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Combining In-The-Money Strikes and Stock Dividends to Provide Protection in Bear Markets + Holiday Discounts

When establishing our covered call writing trades, we must factor in current market conditions to either add protection in bear and volatile environments or to take advantage of normal to bull market scenarios. On May 17, 2019, Mauricio sent me a diagrammatic strategy proposal that would lower the breakeven using an in-the-money (ITM) strike as well as a stock dividend for Exxon Mobil Corp (NYSE: XOM). The background setting for these trades involved a potential trade war with China with both countries raising tariffs causing economic and corporate concerns. This article will analyze the pros and cons of the strategy.

Mauricio’s diagram and summary of the XOM trades

Diagram

covered call writing trades

XOM Trades Using an ITM and an Upcoming Stock Dividend

Summary of trades

  • 5/8/2019: Buy XOM at $76.72
  • 5/8/2019: Sell the ITM 6/21/2019 $75.00 call at $2.67
  • 5/10/2019: XOM for a dividend of $0.89 paid on 6/10/2019

XOM initial calculations with the Ellman Calculator

covered call writing calculations

XOM Calculations Using the

Takeaways

  • The initial 6-week return (ROO) is 1.3% (about 11% annualized- brown cell) with downside protection of that profit of 2.2% (yellow cell)
  • The breakeven is lowered from $76.72 to $74.05 (red arrow) assisted by the component of the ITM strike

The ex-dividend date factor

Shareholders on 5/10/2019 will be entitled to receive the $0.89 per-share dividend on 6/10/2019. This will lower the breakeven to $73.16 or 4.64% lower than the purchase price.

Advantages of the strategy

In a troubling market environment, the breakeven is lowered by a combination of premium time value plus intrinsic value as well as a potential dividend distribution.

Disadvantages of the strategy 

The strategy returns a modest initial time value return which annualizes to 11% which may or may not meet the goals of the call writer. It is also dependent on receiving the dividend which is not guaranteed as early exercise is a possibility.

Discussion (my response to Mauricio)

Hi Mauricio,

This is a sound and appropriate strategy for bear and volatile market conditions. As you know, I am a huge proponent of ITM strikes when additional downside protection is indicated. Now, adding a dividend component will offer potential additional downside but also additional considerations:

1. Enhanced possibility of early exercise the day prior to the ex-date. This is more likely when the strike is ITM and the time value component of the premium is less than the dividend about to be distributed. This may or may not be a factor depending on how important share retention is to the investor. If this occurs, the dividend goes to the option holder, not us.

2. Stock price will drop by the dividend amount on the ex-date. This makes it more likely for share price to drop below the strike than had there not been an ex-date. Also, the premium for calls is lower when there is an ex-date involved because call buyers are not willing to pay “full price” when they know share price will decline by $0.89.

That said, your math is perfect, I love the drawing and the strategy is solid.

Best regards,

Alan

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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.

18 Responses to “Combining In-The-Money Strikes and Stock Dividends to Provide Protection in Bear Markets + Holiday Discounts”

  1. Julio December 7, 2019 3:01 am #

    Hi Alan,

    What would you consider an acceptable or normal downside protection?
    In your book it is says about a 1 month 3.7 % as huge and a 8.9% 6 week covered call as huge.
    I like downside protection so for individual stocks so
    what would be reasonably OK ? 3% 4% 6% 6.5% ?

    Thanks,

    Julio

    • Alan Ellman December 7, 2019 7:49 am #

      Julio,

      You ask a good question. Let me offer a framework that will simplify the process:

      The primary goal for covered call writing is generating cash-flow. Downside protection of that initial time-value profit is a secondary perk in bear and volatile market conditions or in all market conditions for those with extremely low personal risk-tolerance:

      Once a stock or ETF is selected:

      Step 1: Determine an initial time-value return goal, let’s say 2% – 4% for a 1-month contract

      Step 2: Locate in-the-money strike(s) that meet this goal range

      Step 3: Strikes closer to the 2% end of the range will offer the greatest downside protection and those closer to the 4% end of the range will offer the lowest downside protection. We make our selections based on overall market assessment, chart technicals and personal risk-tolerance.

