Check the options chain before selling a covered call or cash-secured put. In addition to determining the premiums and returns we will generate we also need to make sure the interest or liquidity in these options will be adequate enough for favorable trade executions. Below is a typical options chain showing both Vol(ume) and open interest (OI):
BAC-typical options chain
Note that for the circled strikes (and most of the others as well) the open interest stats are much higher than the Vol stats. The reason is that Vol represents the number of times a particular contract is bought or sold in a particular day. Open interest, on the other hand, represents the number of contracts that are currently outstanding (unexercised, not closed by an offsetting contract or not yet expired). Open interest stats are cumulative and not reset to zero each day as are Vol stats. Therefore, it makes sense that open interest will always be higher than Vol stats. However, there is one notable exception. Let’s look at the option chain below:
BAC options chain
I highlighted the $16.50 strike with BAC trading at $16.17. In the yellow row we see an open interest of “0” but significant volume of 3,601 contracts. How can that be? This screenshot was taken on 2-23-15, the first day the March option contracts are the “front month” or month with the earliest expirations. Additional option strike prices were added this month, specifically ones that ended in “0.50” like the highlighted $16.50 strike price. Early in the trading day there were already $3,601 contracts traded leading to a bid-ask spread of one penny ($0.23 – $0.24). So the next question is why is there zero activity in the open interest column and should we avoid these options because of no apparent open interest?
The explanation is that most vendors post open interest stats after market close. Although there are a substantial number of open contracts based on the early volume, we won’t have these stats until the next trading day.
Summary
Option liquidity is measured by Vo(ume) and open interest. Open interest is more reliable, generally, because it is a cumulative stat, not reset to zero each day as is Vol(ume). A rare exception when Vol is greater than open interest is on the first day when contracts become the “front month” and new strike prices are created for that month. Many vendors will leave the open interest column at zero until the second day when reliable statistics can be gleaned from options chains.
Market tone
Global stocks rose modestly as investors reacted favorably to the US Federal Reserve’s release of its April meeting minutes, which reflected a reluctance to raise interest rates until the US economy strengthens further. This week’s reports:
- US housing starts rose a whopping 20.2% in April to a seasonally adjusted annual pace of 1.4 million units, a 7-year high
- Permits for new home construction rose 10.1%
- Sales of existing homes fell 3.3% in April
- Existing home prices prices rose 8.9% year-over-year, reducing affordability
- Initial jobless claims rose 10,000 to 274,000 but the four-week moving average fell 5,500 to 266,250
- Continuing jobless claims were down 12,000 to 2.21 million, both at 15-year lows
- US consumer prices rose 0.1% in April but declined by 0.2% year-over-year
- Core prices excluding food and energy climbed 0.3% for the month and 1.8% for the year
For the week, the S&P 500 rose 0.3% for a year to date return of 3.1%.
Summary
IBD: Confirmed uptrend
GMI: 6/6- Buy signal since market close of May 11, 2015
BCI: Cautiously bullish favoring out-of-the money strikes 3-to-2. Interest rates appear stable in the near-term.
Wishing you the best in investing,
Alan ([email protected])
Alan,
Assuming I bought stock without selling cover calls, what is the best way to put automatically sell order (say for 2 month) so that if the price gap down, the current profit is protected to the maximum? I read your book about different types of order, but still confused about which way is the best. Please help to give examples.
Keith
Keith,
There are two ways to approach this:
1- Set a stop loss order where you instruct your broker to sell at a specified price below current market value. For example, if you own the stock @ $50, you may set a sell stop order @ $45. The catch is that limit order become a market order once $45 is reached so a $45 worst case scenario is NOT guaranteed. If our stock gaps down from $46 to $40 our sell price will be $40, not $45.
2- Buy a $45 put, giving us the right to sell our shares at $45. This is guaranteed but will cost the put premium.
Alan
Thanks Alan. What do you think about trailing stop order?
Keith,
Excellent approach to longer term buy-and-hold portfolios.. I highlight this tactic in my book, “Stock Investing for Students”
Alan
Alan,
I bought your book today and read about it. Why 10% is chosen? Also can you give one detail example on how trailing stop limit order works?
Keith
Premium Members:
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Best,
Barry and the BCI Team
Keith,
The 10% figure is arbitrary and can be adjusted to your specific comfort level. Some use 8% because that is what IBD uses. I like 10% for long-term investing.
Example:
Buy a stock for $30.00 and set a trailing stop loss order at 10% or $27.00. If share price declines below $27.00, the shares will be sold once that mark is broken (could be lower than $27.00 if prices gaps down). Let’s say share price moves up to $32.00. The stop loss will move up in tandem with the price rise to $28.80 (10% of $32.00).
The stop loss can rise but never fall so we can benefit from share appreciation.
Alan
Alan:
It appears that the primary advantage to writing Combinations is to economize on margin requirements in taxable accounts. Are there any advantages to using this strategy utilizing covered calls & cash secured puts in non-taxable accounts?
