also note that SPY went Ex-Div today, 12/15/17, with an expected dividend of 1.48.

    Since these were held in my “buy/hold” portfolio, in which I try to avoid ANY assignments, I felt that even though these were deep in the money positions, the circumstances offered sufficient protection against early assignment, which was my objective.

    However, this morning I was greeted with the message that 200 shares had been assigned at the 256 strike. SPY opened this morning at 265.41, with the option at 10.88 & .47 of time value.

    I would appreciate your help in understanding the reasoning or strategy behind this trade.

    Regards,
    Paul

    • Alan Ellman December 16, 2017 8:45 am #

      Paul,

      You did all the right things and still got assigned 1/4 of your contracts. By skipping the December contracts and moving to the January contracts would normally avoid assignment 99+% of the time. When early assignment occurs related to dividends it will occur when the dividend is greater than the time value component of the option (as in this case) and when the ex-date is close to the contract expiration (not the case here).

      What transpired here is that a retail investor decided that he (she) wanted to capture the dividend and probably also wanted to take possession of 200 shares and sent an exercise notice to the broker who sent it to the Options Clearing Corporation. The OCC randomly sent the notice to your broker who randomly assigned it to you. That is the most likely etiology of this scenario.

      How to avoid: The only way to guarantee this not occurring in the future, you may want to consider using SPY Weeklys during the month of the ex-date and skipping the week of that ex-date and simply not having an option in place for 1 week.

      That said, the retail investor would have benefitted by an additional $26/contract by selling the option, buying the shares prior to the ex-date and capturing the dividend without exercise.

      In the practical world of trading, retail investors will make mistakes and (rarely) these may land in our laps.

      Alan

  2. spindr0 December 16, 2017 11:00 am #

    Paul,

    Your early exercise question dovetails with Alan’s article. He explained how if XYZ is $50.00 and the $40 call is trading below parity at $9.75 then an arbitrage opportunity exists for anyone who can buy the call at that price and provides a risk free 25 cent profit. As he stated, this is not available to retail traders.

    However, suppose you are the owner of that call which has a $10 intrinsic value and you want to sell it. The market maker is only offering $9.75 so you’re going to take a 25 cent haircut to close your position at the market. You could offer it at any price between $9.75 to $10 and you might get lucky and get a fill. But more than likely, it’s going to cost you something to STC. If you do the arbitrage yourself, you avoid the 25 cent haircut (short XYZ at $50 and exercise your call to buy XYZ at $40, netting your $10).

    If you understand this arbitrage then you can see that any time the option trades below parity, your covered call is subject to early assignment.

    What causes deep ITM options to trade below parity? To start with, market makers widen the spreads on them because of the higher cost and cash involved to hedge them. More importantly, as a dividend approaches, since long call owners do not receive the dividend and since the stock exchanges reduce share price by the amount of the dividend on the ex-div date, call owners sell their deep ITM calls to avoid this mark down. Selling pressure drives the call’s price down, hence the discount to intrinsic value.

    The SPY numbers that you provided are closing numbers and do not depict what the bid was in relation to the underlying price throughout the day on Thursday. My guess would be that some time during the day, the selling pressure caused your Jan 19 $256 cal to trade below parity and you were just someone randomly assigned by the OCC “wheel” due to exercises submitted.

    If you want to see an example of this, look at AVGO which closed at $265.73 on Friday. It goes ex-div on Tuesday for $1.75 and many of the ITM strikes for next week are trading at a discount as well as some of the calls expiring in later weeks.

    There are a few less frequent reasons why people exercise early:

    1) They think that they are receiving income by receiving the dividend so they exercise to capture it

    2) They want to own the shares

    3) They throw away time premium by exercising rather than selling the option

    4) They do a Risk Arbitrage, hoping the stock recovers to the pre-adjusted ex-div close

    Alan,

    “When early assignment occurs related to dividends it will occur when the dividend is greater than the time value component of the option”.

    The arbitrage In this scenario loses money so this relationship is not a logical reason to exercise early.

