Why not use covered call writing with only dividend-bearing stocks to generate three income streams; option premium, share appreciation to the (out-of-the-money) call strike plus the dividend itself? This article will explore the pros and cons of this approach to covered call writing.
We screen for stocks that have ex-dividend dates (also called ex-dates) approaching. In order to capture a dividend we must own the shares prior to the ex-date. We then write a covered call on these shares and own the stock at least through contract obligation assuming the option is not exercised or closed. The position is managed with our standard exit strategy arsenal and ultimately replaced with another approaching ex-date stock for the next contract month. If out-of-the-money call options are used we have the opportunity for 3 income streams:
Share appreciation from current market value to the strike
Dividend distribution (days or weeks after the ex-date)
Dividend-bearing stocks from BCI premium Reports: Location of ex-dates
Brown Field Shows Ex-Dates in our Premium (Dow 30) Blue Chip Report
When is early exercise most likely?
Option is trading at parity (all intrinsic value, no time value component)
Strike is in-the-money (out-of-the-money strikes are unlikely to get exercised because shares would be sold at a higher price than current market value)
Ex-date is close to the expiration date of the contract
If there is a time value component to the option, the option holder (buyer) is always better off selling the option (thereby capturing both time value + intrinsic value) and then buying the stock prior to the ex-date to also capture the dividend. Exercising that same option will result in the loss of that time value component. Many retail investors are not aware of this and may exercise early even though it is not in their financial best-interest to do so. This is rare but could happen and that exercise notice may end up in our accounts.
The mathematics of ex-dates
On the ex-date, share value will drop by the amount of the dividend that will distributed at the pay date. If a stock is trading at $20.00 and the dividend will be $0.50, the share value will decline to $19.50 on the ex-date, all other factors remaining the same. This price change has already been factored into the call sale price because call buyers are not willing to pay “full price” for these options knowing about the share decline on the ex-date. For the same reason, put premiums will rise in value prior to ex-dates.
Advantages of the strategy
Opportunity for 3 income streams from one investment
Early assignment results in a maximum covered call return (although no dividend capture) and the cash is freed up to generate another covered call profit in the same contract month
Dividend-bearing stocks are generally higher-quality securities
Disadvantages of the strategy
We are selecting from a smaller pool (dividend-bearing) of potential covered call writing candidates
Prioritizing dividends in the screening process, minimizes our fundamental, technical and common sense screens
Early exercise (also an advantage) may result in loss of shares with potential negative tax issues for low-cost-basis stocks
Share value declines by the dividend amount on the ex-date so how much additional value are we actually capturing?
Dividends will add one more factor to consider and monitor
Dividend-bearing stocks generally offer lower option premiums because they are less volatile than growth stocks
A case can be made for both covered call writing and dividend capture in our wealth-building arsenal. The question is whether we should combine the two. In my view, we should not. It is critical to focus like a laser on the strategy we have selected. If it’s covered call writing, then we concentrate on the 3 required skills: stock selection, option selection and position management. Stock selection requires us to screen from fundamental, technical and common sense perspectives. Dividends are secondary and perhaps icing on the cake if a screened stock does generate dividends but is not a priority that may detract from the stated strategy. As an alternative for those who like both income streams why not have two separate accounts? One that is dedicated to covered call writing and the other to dividend capture. This will allow us to maximize our skill sets and target them specifically for each of the declared strategies.
Printing of new book has begun
Covered Call Writing Alternative Strategies
Portfolio Overwriting- using stocks in buy-and-hold portfolios The Collar Strategy- using protective puts The Poor Man’s Covered Call- using LEAPS options
Covered call writing is a cash-generating strategy that lowers our cost basis thereby improving our opportunities for successful investments. One of the many benefits of incorporating this strategy into our investment portfolios is that the system can be crafted to meet our trading style, market assessment, portfolio net worth and personal risk tolerance. This book details three such covered call writing-like strategies that will highlight:
• Option basics
• Practical application
• Real-life examples
• Role of brokerages
• Pros and cons of strategies
• Option Greeks
• Exit strategies
• Flow charts
• Calculator user guides
• And much more
AN EARLY ORDER DISCOUNT PROMO CODE WILL BE SENT TO THOSE ON OUR MAILING LIST.
