Whenever a study is performed on covered call writing a stock is selected and the nearest out-of-the-money (O-T-M) strike is sold. This is repeated over and over and then the results are compared to the overall market performance. The usual conclusion is that covered call writing slightly outperforms the overall market but with much less volatility. What too many analysts overlook is the fact that the O-T-M strike has its advantages and disadvantages and to use it to our greatest advantage we must explore and understand the circumstances as to when to use this strike and when to avoid it.
An out-of-the-money strike is one where the option’s agreed upon sales price (of the equity) is HIGHER than the current market value of the stock. If we buy a stock for $28 and sell the $30 call option, that strike price is out-of-the-money.
When to use O-T-M Strikes:
Consider this strike the most bullish of our covered call positions. The greatest benefit will come if the stock appreciates in value from the time of purchase to expiration Friday. The closer it comes to the strike price (or surpasses it), the more money we realize and the returns can be eye-popping! So let’s take a common-sense look at some of the factors that would encourage us to favor this strike price:
- A bullish overall market with low volatility
- The stock chart is technically sound
- The positive technical indicators are all on high volume
- The positive momentum is continuous and not the result of a quick spike which could snap back
- The stock’s industry is also technically strong
Advantages of the O-T-M Strike:
- We can benefit from both the option premium AND the stock appreciation. 1-month returns can easily end up between 10-20% if the strike price is reached.
- Less chance of assignment (your stock is sold at the agreed upon strike price) if we prefer to hold the stock
- Time decay works in our favor since the premium consists only of time value. This means that as we approach expiration Friday, if the strike is still O-T-M, the time value will approach zero.
Disadvantages of the O-T-M Strike:
- This strike offers the least amount of downside protection of the overall position and no protection of the option premium
- May be a poor choice for those with low risk tolerance
- The initial option premium is low, so the 1-month return may not be impressive if the stock does not appreciate in value
- This strike has a low delta (amount an option value changes in relation to a $1 change in stock price). If the stock drops in value, the corresponding option will not change as much, thereby making it more expensive to buy back the option for an exit strategy. I-T-M strikes have the highest deltas.
O-T-M strikes and the Ellman Calculator (multiple tab):
- The yellow highlighted rows show O-T-M strikes
- The second row down shows NFLX purchased @ $75 and the O-T-M $80 call sold for $2.60
- This represents a 3.5%, 1-month return
- If the stock appreciates to or beyond the $80 strike, an additional 6.7% will be realized
- Total possible 1-month return is 10.2%
O-T-M strikes have an important place in our portfolios. Those with greater risk tolerance will tend to use them more than those with less. No matter who is writing these calls, they must be used to our greatest advantage. Select the strongest stocks in the strongest industries that have been uptrending with low implied volatility (avoid violent whipsaws on the charts). When constructing your portfolio for the month you can mix or ladder your strikes using a higher percentage of these O-T-M strikes the more bullish you are on the market and decreasing that percentage if you turn bearish. By doing so we are not guaranteeing success but dramatically throwing the odds in our favor of winning more frequently than losing. Some investors will do a combination of covered call writes and long stock ownership in a strong bull market. For example, if you own 300 shares of company XYZ you may sell two O-T-M strikes and allow the remaining 100 shares to appreciate without the restriction of a call option obligation.
Don’t miss out:
Monday December 20th is the last day of our DVD holiday sale. All orders finalized by 12PM EST will be shipped for FREE via priority mail (within the US) so that they will arrive on time for Christmas. Thanks to one and all for the amazing response we received for our new DVD program. Here is the link to our store:
Premium members please enter the store via the premium site for an additional discount:
I have been receiving dozens of emails asking why I have been so bullish on the economy over the past several months (I use the term “moderately bullish”). I am far from an economist and base my decisions on the same information available to other Blue Collar Investors. The economic reports and general market technicals along with the market volatility have simply been positive for a long time. Could it better? Sure. But it’s still favorable for our covered call environment. This week’s reports were no exception:
- On Friday, the Conference Board reported that the index of leading economic indicators rose 1.1% in November and accelerated to an annual rate of 8.6% the past 3 months.
- Industrial production rose 0.4% from October to November
- The FOMC confirmed that it will continue to purchase $600 billion in Treasuries by the 2nd quarter of 2011 to help prevent deflation and assist with the economic recovery.
- Retail sales rose for the 5th consecutive month in November at a better-than-expected rate.
- New home construction starts rose 3.9% in November, higher than anticipated and the October rate was revised upward.
Let’s view a 6-month chart of the S&P 500 with its 50-d simple moving average:
- Since the beginning of September (green column) the price of the index has appreciated in value remaining above the 50-d sma (blue arrows) moving average
- The 50-d sma served as support in early December (red arrow)
IBD: Uptrend under pressure.
BCI: Moderately bullish but taking a slightly more defensive posture due to the market appreciation noted above. Currently selling an equal number of O-T-M and I-T-M strikes.
Happy holidays to you and your families.
Alan and Linda and the BCI team