Blue Collar Investors throughout the world are always looking for ways to generate additional profits into our portfolios. This includes the use of some of the more esoteric maneuvers that may produce small returns of $40, $50 or more. One of the main philosophical approaches to Blue Collar Investing is that by generating small but consistent, low risk returns and then compounding those profits, we can become financially independent.

In my previous books and DVDs, the following phrase appears on numerous occasions:

Sell at the “bid”, the lower price; buy at the “ask”, the higher price. This references the price lists found in the options chains. Before we discuss some common sense applications to maximizing profits by playing the bid-ask spread, let’s review some definitions (stay awake now, this can make you some cash!).

Definitions as they apply to options:

BID: An offer made by an investor, a dealer or a trader to buy an option. It will usually stipulate the price the buyer is willing to purchase the option and the quantity to be purchased. As covered call writers, we sell at the “bid”.

ASK: The price a seller is willing to accept for an option, also called the offer price. The “ask” will always be higher than the bid.

BID/ASK SPREAD: The difference in price between the highest price that a buyer is willing to pay for the option and the lowest price a seller is willing to sell it. If the bid is $2.80 and the “ask” is $3.00, then the bid-ask spread is $ 0.20.

Theoretical Value: The hypothetical value of an option as calculated by a mathematical model such as the Black-Scholes Option Pricing Model.

Black-Scholes Option Pricing Model: A model used to calculate the value of an option, by factoring in stock price, strike price and expiration date, risk-free return, and the standard deviation of the stock’s return.

How the bid-ask spread is set:

There may be several bid prices and several ask prices at any point in time. However, only the highest bid and lowest ask are used to calculate the spread. These are the figures you see when accessing the options chains. Utilizing an estimate of the volatility of the underlying stock, a theoretical option value is calculated using an option pricing model, such as the Black-Scholes model. A market maker will then set the bid below this theoretical value and the “ask” above this theoretical price. This is the spread and is determined mainly by liquidity. For example, the highly liquid ETF QQQ has bid/ask spreads as low as $ 0.01. This is one of the reasons I require all stocks owned in our portfolios and on our watch list trade at least 250,000 shares per day and options to have an open interest of 100 contracts and/or a bid-ask spread of $0.30 or less. Market makers derive their profit from bid/ask spreads. The greater the spread, the more money they make. Playing the spread will decrease their profits and increase ours.

Market order vs. limit order:

If you use a market order when executing a trade, you will sell at the published bid price and buy at the published ask price (this is called “lifting” the offer or “hitting” the bid). This may be okay for the purchase and sale of stocks where the spread is tight (small), but for options, which have a wider bid/ask spread, a limit order is more appropriate and beneficial.

The Show or Fill Rule:

This is also called the Limit Order Display Rule or technically the Exchange Act Rule 11Ac1-4. This regulation requires the market makers to show or publish any order that improves the current bid or ask prices unless it is filled. Any order between the current bid-ask spread will improve the market.

Practical Application:

Most exchanges have a policy in place that requires market makers to fill AT LEAST 10 contracts at the quoted price. For many equities and ETFs the number of contracts required is a lot more and varies from security to security. These players want to buy securities at the lowest price (bid) and sell at the highest price (ask or offer). Now it’s time for Blue Collar Investors all over the world to become annoying and take out our slingshots in much the same way that David approached Goliath. As long as the bid-ask spread isn’t too tight or close together, we place our order between the two quoted prices. If the market maker (MM) does not fill the order, he will be required to publish it and then be obligated to fill at least 10 contracts, perhaps more, at that price. Since most of us are selling small numbers of contracts, let’s say up to 5 per stock, it is in the best interest of our friends on the other side to just fill our orders and settle for a lower amount on 5 contracts rather than be obligated for twice that amount and for many more traders. We got them right between the eyes….I mean between the bid-ask spread.

Example:

In this hypothetical the bid is $2.50 and the “ask” is $3.00. That’s a spread we can work with. As covered call writers, we sell at the bid or in this case, $2.50 per share or $250 per contract. That’s the price at which the MM wants to buy our options. Instead our offer will be $2.65. That betters the current published offer of $3.00. Therefore, our friend on the other side has a dilemma: Do I fill these 5 contracts @ $2.65 or publish the new, improved offer and be responsible to fill 10 or more as required by the Show or Fill Rule? In most cases, we will get our $0.15 and the MM will get rid of us. This little maneuver will pay for our commissions and buy us lunch at Wendy’s. $75 becomes hundreds, becomes thousands, and becomes tens of thousands and so on. The market makers? They’re gazillionaires anyway…they’ll be alright.

****DO NOT CHECK THE ALL OR NONE (AON) BOX ON YOUR TRADE ORDER FORM:

All or None Box

For most of us checking this box is redundant, not necessary because the MM is required to fill at least 10 contracts. If this box IS checked the MM is no longer required to publish our offer and we will lose our leverage when playing the bid-ask spread.

A market order should always get filled as you are buying a said number of shares “at market” so you will hit offers until you have a fill. Limit orders will only fill at your specified limit price or better. If you don’t want partial fills and you are trading a large number of contracts you can use the all or none order. They will fill the whole order or nothing. However, this will be counterproductive when playing the bid-ask spread.

Conclusion:

To take advantage of the show or fill rule we must:

• Improve the market (bid-ask spread)
• Sell 10 contracts or less
• Not check the all or none box on the trade execution form

Blue Collar Investors have certain tools available that will level the playing field with the MMs. Taking advantage of the Show or Fill Rule is an important one especially when selling a small number of contracts. Although each successful trade will generate a small amount of cash, over time this will add up to significant dollars that will help to secure our financial future. Unlike David, though, we are not looking to injure our adversaries, just annoy them.

June 12th: I will be the keynote speaker for the New York City Private Investors Group at the ING Direct Cafe:

To sign up (seating is limited):

http://www.meetup.com/NYCPrivateInvestors/events/49668332/?a=ea1_grp&rv=ea1&_af_eid=49668332&_af=event

Time: 6PM to 7:30 PM

Admission is FREE and non-members are welcome.

Free resources and glossary:

In an effort to provide our members with the most thorough and informative covered call website available, we have recently added two new features to the general site:

1- Covered Call Glossary

2- Free resources including the Basic Ellman Calculator

Look for the links on the top bar of all pages of our site. Although the Blue Collar team is quite proud of our top-rated site, we will continue to listen to your valuable feedback and make enhancements that will take our site to even higher levels.

Market tone:

This was a light week for economic reports but included some encouraging news from the housing market:

• New home sales increased by 3.3% in April and up 9.9% compared to April, 2011
• Existing home sales rose by 3.4% in April following two straight months of declines and up 10% from April, 2011
• Single-family home sales increased by 3.0% and condominium and co-op sales rose by 6.0%
• The national median existing home sales price rose to $177,400 in April, up 3.1% from March and 10.1% from April, 2011
• New orders for durable goods increased by 0.2% in April, slightly below expectations but an increase from the 3.7% decline in March

For the week, the S&P 500 rose by 1.7% for a year-to-date return of 5.70%, including dividends.