Chicago Stock Trader’s Expo: All Stars of Options
Sunday July 22nd 12:30 PM – 1:15 PM
“How to Select the Best Options in Bull and Bear Markets”
Ask Alan 147 - “Why is the Ellman Calculator Showing Negative Returns?” - YouTube
Alan answers a question posed by Duminda, who asks:
I am trying to understand why I am getting a negative ROO on a trade I made with the ETF BOTZ. First, I bought 100 shares for $27.13 and sold the February $27.00 in-the-money strike for $0.75. The option expired worthless and I then sold the March $26.00 out-of-the-money strike for $0.30. That option also expired worthless and the current price is $25.00, a drop of 8.2% from $27.13. I wanted to sell the April $26.00 option for $0.25 but the Ellman Calculator shows a negative ROO of (-)3.4% with downside protection of 4.2%. Can you help me understand how I get a negative ROO and why I would make such a trade?
It’s the 2nd Wednesday of the month. Time for another original episode of Ask Alan. AA#147, “Why is the Ellman Calculator Showing Negative Returns?”
On 8/19/2017, Ron sent me an email detailing a cash-secured put trade he initiated in a virtual account. I saved the email to use in an article because I felt it would be instructive on several fronts.
Ron’s tradewith Abiomed, Inc. (NASDAQ: ABMD)
ABMD Price Chart for August 2017
8/10/2017: Sell August 17 $155.00 put (sale price not disclosed in email but not relevant) highlighted by the red line
8/10/2017: ABMD trading at $155.85 making the $155.00 put slightly out-of-the-money
8/12/2017: Share price moved below the put strike
8/15/2017: Share price moved up to the put strike price
8/17/2017: Share price moved above the put strike which was once again out-of-the-money
8/18/2017: Option exercised and shares put to Ron at the end of the trading day
Why didn’t the option holder exercise on 8/12 or 8/13?
Why didn’t the option expire or get exercised by the day’s end on 8/17?
Could I have bought back the put on 8/18 to prevent exercise?
Solving the mysteries of this put trade
Early exercise is rare
Even when a put strike moves in-the-money, exercise will only capture intrinsic value. The option holder would make more money selling the option by capturing both intrinsic value + time value.
Was it really an 8/17 expiration date?
No, it was 8/18. This is a common error made by retail investors and why Ron is so smart using virtual trading initially. The options chain showed 8/17 but the “17” represents the calendar year 2017. Expiration Friday in August 2017 was on the 18th. This is why the option did not expire or get exercised on the 17th.
Buying back options to prevent exercise
The general rule that applies just about all the time is that any option can be bought back prior to 4 PM ET on expiration Friday to avoid exercise. In this case, Ron had until 4 PM on the 18th but thought the option exit strategy opportunities ended a day earlier…lesson learned.
Fundamental analysis, technical analysis and common sense principles comprise the 3-pronged approach used in the BCI methodology for screening for option-selling candidates. Technical analysis is the factor that changes most frequently and is the main reason a stock will get “bumped” from our Premium Stock Reports. In our 11/10/2017 Premium Stock Report, MKS Instruments (NASDAQ: MKSI) was removed from our “eligible” list and moved to our “Passed Previous Weeks & Failed Current Week” section. Since this equity has been on our eligible list for a good part of 2017 and generated a significant amount of income for our members (this author included), I felt it would be instructive to evaluate why the BCI team moved the stock from our highest-rated category.
Weeks 1 – 4 for the November 2017 contracts (partial image)
MKSI Gets Bumped from our Premium Stock List on 11/10/2017
The yellow fields show that MKSI was eligible in the first 3 weeks of the November contracts but not in the 4th week (red arrow).
