Fri. Mar 1st, 2024

Why the 3% Guideline Applies to Puts but Not to Call Options.
Selling options (covered call writing and selling cash-secured puts) will result in a positive outcome in the first four of the following five scenarios:
Stock price moves up significantly Stock price moves up slightly Stock price remains the same Stock price moves down slightly (less than option premium) Stock price moves down substantially.
Although it is important to enhance gains in the first four situations, it is critical we learn how to mitigate losses when the stock price is declining significantly. Because the BCI approach to selling calls is slightly different than how we approach puts, the 3% guideline will have application for put-selling only. Let’s first define the 3% guideline for put-selling:
If share price drops below the out-of-the-money put strike (lower than current market value) we sold and the stock is under-performing the overall market, we buy back that put option.
This is a defensive maneuver used to avoid catastrophic losses. Generally, closing this put position will result in a net debit because put value increases as share price decreases . Our goal is to keep loses small and then use the cash now freed up to secure another put position with a different underlying security.
Example of the 3% guideline for put-selling.
Stock price = $51 Sell the $50 out-of-the-money put for $1.50 Share price declines to $48.00, 4% below the $50.00 strike Buy-to-close the short put which has an intrinsic value of $2.00 plus a time value component. Let’s say a total cost-to-close of $2.50 Net debit = $1.00 and the now “freed-up” cash can be used to secure a different put position in an attempt to mitigate the $1.00 loss.
Reasons why the 3% guideline is an asset when selling puts.
In the BCI methodology, we select mainly out-of-the-money puts to generate monthly cash flow. The reason we sell puts is to avoid taking possession of the stock. If we sold near-the-money or in-the-money put strikes, the chances of exercise are much greater defeating the purpose of favoring puts over calls. There are exceptions to this rule. For example, when puts are sold in lieu of setting limit orders to buy a stock at a discount, near-the-money or in-the-money strikes are given more consideration.
Also, if we set goals for initial profit to be in the 2-4% range, targeting a 3% below strike price is reasonable to avoid catastrophic losses. It is true we usually will incur a net debit after closing the short put, but it will be a manageable loss.
Strike selection for covered call writing.
With this strategy, we already own the stock prior to selling the call option. This means that in-the-money, near-the-money and out-of-the-money strikes are all in play. The 3% guideline may work for most in-the-money strikes since we collect intrinsic premium when we sell the initial in-the-money call. This will mitigate some of the share price loss when the stock is sold. However, if we sell out-of-the money call strikes the stock price may already be 3% below that strike or close to it.
Real-life example with ANET ($95.00)
With ANET trading at $95.00, the out-of-the-money $100.00 strike generates a premium of $2.40 resulting in a 2.53% initial 6-week profit. If we instituted a 3% guideline, the trade would not be permitted because the stock would have to be sold at $97.00, 3% below the $100.00 strike.
***For detailed information on mastering all three aspects of put-selling and covered call writing check out our books and DVD programs in our BCI store.
Next live events.
Palm Beach Gardens Florida: October 10, 2017.
Information to follow.
Market tone.
Global stocks moved up impressively this week. The price of West Texas Intermediate crude oil moved up to $46.35 a barrel from $44.50 a week ago. Volatility, as measured by the Chicago Board Options Exchange Volatility Index (VIX), dropped to 9.51 from 11.75 last week. This week’s economic and international news of importance:
US Federal Reserve chair Janet Yellen testified on monetary policy before the House Financial Services Committee this week as markets continued to digest the Fed’s recently announced balance sheet reduction plans Chair Yellen reiterated that the Fed expects a tightening labor market to lead to increased inflation. Last month, the central bank raised rates for the third time since December 2016 China’s consumer price index was reported at 1.5%, missing a 3% target. Its producer price index was reported at 5.5%, which was in line with expectations. The slowdown in inflation is consistent with the slowdown in inflation in the US and many other countries The G-20 summit of leaders of major economies concluded in Hamburg, Germany this week after discussions on a broad range of topics, including trade, climate change and immigration policy. Many leaders attending the summit appeared at odds with US president Donald Trump, particularly over trade policy and climate change The Bank of Canada raised rates by a quarter of a percentage point to .75% US retail sales were down .2% month over month, with six of the 16 categories falling into negative territory.
Monday, July 17th.
Eurozone: Consumer price index.
Wednesday, July 19th.
Japan Policy rate Housing starts.
Thursday, July 20th.
Continuing jobless claims Eurozone: Flash consumer confidence indicator United Kingdom: Retail sales.
Friday July 21st.
Canada: Consumer price index.
IBD : Market in confirmed uptrend.
GMI: 5/6- Buy signal since market close of July 13, 2017.
BCI : I am fully invested in the stock portion of my portfolio currently holding an equal number of in-the-money and out-of-the-money strikes. Leaning to moving to a more bullish position when the August contracts begin.
The 6-month charts point to a bullish outlook. In the past six months, the S&P 500 was up 8% while the VIX (11.19) moved down by 20%.
Much success to all,
Alan and the BCI team.
About Alan Ellman.
Connect With Us.
To send us an email, contact us here. Subscribe to our e-mail newsletter or RSS feed to receive updates. Contact us by phone at 866-892-2187. Additionally you can also find us on any of the social networks below:
Related Posts:
Using Implied Volatility to Establish Reliable Trading Ranges for Our Option Contracts When to Roll Options on Successful Trades: A Real-Life Example with iShares MSCI India ETF (BATS: INDA) Rolling Weekly 10-Delta Put Options Prior to a Holiday Weekend: A Real-Life Example with Etsy, Inc. (Nasdaq: ETSY) Understanding 1-Time Special Cash Dividends and Our Current Trade Status: A Real-Life Example with OMF Comparing Implied Volatility and Delta When Establishing Projected Trading Ranges During Our Option Contracts.
89 Responses to “Why the 3% Guideline Applies to Puts but Not to Call Options”
I have observed that the 3% guideline does not work for covered call trades because it usually disables the 20/10 strategy.
Absolutely correct. The 3% guideline is for puts and the 20/10% guidelines are for calls.