The VIX has calmed this past week to a level of 21 but has been erratic at best the past 3 months as shown in the chart below:

VIX- A 3-month chart

Note the following:

• The red arrows highlight the rapid spikes in the VIX during the past 3 months
• The green arrows show the subsequent declines in the VIX
• The yellow field shows a calm and stable VIX, an ideal scenario for the conservative strategy of covered call writing

Summary:

IBD: Market in correction

BCI: Cautiously bullish as the recent housing reports are huge for a recovering economy. This is more than likely a reason for continued improvement in consumer sentiment (79.3, the highest level since October, 2007).  However, I continue to favor in-the-money strikes to hedge the recent market volatility.

Happy holidays to one and all,

Alan (alan@thebluecollarinvestor.com)

www.thebluecollarinvestor.com

First, the original email and trade history…

SUBSCRIBER EMAIL #1:

Alan,

This requests your thoughts about a trade I made that didn’t work out well at all. I lost about 20% of the initial investment in two months. Last month you published a really useful summary by Barry about a trade on CMI that didn’t work out. I wondered if maybe someone on your team would do the same for this trade. If you’re willing to do it and if you want to publish it, it would be fine by me.

The trade details and my thinking at the time of each trade are in the attached Word doc.

Thanks in advance.

INVN Covered call historyINVN- Technical chartINVN Technical chart

INVN Technical chart

• I got in on a good entry point with an up trending stock
• I tried for a couple of doubles on pullbacks.
• I rolled up and out on a positive uptrend.

Any thoughts about what I could have done?
Thanks in advance.

BCI RESPONSE EMAIL #1:
Barry’s initial response:

The BCI system tends to be conservative, with preservation of capital a key component of the methodology. Understanding this…let’s take a look at your trade…

Some initial thoughts…

> As Alan continually advises…stock selection is the most critical element of the BCI
methodology

> I reviewed the Premium Report from 2/17/12…the report published just prior to your
trade entry

- INVN failed the screening process that week
- This means that INVN was not an “elite” covered call candidate that week because…
- The price was at the 20 day EMA
- Both the MACD and Slow Stochastics failed
- No StockScouter rating (not a deal-breaker)
- The stock was only trading since 11/16/11…trading for less than 6 months…Alan
likes to see at least 1 year of price history…stocks with less than 1 year of history
because stocks with less than 1 year history could have higher risk and volatility (also not a deal-breaker)

> INVN then failed to pass the screens per the 2/24/12 report
- Price at 20 day EMA
- Failed MACD and Slow Stochastics
- The stock was only trading since 11/16/11…trading for less than 6 months
- No StockScouter rating

> INVN then failed in the 3/2/12 report

> INVN first appears on the 3/9/12 report with mixed technicals

> Your comment “good entry point with an up trending stock”…
- Just prior to your entry, the stock turned over…not a good sign…could mean that the
uptrend was over. At the time you entered the trade, you didn’t have any idea
whether the stock was pulling back or was, in fact, turning over. You needed
confirmation that this was a pull back.

> On 2/27, INVN closed below to 20 day EMA…this could have been a good time to exit
the trade with only a small loss

> It appears (in my opinion…I could be wrong here) that you were trying to day trade the
covered call…trading/adjusting too soon or over trading

> If you held the trade until expiration on 3/16, the trade would have been profitable

Net/net…
I believe that the primary issue with this trade was stock selection. It did not pass the critical selection criteria until almost 4 weeks into the trade. Also, the stock didn’t have any long term track record/price history…trading less than 1 year (not a deal-breaker but a more risky trade). This trade was then compounded by the adjustment process for the trade.

I think that there are four lessons to be learned from this trade:
[1] Stock selection is the most critical factor to successful covered call trading…follow
the proven BCI methodology
[2] Patience…if you waited a bit longer, the trade would have ended successfully
[3] “Paper Trading” and back testing exit strategies before you commit live cash to the
trades
[4] The initial return appeared to be higher than the typical return the BCI system looks
for, usually 2-4%. In this case it was over 5%. Higher returns are indicative of higher
volatility in the stock.

SUBSCRIBER EMAIL #2 WITH BCI RESPONSE #2 INLINE:

The subscriber then responded to our first pass review of the trade with follow-up questions…

Thanks so much for your response. This is sooooo helpful!!! I really truly appreciate it! I do have a couple of “ah ha’s”, comments, & questions.

1) My big “ah ha” here is that you don’t recommend entering a position from the list that “passed previous weeks & failed current week.” I thought they were there to use, albeit cautiously, until they dropped down to the “stocks removed from running list this week.” I do see it’s in point 4 of the document “running list from the premium report” but I never internalized this point. This is an important misunderstanding on my part but I’m really glad to now understand. It certainly makes my screening process easier, and I hope better.

BCI RESPONSE:
We keep the “stocks removed from running list this week” on the report for readers who may have entered the position previously rather than just dropping the stock. In many cases the stock comes back and continues on the “Running List.” The stock is only dropped from the “Running List” if it fails the screening process for three consecutive weeks.

2) Your comments that it had only been trading 6 months and had no StockScouter rating raises a suggestion for me. If you think those are reasons to avoid an entry, then my recommendation would be for you to not include stocks that fall into these camps in the list. Because if it’s in the list it makes me think you believe it is a viable candidate for a conservative investor’s consideration.

BCI RESPONSE:
As Alan points out, not having a “StockScouter” rating is not, in itself, a reason to eliminate a stock…there are a lot of stocks that “StockScouter” doesn’t cover (usually American Depository Receipts or ADRs which are foreign companies trading on US exchanges). My comment here was to indicate that you didn’t have as clear a picture of the stock as you might have. Many great candidates have not had “StockScouter” ratings in the past.

Having less than one year of chart history has been a point that the BCI Team has discussed numerous times.  Alan prefers to see a full year of history so the subscriber can see how the stock performs, what happens to the stock after an ER, etc. We ultimately made the decision to include these stocks but add a comment about the less than one year history (located in the key at the top of the “running list”).  Since our subscriber base has a very wide range of risk tolerence, we made the decision to include these stocks, but give a warning. That way, the reader could decide whether to include the stock is a potential candidate for them based on their personal risk profile.

3) The points about day trading and patience I understand. I have always managed my covered call positions by writing OTM on stocks I wanted to keep. I think Alan calls it an overwrite strategy. However, I have believed that in order to get Alan’s 2-4% per month, I thought we had to try and hit “doubles” when the opportunity presented itself so I thought buying back the calls on pullbacks was part of the strategy. Both times I did this I did come pretty close to the bottom of the pullback and the one I resold was at a previous resistance level and the stock was higher than my original purchase price so it seemed like a good place to re-sell it. Having said all this, I would be very interested for more clarification about the “hitting doubles” strategy and why what I did was or wasn’t the right way to execute it or seemed more like day-trading. This seems like something important for me to learn more about.

BCI RESPONSE:
The goal of “hitting a double” is situationally dependent. Per page 259 in Alan’s new book:
“As a rule of thumb, we attempt to hit a double when the market tone and stock technicals are mixed to positive earlier in the contract period (especially during the first week or early in the second).”