Why was MKSI Bumped (moved from white to purple cells)? Report Explanation
The green arrows point out the following technical concerns:
The price of the stock is no longer above, but rather at, the 20-day exponential moving average
It is important to recognize the fact that stock prices whipsaw and there frequently are technical improvements from week-to-week, so this is the reason we leave formerly eligible securities on our lists for 3 weeks before removing them entirely from our reports. It is not prudent to immediately sell a stock already in our portfolios if it is moved from the eligible white cells. It is, however, always critical to be alert for all exit strategy opportunities.
MKSI: Technical chart
Technical Chart for MKSI on 11/10/2017
The red arrows highlight the following:
1: Share price moved down to the 20-day exponential moving average (previously above this line)
2: The MACD Histogram moved below the zero-line
3: The Stochastic Oscillator dipped below the 80%, a bearish signal
One of our covered call writing exit strategies is rolling out-and-up. This involves buying back (buy-to-close) the current in-the-money option and selling the later-date higher strike price. For example, we may buy back the October $50.00 call option and then sell the November $55.00 call option. We would consider such action if the expiring strike is in-the-money, the stock still meets all system criteria and the initial return rolling credit meets our goals. One of the terms used in my books and DVDs associated with this strategy is “bought-up” value. This article will explain the meaning and significance of this term by using a hypothetical example and the “What Now” tab of the Ellman Calculator.
Hypothetical example with made-up stock “More Money Corp. (MMC)”
Current contract month
Buy MMC for $28.00
Sell the $30.00 call for $1.00
Near expiration, MMC is trading at $32.00
The cost-to-close the $30.00 call is $2.10 ($2.00 is intrinsic value and $0.10 is time value)
The next-month $35.00 call generates $1.50
The “What Now” tab of the Ellman Calculator
The blue cells of the calculator spreadsheet (left side) are filled in:
What Now Tab of the Ellman Calculator
Once the information is entered, the white cells on the right side become populated:
MMC Rolling Calculations
What is “bought-up value”?
The bottom (smaller) red arrow shows a bought-up value of $200.00 per contract or $2.00 per share. When we sold the $30.00 call our shares can be worth no more than $30.00 due to our contract obligation. However, when we buy back the option and no longer have that obligation in place, our shares are now worth market value or $32.00. This $2.00 difference or $200.00 per contract represents the “bought–up value”
Why include bought-up value in our calculations?
Since we are including the intrinsic value debit of $2.00 as part of our calculations in the $2.10 cost-to-close, we must also include this intrinsic value component on the asset side. This makes the actual time value cost-to-close $0.10.
Calculation results for rolling out-and-up with MMC
The calculator shows an option debit of $0.60 ($1.50 – $2.10) or $60.00 per contract. Factoring in the “bought-up value of $2.00 or $200.00 per contract, we have a net credit of $140.00 per contract. On a cost-basis (current market value with the contract obligation in place) of $30.00 or $3000.00 per contract, this represents a 4.67% initial return. Should share price rise to the new $35.00 strike by contract expiration, the total rolling out-and-up trade could generate a 1-month return of 14.67%
When using the rolling-out-and-up exit strategy for covered call writing, we must factor in the increase is share price when removing the initial obligation. The new “bought-up value” will be current market value or the new strike price, whichever is lower.
American Association of Individual Investors: Charlotte NC Chapter
Saturday June 9th 9 AM – 12 PM
“How to Generate Monthly Cash Flow and Buy a Stock at a Discount Using Two Low-Risk Option Strategies”
Strike price selection is one of the 3 required skills for covered call writing and put-selling. When we sell in-the-money call options we are protecting our positions to the downside while still generating the time value initial profits we have established in our strategy goals. In return, we are relinquishing any opportunity to generate additional profit from share appreciation. Another way to state this approach is that intrinsic value protects time value.
When to consider in-the-money call options
Pre-event (Brexit, elections, Fed watch etc.)
