The Blue Collar Investor

Ask Alan – How to Compute Final Covered Call Returns-Part 2

Alan Ellman — Fri, 24 May 2013 04:24:38 +0000

Alan answers a question posed collective my many of the BCI member family, who ask about calculating final returns after the trade has been completed. This is part 2 of a 3 part series.
This is part 2 of a 3 part series.

Watch part 1 here

If you want more “Ask Alan” videos, you can view the archive.

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”.

Should I Roll My Option When The Stock Price Is DEEP In-The-Money?

Alan Ellman — Sat, 18 May 2013 11:03:40 +0000

Exit strategy execution is a critical skill every covered call writer should master. In addition to managing positions where share price has decreased there are also situations where we can benefit when price has dramatically accelerated. Let’s look at a trade recently executed by one of our Premium Members:

Covered call trade with SODA

Our member generated a nice 1-month return with downside protection of that profit. However, on expiration Friday the price of the stock has accelerated all the way up to $65.16 and the $50 call was very deep in-the-money. The question is “to roll or not to roll” let’s look at the options chain on this expiration Friday (May 17, 2013):

SODA options chain

To buy back the $50 call (BTC) will cost $15.30. Let’s look at the trade if we roll out to the June $50 call:

Rolling out generates no option profit

What if we roll out and up to the $60, $62.50 or $65 strike choices? These scenarios will normally result in a net debit on the options side, but a net credit on the share price side as our $50 obligation to sell is eliminated and share value is enhanced to the new strike or current market value whichever is lower. Let’s look at the trade if we rolled out and up to the $62.50 strike:

SODA: rolling out and up-

The trade results in the following scenario:

We are guaranteed a 1-month return of 4.2% as long as share value does not depreciate by more than 4.1% by expiration Friday because we rolled out and up to an in-the-money strike. In my books and DVDs I give examples of rolling out an up to at-the-money and out-of-the-money strikes as well.

Conclusion:

When a stock price moves up dramatically it usually does NOT pay to roll out as the option credit is negligible or non-existent. Rolling out-and-up may make sense because appreciation of current share value may surpass the option debit.

Next live seminar:

Thursday May 23rd Plainview, NY:

http://www.thebluecollarinvestor.com/event/long-island-stock-traders-meetup/

***A special thanks to BCI members who attended my presentation in Las Vegas for The Money Show. I can’t tell you how great a speaker feels when you’re given a double room and there is still standing room only.

Market tone:

This week’s economic reports put economists at ease regarding the fact that inflation does NOT appear to be rearing its ugly head:

According to the Labor Department, the Consumer Price Index (CPI-A widely followed indicator of inflation. The CPI is a measure of the average
change over time in the prices paid by urban consumers for a fixed market basket of consumer goods and services. The “core” CPI excludes food and energy prices, which account for roughly one-quarter of the broad CPI and tend to fluctuate widely, providing a truer reflection of inflationary trends) declined by 0.4% compared to the previous month. A decline of 0.2% was expected
Core CPI was up 0.1% half the amount anticipated
The Producer Price Index (PPI) declined by 0.7% in April more than the 0.5% projected
Core PPI was up 0.1% in April, half the amount anticipated
Housing starts in April dropped by 16.5%
Single and multi-family housing starts in April rose by 13.1% compared to a year earlier
Building permits form privately-owned homes rose 14.3% in April compared to March and up 35.8% compared to April, 2012
The Conference Board’s index of economic indicators rose by 0.6% in April following a 0.2% decrease in March
Business inventories were flat in March while economists were expecting a 0.3% increase
Industrial production fell 0.5% in April more than then 0.2% decline economists were anticipating
Initial jobless claims for the week ending May 11th came in at 360,000 more than the 330,000 projected
April retail sales rose by 0.1% much better than the 0.3% decline economists had projected

For the week, the S&P 500 rose by 2% for a year-to-date return of 18%, including dividends.

Summary:

IBD: Confirmed uptrend

BCI: Moderately bullish favoring out-of-the-money strikes 2-to-1

Wishing you the best in investing,

Alan (alan@thebluecollarinvestor.com)

www.thebluecollarinvestor.com

Ask Alan – How to Compute Final Covered Call Returns-Part 1

Alan Ellman — Wed, 15 May 2013 19:57:29 +0000

Alan answers a question posed collective my many of the BCI member family, who ask about calculating final returns after the trade has been completed. This is part 1 of a 3 part series.

