Two of the cornerstones of the BCI methodology for covered call writing involves selling options with 1-month expirations and avoiding earnings reports. Several of our astute members have inquired about selling 2-month options instead. The rationale is that all stocks and ETFs have options for the current and next month. The months farther out will vary depending on the cycle that the security was randomly assigned. The proposed strategy is set up as follows:
After an earnings report passes, we can sell a 2-month option on that stock and therefore require less management time and commissions. Once the report passes, if we still like the stock, we then sell another 2-month expiration and so our portfolio turnover will decrease. At first glance this appears to be a reasonable approach that should be investigated.
No one can dispute that commissions will be lower probably cut in half. But if we use an online discount broker, these fees will be negligible especially if we are trading multiple contracts per security. Position management will be the same with the exception that rolling an option will not be necessary should the strike be in-the-money after the 1st month. So far, all other factors being equal, the strategy appears to be viable. However, let’s not forget the most important aspect of covered call writing and that is generating the levels of option premiums and profit and maintain our low-risk posture. In this article I have selected a stock from our Premium Watch List, Opentable Inc. (OPEN), and will evaluate the one and two month returns. I am writing this article on November 18th, the start of the December, 2013 contracts. Here is the options chain for the 1-month December expirations:
OPEN: December contracts
With the stock trading @ $86.16, the out-of-the-money 1-month $87.50 call options are trading @ $3.
Next, let’s view the January, 2-month options chain:
OPEN: January options chain
The 2-month January, 2014 $87.50 out-of-the-money call options generate $4.50.
To compare “apples to apples” we must annualize these returns and then compare.
December, 1-month options annualized:
$300/$8616 = 3.48% = 41.8% annualized
January, 2-month options annualized:
($450/2)/$8616 = 2.6% = 31.3% annualized
The annualized returns are 10% greater for the 1-month expirations than for the 2-month expirations.
Conclusion:
2-month expirations will reduce trading commissions and portfolio turnover. However, these benefits will dwarf in comparison to the financial benefit of selling 1-month options.
Next live seminar:
My team and I are currently in Las Vegas presenting a seminar and doing live interviews for The Money Show. Our next presentation:
January 14, 2014
Houston Chapter American Association of Individual Investors
Details to follow.
Market tone:
There was no news in this week’s reports to change this site’s positive view of overall market conditions:
- Minutes from the recent FOMC meeting reflected an overall assessment of an economy that continues to expand at a moderate pace
- The minutes also demonstrated concerns with high unemployment
- The market reacted slightly to the Fed’s stating that unwinding of the $85 billion in bond purchases may start “in coming months”
- The CPI (measures cost of living) decreased by 0.1% in October, the first decline in 6 months
- The PPI (measures US wholesale prices) declined by 0.2% in October, the 2nd decline in 2 months. Much of this decrease was related to declining gas prices
- Business inventories rose by 0.6% in September, a bullish economic signal
- Retail sales rose by 0.4% in October, the largest rise since July
- Auto sales and parts increased by 1.3%
- Existing home sales decreased by 3.2% in October due to rising mortgage rates
- The median price of existing homes rose slightly to $199,500
For the week, the S&P 500 rose by 0.4%, for a year-to-date return of 29%, including dividends.
Summary:
IBD: Confirmed uptrend
BCI: Moderately bullish favoring out-of-the-money strikes 2-to-1
Wishing you the best in investing,
Alan
To our members:
Thanks to all BCI members who attended my seminar and interviews in Las Vegas as well as those who watched the live webcast. I appreciate all the great feedback.
We will be returning to NY late Sunday and back to our office on Monday. All books and DVDs ordered over the weekend will be shipped on Monday and all emails will be answered by the end of the week.
I have accepted an invitation to participate in the Trading Masters Symposium at the New York Stock Traders Expo at the Marriott Marquis hotel. I will have two speaking presentations at this prestigious event and will also have a booth where I hope to meet many of you in perdson.
Alan
Premium members:
This week’s stock report will be uploaded to your premium site today in the late afternoon or early evening. The MSN Scouter Rating site was down for several hours on Friday evening but my team has been working hard to compensate for this time loss and will be able to produce the report today.
Alan
Sir,
What about monthly options Vs Weekly?
Especially so when you are trying to take advantage of the weekly faster time decay.
Thank you.
