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Our covered call writing and put-selling portfolios have been significantly impacted the past few weeks from extreme market volatility. In addition to rising wages, inflation concerns and projected interest rate hikes, volatility based exchange-traded notes are also playing a role in the market decline. 

What is the VIX?

The VIX is also known as the CBOE Volatility Index. It demonstrates the market’s expectation of 30-day volatility based on option-pricing. It measures market risk and is frequently called the investor fear gauge.

What are exchange-traded notes (ETNs)?

ETNs are unsecured debt securities based on the performance of a market benchmark, like the VIX, less applicable fees. They are traded on major US exchanges during traditional trading hours. ETNs have a maturity and are backed only by the credit of the issuer, a key factor to consider. When they mature, the financial institution takes out fees and gives the investor cash based on the performance of the underlying index.

Risks of ETNs

  • Investors must be directionally correct on index and cover expenses as well
  • The issuer may not be able to pay the cash on time
  • The issuer may default on the loan
  • Limited secondary market may result in large losses or gains
  • FINRA has warned against volatility-linked ETNs and even required Wells Fargo to pay investors $3.4 million for improper sales of these products

Current market and ETNs

In 2017, the VIX was historically low, remaining under 15 while the S&P 500 returned more than 20%. Many hedge funds were playing the current market conditions by purchasing stocks and ETNs that targeted a declining market volatility. This strategy works when the market continues to accelerate and volatility remains low. But we all know what transpired the past few weeks. Wage growth, inflation concerns and projections of interest rate hikes rattled the market causing significant price declines and dramatic increases in volatility. The screenshot below shows a tripling of the VIX in the past month:

Volatility Spikes as Market Declines

Many inverse-VIX ETNs lost more than 90% of their value as a result of the trade no longer working. The chart below, shows the VelocityShares Daily Inverse VIX Short-Term ETN (XIV) dropping from 144 to 5 in a few days:

XIV Drops more than 90% in a Few Days

These events with volatility-based inverse ETNs have resulted in a secondary exacerbation of market volatility as institutional investors unwind these ETN positions and sell stock shares to reduce their leverage. Investors are concerned about VIX-related trading volume and revenues declining and impacting the CBOE itself because 25% of CBOE global market revenue is generated from VIX-related products. This concern is reflected in the chart below:

CBOE Price Decline

Discussion

Volatility-based ETNs are extremely risky and not appropriate for most retail investors. However, it is beneficial to understand how these products may be a secondary factor in impacting our option-selling positions in extreme market conditions.

Volatility and our covered call positions (re-published from last week’s blog commentary)

Many of our members who have never experienced the type of market volatility we have experienced recently have been inquiring about how to incorporate volatility into our investment decisions. I have moved from more aggressive positions (out-of-the-money strikes) to more defensive positions (in-the-money strikes). Both can generate cash into our brokerage accounts. I will also be discussing volatility in this weekend’s blog article.

All other factors being the same, I favor OTM strikes when the VIX is below 20 and either declining or consolidation (moving sideways). I favor ITM strikes when the VIX moves above 20 and confirms the inverse relationship between the VIX and the S&P 500.

It is so important to trade in a non-emotional manner as aberrations like we recently have been experiencing will rear their ugly heads from time-to-time and we need to eliminate fear and greed from our trading influences.

It is true that a market acceleration can make ITM strikes appear to be a bad decision but in an environment of high volatility, defensive trading makes more sense especially for retail investors looking to generate cash-flow in a low-risk manner.

The chart I created below highlights how I address volatility and my option-selling positions as they relate to volatility:

Volatility and our Covered Call Positions

Upcoming speaking event

POINT, or Phoenix Options Investors Networking Traders,
March 2 @ 6:30 pm – 9:00 pm 

Friday March 2, 2018 6:30 PM to 9:00 PM   Rio Salado Community College 2323 West 14th Street · Tempe, AZ

Find out more »

American Association of Individual Investors: Phoenix Chapter
March 3 @ 9:00 am – 12:00 pm 

Saturday, March 3, 2017 9:00 AM    Registration/Social Time 9:00 AM    Refreshments Time 9:30 AM    Program Time Location: Jewish Community Center 12701 N. Scottsdale Road Scottsdale, Arizona 85245 DIRECTIONS: The Center is 3.66 miles south of 101 on Scottsdale Road. The Center is on the left as you drive south from 101 OR Take 101 to E. Cactus. Drive 2 miles west on E. Cactus to N. Scottsdale Rd. Turn right on N. Scottsdale Rd. The Center is 1/8 mile on…

Portfolio Overwriting webinar for The Options Industry Council (OIC)

Date: 3/22 @ 2 PM ET

FREE Registration Link:

https://event.on24.com/wcc/r/1601761/6C464B87CD0C7A4ADA711D117EED7372?partnerref=presenter

Market tone

 This week’s economic news of importance:

  • Federal budget Jan $59 billion
  • Consumer price index Jan 0.5 (above expectations)
  • Retail sales Jan (-)0.3% (below expectations)
  • Weekly jobless claims Feb 10th 230,000 (as expected)
  • Industrial production Jan (-)0.1% (below expectations)
  • Housing starts Jan 1.326 million (above expectations)
  • Building permits Jan 1.396 million
  • Consumer sentiment Feb 99.9 (above expectations)

THE WEEK AHEAD

Mon Feb 19th

  • None: President’s day

Tue Feb 20th

  • None

Wed Feb 21st

  • Markit manufacturing PMI Feb
  • Markit services PMI
  • Existitng home sales

Thu Feb 22nd

  • Weekly jobless claims through 2/17
  • Leading economic indicators Jan

Fri Feb 23rd

  • None

For the week, the S&P 500 rose by 4.30% for a year-to-date return of  2.19%%

Summary

IBD: Market in confirmed uptrend

GMI: 2/6- Sell signal since market close of  February 7, 2018

BCI: Due to the market volatility, I will be selling only in-the-money calls until market volatility subsides. I remain bullish on the economy and the market moving forward.

WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US

The 6-month charts point to a neutral outlook. In the past six months, the S&P 500 was up 11% while the VIX (19.46) moved up by 64%.

Wishing you much success,

Alan and the BCI team

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Ask Alan #143 - How to Use In-The-Money Strikes - YouTube

Alan answers a question posed by George, who asks:

I’m looking to gain more insight into the use of in-the-money strikes. I currently have 2 ITM calls at $307.50 for Biogen Inc. (BIIB) when the stock was trading at $313.80. BIIB is now trading at $318.46. I have 3 questions:
1. Where do you try to position your ITM strikes (slightly ITM or deep ITM)?
2.Near expiration, where do you want your ITM calls to land?
3. What type of stock do you like for ITM strikes…those rising or declining in price?
Thanks, George

———

It’s the 2nd Wednesday of the month. Time for another original episode of Ask Alan. AA#143, “How to Use In-The-Money Strikes”

If you want more “Ask Alan” videos, you can! Become a premium member today, and tune in to the educational power of the complete library!

More Video:

To enter your questions to “Ask Alan”, fill out the form on the contact page. Be sure to begin your message with “ASK ALAN”

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One of the common mistakes made by covered call writers and put-sellers is to make investment decisions based primarily on the highest premium returns. Certainly, we all want to generate the highest levels of success but only when factoring in the risk we will be incurring. This article will look at high premium returns from the perspective of the underlying security as well as from the perspective of the “moneyness” of an out-of-the-money strike.

Time value profit and implied volatility of the underlying security

Our time value percentage profit is directly related to the implied volatility of the underlying security. This means that the higher the percentage return, the greater the downside risk. Generally, implied volatility (IV) statistics are based on a 1-year time frame and 1 standard deviation (accurate two-thirds of the time). If a stock shows an implied volatility of 25% and is trading at $60.00, the expected price range over the next year would be between $45.00 and $75.00, 67% of the time. Another $60.00 stock with an implied volatility of 10% would have an anticipated price range of $54.00 to $66.00. There is no need to look up or calculate implied volatility stats because we can glean the degree of risk by looking at our option returns based on our cost basis. I set a goal for initial 1-month returns for near-the-money strikes of 2-4% per month. I will go a bit higher in bull market environments (up to 6%). In my mother’s more conservative portfolio, I set a goal of 1-2% for 1-month returns. Below is a screenshot of a section of the BCI Premium ETF Report for exchange-traded funds. Pages 7-8 shows the implied volatilities which can be compared to that of the overall market (S&P 500):

Implied Volatilities from the BCI Premium ETF Report

With the IV of the S&P 500 at 7.76 (red arrow), the screenshot shows some ETFs having slightly less than double that implied risk (purple) and some triple to quadruple the risk (brown) of the S&P 500. Investors with a low risk-tolerance will tend to avoid securities like ASHR, EWI and EEM.

“Moneyness” of out-of-money strikes

When we are bullish on the market and on a specific stock, we favor out-of-the-money strikes which generate time value returns and allow for additional share appreciation up to the strike price. Frequently investors will simply decide based on the strike that is above but closest to current market value. These strikes will tend to generate the highest initial returns but offer little or no opportunity to take advantage of share appreciation. In August 2017, Exact Sciences Corp. was trading at $38.66 and we viewed an option chain for the $39.00, $40.00 and $41.00 out-of-the-money strikes. Here are the calculations generated by the multiple tab of the Ellman Calculator:

EXAS Calculations

Looking at the return-on-option column (ROO), the 5.0% ROO for the $39.00 strike seems like the best choice. However, if we look at the “Upside Potential” column (highlighted in yellow) we see additional opportunities to generate cash. The deeper out-of-the-money strikes offer lower ROOs but higher upside. In a firm bull market, we have an opportunity to generate a 1-month return of 8.6% (2.5% + 5.1%) for the $41.00 strike whereas the $39.00 strike will generate a maximum of 5.9% (5.0% + 0.9%).

This is a valuable instructive scenario as the IV of the underlying is similar for the 3 strikes and Theta (time value erosion) will also be comparable for all 3 strikes but yet the premiums are different. This relates to Delta which will be different for each strike. Near-the-money strikes have higher Deltas than deeper out-of-the-money strikes and this accounts for the price difference. Implied volatility is a critical factor in our covered call writing decisions but not the only factor.

Discussion

Implied volatility is a factor we must consider when evaluating the underlying securities we choose. Each investor should set a percentile range for initial returns based on overall market assessment (bearish to bullish), personal risk-tolerance and chart technicals. IV is a critical but not the only factor that determines our option premiums.

