Covered call writing involves buying a stock and selling a call option. When a put is also purchased to avoid significant downside loss, it is referred to as a protective put and the strategy as a whole is referred to as a collar. When a put option is purchased on the same day that a stock is purchased, is it known as a married put. In essence, we are establishing a floor on losses (put strike) and a ceiling on gains (call strike). In its purest form, out-of-the-money calls (strike higher than current market value of underlying) and out-of-the-money puts (lower than current market value) are used.
Strike selection and income goals
We must not lose sight of the fact that covered call writing (with or without puts) is an income-generating strategy. When we buy a protective put, we are purchasing insurance that will cost us money and reduce our overall returns. Before selecting the two strike prices, we must first determine what are goals are and only then can we make informed decisions regarding strike selection. For example, if our covered call writing goal without puts is 2% – 4% per month for initial returns, we may set a goal of 1% – 2% when factoring in the acquisition of puts.
Evaluating an options chain of an elite-performer
GDX is a gold-based exchange-traded fund (ETF) that was a high-flyer as of mid-January, 2016. On February 16, 2016 the screenshot of the call and put options chain for the March 18, 2016 expirations looked like this:
The left side of the screenshot shows the call option chain and the right side reflects the put strikes and premiums. Let’s first start by establishing a goal for initial 1-month returns for the collar. We’ll make it 2%. This means that when we add the credit from the call sale and deduct the debit from the put purchase, we end up with a return of 2% of the current market value of the ETF, which at the time was $18.84. This computes to a net credit of $0.38. Any combination of call credits and put debits that results in a credit of $0.38 or more will meet our goal of 2%.
Calculation examples that meet our goal with GDX trading at $18.84
1- $19.50 call and $17.00 put (shown in screenshot)
$0.42/$18.84 = 2.2%
This also allows for additional share appreciation of $0.66 (from $18.84 to the $19.50 strike). Potential loss on the share side is $1.84 ($18.84 – $17.00).
2- $19.00 call and $17.50 put
$0.48/$18.84 = 2.5%
This allows for additional share appreciation of $0.16 (from $18.84 to the $19.00 strike). Potential share loss on the share side is $1.34 ($18.84 – $17.50).
Note that if we used the combination of the $19.50 call strike ($0.99) and the $17.50 put strike ($0.73), the resulting net credit would be $0.26, falling short of our $0.38 or 2% goal.
When integrating protective puts into the covered call writing strategy, strike selection of both calls and puts must be established based on the net credit generated from the sale of the call and purchase of the put. The process is always initiated by selecting an initial return goal and then viewing the options chains for the elite underlying performer. Our final decisions should be based on the amount of protection we want given the choices that meet our goal. As an example, choice # 2 above will give us more protection than choice # 1 but less opportunity for share appreciation as the more expensive put strike ($17.50) forces us to use a lower strike call ($19.00) in order to achieve a net credit greater than 2%.
Premium Members: Coming in July
The Blue Hour
The BCI team is proud to announce the launching a new educational program free to our members in the form of webinars, Q&A, interviews with experts and much more. Our initial 30 – 40-minute trial run will be held on July 28th at 9 PM ET in the form of a webinar with Q&A and additional comments. Alan will be hosting the webinar and Barry Bergman, the BCI Director of Research will be responding to your questions simultaneously. This event will be free to the first 50 premium members who sign up and will be recorded and available on the premium member site and free to all our premium members. We will be providing a series of these educational events to our premium members throughout the year. Our team is in the process of developing a landing and signup page for The Blue Hour and once ready we will open up registration. Ultimately, the development and format of The Blue Hour will be crafted based on your suggestions and feedback.
Next live event
June 11, 2016
American Association of Individual Investors
Research Triangle Chapter
Raleigh/Durham, North Carolina
10 AM – 12 PM
Global stocks were little changed this week, with investors looking for rate hike signs from the Fed after mixed economic data. The CBOE Volatility Index (VIX) remained static at 13.47. This week’s reports and international news of interest:
- Friday’s weak employment report cast doubt that the Federal Open Market Committee (FOMC) will be able to raise interest rates this summer.
- US nonfarm payrolls rose just 38,000 in May, while the weak April report was revised lower by an additional 41,000 jobs
- Although the unemployment rate dropped to 4.7%, the lowest level in this cycle, it fell mostly because participants dropped out of the labor force, not because more workers found jobs
- Japan’s Prime Minister announced this week that his government would now delay a hike in Japan’s general sales tax, scheduled for next year, until October 2019. Abe also said another dose of fiscal stimulus will be announced this fall because of sluggish economic growth following a 2014 hike
- The Fed’s Beige Book, which sets the economic stage for the FOMC ahead of its meeting later this month, describes growth across the US as modest
- Gross domestic product in Brazil contracted by 5.4% in the first quarter of 2016 This beat economists’ expectations. The country faces further challenges as Rio de Janeiro hosts the summer Olympic Games in August amid concerns over the Zika virus
- The Organization for Economic Cooperation and Development lowered its forecast for global growth in 2016 to 3.0% from its previous 3.3% outlook. Chief Economist Catherine Mann called for urgent government action to stimulate faltering growth in the world’s biggest economies
- Sales of new automobiles in the UDS dipped 6% in May versus a year ago. The decline comes amid six years of US sales gains
- The S&P/Case-Shiller home price index showed that home prices are rising twice as fast as inflation. In the top 20 US metropolitan areas, prices rose an average of 5.7%
- The European Central Bank left all its main interest rates unchanged at a meeting of the Governing Council
THE WEEK AHEAD
- Fed chair Janet Yellen speaks on monetary policy in Philadelphia on Monday, June 6th
- Eurozone Q1 GDP is revised on Tuesday, June 7th
- Japan’s Q1 GDP is revised on Wednesday, June 8th
- China reports its trade figures on Wednesday, June 8th
- China reports consumer and producer price data on Thursday, June 9th
IBD: Market in confirmed uptrend
GMI: 6/6- Buy signal since market close of May 25th
BCI: Cautiously bullish favoring out-of-the-money strikes 3-to-2
WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US