I’m not familiar with all of the rules that you follow here for managing your positions but the best that I can tell (correct me if I’m wrong), the 20/10 is for rolling up whereas the 3% rule is for risk management of a stock that is dropping. If that’s the case, it’s apples and oranges.
Be that as it may, a covered call with the same terms (strike and expiration) as a cash secured short put are equivalent. Any rule that you apply to one, applies to the other. You apply a stop loss rule to a losing position and you apply a profit taking rule to a position that has appreciated. IOW you can’t apply a stop loss rule to a winning investment just as you can’t apply a profit taking rule to a losing investment.
The BCI 20/10 guideline recommends to buy back the short call in the first half of the monthly contract cycle, if it drops to 20% of the original premium received, or if it drops to 10% in the 3rd week. (4th for a 5 week option cycle)
You can then wait a few days for the stock to recover, and sell another CC for additional premium in the same month (hit a double). Obviously this depends on the particular situation and reasons that motivated the unexpected gap down.
At this point, your loss is necessarily above 3%, so, if you decide to unwind your positions at 3% loss, the 20/10 guideline is automatically invalidated.
Thanks for the explanations. It would seem to me that you have several rules regarding risk management and that one kicks in before the other. If you choose to ignore the first one that triggers then the second one may come into play if the stock continues to drop. Either way, it’s good to practice risk management because with covered calls and short puts, there’s always the possibility of losing far more than you can make. Only good discipline can shift that imbalance in your favor.
Well, the BCI guidelines really are as Roni described them. It’s not ignoring one and choosing the other as that is still emotional trading. Basically, it’s a time constrained risk-management. We know that an option is a time-wasting asset. Therefore, at each point in time, we have different metrics for how much we allow our position to waste away before we say, “This is a great opportunity to remove the obligation to part with these shares.” and book some option premium profit. Of course, there’s no cause for overtrading as commissions and slippage can be substantial in excessive trading.
The BCI rules can allow additional profit to be made without creating excessive trading. Of course, they’re guidelines and not 100% hard and fast rules. Sometimes a share price decline is not mere statistical noise but has an actual reason that the company has been harshly revalued. In that case, as in any trading, you take the hit and move on. It’s okay to knock out another successful trade. It’s not okay to knock out several trades or months of trading. The first rule of making money is don’t lose money. The second rule of making money is when you lose money don’t lose much money. After you have those rules worked out, you can go make money.
Last point with regard to rules, I may modify the guidelines depending on volatility environment and reward/risk. Let’s just take something easy like the XLRE (S&P Real Estate) ETF. Let’s say I buy 100 shares and sell one contract against it at the just OTM strike. Let’s assume that I can buy this for about $32 today and get about $0.40 cents in on the 4-week option to keep the math simple. I might pay about $8 in commission for the trade entry which represents about 20% of my premium received. With a low-priced and low-volatility trade like that, if I even assume the risk, I will probably not set a buyback, a decision made before the trade entry. Buying back that option and paying the second commission will throw my reward/risk so far out of line that it makes the risk just foolish. But if I might be able to do that in a higher priced and/or higher volatility stock then it can be a very profitable decision. So, you have to understand the guidelines/rules and be willing to understand where they fit in your trading plan.
I’ve read a few of Alan’s books. I recommend them if you have an actual interest in learning what the system is and dissecting how it works. I have a friend I’ve given some options books to for learning purposes but I only directed him to Alan’s stuff because I won’t part with those books.
When it comes to share price decline and risk management, it doesn’t matter what the reason is for the decline – whether it’s “statistical noise” or for an actual reason. Risk management is about managing the loss not understanding why you incurred the loss. Understanding why you incurred that loss is for improving the decision making for the next position. No matter how many rules you have, if you make bad picks or the market is uncooperative, you’re going to lose money. No amount of rules will prevent that, regardless of how many trades you knock out.
Thanks for the additional details about Roni’s explanation. Words often confuse me so I prefer numbers. Here are two positions. What risk management rule would you apply to each if AAPL declined?
1) Buy 100 share of AAPL at $149 and sell one AAPL Aug $145 call for $6.50 (a buy write)
2) With AAPL at $149, sell one cash secured Aug $145 put for $2.50 (a cash secured put)
As for the commission structure that you mentioned in your XLRE example, $8 per trade is exorbitant and will severely cut into your ROI, even more so with options like XLRE’s which have very low implied volatility. If your account size is of sufficient size to qualify, I’d suggest that you take a look at Interactive Brokers. For purchases, they charge 50 cents per 100 shares. Sale of shares in a little bit more expensive due to exchange fees (approximately 7%) so a share sale of 200 shares might cost around $1.07.
For options, the cost per contract is about 70 cents, 50 cents if the premium is 5-10 cents, and 25 cents if under 5 cents (the $1 minimum ticket charge and exchange fees still apply). Assignment and exercise are FREE.
Such a commission rate will drastically cut frictional costs as well as give you more flexibility n your trading. You’ll be able to focus on buying and selling based on the fundamentals of your position rather than forcing you to make investing/trading decisions based on volatility.
A big advantage of a per 100 share and per contract commission charge is the ability to scale in and out of positions without penalty. Five trades of 200 shares is the same $5 commission as one trade of 1,000 shares. The platform offers many complex features and isn’t the most user friendly and it’s not one for someone who needs hand holding. But for simple buying and selling, if you know what you’re doing, it’s quite easy to use.
Also, take a look at the newcomer tastyworks. They’re somewhat competitive, particularly if you’re buying/selling a larger number of shares.
you are one of my heroes, along with Jay, Geoff and the other experienced guys. Every time you write, I learn something, and incorporate it in my trading skills.
Every single CC trade I enter is expected to end exercised. The tickers in bold on Barry’s list are my main source for trades.
Barry does all the leg work for us, (take a look at his picture on last week’s thread) while we sit here comfortably, he get’s all the mud.
Normally a few of his picks gap down for some mysterious reason, and we must take a loss, but when it is due to the whole market, or some unimportant reason like a downgrade by someone, we can take the opportunity to buy back the call, for a fraction of the premium, and expect it to bounce back in a couple of days. This is a risk I am willing to take. But I then watch it very closely.