Upcoming speaking event

POINT, or Phoenix Options Investors Networking Traders,
March 2 @ 6:30 pm – 9:00 pm 

Friday March 2, 2018 6:30 PM to 9:00 PM   Rio Salado Community College 2323 West 14th Street · Tempe, AZ

Find out more »

American Association of Individual Investors: Phoenix Chapter
March 3 @ 9:00 am – 12:00 pm 

Saturday, March 3, 2017 9:00 AM    Registration/Social Time 9:00 AM    Refreshments Time 9:30 AM    Program Time Location: Jewish Community Center 12701 N. Scottsdale Road Scottsdale, Arizona 85245 DIRECTIONS: The Center is 3.66 miles south of 101 on Scottsdale Road. The Center is on the left as you drive south from 101 OR Take 101 to E. Cactus. Drive 2 miles west on E. Cactus to N. Scottsdale Rd. Turn right on N. Scottsdale Rd. The Center is 1/8 mile on…

Great to meet so many BCI members at my Orlando Money Show presentations

All Stars of Options Event

Market tone

 This week’s economic news of importance:

  • Jay Powell sworn in as Fed chair
  • Markit services PMI Jan 53.3 (expansion)
  • ISM non-manufacturing index Jan 59.9% (above expectations)
  • Foreign trade deficit Dec $53.1 billion (above expectations)
  • Consumer credit Dec $18 billion (last $31 billion)

THE WEEK AHEAD

Mon Feb 12th

  • Fed budget Jan

Tue Feb 13th

  • Household debt Q4

Wed Feb 14th

  • Consumer price index Jan
  • Retail sales Jan

Thu Feb 15th

  • Weekly jobless claims through 2/10
  • Industrial production Jan
  • NAHB homebuilders index Feb

Fri Feb 16th

  • Housing starts Jan
  • Building permits Jan
  • Consumer sentiment Feb

For the week, the S&P 500 declined by 5.16% for a year-to-date return of (-) 2.02%%

Summary

IBD: Market icorrection

GMI: 1/6- Sell signal since market close of  February 7, 2018

BCI: Due to the market volatility, I will be selling only in-the-money calls until market volatility subsides. I remain bullish on the economy and the market moving forward.

WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US

The 6-month charts point to a slightly bearish outlook. In the past six months, the S&P 500 was up 6% while the VIX (29.06) moved up by 160%.

Wishing you much success,

Alan and the BCI team

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After entering our covered call writing trades, we immediately go into position management mode. For most of us who started our stock investment careers buying and selling stock, this may include setting stop loss orders to mitigate losses when share price declines. For example, if we purchase a stock at $40.00, we may set a stop loss order at 10% meaning we are instructing our broker to sell the shares if market price drops to $36.00 or lower.

Definitions

Stop loss order: This is an order to sell a stock when its price declines to the stop price. At that point, the stop loss order becomes a market order (best available price)

Stop loss limit order: This is a combination of a stop loss order and a limit order. Once activated, it becomes a limit order which can only be executed at a specific price or better

Additional considerations for covered call writing

Since our long stock position is protecting (hence the term “covered”) our short call position, we do not want to set a stop loss order on the stock side and end up susceptible to being in a risky naked option position. Furthermore, there are several scenarios where we may benefit from closing the short call but want to retain the long stock position. An example of this would be when an overall market decline brings down the price of a stock but there is no negative corporate news. Here we may close the short call using our 20%/10% guidelines (see the exit strategy chapters in both versions of the Complete Encyclopedia and in our DVD programs) and then consider rolling down or “hitting a double”

More management possibilities

Some broker platforms offer buy-write combination forms where long and short positions can be entered and executed simultaneously. In these instances, the trades can be entered with a pre-determined stop loss price point.

Some platforms offer one triggers other (OTO) orders. These are two-stage brokerage orders, wherein we enter an initial order for a stock sale (for example), and simultaneously place a second order that is contingent upon the fill of the first order. Here we can instruct our broker to buy back the short call option and, once executed, sell the corresponding stock.

Using the 20%/10% guidelines: Nvidia (NASDAQ: NVDA) example

We can automate the buyback of the short calls using our 20%/10% guidelines. With NVDA trading at $171.02 on 8/9/2017, let’s have a look at the 30-day expiration options chain for calls:

NVDA Option Chain on 8/9/2017

Initial calculations using the multiple tab of the Ellman Calculator

NVDA Calculations with The Ellman Calculator

The calculator shows an initial return of 5.2% with the possibility of an additional 2.3% if share price moves to the $175.00 strike. This provides an opportunity for a 1-month 7.5% 1-month return.

Setting limit orders on the option side

Once both legs of the trade are executed, we can immediately set an option stop loss order using our 20%/10% guidelines. This would be a buy-to-close (BTC) order at $1.80 (20% of $8.95) in the first half of the contract and $$0.90 (10% of $8.95) in the latter part of the contract. These orders should be listed as GTC (good-til-cancelled). Should these stop orders be executed, we can then decide whether to roll down, wait to “hit a double” or sell the shares.

Discussion

When setting stop loss orders for covered call writing we must factor in avoiding ending up in a naked option situation. The use of buy-write combination forms, OTO orders and stop loss orders using the 20%/10% guidelines are techniques that must be considered to accomplish this goal.

