“There is less risk using deep in-the-money (ITM) long calls than buying stock and selling the corresponding short calls”. That is the case John made to me when I received his email in January 2018. As an example, John used a $100.00 stock and a call premium of $9.00. The basis of his theory was that call options cost much less than the corresponding stock shares and therefore the amount of capital risk is much lower while upside is unlimited. John suggested buying deep ITM call options with expirations about 6 months out and rolling the options 2-3 months prior to expiration in order to avoid significant time value erosion. When considering when to sell the call if share price declined significantly, John proposed to use IBD’s 7% guideline so when share price moves down by the 7% threshold, the call option (s) should be sold. I thought it would be instructive to look at the pros and cons of this approach as all strategies have advantages and disadvantages and there is never a free lunch.
Advantages of using deep ITM long calls
- Requires less cash per-position thereby allowing for greater diversification
- Deep ITM calls have Deltas approaching 1.00 and will therefore behave much like a stock in terms of price movement
- We are managing only 1 position, covered call writing requires 2 positions (long stock and short call)
- There is no cap on the upside creating a situation for greater potential returns
Disadvantages when share price declines
It is true that we are risking less capital per-position but from a percentile perspective we are much more susceptible to losses. Let’s use John’s example with the $100.00 stock:
- XYZ: $100.00
- $91.00 call with a 6-month expiration: $9.00 (probably a few pennies of time value but we’ll round down to $9.00)
- $91.00 call has a Delta near 1.00
- Share price drops 7% to $93.00
- Call value drops to $2.00 ($9.00 – $7.00) if Delta remains at 1.00
- Delta will not actually remain at 1.00 as stock price approaches the strike price so let’s estimate the call value to be at $3.00, assigning a time value of $1.00 in addition to the $2.00 of intrinsic value
- Option value drops from $9.00 to $3.00 or by 67% compared to the 7% decline in share value
Rolling options when on the buy side will almost always create a net debit because of the additional time value component of the longer term contracts. Although we are decreasing the loss of time value premium in the shorter-term contracts, we are paying the additional time value for the longer-term expirations. The concept of rolling long-term option 2-3 months prior to expiration when using The Poor Man’s Covered Call Strategy is a good idea because we are committed to the underlying for the long-term (using LEAPS) and this is where we will get the greatest benefit (smallest net debit).
Covered call writers will capture corporate dividends as long as they own the shares on the ex-dividend date. Holders of long calls do not capture dividends. Furthermore, on the ex-date, the value of the stock will decline by the dividend amount and so will the corresponding deep ITM call. These calls must make up for time value erosion plus any price decline due to dividend distribution to generate a profit.
Buying deep ITM call options creates the opportunity for large profits to the upside. The risk is in the percentage loss potential when stock price declines as Delta must overcome Theta (time value erosion) and dividend losses. Those on the buy side of options must have a higher risk-tolerance than those on the sell side (covered, of course).
Denver Colorado: American Association of Individual Investors
August 18 @ 9:00 am – 12:00 pm
Saturday August 18, 2018
Click for information and registration details
San Francisco Money Show
August 23 @ 10:00 am – 11:00 am
Hilton San Francisco Union Square
1.Thursday August 23rd: 11:30 AM – 12:15 PM
All Stars of Options: How to Select the Best Covered Call Options in Bull and Bear Markets
2. Friday August 23rd: 10:15 AM – 1:15 PM
Masters Class: How to Generate Monthly Cash Flow and Buy a Stock at a Discount Using 2 Low- Risk Option Strategies (covered call writing and selling cash-secured puts)
This week’s economic news of importance:
- Retail sales June 0.5% (as expected)
- Business inventories May 0.4% (0.3% last)
- Industrial production June 0.6% (as expected)
- Home builders’ index July 68 (68 last)
- Housing starts June 1.173 million (1.303 million expected)
- Building permits June 1.273 million (1.301 million last)
- Weekly jobless claims 7/14 207,000 (224,000 expected)
- Leading economic indicators June 0.5% (0.0% last)
THE WEEK AHEAD
Mon July 23rd
- Existing home sales June
Tue July 24th
- Markit manufacturing PMI July
- Markit services PMI
Wed July 25th
- New home sales June
Thu July 26th
- Weekly jobless claims 7/21
- Durable goods orders June
- Housing vacancies Q2
Fri July 27th
- Gross domestic product Q2
- Consumer sentiment July
For the week, the S&P 500 moved up by 0.02% for a year-to-date return of 4.80%
IBD: Market in confirmed uptrend
GMI: 5/6- Bullish signal since market close of July 9, 2018
BCI: Using an equal number of in-the-money and out-of-the-money strikes. Going into the August contracts cautiously.
WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US
The 6-month charts point to a neutral tone. In the past six months, the S&P 500 was up 0% while the VIX (12.86) moved up by 20%.
Wishing you much success,
Alan and the BCI team
Why is stochastics indicator different on tablet than computer?
On yahoo finance.
Like most vendors, Yahoo Finance gives users the opportunity to use different stochastic oscillator settings. In the screenshot below, “fast” and “slow” stochastic oscillator settings are available on this site. It is possible you have different settings on your devices. See pages 63 – 67 of “The Complete Encyclopedia for Covered Call Writing- classic edition” for an explanation of the differences.
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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 07/20/18.
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:
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:
Barry and The BCI Team
A great concise explanation of ITM calls vs Stock ownership and Covered Call Writing.
As someone who has used this strategy for years I can confirm what you say. The payoffs can be huge and the risk can be huge as a percentage.
The way I view it, using your example, is that I get the growth of say, 1,000 shares of MFST, by buying $9,000.00 of ITM Calls vs $100,000.00 of stock. If the stock declines 7% and I own the stock I lose $7,000.00 the same if I owned the options. But I had $93,000.00 to work with on something else if I owned the options.
If the stock goes to $109 I have made, for discussion purposes, $9,000.00 either way. A 9% return if I own the stock and a 100% return if I owned the options.but by owning the options I had that $93,000.00 to work somewhere else.
Having said this and having traded this way for several years it is still my opinion that Covered Call Writing, the BCI way, is the more conservative, and the best, way for people to go.
Now any good system would probably have worked from the end of March 2009 until January 2018 except for the period of mid August 2015 to mid February 2016.Although most fund managers under performed the indices most of those years.
Much of the same stock analytical skills are needed for either strategy.
To me, the big issue is, are we in the last innings of possibly the longest running bull market or are we in the middle innings of the longest running bull market ever. Either is possible, but the former is more likely. If so I need to get more comfortable with buying puts.:)
BCI’s stock analysis, commonsense, and position management skills are outstanding and well worth more than the price.
Thanks for all you and your crew do.
This site always appreciates and values your perspective and input. One of the many advantages of selling short-term options is that we can re-evaluate our market assessment on a frequent basis (monthly for me, weekly for some). When markets turn bearish, we can use ITM calls and deeper out-of-the-money puts, lower implied volatility underlyings, protective puts and buy-to-close limit order on our short option positions. Then we also have our exit strategy arsenal.
Stocks will benefit from the recent tax plan and the overall economy (ours and global) is still supportive of our share positions (in my humble opinion). Who knows, maybe we’ll go into extra innings as long as political issues are contained.
I appreciate your generous remarks.
I use deep in the money leaps – usually on stocks with low IV – and therefore lower premiums – and then write calls on the underlying leap every 1-3 months. The first month usually covers the leap premium. Upside is capped, but downside is hedged.
Looking for 10-20%/ position.
You are describing “The Poor Man’s Covered Call”, one of the 3 strategies covered in our new book, “Covered Call Writing Alternative Strategies”
Your structuring of the strategy looks sound especially if the short calls are sold on a 1-month basis and if early closure will result in a winning trade.
There are a lot of moving parts to this strategy including rolling the LEAPS prior to expiration, where and how to fund this rolling and changing cost basis when exit strategies are employed. As with all strategies, all nuances must be mastered before risking even one penny of our hard-earned money.
