Although we screen our database of over 2000 stocks weekly for our premium members we ALWAYS include the IBD 50 stocks in that screen. I have selected SWI, a stock ranked #3 in the IBD 50 in the February 6th edition of that resource. The screening process begins:

1- Are options associated with this equity: Yes

2- Does the stock report same store MONTHLY retail stats? No

3- Does it rank at the highest level of all 6 SmartSelect screens? Yes

4- Does it pass the risk/reward Scouter screen with a 5 or better? Yes

5- Does it average a daily minimum trading volume of 250,000 shares? Yes

6- Is there an upcoming earnings report? No

Next we move on to technical analysis. Below is a chart showing a bullish picture, passing all of our technical requirements:

SWI- bullish technical chart

SWI- options chain

We look in the “bid” column (sell at the “bid”; buy at the “ask’) for premium returns and make sure the open interest is at least 100 contracts and/or the bid-ask spread is $0.30 or less.

Now we are ready to feed this information into the Ellman Calculator. You can use the single or multiple tabs (I prefer the multiple tab). The information is entered in the “white cells” on the left and the results are found in the “blue” cells on the right (I colorized them for discussion purposes):

SWI- The Ellman Calculator- Multiple Tab

• ITM $35 strike generates a 5-week return of 2.3% with 5.5% protection of that premium
• Near-the-money $37.50 strike generates a 3.7%, 5-week return with upside potential of an additional 1.3%
• OTM $40 strike generates a 1.5%, 5-week return with the possibility of an additional 8% for upside share appreciation

The strike price that is selected is based on your personal risk tolerance and your overall market assessment. ITM strikes are the most conservative, ATM (at-the-money or near-the-money) are bullish and OTM are the most bullish. One size DOESN’T fit all!

Once your positions are established look for possible exit strategy opportunities to mitigate losses or enhance gains. These will be addressed in future articles and are discussed in great detail in my books and DVDs.

Our new website:

 This was an extremely light week for economic reports. The action will pick up next week:

• The US trade deficit widened in December to $48.8 billion, a six-month high
• Exports increased by 0.7%, the first advance for exports in 3 months
• US consumer borrowing increased by $19.3 billion in December, greater than analyst expectations. This is a positive sign for consumer’s increasing faith in the economy

For the week, the S&P 500 declined by 0.2% for a year-to-date return of 7% including dividends.

Summary:

IBD: Confirmed uptrend

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

My best to all,

Alan (alan@thebluecollarinvestor.com)

]]> http://www.thebluecollarinvestor.com/covered-call-writing-using-the-blue-collar-methodology/feed/ 14 http://www.thebluecollarinvestor.com/portfolio-management-organized-lists-to-improve-our-option-profits-for-covered-call-writing/ http://www.thebluecollarinvestor.com/portfolio-management-organized-lists-to-improve-our-option-profits-for-covered-call-writing/#comments Sat, 04 Feb 2012 15:52:28 +0000 Alan Ellman http://www.thebluecollarinvestor.com/blog/?p=4419 How to trade options: I am a big believer in setting yourself up for success. This is accomplished through education, motivation, commitment and organization. Investors reading this article and others are definitely seeking education, and are motivated and committed. However, without organization the process will become difficult and perhaps unmanageable. As we create a watch list of the greatest performing stocks in the greatest performing industries and then buy certain equities and sell their associated options, it becomes essential to set up organized lists of accurate information. Enter portfolio management.

• Stocks on our watch list
• Stocks selected and purchased for our portfolio that month
• Options sold in a given contract cycle
• Spreadsheet of options sold showing profits (losses) 

Having these organized lists will allow us to do the following in a time efficient and accurate manner: 

• Select the most appropriate covered call candidates
• Prepare for potential exit strategy executions
• Monitor our stock and option positions

 Watchlist of the greatest performing stocks and stocks selected and purchased: 

The figure below demonstrates an organized list of stocks and their current prices, both highlighted in yellow. You can also enter the original transaction price if these were also the actual list of stocks purchased for a particular contract cycle.  

Watch List of Stocks

Watchlist of the options sold in a particular contract cycle:

Watch List of Options Sold

The option symbols and current market values are highlighted in yellow. Transaction prices can also be included. When option values drop, we may want to initiate an exit strategy to generate additional income or reduce losses.  

Spreadsheet of options sold with profits (losses):

Monthly Returns

The spreadsheet of options sold with profits (losses) show the following: 

A- Stock ticker

B- Purchase price of stock (includes intrinsic value of option)

C- Option ticker (original or previous format shown in this example))

D- # contracts sold

E- Premium per contract minus intrinsic value of option

F- Strike price of option sold

G- Breakeven (stop loss price to some)

H- Profit generated by original option sale

I- B-T-C cost for exit strategies 

The Premium Report: 

Premium members of the Blue Collar Investor Corp receive a report each week where my team screens stocks looking for the best 1-month covered call write candidates. Stocks are screened both fundamentally and technically and a watch list, called the running list, is generated. This will reduce the time and effort required although all final decisions and management of positions is still essential. The figure below will show you the first page of the screening process. The “Weekly Stock Screen” portion of the report faithfully follows the Blue Collar Investor stock selection process. Note the thick blue area towards the top categorizes the screens discussed in my books and DVDs:

Premium Report- Stock Screen

 The end of the report generates your watch list of the greatest performing stocks in the greatest performing industries. We call it the running list because it is constantly being re-screened and updated to provide the most recent information. The figure below is one such running list:

Premium Report- Running List

You will note that additional information such as earnings report dates, industry segment analysis and beta are also included on this list.

