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Strike Selection Using Technical Analysis and Market Assessment

Stock and option selection are 2 of the 3-required skills essential to successful covered call writing (position management is the 3rd). There is no one factor that will dictate our choices but rather a mosaic of bits of information which will lead us to the best choices. In this article, I will discuss two of those critical parameters: technical analysis of the underlying security and overall market assessment. Let’s start with viewing the chart of an elite performer on our Premium Watch List dated 3/20/2020, Quidel Corp. (NASDAQ: QDEL).

 

QDEL price chart

 

QDEL: Bullish Chart Pattern

 

At this point, we have an elite performer both fundamentally and technically and one would be leaning to selling one of the bullish out-of-the-money strikes. However, let’s have a look at the chart of the S&P 500 and VIX (CBOE Volatility Index or investor fear gauge) to assist us to evaluate our overall market assessment:

 

Comparison chart of VIX and S&P 500

 

S&P 500-VIX Comparison Chart 3/23/2020

Note that in the past 3 months, the market volatility has increased exponentially (428%) while the value of the S&P 500 has declined precipitously by 31%.  This was directly a product of the coronavirus crisis impacting the global economy. For many investors, this red flag guides us from bullish out-of-the-money strikes to the more conservative in-the-money strikes giving us a bit of a cushion when it comes to capital preservation. Next, let’s view the options chain for QDEL at the time I produced the above screenshots:

 

QDEL 1-month option-chain (www.cboe.com)

 

QDEL Option-Chain 3/23/2020

 

With QDEL trading at $88.75, we will evaluate the in-the-money $80.00 strike feeding the stats into the multiple tab of the Ellman Calculator:

 

QDEL calculations with the Ellman Calculator

 

QDEL Calculations with the Multiple Tab of the Ellman Calculator

 

The in-the-money $80.00 strike creates an initial time-value return of 5.3%. It also yields 9.9% downside protection of that time value initial profit. This means that we are guaranteed a 5.3%, 1-month return as long as our shares do not depreciate in value by more than 9.9% by expiration. I call this downside protection (very different from break-even) an insurance policy that is paid for by the option buyer, not by us.

 

Discussion

Many factors are considered when selecting underlying securities and strike prices for covered call writing. Taking the most bullish positions (out-of-the-money strikes) are most appropriate when both chart technicals and market assessment are bullish. If either component is compromised, selling in-the-money strikes will afford us downside protection and provide a cushion for capital preservation.

***For many retail investors, this may not be an appropriate environment to trade. Market volatility has subsided but is still historically high. Many corporations are not issuing guidance because they cannot predict future performance due to the uncertain impact COVID-19 will have on our economy moving forward. This is, however, a great opportunity to paper-trade in the most challenging of market environments. Once we are past this crisis, I believe that there will be amazing opportunities to benefit from the recovery. I am currently in 50% cash and using a Delta-neutral portfolio (bullish and bearish positions) with in-the-money strikes to navigate the current risky circumstances. So far, so good. For those who missed my trading video for the March contracts click here.

 

Your generous testimonials

Over the years, the BCI community has been incredibly gracious by sending our BCI team email testimonials sharing stories as to what our educational content has meant to their families. Moving forward, we have decided to share some of these testimonials in our blog articles. We will never use a last name unless given permission:

Alan,

I have grown in my knowledge of options by following you and Barry over the years! The calculators improve your risk management. Both you and Barry are excellent teachers and have done a tremendous job of making a complicated subject (options) easy for the lay person to follow.

Thanks for what you’ve done for me over the years.

Warm regards,

Steve

 

Upcoming events

1. Wednesday April 8, 2020 Options Industry Council (OIC) Free Webinar

4:30 ET

Covered Call Writing to Generate Monthly Cash-Flow:

Option Basics and Practical Application

Register here.

2. East Michigan AAII Chapter: Live Webinar

April 23 @ 7:00 pm9:00 pm

Covered Call Writing to Generate Monthly Cash-Flow

Option Basics and Practical Application

Thursday April 23rd

7 PM – 9 PM

Login information to be sent to registered members.

