Why not sell both covered calls and cash-secured puts on the same stock? I’ve been asked this question numerous times. There is actually a strategy that incorporates both BCI go-to strategies into one overall game plan. It is known as the covered strangle.
Components of the covered strangle
- Buy stock
- Sell call option
- Sell put option
The top two components represent the covered call aspect and the last is where we sell the cash-secured put.
Goals
We are looking to generate monthly cash flow while at the same time positioning ourselves to buy a stock at a “discount” should the share price expire below the put strike. Inherent in this plan is that we are willing to own twice as many shares as we currently own even if share price moves below the put strike.
Obligations (assuming no exit strategy intervention)
- Sell stock if share price moves above the call strike
- Buy stock if share price moves below the put strike
Risk
The risk is to the downside only. If there is price decline below the put strike, we double our position with half purchased initially and the other half at the put strike. Share price can move to zero. Of course, we always have our exit strategy arsenal to mitigate losing positions.
Strike price selections
We start by determining our 1-month (or other time frame) time value return goals, in my case it’s 2% – 4%. We use the Ellman Calculator to determine which strikes will fall into this range. We then fine tune our selections with these guidelines:
- The more bullish we are, the deeper out-of-the-money calls and closer to-the-money puts are selected
- The less bullish we are, the closer to-the-money calls and deeper out-of-the-money puts are chosen
All strikes must offer our initial time value return goals.
Real-life example with Applied Materials (NASDAQ: AMAT)
AMAT Options Chain with Calls and Puts
The yellow fields in this option chain highlight the out-of-the-money $57.00 call (with AMAT trading at $56.69) and the out-of-the-money $55.00 put. The bid prices (circled in red) are $1.90 and $1.36 respectively.
Maximum profit
The formula to determine maximum profit: Call premium + Put premium + share appreciation to the call strike
The cost basis is the mid-point between the cost of shares initially purchased and the (put strike – put premium).
Let’s calculate per-share:
[($1.90 + $1.36) + $0.31]/[$56.69 + ($55.00 – $1.36)]/2
$3.57/$55.17 = 6.47%
Discussion
For those investors looking to generate monthly cash flow while at the same time positioning to buy that same stock “at a discount” and doubling our position size, the covered strangle may be an appropriate strategy to initiate.
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“How to Generate Monthly Cash Flow and Buy a Stock at a Discount Using Two Low-Risk Option Strategies”
Market tone
This week’s economic news of importance:
- Consumer credit march $12 billion ($14 billion last)
- Job openings March 6.6 million (6.1 million last)
- Producer price index April 0.1% (0.3% expected)
- Weekly jobless claims for week ending 5/5/18 211,000 (215,000 expected)
- Consumer price index April 0.2% (0.3% expected)
- Federal budget April $214 billion ($182 billion last)
- Consumer sentiment May 98.8 (98.7 expected)
THE WEEK AHEAD
Mon May 14th
- None scheduled
Tue May 1th
- Retail sales April
- Home builders’ index May
- Business inventories March
Wed May 16th
- Housing starts April
- Building permits April
- Industrial production April
Thu May 17th
- Weekly jobless claims through 5/12
- Philly Fed index May
- Leading economic indicators April
Fri May 18th
- Advance services Q1
For the week, the S&P 500 moved up by 2.41% for a year-to-date return of 2.02%
Summary
IBD: Confirmed uptrend
GMI: 6/6- Buy signal since market close of April 18, 2018
BCI: Selling an equal number of in-the-money and out-of-the-money for new positions. The VIX has settled into a bullish range.
WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US
The 6-month charts point to a slightly bullish tone. In the past six months, the S&P 500 was up 5% while the VIX (12.65) moved up by 10%. The volatility trend as well as economic news and corporate earnings bode well for profit opportunities.
Wishing you much success,
Alan and the BCI team
In your opinion what is the minimum amount of money in an account to write covered calls in a manner that is more profitable than just trading options or some other strategy?
