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Beta: Another Tool to Enhance our Covered Call Returns

When we defined the Greeks in a previous article concerning investment basics, it included a discussion of the price sensitivity of the option premium as it relates to the underlying equity, time and other factors. One of the rules was that (all other factors being equal) an increase in share volatility will increase an option premium. An equity with greater volatility will be associated with an option premium which generates greater profit but is also associated with higher risk.

One way to measure the volatility or systemic risk (market risk) of a security is to compare it to the market as a whole; the S&P 500 being the most commonly used benchmark. This is known as beta. Beta stats are calculated using a process known as regression analysis wherein the “market” is assigned a number of “1″. Beta is the tendency of a stock’s returns to respond to changes in the market.

The Numbers:

  • Beta of 1- the equity price will move in conjunction with the market. If the market is up 2%, so will the stock (be expected to).
  • Beta of less than 1 but above zero- the stock will be less volatile than the market. An example would be utility stocks
  • Beta greater than 1- the security price will be more volatile than the market. An example would be tech stocks.

An example:

If a stock has a beta of 1.5, it is considered 50% more volatile than the S&P 500. If the market appreciates by 8%, the expected return of that equity, based on its beta, would be 12%. On the other hand, if the market declines by 8%, that equity would be expected to decline by 12%. There you have the two faces of enhanced volatility…greater potential returns with enhanced risk. If an equity had a beta of .5 and the market was up 8%, one would expect that security to appreciate by 4%.

Negative betas:

A stock with a negative beta tends to move in the opposite direction of the market. An equity with a beta of (-) 2 would decline by 10% if the market appreciated by 5%. It would increase by 10% if the market declined by 5%.

Problems with beta:

There is no such thing as a panacea in the stock market. This ratio does have its flaws and should not be relied upon solely in determining the risk of our investments. Here are the drawbacks:

  • Beta does not account for business changes like a new line of products.
  • Beta looks backward and history is not always an accurate predictor of future events.
  • Beta ignores the price level of a stock.
  • Beta makes the assumption that the volatility is equal in both directions.

The drawbacks are more significant for longer term investments. Beta can be extremely useful to us as 1-month covered call investors. For our purposes of selling 1-month call options, beta is a good measure of risk.

Implementing beta into our decision-making process:

High beta stocks will outperform the uptrending stock market and underperform the downtrending market. Low beta equities will underperform the uptrending market and outperform the downtrending market. In a bullish market, I lean towards high beta stocks and sell O-T-M strikes. In a bearish market, I favor low beta stocks and sell I-T-M strikes. In neutral markets, I “ladder” (use a mix) my beta stocks, in much the same way that I “ladder” my strikes.

Our Premium Report:

Premium members can access beta information directly from the running list on pages 3 and 4 of the Weekly Premium Report as seen on the graphic below:

 

Beta stats from the Premium Report

 

Beta and the Premium Report

Note the relatively high beta stocks indicated by the red arrows and the relatively low beta equities highlighted by the blue arrows. Depending on your overall market assessment, this information can help determine your stock and strike selection. General members can access beta information from several free sites such as:

http://finance.yahoo.com/

  • Type in ticker on upper left
  • Look at left column on next page
  • Click on “key statistics”
  • Look on right side of next page for beta stats

Conclusion:

Beta is simply one tool in our arsenal. Market conditions will dictate whether we should lean towards high or low beta stocks. It should be used in conjunction with all our system criteria. No one factor will make our investment decision evident. By continually throwing the odds in our favor using sound fundamental and technical analysis along with common sense, we will watch our profits rise and our successes dominate our portfolios.

Market tone (as of Thursday, April 12th):

  • This week’s economic reports continue to suggest an expanding economy:
  • The CPI rose 0.3% in March due to the increase in the cost of energy (gas)
  • The Federal Reserve’s Beige Book showd an increase in growth in all 12 districts
  • Producer prices were flat in March, a sharp decline from the 0.4% rise in February
  • The US trade deficit decreased to $46.0 billion, the largest reduction in 3 years 

For the week, the S&P 500 dropped by 2% for a year-to-date return of 9.6% including dividends.