Upcoming speaking event

Orlando Money Show: February 8th –  11th, 2018

Click for information

Thursday, Feb 8, 2018
09:00 AM – 09:45 AM 
All Stars of Options
“How to Select the Best Options for Covered Call Writing in Bull and Bear Markets”

Friday, Feb 9, 2018
12:15 PM – 03:15 PM
Premium Master Classes (Paid event to Money Show)
“Basics of Options Trading Using Covered-Call Writing with Pro-Active workshop”

Friday, Feb 9, 2018 06:30 PM – 07:00 PM
Stage presentation
“Covered Call Writing with Dow 30 and S&P 500 Stocks”

Market tone

 This week’s economic news of importance:

  • Markit manufacturing PMI Jan 55.5 (expansion)
  • Markit services PMI Jan 53.3
  • Existing home sales Dec 5.57 million (above expectations)
  • Weekly jobless claims 233,000 (below expectations)
  • New home sales Dec 625,000 (below expectation)
  • Leading economic indicators Dec 0.6%
  • GDP Q$ 2.6% (below expectations)
  • Durable goods orders Dec 2.9% (above expectations) THE WEEK AHEAD

Upcoming Week

Mon Jan 29th

  • Personal income Dec
  • Consumer spending Dec
  • Core inflation

Tue Jan 30th

  • Case-Shiller home prices Nov
  • Consumer confidence index

Wed Jan 31st

  • ADP employment
  • Pending home sales Dec
  • FOMC announcement

Thu Feb 1st

  • Weekly jobless claims for week ending 1/27/18
  • Productivity Q4
  • Markit manufacturing PMI Jan
  • ISM manufacturing Index Jan
  • Construction spending Dec

Fri Feb 2nd

  • Nonfarm payrolls Jan
  • Unemployment rate
  • Average hourly earnings
  • Consumer sentiment index Jan
  • Factory orders Dec 

For the week, the S&P 500 rose by 2.23% for a year-to-date return of 7.45%

Summary

IBD: Market in confirmed uptrend

GMI: 6/6- Buy signal since market close of August 31, 2017

BCI: I have a short-term bullish approach to the market, selling 2 out-of-the-money strikes for every 1 in-the-money strike. 

WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US

The 6-month charts point to a neutral to a slightly bullish outlook. In the past six months, the S&P 500 was up 15% while the VIX (11.08) moved up by 15% but still historically low.

Wishing you much success,

Alan and the BCI team

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Exit Strategies for covered call writing is the third required skill for successful implementation of this strategy (stock selection and option selection are the first two). This is also known as position management. One of the most common situations we face each month is when the strike price we initially sold is expiring in-the-money (stock price is higher than the strike price) and we are considering retaining the underlying security. On August 15, 2017, Jesse contacted me and shared a trade that required analysis for a possible rolling execution. Since the email was 4 days prior to contract expiration, Jesse and I agreed that final management decisions would be reserved for Thursday or Friday of expiration week. However, we also felt that it would be instructive to do an analysis using current stats if expiration was upon us.

Jesse’s trade with Biotelemetry Inc. (NASDAQ: BEAT)

  • Buy 100 BEAT at $33.63
  • Sell August $34.00 call at $1.67
  • Current share price is $36.65
  • Cost-to-close the August $34.00 call = $3.10
  • Sell-to-open the September $34.00 call = $3.40 (rolling out)
  • Sell-to-open the September $37.00 call = $1.50 (rolling out-and-up)

These statistics were gleaned from the option chains displayed below slightly favoring the market-maker:

BEAT Option Chains for August and September 2017

Calculations using the Ellman Calculator

Next we enter the option chain information into the “What Now” tab of the Ellman Calculator (blue cells on left side of spreadsheet) and the results will appear in the white cells on the right side as shown here:

The spreadsheet shows the following initial results:

  • Rolling out to the September $34.00 call results in a 0.88%, 11% annualized (yellow field) 1-month return with 7.20% downside protection of that profit
  • Rolling out-and-up to the September $37.00 call results in an initial return of 3.09% with a possible 4.12% final return if share value moves up to the $37.00 strike by expiration

Discussion

As expiration Friday approaches and our strikes are in-the-money, we are faced with 3 possible choices. We can allow assignment and sell our shares at the agreed upon strike price thereby maximizing our near-month covered call trade. The second path is to roll out to the forward month same strike, $34.00 in this case. The third path is to roll out-and-up to the forward month higher strike. Given the calculator results shown in this article, most covered call writers would opt for allowing assignment or rolling out-and-up as rolling out offers too low of a time value return.

For more information on position management techniques, check out the exit strategy chapters in both versions of The Complete Encyclopedia for Covered call Writing and our option-selling DVDs.

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  • Total price for entire program $59

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Upcoming speaking event

Orlando Money Show: February 8th –  11th, 2018

Click for information

Thursday, Feb 8, 2018
09:00 AM – 09:45 AM 
All Stars of Options
“How to Select the Best Options for Covered Call Writing in Bull and Bear Markets”

Friday, Feb 9, 2018
12:15 PM – 03:15 PM
Premium Master Classes (Paid event to Money Show)
“Basics of Options Trading Using Covered-Call Writing with Pro-Active workshop”

Friday, Feb 9, 2018 06:30 PM – 07:00 PM
Stage presentation
“Covered Call Writing with Dow 30 and S&P 500 Stocks”

Market tone

 This week’s economic news of importance:

  • Personal income Dec 0.4% (above expectations)
  • Consumer spending Dec 0.4% (below expectations)
  • Core inflation Dec 0.2% (expected)
  • Consumer confidence Jan 125.4 (above expectations)
  • ADP employment Jan 234,000
  • Pending home sales Dec 0.5%
  • FOMC announcement 1.25% – 1.5%
  • Weekly jobless claims 1/27 230,000 (below expectations)
  • Produtivity Q4 (-) 0.1% (below expectations)
  • ISM manufacturing index Jan 59.1 (above expectations)
  • Construction spending Dec 0.7% (above expectations)
  • Non-farm payrolls Jan 200,000 (above expectations)
  • Unemployment rate Jan 4.1%
  • Consumer sentiment Jan 95.7 (above expectations)
  • Factory orders Dec 1.7% (above expectations)