Satisfies personal risk-tolerance
Methodology to select in-the-money call strikes
After establishing a watch list of eligible securities, we must select our target initial time value returns whether they are for in-the-money, at-the-money or out-of-the-money strikes. In my case, I target monthly 2% – 4% time-value in most market conditions and up to 6% returns in bull markets. For in-the-money strikes, the time value is calculated as follows:
Total option premium – Intrinsic value = Time value
Real-life example with Control4Corp (NASDAQ: CTRL)
With CTRL, a stock on our Premium Watch List at the time of this writing, trading at $32.78 on 11/8/2017, we will view the option chain for the 5-week expiration (11/15/2017):
CTRL: 5-Week Options Chain
The $30.00 in-the-money strikes shows a bid price of $3.50. We cannot count this entire premium as initial profit because we can lose $2.78 on the sale of the stock. The Ellman Calculator will deduct this intrinsic value component to yield a time value initial profit. The $2.78, however, does represent protection of the time value. Consider the intrinsic value as an insurance policy paid for by the option buyer, not by us, the option-sellers. Let’s feed this information into the multiple tab of the Ellman Calculator.
The Ellman Calculator
CTRL: Calculations with the Ellman Calculator
Once the blue cells are filled with the options chain information, the white cells will become populated. The red arrow shows the intrinsic value component of the $3.50 premium and this amount will be deducted to calculate the 2.4% initial 5-week return (yellow field). The downside protection (brown field) reflects the protection of this time value, not the breakeven (shown as $29.28). In this case the downside protection is 8.5%. This means that we are guaranteed a 5-week 2.4% return as long as share value does not decline by more than 8.5% by contract expiration. Stated differently, we are guaranteed a 2.4% return as long as share value does not decline from $32.78 to below $30.00 by contract expiration. It is important to remember that the trade-off is that should share value appreciate, we will not participate in those gains.
Selling in-the-money call strikes offers downside protection of the initial time value profits but will not allow for additional income from share appreciation. The approach can be summarized as intrinsic value protects time value.
American Association of Individual Investors: Charlotte NC Chapter
Saturday June 9th 9 AM – 12 PM
“How to Generate Monthly Cash Flow and Buy a Stock at a Discount Using Two Low-Risk Option Strategies”
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
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.
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
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.
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).
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.
New video added to member sites
Premium and video members: Just added to your member sites is Ask Alan 146: The Cost of Rolling Out and Up. Only premiums have access to the entire library of (now 146) Ask Alan videos as well as our Blue Hour webinar series.
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
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%
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.
Ask Alan #146 – “The Cost of Rolling Out and Up” - YouTube
Alan answers a question posed by Carl, who asks:
I am concerned about the cost to roll options when a stock price increases and I want to keep the stock. When I buy back an in-the-money option and roll out-and-up and then the price of the stock goes down, I am actually losing money in some cases. Should I just consider selling only deep out-of-the-money options to avoid these potential losses?
It’s the 2nd Wednesday of the month. Time for another original episode of Ask Alan. AA#146, “The Cost of Rolling Out and UP”
When we sell out-of-the-money call options, we are initiating bullish covered call writing positions. Our goals are to generate option premium as well as share appreciation from current market value up to the call strike price. When share value moves well above the strike, leaving that strike deep in-the-money, there is no opportunity to generate any additional profit in that trade. Our mid-contract unwind exit strategy involves closing both legs of the current trade and entering a new trade, with the cash generated from the sale of the stock, using a different underlying security. It is important to know how to evaluate when it is in our best financial interest to undertake this position management maneuver. In September 2017, Andrew shared with me a trade he executed where such an exit strategy decision was being considered.
