The timing of our option trade executions will impact the success of our covered call writing returns. The BCI methodology prides itself on having rules and guidelines for buying back options, re-selling options and selling long stock positions. One question that many of us have thought about is when to enter our 1-month trades. My books and DVDs have guidelines for this as well:
- For a 4-week contract ( 8 of these per year), we enter the trade within the first few days of the contract
- For a 5-week contract (4 of these per year), we enter the trade within the first 7 trading days of the contract
The reason we don’t want to wait longer than these time frames is due to the impact of theta or time value erosion. Theta is an estimate of how much the theoretical value of an option declines when there is a passage of one calendar (not trading) day while there is no change in stock price or volatility. For near-the-money strikes, theta is logarithmic in nature (not linear) and causes time value erosion to start off slowly and then impact our premiums more as expiration approaches as shown in the chart below:
With this in mind, many covered call writers intuitively feel that they should establish new positions on expiration Friday rather than the following Monday to capture some extra time value and negate the impact that theta will have over the weekend. To see if this approach will benefit us in most cases we must further investigate how traders value the options when using option pricing models. For every calendar day that passes, the option value will decline by the amount of the theta. To really dissect this in a blue collar manner we must ask ourselves when the calendar day is deducted from the pricing model…Friday…Saturday…Sunday…once each day?
It is fair to say that many traders assume the day is deducted and option premium value is decreased at the end of each calendar day and base their trades on that assumption. However, that frequently is not the case as traders anticipate the price decline and calculate option value prior to the end of a trading day or prior to the weekend. We may notice option values declining on the Thursday before expiration Friday and more so mid-day on expiration Friday as options are now being priced at Monday’s theta value. In other words, the weekend days are already deducted and so there may be no added value of entering trades on expiration Friday compared to the following Monday. In addition to this, we are now exposed to weekend risk for very little reward, if any at all.
Of course, there are many other factors that impact option value (the Greeks) so we can’t make a blanket statement that we are always better off waiting until Monday. However, we can say that based on the manner in which theta is factored into option value, waiting until the beginning of the week after expiration is generally a better way to enter new covered call trades.
The end of an era
Next live seminar
Philadelphia Chapter of The American Association of Individual Investors
September 30, 2014
Blue Bell, Pennsylvania
We had a mixed bag of economic reports this week, with an eye on geo-political events in Syria, Iraq, the Ukraine to name a few:
- According to the National Association of Realtors, sales of existing homes fell in August to an annualized 5.05 million after rising the 4 previous months. This represents a 1.8% decline from July but still the 2nd highest level in 2014
- According to the Commerce Department, new-home sales in August were up by 18% from July and 33% year-over-year
- Initial jobless claims for the week ending September 20th came in at 293,000, below the 300,000 expected by analysts
- According to the Commerce Department, durable goods orders in August fell by 18.2%, slightly worse than the decline of 17.9% anticipated. Excluding the transportation sector, there was actually a 0.7% rise in orders
- 2nd quarter GDP growth rate was revise upward to 4.6% from 4.2%. This was the best quarterly growth rate since the 4th quarter, 2011
For the week, the S&P 500 declined by 1.4%, for a year-to-date return of 9%, including dividends.
IBD: Uptrend under pressure
GMI: 2/6- Buy signal since market close 8/15/14
BCI: This site is still bullish on our economy but will tweak positions to half in-the-money and half out-of-the-money strikes as we keep an eye on the aforementioned geo-political events
Wishing you the best in investing,
Alan ([email protected])
Can you recommend a site to get information on theta and the other greeks?
Here is a free site:
• Option calculator
• Enter stock ticker
• Adjust for strike in question
• For implied volatility enter option price in lower right box
You will notice in the screenshot below that the October $101 call option for AAPL (monthly) shows a theta of (-)0.0467. This means that (all other factors remaining constant) for every 1 calendar day that passes the value of the option (currently $1.83- bottom right) will decline by a little more than 4 1/2 cents.
CLICK ON IMAGE TO ENLARGE & USE THE BACK ARROW TO RETURN TO BLOG.
The Weekly Report for 09/26/14 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:
Barry and The BCI Team
Would it also be better to wait until Monday to establish new positions if trading weekly options? As always, thank you for your sage advice.
As a general guideline, yes. If you do trade on Friday, earlier in the day would be better before the day of theta is “taken off” as discussed in this article.
Just wondering if you have a time frame for the release of your new book on Put writing?
The editing process always takes longer than anticipated. It’s been that way with all 5 of my books. The Put Book has 16 chapters and over 70 charts and graphs and I want to make sure everything is as close to perfect as possible before I approve for publication. Best case scenario…1 month. On the outside…2 months.
I will notify BCI members first when I receive the initial shipment of author copies. Shortly thereafter, the book will also be available on Amazon.com.
Thanks for your interest.
I am paper trading a deep ITM strategy. I chose two stocks: ADHD and ACHN.
For ADHD for example I did like this:
Bought 1100 shares @ $20.6
STO 11 contracts of Oct 10 strike @ 11.76
I am expecting the stock price does not fall below $ 10 I will have a ROO of 11.60% and $1276.
I know that both companies were beaten by the market and that is why there was an anomaly with their strike prices presenting extremely high IV and I achieved near delta neutral positions. I have nearly 30% of downside protection and good ROOs. Do you think it is safe to use the deep ITM strategy in the cases in which it brings satisfactory ROOs and downside protection? How do you manage this strategy. Is it done like the “regular” CC strategy?
