Upload
alan-ellman
View
57
Download
4
Tags:
Embed Size (px)
DESCRIPTION
My article in the Strategies section of the March 2015 edition of "Traders" magazine. Part 1: Covered Call Writing.
Citation preview
strategies
58
www.tradersonline-mag.com 03.2015
Part i: Covered Call Writing
generate Monthly Cash Flow with selling stock Options
Retail investors are always seeking ways to generate higher-than-risk-free-returns and still maintain
capital preservation as a key component to the strategy. For most of us, the thought of combining the
stock market with stock options is far too speculative and not for the average blue collar investor. In
this series of three articles, this myth will be debunked and you will be presented with a set of specific
rules and guidelines geared towards enhancing your annualized returns. In this first article, covered call
writing will be highlighted.
What is Covered Call Writing?Covered call writing is a strategy that combines two
other strategies: buying stock (long the stock) and
selling stock options (short the option). We first buy an
appropriate stock screening process will be discussed
and sell the option or sell via online trading an unknown
person the right but not the obligation to buy our shares
from us at a price that we determine (= the strike price)
and by a date that we determine (= the expiration date). In
return for undertaking this obligation we are paid a cash
premium (= the option premium) which is determined by
the market.
strategies
59
Preview ExampleSince option contracts almost always consist of 100 shares
of underlying stock per contract, we will purchase 100
shares of a company at $48 per share for an investment
or cost basis of $4,800. Once we own these shares and
are therefore in a covered or protected position, we are
now free to sell the option. Lets assume we select the
$50 strike price and agreed upon sales prices. In other
words, the option buyer now controls our shares and has
the right to exercise that option and buy our shares from
us at $50.
Every contract eventually terminates and ceases to
exist. Most option contracts expire on the third Friday of
the month at 4 pm ET (= Eastern Time) and we will be
dealing predominantly with 1-month options. Therefore,
the option buyer can buy our shares from us at $50 at
any time from the sale of the option through 4 pm (ET) on
expiration Friday.
A typical option premium for this hypothetical
example would be $1.50 or $150 for the contract (100
shares). A $150 initial profit on a cost basis of $4,800
represents a 3.1 per cent initial return which annualizes
to 37.5 per cent. After the position is entered, it must also
be managed.
Position management or exit strategies will be
addressed later in this article. For now, lets look at the
two major outcomes that are possible by expiration (4 pm
ET, the third Friday of the month).
(1) The price of the stock remains under $50
In this scenario, the option will expire worthless because
the option buyer will not choose to exercise the option
and buy our shares for $50 when they can be purchased
at market for a lower price. We keep the $150 premium
and still own our shares and are now free to sell another
option the following month.
(2) The price of the stock moves above $50
In this situation our shares will be sold at the strike
price of $50, unless we execute an exit strategy to avoid
our shares being sold. If our shares are, in fact, sold
for $50, we have now generated an additional $200
profit on the stock side of this trade (buy at $48, sell
at $50 x 100). Our total 1-month profit is $350 (= $150 +
$200) less small commissions or a 7.3 per cent 1-month
return.
Three Skills Essential to Master this StrategyBefore risking even one penny of our hard-earned
money, we must master all three aspects of this strategy:
1. stock selection (you can also use Exchange-Traded
Funds or ETFs for short), 2. option selection (strike
price and expiration date) and 3. position management
(exit strategies).
1. Stock SelectionSince we first purchase shares before selling the
corresponding options, we should only use securities
that we would otherwise want to own. In other words, in
our 30-day obligation period we want to own shares least
likely to go down in value. This means that our screening
process must be rigorous and not based on option returns
but rather on the quality of the underlying security. As
a result, we demand stocks that are fundamentally and
technically (price chart) sound as well as meeting certain
common sense requirements like minimum trading
volume.
a. Fundamental Analysis
In this first screen, we demand stocks with strong
sales and earnings growth. There are some excellent
proprietary screens like Investors Business Dailys IBD 50
and SmartSelect screens as well as some free screening
sites like finviz.com.
Dr. alan ellmanDr. alan ellman
Alan Ellman is president of the Blue Collar Investor Corp. He holds a Series 65 and is a national speaker for The Stock Traders Expo, The Money Show and the American Association of Individual Investors. Alan has published fi ve books on stock and option investing as well as over 300 journal articles and has produced more than 200 educational videos.
We will be looking at strike prices near the current market value of the stock.
strategies
60
www.tradersonline-mag.com 03.2015
b. Technical Analysis
Since we are undertaking a 1-month obligation, it is
important to identify trend and Momentum and to have
volume confirmation of these indicators. There are a
myriad of useful technical indicators such as the ones
presented in the chart for Centene Corp (CNC) in Figure 1.
For trend identification,we canuse the20-dayand
100-day Exponential Moving Averages (EMAs).
