When we sell cash-secured puts with the goals of generating cash-flow while simultaneously crafting trades with low probability of exercise, strike selection becomes critical. To accomplish these objectives, we can turn to implied volatility (IV) and Delta to assist in our trade decisions. We will utilize deep out-of-the-money (OTM) put strikes, with low probability of being subjected to exercise, and, in return, accept lower annualized premium returns.
What is implied volatility?
This is a forecast of the underlying security’s volatility as implied by the option price in the marketplace. BCI’s Expected Price Movement Calculator will facilitate computing upper and lower price ranges with an approximate 84% accuracy.
What is Delta?
The approximate probability of an option expiring in-the-money (ITM). If we want craft trade low probability exercise, we focus on low Delta put strikes. If our intention is to set up put trades with a 90% probability of avoiding exercise, we look for put strikes with deltas of -10 or less (put strikes have deltas showing a (-) sign, since put value is inversely related to share price movement.
Real-life trade with Mastercard Inc. (NYSE: MA)
- 2/28/2024: MA trading at $474.75
- 2/28/2024: The IV of the $475.00 put strike for the (1-month) 3/28/2024 expiration is 15%
- Goal is to construct a trade with a 25% or better probability of success (option expiring OTM)
- We will use IV to establish an approximate 84% probability of success trade
- We will use a Delta < 25% to initiate a trade with < 25% risk of exercise
Using implied volatility and the BCI Expected Price Movement Calculator to create an 84% probability of success trade ($455.00 OTM put strike)
Using Delta (-0.225) to create a 77.50% probability of success trade (MA option-chain on 2/28/2024)
- Using IV and the BCI Expected Price Movement calculator, leads us to the $455.00 put strike and an 84% probability of success trade
- Using a -22.5% Delta points us to the $460.00 put strike and a 77.50% probability of success trade
MA calculations using the BCI Trade Management Calculator (TMC)
- The $455.00 strike (84% probability of success) has an initial annualized return of 5.40%
- The $460.00 strike (77.50% probability of success) has an initial annualized return of 7.50%
Discussion
Delta and implied volatility can be utilized to create high probability of success trades when seeking to generate cash-flow, while simultaneously avoiding option exercise and having shares put to us. The tradeoff is lower premium returns than traditional selling of cash-secured puts. These stats and calculations are not 100% precise but are statistically meaningful and will provide framework guidelines as how to craft our trades, factoring in our goals and personal risk-tolerance.
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Alan,
Thanks for this excellent article.
I have a question about dividends. You have written that if we want to avoid selling our shares, we should sell deep out of the money calls and avoid ex dividend dates. I get the part about the strikes but slightly unclear about the dividend date.
Let’s say the date is August 15th. Can I sell the call on the 16th? When is it safe to sell and not risking the sale of my stock?
Thanks a lot.
Joe
Joe,
Early exercise of our covered calls is extremely rare. When it occurs, it is usually related to ex-dividend dates, as you suggest.
When early exercise does transpire, it will be the day prior to the ex-date. The option holder (buyer) will then own the shares on the ex-date and be eligible to receive the dividend distribution in a week or two.
This means that we are safe selling the option on the ex-date or later. In your hypothetical, September 15th or later.
Alan
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 07/26/24.
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Alan,
I a recent webinar you said tat in the bci methodology we almost always sell otm puts.
Okay, when do you sell itm puts, even though I understand that it is rare?
Thanks, Alan
Eileen
Eileen,
An investor may want to sell an ITM cash-secured put when the goal is the purchase the shares as soon as possible (after expiration) and at a discount as a result of the put premium.
This will occur unless share price moves up to and above the ITM put strike, which then becomes an OTM strike.
Alan
Hi Alan,
Sorry to bother you. I am basically a value investor, but kind of boring, need some action and income. Bought a copy of the above book, just what I am looking for. Have been running a paper $50,000 account for about a month, all going well.
I am near the end of the book and do have a question. I am looking at the KOR’s situation on page 228. The position is a short deep in the money call. The book has the break even at price minus premium. Would it not be strike plus premium?
Thank you for your time, and again what an interesting book.
Regards,
John
John,
Glad you’re benefitting from my book.
Let’s break down this KORS trade and evaluate both BE price points, the one published in the book ($86.90) and the one you inquired about ($97.00 – the $90.00 strike + the $7.00 premium)).
The trade is as follows:
Buy KORS at $93.90
STO the ITM $90.00 call at $7.00
Now, breakeven is defined as the price point at which there is no gain or loss in the trade.
BE #1 (your inquiry): If share price moves up to $97.00 from the original $93.90, the $90.00 strike remains ITM and the shares will be sold at $90.00. We will profit by 3.44% (see screenshot). Profit does not = BE.
BE #2 (in book): If share price moves down to $86.90, we have a share loss of $7.00 ($93.90 – $86.90), but an option gain of $7.00, thereby resulting in an unrealized breakeven. It will become a realized BE if shares are sold at $86.90.
In the screenshot, using our Trade Management Calculator (TMC), we see a 30-day trade, resulting in an initial time-value return of 3.44%, 41.91% annualized (brown cells). Downside protection of that time-value profit is 4.15% (purple cell).
The BE price point is $86.90 (yellow cell).
CLICK ON IMAGE TO ENLARGE & USE THE BACK ARROW TO RETURN TO BLOG.
Alan
Alan,
Thank you for your guidance and quick response to my question.
Regards,
John
Hi Alan,
If I want to do a leap, how do I account for the dividend that is paid quarterly in the TMC calculator?
Thanks,
Tom
Tom,
Please give me an example of the trade you are considering.
Are you selling LEAPS against long stock positions?
Thanks,
Alan
Alan,
I was looking to do a leap call option using the high dividend yield report. The stock was SPG.
So i was looking to do a deep ITM option exp date 6/20/25. The first option i looked at was 140.00 the stock was 154.28. Premium was 22 but it pays a dividend so do you not worry about the dividend? or if you do, How do you factor it in using TMC.
Thanks,
Tom
Tom,
On the ex-dividend date, add the future dividend distribution to the LEAPS premium ($22.00) and that will ensure that your return calculations are accurate. If the dividend is $2.00, change the $22.00 to $24.00.
Keep in mind that selling shorter-dated options will result in greater annualized returns.
Alan
Premium members:
This week’s 4-page report of top-performing ETFs, along with our sample trade of the week, has been uploaded to your premium site. The Select Sector SPDR section is now crafted to align with our streamlined (CEO) approach to covered call writing. The report also lists Top-performing ETFs with Weekly options, mid-week market tone as well as the implied volatility of all eligible candidates.
We have also included a sample trade taken from one of our BCI watchlists.
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Alan and the BCI team