      Alan

  2. John December 7, 2019 4:40 am #

    Alan,

    In your book Cashing in on Covered Calls you use IBD 100 stocks. I find only 50 stocks. Is there more than one printing of IBD or one form of IBD?

    Thanks,
    John

    • Alan Ellman December 7, 2019 8:00 am #

      John,

      Several years ago, IBD streamlined the IBD 100 list to the now IBD 50 list. I updated this in my more recent books on covered call writing, both versions of “The Complete Encyclopedia for Covered Call Writing”

      In 2019, we enhanced the stock screening process to replace the Scouter rating with On Balance Volume and Median Analysts Ratings. The upgrades were reflected in all our option books.

      I will ask my publisher to replace all IBD 100 references in “Cashing in on Covered Calls” with IBD 50.

      The rationale for the change (I called IBD) was that the list becomes a higher-quality list of eligible securities.

      Bottom line: Only 1 list… the “IBD 50”

      Alan

  3. Barry B December 7, 2019 9:36 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 12/06/19.

    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

    Since we are near the end of Earnings Season, be sure to read Alan’s article, “Constructing Your Covered Call Portfolio During Earnings Season”. You can access it at:

    https://www.thebluecollarinvestor.com/constructing-your-covered-call-portfolio-during-earnings-season/

    Best,

    Barry and The Blue Collar Investor Team

    [email protected]

  4. Steve Brennom December 8, 2019 2:23 pm #

    Alan,

    There is an additional nuance of combining ITM Calls and stock dividends related to early assignment/exercise that might be worth adding to the analysis. As I am sure you know, timing of the dividend with respect to the purchase date of the Covered Call combo and expiration date of the Call can be a useful consideration sometimes. If the ex-dividend date is reasonably close to the date of purchase, very early assignment and loss of dividend can produce a higher annualized rate of return than the primary plan of collecting the dividend. It can be relatively easy to assess the qualitative probability, high or low, of very early assignment by looking at the expected move of the underlying for the week of ex-dividend or the weekly ATR, but having an underlying with some unusual circumstances and personal insight helps, too.

    An example that is currently a work in progress for me:

    On 12/2/19, bought BRY with the underlying at $7.92, an ex-div date of 12/12 and div of $0.12, and sold ITM $7.50 Strike Calls with 12/20 Expiration for a $0.65 premium. In this particular case, BRY had just dropped in price on what I considered to be misinterpreted news about the impact on BRY of a new CA environmental reg on high-pressure steam injection of oil wells [BRY does low-pressure injection so isn’t impacted at all … 🙂 ]. I expect the stock to bounce back up and stay up as the news is digested properly so I expect the Calls to be assigned either on 12/11 by a dividend capturer or at expiration on 12/20 [BRY at close on Friday was back up to $8.51]. If it doesn’t get assigned, I will be happy to own BRY for a while, with a 6.7% div yield on cost, as I work the cost basis down further by selling more Calls, either ITM or slightly OTM (no desire to own it longer term).

    If the Calls are assigned on 11/12, the annualized return becomes 128% ($0.23*365/9/$7.27), minus transaction costs, of course.

    If the Calls are assigned on 20/12, the annualized return becomes 99% ($0.35*365/18/$7.15).

    If the Calls aren’t assigned, the annualized return will become a work in progress.

    So, a better rate of return comes from very early assignment/exercise by a dividend capturer. Of course, the very best rate would come from an early exercise right after the ex-div date, but that is really low probability.

    Normally, I don’t sell premium on underlyings below $15-$20, but I saw the news about BRY, am marginally comfortable with its liquidity and know the company from a previous business life so this set up was just too obvious and too good to pass up.

