Stock movement and delta-hedging chart
Influence of gamma
Pin pressure comes from “gamma traders” attempting to remain delta neutral. Since gamma (rate of change of delta for every $1 change in the stock price) increases as we get closer to expiration Friday traders tend to buy and sell many more shares of stock to stay delta neutral and ensure little to no risk.
Example
- BCI Corp. is trading @ $50 per share
- The dealer (market maker) is long 100 x $50 calls which have a delta of .50 and a gamma of .14. This means that the delta will change by .14 for every $1 change in share price.
- The dealer is also long 100 x $50 puts which has a delta of (-) .50 and a gamma of .14. Once again, the delta will change by .14 for every $1 change in share price.
- The dealer is currently delta neutral: (100 calls x .50 delta) + (100 puts x (-) .50) = 0. (Take another sip!)
- If the stock moves up $1, the new delta position will be 28:
- (100 calls x .64) + (100 puts x (-) 36) = 28 (call and put delta move up by .14 )
- As a result of this $1 increase in share price, the dealer must sell 2800 shares of BCI Corp. to remain delta neutral
To roll or not to roll:
If your stock is trading just under the strike sold at we approach 4PM EST on expiration Friday and it meets the criteria for potential pinning consider rolling the call position if your decision is to keep this stock for the next contract cycle. The cost to close (time value) will be minimal ($0.5 – $0.10) as 4PM EST approaches on expiration Friday.
Conclusion
The evidence suggests that pinning is real and unique to high open interest options on expiration Friday. It is impacted by the hedging forces that are normal market forces used by institutional traders to eliminate risk from their portfolios.
Las Vegas seminar:
For those of you planning to attend my presentation at the Forex and Options Trading Expo at the Paris Hotel on September 14th, PLEASE be sure to introduce yourself to me and my team members. I’d love to meet you in person. Sign up for FREE using the link at the top of this page.
Market tone:
Friday’s disappointing jobs report left the door open for additional stimulative actions by the Fed perhaps as early as next week. Here are last week’s reports:
- The economy added 96,000 jobs in August below the 125,000 expected
- The unemployment rate dropped to 8.1% from 8.3% due to fewer people looking for work
- Manufacturing jobs dropped by 15,000 compared to an increase of 23,000 in July
- Productivity of nonfarm businesses rose by 2.2%, higher than the 1.9% anticipated
- Construction spending dropped by 0.9% in July despite expectations of an increase due to lower spending in home improvements
- There was growth, however, in singe and multi-family housing
- The ISM’s manufacturing index was reported @ 49.6 signaling contraction (above 50 reflects expansion)
- The ISM gauge for service-sector activity was expected to decline but actually rose to 53.7
For the week, the S&P 500 rose by 2.2% for a year-to-date return of 16.1%, including dividends.
A 6-month comparison chart of the CBOE Volatility Index (VIX or Investor Fear Gauge) and the S&P 500 paints a bullish picture although with significant short-term volatility along the way. The S&P 500 has increased 5% in that time frame while the VIX has calmed to a current low level of 14.38:
Market tone as of 9-7-12
Summary:
IBD: Confirmed uptrend
BCI: Moderately bullish slightly favoring OTM strikes with an eye to the FOMC meeting this coming week which could favorably impact our markets
Wishing all our members the best in investing,
Alan ([email protected])
Alan,
When rolling out (or up) what specific criteria do you use to decide when to roll and when to allow your shares to be sold? Thanks for your help.
Paul
Paul,
There are 3 main criteria I use to make this determination. To roll…
1- The stock still meets the BCI requirements: fundamental, technical and common sense INCLUDING no upcoming earnings report.
2- The calculations meet my financial goals (2-4% per month for me)
3- The share price is or is likely to be above the strike price as of 4PM EST on exp[iration Friday.
Alan
Premium Members,
The Weekly Report for 09-07-12 has been uploaded to the Premium Member website and is available for download.
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 BCI YouTube Channel link is:
http://www.youtube.com/user/BlueCollarInvestor
Best,
Barry and The BCI Team
Alan, I want to go over the important exit strategy topic, so as to know how you had made the decisions that you do, and these questions are:-
1. For the ‘hitting a double’ strategy, you say I can buy a share and then if the price drops and comes back up to ‘bought value price’, to resell another option. But wouldn’t it be better to sell the shares at my ‘buy price’, to rebuy at new support level below,- and after a price rise to resell option again.(trade it a bit)?
2. How do you know whether to keep on rolling down the share(if price dropping) or to ‘convert share to cash profits?,- do you go by the number of days price dropped, by the % amount of price drop, or by amount of times you roll-down.(or even a combination of some of these.)?