Thanks for your support.
Normally my trades are between 20k and 30k, and my CC premium target is 2% (near the money). Therefore the $8.00 comission is insignificant. Even when I trade the position several times, the comission is negligeable, because in that case, my return will be much higher than 2%.
I love your statement of the first and second rule for making money. I am writing it in large, bold, red letters on the wall over my computer screen ?
Thanks for the kind words. Investing and trading is an ongoing learning process. I often compare it to learning a new language – it takes time and effort to become proficient at it.
Two points regarding the 20/10% rule and the 3% rule being discussed, as I seem to see some confusion between the different responses.
A. Regarding BCI 20/10% rules:
The 20/10% rule applies only to Covered call. (Applies to either ITM or OTM positions – Alan has shown the percent rule still is applicable.) When the Purchase price of the Option reaches 20% of the value in the weeks 1-2 of 4 week cycle (use the 10% point for Week 3), you are supposed to buy back the option, losing only 20% of your option income. You then wait for the stock to recover to original price to purchase the same option again, calling this the BCI “Hit the Double”. You are getting a second income in the same cycle.
I did that exactly on 7/7/12 with three stocks (QQQ, ATVI, one of my MGM positions), Of course, at week 4 (7/12) of 5 weeks the time decay is much greater than having Week 1 or 2 trading events. which results in smaller net credit to an account, but nevertheless it is additional income compounding are initial option trades.
All 3 stocks gapped down on to 20% of the option purchase price on 7/3/17. The stocks did not recover until July 12, when I woke up and saw before opening bell Dow was 154 points up with the news of the day. Perfect! I created limit order for the 3 stocks, predicting the new Option Premium at my old purchase price, using Delta and Gamma adjustments.
ATVI filled first (2 positions), MGM (strike 32) sometime later in the day and QQQ (3 position in 3 of my accounts) about 2 minutes before the closing bell. Big smile!
B. Regarding the 3% rule.
I do not why it has not been mentioned but the BCI 3% rule ONLY applies to Cash Secured Puts. The headline of this particular blog “Why the 3% Guideline Applies to Puts but Not to Call Options” discusses this issue, which applies only to Cash Secured Puts. Alan’s states in the discussion: ” If share price drops below the out-of-the-money put strike (lower than current market value) we sold and the stock is under-performing the overall market, we buy back that put option.”
Alan’s course free Beginner course for Cash Secured Puts also explains this clearly.
A. The 20/10% rule applies only to Covered call. (Applies to either ITM or OTM positions)
B.. The BCI 3% rule ONLY applies to Cash Secured Puts.
Thanks for the explanation. I’m not trying to be coy or difficult. I’m just wondering to what degree you understand what you are effectively applying. I posed the question to Geoff but perhaps he didn’t see it. Let’s try it distilled down to a much simpler form:
You have indicated that the 20/10 applies only to (A) and the 3% Rule only applies to (B) so which Rule do you apply when (A) equals (B)? It’s not a trick question.
Thank you for your kind mention as one of your heroes. Though I am afraid these days I would have a tough time fitting into a Super Hero costume :). – Jay.
A=B is not a comparison that can mathematically be made because the guidelines are based on different factors.
The 20/10% guidelines for covered call writing are percentiles based on the original option premium sold.
The 3% guideline for puts is based on a percentile below the original put strike sold so the former is based on option premium and the latter on stock price.
Thanks for adding to the constructive dialogue on this blog.
The A=B comparison is easily made because the cost basis is the same for synthetically equivalent positions. It wouldn’t make any sense to apply one risk management rule to position (A) and another risk management rule to position (B) if the two positions are nearly identical and provide the same P&L (see the AAPL example). Therefore, it’s a distinction without a difference unless the two rules mathematically yield the same amount of risk protection.
Much of the distinction relates to the specific paths we take to each strategy in the BCI methodology which are not approached precisely the same. If we did, the synthetic equivalent concept would work.
In the BCI methodology we routinely use ITM, ATM and OTM strikes for covered call writing and frequently want to retain our underlying positions but favor predominantly OTM strikes for puts since most put-sellers want to avoid taking control of the shares. Exit strategies and goals may vary. Having rules specific for each simplifies management of the different approaches we take to each.
We do actually have 20/10% guidelines for puts as well.
The 20/10% guidelines for puts are used for the opposite scenario when share price rises and put value declines. We use these guidelines to close positions when time value cost-to-close approaches zero and the cash is then freed up to secure another put trade that can generate more income than the cost-to-close usually with a different underlying.
Just like differences in trading strategies exist so do differences in position management approaches.
about PYPL, you are right, and I am baffeled: When I looked it up last week EW showed July 20, unless my eyes confused the 6 with a 0, which is not impossible because my eyesight is pretty bad after trombose, glaucoma, and cataract. Getting old is tough. ?
No idea what trombose is but sounds like you’ve had some serious probs there! I wear specs myself btw, do you?
sorry my bad English. The correct word is Thrombosis. Details : in 2001, a blood vessel in my left eye burst. The clot reabsorbed, but I lost part of my vision near the focal point.
Later, around 2009, high pressure formed in both eyes (glaucoma) and destroyed part of the optical nerve in my right eye before I noticed it and went to the doctor. I lost the upper part of my visual field in my right eye, and I am using special drops every day to keep the pressure in check.
Myopia since infancy, 4.5 degrees, but not any more, after my cataract operation.
Yes, now I need to wear specs to read the small print.
But otherwise i’m fine.
Your eyeballs exploded but otherwise you’re fine? Good to hear! ? I never knew anyone having that much eye trouble – was it genetic or self-inflicted? (i.e. unhealthy lifestyle?)
shit happens. The doctors never found out what caused my accidents. I do believe it was stress, leading to momentary hypertension. Also, old age, for sure. ?
PS – if you are over 55, make sure you check your eyes every second year.
Yes aging is the biggest risk factor for just about everything. I feel great for my age (54) but if I wasn’t or was over 60 I’d definitely be looking at taking metformin (DYOR). NMN also sounds very promising: “The cells of the old mice were indistinguishable from the young mice, after just one week of treatment,”
Just returned from our seminar for the Washington DC chapter of AAII. Glad to meet so many BCI members at the event.