    • Alan Ellman December 16, 2017 11:53 am #

      Spin,

      Early exercise in this case and others like it technically should not take place…agreed. However, when the upcoming dividend ($1.48) is greater than the time value component of the option ($0.26), some retail investors will be enticed to exercise early as in this case.

      The option holder would have been better off selling the call and benefitting from the $26-per-contract, buying the shares prior to the ex-date and then collecting the dividend.

      This is an example of the difference between theoretical trading and practical trading that I have alluded to in previous articles and videos. For those who may suffer tax consequences for selling long-term, low cost basis stocks, this must be factored into investment decisions.

      Alan

    • Jay December 16, 2017 10:00 pm #

      Hey Spin,

      When I saw the title of this week’s blog article before I even read it or looked at the comment thread I thought “Spin is going to love these two articles :)!” That is because you have mentioned arbitrage before and I know you are expert on it.

      It would be pure luck if I ever took advantage of it. I don’t have the computer power or pay close enough real time attention. But it is always good to add to my understanding of how markets work even down into the weeds!

      Looks like the votes are in line for the tax bill next week. Should be a nice week to buy any dip and over write any strength out to at least year end if not regular Jan expiry. Though if there is a derailment of the bill priced in expectation will unravel.

      Since we had a huge day yesterday and options are cheap I bought a few ITM insurance puts as speculation/protection for next Friday at yesterday’s close just in case.

      Otherwise I have been adding to core index holdings on weakness like Thursday and also buying 4 to 6 week out ITM credit spreads at about the .8 delta for the bought call on tickers I like: BA, HD, ITT, VZ, CBOE and APPL are my open trades at the moment. I don’t do much over writing this time of year for seasonal reasons. I have been more long this year on the investing side than I have been in the past and had a bullish bias on the trading side. That makes me nervous about my bullish sentiment clouding my objectivity! What goes up……

      I would be interested in your view of market direction out into January and how you are trading it these days. Thanks, – Jay

      • spindr0 December 17, 2017 1:01 pm #

        Hi Jay,

        Me an expert? Heh! The only thing that I have perfected took years of honing: Procrastination !

        In order to find risk free arb situations, you have to have a brokerage platform that allows you to set up combo orders as well as price alerts. You can enhance this via a DDE connection that enables you to have Excel live in real time. The problem is that these opportunities are few and fleeting. Generally, the amount of the arb is low so you need an ultra low commission schedule like IBKR as well as free assignment and exercise. When they do pop up, you have mere seconds to nab them. And with some of these arbs, you have pin risk. While of of this may sound alluring, it’s a ton of effort for pennies of reward and is just not practical on the retail level.

        What is very relevant to the retail trader is my example in my previous reply where you can avoid the”haircut” on a long deep ITM option that you can’t sell for intrinsic value because it is trading below parity. Understanding that arb will save you money.

        While I wouldn’t call it arbing, it’s also worthwhile to understand how one can convert simple option positions into safer combos to linit risk and free up margin (not trade on margin). I won’t labor it but a simple example might be selling cash secured puts and after a modest increase, legging into to various types of spreads.

        I have no view of market direction. It may sound simplistic but this market is what it is until signs indicate otherwise. Until she died, Miss Cleo was my porediction guru ;->) .

        I don’t listen to the talking heads (CNBC, etc.) and like you, I trade options based on the premise of limiting risk and keep premium flowing my way (spreads, overwriting, etc.). I also trade stocks intraday – generally those I’m willing to own – and if stuck with such a position, I’ll add the options, often collars. I doubt that much more of this is appropriate here so if you want to chat, look me up over on Elite Trader. I recently started a chain “Hedging An Appreciated Portfolio”, requesting some help from the experts there on how to hedge an appreciated managed money equity portfolio with index puts. That’s one of the beauty of the internet – access to others who can speed up one’s learning curve.

        Re that hedge: I’m not expecting a large correction but I’d like to be protected to some degree should one occur suddenly (Rocket Man?). A bear market doesn’t concern me because I can react to that. A crash like Black Monday in ’87 was nasty – as you recall – and there’s nothing you can do with that unless you have protection in place prior to it. 30 years ago I could bear the risk but as an older phart now, I wanna keep my toys ($$$).