What you did made sense. My comment, re: “day trading”, was triggered by the number of trades in the 3/12 to 3/16 time frame. There are times when we have to say that chasing the stock to repair it just doesn’t make sense and exit the trade. There were number of times that you could have exited the trade with either a small loss or a small gain. I’ll try to reconstruct the trade as best I can…I’m not an accountant, so here is my best effort (note the numbers may be slightly off due to the early laddering of strikes)…

2/21 – Opened the trade with a cost basis (C/B) of $17.13
- STO calls…the average premium from the different strikes was $1.70, so
your C/B is now $15.43

3/02 – BTC Mar 17.50 C at $0.36. C/B = $15.79…stock price is $15.26…loss if exit at
this time

3/12 – BTC Mar 15 C at $2.80. C/B = $18.59…stock price is $19.12 (numbers could
be slightly off due to initial laddering of strikes)

NOTE: You could have exited at this time (before the next trade) with a
$0.53 profit (3.1% ROO on initial $17.13 or 2.8% ROO on C/B)

- STO Mar $17.50 C at $0.75. C/B = $17.84

3/16 – BTC Mar $17.50 C at $3.19. C/B = $21.03
- STO Apr 20.00 and Apr 22.50 at avg premium of $1.76. C/B = $19.27
NOTE: Your C/B on 3/12 was $17.84. The stock closed at $20.10 at
expiration. If you didn’t enter the subsequent trades on 3/16 and let
your Mar $17.50 short call be assigned, you could have exited the
trade with a $0.34 loss

4/03 – BTC Apr 22.50 C at $0.20. C/B = $19.47

4/10 – BTC Apr 20.00 C at $0.10. C/B = $19.57

4/18 – Close trade

My numbers are not exact but reasonably close so you can get the sense of the opportunities that were available to make other decisions.

4) Your point about the initial return was too good to be true is thought-provoking. My ITM strike had an ROO of 2.5% and the near-ATM strike’s ROO was 5.3%. What do you think an ATM ROO level is that should raise red flags — anything over 4%?

BCI RESPONSE:
My error…I looked at the $2.50 option value but didn’t realize the call was the Mar $15 ITM call. The return for the ATM call was, as you indicate, 5.25%. In ‘normal” market conditions, Alan looks for 2-4% return. Since the return was 20% higher, it set off a yellow flag in my mind. Remember, with due diligence, it may have turned out that the higher return was justified. The BCI methodology tends to be conservative by design. The higher initial return is another factor to consider…among a lot of factors. Your decision to ladder the strikes was spot on!

The 5.25% ROO, by itself, didn’t raise a red flag…more of a yellow flag that suggested a closer look at the stock. When you look at a complete picture, the factors were:

- The stock didn’t pass the initial screening process…immediate disqualifier
- The stock had less than one year history…not a disqualifier, but a flag indicating
a closer look and a decision based on your risk tolerance
- A initial ROO > 4%…not a disqualifier, but a flag indicating a closer look…the
higher the return, the higher the risk

5) My last comment I put last because it’s about the entry point. Now knowing that the recommendation would have been to avoid an entry on this stock because it was not in the white boxes makes this a moot point. But I did want to get more insights about your comment about the trend and the MACD rollover. If you draw a diagonal resistance line across the top of the candle bodies on 11/22 & 2/7 and then draw a diagonal support line across the bottom of the candle bodies on 12/30 & 3/6, you get a very well defined up-trending channel. My entry on 2/21 was at a bounce off the 50% line within this channel. Here’s my question. Since stock selection and entries are important, I would think that entries on pullbacks are better than entries near tops. So having the price pullback or a MACD rollover as part of a pullback doesn’t seem like a bad entry to me. In fact it seems like a good entry. Thoughts?

BCI RESPONSE:
My comment was based on being put in your position on the day you entered the trade, looking at the chart on that day, and making the trade decision. On 2/21, the price chart indicated that the price had rolled over. When you placed the trade, you, most likely, didn’t know that the price was close to the 20 day EMA. Then, if you looked at the MACD and the Stochastics, they were both below their respective trigger lines…reason to disqualify. Now…looking at the up trending channel you defined…in my personal opinion, it was not confirmed by the technicals…volume, MACD, and Stochastics were showing bearish divergence. Bearish divergence is a flag that there could be an impending change in the stock in the direction of the divergence. While bullish/bearish divergence is, not in itself, a part of the BCI methodology…we try to get a sense of impending changes through the use of the technicals. It is the confluence of all of the data that we generate that gives us a clear idea of what the best course of action should be. However, headline risk is always there, and in this case, it impacted the trade.

Your comment about entry based on pull backs is correct, however, you need confirmation that the pull back is temporary vs. a reversal. Looking at the technicals would have helped you make that distinction. As a side note, INVN appeared in the IBD 50 on the Friday prior to your initial trade. Being on the IBD 50 does not necessarily guarantee that the stock will pass the other screens that are part of the BCI screening process.

SUBSCRIBER EMAIL #3:

Barry,  two things.

1) Excellent answers. I really appreciate your thought process.

2) Thanks so much for spending the time to answer in such detail. I’m sure you have plenty of other things to do so I really appreciate the fact that you took the time to help me.

I’ve re-read your answers a couple of times already and I will do it again because I really want to learn to get good at this.

Thanks again.

BCI RESPONSE EMAIL #3:
… When discussing the trade with Alan, we had one question about the price that you bought back the Mar 15 option on 3/12/12…can you please verify that value?

BCI RESPONSE EMAIL #4:
The reason that I asked you to recheck the value of the BTC Mar 15 on 3/12 is because the option price based on the closing price appeared too low. So, I decided to do a deep dive to see exactly what happened that day using the TOS platform’s “OnDemand” feature to see the trading activity that day. With some help from the support team at TOS, we found out the details of the trade:

- Trading range for the stock that day was $16.75 – $20.10
- Your trade was probably executed sometime between 10:40 and 10:50
- The stock price at the time of your trade was $17.80
So…with hindsight, the price of your trade does, in fact, make complete sense…Stock price @ $17.80, Strike price @ $15, Option price @ $2.80.

SUBSCRIBER EMAIL #4:

Barry, sorry I was slow to get back to you. This was my first opportunity to respond.

First, it’s fine to use this as an example. I think it’s great to have all of us learn from one another.

Second, your detective work was excellent. The 3/12 BTC Mar 15 occurred at 10:34:19 EST. In my trading journal, I record the stock price when I STO the call because I have my journal set up to calculate the ROO. I don’t record the stock price when I BTC since the final return isn’t based on the closing stock price. However, I just went back to the chart and for the minute of 10:34, the stock opened at 17.91, the low was 17.55, and it closed at 17.62. So your assumption of 17.80 is probably very close given it executed 19 seconds into the minute as it was going down.

Conclusion (Alan):

In an effort to educate our members, the BCI team will periodically publish real-life trades like these. Although it is impossible to analzyze every trade sent to us, we will make every effort to publish those that would be most beneficial to our BCI community. Many thanks to Barry for his outstanding contribution to this week’s blog.

