Dear Alan,

We have read your books and watched your DVDs and now have a solid understanding of covered call writing. We’re really excited to get started but have one problem. We work a 9-5 job and have limited free time. Is there any way you can provide us with a list of screened stocks that meet your system qualifications? From there we can make our selections and manage our positions.

Thanks, in advance.

Bill, Carol and Irene

For the past year, my team and I have been developing a weekly screen and watch list report that is based precisely on my system criteria. It is a unique report in that all the parameters screened and information provided is specific for successful covered call candidates. What makes our screen even more exclusive, is the fact that it is targeted towards 1-month options, the type that generate the greatest returns. The first part of the weekly report runs the IBD 100 stocks and others we locate through the same screens discussed in my books and DVDs. All fundamental and technical screens are included as well as the more esoteric considerations such as earnings reports and same store monthly retail sales reports. Here is a sample of page 1 of this weekly report:

Weekly Screen and Watch List- Page 1

Once a stock has passed all the fundamental screens and has, at worst, mixed technicals, it will become part of our watch list or running list as we call it. We used this name because the list is cumulative and dynamic and re-screened every week. Here is a look at a sample watch list which is found at the end of each week’s report:

Weekly Screen and Watch List- Running List

To assist you in making the best and most lucrative investment decisions, once a stock has been added to the running list, we provide additional information regarding earnings reports dates, sector and industry and the stocks beta and much more. Notice how all these criteria are specific for 1-month covered call candidates and that is what makes this tool so exceptional.

With this report you can make your own Blue Collar decisions as to which stocks you should include in your current portfolio based on your portfolio size, risk tolerance and investment objectives. We’ll spend hours screening the stocks and you can then make your choices, generate your profits and manage your positions.

Additional benefits for premium members:

• In addition to this weekly stock screen and watch list report, premium members are also entitled to a 10% discount on ALL items in the Blue Collar Store and future seminars and webinars. Look for more products to be added to the store during the 2010 year.
• FREE: All premium members will have  FREE access to the Elite ESOC- Ellman Calculator (coming soon) which has two additional features added onto the basic calculator. First there is an “unwind tab” which calculates your current profits or losses if you close your option positions mid-contract. The second tab is a Schedule D which will assist you or your tax advisor in reporting capital gains or losses to the IRS if trading outside a sheltered account. This is a $29.95 value, free to premium members.
• Resource Center: As of the initial launch of this site on March 2nd, there were over a dozen downloads. This number will be constantly increasing based on your feedback and other ideas developed by me and my team.
• Charter Membership: Join this elite group by March 16th and receive a LIFETIME 10% discount on membership dues for as long as you remain a member. You can opt out at any time simply by sending us an email.

Both the premium and general sites will remain responsive to your suggestions and ideas. The participation and support of both general and premium members are both welcome and very much appreciated.

We are offering charter members (must sign up by Marchg 16th) a trial month for $8.95. You will have immediate access to the previous 5 reports, plus a new updated report for each of the next 4 weeks and access to the resource center. Don’t miss this opportunity! 

http://www.thebluecollarinvestor.com/membership.shtml

Video now playing on the homepage (through March 16th):

The Premium Site: Charter membership

Many thanks to those who are already charter members, to those who will become charter members and to our general members. Your support and participation means the world to me and the entire BCI Team.

My very best,

Alan (alan@thebluecollarinvestor.com)

LEAPS- Long-Term Equity Anticipation Securities. These are option contracts with expiration dates longer than one year. Not all stocks and ETFs have these type of options associated with them.

Calendar Spread-  Simultaneously establishing  long and short options positions on the same underlying stock with different expiration dates. For example, you buy the December, 2010 $20 call and sell the April, 2010 $20 call on the same equity.

Horizontal Spread- A  spread where both options have the same strike price as in the above example but different expiration dates. The terms calendar and horizontal spreads are interchangeable.

Diagonal Spread- A long and short options position with different expirations AND strikes. For example, you buy the December $20, 2010 call and sell the April, 2010 $25 call. 