A 6-m0nth chart of the S&P 500 shows a bullish pattern with an uptrending 50-d simple moving average (SMA- blue line) well above an uptrending 200-d SMA (red line). The benchmark briefly dipped below the shorter-term moving average ( green circle) but quickly recovered:

6-month chart of the S&P 500 as of 4-12-12

 
Summary:
 
IBD (Thursday): Market in correction
 
BCI: This site remains bullish but due to a gap-up in the VIX which has since subsided and global concerns we will now lean to a position of favoring ITM strikes.  
 
My best to all,
 
 
 
 
 

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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 “Beta: Another Tool to Enhance our Covered Call Returns”

  1. Doug April 15, 2012 9:57 am #

    Good info, as always Alan.

    I use Beta as part of my market scanning because a high beta typically means a better return on the options sold (of course…because they tend to move more than the underlying).

    OFF TOPIC: Alan, I’m not sure if you’ve ever done a blog entry on this topic, but I sometimes find myself wanting to “tweak” what I’m doing simply because profiting this way just seems too “easy” and “boring” sometimes. I don’t know why that is…maybe being brought up feeling like you should have to sweat a bit for your payday?

    Anyway, I think it is important to warn practicing covered call writers (or naked put sellers, which I lean toward) to be HAPPY with their returns! It is easy to forget just how well you’re doing when you get used to it month after month, quarter after quarter, year after year. If you’re getting 2% per month, on average, you are kicking ass! Remember that!

    Maybe it’s just me that gets bored and wants to experiment (and I almost always regret it and say to myself, “What in the hell was I thinking?!”), and when I looked last my return since the beginning of 2009 (when I stumbled onto this technique on my own…subsequently found Alan’s site when I was researching because it seemed too good to be true) I was at about 350% cumulative.

    If I can get bored and look to “improve” with a return like that, I think it might be able to happen to anyone! So sometimes, just take a step back and look at what you’re earning compared to other investments that you (have or have not) know about or tried!

    • DJ Swett April 15, 2012 2:08 pm #

      Hello Doug,

      I can’t talk about my 350% return–Yet–but, yes, I see a lot of your comments applying to me. I like to tweak also.

      Every Friday, I eat lunch with friends and I have gotten into the habit of going thru my options and tweaking something so that I can earn an extra $50 to pay for my lunch. How crazy is that?

      We have such a rock solid money making machine–at least with the current up trending market–that my simple mind is looking for extra cash flow to pay for my lunch. I love it, what a great opportunity.

      DJ

    • Lawrence April 16, 2012 12:27 pm #

      Hi Doug

      Do you mind to explain in details your method or system to achieve this huge return? Thank you.

      Lawrence

      • Steve Z April 16, 2012 4:50 pm #

        Doug, to follow-up on Lawrence’s question, I know Alan says one should get 2-4%/mo in normal markets using his method. According to my math, if one made 4%/mo for three years, the original investment would be up 324%, which is very close to your time frame and number of 350%. However, I’d be curious if you’ve tweaked Alan’s method in some way in addition to using high beta stocks which you mentioned, as I wouldn’t think his method should be up quite that much over these three years. Steve

  2. Barry B April 15, 2012 1:55 pm #

    Premium Members,

    The Weekly Report for 04-13-12 has been uploaded to the Premium Member website and is available for download.

