Covered call writing is a low-risk option-selling strategy typically used to generate monthly cash flow. When we capture call premium into our brokerage accounts, we are lowering our cost basis thereby increasing the opportunities for successful trades. This strategy can also be crafted to increase our capital gains (or decrease capital losses) when we decide to sell our shares. To highlight how this can be accomplished, I will use a stock taken from our Premium Stock Report of 4/27/2018, Paycom Software, Inc. (NYSE: PAYC).

 

Trade status as of 5/4/2018

We are considering selling PAYC currently priced at a bid price of $105.19 and not initially attached to a covered call position. By selling deep in-the-money calls we create an opportunity to increase the capital gains (or decrease losses depending on the cost basis). Our plan is to check the option chain and run the calculations.

 

Option status for the deep in-the-money $100.00 call option (bid price)

covered call writing option

PAYC $100.00 Call Option as of 5/4/2018

 

We can sell the $100.00 call option for a bid price of $6.64 or $664.00 per contract. This however, will lower our sale price to $100.00, if exercised. Let’s do the calculations.

 

PAYC Calculations using the Ellman Calculator

covered call writing calculations

PAYC Calculations

 

The time value return we receive for selling the $100.00 call is 1.5% (yellow field). This initial profit is protected by 4.9% (brown field). This means that PAYC can decline in value by 4.9% by contract expiration and we still will have generated an additional 1.5% when shares are sold (less commissions).

 

Cash calculations if share price remains above the $100.00 strike

Here are our 2 choices after deciding to sell our shares:

  • Sell on 5/4/2018 at $105.19 per share
  • Write a $100.00 covered call and receive $6.64 + $100.00 = $106.64 per share

 

Additional returns generated if share price remains above the $100.00 strike

There is a $1.45 per share benefit to selling the covered call which represents a 1.5% benefit. This annualizes to an additional 39% per year (trade initiated 5/4 and contract expires 5/18).

 

Is there risk?

Yes. The risk is the stock price declining more than $5.19 over the next 2 weeks. If share price drops below $100.00, our 1.5% returns starts declining and if share price drops below the breakeven of 98.55, we can actually generate lower returns than selling at market on 5/4. We must always be prepared with our exit strategy arsenal for all our option-selling positions.

 

Discussion

Before selling shares, considering writing deep in-the-money call options which have a time value component and decent downside protection to elevate our capital gains or mitigate capital losses. Despite the significant downside protection offered by deep in-the-money strikes, we must always be prepared to execute our exit strategy maneuvers.

 

New Blue Chip Report uploaded to the premium member site

The Dow 30 (Blue Chip) Report for the November contracts has been added to the member site in the “resources/downloads” section. 2 stocks were eliminated and 5 new securities were added from last month’s report.

 

Upcoming event 

October 26 @ 8:00 am – October 28 @ 1:00 pm

October 26th – 28th, 2018 (Friday through Sunday)

Alan’s presentations: Saturday October 27th at 9:30 AM and 1 PM

Visit Alan, Barry and the BCI team in the exhibit hall Friday, Saturday and Sunday

 

 

Market tone

This week’s economic news of importance:

  • Retail sales September 0.1% (0.6% expected)
  • Business inventories August 0.5% (0.7% last)
  • Federal budget September $119 billion ($8 billion last)
  • Industrial production September 0.3% (0.1% expected)
  • Job openings August 7.1 million (7.1 million last)
  • Home builders index October 68 (67 last)
  • Housing starts September 1.201 million (1.208 million expected)
  • Building permits September 1.241 million (1.249 million last)
  • Weekly jobless claims 10/13 210,000 (as expected)
  • Philly Fed manufacturing October 22.2 (20.5 expected)
  • Leading economic indicators September 0.5% (0.4% last)
  • Existing home sales September 5.15 million (5.27 million expected)

 

THE WEEK AHEAD

Mon October 22nd

  • Chicago Fed national activity index September

Tue October 23rd

Wed October 24th

  • Markit manufacturing PMI October
  • Markit services PMI October
  • New home sales September
  • Beige book

Thu October 25th

  • Weekly jobless claims 10/20
  • Durable goods orders September
  • Pending home sales index September

Fri October 26th

  • Gross Domestic Product Q3
  • Consumer sentiment index October

 

For the week, the S&P 500 moved up by 0.02%% for a year-to-date return of 3.52%

Summary

IBD: Market in correction

GMI: 0/6- Bearish signal since market close of October 8, 2018

BCI: With the VIX hovering near 20, a volatile market and multiple bullish and bearish factors, I am favoring in-the-money strikes 2-to-1 entering the November contracts. Issues of concern include the trade war with China, relations with Saudi Arabia, rising interest rates and moderating retail and housing sectors. On the bullish side, consumer sentiment remains strong, down days have been on unimpressive volume, many stock favorites (FAANG stocks) are at reasonable price points and earnings season has been generally impressive (results like from Netflix). I remain bullish on our economy and stock market but will enter the November contracts fully invested while favoring a defensive posture.

 

WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US

The 6-month charts point to a bearish-to-neutral tone. In the past six months, the S&P 500 was up 3% while the VIX (19.89) moved up by 25%.

Wishing you much success,

Alan and the BCI team

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