strategies

58

www.tradersonline-mag.com 03.2015

Part i: Covered Call Writing

generate Monthly Cash Flow with selling stock Options

Retail investors are always seeking ways to generate higher-than-risk-free-returns and still maintain

capital preservation as a key component to the strategy. For most of us, the thought of combining the

stock market with stock options is far too speculative and not for the average blue collar investor. In

this series of three articles, this myth will be debunked and you will be presented with a set of specific

rules and guidelines geared towards enhancing your annualized returns. In this first article, covered call

writing will be highlighted.

What is Covered Call Writing?Covered call writing is a strategy that combines two

other strategies: buying stock (long the stock) and

selling stock options (short the option). We first buy an

appropriate stock screening process will be discussed

and sell the option or sell via online trading an unknown

person the right but not the obligation to buy our shares

from us at a price that we determine (= the strike price)

and by a date that we determine (= the expiration date). In

return for undertaking this obligation we are paid a cash

premium (= the option premium) which is determined by

the market.

strategies

59

Preview ExampleSince option contracts almost always consist of 100 shares

of underlying stock per contract, we will purchase 100

shares of a company at $48 per share for an investment

or cost basis of $4,800. Once we own these shares and

are therefore in a covered or protected position, we are

now free to sell the option. Lets assume we select the

$50 strike price and agreed upon sales prices. In other

words, the option buyer now controls our shares and has

the right to exercise that option and buy our shares from

us at $50.

Every contract eventually terminates and ceases to

exist. Most option contracts expire on the third Friday of

the month at 4 pm ET (= Eastern Time) and we will be

dealing predominantly with 1-month options. Therefore,

the option buyer can buy our shares from us at $50 at

any time from the sale of the option through 4 pm (ET) on

expiration Friday.

A typical option premium for this hypothetical

example would be $1.50 or $150 for the contract (100

shares). A $150 initial profit on a cost basis of $4,800

represents a 3.1 per cent initial return which annualizes

to 37.5 per cent. After the position is entered, it must also

be managed.

Position management or exit strategies will be

addressed later in this article. For now, lets look at the

two major outcomes that are possible by expiration (4 pm

ET, the third Friday of the month).

(1) The price of the stock remains under $50

In this scenario, the option will expire worthless because

the option buyer will not choose to exercise the option

and buy our shares for $50 when they can be purchased

at market for a lower price. We keep the $150 premium

and still own our shares and are now free to sell another

option the following month.

(2) The price of the stock moves above $50

In this situation our shares will be sold at the strike

price of $50, unless we execute an exit strategy to avoid

our shares being sold. If our shares are, in fact, sold

for $50, we have now generated an additional $200

profit on the stock side of this trade (buy at $48, sell

at $50 x 100). Our total 1-month profit is $350 (= $150 +

$200) less small commissions or a 7.3 per cent 1-month

return.

Three Skills Essential to Master this StrategyBefore risking even one penny of our hard-earned

money, we must master all three aspects of this strategy:

1. stock selection (you can also use Exchange-Traded

Funds or ETFs for short), 2. option selection (strike

price and expiration date) and 3. position management

(exit strategies).

1. Stock SelectionSince we first purchase shares before selling the

corresponding options, we should only use securities

that we would otherwise want to own. In other words, in

our 30-day obligation period we want to own shares least

likely to go down in value. This means that our screening

process must be rigorous and not based on option returns

but rather on the quality of the underlying security. As

a result, we demand stocks that are fundamentally and

technically (price chart) sound as well as meeting certain

common sense requirements like minimum trading

volume.

a. Fundamental Analysis

In this first screen, we demand stocks with strong

sales and earnings growth. There are some excellent

proprietary screens like Investors Business Dailys IBD 50

and SmartSelect screens as well as some free screening

sites like finviz.com.

Dr. alan ellmanDr. alan ellman

Alan Ellman is president of the Blue Collar Investor Corp. He holds a Series 65 and is a national speaker for The Stock Traders Expo, The Money Show and the American Association of Individual Investors. Alan has published fi ve books on stock and option investing as well as over 300 journal articles and has produced more than 200 educational videos.

alan@thebluecollarinvestor.com

We will be looking at strike prices near the current market value of the stock.

strategies

60

www.tradersonline-mag.com 03.2015

b. Technical Analysis

Since we are undertaking a 1-month obligation, it is

important to identify trend and Momentum and to have

volume confirmation of these indicators. There are a

myriad of useful technical indicators such as the ones

presented in the chart for Centene Corp (CNC) in Figure 1.

For trend identification,we canuse the20-dayand

100-day Exponential Moving Averages (EMAs).

FortrendandMomentumidentification,wecanuse

the MACD histogram.

For Momentum identification, we can use the

Stochastic Oscillator.