If you want more “Ask Alan” videos, you can view the archive.

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”.

Binary Options Are The Latest Rage, But Barely Like Traditional Options by Guest Author Tom Cleveland

Alan Ellman — Sat, 11 May 2013 11:52:37 +0000

Over the past few years, the popularity of traditional options has grown exponentially, as investors have been more willing to experiment with a broader set of investment genres. The market has responded to this more expansive behavior by creating a myriad of new products such as “weeklys” and “minis”, topics Alan has addressed on this site.

Along these same lines, trading foreign currencies has garnered enormous popularity over the past decade, but trading forex is not an easy path to riches by any means. Its risk profile is much higher than for stocks, and a great deal of training, analytical expertise, and experience is necessary, not to mention nerves of steel.

But part-time investors tend to become impatient and are unwilling to invest the time required to be an accomplished and consistent trader. As might be expected under these circumstances, casualties run high, but the marketplace has responded with a much easier instrument for trading – binary options, which are also sometimes called “digital” or “all-or-nothing” options. The back office required to support these options is radically different, and for that reason, you may need another broker to go “binary”.

Traditional options bestow the right to the holder to buy or sell an underlying asset at a point in time, typically the expiration date. Rights and obligations are established and may be sold or liquidated, based on the type of option and exchange rules. Binary options appear to replicate these same conditions. There is an underlying asset, like a currency pair, a commodity, a stock or an index, but no ownership potential is involved. There is an expiration point in time, but most brokers will let you extend that point, too.

Basic example of a trade with binary options

Assume for the moment that you have chosen the “EUR/USD” currency pair as your asset class for trading. Trading is web-based. No downloads are necessary, and the look of the execution platform for binary options is fairly standard in the industry. You will see a chart for the Euro with a line drawn at its current value. An Expiration Time will also be shown. The payoff, typically around 75%, will be prominently displayed, and
you will be asked to bet whether the value will go up (a Call) or down (a Put). The prevailing mix of other customers on this option, whether up or down, will also appear.

All you have to do is enter an amount to wager, pick a direction, and push “Execute”. An “Approve” screen will appear, your final action to place your trade. If you are correct at the expiration point, then your bet and an additional 75% will be credited to your account. If you lose, then you may lose your entire bet, or have a portion refunded. These rules are fixed before you execute your trade. In other words, your risk and rewards are known at the get go. There is no possibility of a margin call. This is a simple “High/Low” example, but most brokers offer a variety of ways to play this game.

More details and a recap about binary options

Binary option websites are cloaked in investment terminology, but the genre is more like a hybrid of trading and gambling. The financial dynamics have improved recently, due to broker competition, such that a 75% reward and a 10% refund, if you guess incorrectly, is the norm for most option classes. You need a “55/45” winning ratio to break even under this type of offering, much the same as with currencies and stocks. The thrill is that you can make a 75% return in a matter of minutes. Try finding that rapid a payoff anywhere else, excluding, perhaps, the lottery or the racetrack.

The broker’s back office is busily calculating the odds, similar to pari-mutuel horserace betting. The odds change right up and until the race starts and is concluded, the expiration time for binaries. There are no fees or commissions. Brokers have factored their needs into the payoff ratios.

Your only test then comes down to deciding if a particular market asset will move up or down in value over a specific time period. For that task, you will still need to recognize patterns, observe indicators, and discern key points of support and resistance, either visually or with Fibonacci tools. Every binary option strategy depends on these three leverage points. Yes, luck is involved, but in trading, you make your own luck by applying analytical skills to bias the odds in your favor.

Summary

The advantages of trading with binary options are numerous – simplicity of process, quick turnaround, and a high payoff potential in a short period of time. The cons for this medium are that you must have a desire to speculate, losses can be all or nothing, and unlike American options, you cannot sell or close your position before expiration, although some brokers permit rollover and double-down features.

Trading traditional options may not be for everyone. It is complicated, difficult, and very risky. Binary options, however, dispense with much of the complex infrastructure and allow the investor to focus on one thing, the direction of the market. Risks are still high, but rewards can also be high and quick.

Bio:
Article by Tom Cleveland from forextraders.com. Mr. Cleveland has been writing about investments since 1980 and joined the team at forextraders.com in 2009. Mr. Cleveland’s most notable work on the article’s subject is his binary options series.