Alan speaking at a Money Show event

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Market tone data is now located on page 1 of our premium member stock reports and page 8 of our mid-week ETF reports.

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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.

25 Responses to “Strike Selection Using Technical Analysis and Market Assessment”

  1. Munish April 4, 2020 6:49 am #

    Hi Allan,

    First of all thank you for all your YouTube videos. I thoroughly enjoy them and learn a lot as well.

    I have a quick question for you. I am very inclined on learning about covered calls. I am based in Australia. I wanted to get your advice on what is the best way to go about this is? I was thinking of ordering one of your e-books on covered calls. I noticed there’s two volumes. I wanted to ask you can I order volume 2 without ordering volume 1 or volume 2 is a follow on from volume 1.

    Also I am assuming most of the concepts you explain about covered calls would be the same doesn’t matter where you are?

    Thanks. Looking forward to your response.

    Regards,
    Munish

    • Alan Ellman April 4, 2020 5:11 pm #

      Munich,

      Welcome to our BCI community. We are fortunate to have a significant number of members from Australia.

      You should read Volume 1 first (classic edition).

      The concepts for the covered call writing strategy are universal but US exchanges offer the greatest opportunities. Most online brokers allow international members to trade on US exchanges.

      Alan

  2. Greg April 4, 2020 9:57 am #

    Hi Allan,

    By Delta-neutral, do you mean you sold mostly ATM and ITM positions?

    Thanks for all you do for us,

    Greg

    • Alan Ellman April 5, 2020 6:49 am #

      Greg,

      Delta-neutral implies taking equal bullish and bearish positions. For example, using 50% SelectSector SPDRs (or individual stocks) which go up when the market moves up and 50% inverse ETFs, like SH (short the S&P 500) which moves up when the market declines. This reduces market risk because our overall portfolios are neutral to market movement.

      Once our positions are established, we sell options (I used ITM for the April contracts) to generate time-value premium. Because volatility was so high, my initial 1-month time-value returns were > 3% and strikes were deep ITM.

      This is the first time I am employing a Delta-neutral portfolio. I will report back to our members at the end of the April contracts.the results of this approach and the efficacy of using it in extreme markets, like we have now, in the future.

      Alan

  3. Tony April 4, 2020 1:10 pm #

    Hello Alan,

    Would like to ask you the following:

    NVAX Now close at $ 15.61

    Call expiration for 17- 7 2020

    From The Call Options Chain How To Calculate a Strike Price
    with a Time Value of 1 % ( 1 percent) of the Stock Price??

    Thanks,
    Tony

    • Alan Ellman April 5, 2020 2:22 pm #

      Tony,

      A 1% return would calculate to about $0.16. For out-of-the-money strikes, scroll down the “bid” column for 7/17 expirations to a strike that generates close to $0.16.

      If you are using in-the-money strikes, use the multiple tab of the Ellman Calculator and look for a number close to 1% in the “ROO+ column.

      Alan

  4. Barry B April 4, 2020 9:46 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 04/03/20.

    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

    Best,

    Barry and The Blue Collar Investor Team

    [email protected]

  5. Daniel April 5, 2020 12:32 pm #

    Hello friends,

    How are you? Why is IBD Confirmed Uptrend?
    Is this an error on the report?

    Best Regard

    Daniel

    • Alan Ellman April 5, 2020 4:38 pm #

      Daniel,

      That caught me by surprise as well. I had my team check multiple times before we published it in our recent member report. It has remained on the IBD site since Friday evening.

      Alan

    • Barry B April 5, 2020 5:10 pm #

      Daniel,

      I was surprised as well…So much so that I called Alan late on Friday night while I was preparing the Weekly report to discuss the situation. Needless to say, we were both surprised since the IBD opinion was not a misprint. As a matter of fact, I checked IBD just before posting this response.

      This is the exact situation why we always have three opinions about the market in every report:

      – IBD
      – Professor Wish
      – BCI/Alan Ellman

      I’ll be checking IBD early in the trading week to see if their opinion changes.