    I am not a member of BCI, but I do follow and appreciate your commentaries. There can be nuance in them that I haven’t thought of or experienced yet and/or they can reinforce my confidence in my own skill set.

    Regards,

    Steve Brennom

    • Alan Ellman December 9, 2019 6:26 am #

      Steve,

      There is no question that early exercise while losing the dividend will generally result in a higher annualized return. Good observation.

      The question becomes should we factor in early exercise possibilities into our everyday option-selling systems?

      Here are some of the reasons I do not:

      1. Although it is true that ex-dates are the main reason for early exercise, losing our shares early is extremely rare.

      2. Early exercise is even less rare when the time-value remaining on the option is greater than the dividend about to be captured.

      3. With some exceptions, option-buyers do not want to be share owners, they want to be option-sellers.

      4. It almost never pays to exercise early to capture a dividend when there is time-value remaining on the option. It would make more financial sense to sell the option, buy the stock (prior to the ex-date) and then capture the dividend generating both time-value and dividend income.

      When I capture a dividend in my option-selling accounts or when shares are assigned early resulting in a higher annualized return, I consider it “icing on the cake” rather than part of the formula to bake that cake.

      Thanks for sharing your trade and analysis… very useful.

      Alan

  5. Steve December 9, 2019 2:28 am #

    Hi folks, just getting back to you with that promised update! It actually went a lot better than expected, especially after what I read in that book (it made brokers sound like Blackbeard the Pirate). I was expecting to go to a bad part of town and wander through a semi- abandoned building until I found an office. Nope! The TD office was on prime real estate with a big sign on it, no trouble finding it.

    Once inside I didn’t have to wait at all, sat right down with my new broker agent guy. He didn’t ask me any prying questions or try to sell me anything. He was pretty interested to know the methodology I was using (like what my criteria was for selecting stocks), and asked me what I was trying to accomplish with my activities.

    He took some notes on my goals/strategy and technical problems I’d had with ThinkorSwim, told me to call him if I need any help with anything, signed me up for a tutoring session with ToS, and that was about it!

    So maybe they actually just want me to be a happy customer and become a good trader? It seems like they also want to have a predictable idea of what my trading patterns will look like, I’m going to assume this is for positive reasons and not so they can trade against me or manipulate prices or something.

    Steve

    • Hoyt T December 9, 2019 8:16 am #

      Hi Steve.

      Great! I am so glad your experience was so positive. Maybe we are seeing a new age broker/agent. I am slightly surprised he didn’t broach the subject of additional services. But then, again, you were not the typical client/investor. No one who trades options in any form is typical. My friends would say no one who trades options in any form is “normal.”:)

      I envy you your free training lesson on ToS. I trade with E-trade, have for decades, and use both their website and their Power E-Trade trading platform, which they acquired when they purchased Options House, I really like the platform but a lot of the online seminars I attend use ToS. There appears to be a couple of features ToS has that Power E-trade does not. So I opened, last week, an account at TD just to get ToS. Boy, do I need to learn a lot.

      Based on your experience, I may call my local TD to see if they offer a free tutoring session. See, another benefit of this blog.

      Again, congratulations on a positive experience and a heartfelt “Thank you” for sharing both your initial concerns and the results of your visit.

      Wishing you the happiest of experiences,

      Hoyt

    • Roni December 11, 2019 11:11 am #

      Hi Steve,

      thanks for your feedback.

      I am sorry to have made such a negative comment about the brokers, and your visit with them may change my mind about them.

      In the past few years, I was ill advised by my investment banks personell, and lost a lot of money purchasing their recomended “products”, therefore my negative post.

      Roni

  6. Hoyt T December 9, 2019 8:55 am #

    Hi Everyone,

    As a follow up to my reply to Steve, I would like to ask those of you who use real time trading platforms what you think of them? It would be particularly helpful if those who have used more than one could share their views.

