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Seeking the Highest Option Premiums is a Losing Strategy

One of the common mistakes made by covered call writers and put-sellers is to make investment decisions based primarily on the highest premium returns. Certainly, we all want to generate the highest levels of success but only when factoring in the risk we will be incurring. This article will look at high premium returns from the perspective of the underlying security as well as from the perspective of the “moneyness” of an out-of-the-money strike.

 

Time value profit and implied volatility of the underlying security

Our time value percentage profit is directly related to the implied volatility of the underlying security. This means that the higher the percentage return, the greater the downside risk. Generally, implied volatility (IV) statistics are based on a 1-year time frame and 1 standard deviation (accurate two-thirds of the time). If a stock shows an implied volatility of 25% and is trading at $60.00, the expected price range over the next year would be between $45.00 and $75.00, 67% of the time. Another $60.00 stock with an implied volatility of 10% would have an anticipated price range of $54.00 to $66.00. There is no need to look up or calculate implied volatility stats because we can glean the degree of risk by looking at our option returns based on our cost basis. I set a goal for initial 1-month returns for near-the-money strikes of 2-4% per month. I will go a bit higher in bull market environments (up to 6%). In my mother’s more conservative portfolio, I set a goal of 1-2% for 1-month returns. Below is a screenshot of a section of the BCI Premium ETF Report for exchange-traded funds. Pages 7-8 shows the implied volatilities which can be compared to that of the overall market (S&P 500):

implied volatility and covered call writing

Implied Volatilities from the BCI Premium ETF Report

 

With the IV of the S&P 500 at 7.76 (red arrow), the screenshot shows some ETFs having slightly less than double that implied risk (purple) and some triple to quadruple the risk (brown) of the S&P 500. Investors with a low risk-tolerance will tend to favor securities like ASHR, EWI and EEM.

 

“Moneyness” of out-of-money strikes

When we are bullish on the market and on a specific stock, we favor out-of-the-money strikes which generate time value returns and allow for additional share appreciation up to the strike price. Frequently investors will simply decide based on the strike that is above but closest to current market value. These strikes will tend to generate the highest initial returns but offer little or no opportunity to take advantage of share appreciation. In August 2017, Exact Sciences Corp. was trading at $38.66 and we viewed an option chain for the $39.00, $40.00 and $41.00 out-of-the-money strikes. Here are the calculations generated by the multiple tab of the Ellman Calculator:

covered call writing calculations

EXAS Calculations

Looking at the return-on-option column (ROO), the 5.0% ROO for the $39.00 strike seems like the best choice. However, if we look at the “Upside Potential” column (highlighted in yellow) we see additional opportunities to generate cash. The deeper out-of-the-money strikes offer lower ROOs but higher upside. In a firm bull market, we have an opportunity to generate a 1-month return of 8.6% (2.5% + 5.1%) for the $41.00 strike whereas the $39.00 strike will generate a maximum of 5.9% (5.0% + 0.9%).

This is a valuable instructive scenario as the IV of the underlying is similar for the 3 strikes and Theta (time value erosion) will also be comparable for all 3 strikes but yet the premiums are different. This relates to Delta which will be different for each strike. Near-the-money strikes have higher Deltas than deeper out-of-the-money strikes and this accounts for the price difference. Implied volatility is a critical factor in our covered call writing decisions but not the only factor.

 

Discussion

Implied volatility is a factor we must consider when evaluating the underlying securities we choose. Each investor should set a percentile range for initial returns based on overall market assessment (bearish to bullish), personal risk-tolerance and chart technicals. IV is a critical but not the only factor that determines our option premiums.

 

Upcoming speaking event

POINT, or Phoenix Options Investors Networking Traders,

March 2 @ 6:30 pm9:00 pm 

Friday March 2, 2018 6:30 PM to 9:00 PM   Rio Salado Community College 2323 West 14th Street · Tempe, AZ

Find out more »

American Association of Individual Investors: Phoenix Chapter

March 3 @ 9:00 am12:00 pm 

Saturday, March 3, 2017 9:00 AM    Registration/Social Time 9:00 AM    Refreshments Time 9:30 AM    Program Time Location: Jewish Community Center 12701 N. Scottsdale Road Scottsdale, Arizona 85245 DIRECTIONS: The Center is 3.66 miles south of 101 on Scottsdale Road. The Center is on the left as you drive south from 101 OR Take 101 to E. Cactus. Drive 2 miles west on E. Cactus to N. Scottsdale Rd. Turn right on N. Scottsdale Rd. The Center is 1/8 mile on…