Conclusion: 

Having organized lists of stocks, options and a spreadsheet of options sold, will allow us to become both time efficient and increase our opportunities of achieving the very highest of returns. We are setting ourselves up for success. These lists will facilitate stock selection, prepare us for potential exit strategy opportunities and help us track our returns.

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Market tone:

Over the past several months the general pattern of the weekly economic reports has been more bullish than bearish. This week was no exception:

• The US economy added 243,000 jobs in January mainly due to hiring in the private sector
• The unemployment rate dropped to 8.3%, the lowest stat since February, 2009.
• The Conference Board’s Consumer Confidence Index fell to 61.1 in January, lower than anticipated but not pessimistic
• Construction spending rose by 1.5% in December, more than double the rate expected by analysts
• Nonfarm productivity increased by an annualized 0.7% in the 4th quarter, 2011, but below expectations
• The ISM Manufacturing Index jumped to 54.1 in January, the 3rd consecutive increase
• The ISM Nonmanufacturing Index rose to 56.8, the highest level since February, 2011
• Personal income rose by 0.5% in December but consumer spending remained unchanged
• New orders for manufactured goods increased in December for the 2nd straight month by 1.1%

For the week, the S&P 500 rose by 2.2% for a year-to-date return of 7.1%

A 6-month chart of the VIX and S&P 500 paints a bullish picture. A declining VIX (from 50 in August to under 18 right now) and an accelerating S&P 500 along with the positive economic reports are guiding this site to a more bullish position:

Market tone as of 2-3-12

 Summary:

IBD: Confirmed uptrend

BCI: Moderately bullish selling an equal amount of OTM and ITM strikes. If economic reports continue to impress, a more bullish position will be taken.

Wishing you well on your journey to financial independence,

Alan (alan@thebluecollarinvestor.com)

www.thebluecollarinvestor.com

 Option premium = Intrinsic Value + Time Value

To review, let me define the two latter terms using the definitions given in my books and DVDs:

Intrinsic Value- The value of an option if it were to expire immediately with the underlying stock at its current price; the amount by which the stock is in-the-money. For call options, this is the positive difference between the stock price and the strike price.

For example, let’s say that Dell Computer is trading for $22.50. The DELL 20 call option would have an intrinsic value of $2.50 ($22.50 – $20 = $2.50) because the option buyer can exercise his option to buy DELL shares @ $20 and then turn around and sell them at market for $22.50 thereby generating a profit of $2.50 per share. If we sold the DELL $25 call, the intrinsic value would be zero ($22.50 – $25 = -$2.50) because the intrinsic value cannot be a negative number. Therefore, only in-the-money call options have intrinsic value.

Time Value- The portion of the option premium that is attributable to the amount of time remaining until the expiration of the option contract. Time value is whatever the value the option has in addition to its intrinsic value. Since all options (excluding quarterly contracts of some exchange-traded funds) expire on the third Friday of the month and time value varies significantly from stock to stock, let’s examine the factors that determine the time value of our call options:

1- Time until expiration- When trading options, time is opportunity. The longer the time frames until Expiration Friday, the greater the chance that the options will finish in-the-money. Therefore, an option buyer is willing to pay more for the increased opportunity and the seller will demand more for the increased risk that the additional time requires him to assume. The time component of an option decays exponentially. Approximately 1/3 of its value is lost during the first half of its life; 2/3 during the second half of its life. Here is a chart that depicts such time erosion:

Time erosion of an option premium

2-Volatility- This is the fluctuation, not direction, of a stock’s price movement. It represents the deviation of day to day price changes. It measures the speed and magnitude at which the underlying equity’s price changes.  There are two types of volatility:

• Historical- the actual price fluctuation as observed over a period of time.
• Implied- a forecast of the underlying stock’s volatility as implied by the option’s price in the marketplace.

These are the main factors that influence the time value of your option premiums. Two more but lesser factors are:

3- Interest Rates- As interest rates rise, the value of the call will increase. Cash spent on owning the underlying stock is opportunity (interest) lost, thereby increasing the value of the option.

4- Dividends- As dividends increase, call or option value decreases. This is because it is the option seller (who owns the underlying security) who collects the dividend distribution, not the option buyer.

As sellers of 1-month options, the main factors that affect the time value of our option positions are time until expiation and volatility. I mention the other two only in the interest of completeness.

To summarize:

- Time to expiration decreases…..Call value decreases.

- Volatility increases…..Call value increases.

- Volatility decreases…..Call value decreases.

- Dividends increase….Call value decrease.

- Dividends decrease…..Call value increase.

- Interest Rates increase…..Call value increases.

- Interest Rate decrease…..Call value decreases.

- Share price increase…..Call value increases

- Share price decrease…..Call value decreases

How to use this information:

The intrinsic value of the premium applies only to I-T-M strikes. I view it as the insurance policy the option buyer purchases FOR US. The best environment to take advantage of intrinsic value is in a mildly bearish or volatile market and when stock technicals are mixed.

When time value reflects a potentially volatile situation, we must assess market conditions and equity technicals to determine if that security will be part of our portfolio and if so, which strike to sell. Premiums with high time value (5-8%, 1-month returns for at-the-money strikes) will appear more appealing in bullish markets and when stock technicals are positive.

The complicated mathematical formulas that determine the precise option premium are not critical to our successful investing. I do feel, however, that having a basic understanding of the components that influence this price can only make us better investors and get us closer to our goal of becoming CEO of our own money.