Volume is used to confirm changes in the other

indicators as well as detect divergences.

It is important that we all become proficient at reading

price charts to have the ability to maximize returns when

selling stock options. Although it may be intimidating

initially (it was for me), reading a price chart becomes

quite easy and time efficient as we become familiar with

the parameters we choose.

c. Common Sense Principles

The final set of screens we use in selecting the best

candidates for option-selling fall into the category of

common sense screens. The most important of these

screens is the rule that we never sell an option, when there

is an earnings report due out prior

to expiration of the contract. This

means that we will only hold a stock

for a maximum of two consecutive

months in our covered call writing

portfolio, since most companies

report on a quarterly basis. Other

common sense screens include

minimum trading volume (250,000

shares per day), proper stock and

industry diversification (no one stock

or industry should represent more

than 20 per cent of our portfolio) and

cash allocation (allocate a similar

amount of cash to each position).

Table 1 demonstrates the

screening process (first row on

top) we provide for our premium

members on a weekly basis.

Option SelectionThere are three aspects of an option

we must evaluate before deciding

on which will be most beneficial to achieving the highest

returns while still factoring in capital preservation: a.

strike price (the price we agree to sell our shares for), b.

expiration date of the contract and c. the cash premium

we will receive.

a. Strike Price Selection

Generally, we will be looking at strike prices near the current

market value of the stock. These strike prices are the ones

that will generate the highest returns. The relationship

between the strike price and the current market value of

the underlying security is known as the moneyness of

the option. For call options, if the strike is higher than the

current market value (as it was in the preview example), it

is known as an out-of-the-money strike. If the call strike is

lower than the stock price, it is called in-the-money. If the

two prices are the same, we have the at-the-money strike.

In a bull market environment with strong chart

technicals, we are more likely to choose an out-of-the-

money strike where we have an opportunity to generate

two income streams: one from the sale of the call option

and the other from the share appreciation.

In a bearish or volatile market environment, we are

more likely to select an in-the-money strike which gives

us protection of the option profit. Lets examine this last

sentence: An option premium can have two components

to it: time value (actual profit) and intrinsic value, if the

Figure 1 demonstrates the use of four technical indicators used to identify trend and momentum in order to select the best underlying securities for option-selling. This chart shows a mixed technical picture which will assist in determining strike price and exit strategy choices.

Source: www.stockcharts.com

F1) technical Chart for Centene Corp

strategies

61

navigate through earnings reports which become

public quarterly so we can move in and out of securities

rather easily compared to a longer-term commitment.

Some covered call writers prefer weeklys which may

return higher annualized results.

There are pros and cons to weeklys. For example, we

can use them right up earnings reports and therefore,

hypothetically, 48 weeks of the year. On the other side of

the fence, we have quadruple the commissions and less

time for position management techniques. We must know

all the advantages and disadvantages to each approach

before deciding on which is best for our specific trading

style.

c. Cash Premium Goals

The higher our goal, the greater the risk. This is because

higher premiums mean more volatile stocks and therefore

a greater chance of share depreciation. There is no one

range that is right for every investor.

However, covered call writing is a conservative

option strategy, so a reasonable goal for initial 1-month

returns would fall into the two to four per cent range.

After setting your goal, make sure a trade will meet

this objective before entering the position. Goals can

also be adjusted up or down depending on overall

strike is in-the-money and not profit. For example, if a

stock is trading at $32 and we sell an in-the-money $30

strike for $3, the premium is broken down as follows:

$2 = Intrinsic value: amount strike is in-the-money

and not profit because we will lose $2 on the sale of

the stock.

$1=Timevalue:actualinitialprofit.

By using the intrinsic value to buy down our cost

basis from $32 to $30, our initial profit now calculates to

$1/$30 = 3.3 per cent. This profit is protected as long as

share value does not decline below $30, so our downside

protection is $2/$32 = 6.25 per cent. This means that we

are guaranteed a 1-month return of 3.3 per cent as long

as share value does not decline by more than 6.25 per

cent by expiration Friday. Therein lies the value of an in-

the-money strike. The disadvantage is that we will not

participate in additional profits, if share value appreciates

by expiration.

b. Expiration Date Selection

The shorter the time frame, the greater the annualized

returns. This is why 1-month options have been

highlighted in this article. Monthlys also allow us to

Symbol Company Name

Weekly Rank or Other

Source

PriceOpts Avail (Y/N)

Report Same Store Sales (Y/N)

Pass Fundl And Techl

Screens (Y/N)

Avg. Vol.: >250K

Sh/Day (Y/N)

Pass Risk vs. Reward (Rank 5 or

Higher)

Chart: PRICE BAR above 20

EMA above 100 EMA (Y/N/@)

Tech Ind. OK: MACD & Stoch. (Y/N/?)