Alan speaking at The Hyatt Regency Convention Center in Chicago on Sunday.
Photo by Stock Trader’s Expo & The Money Show
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Can’t see a life line
After reading your material I realized I started behind the eight ball.
Long story short I ‘ve GE Jan 17 2020 13 Call 1 contract
Purchase for 6.88 Mkt value $ 193.00, so far down $494.00
544 days to expiration , any benefit keeping it open ?
I can’t give specific financial advice in this venue but I can make some general remarks that I hope you find useful.
Whenever we are considering an exit strategy maneuver, we base our decisions on current, not past data. This applies to those on the buy-side of options as well as those of us on the sell-side.So you have about $190.00 invested in this position, no longer $688.00. Do we sell and enter a new position? Well, if there is a trade with a better-performer that we can enter for $190.00, this would make sense.
Now, depending on the percentage of our portfolio a trade represents, we may decide to let the trade run if it represents a very small percentage of our overall portfolio. That aside, we generally would move to a new position when the price chart is telling us to do so…see screenshot below.
One of the most important requirements of a successful option trader is to have an exit plan when the trade turns against us like the 20%/10% guidelines in the BCI methodology for covered call writing. Similar to buying a stock, when buying an option, we can set up a limit order to close if the value declines a certain percentage.
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Would you consider holding any of the stocks on our list as a long-term buy and hold?
Absolutely. We have many members who use our lists for longer-term, non-option-selling accounts. This is one of the reasons we leave stocks with low-option liquidity (open interest) on our stock report lists. We identify these stocks with an “N” in the OI (open interest) column in our reports. As an example, a few months ago there was a market downturn and only one stock that passed all our screens was listed in bold (all bullish technical signals). That stock was Grub Hub (GRUB). I had several members email that they purchased GREUB for their longer-term buy-and-hold portfolios and the stock is up about 20% since that report.
However, our lists are geared more specifically to short-term option-selling strategies but can be used for others as well.
Not answering for Alan. Just giving my humble opinion based on 35+ years of stock and option trading.
There are stocks on the list which are candidates for “long term” buy and hold, for long options and for covered call writing. Many of these are the very same stocks
One needs to define what “long term” means to you. Long term used to mean to me 3 to 5 years if certain criteria are met. (At 76 long term is probably 6 months. I hesitate to buy green bananas.):)
But back to the subject at hand.
Basically we should start with a “Blue Chip” stock. This doesn’t necessarily mean DJ 30, but a large cap with some history of growth and earnings. (I think this week’s list, 07/20/18, only has one DJ 30 on the list. That’s V.) If the stock has a positive dividend history all the better.
One, when purchased, the stock should be in an uptrend, preferably the beginnings of an uptrend.
Two, it should be rising greater than the S&P 500. Almost any discount brokerage has charting available to determine this. This sort of follows an old Wall Street maxim, “The trend is your friend.”
Once a stock is chosen it needs to be monitored like any other position. This monitoring doesn’t need to be daily, weekly or even monthly. But at some point most all stocks become dead money. IBM did(2000-2010), CSCO did(2001-2014), INTC did(2000-2014), GLW did(2006-2018). Dead money is when the stock is under performing the S&P 500 on regular basis, not necessarily going down in price.. My personal preference is six months. Once this happens it’s time to take profits and find another “long term” buy and hold.
As an example, two stocks on our list that have met these criteria are MA and V. Both have been in a fantastic one year uptrend, vastly outperforming the S&P 500. How long this uptrend can continue is the question. Both report earnings this week and both have run up prior to earnings. V has gained after 7 of its last 10 earnings report while MA has gained after 6 of its last earnings report.
As Alan has said many times, there is no free lunch and no silver bullets. So here is the risk with MA and V. Have they gotten ahead of themselves? Will technology, Blockchain, replace credit cards? Will MA and V adjust to a changing environment? This week’s list, 07/27/18, will give us further insight on a short term basis. If both remain bold in the report it will be, in my opinion, a very positive sign. If so, I will probably buy Dec or Jan options on both.