It doesn’t get any better for a speaker when we have an audience like this…
Let’s call this a “Roll Out and Up” from last weeks blog :)! I have been around here a long time. I have never seen a blog with over 70 comments to break the record established only the week or so before :)!
Perhaps it is consistent with the growing audiences Alan and Barry are seeing at their events. It seems in these years of low interest rates mention “income”, “yield” or “cash flow” and “They Will Come” as in Field of Dreams….
Thanks for the time, energy and expertise you have been sharing with our community. Your trade detail is both instructive and selfless. And I mean that as well for all the friends who share here, not to exclude anyone.
You mentioned something last thread that grabbed me: despite all your expertise and discipline your YTD results are in line with SPY. That is no critique by any means. SPY is already up YTD more than it is in most years on historical average. If it were having a mediocre year, a flat year or a down year your results might be lower too BUT far above market through disciplined call selling. I have no doubt about that!
The reason it grabbed me is because I am finding the same thing. I, of course,make money in most scenarios selling options as Alan described. And I always wish in hindsight I had sold more at lower strikes in down months :).
It’s tough for even those skilled in this hobby to beat SPY when it’s ahead of itself. I learned that big time in 2013. That led to a blend of tactics within the same strategy (the old Army guy talking again): flex not only your strikes but the amount of your portfolio you cover depending on your market view.
When Alan wrote above that he is thinking about being more bullish for Aug expiry I thought “Hmmm, I am going to write fewer covered calls and let more of my horses run”.
Plus these years have a pattern of September and/or October corrections so that’s when the saddles go back on :). – Jay.
If sample size is large enough, over the long haul the return from covered calls will approach that of the market with a lower standard deviation (see the CBOE’s BXMD Index which is a monthly buy-write strategy where the S&P 500 is bought and one call 30% out-of-the-money is written).
Because of the premium received, the covered call writer will lag in strong up markets and perform better in down markets, hence the reduced standard deviation. For covered calls to exceed, one must have some degree of superior stock selection and good risk management.
The factors that BXM and all studies on covered call write lack are stock selection, option selection(usually just use OTM strikes w/o depth of moneyness) and position management. That’s where we can excel.
Well, it does sound like you just described the BCI methodology, spindr0.
Stock selection is not static. Strike price selection is not static. Trades are not determined by a % out-of-the-money or even an exact fixed number of days. It’s much more active a selection process than the CBOE indices.
To your point, you must surely love the PUTW then, right?
The CBOE has a variety of SP500 option writing indexes. Their advantage is obvious – one stock debacle is softened by the number of holdings. For the individual with a far smaller number of B/Ws and CSPs, the effect of one debacle is far more significant since sample size is much smaller. The little guy’s on chance at success is superior timing, selection and risk management.
As to my loving the PUTW, what is that? Selling short puts?
Thanks, Jay for your kind comments on my “Trading Experiences” post of Friday for the 3 day period 7/12-7/14 period where I stated A – I was I was 8.2% YTD and 16.4 Annualized, B – “Hit the double” on 3 Stocks and C – Had a Mid Contract Unwind for GLW.
I then posted a quick follow-up correction post for GLW to correct the text for some calculations so it would make sense to others.
I reviewed the chart for SPY and noted it’s 17.78% 1 year return and also it 3 year 9.51% return and 10 year return 9.26%.
I am not used to having good returns over the years of my career. Even those who have had it sometimes end up with nothing at the end.
I remember the 10 year period starting before the 2008 drop in the mark and ending after it rose back to its original level. Fate is involved as well. It depends on when you get in and get out what’s your performance and view of the market is. My wife and I even had our portfolio professionally managed but after 10 years it seemed to not move anywhere with a 60/40 portfolio.
The few times I tried the market did not do as well. Needed to concentrate on my career since I found hard work and a paycheck is the only that guarantees you keep bringing in the money to survive and build up your savings.
Living modestly is also important because it easy to spend it all and having liabilities which bite into your retirement. I was also striving to keep up to date and stay technically employable as an Electrical Engineer (Computer networks and design) (Not the power side) and later as a Novell (Master CNE) and Microsoft (MCSE) Network Engineer.
One day that paid off also with a stint as Director of Engineering for four years at a start-up (Video and internet over satellite to South and Central America). I forced myself stayed technically up to date since I knew that was not going to last forever (which came true). I especially remember the night of Year 2000 my mother, wife, and I spent the night as the volunteer to stay at the Data center next to the computer racks while enjoying the goodies we brought to eat and also watching the Doral (Miami) fireworks at midnight). We survived the night. No bits were lost.
Back to the ranch… market, the 2-4% investment goals of the BCI conservative methodology means in reality probably under 2% taking into account percent Invested, bad decisions, mistakes, emotions, and market ups and downs.
I am concerned with the volatility of the market week to week and I understand how the BCI methodology tries to mitigate this with its exit strategies and careful selection of the securities to pick from. If you portfolio is somewhat successful using these technique then you can sort of accept when a downturn occurs, lose some, and realize you are still up from what you had in the past.
I listen, again with concern, as I read from others in this blog, traders, past investors, and others when you mention to use collars and spreads to protect against the downturn. Alan has mentioned the use of a protective put as a collar at times but it is not a recommended tactic if you pick leading stocks from the weekly run list. I have been using mostly (not all) ITM trades to give me downside protection, and watching for MCU (mid contract unwinds) so I can re-use the cash again, thinking that will give me better results and keep me happier.
I just reviewed my weekly ROO% for the last 16 weeks April 7 – July 14). Each week I calculate my monthly ROO% for the cycle and when I start a new contract cycle, I take away the gains from the last cycle (I call that Zero Adjust) so my numbers will be accurate for the new cycle.
Generally i am >90% invested so the Gain / Current Cost Basis is relatively accurate. Of the 16 weeks, 4 weeks were > 30%, 12 weeks >20%, 3 weeks were in negative territory (April 7,13, 20) 3 weeks were from 2 to 12% (June 23, 30, July 7). That is portfolio, at this moment, 20 positions using 10 securities in 4 accounts in 2 brokerages.
