The Case for One-Month Options

04/02/2013 8:00 am EST

Focus: OPTIONS

Alan Ellman

President, The Blue Collar Investor Corp.

In this article, Alan Ellman of TheBlueCollarInvestor.com explains why he primarily chooses to use one-month options for his covered call strategies.

I sell predominantly one-month options when selling covered calls. This decision was NOT based on anything I read or was told, but rather on experience and common sense. Most stocks with options have at least four expiration cycles affiliated with them at any point in time.the current month, the next month, and two more months further out based on the particular option cycle that the equity has been assigned to. Stocks that also have LEAPS (long-term options) have more than four cycles. Add to that the newer weekly and quarterly expirations and we have a lot of options to choose from. Using the options chains and The Ellman Calculator, I will make my case for selling mainly one-month options (weeklys are also currently being studied by the BCI team as more equities are being added to the "weekly pool").

Three Reasons to Sell One-Month Options

  1. It facilitates adhering to a core BCI guideline of never selling an option in a contract cycle that has an upcoming earnings report. Since earnings reports are made public on a quarterly basis for US companies, selling short-term options allow us to move our stocks in and out of our portfolios (yet keep them on our watch lists if they still meet our system criteria).
  2. Stocks have no loyalty to us. They can be our best friends one month and our worst enemies the next. Although we do have exit strategies to help control a negative situation, the shorter the commitment we have to an equity, the less risk we incur.
  3. We make the most money selling one-month options. I'm sure I have your attention now, so allow me to demonstrate via an options chain for Netlogic Microsystems, trading at the time of this writing for $53.22 as shown in the chart below:

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NETL price
Click to Enlarge

The option chain is shown in the chart below:

chart
Click to Enlarge

NEXT PAGE: One-Month Options Outperform

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NETL Options Chain
This information was captured after the February contracts expired. We will hone in on the March (one-month out), April (two-months out), and July (five-months out) contracts. Here is the information we glean from the options chain and will feed into the Ellman Calculator (single tab):

The stock was trading @ $53.22 so we will look at the out-of-the-money $55 call options

The March $55 call returned $1.65/share (red circle)

The April $55 call returned $2.55/share (blue circle)

The July $55 call returned $4.70/share (green circle)

It may be tempting to opt for the higher dollar returns of the longer-term options; however we must factor in the time frame and logically deduce how to best put our money to work so as to generate the most profits. So let's feed this information into the single tab of the Ellman Calculator, as illustrated below:

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The Ellman Calculator
Click to Enlarge

Now, in the chart below, let's examine the results of these calculations:

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Option calculations: NETL- 1, 2 and 5 Month Returns
Click to Enlarge

The ROO (initial option returns) or percentage returns generated does NOT include the upside potential. Although the Ellman Calculator does give this information, I left it out of this graphic because all choices have the same upside, and I want to concentrate just on the initial option profit. Here are the ROO figures derived from the Ellman Calculator:

The March $55 call returns 3.1% (green arrow)

The April $55 call generates 4.8% (blue arrow)

The July $55 call generates 8.8% (red arrow)

Once again, upon first glance it appears that the July $55 call will be the most lucrative for us until we annualize these percentages. To do so, we must convert these figures to a monthly return and multiply by 12, as follows:

March: 3.1%/1 x 12 = 37.2%

April: 4.8%/2 x 12 = 28.8%

July: 8.8%/5 x 12 = 21.1%

The one-month options outperformed the two-month options by more than 29% and the five-month options by more than 76%! I rest my case.

By Alan Ellman of TheBlueCollarInvestor.com

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