Earn. Report In

This Option Month (Y/N)

Passed All Screens - ELIGIBLE CANDIDATES

AAP Advance Auto Parts 26 154.18 Y N Y Y 7 Y Y N

AMAT Applied Materials Inc Other 25.04 Y N Y Y 9 Y Y N

AMBA Ambrella Inc 49 54.69 Y N Y Y 5 Y Y N

ARMK Aramark Other 30.13 Y N Y Y 8 Y Y N

AVGO Avago Technologies Other 103.99 Y N Y Y 9 Y Y N

BIIB Biogen Idec Inc 46 340.87 Y N Y Y 7 Y Y N

CAVM Cavium Inc 16 58.77 Y N Y Y 8 Y Y N

DLTR Dollar Tree Inc Other 68.41 Y N Y Y 9 Y Y N

EA Electronic Arts Inc Other 46.66 Y N Y Y 7 Y Y N

EXR Extra Space Storage Other 59.44 Y N Y Y 9 Y Y N

FFIV F5 Networks Inc 24 133.26 Y N Y Y 9 Y Y N

FL Foot Locker Inc Other 56.70 Y N Y Y 10 Y Y N

IDTI Integrated Device Tech Other 19.90 Y N Y Y 7 Y Y N

The screening process for selecting the most elite option-selling underlying securities should include fundamental, technical and common sense screens as demonstrated in the BCI Weekly Stock Screen of December, 14th 2014.

Source: Blue Collar Investor

T1) screening Process for selecting the Best Option-selling Candidates

strategies

62

www.tradersonline-mag.com 03.2015

market environment, personal risk tolerance and chart

technicals.

3. Position Management (Exit Strategies)Once we have entered our covered call trade, we now

move into management mode. There is no way to give

This options chain for the one-month $77.50 strike price shows a bid-ask spread of $1.94 to $1.97. Since we sell at the bid, our initial return that should be used when calculating initial profit is $1.94.

Source: Blue Collar Investor

F2) Options Chain for Facebook from December, 17th Dec. 2014 this critical subject appropriate justice within the context of this one article. However, there are several key points

that must be discussed.

Events that May Create an Exit Opportunity Stockpricedeclinesprecipitously.

Stockpricegapsdown.

Stockpriceacceleratesexponentially.

An ex-dividend date is scheduled prior to contract

expiration.

Thepriceofthestockisabovethestrikeatexpiration

with no earnings due out the next contract.

The price of the stock is above the strike with an

earnings report due out the following month.

All exit strategies begin with buying back the option.

This will relieve us of our option obligation, and still

leave us long the stock. Now we are in a position to

sell another option, sell the stock or take no immediate

action. An excellent guideline to use, when a stock price

is declining, is to buy back the option when its value

declines to 20 per cent or less of the original sale value

in the first half of a contract or ten per cent or less in the

second half of a contract.

Lets look at a real-life example for Facebook (FB) (see

Figure 2). On 17th of Dec 2014, Facebook was trading at

$75.73. The 1-month January out-of-the-money $77.50

strike generated $194 per contract which represented

a 2.6 per ent 1-month return or 31 per cent annualised.

If the stock price should decline, so will the value of

the corresponding call option. Should the option value

decline below $0.40 in the first half of the contract, the

20 per cent guideline tells us to immediately buy back

that option. If option value declines below $0.20 in the

second half of the contract, we also buy back the option

and evaluate what our next step will be. Factors such as

time to expiration, overall market assessment, personal

risk tolerance and chart technicals will influence our

position management decisions.

ConclusionCovered call writing is a low-risk strategy geared to

retail investors. The trades are constructed to generate

monthly cash flow keeping capital preservation as a

high priority. The three skills that must be mastered to

justify risking our hard-earned money, when using this

trading approach, are stock selection, option selection

and position management.

In Part 2 of this three-part series we will discuss

put-selling.

Strategy Name: Covered Call Writing

Strategy Type: Cash Flow Trading

Time Horizon:Usually longer-term position in a stock plus max. 30-day holding period of short option

Setup:

Technical and fundamentally sound stock, choose short option strike price depending on market state (general hint: at the money, bull market: out of the money, bear market: in the money)

Entry:When holding the stocks, sell 1 options contract of the new series for each 100 shares

Stop-Loss:Optional; put stop loss for stock in case it should massively decline

Take Profit:Buy back option once it falls to 20% (10%) of price shorted in first (second) 15 days of ist 30-day max holding period

Trailing-Stop: -

Risk and Money Management:

Keep positions small as downside protection is limited; diversify positions across sectors

Strategy Profile:

Less risky than outright stock position as short option delivers premium in case of declining or constant stock price; higher hit rate and smoother profits over time; max. profit is capped at strike price of short option

Strategy Snapshot