Covered Call Glossary:

We’ve added a covered call glossary to our ever-expanding website. Look for the link on the top bar of our site:

Glossary link

June 12th: I will be the keynote speaker for the New York City Private Investors Group at the ING Direct Cafe:

To sign up (seating is limited):

http://www.meetup.com/NYCPrivateInvestors/events/49668332/?a=ea1_grp&rv=ea1&_af_eid=49668332&_af=event

Time: 6PM to 7:30 PM

Admission is FREE and non-members are welcome. 

Market tone:

 This week’s economic reports reflect a sluggish, choppy economic recovery with a bit of long-term concern:

For the week, the S&P 500 declined by 4.3% (ouch!) for a year-to-date return of 3.9%, including dividends.

A comparison chart of the S&P 500 and the VIX shows a technical breakdown of overall market parameters:

• The S&P 500 (green field) drops below the trading range at thew blue arrow
• The VIX (currently @ 25)  breaks out above its trading range at the red arrow
• In the past 3 months the S&P 500 has dropped by 5% and the VIX has increased by 37.5%

Summary:

IBD: Market in correction

BCI: Neutral on US economy but concerned about technical breakdown of overall market and concerns expressed by the Fed. Currently selling only in-the-money strikes and using low-beta stocks or ETFs as underlying securities.

Wishing you the best in investing,

Alan (alan@thebluecollarinvestor.com)

www.thebluecollarinvestor.com

Option premium = intrinsic value + time value (or extrinsic value)

This past week I hosted a seminar in New York and there were many inquiries regarding the difference between intrinsic and extrinsic value so I felt a blog article would be appropriate.

There are three types of strike prices as they relate to the stock price:

• At-the-money (ATM)
• In-the-money (ITM)
• Out-of-the-money (OTM)

The ATM strike is when the strike price and current market value are the same. An example would be when you buy a stock for $50 and sell the $50 call option.

The ITM strike is when the strike price is less than the current market value of the stock. An example would be when you buy a stock for $56 and sell the $50 call option.

The OTM strike is when the strike price is higher than the current market value of the stock. An example would be when you buy a stock for $48 and sell the $50 call option.

Of these three types of strike prices only the ITM strike has intrinsic or inherent value. In the example above, if we sold the $50 call when the stock was trading @ $56, the option buyer could exercise that option, buy it from us @ $50 and sell it at market for $56 generating a $6 profit. In this case the intrinsic or inherent value is $6. The ATM and OTM strikes have no intrinsic value so those options consist only of time value or extrinsic value. Let me give some examples:

ATM: Buy a stock for $50 and sell the $50 call for $1.50. The premium is ALL time value (our initial profit) and represents a 3% initial return ($1.50/$50).

ITM: Buy a stock for $56 and sell the $50 call for $8. The premium breakdown is as follows:

Option premium ($8) = Intrinsic value ($6) + time value ($2)

Our initial profit is NOT $8 because we will be losing $6 on the sale of the shares. Therefore, when calculating our initial profit for an ITM strike, we deduct the intrinsic value from the premium and the resulting time value is our real initial profit, in this case $2.

OTM: Buy a stock for $48 and sell the $50 call for $1.20. The premium is ALL time value as in the ATM example. In this case, $1.20 represents a 2.5% initial return ($1.20/$48).

***Do not include intrinsic value when calculating your initial option returns. For those of you who have access to the Ellman Calculator, these calculations will be automatically done for you after entering the information from the options chain.

Pros and cons of each strike type:

ATM:

• Generates the highest initial option return
• No upside potential from share appreciation
• No downside protection of the option profit (time value)

ITM:

• Generates a lower initial return than ATM strikes
• No upside potential from share appreciation
• Provides protection of the option initial profit from the current market value down to the strike price ($6 of protection from the above ITM example)

OTM:

• Generates a lower initial option return than the ATM strike
• No downside protection of the option initial profit
• Does provide upside potential for share appreciation from the current market value up to the strike price sold ($2 per share in the above OTM example.

I use ATM and OTM strikes when I am bullish about the stock and overall market conditions. I favor ITM strikes when I’m bearish about the overall market or when the technicals of the stock are mixed. Strikes can be “laddered” in most market conditions where you select a mix of strike types. The mix can be an equal number of each or favoring one type depending on market assessment and your personal risk-tolerance. More conservative investors will favor ITM strikes.

 Real life example: ASNA:

Let’s take a look at the options chain (June contracts) for a stock currently on our Premium Watch List:

ASNA-options chain

• The $20, ITM strike generates an initial 3.5% return with 4.1% protection OF THAT PROFIT (yellow)
• The $21 ATM (near-the-money) strike generates the highest initial return of 4.6% but very little upside and  no downside protection of that profit (green)
• The $22 OTM strike generates a 2.6% initial return with another 5.5% upside potential if the share appreciates higher. This represents a potential 8.1%, 5-week return (purple)

Conclusion:

Option premium consists of intrinsic value (ITM strikes only) + time (extrinsic) value. Only the time value represents our initial profit. Understanding  the pros and cons of each strike type and basing our selections on chart technicals as well as overall market assessment will allow us to raise our profit returns to the highest possible levels.

• The trade deficit increased by $6.4 billion due to higher imports; exports held steady
• Consumer credit rose $21.4 billion in March twice analysts expectations
• The Producer Price index (PPI) dropped by 0.2% in April, the largest decline since 10/2011 mainly due to a decrease in energy prices
• Initial jobless claims for the week ending May 5th was 367,000, slightly less than the 370,000 the analysts were expecting

For the week, the S&P 500 declined by 1.1%, for a year-to-date return of 8.4%, including dividends.

Summary:

IBD: Market in correction

BCI: Cautiously bullish on our economy, concerned about global issues impacting our markets, and selling predominantly in-the-money strikes.

When selecting appropriate underlying candidates mid-contract we use the same system criteria as we do for full month trades: Elite performers fundamentally and technically while also screening for the “common sense” BCI requirements (no earnings report etc.). Therefore, we initially turn to our watch lists (premium or the one you developed). There are two major differences I employ when entering these mid-contract positions:

1- My goal changes from 2-4% to 1-2% for the remianing two weeks

2- I will favor in-the-money strikes in MOST market conditions because exit strategy execution becomes more challenging the closer we get to expiration Friday so I like the addition protection of ITM strikes. In strong bull markets I would have no issues going with the more aggressive OTM strikes.

This past week I received a few inquiries about this topic so it led me to this week’s blog article. On Thursday evening, May 3rd I accessed our recent premium report and went straight to the “running list”. I then went to an options chain to see which candidates would meet the following goals:

1: 1-2%, 2-week return

2:  Decent downside protection of that profit

Here is a partial view of that running list with a few stocks that I would consider:

The yellow-highlighted cells are candidates worthy of entering into the Ellman Calculator based on option chain information. I then entered the potentially eligible stocks into a spreadsheet, including option chain information and industry information (remember that we must be properly diversified). Here’s what that looked like:

Options chain information

 Next the information is fed into The Ellman Calculator where will look for our goal of 1-2%, 2-week return WITH protection. Below is a screenshot of the results:

In the green-highlighted cells I have selected 5 stocks in 5 different industries that best meet these goals. If I were looking for only one or two equities, the two circled in red would be given strong consideration.

