In our BCI methodology we favor Monthly or Weekly options for our short covered call writing positions. I am frequently asked why I don’t utilize LEAPS options (expire 9 – 24 months in the future) to garner a much higher premium and perhaps require less management time. Dan recently sent me a covered call trade he executed with SLV (iShares Silver Trust (NYSE:SLV) using LEAPS as the short call position. He noted that his assessment was that SLV was undervalued and expected appreciation over the long-term.
Dan’s Trade
- 11/21/2016: Buy SLV at $16.04
- 11/21/2016: Sell the January 2019 LEAPS for $2.92
- 11/28/2016: Share price declines to $15.26
- 11/28/2016: “Ask” price for the LEAPS falls to $2.49
Dan’s question
“Can I buy back the LEAPS to lock in a $43.00 per contract profit and then sell more LEAPS and if so, will I still be considered “covered” since I don’t have naked option-trading privileges.
Response and evaluation of tactic
When buying back the option, we still own the underlying shares so, yes, we are still in a covered position when selling the second round of LEAPS. But does this action benefit us? After one week of being in this position, buying back the short call and re-selling it will result in a net debit due to the spread (Buying at the “ask” costs more than the credit generated from selling the “bid”). In addition to the spread net debit, we are also incurring two unnecessary trading commissions. Position management is critical but there are many occasions when the best action is no action at all.
A look at the technical chart
The brown field shows a 21% loss in share value during the past three months. Although we may have reasons for a future price recovery, it would be more desirable to wait for technical confirmation of those expectations. If one were completely convinced of a bullish turnaround, we should consider selling out-of-the-money cash-secured puts before purchasing the security to give some downside protection.
Calculations can be deceiving
Let’s annualize the returns for a 1-month call option versus a 25-month LEAPS option. I am using the real-life options chain on 12/20/2016 when SLV was trading at $15.06. The 1-month January 2017 $15.00 call showed a published “bid” of $0.50 and the January 2019 $15.00 LEAPS had a published “bid” of $2.65. $2.65 is better than $0.50, right? WRONG…let’s calculate the annualized returns per contract.
1-month call: ($50.00/$1506.00) x 12 = 40% annualized
25-month LEAPS: [($265.00/$1506.00)/25 ] x 12 = 8.4% annualized
Using Monthlys will far supersede the returns of the 2-year LEAPS.
Another factor to consider
We select an underlying security for multiple reasons. In the BCI methodology we use fundamental analysis, technical analysis and common sense principles and then make sure the security options will meet our goals and personal risk-tolerance. When we select a stock today that meets our system criteria, those parameters may not exist in the near or distant future and yet LEAPS imply taking a one-year or two-year obligation.
Discussion
Using LEAPS as our short call positions with covered call writing creates unnecessary complications especially related to lower returns and the risk of depending on long-term future price movement. Our system should be set up to maximize profits and minimize our risks. In my view, Monthlys provide the best combination of pros and cons although Weeklys can work as well.
Next live event
American Association of Individual Investors
Washington DC Chapter
Saturday July 15, 2017
9 AM – 12:00 PM
“Using Stock Options to Buy Stocks at a Discount and to Bring Portfolio Returns to Higher Levels”
Co-presenter: Dr. Eric Wish, Finance Professor, University of Maryland
Market tone
Thursday started with the European Central Bank meeting, followed by ex-FBI director Comey’s testimony later in the day. It wound up with the Conservative Party in the UK losing its majority in the House of Commons. Despite increased uncertainty surrounding the Brexit process, global stocks have shown little net change on the week.
West Texas Intermediate crude extended its decline to $45.50 from $47.35 a week ago after a forecast from the Energy Information Agency projected that US domestic oil output will top 10 million barrels a day in 2018. Equity volatility, as measured by the Chicago Board Options Exchange Volatility Index (VIX), remained historically low, slightly ticking up to 10.7. This week’s reports and international news of importance:
- Prime Minister Theresa May’s attempt to improve her Brexit bargaining position by calling a snap election did exactly the opposite, increasing the uncertainty around the Brexit process
- The Conservative Party lost its outright majority in the House of Commons but will be able to form a government with the backing of the 10 members of Northern Ireland’s Democratic Unionist Party
- Politically, May could be replaced as party leader in the near future. Early indications are that May’s failure to secure a larger parliamentary majority undermines the case for a “hard” Brexit. That is one reason — along with a weaker pound — that markets have taken the election outcome in stride so far. A softer Brexit is less disruptive to UK business interests
- With the economy on the upswing, European Central Bank president Mario Draghi announced on Thursday that the bank is dropping its bias toward cutting interest rates, but it retained its bias toward increasing quantitative easing, if necessary
- The bank raised its growth forecast while at the same time cutting its inflation outlook. Risks to the economy are now broadly balanced, he said. The overall tone of Draghi’s press conference was decidedly dovish
- Former FBI director James Comey testified before the Senate Intelligence Committee regarding the FBI’s investigation into Russia’s interference in the 2016 US presidential election and President Donald Trump’s desire that the Bureau end its investigation of his former national security advisor Michael Flynn. Comey said he would leave it to Special Counsel Robert Mueller to decide whether the president’s conduct rose to the level of obstruction of justice. With Mueller’s investigation in an early phase, there will likely be many months of continued policy paralysis in Washington
- Purchasing managers’ indices released this week show that the eurozone continues to outperform other developed economies. The eurozone composite PMI, which measures both manufacturing and services, stood at 56.8, unchanged from April
- Meanwhile, the United States clocked in at 53.6 and the UK at 56.7, just below April’s 56.8 three-year high. Japan’s composite PMI registered 52.6 and China’s 51.5
THE WEEK AHEAD
MONDAY, JUNE 12th
- Federal budget May
TUESDAY, June 13th
- NFIB small-business index May
- Producer prices May
WEDNESDAY, June 14th
- Consumer prices May
- Core consumer prices May
- Retail sales May
- Core Retail sales May
- FOMC statement
- Yellen press conference
THURSDAY, JUNE 15th
- Weekly jobless claims 6/10
- Philadelphia Fed survey June
- Industrial production May
- Home builders’ index June
FRIDAY, JUNE 16th
For the week, the S&P 500 moved lower by 0.30% for a year-to-date return of 8.62%.
Summary
IBD: Uptrend under pressure
GMI: 6/6- Buy signal since market close of April 21, 2017 (as of Friday morning)
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. I am concerned about the current political turmoil in the US how it may impact the stock market. So far, the market has been surprisingly resilient.
WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US
The 6-month charts point to a cautiously bullish outlook. In the past six months, the S&P 500 was up 7.5% while the VIX (10.30) moved down by 15%.