 

Great to meet so many BCI members at my Orlando Money Show presentations

All Stars of Options Event

 

Market tone

 This week’s economic news of importance:

  • Jay Powell sworn in as Fed chair
  • Markit services PMI Jan 53.3 (expansion)
  • ISM non-manufacturing index Jan 59.9% (above expectations)
  • Foreign trade deficit Dec $53.1 billion (above expectations)
  • Consumer credit Dec $18 billion (last $31 billion)

THE WEEK AHEAD

Mon Feb 12th

  • Fed budget Jan

Tue Feb 13th

  • Household debt Q4

Wed Feb 14th

  • Consumer price index Jan
  • Retail sales Jan

Thu Feb 15th

  • Weekly jobless claims through 2/10
  • Industrial production Jan
  • NAHB homebuilders index Feb

Fri Feb 16th

  • Housing starts Jan
  • Building permits Jan
  • Consumer sentiment Feb

 

For the week, the S&P 500 declined by 5.16% for a year-to-date return of (-) 2.02%%

Summary

IBD: Market icorrection

GMI: 1/6- Sell signal since market close of  February 7, 2018

BCI: Due to the market volatility, I will be selling only in-the-money calls until market volatility subsides. I remain bullish on the economy and the market moving forward.

WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US

The 6-month charts point to a slightly bearish outlook. In the past six months, the S&P 500 was up 6% while the VIX (29.06) moved up by 160%.

Wishing you much success,

Alan and the BCI team

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About Alan Ellman

Alan Ellman loves options trading so much he has written four top selling books on the topic of selling covered calls, one about put-selling and a sixth book about long-term investing. Alan is a national speaker for The Money Show, The Stock Traders Expo and the American Association of Individual Investors. He also writes financial columns for both US and International publications along with his own award-winning blog.. He is a retired dentist, a personal fitness trainer, successful real estate investor, but he is known mostly for his practical and successful stock option strategies.

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28 Responses to “Seeking the Highest Option Premiums is a Losing Strategy”

  1. Terry February 10, 2018 5:06 pm #

    Is there a way to search the blog for a topic? I thought someone posted how to do this at one time. I have not found a way to do this.

    Thanks;
    Terry

    • Alan Ellman February 11, 2018 10:27 am #

      Terry,

      Use the Google search tool at the top of our web pages. Enter the topic you are interested in and it will pull up all the articles I have published regarding that subject.

      Alan

  2. Chuck H February 11, 2018 10:23 am #

    Alan,

    Thank you for a very informative Master Class this week, I look forward to practice using then new tools you presented.

    Chuck H

    • Alan Ellman February 11, 2018 2:22 pm #

      Thanks Chuck,

      My hope is that the information plays a role in cash generation for you and your family for years and decades to come.

      Alan

  3. Dave February 11, 2018 10:25 am #

    Hi Alan,

    I have been using the BCI stock and ETF weekly screens for the past 6 months, and have been earning between 1.5 and 2.5% monthly writing covered calls. During the past 7 trading days the value of my portfolio has dropped 11%. Some of my covered calls expired on Friday out of the money, and were thus not assigned. I could write new covered calls on these securities, and gradually recover some of my portfolio’s value in the coming year. On the other hand, I could simply hold on to my securities in hopes that share prices will rebound in the near future. Do you have thoughts on how best to proceed in these volatile market conditions?
    Thanks,
    Dave in Sacramento, CA

    • Alan Ellman February 11, 2018 2:25 pm #

      Dave,

      As I replied to Kerry last week, when our stocks gap down due to overall market decline and not corporate fundamentals or negative news, it is reasonable to retain the shares and write out-of-the-money strikes. Panic cannot be part of the equation. Corporate earnings, the US economy and global economies are all healthy and the new tax plan favors continued corporate success. US politics remains my concern but the market has proven resilient in this regard.Here is a link to an article I wrote several years regarding this matter:

      https://www.thebluecollarinvestor.com/covered-call-writing-managing-stocks-that-have-gapped-down/

      Alan

  4. Paul February 11, 2018 11:06 am #

    Alan,

    I’m new to options. I have been following my uncle selling covered calls now for about a year. And after seeing his success, I want to do it too. I have been watching your videos on selling covered call options. And I like your teaching style. Reminds me of a professor I had in college.