Market tone:

This week’s economic reports re-enforced this site’s moderately bullish outlook for modest growth:

• The Fed stated that it expects the unemployment rate to fall between 8.2% and 8.5% this year, a more bullish outlook than it had in November
• The Fed projects economic growth between 2.2% and 2.7% this year, slightlty less than previously thought
• The Fed predicts inflation to remain between 1.5% and 1.8% this year, below its target rate of 2%
• The Fed announced that it would keep short-term interest rate near zero through late 2014, an extension of a previous projection
• The Conference Board’s measure of future economic activity increased by 0.4% in December, higher than November’s 0.2% rise giving reason for cautious optimism
• GDP for the 4th quarter rose to an annualized 2.8%, the strongest performance since the 2nd quarter, 2010
• For the year, the US economy grew by 1.7%, down from 3% in 2010. This had a lot to do with debt issues in Europe, disasters in Japan and our bickering Congress
• Durable goods orders rose by a better-than-expected 3% in December, the 5th increase in the last 6 months
• New home sales fell 7.3% in 2011, a record low BUT 4th quarter sales rose an annualized 20% from the previous quarter and 3% higher than the same quarter in 2010 

For the week, the S&P 500 increased by 0.1% for a year-to-date return of 4.8%, including dividends.

In this election year we are and will be hearing doom and gloom scenarios regarding our economy. Politicians (both sides) will do and say anything to get a vote. This site evaluates market tone based on weekly economic reports, the status of the CBOE Volatility Index (VIX) and technical assessment of the overall market (S&P 500). We are aware that catastrophic events (hurricanes, war etc.) can negate the trends but we do all we can to maximize our returns and meet our goals. Creating fear is effective in compiling votes but ineffective in creating successful investment outcomes. When a politician speaks about our economy, I become the little boy who is being chastised by his mother: I put one finger in each ear and break out a chorus of “la-la-la-la-la”. 

This week I decided to take a broad look at the market since the sub-prime debacle and recession of 2008 to present day. I also present a graph of US GDP in that same time frame. The green fields represent the severe drop in the market in 2008 and the negative GDP and the yellow fields represent what has taken place since. Our economy is far from fully recovered. Unemployment, although improving, is far too high and the housing market must strengthen for a return to full economic recovery. When we risk our hard-earned money it’s important that we make our market evaluations based on the facts rather than on self-serving diatribes of others. We report, you decide:

GDP: 2008-2011

S&P 500: 2008-2011

 

 Summary:

 

IBD: Confirmed uptrend

 

BCI: Moderately bullish selling both ITM and OTM strikes

 

***We welcome and thank  BCIers to our growing population of premium membership and ALL our members for your continued support over the years. There will be many exciting enhancements to this site in the very near future. My team and I have been working furiously behind the scenes to make the BCI experience better than ever. You have put us on the financial map in a very big way and we will never forget that.

 

My best to you,

 

Alan (alan@thebluecollarinvestor.com)

 

The major concern for covered call writers is the stock price dropping in value. The option premium collected is money in the bank. Most of our exit strategies are designed to mitigate these losses and turn losses into gains. However, as Blue Collar Investors we should also be prepared to act if the opposite scenario occurs.

From time to time, you will buy a stock, sell the call option and your equity will subsequently dart straight for the moon! That will leave your strike price deep in-the-money. One way of looking at this situation is that you made a significant profit, and now that cash is protected by the difference between the share value and strike price of the option, or the intrinsic value of the option premium (the amount it is in the money). If satisfied with this situation, you will just allow assignment and enter a new position the next contract cycle. There may be, however, an opportunity to generate even more cash in such a scenario, especially when there is still time left until expiration Friday.

When a strike moves deep in-the-money, the time value of that option premium declines and approaches zero. This means that the option premium consists predominantly of intrinsic value. The amount of cash it takes to buy back the option is greatly offset by the share appreciation we would realize by eliminating the option obligation (closing our short option position by buying the option back) and selling the stock. Always consider a mid-contract unwind exit strategy when the time value of the option premium approaches zero and there is enough time remaining in the current contract cycle to generate additional profit with another position.

Real-life example of a mid-contract unwind exit strategy:

There is nothing like a real-life example to clarify the utilization of the mid-contract unwind exit strategy. The charts and graphs below depict the primary stages that occurred when I utilized this strategy in a covered call position for the underlying security, Perrigo Company (PRGO). Initially, 300 shares of PRGO were purchased @ $51.10 on March 22nd, the start of the April contract cycle. At this time, three $50 call option contracts were sold for $2.10, yielding a profit of $100 per contract given that this premium consists of $1.00 of time value ($2.10-$1.10). A week into the contract cycle, PRGO had appreciated in value to $56.79, and the premium for the corresponding $50 call option had likewise appreciated to $6.90, as illustrated in the two figures below:

PRGO heads to the moon!

PRGO $50 call also heads to the moon

The drastic increase in PRGO share price and its corresponding option premium in such a short period of time prompts us to explore the potential to generate more profits by unwinding the initial position mid-contract and then selling the stock. In order to examine the viability of this cash-generating opportunity, we must first explore the current options chain for PRGO, below:

PRGO unwind options chain

"Unwind now" tab of Elite Calculator

Next, we view the results generated from the entry of the foregoing information in the “Unwind Tab of the Elite Calculator, which is depicted below:

Elite Calculator results

Perhaps, some may feel that we can generate the extra cash by rolling up, however, the following two reasons may render the decision to utilize this strategy an unwise one:

• The price of the stock may not be in a favorable position to generate a decent return
• Given the drastic share appreciation over a short period of time, the possibility exists that profit-takers (sellers) could cause the price to experience a drastic decline in value.