Conclusion:

Entering a covered call position mid-contract does make exit strategy execution more challenging but not insurmountable. It has the advantages of putting your money to work more frequently but requires a change in return goals and an adjustment of your strike selections. A well-formed watch list should provide a suitable number of choices to select from.

Live events update:

May 8th: I will be the keynote speaker for the Long Island Stock Traders Meetup Group. I will present a basic review of covered call writing and then proceed with an audience participation section where your favorite stocks are analyzed for potential covered call trades:

Place: Plainview-Old Bethpage Library (Auditorium)

Time: 7 PM – 9PM

Admission is FREE and non-members are welcome.

June 12th: I will be the keynote speaker for the New York City Private Investors Group at the ING Direct Cafe:

http://www.meetup.com/NYCPrivateInvestors/events/49668332/?a=ea1_grp&rv=ea1&_af_eid=49668332&_af=event

Time: 6PM to 7:30 PM

Admission is FREE and non-members are welcome. 

NEW MEMBERS:

We invite you to take our FREE video beginner’s tutorial with FREE powerpoint downloads:

http://www.thebluecollarinvestor.com/beginners-corner/

Market tone:

 This week’s mixed bag of economic reports came out over the backdrop of concerns that the euro zone’s recession may be deeper and longer than anticipated. This concern intensified after reports that their service sector index fell to 46.9 in April compared to 49.2 in March:

• A disappointing jobs report caused the market to plummet on Friday as 115,000 new jobs were created lower than the 165,000 expected
• Temporary hiring increased, however, after falling in March
• The unemployment rate declined to 8.1% from 8.2%
• Nonfarm business activity (measure of economic efficiency) declined at an annualized rate of 0.5%, in line with expectations
• The ISM’s nonmanufacturing index fell to 53.5 from 56.0 worse than the 55.0 expected. A reading above 50 signals expansion so economic activity continues to grow but slower than desired
• The ISM’s manufacturing index rose more than anticipated in April to 54.8 (53 was the expected stat)
• Construction spending rose by 0.1% in March, less than the 0.5% expected. This was due to a decline in government spending. Private sector spending actually increased by 0.7% mainly due to new single family homes
• Consumer spending increased by 0.3%, lower than the 0.4% anticipated
• With about 80% of S&P 500 c0mpanies having reported earnings recently, 67% have been positive surprises while 24% have been negative surprises. This is a critical component to the bullish stance taken by this site over the past 9 months

 For the week, the S&P 500 declined by 2.4% for a year-to-date return of 9.6%, including dividends.

 This site has been generally bullish on the economy and our overall covered call positions since last September but more recently has taken a defensive stance. As previously explained this is due to the volatility the markets have been experiencing:

 Please note the following:

• The S&P 500 (blue line) is up about 2.5% in the past 3 months, a stat we can live with
• The VIX (black line) looks like it just took a ride on the Space Mountain roller coaster ride @ Disneyland
• In the past 3 months the VIX has been up by 20% and down by 20%

Summary:

 IBD: Market in correction

BCI: Cautiously bullish using predominantly in-the-money strikes

My best to all,

Alan (alan@thebluecollarinvestor.com)

www.thebluecollarinvestor.com

One of the incredible features of this tool is that you can tailor the list to your specific priorities and risk tolerance. In this article I will demonstrate several approaches members can take to make our final decisions. The flexibility we have is a testimonial to the amount of information incorporated into this tool and for that I send my kudos to Barry Bergman (Director of Research for The Blue Collar Investor) who oversees the production of this weekly report and the BCI team members.

Here are some of the priorities you can stress in your final stock selections:

• Stocks with the strongest current technicals
• Stocks located in the best-performing industries
• Stocks that perform the best in the current market environment (bullish or bearish)
• Stocks that generate a dividend yield
• Stocks with “staying power” or passed all screens over a long period of time
• Stock price to accommodate a low cash portfolio

Once you determine the category or categories most important to you, the report will help guide you to your ideal portfolio. In the screenshot below, I have highlighted certain aspects of the running list (pages 4-6 in most reports) that relate to the first five of the above categories:

Blue Collar Premium Report: Running List

Blue Collar Premium Report- Weekly Stock Screen Section

Conclusion:

The BCI Premium Stock Report is a tool designed to save our members an immense amount of time. It screens the universe of over 8000 equities into a manageable list of 40-60 securities. At that point you can use your personal preferences and risk tolerance level to make your final selections. If your portfolio requires 5-7 equities, select about 10 stocks from the list and use the Ellman Calculator to make final selections. We report, you decide! Once you use the process for a few months it will become second nature as you use the report to maximize your profits to the highest possible levels.

Upcoming events:

May 8th: I will be the keynote speaker for the Long Island Stock Traders Meetup Group. I will present a basic review of covered call writing and then proceed with an audience participation section where your favorite stocks are analyzed for potential covered call trades:

Place: Plainview-Old Bethpage Library (Auditorium)

Time: 7 PM

Market tone:

• This week’s economic reports continue to show an economic recovery that is both modest and spotty:
• The Commerce Department reported GDP annualized growth of 2.2% lower than the 2.3% expected
• However investment in residential structures rose to its highest level since 2010
• Personal consumption rose from 1.5% in the last quarter to 2% for the 1st quarter this year as exports increased more than imports
• The Conference Board’s Consumer Confidence Index reading of 69.5 was lower than the expected reading of 69.7. However, the reading remains much higher than the recent October low of 40.9.
• Durable goods orders fell by 4.2% in march more than the expected loss of 0.5%
• The Fed announced that it was holding its monetary stance with short-term interest rates between 0% and 0.25% through late 2014
• The Fed revised its long term forecast of GDP increase from (2.2% to 2.7%) to (2.4% to 2.9%)
• New home sales came in at an annual pace of 328,000 higher than the projected 320,000

For the week, the S&P 500 rose by 1.8% for a year-to-date total of 12.3% including dividends.

In the past 3 months the market has been trending higher but the VIX has been erratic as shown in the chart below. That is the reason this site remains bullish on the overall economy but hedging positions with in-the-money strikes:

Market tone: 4-27-11

 Summary:

IBD: Confirmed uptrend.

BCI: Cautiously bullish favoring in-the-money strikes.

Wishing you the best in investing,

Alan (alan@thebluecollarinvestor.com)

www.thebluecollarinvestor.com

All options are defined by an expiration month and date (the 3rd Friday of the month except for some quarterly and weekly expirations of some securities) after which the contract becomes invalid and the right to exercise no longer exists. When options began trading in 1973, the CBOE (Chicago Board Options Exchange) decided that there would be only four months at a time when options could be traded. Stocks were then randomly assigned to one of three cycles:

• January cycle- options available in the 1st month of each quarter (Jan., April, July and Oct.)
• February cycle- options available in the middle month of each quarter (Feb., May, Aug., and Nov.)
• March cycle- options available in the last month of each quarter (March, June, Sept., and Dec.)