    I used a couple of different ones that E-trade had before they purchased Options House. I felt they were clunky. I like Power E-Trade. I am trying to learn TD’s Think or Swim(ToS).

    Power E-Trade’s trade analysis is far more detailed and explanatory than their E-trade’s website.

    I am particularly interested in the analysis of credit spreads as the bought leg decays at a faster rate than the sold leg depending on the spread of the strikes. I deal with SPY and QQQ almost exclusively. What has peaked my interest is that I have created, I love that word, it’s awesome, a spreadsheet which allows me to enter all the pertinent data and calculate a return on the option(ROO). I get both the actual return and the annualized return.

    After making the trade, I can, days later, in my spreadsheet, enter the current prices and it will give me a current ROO and annualized return if I should close the trade at that time. By definition the ROO will be less than waiting to expiration. BUT, much to my surprise, the annualized rate can be much higher because of the shorter time held. Intuitively, it seems that I should close and institute another trade. What do you guys/girls think?

    It may be that I can get this data in Power E-trade but I haven’t figured it out . I may call them to see if it is possible.

    Thanks in advance,

    Hoyt

    • Roni December 12, 2019 8:42 am #

      Hello Hoyt,

      I am with Schwab for 10 years now. They are very good.

      Schwab is the only broker who extends it’s services to Brazil, therefore I have no choice.

      Roni

  7. Patrick December 9, 2019 10:32 am #

    Good morning Alan,

    I have been enjoying my first month with your service and have a question about the likelihood of having my underlying stock being called away.

    Right now, I am paper trading and want to track my progress against an expectation. I understand this may change depending on market conditions, but I wanted to tap into your wisdom on this.

    For the following scenarios, (using your screened stocks), what is your opinion on the likelihood these Covered-Calls will be called away from me?

    Additional Note: I realize I can use Think-or-swim’s OTM percentage feature to have a guess at this, but wanted to ask if your experience points you towards a different answer.

    • 2-4% IN-THE-MONEY –> ???

    • AT-THE-MONEY –> ???

    • 2-4% OUT-OF-THE-MONEY –> ???

    Thanks,

    Patrick

    • Alan Ellman December 10, 2019 7:20 am #

      Patrick,

      One of the definitions of Delta is the % chance that a strike will expire in-the-money (causing sale of our shares). In-the-money strikes have higher Deltas than out-of-the-money strikes or at-the-money strikes.

      Most brokerages provide Delta stats for each strike and expiration. Below is a screenshot taken from the CBOE site showing Deltas for PayPal Holdings (PYPL: $103.78) for the 12/20 expirations ranging from 66.0% ($102 strike) to 39.9% ($105 strike) which give the percentages you are seeking.

      ***We can always avoid assignment at expiration by buying back the option prior to 4 PM ET prior to expiration.

      CLICK ON IMAGE TO ENLARGE & USE THE BACK ARROW TO RETURN TO BLOG.

      Alan

  8. roland December 9, 2019 10:44 am #

    I use the TOS platform from TD Ameritrade. It was overwhelming at first but they set me up with an expert that was able to teach this old dog how to use the platform via phone and internet. Great bunch of guys that won’t insult your intelligence–they are there to help. Almost 2 years later I feel comfortable trading options most days of the week. Any problem i have encountered was quickly resolved by calling in to their expert staff. I highly recommend them.
    Roland

    • Hoyt T December 9, 2019 11:46 am #

      Hi Roland,

      Many thanks for your response.

      Wishing you the best of good buys.

      Hoyt

  9. Alan Ellman December 10, 2019 5:19 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.

    Also included is the mid-week market tone at the end of the report.

    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

  10. Alan Ellman December 11, 2019 8:07 am #

    NEW LIVE SEMINAR JUST ADDED:

    Plainview, NY

    March 10, 2020

    7 PM – 9 PM

    New seminar involving blue-chip and large tech companies

    Info to follow

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