Instead of rolling up, let’s look for a new financial soldier to send out into the financial battlefield (this has all been decided prior to unwinding the original position). To do this, we look to our watch list, which contains 40-60 fundamentally sound equities, and (in this example), Bucyrus International, Inc. (BUCY) surfaces as a viable candidate. This stock was selected from our watch list which was established with the fundamental, technical and common sense principles addressed in my books and DVDs. We then put BUCY through our technical screens, which (in this example) it passed, as depicted below:

Technical analysis of replacement security

BUCY options chain

Conclusion:

When a stock appreciates in value over a short period of time, and there are still two weeks or more remaining in the cycle, unwinding your position may offer an opportunity to generate additional cash into your account. This is one of the strategies that sets us aside from all the others. The keys are that the time value of the option premium must be close to zero, and the new position must generate more cash than the amount of time value paid to close the original position.

All BCI Books now Available in both Nook and Kindle Format:

Nook (Barnes and Noble):

Cashing in on Covered Calls

http://tinyurl.com/cashinginonccs

Exit Strategies for Covered Call Writing

 http://tinyurl.com/exitstrategiesforccw 

Alan Ellman’s Encyclopedia for Covered Call Writing

http://tinyurl.com/encyclopediaforccw 

Kindle (Amazon.com):

Cashing in on Covered Calls:

http://tinyurl.com/cashinginCCs

 Exit Strategies for Covered Call Writing: 

http://tinyurl.com/ccexitstrategies

Alan Ellman’s Encyclopedia for Covered Call Writing:

http://tinyurl.com/covered-call-encyclopedia

Market tone:

This week’s economic reports came in mostly positive as has been the trend for the past 4 months:

• New residential construction was down 4.1% in December but starts were up 24.9% over the past year.
• Building permits are up 7.8 from a year ago and has been uptrending for the past 8 months
• Existing home sales were up 5% in December finishing the year with 3 months of gains
• Industrial expansion rose 0.4% in December connfirming economic expansion
• CPI did not rise for the 3rd consecutive month allaying fears of inflation
• PPI also confirmed this trend by decreasing 0.1% in December, the 2nd decline in 3 months

For the week, the S&P 500 rose by 2.0% for a year-to-date return of 4.7%, including dividends

Technically, the market tone is bullish. We have an ascending, bullish trend (red arrows below) on significant volume (green arrow) with a very comfortable VIX reading @ 18.28 See the chart below):

Market tone as of 1-20-12

That being said, there are limited situations wherein I do retain ownership of the stock through earnings, and thereafter sell the call option when the price of the underlying equity settles, as noted. Let’s look a t a real-life example where I used this strategy with positive results. The following is a brief outline of the six key aspects that existed and affected my decision to retain ownership of RVBD through earnings:

• I bought RVBD and sold the July call
• I closed the short option position when the stock and option price declined, in preparation to execute an exit strategy (discussed more fully in Chapter 10 of Encyclopedia for Covered Call Writing).
• I re-sold the same option in the same contract period when RVBD increased in price (“hitting a double” exit strategy)
• The option expired worthless and the stock was retained prior to the earnings announcement
• The earnings report positively surprised and the share price accelerated
• An option was sold on the next higher strike price after the earnings report was published

For purposes of clarity, I have constructed a line chart depicting the aforementioned six key aspects, which are numbered accordingly on the graph, inclusive of a red arrow indicating the execution of each trade that was effected. Please review this chart and the explanation that follows (trading commissions not included but should be non-events):

Before and after the earnings report

The following numbers reference the numbers shown in the chart:

1- Initial covered call trade:

• Buy 500 x RVBD @ $29.80 (cost basis = $14,900)
• Sell 5 x July $30 calls @ $1.53 (initial profit = $765)
• Initial return = $765/$14,900 = 5.1%

2- Close short call position (buy-to-close):

• B-T-C 5 x July $30 @ $0.20
• Creates a debit of $100

3- Re-sell the same call in the same contract month:

• S-T-O 5 x July $30 @ $0.65
• Creates a credit of $325
• Exit strategy (2 and 3, I call “hitting a double”) credit = $225 ($325 – $100)
• Total profit to date = $765 + $225 = $990

4- Stock price closes below the $30 strike on expiration Friday:

• Option expires worthless allowing the stock to be retained
• one-month profit = 6.4% ($990/$14,900)

5- Earnings report is announced:

• On July 22nd the earnings report is made public
• The market reacts favorably to a positive earnings surprise (I’m a genius….this time!)

6- Sell the next month call option at a higher strike price:

• The stock appreciates to near $35 per share and the slightly O-T-M $35 call is sold for $1.35
• S-T-O 5 x August $35 calls @ $1.35 = $675
• I compute my returns based on share value at that point in time: $675/$17,400 = 3.9%
• At the time this chapter was written, the price of RVBD = $36.80, making the stock worth $35 per share (to me) due to the option obligation

For the fun of it:

Although this contract cycle was far from over as this article was being formatted, let’s compute our returns to date starting with the first covered call sale:

Profit:

$765- initial option profit for the July contracts

$225- net credit for “hitting a double” (exit strategy discussed later in the book) with the July $30 calls

$675- initial option profit for the August contracts

$2600- share appreciation from $29.80 to $35 for 500 shares

Total profit = $4265

Initial investment = $14,900

2-month return = 28.6% ($4265/$14,900)…I’m not even going to annualize that!

Conclusion:

The foregoing example was provided primarily in response to the myriad of inquiries I have received in connection with retaining a favored equity through an earnings report. Although this strategy is not part of the BCI system for selling covered call options, I do occasionally utilize same, (especially in bull markets) as detailed above. Bear in mind, however, that the positive results yielded in above-referenced example are not guaranteed. Had earnings disappointed, we’d be looking for a box of Kleenex! The main point here is to be prepared; holding a stock through an earnings report is for investors with a higher risk tolerance and works best in bull market environments.

