beginners corner

Ask Alan #150: Comparing Index Options and Stock Options

Alan answers a question posed by Jordan, who asks:

I am soaking in all the information on your impressive website. One area I am not clear on is the difference between stock options, which you appear to favor, and index options which I would think can be used for broader diversification. Can you explain the difference between the two?
Thank you.
Jordan

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It’s the 2nd Wednesday of the month. Time for another original episode of Ask Alan. AA#150, “Comparing Index Options and Stock Options”

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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.

10 Responses to “Ask Alan #150: Comparing Index Options and Stock Options”

  1. Josh September 12, 2018 4:12 am #

    Alan,

    I recently finished your Encyclopedia of Covered Calls (a fantastic book by-the-way!) and have begun examining your BCI strategy for improving my own returns and, hopefully one day, for income enhancement for my widowed mother.

    I have a question about capital preservation for those focused on income investing (using the call premium for living expenses). I’m trying to understand how BCI would fare during and after future market crashes like 2008. Since I don’t have fancy Wall Street tools for backtesting, I thought it’d make the most sense to look at the NAV (net asset value) performance of closed-end funds that rely heavily on covered call selling.
    It seems that without re-investment of dividends/premium, these funds crash along with the market but never really recover. In other words, a “downwards ratchet” with each correction in market (the infamous 2008 rout, the 2014-2015 ‘slide’, etc).

    Am I correct in observing this issue? Is this just the mathematical reality of income investing or is there a way for Blue Collar Investors to preserve capital across market cycles while enjoying the fruits of their call option premium?

    Thanks in advance for reading,

    Josh

    • Alan Ellman September 12, 2018 6:21 am #

      Josh,

      These are great questions and precisely what I would investigate before deciding on an income-generating strategy.

      Let me initiate my response by saying that there is plenty of emphasis in the BCI methodology geared to capital preservation, both for trade initiation as well as trade management. Overall market assessment is a critical parameter we use for our stock (or ETF) selection and how we execute our exit strategies.

      Now, for any strategy that seeks to beat “no-risk” investments (short-term Treasuries), by definition, have a risk component. Covered call writing and put-selling have risk inherent in the strategies…low-risk, but risk nonetheless.

      2008: The crash of 2008 was an aberration. There are many safety valves in now place to mitigate future crashes but certainly no guarantees given the possibility of unexpected global events. But should we base our investment decisions on a year that was an aberration? Can we make money writing covered calls in a future crash? How about writing calls on inverse ETFs? In normal market conditions, option-selling should consistently beat the market because we are lowering our cost-basis.

      Covered call funds: They almost all under-perform. They should not be used as a guideline for evaluating these strategies. Most do not only use covered call writing and who knows what other strategies the fund is using. Most are based on benchmarks which include underlyings that are performing well and others that are under-performing. They cannot duplicate the steps we (retail investors) can take to enhance portfolio returns. Position management is a major weakness for most of these funds and administrative fees are impossible to overcome. Bottom line: covered call funds are not a great resource for evaluating covered call writing as set forth in the BCI methodology where all 3 required skills are incorporated into the strategy (stock selection, option selection and position management).

      To summarize: Once the 3-required skills are mastered, expect to beat the market on a consistent basis. In the unlikely event of a future crash, the use of inverse ETFs will allow us to continue to generate profits. Low-risk is inherent in option-selling.

      I’m glad you enjoyed my book and hope you benefit from it for years and decades to come.

      Alan

  2. Alan Ellman September 12, 2018 8:26 am #

    Premium members:

    The latest Blue Chip Report for the best-performing Dow 30 stocks has been uploaded to your member site. Look in the “resource/downloads” section (right side) for the report dated October-2018. One stock from last week’s report has been deleted and 4 new ones have been added.

    Alan

  3. John September 12, 2018 2:26 pm #

    Mr. Ellman,

    Should I pay attention to the put call ratio as far as a hint on which way the market is going. I have tried on the internet for information but a little confusing.