        Spin

        • Jay December 18, 2017 5:37 pm #

          Hey Spin,

          I signed up for your other blog as Jay W. since Jay was taken. The only reason I mention that in this forum is to compliment Alan, Barry and our friends here on the civility and tone of this blog, as always, in comparison to others out there.

          From my initial reading there are Self Proclaimed Einsteins at Elite Trader who talk down to others. You are definitely not one of them and not a part of that problem :)! – Jay

          • spindr0 December 18, 2017 7:17 pm
            #

            Hi Jay,

            Yep, this is an unusual site in that everyone is courteous and civil. Most blogs on the net have a fair share of people who are full of themselves (flamers) or are trying to sell you the latest get rich quickly trading system. It comes with the territory. But if you can get past that, there’s a lot to be learned from those who have traveled down the same road before us. Sadly, ET isn’t what it used to be as the number of participants has dwindled. Some of the participants are former option market makers and their insights can be helpful if you have a secret decoder ring for translation (g).

            Silicon Investor is another good blog and it is more active. I buy/hold/trade preferred stocks for income and they ferret out a lot of interesting issues on the Income Investing chain and provide a lot of good info – some times, info that is buried deep in the financials.

            Spin

  3. Sebastien December 16, 2017 11:39 am #

    Alan How are you?
    I have a question about technical analysis.

    Is it possible to use IBD buy point? And IBD technical analysis? Or for you it’s better to use your technical system?

    Best regard.

    Sebastien

    • Alan Ellman December 16, 2017 11:59 am #

      Sebastien,

      The BCI technical analysis methodology is based on our 1-week and 1-month option positions. Most other vendors use parameters geared to longer-term investments. This is why I use the parameters described in my books and DVDs. For example, in my book “Stock Investing for Students”, a long-term investment plan (not based on options), I use different technical parameters.

      Alan

      • Sebastien December 16, 2017 12:48 pm #

        Thank you for your quickly answer.

        Is it not a good idea to choose stock for a long term and buy weekly option on this stock?

        Do I have to choose only short term stock?

        Thanks.

        • Alan Ellman December 17, 2017 7:12 am #

          Sebastien,

          In my view, unless we are using a covered call writing alternative strategy called portfolio overwriting (selling call options against a long-term buy-and-hold portfolio of low-cost-basis stocks), it will be to our financial advantage to favor short-term stock selection. There are 2 main reasons:

          1. The reasons we selected a specific stock today may not exist in the near future.

          2. We avoid earnings reports which represent risk and corporations report every 3 months.

          By crafting our portfolios on a more frequent basis we will have opportunities to adjust based on stock performance and market tone.

          Alan

  4. Barry B December 16, 2017 11:34 pm #

    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 12/15/17.

    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

    barry@thebluecollarinvestor.com

  5. Marsha December 17, 2017 11:26 am #

    Alan, In looking over this week’s report I noticed some unusual strike prices for EDU like 94.57 and 99.57. Both have high open interest. Please explain how this happens.

    Thank you.

    Marsha

    • Alan Ellman December 17, 2017 4:19 pm #

      Marsha,

      When we see an odd strike as with EDU, it is generally a result of a contract adjustment after a corporate event like a stock split, merger and acquisition or (in this case) a 1-time special cash dividend.

      When a dividend ex-date is reached, the share price drops by the dividend amount, $0.45 in this case. To be fair to call holders, the strike price must also be dropped by that amount.

      This case is a bit unusual in that the strike was adjusted by $0.43, not $0.45 because EDU is a Chinese company (ADR) and there was a $0.02 bank fee for handling the transaction.

      Alan

  6. roni December 17, 2017 12:28 pm #

    Expiry weekend report

    This cycle was unfavorable to me. 🙁

    My total account value is down 1.8%.

    I had 10 positions:

    7 gapped down in the 2nd and 3rd week, and I bought back the CCs following the 20/10 guideline.
    I am still holding the underlying stocks: 5 recovered slowly (ANET, ORBK, PYPL, OLED, NFLX) and are near my BEP.

    The other 2 (CGNX and IPGP) are at 10% loss.