___________________________________________________________________________________________________

Alan on guest bloggers:

As this BCI site has become one of the more popular financial websites (thanks to you), I receive multiple requests every week from outside bloggers to allow their content to be published on our site. The advantage to the guest author is that they benefit from the exposure to the ever-growing BCI community. The advantage to us is that we are exposed to additional content that may add to our investment expertise. Before an article is published on the BCI site from an outside source I read the article and usually edit it and return to the author for final approval. Both parties must be comfortable with the final product. My plan is for me to continue to be the primary source of blog artciles but allow guest features from time to time. I’d like to know how you feel about this. Send your comments to:

info@thebluecollarinvestor.com

Ultimately our members will determine how this matter is handled.

Alan

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Chart of the week from our Premium Stock Watch List:

ARMH: Technical chart

May seminars:

Las Vegas: May 14th

http://www.thebluecollarinvestor.com/event/las-vegas-moneyshow-at-caesars-palace/

Plainview, NY: May 23rd:

http://www.meetup.com/LISTMG/events/70350492/

Market tone:

This was a light week for economic and an historic week for the Dow (closed above 15,000 for the first time) and the S&P 500 (closed above 1625 for the first time):

Consumer credit increased by $8 billion in March, less than the $15 billion anticipated. This was the smallest rise in 8 months
Credit card spending declined by $1.7 billion, the largest decrease since July, 2012 and reversing a 3-month trend
Long-term debt which includes mortgages is still growing at a rapid pace
A recent Fannie Mae survey found that more than 50% of Americans expect home prices to rise over the next year. This positive outlook was the first time in the study’s 3-year history where a majority of Americans were bullish on home prices
Initial jobless claims (a report of the number of individuals who filed for unemployment insurance for the first time the prior week. While the weekly figure indicates trends in the job market, the four-week moving average is considered a truer gauge) for the week ending May 4th came in at 323,000, less than the 335,000 projected

For the week ended May 10, 2013, the S&P 500 Index was up 1% to 1,634 for a year-to-date return—including dividends—of about 15%.

Summary:

IBD: Confirmed uptrend

BCI: Moderately bullish favoring out-of-the-money strikes 3-to-2.

Thanking all of our members for your incredible support.

Alan (alan@thebluecollarinvestor.com)

www.thebluecollarinvestor.com

Ask Alan – Who actually buys my option?

Alan Ellman — Wed, 08 May 2013 23:31:07 +0000

Alan answers a question by Shamin from Belgium. who asks:

“If I sell a covered call and the stock price goes down, and then I decide to buy a call… — do they cancel each other out? (or) — can the person who bought my option originally still ask for my shares?”

If you want more “Ask Alan” videos, you can view the archive.

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”.

Using LEAPS Covered Calls to Increase Dividend Yield

Alan Ellman — Sat, 04 May 2013 10:52:24 +0000

Innovative covered call writers can develop ideas of implementing a strategy in unconventional ways. For example, we can invest in a money market or CD and perhaps not even beat the inflation rate with those dividends. We can buy a quality bond and wait six months to receive our first (ho-hum) return. Covered call writers can invest with 1-month options and generate returns of 2-4% in normal market conditions but incur some risk in the process (the risk is in the stock, not in the sale of the option). Can we incorporate covered call writing and dividends to generate returns somewhere in between the two strategies? We are Blue Collar Investors, of course we can! Let’s buy a stock that we have confidence in and sell an option which will decrease our cost basis and thereby increase our percent returns. This article was motivated by a series of comments and questions from Blue Collar Investors on this blog and is a great example of how we can all learn from each other.

The strategy:

Buy a high-dividend yield stock
Sell a long term (LEAPS- more than 9 months) deep in-the-money call option to reduce cost basis
Increase the dividend yield and create downside protection

Stock requirements:

Must be a candidate for a long-term holding
Must have options
Must have LEAPS
Must provide a dividend yield that meets our goals. Many stocks on our premium report will have not have dividends or yields high enough for this strategy. We must therefore use stocks that require less stringent screening procedures. Since we have huge downside protection with deep in-the-money calls our risk is still limited.