Colin,
This is by far the most frequently asked question at my live seminars. Because there is such a huge interest in weeklys, the BCI team will be including these products in our methodology and reports moving forward. We have been beta-testing the number of stocks and ETFs that pass our screens that actually have weeklys associated with them. That number is still small but growing over time. That said, here are my concerns with weeklys:
1- The limited pool of securities with weeklys (but growing as stated above)
2- The limited time for exit strategy execution if the trade turns against us and the lack of time available to inititate a second income stream with bullish exit strategies when we have a full month
3- Quadruple the number of trading commissions
In the near future, our stock reports will be listing stocks with weeklys, a service we are currently providing in our weekly ETF Reports.
Alan
31% annualized is nothing to sneeze at.
We have to always be mindful that we’re not letting greed cloud our decision making. The closer the time to expiration, at least for me, the more attention I have to pay to it.
I’ve been selling a mix of 1-month and 2-month options for a while now, and I find that it suits me well. When the position moves the wrong way it is nice to have the longer time-frame as a buffer.
Commissions are a non-factor, so that shouldn’t lead anyone to go for 2-month or longer and shouldn’t deter anyone from going weekly, all other things being equal. If you’re concerned about commissions, you’re using the wrong broker!
-Doug
Doug,
Valid points. One of the many strengths of covered call writing is the flexibility investors have to tailor it to their specific needs and risk tolerances. Some may aspire to the higher returns (“greed” may not be the best description, how about “setting higher goals”!) and put a little more time into management while others may prefer the 2-month approach as long as earnings reports don’t get in the way…one size doesn’t fit all. I have always set my goals for the highest annualuized returns but respect those who are more comfortable with the latter again avoidings ERs.
I fully agree with your statement that if commissions are an issue, an investor should seek another broker because as a cc writer we make a significant amount of trades.
Alan
I just signed up and was very interested in this topic. I totally agree with the annualized return comparison, however, wouldn’t it be good to look for stocks with earnings reports more than two monthly cycles out – so that a roll out and up strategy could be used if favorable conditions present themselves (and still use the “no earnings report” rule?
Bob,
Yes that is a good idea but not always practical. ERs are quarterly and most report in January, April, July and October. If we eliminated stocks that report two months prior we would have too small a pool of securities to choose from. Immediately after earnings your guideline would be easier to follow and preferable.
To be in a rolling situation the strike would have to be in-the-money and our trade having maximized its monthly profit potential. Even if we allow assignment because of an upcoming ER…that’s not so bad!
Good thought.
Alan
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 11-22-13.
For your convenience, here is the link to login to the premium site:
https://www.thebluecollarinvestor.com/member/login.php
Best,
Barry and the BCI Team
Hi Alan,
What’s the advantage of rolling an in the money option as opposed to just letting it expire, then re-evaluating it the following week and then repurchasing providing it :
A) again passes all screens in the next Premium Report.
B) You still like it.
I can see it will cost more commission to repurchase the stock, what are the other disadvantages?
Thanks,
Martin
Martin,
I like to roll my options when doing so meets my monthly goal which is 2-4% per month. With no upcoming ER and the price above the strike, these securities will still meet our system criteria (fundamentals change with ERs and no technical breakdown). So, if the deal is there, take it.
Waiting until the next week may mean the investment of additional capital if the price continues to increase and news over the weekend can change the pricing of the options as well. Even if the price stays the same you will have to infuse additional capital into the trade. My preference is to take advantage of a known scenario that meets system criteria than perhaps evaluate one that is different.
One less commission is a very minor factor.
Alan
Offsite Q&A:
I have often read that 80% of calls that are written expire worthless, but I have never seen any evidence quoted for this figure.
Can you shine any light on this statistic?
With best regards,
Hilda from Australia
____________________
My response:
Hi Hilda,
I have seen that stat also and it is frequently quoted but it is inaccurate. 90% of options go unexercised, which is very different than expiring worthless.
Contrary to what many think, the vast majority of options do not expire worthless. The facts are as follows:
1. Approximately 10% of options are exercised
2. From 55% to 60% of option positions are closed prior to expiration
3. About 30% to 35% of options expire worthless
For covered call writers, we can frequently make excellent returns even if the option expires worthless.
Alan
Alan,
Do you ever use margin when purchasing stock to write CCs?
Paul,
In my view, margin is appropriate only for more sophisticated investors with significant experience. For most retail investors, the main demographic for the BCI community, I do not advise margin accounts but rather cash accounts.
Alan
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. The report also lists Top-performing ETFs with Weekly options.
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:
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Wishing ALL our members a wonderful Thanksgiving holiday,
Alan and the BCI team