THE WEEK AHEAD

Mon Feb 5th

  • Markit services PMI Jan
  • ISM manufacturing Jan

Tue Feb 6th

  • Foreign trade deficit
  • Job openings

Wed Feb 7th

  • Consumer credit

Thu Feb 8th

  • Weekly jobless claims for week ending 1/27/18

Fri Feb 9th

  • Wholesale trade

For the week, the S&P 500 declined by 3.85% for a year-to-date return of 3.31%

Summary

IBD: Uptrend under pressure

GMI: 6/6- Buy signal since market close of August 31, 2017 (as of Friday afternoon)

BCI: The increase in market volatility is moving my new positions to a neutral bias, selling an equal number of in-the-money and out-of-the-money strikes. I view this as a short-term bump-in-the-road as our economy as well as the global economy remain strong.

WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US

The 6-month charts point to a neutral-to-slightly bearish outlook. In the past six months, the S&P 500 was up 11% while the VIX (17.16) moved up by 70%.

Wishing you much success,

Alan and the BCI team

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Covered call writing and cash-secured put-selling are conservative strategies geared to retail investors who have capital preservative as a key strategy requirement. When we use high implied volatility underlying securities the strategy will have a broader range of risk-reward exposure. This article was inspired by Randy P. who had outstanding results using Applied Optoelectronics Inc. (NASDAQ: AAOI) as the underlying. The trade and management choices will be evaluated and explained.

Randy’s trade as of 7/13/2017

AAOI Chart

  • 5/5/2017: 600 shares of AAOI were purchased at $48.00 per share(green arrow)
  • 5/5/2017: Sell 2 contracts of the 7/28/2017 $66.00 calls
  • 5/5/2017: Sell 4 contracts of the 9/15/2017 $75.00 calls
  • 7/13/2017: AAOI trading at $75.75 (red arrow)
  • 7/25/2017 (Screenshot created and article written): AAOI trading at 96.62 (blue arrow at top of chart)
  • 8/2/2017: Upcoming earnings report

Implied volatilities on 7/13/2017

The huge risk and high returns are easily defined by the following implied volatility stats (using a Greek calculator):

  • S&P 500: 9%
  • 7/28 $66.00 call: 50%
  • 9/15 $75.00 call: 70%

Time value cost-to-close

When share value moves well above the strike sold, we check to see the time value cost-to-close. This is the amount of the option premium above intrinsic value. Although it will cost us significant cash to buy back deep in-the-money calls, the intrinsic value “buys up” share value from the strike sold to current market value so our main focus is on the time value component. After checking options chains and using mid-points of the spreads (slightly favoring market-maker prices), we learn that the time value costs-to-close are $4.00 (7/28 calls) and $9.00 (9/15 calls), both very expensive due to the high implied volatilities.

8/2/2017 earnings release

The 7/28 contracts expire prior to the report and the 9/15 calls are well after the report.

Position management considerations

7/28 calls

The percentile cost-to-close based on current share value ($66.00 due to option obligation) is 6.1% ($4.00/$66.00). Although we have the advantage of the huge price appreciation after this date, generally we would not spend that amount to roll the option and instead “allow assignment” The more aggressive and riskier plan would have been to buy back the option, hope for a positive earnings report and sell the next call after the report passes. The latter would have resulted in the best results but would not meet the capital preservation requirements of most conservative investors.

9/15 calls

The percentile cost-to-close on current share value ($75.00 due to option obligation) is 12% ($9.00/$75.00). Since the contract expiration is well after the 8/2/2017 earnings release date a decision must be made whether we want to spend 12% to protect against a negative report. The trade has already made huge profits so one may speculate that closing isn’t such a bad idea but given the 6 weeks remaining until contract expiration, taking no action and re-evaluating prior to the report is a viable approach. 

Discussion

The type of securities we use as our underlyings for option-selling will depend on personal risk-tolerance. AAOI is a high risk/high reward stock. This may be appropriate for some and not for others. My personal preference (applies to me but certainly not to everyone) is to target 2-4% 1-month initial time value returns when setting up my trades and up to 6% in bull market environments. I rarely go above these parameters. There is no right or wrong here as one size does not fit all.

Many thanks to Randy for sharing this trade with us and inspiring this article.

For more information on position management of our covered call trades, see the exit strategy chapters of these books:

https://www.thebluecollarinvestor.com/alan-ellmans-complete-encyclopedia-for-covered-call-writing-scover/ 

https://www.thebluecollarinvestor.com/alan-ellmans-complete-encyclopedia-for-covered-call-writing-volume-2/

 

Upcoming speaking event

Orlando Money Show: February 8th – 11th, 2018

Click for information

Thursday, Feb 8, 2018
09:00 AM – 09:45 AM
All Stars of Options
“How to Select the Best Options for Covered Call Writing in Bull and Bear Markets”

Friday, Feb 9, 2018
12:15 PM – 03:15 PM
Premium Master Classes (Paid event to Money Show)
“Basics of Options Trading Using Covered-Call Writing with Pro-Active workshop”

Friday, Feb 9, 2018 06:30 PM – 07:00 PM
Stage presentation
“Covered Call Writing with Dow 30 and S&P 500 Stocks”

Market tone

This week’s economic news of importance:

  • Weekly jobless claims: 261,000 (above expectations)
  • Producer price index Dec: (-)0.1% (0.2% expected)
  • Consumer price index Dec: 0.1% (as expected)
  • Retail sales Dec: 0.4% (o.5% expected)

THE WEEK AHEAD

Mon Jan 15th

  • None: Martin Luther King Jr. Day

Tue Jan 16th

  • Empire state tax

Wed Jan 17th

  • Industrial production
  • Homebuilders Index
  • Beige Book

Thu Jan 18th

  • Weekly jobless claims for week ending 1/13/18
  • Housing starts
  • Building permits
  • Philly Fed

Fri Jan 19th

  • Consumer sentiment

For the week, the S&P 500 rose by 1.57% for a year-to-date return of 4.21%

Summary

IBD: Market in confirmed uptrend

GMI: 6/6- Buy signal since market close of August 31, 2017

BCI: I have a short-term bullish approach to the market, selling 2 out-of-the-money strikes for every 1 in-the-money strike. 

WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US

The 6-month charts point to a bullish outlook. In the past six months, the S&P 500 was up 17% while the VIX (10.16) moved slightly up by 2%.

Wishing you much success,

Alan and the BCI team

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Our approach to covered call writing and put-selling in bear markets include an arsenal of trading concepts that will enhance our opportunities for successful outcomes. These include:

  • Use of deep in-the-money calls
  • Use of deep out-of-the-money puts
  • Use of lower implied volatility securities
  • Use of low-beta stocks
  • Use of exchange-traded funds
  • Lowering our time value return goals during the bear market environment
  • Use of appropriate position management bear-market techniques
  • Use of inverse exchange-traded funds in confirmed bear markets

Some of our members have asked about shorting stocks as an alternative strategy during these bear markets and this article is dedicated to a discussion of this approach.

What is shorting a stock?

This when an investor sells a stock not currently owned and therefore needs to be borrowed before selling. The expectation is for the share value to decline so it can be repurchased at a lower price and therefore generate a profit. The stock is generally borrowed from a broker’s inventory and there will be a lending or interest fee. The short sale will result in a cash deposit into the investor’s account. Eventually the shares are re-purchased at market and returned to the lending broker. The profit or loss will be determined by the price the shares are repurchased. The chart below summarizes the process:

Short-selling a Stock

Note: Short-selling cannot be used with penny stocks and must be sold in round lots (100 share increments)

Why are there short-sellers?

Speculating: Investors speculating that there will be a share price decline

Hedging: Protecting long positions in the same vein that portfolio managers may aspire to achieve Delta-neutral portfolios… a long position is Delta-positive and a short position is Delta-negative

Risks

  • Stock markets have upward bias…short-selling is like running uphill
  • Losses are potentially unlimited (stock price can go as high as infinity) but gains are limited (stock price cannot go below zero). Use of buy stop-loss orders are critical
  • May be exposed to margin call since borrowing shares mean margin trading. We may be required to add cash to our account or liquidate positions
  • A short squeeze (short-sellers covering positions) can cause stock price to accelerate exponentially
  • Short-sellers may be required to pay dividends to the stock lenders (best to short sell a stock that pays no dividends)

Discussion

Shorting a stock is a bear-market strategy that may be appropriate for some sophisticated investors with a high risk-tolerance. For most retail investors, in my humble opinion, there are better, less speculative, approaches to bear market scenarios which I enumerated in the first paragraph of this article.

Upcoming speaking event

Orlando Money Show: February 8th –  11th, 2018

Click for information

Thursday, Feb 8, 2018
09:00 AM – 09:45 AM 
All Stars of Options
“How to Select the Best Options for Covered Call Writing in Bull and Bear Markets”

Friday, Feb 9, 2018
12:15 PM – 03:15 PM
Premium Master Classes (Paid event to Money Show)
“Basics of Options Trading Using Covered-Call Writing with Pro-Active workshop”

Friday, Feb 9, 2018 06:30 PM – 07:00 PM
Stage presentation
“Covered Call Writing with Dow 30 and S&P 500 Stocks”

New speaking event just added

Las Vegas Money Show

Bally’s/Paris Hotel

Monday May 14th

11 AM – 12 PM

Market tone

 This week’s economic news of importance:

  • Industrial production Dec 0.09% (above expectations)
  • Weekly jobless claims for week ending 1/13 220,000 (below expectations)
  • Housing starts Dec 1.192 million (below expectations)
  • Building permits Dec 1.302 million
  • Consumer sentiment Jan 94.4 (below expectations)

THE WEEK AHEAD

Mon Jan 22nd

  • Chicago Fed national activity index Dec

Tue Jan 23rd

  • None scheduled.

Wed Jan 24th

  • Markit manufacturing PMI Jan
  • Markit services PMI Jan
  • Existing home sales Dec

Thu Jan 25th

  • Weekly jobless claims for week ending 1/20/18
  • New home sales Dec
  • Leading economic indicators Dec

Fri Jan 26th

  • GDP Q4
  • Durable goods orders Dec

For the week, the S&P 500 rose by 0.86% for a year-to-date return of 5.11%

Summary

IBD: Market in confirmed uptrend

GMI: 6/6- Buy signal since market close of August 31, 2017

BCI: I have a short-term bullish approach to the market, selling 2 out-of-the-money strikes for every 1 in-the-money strike. 

WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US

The 6-month charts point to a slightly bullish outlook. In the past six months, the S&P 500 was up 15% while the VIX (11.20) moved up by 15% but still historically low.

