Covered Call Writing (Notes Part 1)

Here are some notes I took from the book “Complete Encyclopedia for Covered Call Writing” by Alan Ellman. I’m already familiar with how options work, so these notes only cover the new concepts I learned. I strongly recommend that you buy the book (it’s a good book) for more details and information.

Chapter 2

  • Covered call writing works in most market conditions: moderately bullish, moderately bearish and neutral. If strongly bullish, buy and keep the stock. If strongly bearish, move into another asset class like bonds.
  • To be successful, you must be able to tolerate some risk. In addition, you must only sell options on stocks that you would otherwise want to own. Avoid stocks that offer huge 1-month option returns as these stocks are usually extremely volatile. Select only the best performing stocks, both fundamentally and technically, that are also located within the greatest performing industry groups or segments. Finally, you must have a plan with multiple exit strategies.
  • Selling ITM call options is the most conservative covered call position. ITM options have deltas near 1. Selling OTM options offer the greatest final potential returns and have the lowest deltas. They are the most bullish positions.

Chapter 3

Commonly used fundamental ratios

  • Price-Earnings Ratio (PE Ratio)
  • Earning Per Share Growth
  • *PEG Ratio = PE Ratio/Annual EPS Growth
  • Sales growth
  • Return on Equity = Net income/Shareholder’s equity
  • Pretax Margin
  • Net Profit Margin = Net income/Revenues
  • Operating Margin
  • Debt/Equity Ratio = Total liabilities/Stockholders’ equity
  • Dividend Yield
  • Book Value (Net Asset Value) = Total Assets – Intangible Assets – Liabilities
  • Price to Book Ratio (Price Equity Ratio) = Current Closing Price/Latest Book Value Per Share
  • Free Cash Flow
  • Sponsorship (Shares of a company owned by an institution, such as mutual funds, hedge funds, banks and insurance companies)

* High growth companies typically have high PE ratios. As Peter Lynch states:

The P/E ratio of any company that’s fairly priced will equal its growth rate…. every stock price carries with it a built-in growth assumption.

Therefore, instead of just looking at P/E ratios, a better ratio is the PEG ratio. The lower the PEG, the better. PEG = 1 means the company is fairly priced. Yahoo Finance uses a 5-year expected growth rate and an averaged PE to calculate PEG. Although PEG may be inaccurate due to an inaccurate expected growth rate, it is preferred to the P/E ratio as PEG helps us to compare companies in different industries.

However, PEG ratio does not take dividends into account. Thus, we can consider the PEGY ratio instead.

PEGY = PE Ratio/Expected Earnings Growth + Dividend Yield

Where to access fundamental data

BCI System for Fundamental Analysis

  • IBD 50 index
  • IBD SmartSelect Ratings
  • Mean Analyst Rating (MAR)
  • On Balance Volume (OBV)
  • CANSLIM (auxiliary screen, not required)

IBD 50 Index

Create a list of all optionable securities on the IBD 50 Index (these securities are denoted by an “o” in front of the price). Since its inception in 2003, the IBD 100 has outperformed the S&P 500 by 5-to-1 (at the time this book was written).

IBD SmartSelect Ratings

Type in a ticker symbol on the homepage and click on “get quote”. On the quote page, scroll down under the chart and you’ll find the six SmartSelect Ratings on the left. Focus on the column titled “Checklist” and make sure all of the ratings are green.

MAR and OBV

MAR is available from multiple well-known financial websites such as Yahoo Finance and Finviz. It comes from views of institutional analysts and allows us to follow the “big boys” who drive the market.

The absolute value of the OBV indicator is less important than its direction. It is available on virtually every charting platform including stockcharts.com, freestockcharts.com, barchart.com and tradingview.com).

CANSLIM

You can also run the stocks in CANSLIM through the 4 steps above to find further candidates.

Chapter 4

Technical Indicators

Moving Average (20D EMA and 100D EMA)

This is the most important indicator. However, as with all technical tools, moving averages should not be used alone, but rather in conjunction with our other technical indicators.