3. Also after a stock gaps-down, then to determine if I should keep stock you had said we should see how bad the ‘news’ is. But do we then sell an OTM call option and then compare the chart to the S&P500,- or do I do it the other way around, by comparing price performance charts and then possibly sell OTM options? How long after a gap-down should I be comparing the S&P500 chart to a stock chart?
Hope you can help again. Thanks
Adrian,
My responses:
1- Your assumption here is that the stock price will decline (buy back the option), go back up (then you sell the stock) and then decline again (now buy back the stock) then up again to sell the option all in the same contract cycle. It could happen but I don’t know that I’d want to hang my hat on that strategy. Stocks will whipsaw in a contract cycle. By buying back the option using the 20/10% guideline, we’re in a position to “hit a double”, roll down or completely unwind depending on future price movement. This way we are prepared for all possibilities and can react accordingly.
2- I am more likely to completely unwind my position if the chart technicals have broken down and the stock is underperforming the overall market. If market forces are causing the negative price movement, rolling down can generate additional cash into our accounts and provide more downside protection. Who knows, if the market recovers, causing the stock to recover, we may want to roll the option come expiration Friday. So, look at overall market conditions and chart technicals to guide you to the best decsion.
3- The example I showed in my latest book was a gap down after an earnings report. Most of us would never have been in that situation because of our BCI rule related to earnings reports. Many times such a report may have actually been favorable but didn’t meet market consensus or the “whisper number”. Perhaps guidance was muted. What if one analyst downgraded the stock? These are some situations we may want to hold the stock if it has been a stellar performer to date. Here I write OTM strikes and consider rolling out and up if the upward price movement is strong. I will start comparing the equity price movement to the S&P 500 immediately to get a feel as to what the institutional players are thinking.
Alan
Alan,
This weeks stock list has more candidates than usual. Is there a method you can share to help reduce the number of stocks that should be run through the calculator.
Thank you,
Fran
Fran,
There are many ways to utilize our premium stock list. Here is one way but certainly not the only way:
1- Look at the list of stocks that passed ALL screens and eliminate any that are too pricey for your portfolio (GOOG?)
2- Check the “running list” and select those that are in the top-performing industries (“A” rank)
3- Run the remaining choices through the Ellman Calculator and eliminate candidates that don’t meet your financial goals
4- Refine selections so that you are properly diversified
5- If necessary, go to the list with ‘mixed technicals”
This is an example of one approach and it won’t take too much time to accomplish.
Alan
Hi Alan, Thanks for putting together the BCI. It has helped me get into a successful covered call trading system. It works for me, or course with my own personal selections of stocks and calls. I’ve been building my knowledge of markets and trading for the last two years and just finished reading Van Tharp on successful trading systems. Using his analysis of risk/reward to evaluate a trading system has helped to formulate an open question I have about BCI. With CC’s, upside is capped in exchange for premium. And management of the position is more flexible because of the option, allowing the multiple exit strategies. However, if the stock really goes down significantly (say 20%), the large loss will wipe out a large number of the small upside gains from other positions. Definitely making the BCI trading system less profitable if at all. Can you add to your exit strategies how to manage exits from underlying stock positions? Or have I missed something in your writings. Thanks.
Warren,
Every strategy has its pros and cons and you have certainly identified one of the drawbacks to covered call writing and that is that a stock price can accelerate beyond the strike price thereby capping share appreciation benefits beyond that point. When this happens, of course, you have maximized your trade position for the month with the premium plus any upside captured if selling OTM strikes. This consideration is one for covered call writing in general NOT specific to the BCI methodology.
This is one of a few disadvantages of using this strategy and there is a list (much longer, in my view) of advantages. What we investors need to do is to educate ourselves regarding the pros and cons of any strategy to make an informed decision as to whether this is the right strategy for us and our families. I’ve made my decision but never tell others what to do. This is a decision only you can make.
What I have done over the past two decades is to develop a system that addresses both the pros and cons so that losses can be mitigated and gains enhanced. My second book on exit strategies is the only book I am aware of that was ever written focused ONLY on this one topic. I have added another exit strategy and devoted 75 pages of my latest book (“Encyclopedia…”) to the topic of exit strategies. Suffice it to say, we share the same concerns. ALL strategies have drawbacks. Overcoming them is what separates winning trades from losing trades.
A stock dropping 20% can definitely hurt a portfolio but taking no action will exacerbate the situation. In addition to being prepared with an arsenal of exit strategies, appropriate portfolio diversification will help as well so that no one position will dominate our results. Everything about the BCI methodology was designed to generate a monthly cash flow with capital preservation in mind. This starts with stock selection, continues with strike selection and is followed by management. Originally, when I deveoped the methodology it was for me and my family only. I never expected the “floodgates” to open the way they have. Now I’m happy to share what I have learned (the hard way, admittedly…not what I want for our members) and what I am doing.