Once we have located a stock that has met our requirements, we must look for the dividend and yield information. A good FREE site for this is:

www.finance.yahoo.com

Past example: Dividends and yields

For GSK the dividend is $2.03 per year and a yield of 5.3% based on current market price of $38.07. Dividend yield information for stocks passing the BCI screens can be accessed from the premium report:

Dividend yield and the Premium report

The column highlighted in green shows dividend yield for a running list in a premium report. As stated above, there will NOT be many stocks from this list that would be great candidates for this strategy. A list of outstanding candidates for this strategy is provided to our premium members and will be discussed later in this article.

Once we have decided on an equity we need to access an options chain and check the premiums for long-term deep in-the-money calls:

Options chain for deep I-T-M calls

This example was archived from February, 2011 and the January 2012 $25 call option is highlighted. We can generate $12.90 per share or $1290 per contract by selling this option.

Calculations before covered call writing:

$2.03/$38.07 = 5.3%

Calculations after covered call writing:

By generating $12.90 per share we are reducing our cost basis to $25.17. Our new equation is:

$2.03/$25.17 = 8.07% (slightly lower if the option is exercised and we sell for $25. Our plan, however, is to continually roll the option to later expiration dates).

Increase in returns:

8.07% – 5.3% = 2.77%

2.77%/ 5.3% = 52% increase

Advantages of this strategy:

Superior yields (+2.77% or 52%)
Downside protection (from $38.07 to $25.17)
Immediate cash flow + dividends
You know maximum profit and breakeven
Can implement exit strategies if needed
Deep I-T-M strikes have high deltas. If we want to close our position it will be less costly to do so because option value will decline dollar-for-dollar with the stock price decline
Less time required to monitor positions

Disadvantages of this strategy:

No upside potential if price accelerates
You can lose money if the stock drops more than the premium and dividends collected
May be taxed at the unqualified rate. Check with your tax advisor
Assignment risk because of deep I-T-M calls
Must own securities through earnings reports
Lower yields than selling 1-month options
If the time value of the option is less than the dividend, your option may be exercised prior to the ex-dividend date and the shares sold. In this case you will not lose any money but you will not generate any additional income from this position. The cash will then be used to enter a new position. Let’s explore the possibility of early assignment in more detail:

Early Exercise of Calls for Dividends

When is it likely that the option holder will exercise the call option (we sold) early to capture a dividend? This is the primary risk with this strategy. First let’s recall the equation for the value of a call option:

Call value = intrinsic value + time value

This can be redefined as follows:

Call value = intrinsic value + interest rate value + volatility value – dividend value

Considerations just prior to the ex-dividend date:

Let’s assume a stock is trading @ $50 and will go ex-dividend by $2 the next day. There is a $40 call about to expire in 10 days. The $40 call has a theoretical value of $10 and a delta of 1. Therefore, the stock and the option have similar characteristics. Here are the three choices as the option holder:

1- Hold the option and take no action: The stock will open $2 lower because of the dividend deduction. The option will open @ $8 since the delta is 1 and this is the new parity price. This approach will guarantee a loss of $2, not really a good choice.

2- Exercise the option: We will buy the stock for $40, then lose $2 when the stock goes ex-dividend but also receive the dividend because of our share ownership. This is clearly better than choice 1 as we break even rather than lose $2. This is why sophisticated option holders will exercise prior to the ex-dividend date.

3- Sell the option and buy the stock: If the option is trading at parity (equal to the intrinsic value) this is the same as choice #2. If the option is trading for more than parity, let’s say $10.25, the option holder will generate an additional $0.25 per share making the third choice the best one.

Conditions for early exercise:

1- The option must be trading at parity: If the option is trading at more than parity, the holder should sell the option and purchase the stock at market. Most deep-in-the-money calls will be trading at parity near expiration Friday.

2- The option must have a delta close to 1: This will ensure that the option and the stock have the same characteristics so that the holder is not losing out on any time value. In our example, if the call holder feels that there is a chance that the stock value can drop below $40 prior to expiration he would prefer to hold the call as the potential loss would be limited to the call premium. Holding a long underlying (the stock), on the other hand, can result in a much greater potential loss. If there is a delta close to 1, there is almost no market expectation of the stock going through the exercise price. Here is a breakdown of parameters to consider:

A delta of 1 will almost definitely be exercised
A delta above .95 has a high probability of exercise
A delta below .95 is unlikely to be exercised.