Joanna,
In my view, any option strategy we use should incorporate diversification as an essential requirement. For covered call writing, a useful guideline is to start with $35k – $50k when using individual stocks or $10k – $15k when using exchange-traded funds.
For those who need to build portfolio wealth to get to these levels:
https://www.thebluecollarinvestor.com/stock-investing-for-students/
Alan
Alan,
If my main focus is portfolio overwriting should I determine the strike price to sell CCs as a percentage of annual/monthly return, as a percentage of the current price, or some other metrics about that etf’s/stock’s history?
Thanks,
Tony
Tony,
First determine your monthly or annualized goal for additional portfolio returns from selling call options. Let’s say that goal is an additional 6% per year and we decide on monthly options. That computes to 1/2% per month.
Next, we check an option chain for out-of-the-money strikes that yield 1/2% initial time value return. If our stock is trading at $80.00, we would look for out-of-the-money strikes that yield about $0.40.
Factor in earnings reports and ex-dividend dates and we’re good to go.
Alan
Alan,
Regarding the 20/10% guidelines and setting buy-to-close orders after setting up the initial trade:
– Can we automate the process further so that we can first buy back the option and then sell the shares without being in front of a computer?
– Here I am assuming that we are selling the shares. But I not sure what the answer is if we wanted to roll down here as opposed the selling the shares. Is it possible to sell or roll down in this situation?
Thanks,
Duminda
Duminda,
Here is my understanding of the 20/10% rule process.
The 20/10% rules apply when the price of the underlying declines to a point that the premium to buy back the option is 20% or 10% of your original sale premium for the option. (20% Weeks 1-2, 10% Week of 4 week option).
I do set a limit order for the Buy To Close when I see the stock declining and the premium approaching the 20% or 10% limit.
The strategy is to then wait to through end of Week 2 or Week 3 for a Hit the Double sell to open premium price which you extrapolate using Delta and Gamma values. I do set a limit order for the STO (reduced original premium because of time decay) since the premium could be reached at market open or sudden surges in the price of underlying. Nice when that works. You can fine tune the limit order value as needed.
You can, if the underlying has not recovered in price to your original purchase price by the end of Week 3 of 4, decide to roll down to a lower strike to recover some of your losses. You are ahead by the premium received but the if the underlying does recover in price, you limited your profit by the roll down strike.
The only time you want to sell the underlying in the above process is when the fundamentals are negative and latest news for the underlying indicate that a recovery in price is not indicated and you want your cash back. It that happens, instead of a buy to close at the 20/10% point, you would do complete unwind of your position.
You do not know in advance whether you will roll down later or fulfill a Hit the double premium. Tough to automate that decision.
The last 2 months my roll down experiences have worked against me, as the underlying did recover while my option was assigned at the lower strike. This is even after a stock price remained stable for a some time. My luck.
In one roll down case, the underlying declined further from general market news and I was able to buy back the roll down option at 10% of my STO roll down value. That was interesting, sort of a “mini-double” event.
Mario
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Duminda,
Terrific points from Mario and they should be factored into your investment decisions.
Some brokers offer OTO (one-triggers-other) orders where a second order is executed if an initial order is executed first. So, for example, if a short call is closed, then the shares are sold. Check with your broker if such a platform is offered. If not, and this is what you would benefit from, check out our file of online discount brokers to see if you can find one that does; The file can be found here (enter your email address and you’re in):
https://www.thebluecollarinvestor.com/free-resources/
Some brokers allow net credit limit orders, where an option is bought back and the shares are sold at the same time as a net credit limit order. Let’s say the stock is currently trading at $30.00 and the option “ask” price is $0.10. Set up a net debit limit order at $29.90. Again, check to see if this is offered by your broker.
Alan
Allen,
Friday, I sold to open AMTD (TD Ameritrade) my first paper-trade put. We Sold a 7 day put at .81 with strike of 61.50. Stock was trading at $61.35 at the time.