I like to use the 3rd Week of 4 weeks or 4th week of 5 week cycle as a month to month marker, since so many things are happening Expiration Friday and “Expiration Friday Plus 1 – Monday” as you roll and make changes. The data ROO% (Gain / CostBasis) for the last 4 months is 4/13 (-3.1, -39.8% annualized), 5/12 (1.8, 23.4%), 6/9 (3.0, 39.1%), and 7/14, last Friday (3.1, 32.1%). I checked and Invested % for all those weeks was >90%. The ROO% is very dependent on the market performance on the day of calculation.
If you look at last Friday’s 7/14 number of 3.1 and 32.1%, the week before the ROO% was 0.3, 2.6% when the DOW was 21414.34. Maybe Tech stocks dropped or some other factor was occurring. The market is a casino. We are trying to stay in the profitable part of the game.
I also using three other metrics as a comparison Gain / InvAmt plus Cash, Gain / Account Value, and Performance YTD. They compare to the ROO% very good if you are invested >90%. If you are not highly invested, then the ROO% is only accurate if you haven’t done any unwinds or re-investments otherwise you have to do some kind of averaging.
At the end of the road the YTD is the important metric since that is the account value or dollars you can take home.
Thanks for another of your always great posts packed with useful information for all of us at any level of trading experience.
Your wise comment about living modestly resonated with me. I retired 4 years ago at age 55. I made that a goal in my 40’s not because I disliked my employer or my work but because I just wanted to live freely on my own terms.
I always saved and invested methodically – maybe to a fault :). But, unlike Madonna, I am not a “Material Guy”. I live in modest comfort as one of the fortunate when you look around the world these days.
I find options selling an excellent source of cash flow in retirement. I do other stuff with options but I am not in Spin or Geoff’s league when it comes to mastery of the subject.
And I don’t think I have to be or feel bad that I am not! I know I am ahead of the vast majority of investors who have heard of options but harbor needless fear and shy away.
My friends think I know something about investing – I have them all buffaloed ? – and often ask me about options. I always tell them to start with covered calls. I tell them it is like having rental property only you are renting out your stocks. You will only lose if your stocks go down and you would have lost anyway if that happens. It’s simplistic but it works at parties :).If a friend is serious I suggest this web site and the OIC.
I do a lot of over writing. Not so much these days when premiums are low and the trend seems up but enough to create a cash flow that exceeds my monthly spending. As we all know cash flow and income are different things. It is only income if the underlying stays the same or goes up. Otherwise it becomes loss protection. And that is fine too, it serves a worthy purpose!
Anyway, I will finish this ramble by saying I love this comment board. You don’t have to look very far to find comment boards where people behave badly. They never do here! – Jay.
Good job buffaloing the option talk. You had me fooled too ;->)
Thanks for another of your always great posts packed with useful information for all of us at any level of trading experience.
If you look at covered calls (or short puts) as a binary outcome and conclude that since a covered call generates a credit then it is less risky than just buying the stock outright then in that narrow context, they are it’ true. But the appropriate question is, are there other choices that shift that imbalanced R/R ratio more in your favor? There are.
Over writing isn’t something that lot of people do. It’s good for increasing cash flow and if done moderately, it doesn’t add a lot of risk. But it does add it. You might consider writing bearish call spreads instead in order to manage the tail risk. As always, one strategy isn’t better than the other. It’s a question of the trade offs and how important they are to you. And as they say, never bite off more than you can eat and don’t confuse brains with a bull market :->)
Thanks Spin, if I can buffalo you I am a Player in the Game :).
When premium is better I sell overhead call spreads on SPY and QQQ. I also sell underneath put spreads and turn them into condors when the moon and stars seem right or the trade turns.
I have not been doing much option selling of late for reasons mentioned above. I have been buying ITM call spreads a month or two out since premium is low and I can almost eliminate time value while cranking up delta.
I do over write consistently on part of my base each month. We can debate the efficacy of that.
A fun one you can cheer for me on is GLD for this Friday. I am covered at $119.5. I thought that was safe as Fort Knox :). Now I am not so sure.
I have 500 shares bought months ago through the assignment of a cash secured put. I have been over writing it ever since. I would like to keep it and over write again. But I won’t chase it and if called that is fine. Wish me luck :)! – Jay.
I prefer active management versus putting on a position, sitting back and waiting for Mr. Market to determine the outcome at expiration. So if the opportunity arises to convert short puts into no cost verticals or convert verticals into condors that offer more return or less risk, go for it.
I offer no debate over the efficacy of overwriting since the market as well as your risk management determines that. My suggestion is consider ways to continue to obtain your additional cash flow without adding undue risk. Overwriting spreads instead of short calls achieves this but does not add open ended risk as naked calls do.
As for your GLD covered call, you have your trading rules and I’m not trying to suggest that they are good or bad. I only offer my take which has evolved from 35+ years using options. My first calculation would be premium per day. To keep it simple, assume the strikes are the same and the next write is a month out. If next month’s write offers more premium per day this month, roll the CC. If this week’s expiring premium per day is larger then you have a second consideration. While the first condition has not been met, is it worth waiting several days to glean the last nickle or dime yet risking the opportunity to get a good premium for next week/month? IOW, if you wait until the end of the week and GLD drops several dollars, you’ll have captured that last dime or whatever the current ask price is and the fatter call premium that you could have gotten for next month may be gone. As always, the decision involves trade offs. I’d sacrifice a very small amount of this month’s ROI to assure getting a good ROI for next month, especially since IBKR’s commissions are peanuts. If trading small lots and at a higher schedule, perhaps another story.
I’m in a similar position. I have a multi-legged position in ABX, NEM and RGLD. The RGLD position has a bunch of diagonals (short Jul 82-1/2 calls and long Aug 85 calls) and it’s somewhat delta neutral hedged. Since it’s ATM, I am trying to squeeze out as much of the remaining time premium but I have a short leash on it. So I’ll be happy to cheer you on since my self interest coincides with yours :->)
Thanks Spin. I have used RGLD and NEM in the past. Today being a dead day in GLD helped us both just taking time off the clock. Great point about possibly being so focused on this month I forget about next, I appreciate the teach on that!