Thanks,
Paul
Paul,
I am not a tax expert so please confirm my response with your tax advisor:
NO…each position is either a gain or a loss. That aside, I would never make a stock investment decision based on taxes. If you can trade these strategies in sheltered accounts, do so. If not pay short-term capital gains while compounding profits. I tell members to compare the returns from conservative option-selling strategies to non-taxable bonds and the discussion usually ends. A CPA friend of mine tells me that his goal in life is to have a tax bill north of $1 million.
Alan
Good morning, Dr. Ellman
I have a question to ask you about. I have 900 share agnc I purchased at 28.80/share long time ago. I I sold 9 contract at 20 strike for June 19. but this morning I see my share was all executed at 20 strike price way before and no one even notify me before the execution, in this way, I lost a lot of money. Is this normal? Thanks!
Lina
Lina,
A couple of points here:
1- Selling the ITM $20 call was a blessing in disguise because it appears that the stock had a significant price decline recently and the intrinsic value of the option sold protected you against that loss. Calculate your breakeven as $28.80 – total premium generated from the call sale…you’re probably in good shape.
2- In my books/DVDs I explain that early assignment is rare but when it occurs it is frequently associated with an ex-dividend date and will usually occur the day before that date. Well today (May 27th) is the ex-date for AGNC so it shouldn’t shock us if the assignment notice was sent yesterday and we were notified today.
3- We are not given notice prior to assignment…a risk we take when using option-selling strategies.
Check your bottom line…probably not so bad.
Alan
Running list stocks in the news: AVGO & BRCM:
Both stocks had huge increases in share price this afternoon:
DJ Broadcom is in Advanced Talks to be Bought by Avago
Technologies
Look for opportunities to use the Mid-Contract Unwind exit strategies.
Alan
Alan I have some BRCM stock which I had sold som ATM covered calls. Wish I had bought some extra shares and left noncovered! Oh well! Anyway wondering if you could expand on the Mid-contract unwind for this stock. I am wondering if it is likely that I will be exercised out early on this stock. I don’t want to pay up to buy out the option. So I assume if I am not exercised out early, then I should make sure my buy to close should only be done if the time value is near zero. Last I heard the price on the proposed deal was still up in the air so the June $45.50 call I have still had a large spread. Maybe I just need to wait a day or two and see what shakes out.
Patricia,
Your shares are currently worth $45.50, your option obligation. If you close the short option position based on market close stats, your shares will be worth $57.16, an increase of $11.66 The current bid-ask spread for the June $45.50 monthly is $10.45 – $12.40 with the last trade at $11,.43. Let’s say you can “negotiate” a close price of $11.80. That means the cost to close is $0.14 per share plus commissions. At that point you can take no action and hope to gain from a potential merger announcement which may take place as early as today (risky) or sell the stock to use the cash to enter a new covered call position with a new stock (mid-contract unwind exit strategy). If you do not want to buy back the option, it is in the hands of the option buyer which isn’t so bad because it appears that you maxed the trade you initially executed. Early assignment is possible but not a negative. You can then put that newly-acquired cash to work.
Needless to say, this remains a volatile situation.
Alan
I’ve been an avtive trader for a few years and have recently begun learn about the strategy of covered call writing through the viewing Mr. Ellmans youtube postings. I have recently transfered my Roth IRA into an account that will allow me to write covered calls ( Self Directed IRA) . I am still new to the options world and have questions regading my Roth; A subject that I did not see covered in any of the videos that I viewed.
1. What are my tax implications if I implement this strategy in my Roth?
a. Will my earnings on a particular CC be taxed at the end of the year or when I am able to draw from my IRA at 59. ( I would hate to be taxed on earnings that I will not see till 59)
b. What stocks am I allowed to buy in my self directed IRA?
Thank you for your help!
Eziquel
Eziquel,
As I requested of Paul (above), I am not a tax expert so please confirm my response with your tax advisor:
Covered call writing in a ROTH is treated in the same manner as other ROTH-related investments. Profits are never taxed as long as withdrawals meet the framework of eligibility. In my view, a ROTH is the perfect vehicle for covered call writing because of the constant flow of short-term capital gains.
Check with your broker regarding stock eligibility but generally speaking, if a stock or ETF is trading on one of the major US exchanges, it is also eligible for covered call writing in a ROTH. You will not have an issue locating high-quality covered call writing candidates.
Alan
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Alan and the BCI team
BRCM/AVGO merger:
http://www.marketwatch.com/story/broadcom-agrees-to-be-acquired-by-avago-tech-in-a-37-billion-deal-2015-05-28?siteid=bnbh
Merger to take place in the 1st quarter, 2016
Alan
AVGO reported earnings this morning. After earnings, the price got an additional pop in additional to yesteterday’s increase on news of the merger with BRCM. I am holding the stock and have been waiting to sell the CC until after earnings. Now with the merger news I am unsure to skip the CC this month and wait until the dust settles.
Joe
Congratulations Joe. Waiting for the earnings report to pass generated the pop from a positive report plus the (unintended) pop from the merger news.
Dinner is on Joe everybody!
Alan
Excellent information & well explained, Thanks.