    2 positions (WGO and GRUB) were assigned with a 3% gain. 🙂

    1 position, ESNT, CC ended worthless, 0.11 cents under strike, 2.5% premium gain. 🙂

    Now I am 20% in cash.

    Starting tomorrow I will have to make several decisions:

    First, bite the bullet and liquidate the big losers. Second, select the stocks to keep, and sell CCs against them, and third, replace the others by more promising candidates from Barry’s list.

    Roni

    • Jay December 17, 2017 3:50 pm #

      Roni, congrats on managing some tough breaks this expiry to only a 1.8% portfolio loss. Seven out of ten stocks gapping down will not happen that often in this market. Imagine what it would have looked like without your sold options profits? That loss is still only a paper one since you still have five of the stocks and some dry powder for January.

      I’ll bet you turn that expiry around with some seasonal help, a new round of CC’s and a couple fresh picks!

      Can you find anything in the news about CGNX and IPGP that would suggest the dips are reflective of a fundamental change or just a temporary glitch? I don’t follow them but I do follow PYPL and when it had it’s dip I deemed it a fluke one time news event and opened a new long which luckily worked fine.

      All the best with the new expiry! – Jay

      • roni December 18, 2017 9:03 am #

        Thanks Jay,

        this was really a freak cycle.
        I was forced to hold all 7 gap down positions because it was impossible to know which ones could recover.

        The most recent news about IPGP are positive earnings beat for Jan 30 ER based on the last two recent quarters.

        The latest news on CGNX is also positive, but not recomended for as a buying oportunity.

        PYPL has ER today after the bell. I love PYPL, but ER events have a 50/50 chance, and I am not a gambler.
        My BEP is 76.76 and I have 300 shares. I’ll be watching it closely, with my finger on the triger.

        Roni

        • Terry December 18, 2017 11:19 am #

          Hi Roni;

          I show that PYPL has ER on Jan 18th.

          I got hurt on CGNX as well last month.

          Best;

          Terry

          • roni December 18, 2017 12:11 pm
            #

            Terry,

            you are right about PYPL. Sorry my mistake.

          • Jay December 18, 2017 12:48 pm
            #

            Thanks Terry, I agree with you, just checked and found a 1/25 PYPL earnings date on my Options House platform. But is said “estimated”.

            Glad to see both CGNX and APGP are up today. If one were inclined to sell new CC.s this would be a good day. Or if one assumes the tax bill this week will pass raising the tide and most boats it would not hurt to wait untll Weds or Thurs.

            We all know the risk in that: the bill could get delayed or when it passes a profit taking “sell the news” wave could hit.

            PYPL keeps inching higher but is still below it’s 52 week high resistance so I will hold my shares uncovered. Maybe a lot of people are using it to buy X-Mas presents and think it is a good stock idea :)? – Jay

          • roni December 18, 2017 3:55 pm
            #

            Jay,

            I believe PYPL is still suffering from the data breach in their TIO aquisition.
            I am also holding it uncovered, this event may blow over soon.

            Roni

          • Barry B December 18, 2017 9:05 pm
            #

            Terry,

            There are multiple PYPL ER dates, depending on the website that you use. Most of them say “…sources derive their estimate of the ER date using algorithmic methods which are based on a company’s historical reporting patterns. Depending on the company, these may change from time to time…” in the fine print. As a matter of fact, there aren’t any press releases on the PYPL website announcing any upcoming ER reporting dates!

            Our primary source has a very high accuracy rate. Based on our usage over 10 years, I would estimate that EarningsWhispers.com has a 95+% accuracy rate, possibly higher. As far as we have been able to determine, it is the only site that we have found that indicates when an ER Date is actually confirmed (that is why we like it so much).

            I hope that this helps you better understand the challenge we have in reporting ER Dates in our Weekly Report.

            Best,

            Barry

    • JustinP December 18, 2017 6:53 am #

      You’re handing in your scorecard too early Roni – going by the futures all stocks will be rising 10% each today 🙂

      • roni December 18, 2017 9:18 am #

        Thank you Justin,

        Your moral support is very wellcome.

        you are right. I may have a chance to turn this around, but I always post my expiry report on the weekend after Expiry Friday, in order to keep track of the monthly CC methodology advocated by the BCI team.