Concept behind this strategy:

The investor establishes the long option position by purchasing (usually) I-T-M LEAPS and then selling a near-term, slightly O-T-M call, the short position. Trades are constructed such that, if assigned, the difference between the spread ($5 in the above case where the $20 call was bought and the $25 call was sold) + the short premium collected, exceeds the cost of the long option. If unassigned, where the price of the stock does not exceed the strike price of the short call, we then continue to write calls and generate a monthly cash flow. The problem in this second scenario is that if the stock price falls, the premiums generated from the short call drops unless we write for a lower strike, which may result in a loss for this long-term strategy as the spread (difference between the two strikes) declines.

Let’s take a look at the options chain for a highly traded equity, INTC:

INTC currently priced @ $20.43

With the stock priced @ $20.43 let’s look for a deep I-T-M LEAPS:

INTC- Deep I-T-M Calls

The January, 2012 $10 strike is purchased for $10.60, $10.43 of which is intrinsic value and only $0.17 is time value. Minimal time value is a characteristic of deep I-T-M LEAPS options.

Next let’s check the near-term, slightly O-T-M strikes:

INTC- Near-Term, O-T-M Options

The next month, $21, slightly O-T-M strike can be sold for $0.43.

Let’s do the math, if assigned:

We collect the difference in the spread ($21 - $10 = $11) + the short option premium = $0.43 for a total of $11.43. We deduct the cost of the long call ($10.60) for a profit of $0.83 per share or $83 per contract. The percentage return is $83/$1060 or 7.8%. All calendar spreads are constructed such that there is a profit if assigned.

If the shares are not assigned (price of stock NOT greater than the strike of the short call ($21), our profit is $43/$1060 = 4.1% and we’re free to sell another option. As noted above, this works well as long as the share price does not dramatically decline thereby reducing the returns on the short options. We also must bear in mind that the long call (LEAPS) is a decaying asset and there will become a time when we no longer own the right to purchase INTC at the $10 strike (when the option period expires). If we continue to generate monthly returns of $43, how long will it take us to retrieve the $1060, if never assigned? Here’s the math:

$1060/$43 = 24 months, not counting any difference in the spread.

Our option is good for about 22 months, so if the option ultimately expires worthless and the spread has decreased, we lose! Diagonal spreads work best for rising stocks where we can take advatage of the difference in the original strike prices.

Advantages of using LEAPS:

• Less costly than purchasing stock; remaining cash can be used to generate additional cash
• A declining stock will have time to recover
• Low time value of deep I-T-M LEAPS make option ownership similar to stock ownership where intrinsic value changes dollar-for-dollar.

Disadvantages of using LEAPS:

• You do NOT capture stock dividends
• To stay active, you must sell options in cycles that report earnings, taking on additional risk
• LEAPS have a delta of approximately .50 to .60 making it difficult to close a position at a profit for A-T-M and O-T-M strikes (option value has not moved up in step with share value). This is less of a factor for I-T-M LEAPS.
• A higher level of approval will be required by most brokerages to allow this type of trading
• The long calls will ultimately expire, stocks will not
• Forced assignment may not allow for a profitable trade

Conclusion:

Purchasing LEAPS and selling a call option on that position is NOT a true covered call write. It is an alternate strategy that has its pros and cons. For most Blue Collar Investors, covered call writing is the better path to take. But to some investors who fully understand the nuances of diagonal spreads, this may be a viable alternative.

The Premium Site:

Okay, here’s the deal…….The premium report, The Weekly Stock Screen and Watch List, has matured into an even better product than I originally envisioned and is anxious to get downloaded into your computers. My team and I have also downloaded additional content and resources for our premium members to support your investment decisions and education. I was hoping to launch this site this week (February 28th) but my web master advised me that there are a few MINOR technical glitches that need attention. I defer to him on these matters especially considering the wonderful job he had done with this site over the past few years.

I also asked him if it were possible for us to do something special for our charter members, those who will help launch this site and he is looking into this. In this regard, perhaps I am responsible for the 1-week delay. I am told that we will launch no later than Sunday, March 7th. Thanks for your patience and inquiries in this matter.

Cashing in on Covered Calls- Recommended Reading:

Thanks to “Farmer Ron” of www.coveredcallsfarm.com for highlighting my book, Cashing in on Covered Calls,  for recommended reading. This is a site (still adding content) that, like ours, speaks to the average retail investor and I commend him and his site for helping to spread the word about this powerful investment strategy.

