Covered call writing is a strategy we use to generate consistent monthly cash flow, re-invest profits and ultimately to become financially independent. We strive to beat the market by using sound fundamental, technical and common sense principles. But why are we getting paid more than treasuries, CDs or money market accounts? The answer is that we are generating these high returns for undertaking risk. The whole basis of the BCI methodology is to undertake modest risk and mitigate that risk through a series of guidelines and principles set forth in our books and DVD Programs. Wouldn’t it be great if we were to receive these higher returns and not be required to undertake any risk? That was a rhetorical question…deep down inside we all know that there is no legal way of accomplishing that goal. But it’s always fun trying to find that ultimate strategy that even the most sophisticated of computers has yet to uncover.
Recently, I responded to a comment made by Tony and felt it was worthy of a blog article because of the impressive thinking that went behind the inquiry as well as the lessons learned. The question presented was the following strategy, a “can’t-lose” approach to covered call writing?
- Sell a deep in-the-money strike with a 2% time value premium and downside protection of that profit
- If share price rises or drops less than the downside protection (intrinsic value of the premium), take no action
- If share price drops below the strike mid-contract, close the entire position and generate the 2% profit or a little less if the position is closed below the strike
Principles used to develop this strategy
Tony used his knowledge of the advantages presented to us of using in-the-money strikes. We can generate a time value component of the option premium which represents our initial profit and also have an insurance policy to protect that profit in the form of the intrinsic value component of the premium…intrinsic value protects the time value. It appears 0n the surface that if share depreciates and the position is closed as the strike is approached that we are fully protected and cannot lose (do you sense a “but” coming?).
The reality of options and why there is no free lunch
- A stock price can gap-down and even if we wanted to sell at the strike, there is no guarantee that we will get our price
- To generate a time value component of 2%, the strike can certainly be in-the-money but not deep in the money unless the stock has huge implied volatility which we generally try to avoid. This means that the strike selected will be below market value but not out-of-sight
- ***As the price of the stock approaches the strike originally sold that strike which was originally in-the-money is now at-the-money. Since the time value component of premiums is greatest for at-the-money strikes, the cost to close will most likely result in an options debit despite the impact of theta (time value erosion) mid-contract
- There will also be a small debit from the bid-ask spread, less of a factor than the option time value debit
Time value components for different strikes for FaceBook
The chart below shows the time value components for in-the-money and near-the-money strikes for FB:
- The time value of the near-the-money strike $62.50 is $4.55 – $0.22 = $4.33 (cost to close)
- The time value of the in-the-money strike $60 is $5.75 – $2.72 = $3.03 (original premium generated)
- The option debit in this case would be $1.30 or $130 per contract, about 2% loss. It will actually be slightly less due to the impact of theta or time value erosion but there will be a loss. I created this chart to demonstrate the higher cost to buy back an at-the-money strike compared to the cash generated from selling an in-the-money strike and why there is no free lunch
If we thought about it and there was, in fact, a “can’t lose” strategy, who are the folks taking the other side of our trades? They can’t win! Eventually, they would wise up and such trades would no longer exist. We trade in markets, hopefully we all trade in fair market conditions. Our edge (“the BCI edge”) over everyone else is the due-diligence we execute regarding the major 3 aspects of covered call writing:
- stock selection
- option selection
- position management
This is what gives us our edge in this low-risk, but not no-risk, strategy.
With thanks to Tony.
Next live seminar:
Saturday, June 14th
8:30 – 11 AM
Costa Mesa, California (Orange County)
Economic news continues to be mildly positive as it has for the past few years as recovery and expansion continues to support our stock market:
- The Conference Board’s Leading Economic Index (a composite index of ten economic indicators that typically lead overall economic activity. The index includes indicators such as housing permits, new orders for consumer goods, consumer expectations, and performance of the S&P 500 Index) rose by 0.4% in April to 101.4, as predicted. This was the third consecutive increase.
- Minutes from April’s FOMC meeting reflected discussions regarding “policy normalization” although no decisions have been determined
- The Fed described economic data as showing a pickup after the harsh winter’s slowdown
- In May, the Fed continued to reduce its bond-purchase tapering, reducing mortgage-backed securities and Treasuries by $10 billion
- According to the Commerce Department, April annualized new single-family home sales came in at 433,000, 6.4% better than March stats but 4.2% below that of April, 2013
- April median sales price of new homes came in at $275,800, Below March’s $281,700
- According to the National Association of Realtors, April existing home sales increased by 1.3% to $4.65 million, the first increase this year
- The median price of existing homes in April was $201,700, up 5.2% from April, 2013
- The median time existing homes remained on the market decreased to 48 days, less than March’s 55
- Distressed homes made up 15% of the sales down from 18% a year ago
For the week, the S&P 500 was up 1.2% for a year-to-date return of 4%
IBD: Market in correction
BCI: Moderately bullish selling an equal number of in-the-money and out-of-the-money strikes
Wishing all our members a happy and healthy holiday weekend.
Alan and the BCI team ([email protected])