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 5: Portfolio Management
We need the following lists to easily manage our portfolios (refer to Schedule D of the Elite Version of the Ellman Calculator):
- stocks on our watchlist
- stocks bought
- options sold in a given contract cycle (include stock ticker, purchase price of stock, option ticker, # of contracts sold, premium per contract minus intrinsic value of option, strike price of option sold, breakeven, profit generated by original option sale, buy to close cost for exit strategies)
BCI Premium Report: A report that lists stocks that are screened both fundamentally and technically. Stocks that pass the screens are added to the “running list”.
Modern Portfolio Theory
This theory assumes that investors want the highest returns for the least amount of risk. It states that there is a series of possible portfolio mixes that are optimal, that is, they have the greatest returns for a given amount of risk.
These portfolios are diversified into several asset classes and fall on the Efficient Frontier.
Chapter 6: Calculations
Calculations for selling OTM/ATM options
Return on Option (ROO)
ROO = option premium / share price
Example:
Sell $50 call option for $1.5, buy 100 shares at $48.
ROO = 1.5/48 = 3.1%
Upside Potential
Upside potential = (share price – strike price) / share price
Breakeven Point
Breakeven point = Share price – total option premium
Calculations for selling ITM options
Return on Option (ROO)
ROO = time value / cost basis
* Cost basis = Share price – intrinsic value = Strike Price
Example:
Sell $50 call option for $8, buy 100 shares at $56.
ROO = 2 / (56-6) = 4%
Downside Protection of ROO
Downside protection = intrinsic value / share price
Example: Scenario as above
DP = 6 / 56 = 10.7%
This means our 4% ROO is protected as long as shares do not depreciate more than 10.7%.
Breakeven Point
Breakeven point = Share price – total option premium
Volume vs Open Interest
Volume = The number of contracts traded for that option during that trading day (not the most accurate measure of option liquidity.) For instance, if trader A buys 4 contracts and sells them on the same day, the volume increases by 8 unit.
Open Interest = The number of outstanding options of that particular option which currently have not been closed out or exercised. This is a cumulative figure, not a daily statistics.
Determining which strike to sell
- Risk Tolerance (ITM has more downside protection)
- Market Tone (OTM is more bullish)
- Technical Analysis (OTM is more bullish)
Laddering of Strike Prices
You can sell both ITM and OTM options. For instance, if you sell 5 option contracts for company XYZ, you can sell 3 ITM and 2 OTM strikes.
When to use each strike?
ITM
- an extremely volatile or declining market
- technical analysis demonstrates mixed indicators
- uptrending but volatile chart pattern
- part of laddering of strike prices
OTM
- Bullish overall market with low volatility
- Stock chart is technically sound (indicators are mostly bullish on high volume)
- Positive price momentum is continuous and not the result of a quick split which could snap back
- Stock’s industry is technically strong (based on SmartSelect IDB screen where the group RS rating shows a green circle)
Advantages and disadvantages of OTM strikes
Advantages
- Can benefit from both the option premium and the stock appreciation
- Less chance of assignment
- Time decay works in our favour
Disadvantages
- Offers no downside protection of the ROO
- Higher risk
- Initial option premium is lower than ATM strikes, so one month return may not be impressive if the stock does not appreciate in value
- Has low delta. If the stock drops in value, the corresponding option will not change as much, making it more expensive to buy back the option for an exit strategy.
Deltas
ITM – 0.75 to 1
ATM – 0.5
OTM – 0.25
If option becomes deeply ITM
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 more profit. The key is for the time value to be near zero and the new position to generate more cash than the amount of time value paid to close the original position.
Example:
Bought stock at $51.5 and sold $50 call option at $2.1.
Stock rises to $56.79 and call option is now worth $6.90 ($0.11 IV + $6.79 TV)
If assigned:
Profit = $210 – $110 = $100
If close position:
Profit = ($5679 – $5110) + ($210 – $690) = $89
Therefore, cost to close position = $11 = Time Value of Option
If you can option another position with profit > $11, it makes more sense to close the current position.
Chapter 7: Factors that impact the Value of the Option Premium
Factors that influence time value of option price
Time to expiration
As time to expiration decreases, time value decreases.
Approximately 1/3 of TV is lost during the first half of its life; 2/3 during the second half of its life.
Volatility
As volatility increases, time value increases.
Historical Volatility:
The actual price fluctuation as observed over a period of time.