FortrendandMomentumidentification,wecanuse
the MACD histogram.
For Momentum identification, we can use the
Stochastic Oscillator.
Volume is used to confirm changes in the other
indicators as well as detect divergences.
It is important that we all become proficient at reading
price charts to have the ability to maximize returns when
selling stock options. Although it may be intimidating
initially (it was for me), reading a price chart becomes
quite easy and time efficient as we become familiar with
the parameters we choose.
c. Common Sense Principles
The final set of screens we use in selecting the best
candidates for option-selling fall into the category of
common sense screens. The most important of these
screens is the rule that we never sell an option, when there
is an earnings report due out prior
to expiration of the contract. This
means that we will only hold a stock
for a maximum of two consecutive
months in our covered call writing
portfolio, since most companies
report on a quarterly basis. Other
common sense screens include
minimum trading volume (250,000
shares per day), proper stock and
industry diversification (no one stock
or industry should represent more
than 20 per cent of our portfolio) and
cash allocation (allocate a similar
amount of cash to each position).
Table 1 demonstrates the
screening process (first row on
top) we provide for our premium
members on a weekly basis.
Option SelectionThere are three aspects of an option
we must evaluate before deciding
on which will be most beneficial to achieving the highest
returns while still factoring in capital preservation: a.
strike price (the price we agree to sell our shares for), b.
expiration date of the contract and c. the cash premium
we will receive.
a. Strike Price Selection
Generally, we will be looking at strike prices near the current
market value of the stock. These strike prices are the ones
that will generate the highest returns. The relationship
between the strike price and the current market value of
the underlying security is known as the moneyness of
the option. For call options, if the strike is higher than the
current market value (as it was in the preview example), it
is known as an out-of-the-money strike. If the call strike is
lower than the stock price, it is called in-the-money. If the
two prices are the same, we have the at-the-money strike.
In a bull market environment with strong chart
technicals, we are more likely to choose an out-of-the-
money strike where we have an opportunity to generate
two income streams: one from the sale of the call option
and the other from the share appreciation.
In a bearish or volatile market environment, we are
more likely to select an in-the-money strike which gives
us protection of the option profit. Lets examine this last
sentence: An option premium can have two components
to it: time value (actual profit) and intrinsic value, if the
Figure 1 demonstrates the use of four technical indicators used to identify trend and momentum in order to select the best underlying securities for option-selling. This chart shows a mixed technical picture which will assist in determining strike price and exit strategy choices.
Source: www.stockcharts.com
F1) technical Chart for Centene Corp
strategies
61
navigate through earnings reports which become
public quarterly so we can move in and out of securities
rather easily compared to a longer-term commitment.
Some covered call writers prefer weeklys which may
return higher annualized results.
There are pros and cons to weeklys. For example, we
can use them right up earnings reports and therefore,
hypothetically, 48 weeks of the year. On the other side of
the fence, we have quadruple the commissions and less
time for position management techniques. We must know
all the advantages and disadvantages to each approach
before deciding on which is best for our specific trading
style.
c. Cash Premium Goals
The higher our goal, the greater the risk. This is because
higher premiums mean more volatile stocks and therefore
a greater chance of share depreciation. There is no one
range that is right for every investor.
However, covered call writing is a conservative
option strategy, so a reasonable goal for initial 1-month
returns would fall into the two to four per cent range.
After setting your goal, make sure a trade will meet
this objective before entering the position. Goals can
also be adjusted up or down depending on overall
strike is in-the-money and not profit. For example, if a
stock is trading at $32 and we sell an in-the-money $30
strike for $3, the premium is broken down as follows:
$2 = Intrinsic value: amount strike is in-the-money
and not profit because we will lose $2 on the sale of
the stock.
$1=Timevalue:actualinitialprofit.
By using the intrinsic value to buy down our cost
basis from $32 to $30, our initial profit now calculates to
$1/$30 = 3.3 per cent. This profit is protected as long as
share value does not decline below $30, so our downside
protection is $2/$32 = 6.25 per cent. This means that we
are guaranteed a 1-month return of 3.3 per cent as long
as share value does not decline by more than 6.25 per
cent by expiration Friday. Therein lies the value of an in-
the-money strike. The disadvantage is that we will not
participate in additional profits, if share value appreciates
by expiration.
b. Expiration Date Selection
The shorter the time frame, the greater the annualized
returns. This is why 1-month options have been
highlighted in this article. Monthlys also allow us to
Symbol Company Name
Weekly Rank or Other
Source
PriceOpts Avail (Y/N)
Report Same Store Sales (Y/N)
Pass Fundl And Techl
Screens (Y/N)
Avg. Vol.: >250K
Sh/Day (Y/N)
Pass Risk vs. Reward (Rank 5 or
Higher)
Chart: PRICE BAR above 20
EMA above 100 EMA (Y/N/@)
Tech Ind. OK: MACD & Stoch. (Y/N/?)