Market tone:

This week’s reports pointed to a strengthening of our economy:

• Consumer borrowing rose about 10% in November, the largest increase since October, 2001
• Retail sales rose by 0.1% in December, the slowest increase since May but an increase nonetheless
• Business inventories (a measure of change in GDP) rose 0.3% in November
• The trade deficit widened but reflected stronger consumer demand and business restocking
• The Beige book Report showed strengthening job growth and production in ALL regions from late November to the end of December

For the week, the S&P 500 rose by 0.9% for a year-to-date return of 2.6%, including dividends.

Summary:

IBD: Confirmed uptrend.

BCI: Cautiously bullish beginning to utilize a small percentage of OTM strikes.

Wishing you the best in investing,

Alan (alan@thebluecollarinvestor.com)

The stochastic oscillator is a momentum indicator that shows the location of the current closing price relative to the high-low range over a set number of periods, usually 14 trading days. Closing levels that are near the top of the range indicate accumulation or buying pressure while those near the bottom of the range indicate distribution or selling pressure. Another way to frame this is that it is the battle between the bulls and the bears and who is in charge. The indicator oscillates between 0 and 100. Readings below 20 are considered oversold while readings above 80 are considered overbought. The idea behind this indicator is that prices tend to close near the extremes of the recent range before turning points.

Let’s set up an example as to how this works. We will assume that during the past 14 trading days stock XYZ has seen a low of $30 and a high of $40. Today it closed at $38. Within the $10 trading range, the stock is $8 up or in the 80%. If the stock closed today at $32, it would be at the 20%. This is known as %K in stochastic lingo. Transaction signals occur when %K crosses its 3-day simple moving average called %D. This is also known as the trigger line. Let’s look at a chart that shows the stochastic oscillator:

Note the following:

• Stochastic oscillator = thick black line highlighted by the black arrow = %K
• Trigger line = red line highlighted by red arrow = %D
• Overbought (80%) and oversold (20%) levels are highlighted by the green circles.

Some chartists use crossovers of %K and %D as buy/sell signals. However, these signals occur quite frequently and can result in whipsaws or a myriad of short term signals. A more reliable reading (in my view) is when the oscillator moves from overbought (above 80%) to below that level or from below oversold (20%) to above that level. A strong stochastic signal occurs when the positive divergence above 20% or a negative divergence below 80% takes place for a second time or a double dip. Here are the guidelines:

Buy signal: %K crosses above the 20% for the second time

Sell signal: %K moves below the 80% for the second time.

In the chart below, we see a clear buy signal highlighted by the green circle and the price then accelerating as seen by the green arrow. There is also a definite sell signal highlighted by the red circle with the subsequent price decline shown by the red arrow.

Slow versus Fast Stochastics:

One of the problems with %K in relation to %D is the high number of false breaks, whipsaws and crossovers. To mitigate this issue, the slow stochastic oscillator was developed. This is derived by applying a 3-day simple moving average to the %K thereby smoothing the data to form a slower version of %K. An equation that can be used to visualize this would be:

%K (slow) = %D (fast)

Then to form a trigger line for this slower version, a 3-d SMA is created and applied to the new %K (slow).

When building a chart, there is usually a choice of selecting slow or fast stochastics. I always opt for the slow stochastic oscillator as it is easier to read and interpret and eliminates many of the false triggers inherent with the fast oscillator.

Full Stochastic Oscillator:

There is actually a third stochastic oscillator called full stochastics. Rather than being required to use the 3-day SMA of the %K as in the slow stochastics, traders felt that this should be a variable so more flexibility could be achieved. A third variable was created called the smoothing variable which alters the amount of days used in the smoothing of %K. One can also recreate the fast and slow stochastics by the full stochastic. To mimic the fast stochastic, use a 1-day smoothing number. To mimic the slow stochastic oscillator, use a 3-day smoothing number.

Conclusion:

For purposes of 1-month covered call writing, I have found the slow stochastic oscillator most useful and time efficient. It is a widely used momentum indicator that measures who is winning the daily battle between the bulls and the bears. As always, it is prudent to use this oscillator in conjunction with our other technical indicators. See chapter 8 of Cashing in on Covered Calls or chapter 4 of the Encyclopedia for Covered Call Writing for a review of all technical indicators used in the BCI system.

Market tone:

We’re off to a great start in 2012…all positive economic reports:

• The US economy added 200,000 jobs causing the unemployment rate to drop to 8.5%, the lowest level since February, 2009.
• In December, the ISM manufacturing index rose from 52.7 to 53.9
• The US Department of Labor reported a 0.2% increase in hourly wages
• The ISM non-manufacturing index rose from 52.0 to 52.6, the first monthly increase since August
• Construction spending rose by 1.2% in November, beating analysts’ expectations
• New orders for manufactured goods increased by 1.8% in November

For the week, the S&P 500 rose by 1.6%, a great start to the New Year.

The market is also shining from a technical perspective as the S&P 500 has moved above both the 50-d and 200-d simple moving averages while the VIX has declined to a very comfortable 20.63:

S&P 500 trading above its moving averages

VIX dropping to a calm 20.63

 If the current trends continue, an opportunity to take a more aggressive stance with our covered call positions should present itself.

Summary:

IBD: Confirmed uptrend

BCI: Cautiously bullish but leaning towards a more aggressive approach to our covered call positions by increasing our OTM positions.