    So it says in your disclosure not to email you for advice. But what would you recommend I buy as educational material from you to start out? I have purchased a stock and once it is set up with TDAmerica I feel fairly confident starting the process.

    Thanks. Paul

    • Alan Ellman February 11, 2018 2:41 pm #

      Paul,

      Here are links to our most comprehensive educational package for covered call writing and a Plan B:

      https://www.thebluecollarinvestor.com/package-complete-encyclopedia-dvd-series-1-month-free-membership/

      https://www.thebluecollarinvestor.com/alan-ellmans-complete-encyclopedia-for-covered-call-writing-scover/

      Please take your time and make sure you have mastered every aspect of this strategy before risking even one penny of your hard-earned money…it won’t take that long.

      Alan

      • Paul February 11, 2018 2:52 pm #

        Hey, I have a question. So if i sold to open an option on stock MU at a strike price of say 45, and during the cycle the stock is trading in the money and i want to buy to close, why would not the person who bought my option exercise it right away. i see in your examples of rolling out and in, you trade back and forth. But if it looking great for the stock going to the moon why would the other guy give me a chance to take back my option to sell? He/she can exercise the right to buy at any time during the cycle, correct?

        Thanks
        Paul

        • Alan Ellman February 12, 2018 8:27 am #

          Paul,

          Yes, you are correct that the option buyer can exercise at any time during the contract up to 4 PM ET on expiration Friday. These are American style options and, by definition, can be exercised at any time.

          The reasons that early exercise is extremely rare:

          1- Exercising early results in capturing intrinsic value (amount the strike is in-the-money) but the loss of time value. This means that the option holder will make more money by selling the option.

          2- Most call option buyers do not intend to take possession of the shares but rather are hoping to make money on option appreciation if they are directionally correct about share price movement.

          That said, early exercise is more likely (but still rare) when associated with an ex-dividend date).

          Alan

        • spindr0 February 13, 2018 12:08 am #

          Paul

          Yes, the owner of the call can exercise the right to buy at any time during the cycle. But why would he?

          If the call has any time premium remaining, he would get more for selling the call in the option market than exercising it and losing that time premium.

          Secondly, why would he want to pony up the cash to buy the shares and risk a lot more money than having just that modest call premium at risk? As an example, you buy MU for $42 and sell the covered call for $1. If things work out and MU is over $45 at expiration, you make $4. The call buyer is betting on a larger move. All he has at risk is $1. Once the call goes in-the-money, why would he exercise the call to buy the stock for $45 and now have $46 at risk? He’ll just sit there with his $1 bet, hoping that MU goes higher and higher and sell the call when so inclined to book the profit.

          Early exercise can occur at any time. It’s unlikely unless the call is ITM and trades below parity (the bid price plus the strike price is less than what the stock trades at). This discount is often caused by call selling prior to a dividend and sets up discount arbitrage which involves exercise.

  5. Doyle Johnson February 11, 2018 12:33 pm #

    I am down about $150,000 on BP in the last 2 weeks. I think BP is at or close to its support bottom. After I collect the 0.60 dividend this Wednesday, I am thinking of selling a series of 250 contract weekly puts 3 strikes OTM with a delta of about -0.30. If I get assigned , I would probably sell the stock and start over again. What do you think about this plan.

    I plan on making your Phoenix meeting in April.

    Thank You

    • Alan Ellman February 11, 2018 7:08 pm #

      Doyle,

      If I understand your plan, you want to generate cash flow by selling out-of-the-money puts on a stock you believe is unlikely to decline in value. This plan makes sense but we should always be prepared to manage our positions should share value decline below the strike to mitigate potential losses. Also, have you evaluated Monthlys to allow for more management time and decrease the number and amount of trading commissions…both could work.

      BTW: I’ll be in Phoenix March 2nd and 3rd.

      Alan

    • spindr0 February 11, 2018 8:16 pm #

      30 delta options are sufficiently OTM to make the dividend irrelevant to the decision (it’s already priced into the puts).

      Now, taxation. If assigned on the puts, unless you can effectively designate that your broker sell specific shares, you’ll be realizing the loss on the current shares if you sell. That assumes that down $150,000 in the last two weeks means you have a $150k paper loss rather than having given back $150k of profit. If not in the red then you’ll be realizing the gain.