35+ years trading options is impressive. I am glad you found us, glad you are here and can help us along. I hope in some small way we can assist you too! – Jay.
Here’s a wordy blast from the past (g). I got my market introduction from my pop. I read about covered calls when they were introduced (1973?) and I suggested them to him for generating income. I was lost in 8 years of college and when I hatched, I began writing covered calls as well. Along the way, I learned that synthetic short puts were preferable because if they worked out, there was less slippage and commissions. This was before the discount broker era when a 500 share trade might have cost $75-$100.
As a rule, the last week before expiration, I rolled options out a month to maintain premium flow (weeklies didn’t exist). Friday October 16, 1987 was expiration and I did the usual rolls and added a few new short put positions. Everything appeared to be on sale since the DJIA had dropped about 500 pts (18%) from its August highs.
The next trading day was Monday the 19th which is now known as Black Monday. The DJIA dropped 508 pts, another 23%. The market was in disarray. Many market makers walked away from their posts. B/A spreads were several dollars wide. Even if you wanted to execute at those crazy rip off prices, it was nearly impossible to transact since phone lines were jammed with panicked callers. One of my brokers took 7 business days to determine whether my 800 share Bear Stearns covered call which had expired ITM had been exercised or not. Think Flash crash with no rebound. For every stock that I sold short puts on, I basically owned all of them on Monday afternoon, most with paper losses. I had a small margin call and I ponied up the cash. Since the DJIA ended the year flat, I incurred no losses and many of my newly owned stocks went on to do quite well.
I’m not fear based but things looked pretty dismal that afternoon. Shortly before the close I took $1,000 out of the bank because I wondered what might happen in subsequent days if the free fall continued. Think bank run. Thankfully, none of that occurred.
I wouldn’t call Oct 1987 a mistake – perhaps just not a happy month or two. That day taught me the lesson of how fast a market can take it away from you as well as the need for good risk management. It also taught me to respect margin and the need to have a Plan B for when you’re 100% long. I use margin occasionally (overwriting, etc) but I run a tight leash on it. It may have taken me several more years to learn enough about risk management as well as how implement it practically but by the time the Internet Bubble arrived, I was no longer the blood donor. By 2008, I was taking it rather than donating it. I may be net short but I usually have a decent amount of protection hedge delta (spreads, iron condors, collars, etc.) so that the worst collapse will never be a disaster for me. I’ve accumulated my toys and now it’s time to keep them. I don’t share them well (g). As the video game says when it starts, “Protect Your Cities”.
This stroll down memory lane doesn’t just apply to margin. Don’t assume it will always be a Three Little Bears Market like we’ve had since the 2016 election (Not too hot. Not too cold. It’s just right!). It isn’t always ‘Just Right’ so plan accordingly.
As for RGLD and GLD, today was a “nothing burger” day so now it’s down to a 48 hour clock. Tick tock …
It is both ironic and interesting I went through my broker training with Merrill Lynch just after the ’87 crash. The mood was somber and everyone was talking conservative strategies. Little did we know the 90’s boom was just around the corner.
So I think the old contrarian advice of being fearful when others are bullish and bullish when others are fearful still works. We may be coming into one of those overly bullish correction traps soon. I have been using S&P 2500 as a target for when I at least start placing stops under things, selling more calls and taking chips off the table. For what it is worth…. – Jay.
I know that the market is dangerous and unpredictable. That is why I keep a relatively small part of my hard earned economies in play. (and never use margin)
But, at the moment I don’t see any major cloud in the sky, and with all other investment alternatives yielding almost nothing, the tendency seems to be favorable for equities in the near future.
Technology is taking over, and it looks like there is no end to it, even when you look long term.
Something to think about…never take a current “good” market and assume it will continue. Just one geopolitical issue, a crazy news item, etc. can change everything in a second. To paraphrase the US President Regan…”Trust But Hedge!”. ?
Thank you Barry,
I did not intend to sound overconfident.
Will heed your wise words.
Jay, I think the second hardest lessons I had to learn was to take chips off the table (book profits and reallocate) when you feel great about the market and buy (hedged) when you feel the worst about it. The hardest lesson was to get comfortable shorting when the IT hits the fan (2008-2009).
I know how you feel. With record highs almost every day and a new options month ahead it is difficult to imagine anything but blue skies.
Likely a good time to continue doing what has been working, don’t take on unusual risk and think about how best to protect profits YTD. August and September are best approached with balance knowing they are the height of hurricane season in the Atlantic and Gulf and sometimes the market too ? – Jay.
You know that I am still the same old trading coward, and that is why the BCI Covered Call methodology fits me so well.
Interesting and good discussion on cash secured puts. Let’s say you have a gap down like we had with ULTA this past week. Since there was two weeks to go to expiration should you immediately take the HUGE loss in buying back the put or should you give it a little time to \try to recover?
David, one thing you may want to consider is how much is extrinsic value versus intrinsic value. Volatility does expand on stock collapse which works against you in a short-option position. That’s something to note. Beyond that, if you believe it’s just a short-term plunge and it will recover you have two things then working you out of your poor position, 1) the stock price increase will be decreasing your “owed” intrinsic value (although the delta will be working against you through the recovery, too) and 2) the “emotionally high” implied volatility may bleed away which will greatly reduce the extrinsic value you would have to buy out.
There’s not going to be a hard and fast rule for how you manage the position unless you set one that’s the same every time. Some stock plunges are driven by fundamental factors and others are just purely driven by trading–supply and demand imbalances (actually, this is always how/why price is moving but I digress).
If I look at a position and decide that there was just a blip of a trading day rather than a real reason for stock price decline–maybe a competitor released bad news or the sector just underperformed for whatever reason but nothing fundamental and I expect recovery in the stock price then I will be looking at what I might do to either a) roll out the position in time to collect more credit b) evaluate what the call is selling for at the same strike as the sold put.