Last Week’s Economic News:

Last week’s reports were a mixed bag so we’ll start with the bad news and finish on a pleasant note;

• Consumer confidence declined sharply to 46.0 well below the predictions of economists and the lowest level since April of 2009.
• Existing-home sales fell 7% in January and new home sales dropped by 11%
• Fed Chairman Ben Bernanke told Congress that short-term interest rates would remain at record lows for at least several more months to help fuel economic expansion
• GDP grew by 5.9% in the 4th quarter, the fastest rise in six years. This stat is the broadest measure of our economic activity
• Durable goods orders rose 3.0% in January, a great sign for capital spending and industrial production
• For the week, the S&P 500 was down 0.4%, for a year-to-date return of -0.6%

Next Week’s Economic Reports:

• Monday: ISM manufaturing, personal income and construction spending
• Wednesday: Fed’s Beige Book and ISM non-manufaturing
• Thursday: Factory orders and productivity and costs
• Friday: Employment and consumer credit

Video now playing on the homepage:

Executing a Covered Call Trade, Parts 1 and 2

My best,

Alan (alan@thebluecollarinvestor.com)

There are other investors who sell call options in a different manner, called portfolio overwriting. In this instance, a call option is sold on a stock already part of an existing portfolio. That option is selected in a manner where the option is NOT expected to be exercised.

Why a Portfolio Overwriter does not want his shares assigned:

This is basically a tax issue. The holding period for short-term versus long-term capital gains is one year. If the stock has been held for less than that time frame, the writer would prefer to retain the equity for a longer time frame. In addition, if the shares have appreciated substantially from the cost basis, selling in any time frame may not be in the investors best interest.

Another important tax issue:

If the underlying stock has not accumulated the full 1-year holding period for long-term capital gains, covered call writing may suspend or eliminate the current accumulated holding period. It is advisable to consult with your tax advisor on this matter.

Advantages of portfolio overwriting:

• Achieve higher returns in declining, neutral and slightly bullish markets.
• Beat the returns of long-term holders of equities
• Increase portfolio downside protection, thereby minimizing risk
• Generate a monthly cash flow
• Use option profits to compound your money

Strike selection for portfolio overwriting:

Since our goals are to generate a monthly cash flow and NOT have our shares assigned, common sense dictates that we sell O-T-M strikes. This will benefit us in that time decay is greatest for these strikes and option value will dissipate as we get closer to expiration Friday. Remember, we don’t want our option strike price ending up I-T-M. Our mindset needs to be slightly different when selling these O-T-M strikes in that a 2-4%, 1-month return is too lofty a goal. I would set it more at 1-1 1/2% per month, ensuring that the implied volatility of the option is not too high. A high IV means that the market is anticipating a large price movement and that increases the possibility of the option ending up I-T-M. So settle for a lower premium and therefore less chance of assignment. As a guideline, I like to see the share price at least 5% lower than the strike sold. As an example, if I sold a $50 strike, I would want that equity to be currently trading @ $47.50 or less, with the option premium generating 1 to 1 1/2% for the month.

Why some portfolio overwriters sell I-T-M strikes: 

This is a riskier strategy if keeping the stock is important to the investor but there is a case that can be made for it. It is generally used when the stock or market in general is declining and the I-T-M strikes will generate greater returns with more protection. Also, the higher delta of the option (amount the option changes with a corresponding $1 change in the stock price) will make it easier to close or roll the position (buy back the option). Investors also use the I-T-M approach in conjunction with technical analysis where support and resistance points are identified and I-T-M strikes are sold at resistance and closed or rolled if still I-T-M near expiration Friday.

What if early assignment occurs?

This will not occur often but it will eventually happen. In these cases, purchase an amount of shares equal to the obligation to deliver and notify your broker that these newly acquired shares should be indentified as the shares delivered to meet the option obligation. Check with your broker, before the fact, as to the best way to manage such scenarios.

Conclusion:

Portfolio overwriting provides many of the advantages of the buy-write strategy but because of tax implications, income goals and strike management differ and need to be fully understood before taking action.

