I sell predominantly one-month options. This decision was NOT based on anything I read or was told, but rather on experience and common sense. Most stocks with options have at least four expiration cycles affiliated with them at any point in time…the current month, the next month and two more months further out based on the particular option cycle that particular equity has been assigned to. Stocks that also have LEAPS (long-term options) have more than four cycles. Using the options chains and the Ellman Calculator, I will make my case for selling mainly one-month options.
Three Reasons to Sell One-Month Options
1- It facilitates adhering to a core BCI guideline of never selling an option in a contract cycle that has an upcoming earnings report. Since earnings reports are made public on a quarterly basis for U.S. companies, selling short-term options allow us to move our stocks in and out of our portfolios (yet keep them on our watch lists if they still meet our system criteria).
2- Stocks have no loyalty to us. They can be our best friends one month and our worst enemies the next. Although we do have exit strategies to help control a negative situation (detailed in all my books and DVDs), the shorter the commitment we have to an equity, the less risk we incur.
3- We make the most money selling one-month options. I’m sure I have your attention now, so allow me to demonstrate via an options chain for Netlogic Microsystems (NETL), currently trading for $53.22 as shown in the figure below:
The option chain is shown in the chart below:
This information was captured after the February contracts expired. We will hone in on the March (one month out), April (two-months out) and July (five months out) contracts. Here is the information we glean from the options chain and will feed into the Ellman Calculator (single tab):
- The stock is trading @ $53.22 so we will look at the $55 call options
- The March $55 call returns $1.65/share (red circle)
- The April $55 call returns $2.55/share (blue circle)
- The July $55 call returns $4.70/share (green circle)
It may be tempting to opt for the higher dollar returns of the longer-term options; however we must factor in the time frame and logically deduce how to best put our money to work so as to generate the most profits. So let’s feed this information into the single tab of the Ellman Calculator, as illustrated in the chart below:
Now, in the next chart let’s examine the results of these calculations:
The ROO or initial percentage returns generated does NOT include the upside potential. Although the Ellman Calculator does give this information, I left it out of this graphic because all choices have the same upside, and I want to concentrate just on the initial option profit. Here are the ROO figures derived from the Ellman Calculator:
- The March $55 call returns 3.1% (green arrow)
- The April $55 call generates 4.8% (blue arrow)
- The July $55 call generates 8.8% (red arrow)
Once again, upon first glance it appears that the July $55 call will be the most lucrative for us until we annualize these percentages. To do so, we must convert these figures to a monthly return and multiply by 12, as follows:
- March: 3.1%/1 x 12 = 37.2%
- April: 4.8%/2 x 12 = 28.8%
- July: 8.8%/5 x 12 = 21.1%
The one-month options outperformed the two-month options by more than 29% and the five-month options by more than 76%! I rest my case.
Video highlighted on homepage– Multiple Exit Strategies for the Same Contract Period:
Market tone + Let me vent:
Are you as angry as I am about the way Congress is representing our interests? This past week, the Super Committee’s failure to come up with $1.2 trillion in budget savings over the next ten years was yet another breakdown by Congress impacting our well-being (it should not, however, affect the U.S. credit rating or the interest rates paid on Treasuries or their value). Like spoiled little children our representatives are putting their mean-spirited politics above the best interests of the folks. In our BCI methodology of screening for stocks, the number one screen is “are options available”. This is an essential requirement for covered call writing. It is so obvious that some of you have suggested removing it from the stock screen. Can we draw an analogy as to the first screen or requirement for selecting a Senator or Representative? How about having the ability to compromise and negotiate? Too obvious and simple to mention? Not any more in my view. Most members of Congress don’t pass the first screen! Our watch list of politicians can be counted on one hand. Why can’t they understand that they represent all the people not only those that agree with their every talking point? Derek Jeter thinks he’s worth $20 Million/year for 4 years. The Yankees think he’s worth $15 Million/year for 2 years. He gets $15 Million/year for 3 years and everybody is happy. Both sides were represented. This viewpoint may be a bit overstated as there are probably a decent percentage of fair, competent and hard-working members of Congress. The others need to go and quickly. This isn’t American Idol where we may vote for our favorite character. In the eyes of this investor, if you are a member of Congress and you can’t compromise and negotiate or simply won’t you must go… now. Then let them try to get a job and see what it feels like on the other side. Enough venting!
This holiday-shortened week’s economic reports were positive but muted due to the failure of the supercommittee, Europe’s debt crisis and the Fed’s announcement of future stress tests for 31 US banks:
- GDP was revised downward to 2% annualized (from 2.5%) however…
- 3rd quarter GDP was an upgrade from the 0.4% in the 1st quarter and the 1.3% in the 2nd quarter
- The revision was due to a decline in inventories which bodes well for 4th quarter production
- Corporate profits rose by 2.1% in the quarter much better than the 1% in the 1st quarter but less than the 3.3% in the 2nd quarter
For the week, the S&P 500 declined by 4.7% for a year-to-date return of (-) 6.2% including dividends.
Technically, the market tone is in negative territory. The VIX currently sits @ 34.47, well above our comfort level of under 30. The 6-month chart of the S&P 500 shows that the benchmark has dropped below its recent trading range support (green arrow):
On a positive note corporate earnings continue to impress and December is the month that pensions are funded with stocks.
IBD: Market in correction
Hoping all our members had a wonderful Thanksgiving holiday,
Alan and the BCI team ([email protected])