My best to all,

Alan (alan@thebluecollarinvestor.com)

• in-the-money
• at (near)-the-money
• out-of-the-money

Let’s look at the options chain for the December contracts which represent a 4-week period expiring on December 16th. This was the options chain after the November contracts expired:

RHT- Options chain for the December contracts

With the current market value @ $49.04, I have selected the following strikes to evaluate (additional strikes can also be viewed):

• $47 in-the-money (green field) generates $3.60
• $49 near-the-money (yellow field) generates $2.40
• $52.50 out-of-the-money (purple field) generates $0.95

Next let’s enter these stats into the “single tab” of the Ellman Calculator:

Ellman Calculator- information entered

Once this information is entered in the blue cells, the results appear in the white cells on the right side of the page:

RHT- Ellman Calculator results

Each strike tells an important story:

$47 (green field):

• 3.3%, 1-month initial  return
• 4.2% downside protection of the option profit
• No upside potential

$49 (yellow field):

• 4.8%, 1-month initial return
• Little or no downside protection or upside potential

$52.50 (purple field):

• 1.9%, 1-month initial return
• No downside protection of the option profit
• 7.1% upside potential (possible total of 9%, 1-month return)

What these calculations tell us:

• The time value or option profit for I-T-M strikes offer lower returns than the near-the-money call but the greatest protection for the option premium
• A-T-M (near) calls provide the highest ROO (initial premium profit) but little or no upside potential or downside protection of the premium
• O-T-M calls offer less option profit than the A-T-M calls but the greatest total profit potential should the upside be realized or almost realized.

When to use each strike:

• I-T-M strikes are the most conservative and easiest to unwind because of their high delta (move down in price nearly dollar-for-dollar with stock price decline). Use these when technicals are mixed and/or the market is bearish or volatile.
• A-T-M strikes can be used when technicals are good and market conditions are positive.
• O-T-M strikes are used when extremely bullish on the stock and general market conditions are favorable 

Laddering the strikes:

There is no law that says you must use the same strike when you have multiple contracts. You can use some of each, favoring a particular strike based on the overall environment.

Conclusion:

When it comes to strike selection one size DOESN’T fit all! Evaluate the stock and market parameters and then make a Blue Collar decision that has the best chance to maximize your returns.

Get a Kindle for the Holidays? ALL BCI Books Now Available in Kindle Format:

 Cashing in on Covered Calls:

http://tinyurl.com/cashinginCCs

 Exit Strategies for Covered Call Writing: 

http://tinyurl.com/ccexitstrategies

 Alan Ellman’s Encyclopedia for Covered Call Writing:

http://tinyurl.com/covered-call-encyclopedia

Market tone:

The final week of 2011 showed a rising consumer confidence to 64.5 in December, up from an October low of 40.9. This was well above the consensus estimate of 58.3. To get a more substantial boost we would need to see a stronger recovery in the unemployment figures. For the week, the S&P 500 was down 0.6% for a final year-to-date return of 2.0% including dividends. Here are the major index results for 2011 (without dividends):

• Dow 30- + 5.5%
• S&P 500- Flat
• Nasdaq- (-) 1.8%

With just this information it would seem like we had a rather uneventful 2011, kind of quiet. The truth, however, is that the following photos can best describe our stock market for this past year:

2011: A wild ride

Every once in a while, when using our covered call writing strategy a stock will gap up or down. A gap is a break between prices on a chart that occurs when the price of a stock makes a sharp move up or down with no trading occurring in between. Gaps can be created by factors such as regular buying or selling pressure, earnings announcements, and changes in an analyst’s outlook or any other type of news release. Here is a chart of BCSI which gapped down after an earnings report disappointed:

BCSI gaps down

How to manage a stock that has gapped down:

When a stock gaps down, human nature is such that you want to get your money back with this same equity. In this way, it will no longer be perceived as a loss. As a result, many investors will not unwind their position and just ride it to wherever it goes. This approach is misguided in some instances. Think back to stocks like Enron, Tyco, WorldCom, Citi, Bear Stearns, Lehman and many others. Holding positions in these companies spelled disaster even though these corporations were considered pillars of our economy at one time. Circumstances change and so we must be willing to change our perspectives as well. When a stock drops from $29 to $22 as it did in the figure above, we now have $2200 in cash per contract. We no longer have $2900 per contract. That was yesterday, not today.  The question becomes “where do we want this cash to be placed to give us the best chance for a successful investment?’ It may or may not be with this same security. So step one is to determine what caused the gap down. We must check the news to see what precipitated this unexpected turn of events. If it is a serious matter like corporate fraud, a key member of the Board of Directors leaving the company, the loss of a patent, the FDA disapproving a new drug, new legislation that negatively impacts that company or other events that dramatically alter the prospects for that company, it is time to hand that cash over to a new financial warrior. If, on the other hand, it dropped in price due to a less serious matter like a single analyst downgrade or guidance being amended slightly and a market over-reaction followed, we may opt to stay with the same equity.

Let me give you an analogy for those of you familiar with casino blackjack. In this hypothetical you hold a “15” and your prospects look bleak. This is analogous to the stock after it has gapped down. The dealers hand represents the circumstances that will dictate how to manage the gap-down. Now do you stay with the “15” or do you make a change? Well that depends on the cause of the event or the dealers hand. If the dealer has a “5”, the event was not a serious one and the corporation remains a great opportunity in your eyes. Therefore you hold your position as there is a good chance the dealer will “go bust” or go over “21” with his next card. Your investment outlook by holding your position looks positive. If, however, the dealer is sitting with a “10”, the cause of the gap down was a serious blow to the stock and holding would be a poor decision as the dealer has great prospects of having a “20” and destroy your prospects of a successful investment. Therefore, we must change financial soldiers and take another card. The point here is that given the same hand but different conditions, we must make different decisions. In much the same way, once we determine the cause of the gap down, we must have the non-emotional flexibility to make a change if that approach is indicated.

