Whenever a study is performed on covered call writing a stock is selected and the nearest out-of-the-money (O-T-M) strike price is sold. This is repeated over and over and then the results are compared to the overall market performance. The usual conclusion is that covered call writing slightly outperforms the overall market but with much less volatility. What too many analysts overlook is the fact that the O-T-M strike has its advantages and disadvantages and to use it to our greatest advantage we must explore and understand the circumstances as to when to use this strike and when to avoid it.
An out-of-the-money strike is one where the option’s agreed upon sales price (of the equity) is HIGHER than the current market value of the stock. If we buy a stock for $28 and sell the $30 call option, that strike price is out-of-the-money.
When to use O-T-M Strikes:
Consider this strike the most bullish of our covered call positions. The greatest benefit will come if the stock appreciates in value from the time of purchase to expiration Friday. The closer it comes to the strike price (or surpasses it), the more money we realize and the returns can be eye-popping! So let’s take a common-sense look at some of the factors that would encourage us to favor this strike price:
- A bullish overall market with low volatility
- The stock chart of the equity is technically sound
- The positive technical indicators are all on high volume
- The positive momentum is continuous and not the result of a quick spike which could snap back
- The stock’s industry is also technically strong
Advantages of the O-T-M Strike:
- We can benefit from both the option premium AND the stock appreciation. 1-month returns can easily end up between 10-20% if the strike price is reached.
- Less chance of assignment if we prefer to hold the stock
- Time decay works in our favor since the premium consists only of time value. This means that as we approach expiration Friday, if the strike is still O-T-M, the time value will approach zero.
Disadvantages of the O-T-M Strike:
- This strike offers the least amount of downside protection of the overall position (breakeven) and no protection of the option premium
- May be a poor choice for those with low risk tolerance
- The initial option premium is low, so the 1-month return may not be impressive if the stock does not appreciate in value
- This strike has a low delta. If the stock drops in value, the corresponding option will not change as much, thereby making it more expensive to buy back the option for an exit strategy. In-the-money strikes have the highest deltas.
O-T-M strikes and the Ellman Calculator (multiple tab):
Ellman Calculator Multiple Tab
- The yellow highlighted rows show O-T-M strikes
- The second row down shows NFLX purchased @ $75 and the O-T-M $80 call sold for $2.60
- This represents a 3.5%, 1-month return
- If the stock appreciates to or beyond the $80 strike, an additional 6.7% will be realized
- Total possible 1-month return is 10.2%
O-T-M strikes have an important place in our portfolios. Those with greater risk tolerance will tend to use them more than those with less. No matter who is writing these calls, they must be used to our greatest advantage. Select the strongest stocks in the strongest industries that have been uptrending with low implied volatility (avoid violent whipsaws on the charts). When constructing your portfolio for the month you can mix or ladder your strikes using a higher percentage of these O-T-M strikes the more bullish you are on the market and decreasing that percentage if you turn bearish. By doing so we are not restriction of a call option obligation.
Reminder: The $100 discount for the NEW DVD Program and the DVD Program with the new book (“Encyclopedia…”) ends Saturday June 30th. Premium members are entitled to an additional 10% discount. Be sure to enter the Blue Collar Store from your premium site.
Las Vegas seminar:
I will be appearing as a guest speaker at the Forex and Options Trading Expo at the Paris Hotel in Las Vegas on September 14th. Here is a link to the list of speakers who will also be presenting at this great event:
Go ahead…make my day!
Kudos to you. Had a licensed broker and financial advisor look into our affairs to learn about estate planning reviews and to check what we did a few years ago. As you know things change. Bottom line after she looked at all our equities and portfolios, she said we ( I ) was far above the pros and have been averaging over 17%/yr over the past two yrs. But the best was my trading acct @ Tradestation, where I’ve been beating the markets over the past nine months since I’ve been with BCI.
We were told our portfolios and trades were better than most pros.
Bottom line our Covered call portfolio the past 9 months has averaged over 24%. We put $100,000 of our assets into our covered call account at Tradestation last Oct. since then we have withdrawn $30,000 in cash, and the balance today is $98,000 with over $30,000 in cash.
After two meetings wIth the FA, she said don’t go back to private practice, your job since you have been successful with Covered Calls is better than what you can do in a part time dental practice. So my job as CEO of my money has been successful and a big part of that success has been due to the BCI site and my premium subscription besides the BCI goals to be the CEO of my assets.