PRGO vs. S&P 500:

A few weeks ago I highlighted PRGO for its strong fundamentals and analyst recommendations. Dave commented that the stock seemed to be outperforming the market which was heading south at the time. One way to visualize a stocks performance as it relates to overall market tone is to overlay one chart on the other. Let’s examine such a chart:

PRGO vs. S&P 500

• Red arrow- PRGO is under-performing the market
• Blue arrow- The stock and index are consolidating and performing equally
• Green arrow- PRGO breaks out and starts diverging from the index and is now headed for the moon.

An uptrending price chart is particularly impressive when it is doing so despite an overall negative market tone.

Last Week’s Economic News:

A very impressive week overall on this front:

• The Fed “tightened” interest rate policy with a symbolic hike in interest rates it charges banks for emergency loans
• The minutes from the last FOMC meeting reflected confidence that the U.S. economy was in the middle of a moderate expansion and a low inflationary environment
• The CPI was up a mere 0.2%, relaxing fears of inflation
• New home construction was up 2.8% in January
• Industrial production was up 0.9% in January, showing an improving manufacturing sector
• For the week, the S&P 500 rose 3.1% for a year-to-date return of -0.3%

Next Week’s Economic Reports:

• Tuesday: Consumer confidence
• Wednesday: New-home sales
• Thursday: Durable goods
• Friday: Existing home sales and 4th quarter GDP growth.

Video now playing on the homepage:

Why Don’t More Investors Write Covered Calls?:

Wishing you much success,

Alan (alan@thebluecollarinvestor.com)

American style options: an option contract that may be exercised at any time between the date of purchase (sale) and the expiration date. These are the options that we, as CC writers, deal with.

European style options: an option contract that can only be exercised on the expiration date.

For the most part, share assignment will not occur until after expiration Friday when the agreed upon strike price is below the current market value. For example, if we sold the $50 strike and the current value of the stock is $52, the option holder or brokerage will exercise that option and achieve a $2 per share profit.

Why aren’t most options exercised early?

Option value consists of intrinsic + time value. Early exercise will result in the holder surrendering this time value, so it rarely occurs. The option owner may sell the call to capture the time value but early exercise and purchase of our shares does not make sense if there is significant time value remaining ($0.25 or more). It’s true that the shares can be purchased and then sold at market to capture this value but why not just sell the call? This concept applies to I-T-M and at or near-the-money strikes as O-T-M strikes would never be exercised.

How is it determined which shares are assigned if early assignment?

This is a completely random process whereby the Options Clearing Corporation (OCC) decides to which brokerage the assignment will be given and the brokerage will then pass it on to one of its clients.

Why does early assignment occur?

As time value declines (below the aforementioned $0.25), the chances of early assignment increases. There are times when the calls trade below the intrinsic value and in these cases the chances of early assignment are much greater. This will occur when the strike is deep I-T-M. Let’s look at the options chain for VIT, as an example:

Early Assignment Possible for $12.50 Call

Note that the intrinsic value of the $12.50 call is @ $3.25 (since the stock price is $15.75) and yet the bid or sale price of the option is $3.10 (red circle). Not only is there no time value for this option but it is actually trading below the intrinsic value. The $15 strike, on the other hand, has time value of $0.35 ($1.10 - $0.75). As your strike moves deeper I-T-M, the chances of early assignment increases.

Other factors that may lead to early assignment:

1- Dividends- When your equity is about to distribute a dividend, early assignment is possible for I-T-M strikes when that dividend value is greater than the time value remaining for that option. This will take place prior to the ex-dividend date or the date share ownership is required to be eligible to capture this dividend. Here is a link to a FREE site that tracks these dates:

http://www.dividendinvestor.com/tracker.php

2- High Open Interest- When you see thousands of open contracts we know that the institutional players are involved. Their trading costs are near zero and their arbitrage opportunities are greater than ours when time value approaches zero.

3- Pinning the strike- when puts and calls are near the money on expiration Friday, there is a tendancy called pinning the strike for the stock to move to the strike price or slightly beyond. This may result in assignment (not early, but unexpected) after the bell. This can also take place if there is a report or late news coming out the day of expiration.

How to avoid assignment:

1- To generate more cash (mid-contract) - If there is little or no time value remaining in our option (sold) why not unwind our position? B-T-C the call and sell the stock thereby re-capturing the time value. Now take that bundle of cash and re-invest it in another CC position. You can also roll the call out or up and out if the calculations are favorable. Remember, CC writers are tough “bosses”. No vacations or days off for our cash. They are put to work at all times during normal market conditions.