After hours on Friday the stock dropped $3.51 or 5.7% with I assume was low volume. I’m trying to avoid a $270 loss within hours of our first trade (-:
If I buy to close first thing Monday it might cost me $75 if the options chain stays the same at market open. Will the options chain stay the same at Monday open or will the after hours price be reflected first thing Monday?
What is the better strategy:?
A. Get pushed the stock – l do like the stock
B. Roll out and down first thing Monday (thinking this large price drop might encourage put buyers to put the stock to me early Monday).
C. Wait until Execution Friday of next week to make any decisions
Thank you again!!
Anthony
I can’t confirm the after-hours movement you allude to. It looks unchanged to me. I wouldn’t pay too much attention to after-hours quotes unless they’re on the futures market where they’re legitimately trading. A lot of times market makers will just set very wide bids/asks on stocks which can even have an impact on otherwise liquid stocks. When an unsuspecting retailer enters a trade the way most retailers do (market order) they get the market. So, they might sell a 1 lot of a stock they own and get scalped for several hundred dollars. The market exists to steal from you, not give to you. So, you have to know the game. Don’t fall into those sorts of traps and you can make a really nice return. But, nobody can afford to take a 3.5% haircut on nothing more than ignorance.
In short, I think the trade is a one-off and there isn’t any good reason for the company to have just lost 3.5% of its value. Expect a normal open on Monday unless we have a massive geopolitical event or something noteworthy.
It’s important to remember that most pricing and repricing in the market is merely “noise” and can safely be ignored. If there’s a good reason for the repricing like a massive news event or earnings then there may be reason to see the price action as more than noise. See also, Symantec recently–that is a potentially major development in the stock and not just noise.
I will do this if I want to aggressively buy down my break-even point on a stock and I’m pretty bullish on the stock. The CBOE calls this strategy a “Covered Combo.”
I may manage the short put more aggressively as it represents increased downside risk. I will typically target a profit on the short put at about 50% of the initial premium received. It’s enough to get the additional benefit of increased premium income while simultaneously choosing to limit that exposure where possible.
http://www.cboe.com/strategies/intermediate/equity/covered-combinations-strategy/part1
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 05/11/18.
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
Since we are near the end of Earnings Season, be sure to read Alan’s article,”Constructing Your Covered Call Portfolio During Earnings Season”. You can access it at:
https://www.thebluecollarinvestor.com/constructing-your-covered-call-portfolio-during-earnings-season/
Mea Culpa… this posting was originally posted to the “Ask Alan Video” last night instead of posting it here. Sorry for the confusion.
Best,
Barry and The BCI Team
[email protected]
Alan:
Thank you for all your premium membership benefits including your wonderful weekly stock and ETF reports . The equities that you screen are fantastic. I have been doing paper trading and I am now very comfortable and ready to enter the June 18 expiration contract.
My question is when do I do that? Do I enter on the Expiration Friday this month on 5/18 or before that? I read on your blog, that you prefered the following Monday following the expiration Friday (which means 5/21) to enter. If you could please confirm that I would greatly appreciate it. Again thank you so much for you fantastic contributions.
Best
Kaveh
Kaveh,
Thank you for your generous feedback.
I prefer to enter my new positions on the Monday of the new contract month unless I am rolling options from the previous month. By entering Monday (or even Tuesday if Monday is not convenient) we are avoiding weekend risk and losing almost no time value premium as market makers factor in weekend time value erosion on Thursday or Friday prior to the weekend.
Alan
Hi Alan:
Thank you very much for your reply. I have a follow up question that I wonder if you be kind and clarify that for me too. Looking beyond the June contract, some stocks that I really like (from our premium report list) have option schedules assigned to them for Aug and/or September but not July. For instance, Atlassian Corp, Team has June but no July contract. The next one for Team is September. How do you handle that? I am thinking ahead in terms of exit strategies like rolling it out….. in this case will you roll it out to September if rolling makes sense?