The FA ran the numbers on my Covered Call act at TradestAtion and for the last nine months it has surpassed %30. Enough said. So glad I found you.
Our economy continues to grow modestly, neither gaining nor losing momentum:
- The Federal Open Market Committee, chaired by Ben Bernanke, extended Operation Twist bond-buying program for another 6 months. This will put downward pressure on longer term interest rates.
- The Fed re-iterated its plan to keep short-term interest rates extremely low through late 2014
- The Conference Boards index of leading economic indicators (page 390 of “Encyclopedia…”) rose 0.3% in May surpassing the 0.1% expected. This represented the 7th increase in the past 8 months
- Housing starts fell by 4.8% in may month-to-month but were up 28.5% compared to May, 2011
- The more forward-looking housing permits rose by 7.9% to reach their highest level since 2008
- The National Association of Homebuilders reported homebuilder confidence at a 5-year high
- The median price of previously owned homes rose by 7.9% compared to a year ago
- Sales of previously owned homes fell by 1.5% from April but were up 9.6% from a year earlier
For the week, the S&P 500 fell by 0.6%, for a year-to-date return of 7.3% including dividends.
A 6-month chart of the S&P 500 and the VIX shows the S&P 500 up 6% during this time frame while the VIX went on a wild ride and settled Friday @ a calm 18.11, down 15% over that same time frame:
IBD: Uptrend under pressure
BCI: Moderately bullish on the US economy and stock market but hedging through in-the-money strikes because of the tail risk presented by European debt issues.
Your positive feedback, generous testimonials and kind referrals are appreciated and will never be taken for granted.
Wishing you the best in investing,
Alan ([email protected])
When you say your goal is 2-4 percent per month does that iclude the upside potential? keep up the good work.
No it doesn’t. The 2-4% GUIDELINE is based on the time value of the premium or initial option return (ROO). When dealing with individual equities I will rarely enter a position with one full month remaining and a time value under 2% for ANY of the strike prices. In my mother’s account where I use ETFs my goal parameters decrease to 1-2% because of the lower implied volatility of these securities.
Hello, Dr. Ellman
I am an active endodontist and it’s great to see a fellow dentist is sharing the knowledge on investment. My question is whether your total return is any different than the total return on your mom’s account. I am pretty sure the return in your account is more volatile since you have more individual stocks and they do have higher IV and more risks. Also, do you feel it’s worth spending time on researching companies for underlying stocks and stuff for people with a day job?
My accounts average at least 1% more per month more than my mother’s. You are 100% correct that there is more volatility, higher premiums and more risk but still manageable risk in my view as my target is 2-4% initial time value returns in my accounts and 1-2% in my mom’s.
Most of my professional career I traded this way while also a full-time dentist in a busy practice. I would suggest starting with ETFs and then deciding whether moving to individual securities is right for you. It’s much easier than performing root canal on # 15!
Much success to you.,
The Weekly Report for 06-22-12 has been uploaded to the Premium Member website and is available for download.
Barry and The BCI Team
Great article – of course I’ve found the way to drive stocks down – sell upside calls ;-(
I’m having trouble knowing what stock purchase price to use with your calculator after I’ve rolled out. A while ago I asked you about the price to use for the multiple tab and you told me the price the stock was at when I rolled out (for comparison purposes) and that made sense. My question now is about the UNWIND tab. I bought QCOR on April 25th and it has been very good to me. Initially I STO the $40 call. Then I rolled out and recently I rolled out and up to the $45 call. It is now at $52.66. Last I checked it has an earnings report on July 26 and since I’m not very familiar with protective puts I won’t be able to hold onto it. As one of the choices I need to consider is the possibility of unwinding I’m not sure what stock purchase price I would use. I’m also not sure about the date of transaction but I’m sure that will go with your answer to the previous question.
Thanks again for all your effort. Things are becoming clearer all the time and I seem to be getting better at it as well.
Congratulations on a very successful trading sequence. My responses:
1- Expiration Friday for the July contracts is July 20th, prior to the ER date. If the share price remains above the last strike sold ($45) the option will be exercised and the shares sold at that strike price so no action will be required on your part to exit the stock prior to the ER date.