2- To avoid tax consequences- If your cost basis is much lower than the current market value of your shares, assignment may result in an unfavorable tax consequence. In these cases, you will want to close or role your calls before assignment. If your shares are unexpectedly assigned, you can purchase new shares at market and inform your broker that these new shares are to be the ones associated with the assigned option. Please check with your tax advisor and brokerage on these matters.

Conclusion:

Early assignment of your shares is rare but possible. Understanding why and when it may occur will further add to the bottom line of your investment success.

Blue Collar Updates:

1- Both of my books are now available at The Book Revue, Long Island’s largest independent book store.

2- I will be hosting a basic covered calls class on behalf of The Learning Annex on April 22nd in New York City. I will be sending out discount and other related information to all those on my mailing list.

To join my mailing list:

http://www.thebluecollarinvestor.com/joinfrnds.shtml

Last Week’s Economic News:

I don’t know which was worse: the triple digit twists and turns of the market or all that snow I had to shovel! Each time I had to clear the driveway, I considered it a workout and stayed home from the gym. Anyway, here’s what happened:

• The trade deficit rose but mainly due to increased petroleum imports. This is a possible sign of economic expansion due to increased demand.
• Retail sales rose 0.5% due to fewer layoffs and slightly increased wages.
• Business inventories fell in December by 0.2% due to increased consumer demand.
• For the week, the S&P 500 rose by 0.9% for a year-to-date return of - 3.3%.

Next Week’s Economic Reports:

• Wednesday: Minutes from the FOMC meeting, industrial production and new residential construction
• Thursday: Jobless claims, leading indicators from the Conference Board, and producer prices
• Friday: Consumer prices

Video now playing on the homepage:

The 10 Most Common Mistakes Made by CC Writers

The best in investing to one and all,

Alan

alan@thebluecollarinvestor.com

Definition:

Delta measures the amount an option price will change as a result of a $1.00 price change of the underlying security (stock, ETF). Other major factors that impact option value include the price of the stock, implied volatility and time to expiration. Since call options rise and fall directly with the price of the stock, they are assigned deltas between 0 to 1.

Look at delta as a bet: What is the percentage chance that the option will end up in-the-money (lower than the market value of the stock) or be exercised by expiration Friday? The higher the delta value, the greater the chance of this happening. A delta of .9 or 90%, for example, means that the strike price will almost definitely end up I-T-M. In the scenario where we sold a $50 call and the stock is trading @ $70 with one week remaining, the delta will be at or near 1 and for every $1 change in the price of the stock, the option will also change by approximately $1. This is typical of deep I-T-M strikes.

For at-the-money strikes, deltas will be closer to .5 or 50%. In this scenario, for every $1 change in the price of the underlying, the option value will change by $.50, reflecting about a 50-50 chance that the strike will end up I-T-M.

For deep out-of-the-money strikes, deltas would be quite low, between .1 to .2 or 10% to 20%, for example.  If we sold the $50 call and the stock was trading @ $30, the odds of that $50 ending up I-T-M is quite low. If the stock price moves up or down by $1, the option value will change by perhaps .10 because of the low delta.

The chart below summarizes the approximate deltas for the 1-month options we sell when writing covered calls:

Deltas for 1-Month options

 RULE:

Delta values increase as the strike moves further I-T-M and decrease as the strike moves deeper O-T-M. This can be visualized in the graph below: 

Delta vs. Strike Prices

• I-T-M strikes- highest deltas
• A-T-M strikes- deltas near 50% or .5
• O-T-M strikes- low deltas 

Strike selection based on delta:

• I-T-M strikes- if bearish or conservative as option premiums will decline faster with decreasing share price making it easier to B-T-C.
• A-T-M strikes- for maximum premium return.
• O-T-M strikes- if bullish so option premium AND share appreciation can be realized.

Conclusion:

Understanding the relationship of delta to our option premiums will make us sharper investors as it will allow us to select the best strike price for a given situation.

Should we continue to write calls on declining stocks?:

The recent global market decline has spurred many emails similar to the one Dave sent:

One of the stocks I currently own is HEAT. I purchased this stock for $16.30 and currently the stock is at $11.07… This is a loss of 5.23… BUT, with the option profits I have made (.80c + 1.35) its only 3.13…

If I sell now, I incur a loss of around $3.00.