      Selling OTM uncovered options is a great plan if the underlying cooperates. If it doesn’t, NOT so much.

  6. Mike February 11, 2018 12:54 pm #

    Hi Alan.

    I want to offer my thanks for your services. I recently signed up for the Premium Membership and have read two of your books – Exit Strategies and The Covered Call Writing Encyclopedia. You have opened up a new world of investing opportunities for me!

    I’m wondering if you would clarify a point for me? Because you recommend writing one month covered calls, does that mean the original options should only be written during the first week following the monthly options expiration date? For example, the February 2018 options expire on 2/16. Does that mean that new options should only be written during the week of 2/19?

    I realize that once the call is written, BCI has rules for tracking and taking action during the subsequent weeks leading up to the next expiration date. I’m just trying to understand the timing of writing a new covered call position.

    Thank you so much for the BCI program and answering my question.

    Best regards,
    Mike

    • Alan Ellman February 11, 2018 7:17 pm #

      Mike,

      Due to Theta (time value erosion), I like to write new options at the very beginning of the new contract month. For 4-week contracts, I like to enter new positions on Monday or Tuesday after expiration Friday (some positions are “rolled” on or near expiration Friday). For 5-week contracts, we can wait a few more days but I usually stick to Monday or Tuesday for those as well.

      Alan

      • Mike February 12, 2018 7:55 am #

        Alan,

        That is what I was assuming so your clarification is most helpful. I may have missed that point in your books and videos. As a new BCI member I have also been digging into the Ellman calculator tools and find them extremely valuable.

        I have been impressed by the responsiveness of your service and the easy to comprehend manner of your instructional materials. As an aside, I have an MBA and an undergrad Finance/Economic degree from a major university and was never taught any of these Options concepts. I wish had learned all of this earlier in my life. However, the good news is I have adult children and I plan to share this knowledge with them. Teach a person to fish…

        Thanks again and keep up the great work.
        Mike

        • Alan Ellman February 12, 2018 8:00 am #

          Mike,

          Thank you for your generous comments. One of the most rewarding trends I have been noticing lately is more seasoned investors bringing their children and grandchildren to educational events. It was quite noticeable at the recent Orlando Money Show I recently presented at.

          Alan

    • MarioG February 12, 2018 2:49 am #

      Mike,
      Complementing Alan’s comments on preferably writing your options during Week1 because Time Value is the highest, there is nothing to prevent you from writing options in Week 2,3 of a 4 week period or 2-4 of a 5 week period as long as the ROO% values are in the 1.5% and up area or greater than 2% early in the cycle and the price chart looks good with respect to the Breakeven point and favorable volatility swings.

      I also sometimes wait for a good buying opportunity (dip in market) and often end up in early week 2 finishing up being 92% invested.

      Mario

  7. MarioG February 11, 2018 3:12 pm #

    Alan,

    Excellent article this week. I noticed that the current IV of the S&P 500 is this weeks ETF report (2/6/18) was 43.58 while the previous week’s report it was only 11.98.

    I was wondering if your statement in this week’s article “Seeking the Highest Option Premiums is a Losing Strategy” which states:

    Investors with a low risk-tolerance will tend to avoid securities like ASHR, EWI and EEM.

    should read:

    Investors with a low risk-tolerance will tend to select securities like ASHR, EWI and EEM (those with lower volatility).

    or, alternatively:

    Investors with a low risk-tolerance will tend to avoid securities like KWEB, XBI, GDXJ (those with higher volatility).

    I am assuming that “low risk-tolerance” is an investor that tend to avoid high risk investments.

    Regards,

    Mario

    • Alan Ellman February 11, 2018 3:18 pm #

      Good catch Mario…corrected to the intended “favor”

      Alan

  8. Rick Doelle February 11, 2018 4:28 pm #

    If you look at the 44 strike in EXAS and assume the premium is $0.50, the ROO is 1.3% with an upside potential of 13.8% for a total of 15.1%. Although this looks a lot more attractive than the total result for the 41 strike, what’s the probability of achieving this total return for the 44 strike?

    How do you balance the cash-in-hand that you get from the premium and the higher upside potential from the higher strikes to get a “reasonable” or optimum result?

    • spindr0 February 11, 2018 8:30 pm #

      (1) Selling a lower strike provides more premium, more downside protection with a lower potential profit.

      (2) Selling a higher strike provides less premium, less downside protection with a higher potential profit.

