In last week’s article concerning option trading basics I highlighted the in-the-money strike in our covered call writing strategy. In this article I will expand our options calculations to all three types of strike prices. First, let’s review each of these categories:
There is a reason why these are popular strikes for many investors. When an option is sold, we generate an option premium that is ours to keep no matter what happens to the stock or whether that option is ultimately exercised. In the case of an O-T-M strike, we have an opportunity to make additional profit on stock appreciation. For example, if we buy 100 x XYZ @ $28 and sell the $30 call, we can generate an additional $200 on the sale of the stock (28 to 30 times 100). When we sell at-the-money or in-the-money strikes, there is NO CHANCE of such additional profits (additional capital can be made via exit strategies but that’s an article for another day). So from a profit perspective, O-T-M strikes are more attractive. Blue Collar Investors love profit but understand that it is only part of the big picture. Not factoring in risk is a major error that many covered call sellers make and in my view is what separates the men (women) from the boys (girls).
In-The-Money Strike Prices:
An example would be if we buy a stock for $32 and sell the $30 call. We are obligated to sell our shares for $30 per share. If the equity goes from $32 to $40, we make no additional income due to our obligation to sell @ $30. The option premium we receive from the sale of this option has an intrinsic value of $2 (32 – 30). The remaining option premium is time value and our true profit (ROO). However, the $2 additional premium we receive from this I-T-M strike will give us downside protection. For example, if we sell the $30 call for $3.50, we deduct the $2 of intrinsic value for an option profit of $150 per contract. This represents a 5% return. This profit is fully protected as long as our shares do not decline below $30. This $200 per contract represents a 6.3% downside protection. In other words, we are guaranteed a 5% 1-month return as long as our stock price does not decline by more than 6.3%.
At-The-Money Strike Prices:
When the strike price sold is the same as or close to (near-the-money strike) the current market value of the security it is said to be at-the-money. These strikes return the greatest initial option returns but offer no upside potential or downside protection of the initial profit. It is a bullish position to take.
Factors that determine which strike to sell:
1- Your risk tolerance: If you can’t sleep at night when your portfolio value declines, opt for the I-T-M strikes that offer more downside protection. Be sure not to complain if your shares appreciate!
2- Market Tone: In an uptrending and stable market environment, O-T-M or A-T-M strikes make sense to take advantage of share appreciation and/or initial returns. In a volatile or bearish market, I tend to favor I-T-M strikes.
3- Technical Analysis: The stronger the chart pattern of a stock, the more likely I am to sell an O-T-M strike. This would involve uptrending moving averages with all confirming indicators (see Chapter 4 of my Encyclopedia for Covered Call Writing).
Laddering of Strike Prices:
Laddering is an investment technique whereby investors purchase multiple financial products with different maturity dates. For example, when I purchase bonds (boring!!!!), I may buy 1,2,3,4 and 5 year maturations. This will protect me from interest rate risk. I have borrowed this term and applied it to strike prices. Each month, I will try to have a mix of I-T-M, A-T-M and O-T-M strikes. In a favorable market environment, I will lean towards more O-T-M. In a volatile or declining market, more I-T-M strikes. This is just another way of throwing the odds in our favor. It’s not a guarantee but rather a smart, sophisticated approach to cc writing that few others even think about, never mind actually employ.
Real life example (HITK: February, 2010):
Let’s look at the following strikes:
- ITM $20
- ATM (near-the-money) $22.50
- OTM $25
Next, let’s feed this information into the single tab of the Ellman Calculator:
Now let’s review the results that will guide us to the best covered call decisions:
One month returns
$20 ITM strike (red):
- ROO = 3.8%
- 10.5% protection of that profit
$22.50 ATM (near-the-money) strike (green):
- ROO = 7.6%
- Upside potential (minimal) = 0.7%
- No downside protection of initial profit
$25 OTM strike (blue):
- ROO = 3.6%
- Upside potential = 11.9%
- No downside protection of the option profit
When determining which is the best strike price to utilize for cc writing we must factor in several parameters. Market assessment, chart technicals and personal risk tolerance are the three most important parameters to consider when making these investment decisions.
New event planned:
There were several positive signs coming from this week’s economic reports:
- Industrial production (output of nation’s factories, mines and utilities) rose 0.6% in July, better than the 0.5% expected
- The Producer Price Index (a measure of the average change over time in the selling prices of a fixed basket of goods by stage of production, industry, and commodity. It is considered a leading indicator for consumer inflation) or PPI rose by 0.3% in July higher than the 0.2% anticipated
- Business inventories (a gauge of the number of months it would take to deplete existing inventories at the current rate of sales, which is an important indicator of the near-term direction of production activity) rose 0.1% in June, down from the 0.3% in May
- The Conference Board’s index of leading economic indicators increased by 0.4% in July, doubling the figure predicted. This bodes well for future economic activity although most economists still predict slow growth through the end of 2012
- Retail sales rose a whopping 0.8% in July after declining in April, May and June. A rise of 0.3% was expected
- New home starts dropped by 1.1% in July after a strong rise in June but housing starts were still 21.5% higher than a year ago
- New building permits (indicator for future homebuilding) rose by 6.8%, the largest increase since 2008
- Housing completions rose by 7.1%
For the week, the S&P 500 rose by 0.9% for a year-to-date return of 14.4%, including dividends.
IBD: Confirmed uptrend
BCI: Moderately bullish slightly favoring out-of-the-money strikes
With much appreciation for your continued support,
Alan ([email protected])