    Best,

    Barry and The BCI Team

  3. Steve Z April 15, 2012 4:09 pm #

    Doug & DJ, I’ve been experimenting with covered calls and naked puts on VXX. It may end up being a bad idea but it has lots of volatility so lots of premium and when we get a significant pull back it should move up enough to make some big profits on OTM covered calls. This could be something more interesting for you than “tweaks.” Steve

  4. Alan Ellman April 15, 2012 6:11 pm #

    A great weekend:

    I returned today from a weekend in Atlanta where I was the keynote speaker for an AAII investment group. I was so gratified to meet several BCI members some of whom traveled long distances to hear me speak…thank you for that. The group has impressive leadership (thanks to Gale Brown and Bill Lyman) and if there are any BCI members who live in the Atlanta area I encourage you to check out this group. Needless to say, I am well behind in my email responses but will catch up during the upcoming week.

    Alan

  5. Stan April 17, 2012 5:37 am #

    Alan,

    How would you describe the relationship between beta and implied volatility? Which is more important to covered call writing? Thanks again for all you do.

    Stan

    • Alan Ellman April 17, 2012 6:35 pm #

      Stan,

      Beta is market risk based on past data. Implied volatility is a forecast of an equity’s volatility based on the current options pricing. I use the former as a seconday screen for stock selection and the latter for strike selection. For example, if the IV causes an ATM strike to return > 7% in one month I will pass it by due to the excessive risk “implied” in the option premium.

      Alan

  6. Doug April 17, 2012 11:33 am #

    Hi All,

    Well, for the most part, I tend to look more for higher beta instruments that tend to “roll” more than trend for a long time up or down.

    I also am not shy about using leveraged ETFs, so I get some nice returns from those. One thing I have learned in my 20+ years of trading (and losing, for many of those years) is not to get too excited if your moves don’t go your way right off the bat. If you study the fundamentals of whatever your underlying might be and truly believe that you have an idea on what it’s range should be, you won’t get too scared if it breaks through the top/bottom of whatever channel you think it should be rolling in.

    I have had a few losing quarters in the past 3 1/2 years, but they were small. I think that all 3 times (I think it was 3…) the broad averages lost well more than I did. I’ve also had killer quarters after those losing ones because I knew my underlying and it returned to “normal” for me, earning me what I thought I should have made in the prior quarter, plus what I thought I should make in the current one.

    Overall, Alan’s system is sound. VERY sound. I wrote after my trial that the methodology was contrary to what I was comfortable with (i.e. technically strong stocks mostly hitting new highs, counting on them going higher) because I am too nervous about those stocks who are hitting new highs and then the bottom falls out…they just have SO FAR to fall!! To each his own–Alan knows what he’s doing.

    I guess what I’m saying is that there is more than one narrow way to use covered calls (and naked puts) to your advantage. It is just SO GREAT to be able to be WRONG about the direction of your underlying and still profit!

    It has been a great 3 1/2 years, and I truly hope that it is a sign that I’m finally on the right track. I’ve lost a lot of money before that and before I found what I was comfortable with.

    That was the key point of my comment–if you’ve found this place, BE HAPPY! Don’t take 20 years only to return to it after tweaking…tweaking…tweaking only to end up regretting it. Maybe you won’t earn 4% per month for a while…maybe never. Maybe you’ll make 6%…who knows. But just do a simple spreadsheet over the long haul and plug in that you are making 2% per month and you can see that starting with only $10,000 if you make 2% per month you’ll have over $1,000,000 in under 20 years!

    YOU CAN EASILY AVERAGE 2% PER MONTH HERE! JUST DO IT AND DON’T GET (TOO) GREEDY!!!

    You’re doing great work, Alan.

    • Steve Z April 21, 2012 5:14 pm #

      Good advice Doug.

    • Lawrence April 21, 2012 7:27 pm #

      Hi Doug

      Thanks a lot.

      Lawrence

  7. Alan Ellman April 17, 2012 6:47 pm #

    To our members:

    I want to thank you for sharing your ideas with our BCI community. Your feedback and commentary are so important in making us all better investors. From time to time, we have received recommendations of investment professionals (on and off site) which I have never published on this site. This in no way is a repudiation of your testimonial but rather the policy of the BCI site not to publish contact information of professionals we do not personally know. We are so fortunate to get tens of thousands of visits each month and so it is imperative that this apply to all members. Your continued participation in our BCI community is very much appreciated.

