Covered call writing is a low-risk option-selling strategy typically used to generate monthly cash flow. When we capture call premium into our brokerage accounts, we are lowering our cost basis thereby increasing the opportunities for successful trades. This strategy can also be crafted to increase our capital gains (or decrease capital losses) when we decide to sell our shares. To highlight how this can be accomplished, I will use a stock taken from our Premium Stock Report of 4/27/2018, Paycom Software, Inc. (NYSE: PAYC).
Trade status as of 5/4/2018
We are considering selling PAYC currently priced at a bid price of $105.19 and not initially attached to a covered call position. By selling deep in-the-money calls we create an opportunity to increase the capital gains (or decrease losses depending on the cost basis). Our plan is to check the option chain and run the calculations.
Option status for the deep in-the-money $100.00 call option (bid price)
PAYC $100.00 Call Option as of 5/4/2018
We can sell the $100.00 call option for a bid price of $6.64 or $664.00 per contract. This however, will lower our sale price to $100.00, if exercised. Let’s do the calculations.
PAYC Calculations using the Ellman Calculator
PAYC Calculations
The time value return we receive for selling the $100.00 call is 1.5% (yellow field). This initial profit is protected by 4.9% (brown field). This means that PAYC can decline in value by 4.9% by contract expiration and we still will have generated an additional 1.5% when shares are sold (less commissions).
Cash calculations if share price remains above the $100.00 strike
Here are our 2 choices after deciding to sell our shares:
- Sell on 5/4/2018 at $105.19 per share
- Write a $100.00 covered call and receive $6.64 + $100.00 = $106.64 per share
Additional returns generated if share price remains above the $100.00 strike
There is a $1.45 per share benefit to selling the covered call which represents a 1.5% benefit. This annualizes to an additional 39% per year (trade initiated 5/4 and contract expires 5/18).
Is there risk?
Yes. The risk is the stock price declining more than $5.19 over the next 2 weeks. If share price drops below $100.00, our 1.5% returns starts declining and if share price drops below the breakeven of 98.55, we can actually generate lower returns than selling at market on 5/4. We must always be prepared with our exit strategy arsenal for all our option-selling positions.
Discussion
Before selling shares, considering writing deep in-the-money call options which have a time value component and decent downside protection to elevate our capital gains or mitigate capital losses. Despite the significant downside protection offered by deep in-the-money strikes, we must always be prepared to execute our exit strategy maneuvers.
New Blue Chip Report uploaded to the premium member site
The Dow 30 (Blue Chip) Report for the November contracts has been added to the member site in the “resources/downloads” section. 2 stocks were eliminated and 5 new securities were added from last month’s report.
Upcoming event
AAII National Investor Conference: Las Vegas Nevada
October 26 @ 8:00 am – October 28 @ 1:00 pm
October 26th – 28th, 2018 (Friday through Sunday)
Alan’s presentations: Saturday October 27th at 9:30 AM and 1 PM
Visit Alan, Barry and the BCI team in the exhibit hall Friday, Saturday and Sunday
Market tone
This week’s economic news of importance:
- Retail sales September 0.1% (0.6% expected)
- Business inventories August 0.5% (0.7% last)
- Federal budget September $119 billion ($8 billion last)
- Industrial production September 0.3% (0.1% expected)
- Job openings August 7.1 million (7.1 million last)
- Home builders index October 68 (67 last)
- Housing starts September 1.201 million (1.208 million expected)
- Building permits September 1.241 million (1.249 million last)
- Weekly jobless claims 10/13 210,000 (as expected)
- Philly Fed manufacturing October 22.2 (20.5 expected)
- Leading economic indicators September 0.5% (0.4% last)
- Existing home sales September 5.15 million (5.27 million expected)
THE WEEK AHEAD
Mon October 22nd
- Chicago Fed national activity index September
Tue October 23rd
- None scheduled
Wed October 24th
- Markit manufacturing PMI October
- Markit services PMI October
- New home sales September
- Beige book
Thu October 25th
- Weekly jobless claims 10/20
- Durable goods orders September
- Pending home sales index September
Fri October 26th
- Gross Domestic Product Q3
- Consumer sentiment index October
For the week, the S&P 500 moved up by 0.02%% for a year-to-date return of 3.52%
Summary
IBD: Market in correction
GMI: 0/6- Bearish signal since market close of October 8, 2018
BCI: With the VIX hovering near 20, a volatile market and multiple bullish and bearish factors, I am favoring in-the-money strikes 2-to-1 entering the November contracts. Issues of concern include the trade war with China, relations with Saudi Arabia, rising interest rates and moderating retail and housing sectors. On the bullish side, consumer sentiment remains strong, down days have been on unimpressive volume, many stock favorites (FAANG stocks) are at reasonable price points and earnings season has been generally impressive (results like from Netflix). I remain bullish on our economy and stock market but will enter the November contracts fully invested while favoring a defensive posture.
WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US
The 6-month charts point to a bearish-to-neutral tone. In the past six months, the S&P 500 was up 3% while the VIX (19.89) moved up by 25%.
Wishing you much success,
Alan and the BCI team
Good morning Alan.
I am curious about your feeling using protective puts. To me the income you are receiving might help some unanticipated loss, and I hate to make this a standard practice. Do you use puts in your portfolio on a consistent basis.
Harry
Harry,
Protective puts are useful tools for those with a low-risk tolerance and looking to minimize catastrophic losses at the cost of lower overall returns. When combined with covered call writing, the strategy is known as the “collar strategy” Interestingly, this is the strategy Bernie Madoff pretended to use in his fake accounts. He called it the “split strike conversion strategy” but it was simply the “collar” I rely on our exit strategy arsenal but have no issue whatsoever with members who also incorporate protective puts into their portfolios. Many of our members do use protective puts to establish a floor for each trade.
In bear markets, I do use out-of-the-money cash-secured puts to enter covered call trades when exercised. I refer to this approach as the “PCP (put-call-put- Strategy”.
For more information on the collar strategy, here is a link to our latest book, “Covered Call Writing Alternative Strategies”
https://thebluecollarinvestor.com/minimembership/covered-call-writing-alernative-strategies/
The BCI team has also developed a calculator specific for this strategy:
https://thebluecollarinvestor.com/minimembership/collar-calculator/
Alan
Alan,
I always appreciate the content of your weekly articles. Plus I want to thank you for the extra insight you have been adding about your market perspective, the things on your mind as you evaluate the environment and what leads you to the conclusions you have drawn for your asset allocation. You have been at this crazy game longer than most of us so your perspective is valuable to me!
I also get all the lawyer stuff and know you are not making recommendations, just stating your opinions :)!
I have a somewhat different view of November expiry. I am not a Trump fan. But he is a survivalist and I never under estimate him. My hunch is he will do whatever he can to prop up the market going into the elections and then, should one party control remain in place, that will trigger a rally on expectation of more tax and regulation relief.
That said, I am over writing less for November than I did in October. And I will use OTM. Particularly on tech, healthcare and financials all of which I think will strengthen.
Implied volatility is so high there is decent premium to be had OTM and still allow a little upside. I think the air will come out of that balloon in the near future so it’s good to sell calls on any up action early this week and sell csp’s on any dips on things one may want to acquire.
I have been buying some calls and puts in my day trading hobby and, man, that is a tough racket these days because premium is so inflated if you get the direction wrong that, time decay and evaporating volatility are all over you like three unblocked pass rushers :)! I even had one trade where I got the direction right, it finished ITM but I still lost a couple bucks because the movement was not extreme enough to overcome the “volatility crush”.
All of this is simply to suggest these are good times for options sellers. And since premium is elevated one can afford to be a bit more bullish than they might otherwise be. – Jay
Jay,
You may consider taking the credit side of the trade if your view of IV/pricing is that it’s high. Instead of buying a call, just sell an ITM put. Due to put-call parity, the trade should have the same or similar extrinsic value component. This puts, no pun intended, one more factor in your camp which means that if you’re right on relative IV that may give you enough extra that it may overcome being directionally wrong.
The more similar synthetic position would be long stock plus a long put (equals long call). In order to flip that to a credit position you may consider selling an OTM put to finance an OTM call AKA risk reversal.
Good luck! I don’t typically day trade options (or day trade for that matter) because the slippage and commission doesn’t give you much room to operate profitably unless you’re sticking with extremely liquid products (penny-wide markets) like AAPL, SPY, IWM, TLT, /ES type things–probably only about 30-40 issues exist where it may be viable, IMO.
Geoff,
Thanks for the great inputs and suggestions! Welcome back, seems we had not heard from you in a while :)?
My day trading is limited to very liquid SPX puts and calls on M/W/F when they expire and usually mid day and later when most of the time is out of them. They can still be expensive due to IV but since I am controlling the full value of SPX with just a few dollars the risk/reward can be very good as the day goes on. – Jay
Jay,
You’re braver than I. If I was going to play the futures market at all, I’d probably be in the /ES or /NDX. It’s not the kind of leverage I’m comfortable with, personally. I think my risk-aversion applied to leverage like that would be a great way to take large losses. I’ve never struggled with risks within my comfort zone but if I get outside sometimes emotions beat me down and/or I have to work double-overtime to stick to my plan. Long story short, I’m just better off in waters where I’m comfortable.
