In the BCI methodology for covered call writing we use predominantly 1-month options. The reasons are as follows:
- Generate the highest annualized returns
- Allows us to avoid earnings reports, a key rule in the BCI methodology
- Keep our obligation to a short-term time frame allowing us to keep only the best current performers in our portfolio
When we look at a typical options chain we do note that there are several additional choices other than 1-month options and because these choices are not always the same from stock-to-stock, an explanation is required.
All options are defined by an expiration month and date (the third Friday of the month, except for some quarterly and weekly expirations of some securities) after which the contract becomes invalid and the right to exercise no longer exists. When options began trading in 1973, the CBOE (Chicago Board Options Exchange) decided that there would be only four months at a time when options could be traded. Stocks were then randomly assigned to one of three cycles:
- January cycle– options available in the first month of each quarter (Jan., April, July and Oct.)
- February cycle– options available in the middle month of each quarter (Feb., May, Aug., and Nov.)
- March cycle– options available in the last month of each quarter (March, June, Sept., and Dec.)
The foregoing cycles proved to be a workable concept until options gained in popularity, increasing the demand for shorter-term options. In 1990, the CBOE decided that each stock (with options) would have the current and following months to trade, PLUS the next two months from the original cycle (hope your head isn’t starting to spin). Let’s simplify things by looking at the chart below:
If the current month is January, we see that all options are available for both the current (January) and next month (February). The last two option expiration months available will depend on their original placement in one of the three cycles:
- January cycle- will also have April and July expirations
- February cycle- will also have May and August expirations
- March cycle- will also have June and September expirations
Now, if your head has stopped spinning and you’re feeling a bit better, I ask you NOT to put away the Tylenol, at least not yet! Here come the LEAPS (Long-term Equity Anticipation Securities), which are options with longer-term expirations. Only the more heavily traded securities such as Microsoft have these types of derivatives. LEAPS will have options with more than four months of expirations, with some having up to seven months to choose from. LEAPS can further complicate these cycles, however, those of you who follow the BCI system of selling predominantly 1-month call options need not be concerned with these extended expiration periods. However, intelligence does breed curiosity, so for those of you interested in learning more about LEAPS and potentially using these longer-term options as part of your covered call writing strategy, a more detailed discussion of same is included in my latest book, Alan Ellman’s Encyclopedia for Covered Call Writing. For purposes of this article, simply take note that the vast majority of stock options will fall into the four month cycle depicted in the chart above. To determine which cycle an equity is assigned to you must look at the third and fourth expirations out as all securities will have the current and next month options available.
Lately, another breed of options has gained in popularity…the weeklys. They behave like monthly options in every respect except that they only exist for eight days. They are introduced each Thursday and they expire eight days later on Friday (with adjustments for holidays). Option traders should be diligent in checking expiration dates when viewing options chains on securities that have LEAPS and weeklys.
Most recently, we have seen the introduction of mini options which have only 10 shares (instead of the standard 100) per options contract. Although these only exist for 5 securities at the time this article is being written, that population will definitely expand and so even more diligence is required when examining options chains. Here is a screenshot of the options chain for Apple computer showing the new mini options:
Most stocks still have the traditional 4 expiration choices but with the demand for more option products many have more. It is important to carefully determine the exact expiration date before entering into a covered call trade.
Next live event: Baltimore on June 8th:
I’ll be taking the summer off for live events and then get back into action in September in Philadelphia.
New look to premium site:
Premium members may have noticed that we have enhanced the organization of the premium reports so that all reports are on the left side of the page organized by stock (5 recent reports), ETF (5 recent reports) and High Dividend Yield Stocks with LEAPS (most recent quarterly report) reports:
The market got a bit nervous this week as many worried that the Federal Reserve was about to decrease its bond buying program which now stands @ $85 billion per month. A change would be based on unemployment dropping below 6.5% and inflation moving above 2.5%. Here are this week’s mostly favorable reports:
- Minutes from the April 30-May 1 meeting reflected that the Fed planned to keep target interest rates near 0% unless unemployment or inflation rates dictated otherwise
- New orders for manufactured (durable) goods increased by 3.3% in April, well above the 1.6% expected. Durable goods are a measure of the number of orders for a broad range of products—from computers and furniture to autos and defense aircraft—with an expected life of at least
three years. Durable-goods orders are a leading indicator of industrial production and capital spending
- Sales of existing homes increased by 0.6% in April, the fastest pace since November. 2009
- Single-family home sales rose by 1.2% in April. 0.9% better than 1-year ago
- Sales of existing co-ops dropped by 3.3% in April but were still 15.7% higher than one year ago
- The national median existing-home price came in @ $192,000 in April, 11% higher than one year ago
- The median price for a new home in April was $271,600, 14.9% higher than one year ago
- Initial jobless claims for the week ending May 18th was 340,000, slightly lower than the 346,000 anticipated
For the week, the S&P 500 fell by 1.1% for a year-to-date return of 17%, including dividends.
IBD: Confirmed uptrend
BCI: Moderately bullish favoring out-of-the-money strikes 2-to-1
Thanks to one and all for your continued support and loyalty.
Alan: [email protected]
Running list stocks in the news: FLO:
On Wednesday Flower Floods announced a 3-for-2 stock split and an increase in their dividend. The split and dividend are payable on June 19th to shareholders of record June 5th. The dividend increased by 5.5%
Here is a link to an article I pubhlished showing how a 3-for-2 split impacts our cc writing positions:
The Weekly Report for 05-24-13 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
DEEP IN-THE-MONEY-STRIKES: Offsite Q&A:
Now that I have been doing this a few months and am seeing first hand what is happening, I am wondering whether many investors use your approach as a primary retirement income strategy? I have a reasonably significant portfolio which is still largely invested in stocks and have applied a small portion towards experimenting with the covered calls. With a small sample size, it appears that it is certainly possible to achieve one month returns of 2-3% or more (granted the market has done well anyway over the past 3 months).
I notice on many of the option chains that there are opportunities to earn about a 1% premium on very deep in the money covered call positions that offer downside protection of 10-25% or even more. This looks like an extremely low risk way to invest that would almost certainly yield a 1 year return of 8-12%. While that’s not necessarily a good option for someone trying to build a large retirement nest egg, for someone that is entering retirement with reasonable means, this is attractive.
Also, I notice that there are open positions for covered calls that offer negative return…am I missing something?
You are 100% spot on in your assessment of deep ITM strikes…you can generate decent returns with excellent protection OF THOSE RETURNS. Some of the reasons I don’t recommend specific stock/option combinations are because investors have different goals, needs and risk tolerances, not to mention portfolio sizes. A few things you should consider:
1- If we sell ITM strikes or if the strike becomes ITM by expiration Friday lour shares will be sold that Saturday, even if the price is only $0.01 above the strike price. If you want to retain your shares, you must roll then option prior to 4PM EST on expiration Friday.
2- If your shares generate quarterly dividends there is a chance of early assignment the day prior to the ex-dividend date so here to you will need to roll ther option 2 days or more prior to the ex date if you want to retain your shares. This is because most deep ITM strikes have little or no time value and the option holder may generate more favorable returns via early exercise.
3- NEGATIVE RETURNS: As I stated above, deep ITM strikes have little or no time value as the strike moves deeper ITM. Throw in the bid-ask spread differences and a negative return is possible. Needless to say, avoid these situations and look to another cc writing opportunity.
This week’s 6-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.
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Alan and the BCI team