This proved to be a workable concept until options gained in popularity and there was a demand for shorter-term options. In 1990, the CBOE decided that each stock (with options) would have the current and following months to trade PLUS the next two months from the original cycle (hope your head isn’t starting to spin). Let’s simplify things by looking at the chart below:

Stock Option Expiration Cycles

If the current month is January, we see that all options are available for both the current (January) and next month (February). The last two option expiration months available will depend on their original placement in one of the three cycles:

• January cycle- will also have April and July expirations (1st month of next 2 quarters)
• February cycle- will also have May and August expirations (second month of next 2 quarters)
• March cycle- will also have June and September expirations (third month of next 2 quarters)

Now if your head has stopped spinning and you’re feeling a bit better, I ask you NOT to put away the Tylenol, at least not yet! Here come the LEAPS (Long term Equity Anticipation Securities) which are options with longer term expirations. Only heavily traded securities like Microsoft have these types of derivatives. These equities will have options with more than four months of expirations, some up to seven months. LEAPS can further complicate these cycles but that’s a discussion for another day. Suffice it to say that a vast majority of stock options will fall into the four month cycle.

Those of you following the Blue Collar System of selling predominantly 1-month options need not be concerned about those dates further out. However, intelligence does breed curiosity and many of you have “peaked” ahead and wondered what was up. Now we know so it’s back to generating cash by selling covered call options.

Expiration Cycles- Additional Months Program 

Additional Expiration Months Pilot Program

On Monday, November 1, 2010, pursuant to SEC Approval, ISE introduced additional expiration months on 20 actively traded option classes listed on the ISE on a pilot basis until October 31, 2011.  Under the pilot, the ISE added up to two new expiration months in addition to the expiration months the exchange already listed.  Pursuant to the pilot, ISE listed four consecutive near-term expiration months plus two months from the quarterly expiration cycle.  After the additions were made on November 1, ISE maintained the pilot by adding a single new expiration month at expiration.

Classes selected for the pilot were made available throughout the pilot period.  Any class that was delisted at the ISE was not replaced.  The pilot program allowed ISE to also list additional expiration months for option classes selected by other exchanges if another exchange adopted a similar pilot program (assuming the option class selected by another exchange was listed on the ISE).  

Below are the 20 classes selected for the pilot along with the expiration month(s) that were added: 

The pilot program ended and was NOT extended. However, the securities that were originally part of the program still maintain those additional expiration months.

Upcoming events:

May 8th: I will be the keynote speaker for the Long Island Stock Traders Meetup Group. I will present a basic review of covered call writing and then proceed with an audience participation section where your favorite stocks are analyzed for potential covered call trades:

Place: Plainview-Old Bethpage Library (Auditorium)

Time: 7 PM

Thanks for coming:

I was honored to meet many of our BCI members when I was the keynote speaker for the AAII-Atlanta April meeting. Many of you traveled quite a distance. I appreciate your loyalty and support.

Market tone:

 This past week’s economic reports were generally positive led by favorable consumer spending stats:

• Retail sales rose by 0.8% in March above the 0.3% expected
• Sales are up 6.5% from a year ago
• New home construction in March fell by 5.8%, below expectations, the 2nd straight monthly decline
• Building permits, however, were up 4.5% (up 30.1% from a year ago)
• Building completions increased by 4.2% (up 0.5% from a year ago)
• Housing starts were up 10.3% from a year ago
• Business inventories increased by 0.6% in February, ahead of expectations. The inventory-to-sales ratio shows that businesses are effectively controlling their inventories
• Sales of existing homes fell 2.6% in March, the 2nd straight monthly decline and below expectations. Compared to a year ago, however, the rate is up 5.2%
• US industrial production was flat for the 2nd month in a row, below analyst expectations
• The Conference Board’s index of leading economic indicators increased by 0.3% in March, better than the 0.2% expected. This represented the 6th straight monthly increase
• The coincident indicator (measure of current economic conditions) rose by 0.2%, the 4th straight increase  

For the week, the S&P 500 was up 0.6%, for a year-to-date return of 10.3% including dividends.

Last week, this site, although still bullish on our economy and overall market outlook, took a more conservative position (favoring in-the-money strikes) due to the increased volatility of the VIX. A 3-month chart of the VIX and S&P 500 shows that the market benchmark is up 5% while the VIX has calmed to an encouraging 17.44. However, in the current month, the VIX has had several swings of 10% -15% and that concerns this conservative investor. The chart below demonstrates these points:

The VIX and S&P 500 as of 4-20-12

One way to measure the volatility or systemic risk (market risk) of a security is to compare it to the market as a whole; the S&P 500 being the most commonly used benchmark. This is known as beta. Beta stats are calculated using a process known as regression analysis wherein the “market” is assigned a number of “1″. Beta is the tendency of a stock’s returns to respond to changes in the market.

The Numbers:

• Beta of 1- the equity price will move in conjunction with the market. If the market is up 2%, so will the stock (be expected to).
• Beta of less than 1 but above zero- the stock will be less volatile than the market. An example would be utility stocks
• Beta greater than 1- the security price will be more volatile than the market. An example would be tech stocks.

An example:

If a stock has a beta of 1.5, it is considered 50% more volatile than the S&P 500. If the market appreciates by 8%, the expected return of that equity, based on its beta, would be 12%. On the other hand, if the market declines by 8%, that equity would be expected to decline by 12%. There you have the two faces of enhanced volatility…greater potential returns with enhanced risk. If an equity had a beta of .5 and the market was up 8%, one would expect that security to appreciate by 4%.

Negative betas:

A stock with a negative beta tends to move in the opposite direction of the market. An equity with a beta of (-) 2 would decline by 10% if the market appreciated by 5%. It would increase by 10% if the market declined by 5%.

Problems with beta:

There is no such thing as a panacea in the stock market. This ratio does have its flaws and should not be relied upon solely in determining the risk of our investments. Here are the drawbacks:

• Beta does not account for business changes like a new line of products.
• Beta looks backward and history is not always an accurate predictor of future events.
• Beta ignores the price level of a stock.
• Beta makes the assumption that the volatility is equal in both directions.

The drawbacks are more significant for longer term investments. Beta can be extremely useful to us as 1-month covered call investors. For our purposes of selling 1-month call options, beta is a good measure of risk.

Implementing beta into our decision-making process:

High beta stocks will outperform the uptrending stock market and underperform the downtrending market. Low beta equities will underperform the uptrending market and outperform the downtrending market. In a bullish market, I lean towards high beta stocks and sell O-T-M strikes. In a bearish market, I favor low beta stocks and sell I-T-M strikes. In neutral markets, I “ladder” (use a mix) my beta stocks, in much the same way that I “ladder” my strikes.