      The optimum result is attained by knowing what share price is going to do by expiration. Since that can’t be known, you have to find a balance between the two choices. What the motivation for the position, fear or greed? (g)

      The delta of the option is an approximation of the probability that the option will expire ITM. Since delta is affected by implied volatility, that number can change significantly along the way. Higher IV has minimal affect on ATM options. It lowers delta for ITM and raises delta for OTM.

      Probability of Touch is higher than probability of expiration ITM. Using an option calculator will give you an idea of the numbers.

    • Alan Ellman February 12, 2018 8:41 am #

      Rick,

      Adding to Spin’s excellent response:

      As a guideline, we will use deeper out-of-the-money strikes when we are more bullish on share appreciation. We base this evaluation on overall market assessment, chart technicals and personal risk tolerance.

      In bear and volatile market conditions, we favor in-the-money strikes that will provide greater downside protection as it lowers our breakeven points greater than ATM or OTM strikes.

      Alan

  9. Barry B February 11, 2018 9:53 pm #

    Premium Members,

    This week’s Weekly Stock Screen And Watch List has been uploaded to The Blue Collar Investor premium member site and is available for download in the “Reports” section. Look for the report dated 02/09/18.

    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 link to the BCI YouTube Channel is:

    http://www.youtube.com/user/BlueCollarInvestor

    Since we are still in Earnings Season, be sure to read Alan’s article, “Constructing Your Covered Call Portfolio During Earnings Season”. You can access it at:

    https://www.thebluecollarinvestor.com/constructing-your-covered-call-portfolio-during-earnings-season/

    Best,

    Barry and The Blue Collar Investor Team

    barry@thebluecollarinvestor.com

  10. MarioG February 13, 2018 4:32 am #

    Trading 2 Monday 2/12/18 – Looked for a good roll down candidate for this first day of week 4 or 4 cycle. Found CRM with good option bid price.

    Long position CRM ER 2/27:
    Rolled down CRM (Salesforce.com) to Strike 109.

    Original strike was 114 with Covered call 1/24/18 Purchase price 113.61. Return Cost Basis 113.61, Breakeven 111.45. ROO 1.9% Upside 0.4%.

    Executed Week 3 Rule10% with GTC order Buy to Close on 2/8. New Breakeven 111.65

    2/12/18 – Rolled down CRM. Last Price 108.32 Gain -3.0% before roll down. Executed roll down to strike 109. Premium 1.26 after commission (Bid /Ask was 1.13/1.32, filled at 1.28 after playing spread). New Breakeven 110.43 Gain after roll down -1.9% ((108.32 – 110.43)/113.61), a 1.1% reduction in position loss. Check Premium / RCB 1.26 / 113.61 = 1.1%)

    If on Expiration Friday 2/16 position is assigned at strike 109,
    with the upside appreciation from the roll down underlying price, shares will be sold at 109 and the new position gain will improve by 0.6% ((109/108.32)-1) and the new position gain will be ((109-110.43) / 113.16) =-1.3% (loss). Net reduction in loss with the roll down 1.1% + 0.6% = 1.7%.

    If the price remains below 109, the option will expire worthless and I have till the Earnings date of 2/27/18 to sell the shares, hopefully at a good price peak and including the benefit of the roll down income.

    Mario

    • MarioG February 16, 2018 1:21 am #

      Update on Roll down trade of CRM (Salesforce.com) 2/15/18 after Market Close:

      CRM is at 111.69, above my roll down strike of 109. Just two days ago on 2/13, it was at 107.78, well below my strike. Some volatility.

      If it stays above 109, I will let the trade be assigned (Earning Date in a few days) and take the 1.3% loss in the position and the 1.7% benefit of the roll down. My actual net dollar loss with 300 shares will be $443.08 (G% * RCB * Shares = -.013 * 113.61 * 300).

      If I had not rolled down and assuming the last price stays at 111.69: My BEP was 111.65 after the 10% rule trade. With a last price of 111.69, my gain would be $0.04/share or 0% gain. Dollar gain with 300 shares is $12.

      Mario

  11. Alan Ellman February 13, 2018 4:54 pm #

    New webinar- just in:

    I will be presenting a free webinar for the Options Industry Council OIC) on 3/22 @ 2PM ET

    Here is the link to register for free:

    https://event.on24.com/wcc/r/1601761/6C464B87CD0C7A4ADA711D117EED7372?partnerref=presenter

    Alan

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