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Black Jack & Covered Call Writing
03/06/2014 8:00 am EST
Even though he doesn’t advocate gambling, option expert Alan Ellman of TheBlueCollarInvestor.com takes a black jack analogy to detail the steps to becoming an topnotch covered-call writer.
Covered call writers and all investors using stock options strategies have one thing in common: we all want to achieve the highest possible returns within the framework of our own personal risk tolerance. The focus of The Blue Collar Investor is to provide the education and to share ideas that will help achieve these goals. Education is power and that is our starting point but where do we go from there? In this article, I will focus on the thought process that can be used to become an elite covered call writer and how it reminds me of the casino game of blackjack.
Recently, Mark T. wrote to me with a valid question: If I achieve a 2% return on the sale of my option and one of my trades turns against me, I will end up with less than a 2% return…should my goal be higher than 2% to end up with that goal?
So the question becomes how can we generate an initial return and protect and manage our positions such that it will coincide with our final returns or at least as close as possible. The answer lies in throwing the odds in our favor in ways that few covered call writers ever think of.
Let’s turn to blackjack first just for the fun of it. I am no expert in this card game but when I do play, I have all the charts memorized. That tells me that given my two cards and dealers one up card, what the computers say is the best play…take a card, stand pat, split, double down. If we have a two-card total of 11, and the dealer is sitting with a six, we double down (double our bet) and take advantage of a situation where we can increase our returns. If we are sitting with a six against a dealer’s ace, we take a card hoping to improve a losing situation. Each situation is handled on its own merit as we strive to move the odds in our favor, and much like covered call writing, it all starts with education. The major difference between these two strategies is that covered call writers will make money in the long run and most blackjack players will lose money. The main point here is that Blue Collar Investors must take advantage of all aspects of our BCI methodology to throw the odds in our favor and that is what will make us elite covered call writers.
The three aspects of the strategy that will give us opportunities to generate the highest possible returns are:
- Stock Selection
- Option Selection
- Position Management
By selecting the best performing underlying securities from fundamental, technical, and common-sense perspectives, we begin the process of throwing the odds in our favor. Option selection is based on overall market assessment, personal risk tolerance, and chart technicals. Let’s look at a real-life example for Michael Kors (KORS), a stock on our Premium Stock List at the time I am penning this article. With KORS trading @ $95.56, here is the options chain for March 2014, a five-week return:
We will evaluate the in-the-money $92.50 and $95 strikes as well as the out-of-the-money $97.50 and $100 strikes as we feed these stats into the “multiple tab” of the Ellman Calculator:
Now it’s time to throw the odds in our favor. In a bull market environment with chart technicals favorable, we are sitting with an 11 against the dealer’s six. Time for an out-of-the-money strike. These will generate excellent initial returns (2.9% and 2% in yellow field) but also give us the opportunity for additional income streams from share appreciation (2% and 4.6% more in pink field). This is like doubling down in blackjack or taking advantage of a favorable situation to elevate our returns.
In a bear market environment or with chart technicals mixed, we need an insurance policy to protect our capital. We are sitting with a six against the dealer’s ace. We throw the odds in our favor by selling an in-the-money strike, both of which return decent initial option profits (2.5% and 3.6% in yellow field) and one (the $92.50 strike in brown field) offers decent protection of that option profit. So what we have accomplished here is to generate some protection against a potential losing trade and to enhance profit potential for winning trades and this will allow us to achieve our goals in normal market conditions.
We are not finished yet because we haven’t started to execute our exit strategy opportunities. Some (“hitting a double,” the “mid-contract unwind”) will allow us to generate a second income stream in the same month with the same cash) and others (like rolling down or closing the entire position) will allow us to mitigate losses.
Throwing the odds in our favor and taking advantage of opportunities are factors that distinguish Blue Collar Investors from all the others. When we’re sitting with a 16 against the dealer’s ace we do not sit there like a deer in headlights with sweat pouring down our foreheads…we take a card. There may not be a great play all the time but there is always a best play and it’s all about throwing the odds in our favor like nobody’s business (an expression my mother uses).
By Alan Ellman of TheBlueCollarInvestor.com