I am not a financial advisor. I am not a stock promoter, nor do I hype stocks that I own. My opinion, and that is all it is, is worth exactly what you are paying me for it.:)
Boy, GLW is not dead money today.
This is Don from Lexington KY. If ever I go sell ITM must intrinsic value be less then the premium to make it worth the trade?
This is such an important question for those of us who take advantage of in-the-money call strikes when greater downside protection is required. We must understand the components of the premium we receive and what each component represents before entering these trades.
The short answer to your question is YES, the intrinsic value must be less than the total premium.
The equation for in-the-money option premiums is:
Premium = intrinsic value (IV) + time value (TV)
IV = amount the strike is in-the-money
TV = Total premium – IV
When we sell an ITM strike, we are agreeing to sell the stock at a lower price than when the trade was initially executed. There will be a loss on the stock side of the trade. We must be sure that the premium generated from the sale of the ITM option compensates us for that loss + a little bit more (TV). That “little bit more” must meet our initial time value goals. Let’s create a hypothetical that will add some clarity:
We buy a stock for $32.00
We sell the $30.00 (ITM) call for $3.00
Premium ($3.00) = $2.00 (IV) + $1.00 (TV)
The IV ($2.00) compensates us for the $2.00 we will lose on the sale of the stock; the TV ($1.00) represents our initial time value return. Using the IV to “buy down our cost basis, our initial time value return is $1.00/$30.00 = 3.3%. If our goal is 2% – 4%, this would be an appropriate trade to enter.
Now, let’s get back to your question and create a hypothetical where the IV is greater than the premium. Let’s say given the same scenario, the premium was $1.90, instead of $3.00. Well, we are losing $2.00 on the stock side ($32.00 – $30.00) but gaining only $1.90 on the option side…a losing trade.
Bottom line: ITM strikes are perfect in bearish and volatile market environments because the intrinsic value component of the premium lowers our cost basis (breakeven) more than ATM and OTM strikes. We must determine the time value initial returns to be sure that the trade meets our goals.
Understanding and implementing these decisions will help elevate our portfolio returns to the highest levels.
I don’t buy green bananas either :). I am only 60 but who knows what tomorrow brings :)?
Thank you for joining our circle sharing your decades of wisdom.
I may be a voice in the wilderness but the more I play our crazy game the more simple I try to make it !?
I used to trade everything under the sun. I got some great tans and some serious sun burns too :).
I have read often the key to good trading is specialize in one thing and master it. Alan has done that with option selling.
I have begun to specialize in SPY and QQQ. They are not flashy but they are easy to track and over write or sell CSP’s on accordingly.
I suspect I will never beat the market if I am the market but my goal is to keep pace and spin off some cash flow. – Jay
Thanks for the kind words.
I wouldn’t say wisdom, more like experience. You know some people have 35 years experience and some people have one years experience 35 times. I’m still trying to figure out into which group I belong.
I admire and respect that you have the discipline to simplify your trading strategy. I am sure that reflects what you do in your non-trading life. I wish I had that discipline.
For a couple of years I basically traded weekly and bi-weekly options on BAC. That worked really well until it didn’t.
As I have stated before, the BCI strategy is the best strategy for intelligent people to implement.
In my post about long term buy and hold I left out one of the things I learned in the 1990s. I don’t remember who said it best, maybe Roger McNamee. “You shouldn’t own tech stocks, you should rent them.” BCI’s strategy applies that principle to all stocks. That’s where I am with my “long term” holdings like AMZN. They must maintain their outperformance of the S&P 500. Trees do not grow to the sky. There is most always a reversion to the mean.
In Feb 2007 I bought two stocks on a wild hair, MDVN and SGEN. I can’t remember who the analyst was, a woman, on Nightly Business Report with Paul Kangas. MDVN was about $2.00 a share split adjusted. SGEN was about $7.00. In 2016 MDVN was acquired by PFE at about 32 times what I paid. I am still holding on to SGEN, looking for buyout here too. I also bought several others that went to zero 🙂
I don’t have the time left to take on “flyers” like this. That’s where options come in for me.
