Alan Ellman, of TheBlueCollarInvestor.com, compares and contrasts covered call writing versus cash-secured put selling, which are both great strategies that can be tailored to meet overall market assessment and personal risk tolerances.
Covered call writing or put-selling? In-the-money or out-of-the-money strikes? When we view an options chain, there are some basic principles we must factor into our final covered call writing or put selling decisions. First, which of these two strategies is most appropriate? Unfortunately, there is no one answer that is right for every investor. I prefer covered call writing, but that is a product of the success I've enjoyed using that strategy over the past two decades. Others favor selling cash-secured puts. When I do use put selling, it is because I have a bearish market outlook and slightly favor put selling in those environments. Both are great strategies that can be tailored to meet our overall market assessment and personal risk tolerances.
Once a strategy is selected, we must next choose a strike price. In both strategies, this choice is based on the following factors:
- Overall market assessment
- Chart technicals
- Personal risk tolerance
In other words, are we bullish or bearish about the market in general and the stock in particular? In a future article, I will discuss a bear market scenario. In today's blog, I will use a bull market situation and highlight the options chain for Michael Kors Holdings Ltd. (KORS). In this example, I will show potential trade selections for both strategies. Finally, I will show the calculations for these trades, which will demonstrate to us if these results meet our monthly goals. Please note that we are showing six-week returns, so to annualize, we multiply by 8.5.
Options Chain for KORS as of May 4, 2014:
Implied volatility and earnings seasons
Click to Enlarge
In the pink-highlighted row I show strikes we may consider in bear markets. In this article, we will focus in on the yellow-highlighted rows, which are appropriate for bull market environments.
Bull Market Trade and Calculations for Covered Call Writing
We favor out-of-the-money strikes which will generate time value returns that meet our goals along with upside potential from share appreciation moving from the purchase price up to the strike price. The deeper out-of-the-money we go, the greater our upside potential but the lower the initial time value profit. With KORS trading @ $93.90, we will view the $97.50 OTM strike:
- Call premium = $3.20
- Upside potential from $93.90 to $97.50 is $3.60
- Time value of the premium = $3.60 (ATM and OTM calls are all time value)
- Initial profit = $320/$9390 per contract = 3.4%
- Annualized return = 29%
- Upside potential = $3.60/$93.90 = 3.8%
- Maximum 6-week return = 3.4% + 3.8% = 7.2% or 61% annualized
- Breakeven = $93.90 - $3.20 = $90.70
Bull Market Trade and Calculations for Selling Cash-Secured Puts
We favor slightly out-of-the-money strikes as well as at-the-money and slightly in-the-money strikes which will generate higher initial returns than deeper out-of-the-money strikes. We do this to take advantage of the bull market environment to generate the highest possible returns while still having capital preservation in mind. With KORS trading @ $93.90, we will view the $95.00 slightly ITM strike.
- Put premium = $5.30
- Initial profit = $530/$9500 per contract = 5.6%
- Annualized return = 47.4%
- Breakeven = $95.00 - $5.30 = $89.70
Note: This information was taken from my new book: Selling Cash-Secured Puts.
Summary
By incorporating overall market assessment, chart technicals, personal risk tolerance, and calculation results we can make informed, non-emotional decisions as to which strategy and strike price will be most appropriate for our portfolios.
By Alan Ellman of TheBlueCollarInvestor.com