2- If you are considering the “mid-contract unwind” exit strategy (pages 264-271 of “Encyclopedia….”) you would use the “unwind now” tab of the Elite Calculator and use the following:
• Start date is the date you rolled out and up
• Finish date is the date you unwind
The cash from unwinding can be used to establish a second income stream in the SAME month with the SAME cash.
I’m impressed with your overall assessment of this situation.
The equations I wrote for the Ellman and Elite Calculators were geared to making the best investment decisions at any given point in time. They are NOT geared for tax purposes. That’s for the Schedule D of the Elite Calculator.
3- For tax calculations or final results use the appropriate entry codes available in the Schedule D (chart below-click to enlarge).
Keep up the good work.
When is it appropriate to use the mid contract unwind strategy? How much time value are you willing to give up? Thanks a lot.
Page 264 of “Encyclopedia….”
“Always consider a mid-contract unwind exit strategy when the time value of the option premium approaches zero and there is enough time remaining in the current contract cycle to generate additional profit with another position.”
I am willing to sacrifice some minimal time value if I can generate significantly more time value in the new position.
Radio interview re-broadcast:
Alan this is a little off topic but what happens if you buy an option and the company is acquired by aniother and ceases to exist on its own prior to the expiration? thanks.
Mergers and acquisitions come in all shapes and sizes. Rarely are any two the same. As a VERY general guideline, in all-cash deals your call will be worth the difference between the strike and market value. If you bought a $30 call and the merger or acquisition values the equity at $35, you receive $5.
It’s best to ask your broker or access information from a reliable rersource like this one:
Running list stocks in the news: QCOR:
On April 24th, QCOR reported an outstanding 1st quarter earnings report. Earnings beat estimates by 16% and were up 222% year-to-year. Revenues rose by 161% well above estimates. This was the 4th consecutive positive earnings surprise with an average “beat” of 22.6%. QCOR reported cash on hand of $223.7 million with NO long-term debt. On May 15th, QCOR announced a continuation of its share buy-back program, enhancing the value of investor shares. All this has resulted in a new 52-week high price on June 26th. Our premium report shows an industry segment rank of “B” and a beta of 1.01.
This week’s 6-page report of top-performing ETFs and analysis of ALL Select Sector Components has been uploaded to your premium site.
For your convenience, here is the link to login to the premium site:
Not a premium member? Check out this link:
Reminder: The $100 discount for the NEW DVD Program and the DVD Program with the new book (“Encyclopedia…”) ends Saturday June 30th for ALL members. Premium members are entitled to an additional 10% discount. Be sure to enter the Blue Collar Store from your premium site.
Alan and the BCI team
I have a significant number of shares of AEP in my account and was wondering if this would be a good candidate for your high dividend yield strategy (page 437 of your latest book)? Great book!
AEP DOES meet the BCI criteria for the high dividend yield strategy. Here are the current stats for your stock:
Yield = 4.8% (4-8% required)
6-month RS rating = 62 ( >50% required)
Years paying dividends = 103 years (consistency!)
# annual payments = 4
Last ex-dividend date = 5-8-12
As a matter of fact, the BCI team is currently putting the finishing touches on our next quarterly high dividend yield report. It should be uploaded to your premium site in the next few days. Premium members will receive an email when it is available.
Alan sent me an email indicating that some people have been asking about using weeklies for covered call writing. The weeklies are problematic.
If you are dealing with a reasonably priced stock, there is pretty much not enough premium to make it worthwhile. If you are dealing with a stock with a decent option premium, you are talking about the $500 – $700 monsters like Apple, Google and Priceline.
Example: 100 shares of LULU at 3;40PM on 6/29 is $5,931. You can sell a JulWk1 $60 call (exp 7/6) for $0.85. After you subtract $15-$18 for broker’s fees, there isn’t much left for you.
Now, an Apple JulWk1 $590 call will get you $4.10, but you have to put up $58,255 to buy the stock.
The biggest danger of the weeklies is that there is little margin for error if the price turns. With only 7 days to begin the transaction you do not have enough time to “wait a day or two” to see if it fixes itself.
A slow nickel is still safer than a fast dime. If you can turn 1%-2% per month you are doing better than almost everyone else. Remember the Wall Street rule: Bears roar, bulls stampede and pigs get slaughtered.
Call a stock broker. Teach him how to make money.