Earn. Report In
This Option Month (Y/N)
Passed All Screens - ELIGIBLE CANDIDATES
AAP Advance Auto Parts 26 154.18 Y N Y Y 7 Y Y N
AMAT Applied Materials Inc Other 25.04 Y N Y Y 9 Y Y N
AMBA Ambrella Inc 49 54.69 Y N Y Y 5 Y Y N
ARMK Aramark Other 30.13 Y N Y Y 8 Y Y N
AVGO Avago Technologies Other 103.99 Y N Y Y 9 Y Y N
BIIB Biogen Idec Inc 46 340.87 Y N Y Y 7 Y Y N
CAVM Cavium Inc 16 58.77 Y N Y Y 8 Y Y N
DLTR Dollar Tree Inc Other 68.41 Y N Y Y 9 Y Y N
EA Electronic Arts Inc Other 46.66 Y N Y Y 7 Y Y N
EXR Extra Space Storage Other 59.44 Y N Y Y 9 Y Y N
FFIV F5 Networks Inc 24 133.26 Y N Y Y 9 Y Y N
FL Foot Locker Inc Other 56.70 Y N Y Y 10 Y Y N
IDTI Integrated Device Tech Other 19.90 Y N Y Y 7 Y Y N
The screening process for selecting the most elite option-selling underlying securities should include fundamental, technical and common sense screens as demonstrated in the BCI Weekly Stock Screen of December, 14th 2014.
Source: Blue Collar Investor
T1) screening Process for selecting the Best Option-selling Candidates
strategies
62
www.tradersonline-mag.com 03.2015
market environment, personal risk tolerance and chart
technicals.
3. Position Management (Exit Strategies)Once we have entered our covered call trade, we now
move into management mode. There is no way to give
This options chain for the one-month $77.50 strike price shows a bid-ask spread of $1.94 to $1.97. Since we sell at the bid, our initial return that should be used when calculating initial profit is $1.94.
Source: Blue Collar Investor
F2) Options Chain for Facebook from December, 17th Dec. 2014 this critical subject appropriate justice within the context of this one article. However, there are several key points
that must be discussed.
Events that May Create an Exit Opportunity Stockpricedeclinesprecipitously.
Stockpricegapsdown.
Stockpriceacceleratesexponentially.
An ex-dividend date is scheduled prior to contract
expiration.
Thepriceofthestockisabovethestrikeatexpiration
with no earnings due out the next contract.
The price of the stock is above the strike with an
earnings report due out the following month.
All exit strategies begin with buying back the option.
This will relieve us of our option obligation, and still
leave us long the stock. Now we are in a position to
sell another option, sell the stock or take no immediate
action. An excellent guideline to use, when a stock price
is declining, is to buy back the option when its value
declines to 20 per cent or less of the original sale value
in the first half of a contract or ten per cent or less in the
second half of a contract.
Lets look at a real-life example for Facebook (FB) (see
Figure 2). On 17th of Dec 2014, Facebook was trading at
$75.73. The 1-month January out-of-the-money $77.50
strike generated $194 per contract which represented
a 2.6 per ent 1-month return or 31 per cent annualised.
If the stock price should decline, so will the value of
the corresponding call option. Should the option value
decline below $0.40 in the first half of the contract, the
20 per cent guideline tells us to immediately buy back
that option. If option value declines below $0.20 in the
second half of the contract, we also buy back the option
and evaluate what our next step will be. Factors such as
time to expiration, overall market assessment, personal
risk tolerance and chart technicals will influence our
position management decisions.
ConclusionCovered call writing is a low-risk strategy geared to
retail investors. The trades are constructed to generate
monthly cash flow keeping capital preservation as a
high priority. The three skills that must be mastered to
justify risking our hard-earned money, when using this
trading approach, are stock selection, option selection
and position management.
In Part 2 of this three-part series we will discuss
put-selling.
Strategy Name: Covered Call Writing
Strategy Type: Cash Flow Trading
Time Horizon:Usually longer-term position in a stock plus max. 30-day holding period of short option
Setup:
Technical and fundamentally sound stock, choose short option strike price depending on market state (general hint: at the money, bull market: out of the money, bear market: in the money)
Entry:When holding the stocks, sell 1 options contract of the new series for each 100 shares
Stop-Loss:Optional; put stop loss for stock in case it should massively decline
Take Profit:Buy back option once it falls to 20% (10%) of price shorted in first (second) 15 days of ist 30-day max holding period
Trailing-Stop: -
Risk and Money Management:
Keep positions small as downside protection is limited; diversify positions across sectors
Strategy Profile:
Less risky than outright stock position as short option delivers premium in case of declining or constant stock price; higher hit rate and smoother profits over time; max. profit is capped at strike price of short option
Strategy Snapshot