Wishing you much success,

Alan and the BCI team

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When covered call writing is combined with protective puts the strategy is known as the collar strategy. The short call places a ceiling on gains and the long put represents a floor protecting losses. The two option positions should result in a net credit. Typically, out-of-the-money calls and puts are selected.

Covered call writing and selling cash-secured puts are low-risk option-selling strategies used to generate monthly cash flow. Low-risk does not mean no risk so how can we measure the degree of risk we are undertaking? Let’s first all agree that any strategy that aspires to generate higher than a risk-free return (Treasuries, for example) will incur some degree of risk. Portfolio managers and institutional investors focus in on market risk like a laser and use Delta in many instances to ascertain and manage market risk (also called systematic risk).

Delta-Neutral Portfolios

These are portfolios consisting of positive and negative Delta positions which balance out to bring the net change to zero. Institutional traders use Delta-neutral positions to eliminate market risk from their positions. For example, if 1000 shares of stock are purchased for a positive Delta of +1000 (1.00 x 1000), the trader may then purchase 20 put contracts (representing 2000 shares) with a Delta of -0.50, thereby creating a Delta-neutral position. If share value declines, put value increases.

Delta and the collar strategy

Using the option Greeks and Delta in particular, we can see how the collar mitigates risk in much the same way portfolio managers attempt to mitigate market risk in their portfolios.

The 3 components of the collar

  • Long stock (Delta of +1.00)
  • Short call (negative Delta)
  • Long put (negative Delta)

Generally, out-of-the-money calls and puts are used.

 

Strategies overview

Covered call writing (consisting of the first 2) lowers overall Delta and therefore decreases market risk. Adding in the long put further mitigates systemic risk. The disadvantage of the long put component is the cost of the put which will decrease potential returns but enhance portfolio protection.

Real-life example with Microsoft (MSFT) as of 7/21/2017

Here are the stock and option pricing as market opens on 7/21/2017:

 

MSFT: Option Chain for Collar Strategy

  • Stock price: $74.22
  • $75.oo call price (bid): $1.54
  • $70.00 put price (ask): $0.68

Portfolio Deltas for each strategy (100 shares and 1 contract of each component)

MSFT: Call and Put Deltas

  • Stock: +100
  • Covered call writing: (+100 -46) = +54
  • Collar: (+100 -46 -19) = +35

Maximum gains per 100 shares

  • Stock: Unlimited
  • Covered call writing: ($154.00 + $78.00) = $232.00 (call premium + share appreciation to strike)
  • Collar: ($154.00 + $78.00 – $68.00) = $164.00 (call premium + share appreciation to strike – put premium)

Maximum loss (with no position management, a ridiculous assumption…does not apply to Blue Collar Investors)

  • Stock: $7422.00 (if stock price declines to zero)
  • Covered call writing: ($7422.00 – 154.00) = $7268.00 (stock price drops to zero)
  • Collar: [(7422.00 – $7000.00) + $154.00 – $68.00] = (-) $336.00 (stock price drops below the $70.00 put strike price)

Collar calculator

BCI Collar Calculator

After entering option chain information into the white cells, the green cells become populated with the following calculations:

  • Initial return: 1.16% (15.10% annualized)
  • Maximum return: 2.21% (28.80% annualized)
  • Breakeven: $73.36
  • Maximum loss: 4.53% (59.01% annualized)

The pink cells reflect the price points to buy back the short calls to initiate our exit strategies.

Discussion

Portfolio managers tend to reduce market risk by seeking Delta-neutral portfolios. By using this analogy, we can visualize the benefits of selling covered call options and buying put options after taking a stock position. A critical skill not discussed in this article is the use of position management techniques which will enhance our gains and mitigate losses.

Upcoming speaking event

Orlando Money Show: February 8th –  11th, 2018

Click for information

Thursday, Feb 8, 2018
09:00 AM – 09:45 AM 
All Stars of Options
“How to Select the Best Options for Covered Call Writing in Bull and Bear Markets”

Friday, Feb 9, 2018
12:15 PM – 03:15 PM
Premium Master Classes (Paid event to Money Show)
“Basics of Options Trading Using Covered-Call Writing with Pro-Active workshop”

Friday, Feb 9, 2018 06:30 PM – 07:00 PM
Stage presentation
“Covered Call Writing with Dow 30 and S&P 500 Stocks”

Market tone

 This week’s economic news of importance:

  • Markit manufacturing PMI for Dec.  55.1 (expansion)
  • ISM manufacturing for Dec. 59.7% (expansion)
  • Construction spending for Nov. 0.8% (above expectations)
  • ADP Employment for Dec. 250,000 (last 185,000)
  • Weekly jobless claims for week ending 12/30/17 250,000 (above expectations)
  • Non-farm payrolls 148,000 (below consensus)
  • Unemployment rate 4.1% (as expected)
  • Trade deficit $50.5 billion (above expectations)
  • ISM non-manufacturing for Dec. 55.9% (expansion)
  • Factory orders for Nov. 1.3% (above expectations)

THE WEEK AHEAD

Mon Jan 8th

  • Consumer credit for Nov.

Tue Jan 9th

  • Job openings for Nov.

Wed Jan 10th

  • Wholesale inventories

Thu Jan 11th

  • Weekly jobless claims for week ending 1/6/18
  • Producer price index
  • Federal budget for Dec.