        In my opinion, the long term validity of this methodology is more important than any single mothly result (good or bad).

        Roni 🙂

        • roni December 18, 2017 4:05 pm #

          Justin,

          as you forecasted, today was really very good, and I managed to recover part of my loss. 🙂

          But I’m still licking my wounds – Roni

          • Justin P. December 19, 2017 12:38 am
            #

            Roni,

            I also had a bad month (-0.85%), though was a fair bit worse for a while there – first loss in six months of ‘real trading’ and four of paper trading. Mainly due to TROX plummeting 25% due to an FTC lawsuit – just because I’m paranoid doesn’t mean they’re not out to get me…

            Justin

  7. Barry B December 17, 2017 9:23 pm #

    Premium Members,

    the Weekly Report has been revised and uploaded to the Premium Member site. There was a minor revision that didn’t impact any stock. Added the bold dashed line between the February and March options months. Look for the report dated 12/15/17-RevA.

    Best,

    Barry and The Blue Collar Investor Team

  8. Bill R December 18, 2017 11:03 am #

    Alan,

    I made my first trades in a while last week, and may have been a bit rusty/rushing as I was excited to get back into the game. Based on the 12/08/17 screen list I assumed that since CTAS was in bold that I was in the green to invest. I didn’t realize until today that they have an ER on 12/21 which I know is a no no. Not sure how I missed that, only can explain that I was multitasking. I searched the videos to try and locate an ask Allen on how to best remedy this, but didn’t find anything in my browsing. Do you have anything off hand?

    My example is below.

    Purchased 200 shares at 157.44 on 12/11
    Sold 2 ITM contracts 1/19 155.00 at 6.17 per
    2.44 intrinsic with 2.4% ROO

    Current choices

    Let it ride – I have 3% downside protection with the added intrinsic value, along with 5% break even.

    Close out – By using the Daily Covered Call check up Calculator It shows that if I close both position’s today I have a .3% gain after fees (Assuming no other changes)

    Again if you have an Ask Alan on the topic I’d love to check it out and make a decision. I’m embarrassed I’m in this situation, but I’d rather handle it right and learn from it.

    Bill R

    • Alan Ellman December 18, 2017 1:40 pm #

      Bill,

      Writing calls on stocks that are about to report earnings was the most common error I made back in the 1990s when I started teaching myself these strategies. I learned the hard way!

      Congratulations on picking this up before you lost money…the best way to learn a lesson.

      At this point, there are 2 paths that can be taken:

      1- Buy-to-close the short call in anticipation of a favorable report and then sell the call after the report passes. This is an aggressive approach I take only from time-to-time.

      2- Close both the short call and long stock positions and reconsider using this stock after the report passes. This is a more conservative approach and the one I would take most of the time.

      For future reference, stocks located in “gold cells” (pages 3 and 15 of the report) are eligible but report earnings in the current contract month. They should be considered only after the reports pass.

      Keep up the good work.

      Alan

      • Bill R December 18, 2017 3:00 pm #

        Alan,

        Thank you so much for the reply. I’ll monitor them tomorrow morning and likely close both out. Thank you again for the reply and helping to keep me in check. I was thinking of just letting it ride, but that’s not the blue collar way haha.

        Best,
        Bill R

  9. Sandy December 18, 2017 11:44 am #

    First a thank you for your service. You make it easy to make a few shekels. Over the years I have used both VectorVest and you. Both are excellent, but, frankly, when I feel lazy, I just go Blue Collar.

    My question is simple and one I’m sure you’ve addressed hundreds of time. Personally what makes you choose an ETF or a stock for covered call purposes? When do you seek out one or the other? The ETF’s just seem – if chosen wisely (by looking at your report!) – to be a bit more predictable. Or am I wrong?

    Again, thanks for a great service. People are crazy not to belong to your service!

    Sandy

    • Alan Ellman December 19, 2017 6:06 am #

      Sandy,

      Thanks for your generous remarks.