Take care and “May the trend be your friend”,
I very much appreciate your kind words as well.
Gosh, there is likely no better wealth building strategy than buying and holding good stocks. Ask anyone who bought APPL or AMZN a long time ago 🙂 I think there is value in having a growth portfolio set aside you do not touch.
And there is also value in having a covered call portfolio. Let’s see, how can I screw up my metaphors here :)? It’s either a garden we tend in the rain or a football we advance in the snow :). Progress will be slow yet worth the effort regardless!
Hope everyone is having a great week, – Jay
Concur on having a growth portfolio separate from trading portfolio. I do that too.
Didn’t buy AMZN long ago but it has tripled since I bought it. I don’t own APPL but have made good money on APPL Calls.
By the way, the company I owned for 40 years was a graphic arts company. We had 40+ computers running Intel processors and Microsoft software. We also had 15+ Apple Macs. The Macs were far superior to the Windows machines for graphic arts work, design, photo manipulation, etc.
About 20 of my employees owned, in our pension plan, from 1,000 to 5,000 shares of Apple. This would be before the 7 to 1 split. The stock at that time was probably $13-$14 a share. All of them to whom I have spoken since I sold the company in 2012 have told me they sold APPL long before it took off like a rocket.
Someone once said, “The saddest words of tongue or pen are ,’It might have been.'”
You are absolutely correct, “Gosh, there is likely no better wealth building strategy than buying and holding good stocks.”
I really appreciate how much you emphasize risk and how to manage it when investing like earnings reports and strike selection for example. Do you know of any statistics done on the risk of covered call writing versus just owning stocks?
Thanks for all you do you us retail investors,
Good morning Marsha,
Alan will no doubt get back to you but to me selling a covered call adds zero risk to the equation of owning stock. If we own stock the risk lies CC’s reduce the risk of stock ownership because they give us some downside protection. The bummer about them can be we limit our upside if we sell a covered call on a hot stock that keeps moving up. So we buy back, roll up and out, etc..
In my view covered call writers have less risk than simple stock owners. – Jay
I wholeheartedly agree. CCW reduces risk.
In buying a stock you must get one thing right, the future direction of the stock price. In buying a call or a put you must get two things right, the future direction of the stock price and the timing.
I can’t tell you how many times I have got the direction right but was one or two weeks, or months, off on the timing. While the direction is never a slam dunk, the timing, for me has been far more difficult.
Fortunately more winners than losers.
OOPS. left out a word in the second sentence meant to say “risk lies there”
Outstanding responses from Jay and Hoyt.
Covered call writing definitely reduces risk because we are lowering our cost-basis or breakeven. In-the-money strikes lowers cost basis even further than at-the-money and out-of-the-money strikes because of the added intrinsic value component. This is why we favor ITM in bear and volatile market conditions.
Ibbotson did a 16-year study of covered call writing from 1988 – 2004 and came to the conclusion that (paraphrasing) covered call writing slightly out-performs the overall market and with less portfolio volatility. That study, like other similar ones, did not use many of the rules and guidelines (exit strategies, strike selection and others) we use so our results should substantially out-perform those of any study.
More recently, Wilshire Analytics did a study from 1986 – 2016 and measured market (S&P 500) risk at 15.2% (based on standard deviations) compared to 10.8% for the CBOE BuyWrite (BXM).During that time frame the S&P 500 rose by 9.8% while BXM was up 10.6%. Once again, BXM cannot perform many of the trading processes we can, so our results will be substantially better.
There is no question that covered call writing lowers risk.
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.
New members check out the video user guide located above the recent reports.
For your convenience, here is the link to login to the premium site:
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Alan and the BCI team
Hope no one has Facebook shares.
Alan good morning,
When the market opens the price move very fast so I have difficulty to record the number on Elite Calculator in order to take a decision.