Our Premium Report:

Premium members can access beta information directly from the running list on pages 3 and 4 of the Weekly Premium Report as seen on the graphic below:

Beta stats from the Premium Report

Beta and the Premium Report

Note the relatively high beta stocks indicated by the red arrows and the relatively low beta equities highlighted by the blue arrows. Depending on your overall market assessment, this information can help determine your stock and strike selection. General members can access beta information from several free sites such as:

http://finance.yahoo.com/

• Type in ticker on upper left
• Look at left column on next page
• Click on “key statistics”
• Look on right side of next page for beta stats

Conclusion:

Beta is simply one tool in our arsenal. Market conditions will dictate whether we should lean towards high or low beta stocks. It should be used in conjunction with all our system criteria. No one factor will make our investment decision evident. By continually throwing the odds in our favor using sound fundamental and technical analysis along with common sense, we will watch our profits rise and our successes dominate our portfolios.

Market tone (as of Thursday, April 12th):

• This week’s economic reports continue to suggest an expanding economy:
• The CPI rose 0.3% in March due to the increase in the cost of energy (gas)
• The Federal Reserve’s Beige Book showd an increase in growth in all 12 districts
• Producer prices were flat in March, a sharp decline from the 0.4% rise in February
• The US trade deficit decreased to $46.0 billion, the largest reduction in 3 years 

For the week, the S&P 500 dropped by 2% for a year-to-date return of 9.6% including dividends.

A 6-m0nth chart of the S&P 500 shows a bullish pattern with an uptrending 50-d simple moving average (SMA- blue line) well above an uptrending 200-d SMA (red line). The benchmark briefly dipped below the shorter-term moving average ( green circle) but quickly recovered:

6-month chart of the S&P 500 as of 4-12-12

Normal Yield Curve

There are, however, several shapes a yield curve can take. Here are some of the most important:

Normal Curve:

As seen above, this scenario is when investors are anticipating the economy to expand at normal growth rates without significant inflation or capital availability issues. This defines a period of economic and stock market expansion and good news for investors and economists. The yield curve slopes gently upward as bond (longer term treasuries) investors demand more of a return to counterbalance interest rate risk in the future.

Steep Curve:

Steep Yield Curve- 1992

 This results when we have a greater-than-normal gap between the shorter and longer term treasuries as we see here in April of 1992. This marks the beginning of an economic expansion shortly after a recession. By 1993, the GDP was expanding by 3% per year and by the following year short-term interest rates had increased by 2 percentage points. That’s why investors were demanding greater long-term returns. Those investors who used this curve to increase their stock holdings were rewarded with a 20% return over the next two years (Russell 3000).

Inverted Curve:

Inverted Yield Curve- 2000

 This occurs when long-term yields fall below shorter-term yields. Long term investors are betting that the economy will decline in the future. An inverted yield curve has predicted a worsening economy in the future 5 out of 6 times since 1970. The NY Federal Reserve regards this yield shape to be predictive of recessions two to six quarters ahead. Stock investors should take this situation seriously. These curves are rare but are almost always followed by economic slowdown or even recession.

Flat or Humped Curve:

Flat or Humped Yield Curve-2008-09

In the case of a flat curve, all maturities have similar yields. For humped curves, short and long term maturities are the same while intermediate maturities are higher. It is important to note, that for a yield curve to become inverted, it must pass through this phase first. Now, not all flat or humped curves become inverted but most are predictive of economic slowdown and lower interest rates. Like inverted curves, it is a red flag for stock investors.

Recent Yield Curve:

Yield Curve as of 4-2012

Here is a free website to access the current yield curve:

http://www.bloomberg.com/markets/rates/index.html

Event updates:

1- Last weeks interview with Kerry Lutz of the Financial Survival Radio Network has been uploaded to YouTube:

http://www.youtube.com/watch?v=JdK9Qj1npfc&feature=email

2- This Saturday, April 14th:

I will be the keynote speaker for the American Association of Individual Investors/Atlanta Chapter at the Cobb Galleria. The meeting runs from 10AM to 1PM EST and everyone is invited. The club charges $10 for pre-registration and $15 at the door. Here is the link to register:

www.aaii-atlanta.com

Market tone:

 This week’s reports were mixed to negative but not game-changing:

• In the minutes of its march policy committee meeting the Fed seemed less inclined to institute another round of bond purchases to loosen credit
• The Fed re-iterated its intention to keep its target interest rate near zero until late 2014
• There was a slight rise in the broad manufacturing index in March
• The Commerce Dept reported that February’s rise in overall factory orders more than made up for January’s decline
• The ISM manufacturing index came in at 56, slightly below the expected 57
• Although construction remains relatively depressed it is still ahead of its pace of a year ago
• On Friday, a weaker-than-expected jobs report came in at 120,000 new jobs added, less than expected as the unemployment rate dropped to 8.2%. This news was NOT a game-changer because:
• Unseasonably warm weather in December through March resulted in fewer layoffs and therefore fewer hires in March
• 60% of all industries are actually adding jobs
• The trend is positive as the labor force has expanded an average of 273,000 jobs/month over the past 3 months

For the week, the S&P 500 fell by 0.7% for a year-to-date return of 12%.

Summary:

IBD: Market in correction

BCI: Moderately bullish selling an equal number of ITM and OTM strikes

Happy holidays to all our members and your families,

Alan, the BCI team and our families (alan@thebluecollarinvestor.com)

www.thebluecollarinvestor.com

The VIX is the ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index, which is a measure of the implied or expected volatility of S&P 500 options over the next 30 days. This implied volatility is reflected in the premiums paid for the options.  It is constructed using the implied volatilities of a wide range of S&P 500 index options. This volatility is meant to be forward looking and is calculated from both calls and puts. The VIX is a widely used measure of market risk and is often referred to as the investor fear gauge.

There are three variations of volatility indexes: the VIX tracks the S&P 500, the VXN tracks the Nasdaq 100 and the VXD tracks the Dow Jones Industrial Average. In our BCI methodology we focus in on the VIX because it gives us the broadest view of the overall market.

The VIX is a useful indicator for short-term investors including 1-month covered call writers. Generally speaking as market volatility increases the market pricing will diminish and vice-versa. The VIX is said to have an inverse relationship with the S&P 500. If we see a declining VIX or one that is remaining stable at a low level (below 30) along with an appreciating S&P 500, we have a favorable environment for selling covered call options. Below is a chart showing the inverse relationship between the VIX and the S&P 500 over a 3 month time frame:

Inverse relationship between the VIX and the S&P 500

The red arrows highlight areas when the VIX was declining and the S&P 500 was appreciating and the blue arrows show just the opposite. This relationship is reliable but not 100% accurate. However, it does add information that will help guide us in our investment decisions like strike selection for example. Like all other technical tools the VIX should be used in conjunction with other fundamental, technical and common sense indicators.