I wasn’t in ULTA so I can’t speak to the changes in the price of the stock or the options but if it’s pretty far gone maybe just stick to evaluating the Greeks on it. It may be that volatility will drain out quickly and create a nice “discount” to the immediate option pricing. Quick reference, volatility tends to mean revert so buying some time can be a good decision. Also, you know that the option will eventually have no extrinsic value left at expiration which means that you can decide whether the juice is worth the squeeze. With 2-weeks to go, how much is just volatility premium? You’re selling volatility premium so don’t be willing to go buying it back at appreciated prices. If a great deal of it is already turned into intrinsic value, do you think you can get a turnaround in the stock?
Final note, there are a million things you can do with options. With a few extra tools in my belt from experience and education, I might be willing to take the assignment and turn it into a repair strategy by selling two OTM calls to finance the purchase of an ATM or NTM call. If there is a turnaround, you can make back the loss quite quickly (but are still locked into a max gain of around $0 depending on strike selection). I used a bit more of a blunt instrument on a FIZZ sell off in the last contract cycle. I sold an ATM put when it collapsed into the $87 range. That assumes much more risk whereas the former option doesn’t entail any additional risk when the trade is put on for no extra cash or a small credit (I shoot for a small credit so I’m getting paid if the stock doesn’t appreciate).
The Repair Strategy is effective if you can find one for little to no cost and the width of the spread isn’t much less than 1/2 the stock’s total loss. These can often be found in very distant expirations but they aren’t good candidates due to theta decay issues. Something 2-3 months out tends to be the sweet spot. If the stock price collapse is huge, it won’t be a viable solution.
The Repair Strategy can also be used for a new purchase to goose the return (bullish). Since there’s no repair involved, for lack of an established name, I’d call it a Covered Call Spread since it’s a combination of a covered call and a bullish vertical spread. While that’s the simplest way to visualize the position, a better entry is the short put and a bull put spread because if the position works out, all options expire worthless, saving you closing costs and thereby increasing your ROI.
In the long run, the main cause of gap-downs is disappointing earnings releases which we routinely avoid. Other unexpected bad news is unavoidable, rare and manageable.
When there is a gap-down, we check the news ( is an excellent free resource) to see if we want to stay with the security and manage.
In the case of ULTA, it appears that there has been a price decline over the past month and the technical chart turned all bearish prior to the start of the July contracts (see screenshot below).
When evaluating this trade check to see if entering the trade based on conditions at that point in time was appropriate and if there were earlier opportunities to manage the downturn.
We have all made trades like this and it is important to evaluate and learn from them.
For what it is worth on the chart for ULTA, you could have made the same argument in each of the previous two months April and May for declining technical indicators and drawn the same arrows. The difference is that the stock recovered in these two months but this time it didn’t.
You could have made the same argument in December and February that the moving average was breached and that the indicators had turned down and yet, the stock achieved nice gains shortly thereafter. Technical analysis is very subjective and news, good or bad, always overwhelms it.
When you have a broken stock, all the “option speak” is meaningless. You one decision to make. Do you believe that the stock has a chance to recover? If the answer is no, it’s time to cut your losses. If yes, then you hang in there. No one knows what will happen with price in the future so no one can tell you what the best thing to do is.
This week’s Weekly Stock Screen And Watch List has been uploaded to The Blue Collar Investor premium member site and is available for download in the “Reports” section. Look for the report dated 07/14/17.
Also, be sure to check out the latest BCI Training Videos and “Ask Alan” segments. You can view them at The Blue Collar YouTube Channel. For your convenience, the link to the BCI YouTube Channel is:
Since we are about to enter Earnings Season, be sure to read Alan’s article, “Constructing Your Covered Call Portfolio During Earnings Season”. You can access it at:
Barry and The Blue Collar Investor Team [email protected]
You talked about covered call studies. Can you give an example.
A well-known study of covered call writing was performed by Ibbotson over a 16-year time frame. Paraphrasing his conclusion:
“Covered call writing slightly outperforms the overall market and with less portfolio volatility”
As I alluded to in my previous comment, this is without stock or option selectivity and with no position management. Taking a pro-active approach to covered call writing rather than the old-school passive approach will absolutely enhance returns.
With earnings season about to begin next week, don’t forget about the other resources in this week’s report. Per this week’s Premium Stock Report, there are currently 11 stocks that report after 8/18/17.
However, when you add the 9 ETFs from the current ETF report and the 34 stocks that will report earnings next week, we have a total of 54 stocks that become eligible for the August options expirations month over the next week. Once the ER date passes for the stocks reporting next week, don’t forget to check the news to see if the ER met expectations. A great web site for news is FinViz (
Barry and The Blue Collar Investor Team.
Re MDSO btw I closed out for a 0.7% profit rather than hang on and hope my 2.9% profit if it stayed above $75 would hold up – the odds of a possible ER disaster tomorrow didn’t seem to make it a good bet even with the $6 cushion it still has.
You did just fine. That $105 in your pocket with 200 shares for your 0.7% == 8.4% annualized. With Last Price at 81 a 10% gap down would have put you at 73 right near your BEP of 72.69. I had mapped out your trade earlier and your numbers are correct if you unwind for about 7.80 of Premium. Though i did not comment, I noted that other made some useful comments on options you might take.
I assume you did an unwind with 7.80 of premium, which gave you an Intrinsic of 6 and Time Value of 1.80. The loss on your close from your original ROO of 3.1% was therefore 1.80 /75 = 2.4%.or $360 with 200 shares at $75 Strike.
I am starting to think of commission impact on my trades, particularly when you paying back to unwind. With a $75 strike cost basis, the commission becomes less significant to your investment but not zero to your gain number. Assuming you are paying a commission of $8 to unwind stock and option, that is only 0.053% of your investment, so the actual final gain is around $97. ($8 / 200 = $.04 per share, .04/75 = 0.053%).
Commission: Regarding commissions, I got 15 free trades from Fidelity last month for my inconvenience when a freaky thing happened. I placed an order at 2am to MCU unwind at a certain limit on 800 shares. At the same time somebody in this world was assigned 200 of my shares out of the blue. It was not ex-div time. The time value on the Call was more than the dividend.