I’ve been missing a bit, yes. I sometimes miss emails and I’ve been tied up in so many projects that it’s simply crazy. I do small business mentoring on top of pursuing a Masters of Science in Financial Engineering (if you don’t know the term, it’s commonly called a “Quant”) as a followup to my many moons ago Bachelor of Science in Finance.
I’m glad to see that you’re still at it and finding success!
Thanks Geoff,
I don’t have futures clearance in my IRA where I do all my trading so I just use the SPX for M/W/F expiration day trading watching the flow of the ticks and support and resistance along with a news wire. It’s fun, I have been doing it for 7 weeks now and have had only one negative week. I like SPX over SPY because it cash settles, there is nothing to “assign” and it does not take as many contracts. I only trade a couple contracts at a time.
I may have to adjust my somewhat bullish stance above :)? Can’t remember hearing this much negativity about the market, at least until the elections, in quite a while! But isn’t negative sentiment supposed to be a good thing :)?
Congrats on all your pursuits, you are a busy guy! – Jay
Jay,
Our BCI community always appreciates your perspective and contributions to our blog.
Alan
Thanks Alan, it is a great place to learn and share! – Jay
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 10/19/18.
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 in 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 BCI Team
[email protected]
Hi Alan,
I am currently reviewing my paper trades from options expiring on Friday.
Wanted to get your thoughts on how I can improve my trade management on one trade:
1. WWE:
• 28-Sep: Bought stock at $96.73 on 28-Sep & Sold $100 OTM call for $1.74
• 4-Oct: Bought $100 call back for $0.35 (20% rule)
• 12-Oct: Sold $85 call for $2.5 (rolled down)
• 19-Oct: All expire
• Stock p/l: -$1470 ($96.73-$82.03 x100 shares)
• Option p/l: $389 ($174-$35 + $250)
• Net p/l: -$1081
Thanks,
Alvin
Alvin,
Your response within this trade to the recent market decline was outstanding. The initial short call ($100.00 strike) was closed perfectly (20% guideline). Re-selling the option by rolling down helped mitigate losses with an additional net option credit of $215.00.
Possible way to have done even better regarding management:
October 8th -12th represented the 3rd week of a 4-week contract. The time value of our options were rapidly eroding due to Theta. It is possible you could have roiled down 2 times during that week as share price plummeted $9.00 per share. Selling the shares may have also been a consideration but overall market performance was most likely the main factor in the price decline rather than a specific corporate issue.
Losing $1081 is certainly no reason to break out the champagne, but by selling and managing your option positions, your loss was mitigated by $389.00.
These past 2 weeks have been challenging, but if we can learn to manage positions through these aberrations, we will be impressively successful during more normal market environments.
Keep up the good work.
Alan
Alan,
Does it makes sense implement ‘stock repair strategy’ in this example (WWE)?
Buy 1 Nov/18 $85 Call for $3.80
Sell 2 Nov/18 $90 Calls for $3.60 (2 x $1.80)
Or it’s better to take loss and move to the new position?
Thanks,
Sunny
Sunny,
For those who want to retain WWE in a “stock-only” portfolio, using the combination of options you presents makes good sense as it lowers the breakeven from $96.73 to $90.97 as shown in the screenshot below (The Stock Repair Calculator will be available to the BCI community in the near future).
For covered call writing portfolios, our standard exit strategy arsenal applies.
WWE recently announced a dividend distribution so that may boost share price but a full analysis must be made before deciding whether to retain these shares.
CLICK ON IMAGE TO ENLARGE & USE THE BACK ARROW TO RETURN TO BLOG.
Alan
Alan,
in Sunny’s case, I believe he did not consider the WWE upcoming Ernings Report confirmed for 10/25, and I would wait to do the repair, or not, after this date.
Or maybe sell the his WWE shares before, to avoid possible losses.
I have 300 WWE ahares myself with considerable paper loss, and watching it very closely before deciding my next move.
Roni
Hi
Alan and BCI members
I have 2 questions :
1) I ‘ m reading some articles on SeekingAlpha and they seem to suggest that selling some csp ‘s on FB and BABA can be a good trade for november month. What do you think?
2) i ended the 10/19 period with the 77 csp on XLI assigned, actually it trades at 73,50, should i immediately write a call on it or wait a couple of days to see a price increase? Or sell It?
Any comment is welcomed
Hi Federico,
Since you asked your question to any of us I’ll share a few thoughts:
1) on FB and/or BABA the first question on csp’s is would you like to own the stock? If “No” than do not sell a csp. If “yes” in this case they are both social media so you may want to read about each, at least a summary, see how they compare on the chart/technicals and pick one. If that is still a toss up take the total cash you would be willing to set aside for the sector and split it on both
2) on XLI It’s a broadly held ETF with S&P Industrial names every investor has heard of. Many would consider that an investment for a longer horizon since earnings dates are a non issue. If that is your intention you might want to switch to Alan’s guidelines on Portfolio Overwriting in past articles and latest book and manage it that way?