If I’m trying to do that before the opening my platform (TradeStation) not always show the correct value or when open the market the scenario change.
Do you have any suggestion? Maybe I should wait some time before to take note of the numbers?
Last question: I bought your last book and the set of calculators, honestly I just start to read the book but I would like to know if this set of calculator replace the Elite one or it’s complementary of it?
Thanks in advance and have a nice day.
Early morning and late afternoon computerized institutional trading frequently results in high volatility as you described. Exit strategy execution aside, I make the bulk of my trades between the hours of 11 AM and 3 PM ET. Calculations can be run the night before to get a general idea if the option sales will meet our goals but must be re-run prior to trade execution…won’t take that long.
The 3 new calculators are geared specifically to the 3 covered call writing-like strategies detailed in the new book and are, therefore, complimentary to the Elite version of the Ellman Calculator.
All BCI members and followers,
A real life test testimonial to what Alan has been teaching for years.
On 03/26/2018 I purchased OTM 10 contracts FB Sept 21 ’18 $170 Call at $7.70.
Fees and commission were $9.95(totally irrelevant). Total Cost = $7,709.95.
FB was trading at $159.83.
I have mentioned in a previous post how I had violated most all of my position management rules on this trade all along. Well long story short:
Yesterday FB Sept 21 ’18 $170 Call closed at $39.35 giving me an unrealized profit of $31,454.88 or a 407.44% gain. Note: These numbers are taken of my daily brokerage statement as of yesterday’s close so they may be fractionally off, but close enough.
This morning FB Sept 21 ’18 $170 Call opened at $7.50 giving me a drop of $32,000.00 in position value and now a loss of $209.95 in my position. My $7709.95 investment was now worth $7500.00.
What’s the lesson here? Let me count some of them.
1. Follow the rules.
2. Earnings dates are not to be trifled with, ever. (see BCI)
3. Bulls make money, Bears make money, Hogs get slaughtered.
4. An old friend once told me, “The greedy soon join the ranks of the needy.”
I am sure you can think of more.
By the way I knew last night that this was going to happen. The Delta on FB Sept 21 ’18 $170 Call yesterday was .92 so I could calculate based on the drop in price approximately what my drop in value was. Did I sleep good last night? Surprisingly, yes.
This morning I had to decide if I had not owned FB Sept 21 ’18 $170 Call would I buy it at $7.50. My answer was yes. In a few minutes it briefly got to over $9.00. I felt better. As I post this it is done to $7.00. Aren’t I smart?:)
For what it is worth,
I have a hunch most of us who dabble in buying options have a FB story. Or we have either not done it enough or been very lucky! Like Kevin Bacon’s character in the classic Animal House I have “assumed the position” many times and taken my share of paddling :).
Like you I seek lessons each time. It’s funny how they keep coming back to the same things: trade small, take profits when I have them, cut loses early and never take myself too seriously!
I don’t think investors who hold quality positions and over write them have these dilemnas. They don’t have that little ounce of gambler’s blood in their system I have :). – Jay
Thanks a million for sharing. I may use this for a future blog article or video…valuable information for our community. I know you must have an impressive file of winning trades as well.
I think you have hit the nail on the head. The gambler’s blood keeps me sometimes from following the rules I have set for myself. In the case of FB I knew that there certainly was the possibility of problems due to the EU’s new law, privacy concerns and added security costs. I just didn’t expect them to have an effect this soon. To be clear the major drop in FB did not occur initially with the earnings report. That drop was roughly 2%. The real drop came at the conference call when FB executives really talked down future growth and profits. They have done this twice in the past, supposedly to dampen expectations after unusual run ups like we had here, all time high on Wednesday. One positive in the report was that revenue per user was up. I think at its current PE the stock can move up.
I am not an active FB member. I signed up years ago and have not done anything on it.
As I have said before I admire those who have the self discipline to follow their rules and not gamble. Having said that I have, all my life, at times pushed the envelope. You only live once so sometimes you just do some wild things. But I don’t spit in the wind or tug on Superman’s cape.:)