      Best,

      Barry

    • Barry B April 7, 2020 12:37 pm #

      Daniel,

      I checked IBD at Noon EST today (4/7/20). IBD still shows the market is in a “Confirmed Uptrend”. Their outlook will change when there is a change in their opinion combined with a follow-through day.

      Best,

      Barry

  6. Dan April 5, 2020 1:01 pm #

    Dr. Ellman:

    I understand that you favor ETF covered calls during earnings season. The May 15th XLE calls look attractive to me. However ALL of the top ten holdings of XLE (representing 79.15% of the total weight) will be announcing earnings before expiration. Do you feel that the diversification of an ETF is enough to mitigate the downside of one or a few surprise earnings?

    By the way, I bought “Complete Encyclopedia for Covered Call Writing” and “Selling Cash-Secured Puts” and think they are the best written and most useful of the books I have read on option trading.

    Best regards,

    Dan

    • Alan Ellman April 6, 2020 7:37 am #

      Dan,

      In general, earnings are not a concern with ETFs because some individual company reports may be favorable, some unfavorable and, as a whole, will not be impacted to the extent one individual company can be.

      Now, XLE has been the worst-performing of the SelectSector SPDRs over the past 3 months (see screenshot below) and this is information that should be factored in.

      Thank you for you generous comment about my books.

      CLICK ON IMAGE TO ENLARGE & USE THE BACK ARROW TO RETURN TO BLOG.

      Alan

  7. Ed April 6, 2020 12:25 am #

    Hello Alan:

    You referred , in your last Weekly Stock etc Watchlist, to deep ITM calls.

    For you , how deep in the money , are deep in the money calls ?

    I look at this in terms of the Delta Value for the call. I suppose that one can also look at it as what the strike price , as a percentage of the current stock price is as well.

    So using either criteria , can you let me know what you consider deep in the money calls?

    Best regards,

    Ed

    • Alan Ellman April 6, 2020 7:53 am #

      Ed,

      Here’s how I determine my strike (ITM or OTM):

      1. Define my initial time-value return goal range for the time-frame obligation. For me, it’s 2% – 4% per month.

      2. Determine the “moneyness” of the strike based on overall market assessment and chart technical analysis. I am currently using all ITM strikes.

      3. Check an option-chain for ITM strikes that meet our initial time-value return goal range. When going DEEP ITM, I will favor strikes closer to 2% which allow us to use a lower strike and still align with our strategy initial time-value goal range.

      I prefer this approach over using a specific Delta stat on all trades which may or may not meet our strategy goals.

      Alan

      • Ed April 7, 2020 5:37 am #

        Hello Alan:

        Thanks for the insight.

        Best regards, Ed

  8. Alan Ellman April 7, 2020 5:12 pm #

    Premium members:

    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.

    Also included is the mid-week market tone at the end of the report.

    For your convenience, here is the link to login to the premium site:

    https://www.thebluecollarinvestor.com/member/login.php

    NOT A PREMIUM MEMBER? Check out this link:

    https://www.thebluecollarinvestor.com/membership.shtml

    Alan and the BCI team

  9. Kevin April 8, 2020 2:28 am #

    Dear Alan.

    In March pre Corona drop I sold a 19.00 otm put for 1.05 (PAAS), and as you guessed it dropped right past that and now is 10 days away from expiration. and very likely to get assigned.

    I would like to have you critique this possibility. Buy back the option for approx. 3.00 and turn around and sell a may expiration for 3.20 for the same 19.00 strike price.

    My logic is $1.05 plus $3.20 is greater than my buy back cost. potentially turning a loss into a little profit. in a little longer time frame than I would of liked. Your thoughts please.

    Sincerely
    Kevin

    • Alan Ellman April 8, 2020 6:58 am #

      Kevin,

      Rolling the option as expiration approaches implies that this is still a security we want in our portfolio. If that is the case, we have 2 choices:

      1. Roll-out as you suggest

      2. Allow assignment, take possession of the shares and write a covered call

      Before rolling our options, we check to see if there is an earnings report due out in the next contract month. In this case, PAAS reports on May 6th so if the BCI system is followed, rolling is out.