Current VIX:

A 6-month chart of the VIX and the S&P 500 shows an accelerating market benchmark and a declining VIX.  More recently the VIX has remained stable at a low level. These factors, along with predominantly bullish weekly economic reports,  have painted a bullish market tone in the eyes of this investor. Below is a current comparison chart of the S&P 500 and the VIX:

Vix and the S&P 500 as of 3-30-12

• Sell out-of-the-money strikes
• Use high beta stocks
• Roll out-and-up rather then just out
• Be fully invested

Conclusion:

The VIX is a short-term window into potential market risk. The less risk implied in the stock market, the more likely investors will participate in the market. This CBOE fear gauge should be used in conjunction with our other screens to make the best non-emotional investment decisions which in turn will maximize our profits to the highest possible levels.

Upcoming events:

April 3rd:

I will be interviewed by Kerry Lutz of the Financial Survival Radio Network on the topic of covered call writing. When I receive the link to listen to the broadcast, I’ll publish it on this site.

April 14th:

I will be the keynote speaker for the American Association of Individual Investors/Atlanta Chapter at the Cobb Galleria. The meeting runs from 10AM to 1PM EST and everyone is invited. The club charges $10 for pre-registration and $15 at the door. Here is the link to register:

www.aaii-atlanta.com

May 8th:

I will be the keynote speaker for the Long Island Stock Investors Meetup Group at the Plainview-Old Bethpage Library Auditorium. There is no charge to attend and all are invited. I will post additional information as we get closer to this event.

Market tone:

This week’s economic reports were mixed to positive:

• The Conference Board Consumer Confidence Index fell to 70.2 in March from February’s level of 71.6. Despite this decline, the level shows that consumers have not lost faith in the economic recovery
• The US economy grew at an annual rate of 3.0% in the 4th quarter up from 1.8% in February, the highest level for any quarter in 2011
• Personal spending increased by 0.8% in February, the highest since July while wages increased by only 0.3%. This is seen as a sign that consumers are confident in our economy
• New durable goods orders increased by 2.2% in February much better than the previous month but slightly below expectations

For the week, the S&P 500 rose by 0.8% for a year-to-date return of 12.6%.

Summary:

IBD: Uptrend under pressure

BCI: This site remains moderaterly bullish favoring out-of-the-money strikes

Welcome to our growing community of premium members.

My best to all,

Alan (alan@thebluecollarinvestor.com)

www.thebluecollarinvestor.com

Market Order:

This is the most common of customer orders where we ask the broker to buy or sell a stock or option at the best available price. It is also called an “unrestricted order” and will always be executed.

Limit Order:

This is an order to buy or sell a specific number of shares at a certain price or better. A buy limit order can only be executed at the limit price or lower. A sell limit order must be executed at the limit price or higher. These are particularly useful on low-volume or highly volatile stocks.

Stop Order:

An order to buy or sell a security when its price surpasses a specific price called the stop price. At that point the stop order becomes a market order. A sell stop order is placed below the current market value of the stock and is used to prevent or limit a loss or to protect a profit on a long stock position. For example, you may have purchased a stock for $20 per share and it has appreciated to $30. A sell stop order @ $25 will guarantee at least a profit of $5 per share (barring a gap-down in the price of the stock). A buy stop order is always placed above the current market price of the stock. It is typically used to protect a profit or limit a loss on a short sale (selling a stock you didn’t own by borrowing it). For example, if you sell short a stock @ $30 expecting to buy it back at a lower price but it starts going up in value instead, a buy stop order can limit your loss. It may kick in @ $32 thereby minimizing losses to $2 per share. Once the buy stop price is reached, the order becomes a market order.

Stop Limit Order:

This is a combination of a stop order and a limit order. Once activated, it becomes a limit order which means that it can only be executed at a specific price or better. The benefit is that the trader has precise control over when the order should be filled. The disadvantage is that it may never get filled. A sell stop-limit order is always placed below the current market price of the equity and is used to limit the loss or protect the profit on a long stock position. Once activated, it becomes a limit order. A buy stop-limit order is always placed above the current price of the stock and is used to limit a loss or protect the profit on a short stock position. Once activated, it becomes a limit order.

Trailing stop:

A trailing stop adjusts the stop price at a fixed percent or number of points below the market price of a stock. The purpose of the stop is to protect against a move by the stock or option price in the opposite direction from which you expect. When the price of your stock rises, the trailing stop rises with it, helping to protect you against a larger loss and eventually capturing a portion of your profit. With a trailing stop, you continue to hold the stock so you still receive the dividends from the stock, if they are paid. Should the stock plunge past your stop, your shares are sold at the next available price, not necessarily the stop price, assuming you have not placed the stop order with a limit price.

Summary of Orders entered Above the Market:

• Buy Stop-Limit
• Buy Stop
• Sell Limit

Summary of Orders entered Below Market:

• Buy Limit
• Sell Stop
• Sell Stop-Limit
• Trailing stop

Covered Call Trade Orders:

As discussed in previous articles, most writers of covered calls place their trades by legging in. This where a market or limit order is placed to purchase the equity and once executed, a second order (usually limit) is placed to sell the option. For maximum profits, these two legs should be executed simultaneously (Buy the stock and immediately sell the option. Do not buy the stock, go to the mall and then come back home to sell the option). Another methodology permitted by some online discount brokers (not USAA, the one I use) is to place a net debit order. This is where you buy the stock and sell the option at the exact same time, not for specific corresponding prices but for a limit net debit. For example, if a stock is selling for $20 and the A-T-M call is selling for $1.50, the net debit or amount we would owe is $18.50 ($20 minus $1.50). This way, even if the price of the stock and option change, the order can still be filled if it meets the requirements of our debit order. This would be particularly useful for investors who can’t be in front of their computers but want to execute a covered call trade. As stock investors and covered call writers it is critical to know and understand the different types of customer orders and the appropriate time to implement them.

 Covered call limit order example:

In the options chain below, ULTA is trading @ $93.55 and the bid-ask spread is $1.95 – $2.30. Placing a market order may generate $1.95 but placing a limit order slightly below the mid-point @ $2.10 has an excellent chance at being executed for an additional $15 per contract:

Options chain for ULTA

Market tone:

 Economic reports this past week were dominated by mixed housing information:

• New home construction decreased by 1.1% in February but still near a 3-year high
• Building permit applications rose by 5.1%, the highest rate since October, 2008
• The rate of housing completions was up 6.2% from January
• Single-family home starts were up 18% from February, 2011
• New home sales dropped by 1.6% in February, the second straight monthly decline but…
• New home sales rose by 11% from February, 2011
• The Conference Board’s leading economic indicators rose by 0.7% in February, the 5th consecutive monthly gain and an 11-month high

For the week, the S&P 500 fell by 0.5% for a year-to-date return of 11.6%.

A 6-month comparison chart of the S&P 500 and the CBOE Volatility Index (VIX) shows bullish signals:

• Uptrending S&P 500 (red arrow)
• Calming VIX (green arrow)
• Consolidating signals the last two weeks, perhaps a welcome breather (yellow fields)

Market tone 3-23-12

 

Summary:

 

IBD: Confirmed uptrend

 

BCI: Moderately bullish favoring out-of-the-money strikes

 

Much success to all,

 

Alan (alan@thebluecollarinvestor.com)

 

www.thebluecollarinvestor.com