      There are pros and cons to ETFs versus stocks. I use individual stocks in my covered call accounts and ETFs in my mother’s account. ETFs should be considered:

      1. To achieve instant diversification with less cash requirements.

      2. To require less position management as earnings reports are not a factor.

      3. For those with lower risk tolerance as, in general, ETFs have lower implied volatility than individual stocks (there are exceptions). See the last 2 pages of our ETF Reports for IV stats compared to that of the S&P 500.

      4. For those willing to achieve lower portfolio returns in return for ETF benefits.

      Alan

  10. Jay December 18, 2017 8:05 pm #

    Alan.

    I had a little surprise on a trade I thought you might help me better understand. I held 100 shares of AAPL and had BOUGHT one put contract ITM as protection at the 177.5 strike for Dec regular expiration.

    I guess in the past when I have bought puts either for protection or speculation I had always sold them before expiry when ITM. I forgot about this one, it expired ITM and I just figured I would keep the intrinsic value and the shares.

    Instead my broker bought the shares from me above market at 177.5 even though I did not sell them the right to exercise anything. I had bought the put option. Does that sound like normal practice to you? Thanks, – Jay

    • Alan Ellman December 19, 2017 6:26 am #

      Jay,

      The Options Clearing Corporation has provisions for the automatic exercise of certain in-the-money options at expiration, a procedure also referred to as “exercise by exception.”

      Generally, the OCC will automatically exercise any expiring equity call or put that is $0.01 or more in-the-money. However, a specific brokerage firm’s threshold for such automatic exercise may or may not be the same as OCC’s.

      An investor with an expiring long equity call or put position that is subject to automatic exercise does not have to exercise the contract. Instructions may be given through a brokerage firm to OCC not to exercise a call or put that is in-the-money by any amount.

      Any investor with an open short position in a call or put option can cancel the obligations inherent in that short (or written) contract by buying back the option. This transaction must be made before assignment is received. regardless of whether we have been notified by our brokerage firm to this effect or not.

      Alan

      • Jay December 19, 2017 9:43 am #

        Thanks Alan

        I was very much aware of the automatic exercise when I allowed my sold CC’s to expire a penny or more ITM. I just did not realize it pertained to bought options as well unless I take some action. Helpful info.

        I noticed I also had a speculative simple put buy on BBT that also finished ITM but with no underlying shares. I am now short 200 shares at the strike price and the market is lower so, like the APPL, there is a positive outcome here and I am more informed on how the process works! -Jay

  11. Mike December 18, 2017 8:52 pm #

    Very informative article. Thank you.

  12. John December 19, 2017 6:14 am #

    I just subscribed to the BCI Premium site. I would like to invest part of my retirement cash in an ETF conservative portfolio, just like you mentioned that you are doing for your mom account, what ETFs would be good to start with a diversified and conservative portfolio, writing naked cash backed puts? How far from the ATM, or OTM puts? ITM? Etc… I do understand that all the responsibility of the investment is mine, in this premise.

    I sure would appreciate your input.

    Looking forward to your reply.

    Regards, John

    • Alan Ellman December 19, 2017 7:34 am #

      John,

      There are 2 ETF selection approaches you can take to achieve your goals:

      1- Check the last 2 pages of the ETF reports and look for the lower implied volatilities. These would be the most conservative securities with the least amount of market risk.

      2- Focus in on page 4 of the report that highlights the top-performing SelectSector SPDRs. These will give you exposure to the top 30% of the S&P 500 stocks.

      Regarding strike selection for cash-secured puts: Start with your monthly initial return goal, say 1-2%. Check the option chains for out-of-the-money cash-secured puts and use the strikes that are deepest out-of-the-money that meet your goals. These are the strikes least likely to get exercised while still meeting your return goals.

      Alan

  13. ocharo December 19, 2017 6:37 am #

    hi,

    i have been learning from your videos on youtube and some online i do have a question what capital do i require if i only want you sell puts option strategy for a monthly return of $3500 using sell to open and buy to close position keeping in mind money management skills

    thanks
    ocharo

    • Terry December 19, 2017 3:25 pm #

      Hi ocharo;

      Set a goal that you want to achieve, for example 2% per month. Then if you want $3500 per month, divide that by your 2% requiring an investment of $175k.