Thank you in advance
Best
Kaveh
Kaveh,
Search the internet for “option expiration cycles” (include the quotes) for understanding how option months work (check Investopedia). Also “cycles & month codes” (include the quotes) (CBOE has a nice table.)
Here is a short explanation as I understand it.
There are always 4 months with options. Stocks are assigned to one of 3 expiration cycles (Jan, Feb, March, also called Cycle1, Cycle2, and Cycle 3) with 4 quarterly option months in each cycle.
With the current option rules there is a front month, a near-term month and 2 quarterly months available. This means if it is May, every stock has a May and Jun option month available for trading, but not necessarily July yet (see below).
The stocks you were looking at were Feb. and March Cycle stocks, which have Aug and Sept months, respectively.
Let’s look at the 3 possible Expiration cycles in May (before Expiration in May) of any year:
****
January cycle stock has option months for: May (current), June (near-term) , July (quarter), Oct. (quarter)
After May expiration, will change to: June, July, Oct, (quarter) Jan (quarter)
****
February cycle stock has option months for: May (current), June (near-term) , Aug. (quarter), Nov. (quarter)
After May expiration, will change to: June, July, Aug (quarter), Nov. (quarter)
****
March cycle stock has option months for: May (current), June (near-term) , Sept. (quarter), Dec. (quarter).
After May expiration, will change to: June, July, Sept. (quarter) Dec. (quarter)
****
Hope this helps.
Mario
.
“All Stars of Options” event at the Las Vegas Money Show Bally’s Hotel:
A special thanks to those BCI members who attended…great to meet you in person.
CLICK ON IMAGE TO ENLARGE & USE THE BACK ARROW TO RETURN TO BLOG.
New Blue Chip (Dow 30) Report now available
Premium members: The latest Blue Chip report has been uploaded to the member site to highlight the best-performing Dow 30 stocks eligible for option-selling.
We lost 2 stocks from the May report and added 3 others.
Moving forward, this monthly report will be published the week prior to the new monthly contract period.
Alan
Alan,
very interesting article on Covered Strangle.
I did not have time to read it before, and I am today fully invested, but I am eager to try it out next week, after several of my positions will probably be assigned to me.
Thanks again and again for sharing your best ideas with us.
Roni
Premium Members,
The Weekly Report for 05/11/18 has been revised and uploaded to the Premium Member website. Look for the report dated 05/11/18-RevA. The reason for the revision is that we received updated risk/reward data today.
No stock pass/fail decisions were impacted.
Best,
Barry and The Blue Collar Investor team
Alan,
I have a question about LGIH. I own shares and sold a covered call in previous months. On 5/8 they had there Earnings report. I held onto the stock but did not sell the call because of the principals you teach in your book. LGIH seemed to have beaten earnings and the stock jumped in the morning, but has plummeted since. I have been trying to find information on why the stock has declined so swiftly with beating earnings. I have been using FINVIZ. Is there a reason why the stock has dropped so quickly with the positive earnings? And am I looking in the wrong website for my current news? Thanks so much for any help you can enlighten me with.
Thank you,
Kerry
Kerry,
You’re right that information regarding this price decline is hard to find. It appears it started prior to the earnings release (May 8th) on May 4th. I did find a press release put out by the company on May 3rd:
http://investor.lgihomes.com/news-releases/news-release-details/lgi-homes-inc-reports-april-2018-home-closings
Now this was published by Investor Relations of the company itself which always puts a positive spin on things. It is possible that the information contained in the press release disappointed the “market” as share decline started the following day.
Going to the Investor Relations link of a company’s website is one way to access additional information.
What ever the cause of price decline, we must react decisively with our exit strategy arsenal to mitigate losses whether its rolling down or closing the entire position.
Alan
Kerry and Alan,
Attached is a Fidelity price chart of LGIH with Earnings markers going back 10 months to show the previous 3 earnings points..
