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Every investment strategy, including covered call writing and selling cash-secured puts, has advantages and disadvantages. When we decide to implement a plan, it is with the understanding that we accept and embrace these pros and cons. It is not productive to look back and say we could have made more money using a different approach. Recently, Scott sent me a series of hypothetical trades comparing covered call writing and traditional stock ownership. His premise was that if a stock was in an uptrend, it would be preferable not to write the call and allow for full price appreciation.

 

Scott’s hypothetical trades

Buy-and-hold the stock: Scenario I

  • Buy XYZ at $100.00 per share
  • Price rises to $104.00 in 2 weeks
  • Sell stock at $104.00
  • Net profit = $4.00 per share

Buy stock, sell covered call and close short call to avoid assignment: Scenario II

  • Buy stock at $100.00 per share
  • Sell 1-month $102.00 (4-week) covered call for $1.00 per share
  • Price rises to $104.00 in 2 weeks
  • Buy-to-close the $102.00 call for $2.50
  • Sell stock for $104.00
  • Net profit = $2.50 (a gain of $4.00 on the share side and a loss of $1.50 on the option side)

Buy stock, sell covered call and allow assignment: Scenario III

  • Buy stock at $100.00 per share
  • Sell 1-month $102.00 (4-week) covered call for $1.00 per share
  • Price rises to $104.00 in 2 weeks
  • Stock is assigned at the $102.00 strike price
  • Net profit = $3.00 per share (a gain of $2.00 on the stock side and $1.00 on the option side)

 

What can happen to share price of a carefully screened stock?

Anything! There are too many factors influencing share price to be 100% certain that a stock that has been screened from fundamental, technical and common-sense perspectives will automatically only appreciate in value. That, also, does not mean that stock screening is an exercise in futility because we are dramatically throwing the odds of a successful trade in our favor. Let’s view the possibilities of share price movement and how that result will impact our covered call writing results:

  • Share price moves up a lot: we win generating option premium + share appreciation to the strike for out-of-the-money strikes
  • Share price moves up a little: we win generating option premium and modest share appreciation if out-of-the-money strikes are sold
  • Share price remains the same: we win generating option premium
  • Share price moves down a little (less than option premium): we win generating a net credit return
  • Share price moves down a lot: we lose and use our position management skills to mitigate these losses

 

Evaluating Scenario I

Pure stock ownership, looking back, will produce the best results because the maximum covered call writing profit is $3.00 per share ($1.00 option premium + $2.00 share appreciation). Since the stock moved up $4.00, this turns out to be the best approach under this specific circumstance.

 

Evaluating Scenario II

The short call was closed at a time value cost of $0.50 ($2.50 – $2.00). This represents 50% of the original $1.00 premium. This is not the proper management approach in this situation. If share price continues to move up causing the time value component of the option premium to approach zero, we may consider the mid-contract unwind exit strategy. Scenario II is not a valid consideration.

 

Evaluating Scenario III

This trade has been maxed with a $1.00 realized option profit and a $2.00 realized share profit resulting in a $3.00 total profit or a 1-month 3% return, 36% annualized.

covered call writing calculations

Scenario III: Calculations with the Multiple Tab of the Ellman Calculator

Discussion and perspective

Every strategy has pros and cons and we must understand and accept these parameters before deciding to utilize that approach. If we have a 1-month return goal of 3% and then successfully meet that objective, it is not productive to look back and feel that if we used a different strategy, a better result would have been achieved. In the above series of trades, covered call writing would have achieved better results than pure stock ownership if share price remained under $103.00. Covered call writing also would have produced a profit when share price moved between $99.01 and $99.99 while pure stock ownership would have resulted in a loss. The math speaks for itself.

Next live event

AAII National Conference

November 3rd – 5th: Loews Royal Pacific Resort Orlando Florida:

Exhibit Hall # 303

Alan’s Workshop presentation Saturday 10:30 – 11:45 AM

Market tone

Global continued their gains this week supporting signs of global economic expansion. Oil prices held steady, with a barrel of West Texas Intermediate crude oil closing at $51.70. Volatility, as measured by the Chicago Board Options Exchange Volatility Index (VIX) was also unchanged, at 9.80. This week’s economic and international news of importance:

  • Investor sentiment readings continued to improve this week as 60% of Wall Street newsletter writers were bullish on the market, up from 47% in early September, while the American Association of Individual Investors sentiment survey showed that 40% of retail investors were bullish on stocks over the next six months, an above-average reading
  • The Merrill Lynch fund manager’s survey reported that cash is moving off the sidelines and into stocks, bringing average cash balances down to 4.7%, the lowest level since May 2015
  • Negotiators from the United States, Canada and Mexico extended the talks into the first quarter of 2018. Officials from the three nations made clear they are at an impasse and have called for a nearly month-long break in order to regroup. US trade representative Robert Lighthizer said he had seen no indication that the trading partners were willing to make any changes that will result in a reduction in trade deficits
  • The US Federal Reserve’s Beige Book stated that the US economy continues to grow at a moderate pace despite some disruptions from a series of hurricanes
  • Markets expect one more rate hike from the FOMC before the end of the year, probably in December
  • The US Senate passed a fiscal year 2018 budget resolution late Thursday evening, helping pave the way for a tax reform bill later this year
  • The Spanish government is said to have reached agreement with socialist opposition parties to hold regional elections in Catalonia in January

THE WEEK AHEAD

Sun Oct 22nd 

Mon Oct 23th

Tue Oct 24th

  • Global: Purchasing managers indices for October

Wed Oct 25th

  • UK: Q3 gross domestic product
  • US: Durable goods orders and new home sales
  • Canada: Interest rate decision

Thu Oct 26th

  • Eurozone: European Central Bank rates decision

Fri Oct 27th

  • US: Q3 gross domestic product

For the week, the S&P 500 rose by 0.76% for a year-to-date return of 14.90%

Summary

IBD: Market in confirmed uptrend

GMI: 6/6- Buy signal since market close of August 31, 2017

BCI: My portfolio makeup reflects neutral market assessment with an equal number of in-the-money and out-of-the-money strikes

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

The 6-month charts point to a slightly bullish outlook. In the past six months, the S&P 500 was up 10% while the VIX (9.80) moved down by 10%.

Much success to all,

Alan and the BCI team

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