I will be very grateful to have your thoughts.
Knowing when and how to sell ITM or deep ITM strikes is an important aspect of the BCI methodology. You have identified (with ADHD) an unusual situation where you can generate a huge 1-month return (11.6%) with downside protection of > 50%. Seems like a no-brainer. However, as we all know, there are no free lunches. So why are we presented with this opportunity?
The answer is the high implied volatility in the underlying security. ADHD is not a stock that meets the BCI criteria so I did a bit of quick research. It is an Israeli BioTech company and perhaps the market is anticipating an upcoming event on one of its products:
The news can be positive or negative but the anticipation is for a large price movement by expiration. In other words, when we take a position like this we are getting paid to undertake that risk.
The best way to determine if this approach is right for you is to do exactly what you are currently cdoing…paper-trade several of these. They ARE managed the same way described in my books/DVDs.
Also paper-trade more conventional cc writing candidates with lower ROOs and less downside protection and see which camp you fall into.
Below is a 1-year chart of ADHD showing the price volatility which explains the high option returns. CLICK ON IMAGE TO ENLARGE & USE THE BACK ARROW TO RETURN TO BLOG.
After gaining a level of comfort with the BCI Trading System through back testing, paper trading and “dipping my toe into the live trading pool”, it is my goal to devote a relatively large sum to covered call writing, and thus may open 10 to 15 positions using different underlying stocks. And the question comes to mind as to whether I am better off opening all these positions at the beginning of an expiration period, or to spread this effort out over the first 5 to 7 days of the period. (This question assumes of course that there are enough viable candidates, and that there are few positions that are rolled out from the previous month).
The benefit of doing them all at once (or over the 1st couple of days) is that one would get a slightly larger premium on average. The benefit of spreading the acquisition out over several days would be having the ability to somewhat reduce overall portfolio risk if unexpected events occur during the acquisition period.
Do you have any thoughts or suggestions on this question? Are there additional things that I should consider?
Yes, we can stagger trades to reduce portfolio risk but the time frame we are working with is limited due to the fact that most of us are selling 1-month options and we have theta (time value erosion) working against us initially. Here are the guidelines:
1- Some trades are entered on or near expiration Friday if we roll any of our previous month options.
2- Remaining trades can be entered during the first 2-3 days of a 4-week contract (there are 8 of these per year)
3- Remaining trades can be entered during the first 7 trading days of a 5-week contract (there are 4 of these per year).
Stated differently, I will always want to capture a minimum of 3 1/2 weeks of time value when selling 1-month options. Many BCI members do sell options early in the first week whether 4 or 5 week contracts.
This week’s 8-page report of top-performing ETFs and analysis of ALL Select Sector Components has been uploaded to your premium site. The report also lists Top-performing ETFs with Weekly options as well as the implied volatility of all eligible candidates.
The report reflects the increased implied volatility of the ETFs with the market downturn as well as the improved performance of the inverse ETFs…no surprise there. Keep in mind the 20/10% guidelines for buying back options and perhaps taking advantage of some “hitting a double” opportunities if the market recovers quickly. Rolling down would be a plan B.
For your convenience, here is the link to login to the premium site:
NOT A PREMIUM MEMBER? Check out this link:
Alan and the BCI team
Was wondering what your strategy is when the market is in correction? I’m sure you’ve covered these elsewhere, so if you’d point me in the right direction I would greatly appreciate it! Thanks!
Absolutely. Position management is a major aspect of the BCI methodology. A good place to start is Chapter 10 in the Complete Encyclopedia for Covered Call Writing and the material is detailed in both DVD programs. Here are some other techniques:
Favor in-the-money strikes
Use low-beta stocks
Consider less-volatile ETFs
Set lower monthly goals (2-3%) so the implied volaitlity of the options is lower
For those more knowledgeable with options:
Selling cash-secured puts (my next book)
Buying protective puts (collars)
These are general topics. The specific and detailed information with examples is in our books and DVD programs.
Thanks Alan! I’ve got your book and DVDs at home and will give myself a homework assignment. Looking forward to your next book!
Money Central recently reconstituted its website and as I write this article, the Scouter stats are not available. My team is reaching out to site support to ascertain whether those stats will be available and, if so, when. If not, we will put an alternate plan in place. This has happened in the past with the IBD site. We can always tweak the screening process so that it remains among the elite screens available for option selling. We will keep you informed.
Alan and team
It was always my understanding that ALL covered call options strategies have downside protection, but you say in your video that ITM options have no downside protection. I say they do, and here’s why:
If I purchase a $30 stock, and sell a $28 ITM call for $300 premium, the stock drop as low as $27 before I lose any money. So please explain why you say no downside protection exists for certain strikes. The premium received for any option I sell allows me to have a breakeven point below what I paid for the stock, and this by definition to me would be considered “downside protection.”
In the BCI methodology, there is a distinction between downside protection of the option profit and breakeven. In-the-money strikes provide protection of the time value component of the option premium. Stated differently, intrinsic value protects time value. In the example you gave, $2 of intrinsic value does protect the $1 of time value. At-the-money strikes and out-of-the-money strikes offer time value only (no intrinsic value) and therefore no downside protection of the option profit.
All covered call options have a breakeven. This is where we agree:
Stock price – entire premium = breakeven
It is important to make this distinction between DP of the option profit and breakeven because it highlights one of the advantages of ITM strikes.