You decide to keep the stock:

If your decision is that the cause of the gap-down was not serious and you still have a great opportunity with the same equity, we first buy back the option. Since the price has declined dramatically, the price of the option has also done so. If we are mid-contract or earlier, I will wait for a bounce back and resell the same strike to hit a double. If the stock is slow to recover, we can roll down to a lower strike price that is still above the current market value. In the example above, selling the $22.50 strike will generate income to help offset the share value depreciation. If we are correct and the stock continues to recover, we can nurture this security up by selling out-of-the-money strikes.

When we decide to hold a stock that has gapped down, we are employing a strategy I have named technical nullification. In a manner similar to jury nullification, where a jury ignores the facts and opts for an atypical conclusion, we will be ignoring the technicals like the chart pattern and accumulation/distribution (A/D) and others and still hold this equity. Let’s look at a chart of BCSI three weeks after the gap-down where it is consolidating and forming a base from which it may head back north:

BCSI after gap-down

Notice how BCSI after the huge gap-down (red arrow) has been trading sideways between $22 and $23.50. Using technical nullification and feeling the prospects of a return to previous pricing will lead us to selling out-of-the-money calls, in this case the $25 strike. The option chain shows a return of near 2% for the next month out-of-the-money $25 call:

BCSI- option chain

In addition to looking at the short term technicals of the stock after the gap down, we should also compare its price performance to that of the broad market. If it is consolidating (trading sideways) but well-underperforming the general market, I would view that as a negative and consider selling the stock. In the chart below, we see however, that BCSI has equaled the recent price performance of the S&P 500, re-enforcing the confidence we may have in this equity.

You decide to sell the stock:

If you feel that the cause of the gap down was a longer term issue, buy back the option and sell the stock. We then utilize the cash generated from this sale to enter a new covered call position.

Both management decisions can be re-evaluated as time progresses using the same exit strategy maneuvers discussed in my books, Alan Ellman’s Encyclopedia for Covered Call Writing, Cashing in on Covered Calls and Exit Strategies for Covered Call Writing.

Conclusion: After a stock gaps down as a result of an unusual event we have the choices of either unwinding our position or keeping the stock. We base our decision on the reason for the gap-down. Should we consider keeping the stock, it will require technical nullification, monitoring the technical pattern of the stock after the gap-down and comparing the price action to that of the broad market.

Available in kindle:

My latest book, Alan Ellman’s Encyclopedia for Covered Call Writing is now available in kindle format:

http://tinyurl.com/covered-call-encyclopedia

2012, A Look Ahead:

My team and I are planning major enhancements to this site. Our goal is to augment the information we share with each other and present it in a user-friendly manner. Members who have been with us for years know that we listen to you and make upgrades whenever possible. This year you will see this reflected in an important and compelling manner. With your support The Blue Collar Investor will continue to be one of the top go-to sites for covered call writers.

Radio Interviews:

A re-broadcast of my interview on the Business Author’s Program is now available:

http://www.wnbnetworkwest.com/WnbAuthorsShowBusiness.html

Another interview with cdtv.net is also playing:

http://www.cdtv.net/users/content/investment-strategies-featuring-exit-strategies-covered-call-writing

Market tone:

With only one more week of economic reports remaining in 2011 the trend seems apparent. The US economy is improving while the global economy is struggling. This week’s reports were much more positive than negative:

• The GDP grew at an annualized rate of 1.8% in the 3rd quarter, less than expected
• Final sales (GDP – change in inventories) was a strong 3.2%
• Sales of exisiting homes rose by 4.0% in November, the highest level in 10 months
• Sales of new single-family homes increased by 1.6% in November and October sales were revised upward for the highest pace since April surpassing analyst expectations
• New residential construction increased by 9.3% in November, better than anticipated
• The Conference Board’s Index for leading Economic indicators rose by 0.5% in November, better than expected
• Increases in building permits suggests that the housing decline may be turning around
• New orders for durable manufactured goods rose by 3.8% in November better tha expected for the 4th rise in 5 months
• Personal income and consumer spending grew by 0.1% in November, less than expected

For the week, the S&P 500 rose by 3.7% for a year-to-date return of 2.7% including dividends.

Summary:

IBD: Confirmed uptrend

BCI: Cautiously bullish but maintaining a defensive posture using low beta stocks and exchange-traded funds in conjunction with in-the-money strikes.

Happy holidays to our BCI community, our extended family,

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

Premium Running List

1- Check the stocks that ARE eligible and determine whether there are enough equities for our portfolio size that are well-diversified by industry segment. If there are, you’re good to go. If not, you can start to invest with these stocks and leave cash on the sidelines for the next entry point.

2- You will note that there are many stocks that report early in the cycle. Allow the ER to pass and re-check our system criteria. Once the post-ER dust settles and if the stocks are eligible, we can enter those positions. ***Some cycles last 5 weeks so entering in the second week or the start of the third should still generate favorable returns.

3- If the first two strategies fall short and you still need more “security-power” to write your calls, why not turn to exchange-traded funds (ETFs) for our covered call writing? These are mutual funds that behave like stocks and represent a “basket” of equities so there is instant diversification and earnings reports are no longer a concern. The BCI Corp. also produces a weekly 6-page report of top-performing ETFs suitable for covered call writing. Here is a partial sample of a recent report:

Premium ETF Report

Premium members will find this in the “Resource/Download” section of the premium site.

All exchange-traded funds listed in the report have outperformed the S&P 500 (black) over the past three months as of that post. These would be CC candidates to consider if you couldn’t locate enough individual equities to populate your portfolio. These are also appropriate for more conservative investors and those with limited time to devote to this strategy. Although many of the stocks within these ETFs do report, the fact that we are dealing with such a large basket of securities, the ER issue becomes much less of a concern as they tend to counterbalance each other.