We like to see the 20D EMA above the 100D EMA and the price bar at or above the 20D EMA. If it is trending upwards, we have a strong buy signal.

Most winning stocks never make a serious breach of the 20D EMA. If a stock drops sharply below the 20D EMA on high volume, the major players are moving out of the stock and so should we.

Moving averages confirm trends but do not predict them. They have little value when the stock price is in a period of consolidation. In these instances, we turn to our confirming indicators or exclude the stock from consideration.

What to do?
  • When uptrends (higher highs and higher lows) are identified in normal market conditions, they present ideal situations to sell out-of-the-money call options
  • Avoid equities in a downtrend
  • Avoid the stock or sell ITM strikes when stocks are trading sideways
  • If the stock breaks through support (e.g. 20D EMA) on high volume, be prepared to execute an exit strategy
  • If a stock breaks through resistance (e.g. 20D EMA) on high volume, consider this a major technical positive

MACD

  • MACD gives us prior notice before two EMAs cross.
  • MACD = 12D EMA – 26D EMA
    Trigger line = 9D EMA of MACD
    Histogram = MACD – Trigger line

Bullish MACD Signals: Positive Divergence, Bullish Moving Average Crossover, Bullish Centerline Crossover

Positive Divergence
MACD advance while stock remains in a downtrend

Bullish Moving Average Crossover
Actual MACD moves above its 9D EMA. This means the histogram will be positive. MACD histogram is favoured by the author.

Bullish Centreline Crossover
MACD moves above the zero line and into positive territory

Bullish Histogram Signals (faster and preferred by author): Centerline crossover (i.e. histogram becomes positive), increase in positive histograms, positive divergence of the histogram (will usually precede a positive move of the MACD itself)

Stochastic Oscillator

  • 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)
  • Below 20 considered oversold and above 80 considered overbought
  • %k = range value, %D (trigger) = 3D SMA of range value
  • Buy signal = Oscillator moves from oversold to above 20%
    Sell signal = Oscillator moves from overbought to below 80%
  • Signal is stronger when the buy/sell signal takes place for a second time (or a double dip)
    Buy signal = %k crosses above the 20% for the second time
    Sell signal = %k moves below the 80% for the second time
    No need to worry about the trigger line for this indicator
  • Slow Stochastic Oscillator is the most useful and time efficient

Volume

  • Any price/MACD/stochastic movement up or down with relatively high volume is seen as stronger and more reliable than a similar movement in price on weak volume.
  • Weakening traffic for a trending stock indicates that we may be in for a trend reversal.
  • Volume surges (1.5 x normal volume) are especially significant.

BCI System for Technical Analysis

Technical analysis is used for stock selection, strike selection and exit strategy determination. However, we also factor in market tone, equity fundamentals, earnings reports and other parameters.

Positive Chart Pattern

More likely to

  • buy a stock with positive chart pattern
  • sell ATM or OTM call options with positive technicals
  • attempt to “hit a double” rather than roll down or unwind when using mid-contract exit strategies
  • roll out and up (rather than just rolling out) when utilizing exit strategies on or near expiration Friday

Mixed Technicals

Less likely to

  • buy a stock

More likely to

  • sell ITM call options
  • roll down or unwind when using mid-contract exit strategies
  • roll out as opposed to out and up when utilizing exit strategies on or near expiration Friday

Other Theories

Short Interest Theory: A larger short interest is the predecessor of an increase in the price of a stock. A rising short interest is considered a bullish indicator. http://finance.yahoo.com (under “more key statistics”)

Odd Lot Theory: A bullish signal is when odd-lot sell orders increase relative to odd-lot buy orders

Advance-Decline (Breadth of Market) Theory: It is considered bullish if more shares are advancing than declining. https://www.marketinout.com/chart/market.php?breadth=advance-decline-line

Dow Theory: A major trend is identified only when BOTH the Dow Industrial and Dow Transportation Averages reach a new high or a new low. https://money.cnn.com/data/markets/dow, https://money.cnn.com/data/markets/dowtrans


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