    Alan

  8. Alan Ellman April 18, 2012 9:54 am #

    Recent Q&A posted after a previous blog article:

    I have been reading about the VIX and know that it is a good sentiment indicator, – but can I use the put/call ratio instead?(or is this not recommended?)
    -Also how many different types of sentiment indicators should I use?
    -Do you also suggest we look at it(or them) before each trade?
    * I am also wondering if we need to use market-breadth indicators?
    If the answer to this is YES then the same questions would need to apply to this as well, which again are:-
    -How many different types of market-breadth indicators should I use?
    -Do you suggest we look at it(or them) before each trade?
    -And also which one(s) are best to use?
    To get answers to all this would really help my understanding!
    ____________________________________________

    Adrian,

    This is an example of a great question that has no ONE right answer. It’s similar to asking which and how many technical indicators should be used when evaluating a price chart. Each investor must find the indicators that work best for him or her. I’m happy to share the ones that work best for me. For members not familiar with the market sentiment indicators Adrain alluded to:

    1- Put/Call ratio: Dividing the # of put options traded by the number of call options traded. The higher the ratio, the more bearish are investors. It is used as a “contrarian” indicator theorizing that investors may be unjustly bullish or bearish.

    2- Advance/Decline line: # advancing stocks – # declining stocks + previous day’s A/D value. It is used to identify changes in trend or confirm trends. If the market is uptrending and A/D line is declining, a trend reversal may be coming. If both are uptrending the trend is confirmed.

    These are great indicators and used by many investors but not part of the BCI methodology. I have no problem with investors who want to include these in their market analysis. Here are the indicators used in the BCI methodology to evaluate market sentiment (tone):

    1- VIX
    2- Technical chart of the S&P 500
    3- Weekly economic reports

    As “CEO of your own money” we must each decide the parameters we are most comfortable with.

    Alan

  9. Fran April 18, 2012 10:15 am #

    Alan,

    I’ve been following PII since I found it on your weekly list a few months ago. Today its up $6 after a strong earnings report. My question is would you use this stock for covered call writing at this point after this large increase in share price or would you wait for a pullback?

    Thank you.

    Fran

  10. Alan Ellman April 19, 2012 7:16 am #

    Fran,

    With a few days remaining in the April contracts, we look to the May contracts. As the price of PII settles and it still meets our system criteria, it becomes a stock deserving of our watch list and consideration for our portfolios. I don’t believe in penalizing a stock for success. Should we have ignored AAPL after it “jumped” from $60 to $70? Savvy investors might have concern for price retracement or profit-taking and that is valid. That’s where ITM strikes should be considered to generate nice profits with protection. Only use securities that you are comfortable with and fit your risk-tolerance profile.

    Alan

  11. Alan Ellman April 19, 2012 4:43 pm #

    Premium members:

    This week’s 6-page report of top-performing ETFs and analysis of ALL Select Sector Components has been uploaded to your premium site.

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

    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

    ***This week’s “Weekly Stock Screen and Watch List” will be published on Sunday as Saturday is a “day of eduction” for the BCI team. We are constantly working hard to provide our members with the BEST and LATEST education to elevate our investment success to the highest possible levels.

  12. Alan Ellman April 20, 2012 8:47 am #

    Running list stocks in the news: SHFL:

    On March 5th Shuffle Master reported revenues of $56 million well above the $44 million of a year ago. Earnings per share was 40% higher than expected. The share price increased by 10% after the “beat”. As a result of of recent positive earnings surprises the consensus estimates have been rising. SHFL trades at a forward PE of 22x, compared to its industry peers PE of 23x. Our premium watch list shows an industry rank of “A” and a beta of 1.34. Below is a chart showing recent positive earnings surprises (click on chart to enlarge and use the back arrow to return to this blog):

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