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,