Your basis is $77 less the premium you received and it’s not far under that simply as a result of the tidal cycle of the market lately taking most things lower. Assuming XLI now has a home in your non-trading portfolio I would give it some bounce time towards your basis then start an ongoing overwrite campaign. – Jay
Hi Alan,
Hope this finds you well. Thanks again for your answers recently. Since then I’ve also become a premium member and I’ve been finding your commentaries and screenings very helpful. Thanks for that.
Wanted to come back and ask about your view regarding the selection of the expiration date. You make the point that we would want to typically pick the next month expiration, and not months further out. That part is clear, also as the annualized ROO shows. However, what I’m finding is that the expirations 2-3 weeks out can have the highest annualized ROO. For my ROO calculations, I’m actually adding two days to the expiration date (as if they expired on the Monday after), that way the comparisons of the annualized ROO are more realistic also for the shorter expirations. Side question: have you found a better way of adjusting ROO for the shorter days to expiration? But here now my main question: assuming OI and Volume is adequate, why wouldn’t we go for the shorter expirations e.g. 2-3 weeks out? Do you prefer the full month so that there is more time for possible exit strategies? Any other reasons? Was wondering how your thinking has evolved since writing the corresponding paragraphs in the books.
Best regards,
Attila…
Attila,
My thinking regarding contract expirations has not changed since publishing “The Complete Encyclopedia for Covered Call Writing”-classic edition. I do, however, believe that impressive results can be achieved with both Weekly and Monthly options.
Weeklys may present opportunities for higher annualized returns (I am not 100% convinced that this is true but leaving the door open for that possibility) and are effective in circumnavigating around earnings report and ex-dividend dates.
Using Monthlys allows for adequate time for exit strategy execution, less rolling out decisions, tighter bid-ask spreads, all contracts expiring on the same date and fewer and less costly trading commissions.
Many of our members use Weeklys and I have no issue with that. I have had my greatest success with Monthlys and that’s where I currently trade. There are more than one way to make money selling stock options and using Weekly or Monthlys, while implementing the 3 required skills, will lead to success.
Alan
You’ll find that shorter dated options will have a higher implied ROC. However, you’re facing a trade-off. To best illustrate this, let’s move to an extremely short time frame of a one-day option. This very quickly becomes a “binary option” (in quotes because there are other very horrible products called binary options)–literally at the end of the day you win or lose. You can imagine, as the share price is moving up and down throughout the day, that the chance of you winning or losing is changing drastically–every down tick increasing the chance that you’re going to keep the full sold call option premium and every up tick increasing the chance that you’re on the hook to deliver shares. That’s called Gamma risk and it’s the next derivative above delta–it’s the marginal rate of change of delta.
If you extend your time horizon, the stock may be up one day and down the next, etc. so gamma is not as large. Moves are likely to wash out with random up moves and random down moves.
So that’s a long explanation to say one thing, your risk is the same and your expected payoff is the same. You will have much more volatility in your results shortening your time horizon. Over many trades, the losses you incur will offset some of your outsized gains. You should have the same payoff over time, it’s just that your account value is going to be bipolar with big win streaks and large losses in short periods of time.
With proper management, you should have a pretty smooth P/L over time and a reasonable and fairly stable daily theta income.
The shorter time frames are where market makers really want you because that’s where they’re making their money–gamma scalping. It’s best left to the pros, in my opinion.
Thanks for Your answer Jay
Hi Jay,
I tried to look into your EWZ question, and it seems to be based on all of the largest Brazilian companies, which means it will fluctuate along with the MSCI Brazil index, and will therefore depend on the investors’ mood and confidence in the recovery of the Brazilian economy.
At the moment, expectations are very favorable because the far right candidate Bolsonaro is far ahead in the polls, and will probably win the election on October 28.
I have a feeling that it is a case of “buy the rumor” situation, and it may end up stabilizing, once thr polls are confirmed next weekend.
Roni
Hi Roni,
Thank you for your kind and helpful follow up. I am going to hang on to EWZ, I had assumed it was the “Blue Chips” of Brazil and am fine with that.
New expiry starting, hope November is profitable for one and all. – Jay
Hi Roni,
Thank you for your kind and helpful follow up. I am going to hang on to EWZ, I had assumed it was the “Blue Chips” of Brazil and am fine with that.
New expiry starting, hope November is profitable for one and all. – Jay
New ETF Report:
Premium members,
Our latest ETF report is now available on your member site. Especially in these challenging market environments, it is our responsibility to locate the best performers in addition to focusing in on our exit strategy opportunities. This report highlights the best-performers over the short-term that also meet our other system criteria.
Earnings has been good and there are now many stocks favorably priced.
Alan