Implied Volatility:
A forecast of the underlying stock’s volatility as implied by the option’s price in the marketplace.
When implied volatility percentages are quoted, they are based on the current option value and on 1 standard deviation. Therefore, if the implied volatility is 10%, 68% of the time the stock price will be +/- 10%.
If the historical volatility is @ 14.3% and the current implied volatility is @ 30%, that option is considered by some to be overpriced. To access historical and implied volatility, go to ivolatility,com.
Interest Rate
As interest rate increases, time value increases.
When interest rate is high, cash spent on owning the stock is opportunity (interest) lost, thereby increasing the value of the option.
Dividend
As dividend increases, time value decreases.
This is because the option buyer is not entitled to the dividends.
Greeks
Delta
Delta measures how much the theoretical value of an option will change if the underlying value of the stock moves up or down $1.
Look at delta as a bet: What is the percentage chance that the option will expire in-the-money (strike price lower than the market value of the stock) or be exercised by expiration Friday?
OTM call options have low deltas. If the stock drops in value, the option price will decline at a much slower pace. This will make it more expensive to buy back the option if we are looking to institute an exit strategy and/or close our position.
Gamma
Gamma indicates how the delta of an option will change relative to a $1 change in the underlying asset.
When an option is deep in-the-money or deep out-of-the-money, its gamma is small. When the option is near-the-money or at-the-money, gamma is the largest.
Theta
Theta is an estimate of how much the theoretical value of an option declines when there is a passage of one day (assuming there is no change in the stock value or volatility).
Theta is highest for ATM strikes and lower as options go deeper ITM or OTM.
Theta increases as volatility increases and days to expiration decreases.
It is critical to sell our options early in the one-month cycle, preferably in the first week of a four week expiration cycle and no later than the beginning of the second week of a five week cycle.
Vega
Vega measures the change in the price of an option that results from a 1% change in volatility.
Vega is highest for ATM calls and lessens as options delve deeper ITM or OTM. Vega also declines as Expiration Friday nears.
When I see a 7% or greater one-month return for a one-month option (discounting share appreciation), I check the chart and usually see a major roller coaster pattern. Avoid these.
Rho
Greek, Rho measures the change in the option price due to a change in interest rates.
Beta
Beta is a measure of volatility or market risk. It is calculated by comparing the volatility of a stock against a benchmark, typically the S&P 500.
Beta < 1 (but positive) => less volatile than the market
Beta > 1 => more volatile than the market
For our purposes of selling one-month call options , beta is a good measure of risk .
Bullish market: Sell OTM strike for high beta stocks
Bearish market: Sell ITM strike for low beta stocks
Neutral market: Use a mixture of high and low beta stocks
Open Interest
If the price of an option is increasing on increasing open interest, the likelihood of continued price increases is greater. Try to sell options with an OI of at least 100 contracts and/or a reasonable bid-ask spread ($.30 or less).
Chapter 8: Common Sense Factors
Earning Reports
Most companies report earnings in January, April, July and October. Never sell a covered call option on a stock about to report earnings in the current contract period. These dates can change from time to time, so always double check before entering a position.
Two free websites where earnings report dates can be accessed are:
http://www.earningswhispers.com/
https://finance.yahoo.com/calendar/earnings
In most cases, we would sell an equity prior to a earnings report and re-purchase the stock after earnings are announced, assuming, of course, that the security still meets the BCI system criteria.
However, if you want to own a stock through an earnings report, you should at a minimum, require the stock to have a history of positive earnings surprises. You can sell the option after the earnings report.
Holding a stock through an earnings report is for investors with a higher risk tolerance and works best in bull market environments.
Same Store Monthly Retail Sales Reports (“Banned Stocks”)
Never sell options on stocks that report monthly same stores sales statistics. Most companies have opted out of reporting monthly sales. The latest list of companies that still report can be downloaded from the BCI website.
Minimum Trading Volume
Never buy a stock with an average trading volume lower than 250,000 shares per day. Sell call options associated with a minimum open interest of 100 contracts at the time of trade execution and/or a bid-ask spread of $0.30 or less.
Stock and Industry Diversification
Invest in a minimum of five different stocks in five different industries, so that no one security or group will represent more than 20% of your portfolio.
Cash Allocation
Need about $50k capital. Leave a small percentage of cash (2 to 4%) for potential exit strategy execution. Allocate the remaining cash evenly among five stocks. Round off the number of shares to the nearest 100.
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