On the other hand, if I hold the stock and continue to sell options on it, perhaps I will lessen the loss and eventually arrive at a profitable position… What are your thoughts of doing this? In your experience, is this a wise thing to do?

I felt that I should address this briefly in this article and in greater detail in a well-prepared future commentary. So we have a declining stock and the question is: Do we roll down, take no action and hope the stock appreciates in value, look to hit a double, sell the stock and stay in cash, or convert dead money to cash profits (sell the stock and use the cash to open a new position)?

Here are two assumptions I make that factors into my decisions:

1- There is nobody out there who can accurately time the market and I mean nobody. We can, however, make some common sense conclusions that will dramatically throw the odds in our favor.

2- Freezing up and doing nothing is the worst decision an investor can make…it’s really not even a decision, it’s a non-decision.

So now we’re down to 4 possibilities:

• Rolling down
• Looking to hit a double
• Selling the stock and opening a new position
• Selling the stock and staying in cash

As we are standing at the crossroads of these 4 paths, there is one question I ask myself to help guide me: Why is the stock declining? So we must check the news. I am not talking about the normal whipsaw up-and-down movement of an equity over time. I’m referencing the precipitous drop in price that Dave was alluding to with HEAT. (We don’t have to check the news on every stock that goes up or down $0.50). For example, a few weeks ago many of us suffered through a severe loss in MED, the stock of the decade! We checked the news and found that there were allegations of corporate fraud. I sold half my position that day and the rest a few days later. Now, if MED had dropped a few dollars in price with no news but was trading above support (moving average) after a run-up, hitting a double would have been my goal. In this last scenario, if the price did not rise within a reasonable time frame, I may have switched my goal to rolling down. Finally, if in that same scenario, had the stock continued to decline, I would look to unwind my position and sell the stock. If, in normal market conditions, I would then put that cash to work and open a new position as I almost always want to keep my money working for me. So let me summarize this way: With extreme negative news, I unwind my position and move on to a new equity. Otherwise I reference the chart and look for moving average support. If support is broken on high volume with MACD and stochastics negative, I will unwind. Otherwise, hit a double and roll down in that order.

Now, all that being said, none of it applies to Dave’s current situation (I’m sorry to say). That’s because we are in a near market correction of late and almost ALL stocks are being dragged down. Lately, it’s been shades of 2008 and 2001. The charts of the S&P 500 and the VIX are telling us that the general market tone is negative and that is like swimming upstream with a shark in pursuit. In these cases, I unwind a sharply declining stock and take my minor lumps before they exacerbate into a full blown abcess! Does this market reaction make sense to me? NO! Is the economy so different today than in mid January? I don’t think so. All economic reports are at least decent, some very good so I’m hopeful that things will turn around quickly. Perhaps I should start writing some valium prescriptions for some of our institutional friends or ask them to stop worrying about soveriegn debt in Portugal! In any case, it seems that Dave sold the $15 call and rolled down to the $12.50…well done! Given the current market situation, I would wait until Monday or Tuesday at the latest and unwind on any further share loss. I would not in this case and market condition continue to sell options on HEAT in hopes of a price recovery. More on this at a future date and perhaps a full chapter in my next book.

Thank you:

For your kind emails about my latest radio interview. Glad you liked it. For those who missed it:

http://www.blogtalkradio.com/stockgoodies

Click on the arrow in the middle of the page.

Last Week’s Economic News (the sky is falling!):

• The unemployment rate dropped below 10% for the first time since September
• Factory orders rose 1.0% in December, doubling analysts’ expectations
• Personal income rose 0.4% in December, the 6th consecutive monthly increase, although wage growth was a modest 0.1%
• The manufacturing index (ISM) rose to its highest level since 2004, although service sector activity was virtually flat
• For the week, the S&P 500 was down 0.7% for a year-to-date return of - 4.3%

Next Week’s Economic Reports:

• Wednesday: December trade deficit
• Thursday: January retail sales and December business inventories

 Video now playing on the homepage:

What Option Premiums Tell us about the Underlying Stock

Wishing you all the best in investing,

Alan

alan@thebluecollarinvestor.com