3- Volatility considerations: Options in low-volatility markets are exercised more frequently than those in high-volatility markets.

4- Time to expiration considerations: With all other factors being equal, the delta will rise as we approach the expiration date. This will increase the chance of early exercise. Those selling deep-in-the-money LEAPS to increase dividend yield may want to roll the call option as the delta approaches .95.

Strategy objective:

Try to sell an option that will bring the cost basis down to as close to the strike price as possible. For example if a stock trades at $38 and you can sell the $25 call for $13, we have an ideal scenario.

Stocks to consider (as of May, 2013):

Here are a few stocks that have dividend yields between 4% – 8% and also trade more than 250,000 shares per day. They also have LEAPS options associated with them:

AZN
CPNO
DUK
VZ

Premium dividend yield stock list (produced quarterly):

As a result of the tremendous interest our membership has expressed in this strategy I have asked our BCI team to screen our huge database of stocks to locate outstanding candidates for this strategy. We are using stocks with LEAPS that trade 250,000 shares per day or more, have a dividend yield of 4% – 8%, priced lower than $200/share and a RS rating of 50% or higher. This list will be updated quarterly and can be found in the “resources/downloads” section of your premium site. Look for the file titled High dividend yield stocks. Also check the “resources/downloads” section of the premium site where we have archived an expanded version of this article which also explains how to monitor the stocks on the premium dividend yield stock list. This file is titled High Dividend Yield Strategy.

Conclusion:

Selling deep in-the-money call options will enhance the dividend yield and provide downside protection. Our risk of early assignment can be mitigated by monitoring the delta of the option and rolling out should the delta reach or exceed .95. Please note that this is not a strategy I use myself but one which I researched and wrote about in response to the interest of many of our members. It is a strategy most appropriate for ultra-conservative investors.

New seminars (just added):

Delray, Florida: March 18, 2014

Fort Lauderdale, Florida: March 19, 2014

May seminars:

Las Vegas: May 14th

http://www.thebluecollarinvestor.com/event/las-vegas-moneyshow-at-caesars-palace/

Plainview, NY: May 23rd:

http://www.meetup.com/LISTMG/events/70350492/

Market tone:

A positive jobs report boosted a week of mixed economic signals:

165,000 jobs were added in March (150,000 expected) causing the unemployment rate to drop to 7.5%, a 4-year low
January and February jobs stats were revised upward, adding an additional 114,000 jobs
The Conference Board’s index of consumer confidence (gauge of consumers’ attitudes about the present economic situation as well as their expectations regarding future conditions. Consumer confidence tends to have a strong correlation with consumer spending patterns) rebounded to 68.1 well above the 60.8 anticipated
Personal spending rose by 0.2% in March above the 0.1% expected
Personal income rose by 0.2% in March less than the 0.4% expected
Nonfarm business productivity ( measure of the growth of labor efficiency in producing the economy’s goods and services) rose by 0.7% in the first quarter, less than the 1.5% anticipated
The trade balance narrowed to $38.8 billion, much better than expected
Construction spending dropped by 1.7% in March perhaps a reflection of the “sequester” squeezing state and local government spending
The ISM manufacturing index fell to 50.7, below expectations
The ISM service-sector survey also dipped below expectations

For the week, the S&P 500 rose by 1.1% for a year-to-date return of 14%, including dividends.

Summary:

IBD: Confirmed uptrend

BCI: Cautiously bullish selling an equal number of in-the-money and out-of-the-money strikes

Wishing you the best in investing,

Alan (alan@thebluecollarinvestor.com)

www.thebluecollarinvestor.com

Ask Alan – Evaluating a Covered Call Trade

Alan Ellman — Wed, 01 May 2013 21:10:01 +0000

Alan answers a question by William of Manteca, CA. who asks:

“With these Details in mind…

* RAX was trading at $59

* $50 call option was selling at $5.70.

* Initial return for selling $55 in-the-money call option was 3.1%.

– $1.70 of time value

– $4 in-the-money ($4 of intrinsic value)

… how would you address these Qs:

1. I assume you own 100 shares of RAX that you bought at $55 and now trades at $59.

2. If you don’t own the stock and it falls below $55, what are you faced with?

3. Why not buy at $59 and sell the $60 for $2.75 and capture more time value?”

If you want more “Ask Alan” videos, you can view the archive.

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”.