Covered call writing and put-selling generate monthly cash flow with the inherent risk of share depreciation. One of the major advantages of these conservative strategies is that they can be tailored to all market environments. In today’s article I will address one way to “stay in the game” even when market conditions are working against us as they have been recently with global economic concerns in China and Greece along with the technical breakdown last week at the New York Stock Exchange. Our goal is to achieve an annualized return of 10% per year in bear and volatile market conditions and NO this concept is NOT taken from the Bernie Madoff School of Sociopathic Investing!
- We will initiate our trade by selling a deep out-of-the-money cash-secured put targeting a 1%, one-month return
- If that option expires worthless, we continue to sell similar put options
- If exercised, the stock is purchased at the discounted strike price less put premium as our cost basis
- Once shares are purchased, in-the-money covered calls are sold targeting a 1%, one-month time value return
- With both calls and puts we select as deep out- or in-the-money strikes as possible while still approaching our one-month option profit goal
- We will assume no greater than a 1-month price decline of 5%, so if the put is exercised, it will be purchased near market price
- In the event that share decline is catastrophic, use of our exit strategy arsenal is essential
The challenge as I write this article is to find a security not reporting earnings prior to September 18, 2015 as I am crafting a two-month trade. Our Premium Watch List shows that Nike (NKE) is due to report on September 24, 2015 so that will represent our underlying security. The trades will initiate on July 9, 2015 and terminate on September 18, 2015. Here are the initial stats:
Entering the trade
- NKE is currently priced at $110.42
- The out-of-the-money August 21, 2015 $105.00 put generates a premium of $0.99, near our 1% target
- The in-the-money $105.00 call generates $6.43 of which $1.01 is time value, meeting our 1% target goal
- We will make the assumption that strikes that are in-the-money strikes by $5.00 in future months will also return about 1% in time value with the understanding that stock implied volatility may change
Calculating the out-of-the-money put
Note the following
- NKE calculations are in the last column circled in red
- The return of the put option sale is 0.95% (green arrow)
- If exercised, our cost basis is $104.01, a discount of 5.81% from the price when the trade was initiated
Calculating the in-the-money call (in-the-money by approximately $5.00)
Note the following
- The time value return by the strike about $5.00 in-the-money is 1%, meeting our target
- That profit is protected as long as NKE does not decline in value by more than 4.9%
- Our 10-week return in a bear market is 0.95% + 1.0% = 1.95% which annualized to our target of 10%
This article was designed to show how flexible option-selling can be even in extreme bear and volatile markets. In order to accomplish this certain assumptions were made with the understanding that there are a myriad of exceptions that may occur. The concepts behind these assumptions, however, are “gold” and can be applied in countless other scenarios.
I spent four years writing the original Encyclopedia for Covered Call Writing which has remained the #1 best-seller on this topic on Amazon. Now four years later Volume 2 is almost ready and will be available later this summer.
Next live seminar
Greece’s uncertain status and concerns regarding the declining economy in China subsided a bit on Thursday and Friday resulting in a partial market recovery. There are also concerns regarding the impact of Greece on other nations like Italy and Spain. How about the imminent reaction to the Fed raising short-term interest rates? I’m convinced that there will always be a reason for the market to be nervous. Next up…earnings season. Our best path is to stay focused on non-emotional investing and adhere to the guidelines and principles of a strategy we have confidence in. This week’s economic reports:
- The US labor market reported 5.36 million job openings in May, the highest since tracking began in December 2000
- The Institute for Supply Management services purchasing managers’ index rose from 55.7 in May to 56.0 in June
- The service sector PMI fell from 56.2 to 54.8 over the same period. Though moving in opposite directions, both gauges reflect expansion in US service sector activity last month.
- The US trade deficit widened to $41.9 billion in May
- Initial jobless claims rose 15,000 to 297,000 for the week ended 4 July, the 18th straight week below 300,000
- Continuing claims jumped 69,000 to 2.334 million for the week ending June 27th
For the week, the S&P 500 rose by 0.90% for a year-to-date return of 0.86.
IBD: Uptrend under pressure
GMI: 0/6- Sell signal since market close of June 30, 2015
BCI: Cautiously bullish but still selling an equal number of in-the-money and out-of-the-money strikes. I am more bullish on the upcoming earnings season than many of the economic experts and that is why I haven’t decreased the percentage of out-of-the-money strikes I’m currently using. Those less enthusiastic about upcoming earnings should consider a more conservative investment mix.
Wishing you the best in investing,