      Now, this was a great-performer until the recent crisis and has recovered to a small extent. PAAS recently shut down some of it’s mining operations due to the coronavirus protocol. Price recovery may be dependent on how fast it can resume operations.

      Let’s assume no ER for a second: You are correct that rolling-out will result in a net option credit but there remains the obligation to buy at $19.00 by the May expiration.

      Should we decide that this is no longer a stock we want in our portfolio (or as an underlying), we buy back the short put (if still in-the-money) and take a hit of $1.95 if the cost-to-close is still $3.00.

      To sum up: Rolling decisions depends on our bullish or bearish assessment of the underlying security and the earnings report date.

      Alan

      • Kevin April 8, 2020 11:29 am #

        Thank you, I am on the right track with my thinking! Thank you again!

  10. Andrey April 19, 2020 8:22 am #

    Respected Alan,
    Recently I came across quite a simple strategy,which IMHO I presume to be ideally suited for such volatile conditions! Because I think it is almost risk free!
    I would like to have your esteemed opinion regarding the disadvantages of it.
    Maybe you have a better strategy?….
    1. Sell a ATM Covered Call,and at the same time buy a Protective Put (Collar) say for 3-6-9 months in advance, whatever Expiration is comfortable for you,
    2.Put a stop Loss for the underlying stock at say 7-10% of the cost basis (emergency bail out),
    3.a. If the stock tanks, your emergency bail out is activated.You make a loss on your stock BUT the Protective Put shoots up and is now worth real money to more than cover your loss,hence in overall basis you profit considerably from this seemingly negative scenario!
    b.If the stock goes past your Covered Call strike or is flat you have the Premium and can repeat the above steps.
    Maybe you can fine tune this strategy?

    Thanks profusely

    • Alan Ellman April 19, 2020 5:18 pm #

      Andrey,

      I really admire our members who think outside the box.

      Let’s break down this proposed strategy which is a collar with a stop loss order on the stock:

      Most retail investors have a lower level of trading approval for covered call writing, cash-secured put-selling and protective puts. This means if we closed the long stock with a 7% – 10% limit order, we would be in a naked short call position which most brokers would not permit without a much higher level of trading approval.

      Okay, so let’s say we first buy-to-close the short call and then sell the stock based on the 7-10% threshold. Now we are long the put which probably has appreciated in value. We have a net loss on the stock/short call position and a probable gain on the put side. The question is will the put increase in value compensate or supersede the covered call loss?

      If we lost 6% on the covered call trade, will we gain > 6% on the put side?

      Run some numbers and see what you come up. I suspect that this not turn out to be the risk-free strategy we all would love to have.

      Keep up the good work.

      Alan

      • Andrey April 20, 2020 5:41 am #

        Respected Alan,
        Thanks for your kind words and answer!
        I totally agree with your answer and that’s exactly how I was to act (buying back the short call BEFORE selling a stop loss stock).
        Your answer gives me the confidence to enact this scenario.
        I would like to add the following to my strategy:
        Maybe make it less risky and boost up ROI, I should use a LEAP option (Poor man’s Covered Call)?.
        So that I can make more profit by a lesser investment and also decrease my loss if some of the moving parts goes wrong in such a wild wild environment.
        All the Best to you!

        • Andrey April 21, 2020 7:59 am #

          One more thing Alan, should such an Order be executed as a single Order OR as 2 maybe even 3 separate Orders on different days,depending upon the price movement of the underlying due to extreme volatility?
          Thanks again

          • Alan Ellman April 21, 2020 4:26 pm
            #

            Andrey,

            Once we have made our stock and option selections and confirmed that the returns, at that point in time, meet our initial time-value return goal range, we should enter all 3 legs. Waiting days between executing each leg of the trade may improve or detract from the current status. If the “deal: is there, take it.

            Alan

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