      Best;
      Terry

    • Jay December 19, 2017 5:21 pm #

      Hi ocharo,

      Welcome to our group and welcome to the wonderful world of options selling for income!

      I have found it is the best strategy for conservative income investors out there. And there is no better place to learn about it than with the resources on this site and in Alan’s books.

      I encourage you to read those resources thoroughly, get so conversant on these strategies you can explain them to a friend and do some paper trading first.

      It is very easy and tempting – I should know because I did it when starting out – to focus on a target income before knowing all the risks and doing some practice.

      Even if you put $200K into stocks or cash secured puts each month and write 2% calls generating $4K in monthly cash flow how much you keep as portfolio “income” will be dependent on your stock pick performance and your exit strategy use. Nothing is ever easy :)! – Jay

    • Alan Ellman December 20, 2017 6:51 am #

      Ocharo,

      Let me add one more thought to Terry and Jay’s outstanding responses:

      If avoiding exercise is part of your investment strategy, selling deeper out-of-the-money puts should be considered. These will result in lower option premiums and therefore require a larger investment to achieve a $3500.00 initial time value monthly return. Moving deeper out-of-the-money to achieve a 1% initial time value return (and more protection against exercise) would then require an investment of $350,000.00 (less put premiums) to secure these puts.

      Alan

  14. Mike December 20, 2017 2:42 pm #

    Have there ever been months where you couldn’t find enough stocks that meet your guidelines to complete your portfolio. Or perhaps I am just being too picky.

  15. MarioG December 21, 2017 9:00 am #

    Trading Experiences through Expiration Friday 12/15/17 – 4 Accounts Portfolio:

    What a month! What a year! This This past Friday marked a full year for my YTD portfolio starting on 12/16/16.

    December looked bad. I agree with others here some of our “best” picks lost some steam and it did not look good. But Expiration week was good for me at the end.of the week, ending in overall positive gain. I ended up up 0.84% for December cycle compared to 2.87% in November.

    Annualized performance 24.88%:
    Attached is my updated performance chart for the 4 accounts portfolio (2 of them IRAs) at Fidelity and Etrade. Note in column G the 0.84% and in column F the composite annualized gain was 24.88%. The stocks I traded in December are listed in column G. I also include in column G, for reference, 4 ETFs I traded which in my conservative ETF portfolio. I will present that performance in a separate post.

    Broken down by account, the performance of the 4 accounts was:

    Fidelity – 16 36.1%
    Fidelity – 91 (IRA) 22.3%
    Etrade – 37 23.4%
    Etrade – 94 (IRA) 21.1%

    Expiration Friday Trades:
    (I normally for a Symbol place 4 orders in parallel at a limit, then I play the spread on one of the orders till it is filled, then proceed to adjust the limit order for the other accounts. That has worked well for me to improve my profit.)

    FIVE – Rolled out Strike 65 to 65 – Additional gain 3.1% (4 orders)
    LGIH – Rolled out Strike 70 to 70 – Additional gain 2.57% (4 orders)

    The next 8 orders to unwind TER and PYPL were interesting. I made a date with my wife to drive her to the other side of town for a special appointment at 3pm. I thought I would be completed with my trades by 2:30pm. But I noticed the TER and PYPL were rising in price around 2:30pm approaching my breakeven point with a small loss. I decided to trade them in my car with my Fidelity and Etrade Mobile Apps while at my destination. It turned out I completed 6 of 8 orders by closing bell. I found I had conflicting open orders to sell at a limit, so I had to cancel the orders first before unwinding. Was tricky.

    I traded the last 2 unwind orders for TER and PYPL on Monday the 18th at a slightly higher favorable price.

    Security selection:

    As i have mentioned before, I enter in a finwiz.com portfolio(s) each weeks run list so I can quickly see the changes in price during the week. Since finviz automatically enters last Friday’s price if I create the portfolio before Monday’s bell, it is a convenient reference of the stock’s price trend when looking for a selection. I also mark those not recommended in the run list (ER approaching, open Interest shaded by select Short Sell n Finviz. Mousing over a symbol instantly gives me the chart for a security so I can see visually the past volatility.