When I got up at 10am I looked at my order and I had 1 Long call and 1 short call in my positions. Not allowed in an Ira. My 800 share MCU executed at 9:32am, then the 200 share assignment saw I had nothing to play with. The eventual solution was a 0 charge closing transactions for each option.
Note: i need to post another message later regarding my post to you recently on how Intrinsic value in an ITM option reduces the cost basis for calculating your ROO% = TV / Strike. I have another viewpoint to present.
Thanks Mario, yes if companies switched ER dates to a few days before the end of monthly contracts more often it would be extremely annoying, since in this case at least it cost me about 75% of what had seemed a fairly certain profit. However since I gather it’s rare then it doesn’t matter that much. Personally I’d love it if they did in the US what we do here in Australia, which is to have only TWO earnings reports each year – four is just wasting companies time and money when they should be focusing on their biz (and hurting us CC players as well). I’m with IB so commission is cheap – paid a total of $3.40 buying and selling the stock and only 29c for the options.
How is platform at IB. Have you worked with other platforms?
I am using Fidelity and Optionshouse.
Optionshouse just released a new platform using the latest HTML5 technology. They are making improvements to it on an active basis. It is nice to use. Optionshouse if formally switching into the ETRADE system on August 6 but still using the new Optionshouse/Etrade platform.
Fidelity has an active design team also adding improvements now and then. I like the charting in Fidelity’s platform. I also like the fact that I can create a Portfolio Watchlist with purchase prices and quantity so I can keep track of several accounts in one Portfolio Watchlist. I can either go to my Chrome or Firefox Browser and also the Platform to view the portfolio and make changes. as well from anywhere.
Recently Fidelity fixed the synchronization of the databases so the Browser and the Platform portfolios I created agree identically. Before it was off several $100 or more because one system used the ASK price of options and the other the LAST PRICE. Now they both use the ASK PRICE. I know Optionshouse uses the MARK price (midway price between Bid and Ask). As long as you know what is going on.
I’ve only used IB for US trading Mario – cheaper than others apparently, though they enforce T + 3 meaning that I have to wait three trading days after closing a position before I can access those funds (though soon to be T + 2 I gather.) I assume that’s not a problem for you at your brokers?
One of the IBKR’s attractive features for me is their DDE interface which allows you to link Excel to the platform and have it updating in real time. That permits you to analyze and display custom information if you have such a need.
AFAIK, the most advanced option analytics are available at ThinkOrSwim but their commission schedule is too high for me. Some traders that I know use both platforms for that reason.
There are several reasons for early assignment. The first two are the main reasons. They risk free and they are simply a function of price relationships:
1) Discount Arbitrage: The call trades for below parity.
2) Dividend Arbitrage: The time premium of an ITM put (not call) is less than the dividend.
3) Risk Arbitrage: A bet that the stock does not drop as much on the ex-date or it recovers after the ex-date sufficiently to make it profitable. Profit is not guaranteed.
4) Inexperience: Someone exercises their long call (which still has time premium remaining) to acquire the stock, not realizing that it would be cheaper to sell the call and buy the stock at a lower price.
5) User error: Someone fat fingers a bad trade on their keyboard.
In general, early assignment is a good thing unless it’s partial and runs up your commissions.
Question: When creating a portfolio on which to sell covered calls or naked puts, is the entry price of the underlying important? It seems to me it is, otherwise one might be playing catch-up until the portfolio is breaks even and starts going into the green. If so, how does one go about determining the right time/price at which to enter the underlying position?
Because of the time value erosion of our options (Theta), we want to enter our trades during the first few days of a contract. If we wait too long into the contract, we will not be able to achieve our initial time value return goals..We have a bit more flexibility during the contract months that last 5 weeks but I still like to enter during that first week. We select securities that are performing well at that point in time.
I am interested in writing a covered call option on PURE Bioscience Inc (PURE).
Can I write a covered call option on the stock even if there are currently no options available on the stock at the moment?
I understand that there would be liquidity concerns etc. but I just want to know if it is possible.
Thanks for your time.
I’m glad you asked this question because it allows me to reiterate to those new to options that not all stocks and exchange-traded funds have options associated with them. It’s based on demand. So we cannot write calls on PURE at this point in time.
I got home from Saturday’s seminar and reread my notes. One thing you said that i did not understand was the market maker spread. Your example was bid 2.50 ask 3.00, so you limit bought at 2.70 to appease the market maker. Then you said that they had to “something ” your request and change the spread.
Making the spread less?
Can you advise or lead me to where you talk about this?
When entering a limit order that “improves” the market (between the bid and ask quotes), the market maker must either execute the trade or publish it (as long as the AON box is not checked). The MM can execute or the published bid-ask will change to $2.50 – $2.70. This is based on the “Show or Fill Rule” Here is a link to an article I published on this topic:
MGM Gaps up! ! Wow! Anyone else pick that up?
I can’t believe it. Holding on to MGM casino stock since 7/5 waiting to Hit the Double (too late for that now) the Stock today gapped up to near my breakeven point losing only less than $200 including the income from the Options I had closed.
While the Dow went down 100 points MGM rose in value about 1.5%. Like being in a casino playing the slot machines. Not sure what comes next. I thought I would end up losing lots more since the ER was coming on 7/27.
In my Fidelity portfolio when I have a stock only position I sometimes change my Purchase price to the Breakeven point of my position including the income from the options. That way I can see when the stock reaches my breakeven point easily. I know I made the change to the Purchase Price because I append a 9 or 99 to the Purchase price. When I set up the order to sell the stock, I also increase my limit to include the commission n case the price reaches the point. Unfortunately MGM consolidated just near that point and I changed my order to Market orders before losing this opportunity.
I also made a mistake and instead of 1400 shares I sold only 700 at Optionshouse. 15 minutes later I realized it when my portfolio was short some money as I adjusted the cash balance. I then copied the last order and placed another market order at slight better price.
I contacted Optionshouse through the Chat window and explained what happened. They gave me a credit of one trade for my next order.