We agree 100% that exit stategy and managment is critical to successful covered call writing. I will continue to write about this subject and produce more videos on the subject in hopes that my experiences will benefit our members and enhance their chances of becoming financially independent.
Thanks for the question.
Alan
Alan,
On your watch list do you favor IBD ranked stocks over the ones listed as “others” Thanks for all your assistance.
Jorge
Jorge,
Both the BCI database of over 3000 stocks and the IBD 50 stocks that our team screens weekly must meet the same strict BCI requirements. Therefore I treat them equally when making my selections.
Alan
Alan, thanks for replies above, I think I am understanding it a bit better now, although I may have to reread over the book information for that no.3 answer given!
If I could just finish off this topic by asking you about the buying back of
shares/options, which I know is related to those exit strategy queries I had asked above. My list is again below:-
1. In your book I see that you have calculated the return for OTM options as the ‘premium over the share price bought’, but then use another calculation as the ‘premium amount over cost-basis price’ – like for when there is a collar strategy used. But why do you use it over ‘cost basis’ when buying put options?
2. If I sell a covered call and buy a protective put option and then sometime before expiry this stock goes into a ‘trading halt’ – with the share price dropping also, then what am I to do about this.(as I can’t close position or sell shares.)?
3. If I am selling more than 10 contracts per stock, then should I still be checking the ‘all or none’ box?
4. And also if it’s true that if the share price goes up above the strike price and the added premium value, that we would actually be losing money if we were exercised then wanted to rebuy this same share, – then how do you know whether to buyback the option before expiration(if price going up quickly), or to hold on and hope price doesn’t go above ‘premium and strike price value’?
With the last question above I vaguely remembered reading somewhere on this blog a similar question, but I can’t remember now where it is!
Having all this answered would be a great help anyway. Thanks
Adrian,
1- I calculate cost basis in two ways:
For ATM and ITM = share price x 100
For ITM = Share price – Intrinsic value of option = strike price
As an example of the ITM: If you buy a stock for $56 and sell the $50 call for $8, the initial profit (time value) is $2 and the $6 of intrinsic value is used to “buy down” the price of the stock so the initial return = $2/$50 = 4%
2- If a stock is halted so are the options. In these rare circumstances, call your broker or go to:
http://www.optionsclearing.com
If expiration is nearing I have included an OCC rule below.
3- Do NOT check the AON box if negotiating a better price using the bid-ask spread. This strategy will work for many securities even if selling more than 10 contracts.
4- When share price is accelerating exponentially, I will buy back the option when the time value of the premium approaches zero. Then the entire position can be closed at virtually no cost to us and we can use the cash from the sold shares to implement a second income stream in the same month with the same cash. This is after maximizing our return on the first position. See pages 264- 271 of “Encyclopedia…” for more details on this strategy.
Alan
***CLICK ON IMAGE TO ENLARGE AND USE THE BACK ARROW TO RETURN TO THIS BLOG
Alan, I’m sorry but I just need to confirm about the first question above again.
In encyclopedia book on p.101 the return for OTM option is $150/$4800. But on p.233 for the collar trade it shows it as $2-$1/$4700.
Why is it that the calculation isn’t the same as in 1st equation above(ie. $2-$1/$4800)?, does the put option bring in a cost basis or something?
All other answers I have understood better, and for any unexpected trading halt then ringing the broker for what to do is most likely what I would do.
From all the questions that I have asked you so far, then I would say I now have about another 20 more to go. This has been the reason why I ask about 3 of them at a time – because I had so many to get through!
I will ask a few more soon and then a possible break for some
tech. analysis study. Thanks for your help.
Adrian,
Excellent observation. I love to see how meticulous our members are in studying this strategy…a sure formula for success. In the first instance we are using the calculations to make our decisions going forward. We don’t know the final outcome. This is the way I calculate ALL my cc positions prior to entering them. I encourage re-investment of the time value of the premiums to compound returns…not to decrease cost basis. In the latter example where we are in three positions (long stock and put, short call) I was preparing to show FINAL results (page 234). The standard accounting practice to calculate returns AFTER-THE-FACT is as shown on page 233 and 234.
Keep up the good work.
Alan
Premium members:
This week’s 6-page report of top-performing ETFs and analysis of ALL Select Sector Components has been uploaded to your premium site.
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Alan and the BCI team
***Barry and I along with a few team members are leaving for Las Vegas early tomorrow morning. We’ll catch up on emails and comments we can’t get to this weekend, next week.