    After checking the Bid / Ask spread and Open interest, I manually calculate the ROO and upside potential for ITM and OTM cases to see if they are acceptable. I calculate the breakeven to see how it compares to past support points and review the volatility. I then recheck the ER and Analyst Recommendation (Barchart, Yahoo).

    After filling an order, my next step is to enter the Security and Option symbol in a Fidelity composite portfolio (4 accounts) with my quantity and purchase prices so I can track the time value for exit strategies (up or down) and stock performance.

    Very pleased with Alan’s support and trading methodology after 18 months with his system. Has made a big difference in my accounts values. A winning rising market and economic outlook and common sense trading has helped in getting those results.

    Mario

    • roni December 22, 2017 8:32 am #

      Mario,

      simply spectacular results.
      It proves that hard work and consistent methodology is a winning strategy.
      Congratulations.

      Roni

  16. MarioG December 21, 2017 9:22 am #

    Trading Experiences for Expiration Friday 12/15/17 – ETF Joint Trust account:

    Annualized performance 4.77%:
    Attached is my performance chart for my conservative Joint Trust Account. December I lost 1.99%. The previous month was also negative at -0.24%. YTD annualized (inception date 4/2017) is 4.77%, still better than a 1.25% CD. This portfolio still has 5 months of trading to complete a year.

    The securities traded in the account are in column H. 3 of the 4 securities expired worthless. I exited under performing SMH, SOXX, and LIT on Monday the 18th after a Gap up, from market events, in all 3 stocks near the breakeven point. LIT was rolled from the last 2 cycles so it had a good gain.

    On Tuesday 12/19/17, I bought 3 covered call with KBE, TAN, and KRE with ROO% of 2.3% (upside 0%), 1.12% (upside 0.7%), and 2.49% (upside 0.3%)l, respectively.

    This makes me over 92% invested in all my accounts.

    Mario

    • Terry December 22, 2017 7:18 am #

      MarioG;

      Based upon your trading results, ETF CC returns are significantly less than stocks.

      Best;
      Terry

      • Jay December 22, 2017 4:07 pm #

        Hey Terry,

        It is always tough to beat SPY no matter what you do.

        Just holding it and writing CC’s OTM for half a percent a month to make it yield an extra 6% a year is simple and not a bad idea…-Jay

        • Terry December 22, 2017 6:35 pm #

          Hey Jay;

          What about using that approach on the Q’s?

          Best;

          Terry

          • Jay December 22, 2017 10:32 pm
            #

            Hi Terry,

            I love the Q’s and have a pile of it! I plan to cover it nearer the money after the next couple Santa weeks because Tech has seasonal weakness early in the year. There is nothing scientific about that, just a pattern that seems to repeat itself like IWM (small caps) doing better this time of year.

            I can not fault Alan and Barry’s methods. They can just be a little time intensive if this stuff is not in your blood :)!

            Holding a portfolio of SPY/QQQ/TLT and GLD over writing it for a small amount like half a percent each month may just be the tortoise that beats the hare! – Jay

          • Terry December 23, 2017 1:57 pm
            #

            Hi Jay;

            “Holding a portfolio of SPY/QQQ/TLT and GLD over writing it for a small amount like half a percent each month may just be the tortoise that beats the hare! – Jay”

            Throw in the RUT (or in your case IWM) as well just for good measure!

            Best;
            Terry

        • MarioG December 23, 2017 7:06 pm #

          Great comments from everyone. One needs to sit back sometimes and take a look at the possible alternative worthwhile strategies that achieve one’s current goals.

  17. MarioG December 22, 2017 11:27 am #

    ETF are in the 1-2% per month range. So typically I would be in the grater than 12% range. Still have 4 months to complete the year. I found out that ETFs do have cycles as well but with some rollouts and exit strategies you can mitigate to some extent negative events.

    I did have some unfortunate losses with MGM and other stocks which looked initially as sure wins (It’s a casino (sic)!). The typhoon that hit Macau took care of that.

    The stocks were not ETFs and violated my initial trading plan. I added a note in column H for Sept. to use ETFs only. I am still ahead of the CD rates, which was a large goal and since that account is invested in joint funds that we wanted to get a better low risk return.

    Mario

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