9/20/2017: By Ultra Clean Holdings, Inc. (NASDAQ: UCTT) at $27.90
9/20/2017: Sell the $30.00 Oct. 20th call at $0.77
10/11/2017: UCTT trading at $31.62
10/11/2017: “Ask” price to buy back the $30.00 call traded at $2.50
The initial return on the option sale (ROO) is 2.8% with the possibility of an additional upside potential of 7.5% if share price moves from current market value ($27.90) to the call strike of $30.00. There is a potential 1-month return of 10.3%
It is critical to calculate the actual time-value cost-to-close which will be less than the “ask” price of $2.50 highlighted in Andrew’s trade. Since the sale price can be no more than $30.00 while the option obligation is in place, share value will rise to current market value of $31.62 if the option is bought back (buy-to-close). The “unwind now” tab of the Elite version of the Ellman Calculator (free to premium members and available for purchase in the Blue Collar store), will deduct the intrinsic value component of the $2.50 premium and calculate the actual time value cost-to-close as shown in the screenshot below:
UCTT: Time Value Cost-To-Close
With 8 trading days remaining until contract expiration, our cost-to-close is 2.93%. We now ask ourselves if we can generate at least 1% more than 2.93% (3.93% or more) in the next 8 trading days?
Generating 3.93% or more in 8 trading days is highly unlikely unless we use an extremely volatile underlying security. This makes little sense since we are employing one of the most conservative option strategies available. At this point in time, Andrew had an unrealized, 1-month profit of 10.3% with a downside protection of 5.4% (the 10.3% is guaranteed as long as hare value does not decline below $30.00). In this case, the best action is no action at all. As expiration Friday approaches, we can evaluate for the possibility of rolling the option makes financial sense.
When our covered call positions end up moving deep in-the-money, we are faced with the decision to close as our maximum profit has been realized or take no action and allow assignment. In October 2017, Andrew shared with me a trade he successfully executed and was faced with such a dilemma.
Andrew’s trade with Ultra Clean Holdings, Inc. (UCTT)
9/20/2017: Buy UCTT at $27.90
9/20/2017: Sell $30.00 Oct. 20th call at $0.77
10/11/2017: UCTT trading at $31.62
10/11/2017: “Ask” price for the $30.00 call traded at $2.50
Let’s view this trade graphically:
Price Chart of UCTT Trade
The question at hand is whether it is too expensive to close at $2.50…to close or not to close!
Andrew’s initial and now maximized trade
UCTT: Initial Calculations
The Ellman Calculator shows a total maximum return of 10.3% (2.8% + 7.5%). This 1-month return will be realized as long as share value remains above $30.00.
Time value cost-to-close using the Elite version of the Ellman Calculator (Unwind Now tab)
Cost-To-Close the UCTT Trade
The “Unwind Now” tab of the Elite version of the Ellman Calculator shows a time value cost-to-close of 2.93% based on current share value of $30.00. Let me break this down based on calculations after the option is bought back:
Share appreciation: $31.62 – $27.90 = + $3.77
Option credit: $0.77
Option debit: (-) $2.50
Net credit: $1.99
Percentage lost to time value:
Cost-to-close: (-) $2.50
Share appreciation as a result of closing short call: $31.62 – $30.00 (strike price) = + $1.62
Net debit = (-) $0.88
Cost basis is $30.00 (current value of UCTT due to strike in place
Time value lost: $0.88/$30.00 = 2.93%
In order to justify spending 2.93% to close, we must be able to say that investing the proceeds from the sale of the stock will result in a return at least 1% higher then 2.93%. With only 8 trading days remaining until contract expiration, this is highly unlikely.
As long as share value does not decline by more than 5.4% ($1.62/$30.00) in the next 8 trading days, we will have realized our maximum 10.3%, 1-month return. Many times, the best action is no action at all. If share value continues to rise and the time value cost-to-close approaches zero, we can re-evaluate and possibly take action. As expiration Friday approaches, we can also evaluate for possibly rolling our options.
When share price accelerates substantially and we cannot benefit any more from share appreciation positions can be closed based on the time value cost-to-close. We will spend the money if the cash generated from selling the underlying can generate a higher return than the cost-to-close by at least 1%.