Covered call writing requires a logical sequence of stock and option decisions. Once we have screened our stocks to locate the greatest performing stocks in the greatest performing industries we must make a decision as to which strike price to use. Our choices include:
- at (near)-the-money
Let’s look at the options chain for the December contracts which represent a 4-week period expiring on December 16th. This was the options chain after the November contracts expired:
With the current market value @ $49.04, I have selected the following strikes to evaluate (additional strikes can also be viewed):
- $47 in-the-money (green field) generates $3.60
- $49 near-the-money (yellow field) generates $2.40
- $52.50 out-of-the-money (purple field) generates $0.95
Next let’s enter these stats into the “single tab” of the Ellman Calculator:
Once this information is entered in the blue cells, the results appear in the white cells on the right side of the page:
Each strike tells an important story:
$47 (green field):
- 3.3%, 1-month initial return
- 4.2% downside protection of the option profit
- No upside potential
$49 (yellow field):
- 4.8%, 1-month initial return
- Little or no downside protection or upside potential
$52.50 (purple field):
- 1.9%, 1-month initial return
- No downside protection of the option profit
- 7.1% upside potential (possible total of 9%, 1-month return)
What these calculations tell us:
- The time value or option profit for I-T-M strikes offer lower returns than the near-the-money call but the greatest protection for the option premium
- A-T-M (near) calls provide the highest ROO (initial premium profit) but little or no upside potential or downside protection of the premium
- O-T-M calls offer less option profit than the A-T-M calls but the greatest total profit potential should the upside be realized or almost realized.
When to use each strike:
- I-T-M strikes are the most conservative and easiest to unwind because of their high delta (move down in price nearly dollar-for-dollar with stock price decline). Use these when technicals are mixed and/or the market is bearish or volatile.
- A-T-M strikes can be used when technicals are good and market conditions are positive.
- O-T-M strikes are used when extremely bullish on the stock and general market conditions are favorable
Laddering the strikes:
There is no law that says you must use the same strike when you have multiple contracts. You can use some of each, favoring a particular strike based on the overall environment.
When it comes to strike selection one size DOESN’T fit all! Evaluate the stock and market parameters and then make a Blue Collar decision that has the best chance to maximize your returns.
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Cashing in on Covered Calls:
Alan Ellman’s Encyclopedia for Covered Call Writing:
The final week of 2011 showed a rising consumer confidence to 64.5 in December, up from an October low of 40.9. This was well above the consensus estimate of 58.3. To get a more substantial boost we would need to see a stronger recovery in the unemployment figures. For the week, the S&P 500 was down 0.6% for a final year-to-date return of 2.0% including dividends. Here are the major index results for 2011 (without dividends):
- Dow 30- + 5.5%
- S&P 500- Flat
- Nasdaq- (-) 1.8%
With just this information it would seem like we had a rather uneventful 2011, kind of quiet. The truth, however, is that the following photos can best describe our stock market for this past year:
Strike price selection and exit strategy execution has been particularly critical this year and continues to be so moving forward. Once the market establishes a quieter trading pattern we can move to a more aggressive stance and integrate our out-of-the-money strikes and higher beta equities.
IBD: Confirmed uptrend (see above chart)
BCI: Cautiously bullish but hedging positions with ITM strikes and low beta stocks.
Our thanks to you:
The BCI never dreamed that it would garner the support and following that you made possible. We will never take that for granted. Our goal for 2012 is to work even harder to justify the confidence you have shown us. Look for many positive surprises this year that will make the BCI community better than ever.
Happy New Year,
Alan and the BCI team