Fri Jan 12th

  • Consumer price index
  • Retail sales
  • Business inventories

For the week, the S&P 500 rose by 2.60% for a year-to-date return of 2.60%

Summary

IBD: Market in confirmed uptrend

GMI: 6/6- Buy signal since market close of August 31, 2017

BCI: I have a short-term bullish approach to the market, selling 2 out-of-the-money strikes for every 1 in-the-money strike. A strong global economy, the tax plan’s favorable impact on corporations, the accommodative Fed funds rate, low unemployment and strong corporate profits all factor in to this assessment. Potential political fireworks needs to be monitored but the market has been extraordinarily resilient thus far.

WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US

The 6-month charts point to a bullish outlook. In the past six months, the S&P 500 was up 13% while the VIX (9.22) moved down by 17%.

Wishing you much success,

Alan and the BCI team

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Ask Alan #142 - “Evaluating the Cost-To-Close Prior to Contract Expiration” - YouTube

Alan answers a question posed by Andrew, who asks:

I purchased UCTT for $27.90 and wrote an October 1-month $30 call for $0.77. The stock is now trading at $31.62 and the “ask” for the call is $2.50. Should I unwind or is it too costly?
Thanks,
Andrew

———

It’s the 2nd Wednesday of the month. Time for another original episode of Ask Alan. AA#142, “Evaluating the Cost-To-Close Prior to Contract Expiration”

If you want more “Ask Alan” videos, you can! Become a premium member today, and tune in to the educational power of the complete library!

More Video:

To enter your questions to “Ask Alan”, fill out the form on the contact page. Be sure to begin your message with “ASK ALAN”

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Trading volume is the number of trades for a security in a given time frame. On a chart volume is typically represented as a histogram (vertical bars) and represents a confirmation or lack thereof of the other technical indicators. For example, if a moving average breaks below support on high volume, it is more significant than if the event took place on low volume. Volume can also serve as a red flag if a stock is trending higher on decreasing volume. We also want to confirm that there is adequate trading volume for our stocks and options to ensure the best opportunities for favorable price executions. In the screenshot, note how the accelerating volume is confirming a series of bearish signals:

Volume Bars Confirming Bearish Signals

Most traders are familiar with trading volume but many have never been introduced to the term deliverable volume.

What is deliverable volume?

This is the actual percentage of total trading volume that results in transfer of shares from one account to another’s. Stated differently, ownership is actually transferred. For stocks, deliverable rate is quite high because a buyer wants to buy and a seller wants to sell and so a transaction occurs with ultimate delivery of the underlying.

When is trading volume high but deliverable volume low?

This occurs when shares are bought and sold multiple times for the same date. The credits and debits are netted against each other and only the difference is settled.

These scenarios fall into 3 categories:

  • Lots of day-trading with little intent to actually own the underlying
  • Initial Public Offerings (IPOs)
  • Newly-listed stocks

IPOs and newly-listed stocks do not have the history necessary to gain entrance onto our watch lists while stocks that are day-traded are usually highly volatile and speculative and therefore  inappropriate for conservative option-selling strategies.

How to interpret deliverable volume

  • Bullish: Increase in deliverable % with high volume and price increase
  • Bearish: Decrease in deliverable % with a price decline

Discussion

The percentage of deliverable stocks reflect the interest of long-term investors in taking positions with the underlying. The stocks we deal with in our covered call writing and put-selling portfolios generally do not fall into the 3 categories where the percentage of deliverables is significantly lower than normal. Confirming adequate stock and option trading liquidity is where we must be most focused.

Upcoming speaking event

Orlando Money Show: February 8th –  11th, 2018

Click for information

Thursday, Feb 8, 2018
09:00 AM – 09:45 AM 
All Stars of Options
“How to Select the Best Options for Covered Call Writing in Bull and Bear Markets”

Friday, Feb 9, 2018
12:15 PM – 03:15 PM
Premium Master Classes
“Basics of Options Trading Using Covered-Call Writing with Pro-Active workshop””

Friday, Feb 9, 2018
06:30 PM – 07:00 PM 
Covered Call Writing with Dow 30 and S&P 500 Stocks””

All DVD Programs now available in streaming format with downloadable workbooks (click for information)

Covered Call Writing

Exit Strategies for Covered Call Writing

Selling Cash-Secured Puts

All 3 programs bundled at a discount

Streaming DVD Programs

Market tone

 This week’s economic news of importance:

  • Case-Shiller home prices up 6.2 for October
  • Consumer confidence index came in at 122.1
  • Pending home sales for November 0.2%
  • Weekly jobless claims for week ending 12/23 came in at 239,000, below expectations
  • The stock market moved up 19.42% for the calendar year 2017

THE WEEK AHEAD

Mon Jan 1st

  • None New Years Day

Tue Jan 2nd

  • Markit Manufacturing PMI for Dec

Wed Jan 3rd

  • Consumer spending
  • ADP employment
  • ISM manufacturing
  • Construction spending

Thu Jan 4th

  • Weekly jobless claims
  • Markit services PMI for Dec

Fri Jan 5th

  • Nonfarm payrolls
  • Unemployment rate
  • Foreign trade deficit
  • Ism manufacturing
  • Factory orders

For the week, the S&P 500 declined by 0.36% for a year-to-date return of 19.42%

Summary

IBD: Market in confirmed uptrend

GMI: 6/6- Buy signal since market close of August 31, 2017

BCI: My portfolio makeup moves to a bullish, selling 2 out-of-the-money strikes for every 1 in-the-money strike.

WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US

The 6-month charts point to a neutral outlook. In the past six months, the S&P 500 was up 10% while the VIX (11.04) moved down by 1%.

Wishing you a prosperous 2018,

Alan and the BCI team

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