    Thank you,
    John

    • Alan Ellman September 13, 2018 7:14 am #

      John,

      I consider the put-call ratio as a secondary indicator. If rising, it indicates a bearish sentiment and vice-versa. If the indicator is “1”, there is an equal number of calls and puts traded, a neutral position. Some use .7 as neutral because investors generally buy more calls than puts.

      The ratio is also used as a contrarian indicator when the ratio is extremely high or low where investors are viewed as being overly bullish or bearish. When interpreted in this manner, a high put-call ratio is considered bullish.

      The ratio does provide important information and interpretation is critical. Again, I would not hang my hat on this one indicator but have no problem incorporating it into our trade decisions.

      Alan

  4. Jake September 12, 2018 2:38 pm #

    Alan,

    I think I have been all around the circle in this business of trying to make money in the stock market. I have not been paying attention to your website for sometime. Of recent, I started thinking more about your strategies, and in particular covered calls, and I intend to return to get myself reinforced.

    One question I have pertains to asset allocation.

    In my case, I don’t have a problem in purchasing 100 shares up to say $300, however I am trying to help my daughter who only has an account size of $40,000. I want to give consideration to trade size and the risk of ruin, which I would think would be very limiting in her case. Is it possible to trade covered calls in such a small account?

    What maximum percentage of an account do you recommend per trade? I suspect ETF’s could be higher than stocks.

    Thanks, Jake

    • Jay September 12, 2018 7:21 pm #

      Hi Jake,

      You did not ask me the question yet I hope you do not mind if I toss a penny in the pond on this one :)!

      I will assume your daughter is perhaps in her twenties or thirties with a fantastic jump on her peers with $40K saved?

      Before I retired I counseled young engineers on money management as a small part of my work. I told them they can not control the market but they can control their rate of savings. Put the most of every raise each year into a simple S&P index fund through payroll deduction until they max their 401k pre and post tax. Then max out their IRA and put anything left into a cash account.

      When I see pictures from Alan’s workshops everyone there looks like me: an old bald guy!

      Younger people should not be screwing around with options trading. They should be focused on their young family, on getting ahead at work and saving/investing as much as they possibly can. – Jay

    • Alan Ellman September 13, 2018 7:27 am #

      Jake,

      Good advice from Jay.

      As a guideline for accounts with $40k cash value and option-selling is being considered, I would lean to ETFs where instant diversification is achieved with one security.

      As an example (not necessarily a recommendation), if we purchased the top-performing 2 or 3 SelectSector SPDRs and wrote calls against these, we would hold the top 20% to 30% of the S&P 500 and lowering our cost-basis by writing these calls.

      In my book, “Stock Investing for Students”, I discuss the use of low-expense-ratio, broad market index funds invested via dollar-cost averaging and dividend re-investment to build a retirement portfolio for those not near retirement. Options can be added as portfolio size grows to elevate returns to even higher levels.

      What a great service you are providing for your daughter.

      Alan

    • Roni September 14, 2018 6:17 pm #

      Hello Jake,

      your post and question is very interesting, and I would like to add my opinion, because when we discuss our issues here, we always learn.

      I am also old, and bald, probably older than most of the members.

      I wish I had 40K when I was much younger, like your doughter, and my father could coach me to learn options trading at that time.
      Options trading is such a great experience, and, when your doughter masters the skills, she can make more money in a couple of hours per day, than working long and boring hours at a job at some corporation, or any other occupation she has.

      With $40,000.00, I would encourage her to start trading 4 monthly positions chosen from Barry’s bold weekly Stock Screen, leaving 1 or 2K for executing management or exit strategy, and compounding her gains to grow her portfolio, plus adding any other extra income she can spare, to grow the portfolio gradually, and increase the number of tickers and the purchasing cost for 100 shares slowly, but surely.

      Maybe she can achieve a comfortable situation like her father’s while she is still young and full of energy to enjoy spending part of the proceeds, and have a bright life while doing it.

      Roni

  5. Alan Ellman September 12, 2018 5:39 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.

    New members check out the video user guide located above the recent reports.

    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

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