Interesting to note that in the last 4 earnings report there was a negative drop / swing of the price chart. No sustained gap up occurred. Recovery time for a new breakout took, from the oldest date, 53 days, 12 days, 20 days. In all cases, the stock eventually recovers back the price it had before the earnings reports.
Mario
Kerry,
Had one other comment regarding you original question.
You said you held LGIH through Earning Report by not selling the option but holding onto the stock per the BCI Methodology.
Just want to make clear that, unless you are talking about a stock you want to hold and not sell at all, that the BCI methodology says to not hold onto the stock through earnings reports in addition to not writing any options. There is too much risk and the LGIH results show that.
The market performs what seems are illogical responses when earning are positive. I have been seeing sudden changes in prices just one or two days before expiration for the last few months when I was thinking of being in-the-money.
I also had LGIH in the past but it is not in my current holdings.
Mario
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.
New members check out the video user guide located above the recent reports.
For your convenience, here is the link to login to the premium site:
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Alan and the BCI team
Good Morning
Thank you very much for clearing up the cycle question! I think I understand the option cycles now, it took me a while but I’ve got it.
On a different note, I’ve been using the premium site’s Daily-CC-checkup spread sheet for my practice trades. This spread sheet is fantastic! I have gone thru the return calculations that you have in there and I am very comfortable with them. I have one question regarding the ‘ Today’s option price’ tab in Daily-CC-Checkup spread sheet and the question is the following:
Do we use the Bid price for that tab or do we use the ask price for that tab? because the spread sheet uses the ‘Today’s option price’ to calculate the return on several alternatives using that tab as the cost of buying back the option. If that is the case should I use the ask price to be more accurate? I have been using the Bid price for that tab.
Again thank you very much in advance.
Best
Kaveh
Kaveh,
The current option price is most relevant if we buy back the short call. Therefore the “:ask” price is more appropriate. However, since our educated BCI community is familiar with how to leverage the “Show or Fill Rule”, using the mid-point of the bid-ask spread (slightly favoring the “ask” price)would be most accurate. For example, if the spread is $2.50 – $3.00, I would use $2.80 in the option current price cell.
Alan
I have a question on the weekly ETF report regarding the charts.
Let’s take the top rated ETF XOP for example. Last week 5-9-2018 lists XOP up 26%. This week 5-16-2018 XOP is up 25%. To me this is down 1% from last week; however, the chart shows an uptrending pattern from last week and not down. Why is this?
Thanks;
Terry
Terry,
The charts we publish in our weekly ETF reports are 3-month charts. Each week, the starting and ending dates charted are moved up 1 week. Therefore, comparing last week’s +26% and this week’s +25% is not comparing apples to apples since there are different starting points.
As we see from the latest report, energy-related ETFs dominate.
Alan
Alan,
The IBD 50 is a fabulous choice to screen for stocks with both fundamental and technical traits the covered call writer would seek. Increasingly, however, the stocks on this list are $100+ which means a 5 figure commitment in order to write just one option. For a large percentage of investors, this could push their portfolio to a state where they are not properly diversified. Is there any other screen you are recommending as a starting point that may produce a wider variety of underlying stock prices?
Thanks for the books and the methodology.
Jon
Jon,
It seems that stock splits are a thing of the past. However, there are always ways to manage a challenge, in this case rising share prices.
The use of exchange-traded funds will allow for instant diversification, thereby requiring less securities and lower cash requirements. Our current ETF Report lists 8 securities priced under $30.00.
We can also expand our screening beyond the IBD 50. BCI uses our database of over 3000 stocks in addition to the IBD 50 to create the watch list for our members and there will generally be several lower-priced securities.
A free-screening site is finviz.com for those who are not premium members. Enter parameters that simulate the BCI methodology. It’s not as precise as our member reports but an alternative to locating lower-priced stocks.
Alan