Conclusion:

During the four earnings seasons, we must avoid selling calls on stocks that report in the current cycle, prior to those reports. In these instances, we look to candidates not reporting in the current cycle, wait for reports to pass and then enter into those positions and consider selling calls on the best-performing ETFs. Problem solved!

Market tone:

Despite decent signs of economic recovery in the US, concerns of Europe heading into recession and slowing economic growth in Asia has investors nervous. Here are this week’s key reports:

• The Fed announced that it will take no additional steps to ignite the economy as it cited “moderate economic growth”
• The Fed reiterated its pledge to keep its key interest rate near zero through mid-2013
• Retail sales rose by 0.2% in October, the weakest showing since June
• Retail sales stats for September and October were revised upward
• US industrial output declined in November, the first time since April, however, floods in Thailand caused shortages of parts for US automakers
• Low ratios of retail inventories due to nervous retailers may bode well for future production
• Year-0ver-year inflation rate is only slightly above the Fed target of 2%

For the week, the S&P 500 declined by 2.8% for a year-to-date return of (-) 1%.

While the VIX remains at a comfortable sub-30 level a 6-month chart of the S&P 500 shows it trading slightly below its 50-d simple moving average. You will note a volume spike on Friday which was related to Quadruple Witching Friday. The constant whipsaws that the market is experiencing due to global issues has rendered technical analysis challenging as left tail risk rears its ugly head:

S&P 500 as of 12-16-11

Summary:

IBD: Market in correction

BCI: Taking a cautious, defensive posture using low-beta stocks and ETFs with in-the-money strikes. This market is geared to turning bullish once the European issue is resolved favorably.

Happy holidays to one and all,

Alan (alan@thebluecollarinvestor.com)

Diversification by industry

Note the following:

• Yellow field identifies industry segment
• Green field identifies industry rank and in most cases the previous week’s rank
• You would NOT want to have a portfolio consisting of all stocks in the same industry (red arrows)

If we have five stocks selected, do we buy an equal number of shares of each? That would work if the stocks sell for the same price. Then we would be investing equal amounts of cash in each security. However, we are generally purchasing equities of different market values. How then do we calculate how many shares to purchase and how many contracts to sell? Stated differently, how do we allocate our cash? Once determined we can then sell our covered calls.

Let’s assume we have gone through the process of stock selection or referenced our premium report. The number of stocks to include in this months portfolio would depend on the amount of cash we have to invest. Here is a guideline:

• $50k or less = 5 to 6 stocks
• $100k or less = 5-10 stocks
• $250k or less = 10-15 stocks

Once we have ascertained the number of different stocks to include in our portfolios, every effort is made to invest a similar cash amount into each equity. In this article’s hypothetical, we have nine stocks and $100k to invest:

Cash Allocation Chart

With nine stocks and $100k, we approximate $11k per stock. Next we divide the price per share into $11k and get the number of shares we can purchase. Since 1 options contract = 100 shares, we must round off to the nearest one hundred. If the number is near the middle as it is with FFIV, I will round up or down based on previous experience with that security or on the technical status of that equity.

Next I will multiply the number of rounded off shares by the price per share and calculate the total cost to purchase all shares. In the above chart, that comes to $96,780. I do this for two reasons. First I want to make sure that I can pay for all these shares and don’t go over my $100k budget. Second, I want to be sure that I also have extra cash left over for possible exit strategy execution. In the above example, $3220 is the cash balance, quite adequate. We take this information together with the calculations computed by the  Ellman Calculator and sit down in front of our computer and start generating cash!

Note also that with the exception of  XEC, we sell more than one contract for each stock. That will allow us to “ladder” our strikes if we so choose. In other words, for an equity like PAY we can sell three O-T-M strikes and two I-T-M strikes or some other combination depending on our market outlook. If we were extremely bullish on the market and stock technicals were impressive and confirming, we may opt for five out-of-the-money contracts.

Conclusion:

When creating our covered call portfolio stock and industry diversification is critical as is cash allocation. This way, no one stock or industry will impact our portfolio in an extreme manner.

Radio interview:

I was recently a guest author on Danielle Hampson’s popular Business Author’s Show. Here is a link to access that interview:

http://www.thebluecollarinvestor.com/member/signup.php

Welcome to our new premium members:

A warm welcome to our new members including several from Australia. In 2012 we plan to expand and enhance both the general and premium sites as we continue to maximmize the quality and organization of the content we provide to our members. Thank you to ALL our members for the confidence you have shown in our BCI team.

Market tone:

We had another mixed-bag of economic reports this week which were overshadowed by reports coming out of Europe:

• Factory orders fell by 0.4% in October
• The ISM Non-Manufacturing Index fell by a point to 52.0 in November, the third straight monthly decline
• Consumer credit rose to $7.6 billion in October, the 9th monthly increase this year
• The US trade deficit narrowed in October for the 4th consecutive month, a positive signal for economic growth

For the week the S&P 500 rose by 0.9% for a year-to-date return of 1.8% including dividends.

The charts below show the S&P 500 slightly above its recent trading range. The VIX has been declining to the 26 level, also a positive for the market. Despite these technical plusses it is obvious that the market in the short run is at the mercy of Europe and resolution of its debt crisis:

Market tone as of 12-9-11

A calming VIX as of 12-9-11

Summary:

IBD: Market in correction

BCI: This site continues to take a defensive posture and sell mainly in-the-money strikes as long as global issues remain the determining factor in market direction.

Wishing you the best in investing,

Alan (alan@thebluecollarinvestor.com)