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Wednesday, October 31, 2007

Roll Up -- iShares MSCI South Korea Index ETF

The Covered Calls Advisor Portfolio (CCAP) covered call positions in iShares MSCI South Korea Index ETF(EWY) were rolled up today (10/31/07) from the Nov 70S to the Nov 75s. The transactions were as follows:

10/31/07 Buy-to-Close (BTC) 8 EWY Nov 70s @ $5.20
10/31/07 Sell-to-Open (STO) 8 EWY Nov 75s @ $1.75
Net Debit on Roll Up $3.45

The ‘net debit to strike price difference ratio’ was 69% [($5.20-$1.75)/($75-$70)]*100, which achieved the desired threshold of rolling up when the ratio is <75%.

A summary of the EWY transactions so far is as follows:
Initial EWY Post: EWY Link
10/23/07 Initial ETF Position -- Bought 800 EWY @ 68.40
10/23/07 Initial Calls Postion -- Sold 8 EWY Nov07 70 Calls @ 1.90
Today:
10/31/07 Roll Up Transaction -- BTC 8 EWY Nov 70s @ $5.20
10/31/07 Roll Up Transaction -- STO 8 EWY Nov 75s @ $1.75
Note: EWY ETF was trading at $74.45 today when the roll up transaction was executed.

The results-to-date through the completed Nov 70 covered calls and the status on the newly established Nov 75 covered calls position (including commissions) are each summarized below:

(a) Completed Covered Calls Transactions:
Original Stock Investment 10/23/07 – Purchased 800 shares EWY @ $68.40
= $68.40*800 + $9.95 commission = ($54,729.95)
Change in ETF Value ($74.45-$68.40)*800 = $4,840.00
Change in Options Value = Options Write Income $1,504.05($1.90*800-$15.95 commission) minus Options Buyback Cost $4,175.95($5.20*800+$15.95 commission)=
-$2,671.90($1,504.05-$4,175.95)

Net Change (+$4,840.00-$2,671.90) = $2,168.10

ANNUALIZED RETURN ON INVESTMENT:
(2,168.10/54,729.95)*(365/8 days) = 180.7%

(b) New Covered Call Position Established Today:
10/31/07 Retained 800 EWY at $74.45 = ($59,560)
10/31/07 Sold 8 Nov07 75 Calls @ $1.75 = $1,384.05 ($1.75*800-$15.95 commission)

Annualized Return If Unchanged (ARIU) 50.5%
Annualized Return If Exercised (ARIE) 66.3%
Downside Breakeven Protection 2.4% =Avg. of .14%/day for 17 days until expiration which exceeds the minimum threshold average of .06%/day required by the covered calls advisor.

Tuesday, October 30, 2007

Roll Up -- Honeywell

The Covered Calls Advisor Portfolio (CCAP) covered call position in Honeywell (HON) was rolled up today (10/30/07) from the Nov 57.5 to the Nov 60. The transactions were as follows:

10/30/07 Buy-to-Close (BTC) 5 HON Nov 57.5s @ $3.00
10/30/07 Sell-to-Open (STO) 5 HON Nov 60s @ $1.25
Net Debit on Roll Up $1.75

The ‘net debit to strike price difference ratio’ was 70% [($3.00-$1.25)/($60-$57.5)]*100, which was better than this advisor’s desired minimum threshold of <75% for roll ups.

A summary of the HON transactions so far, including today's roll up is as follows:
9/10/07 Initial Stock Position -- BTO 500 HON @ 54.23
9/10/07 Initial Call Option -- STO 5 HON Oct07 55 Calls @ 1.80
9/26/07 Roll Up Transaction -- BTC 5 HON Oct 55s @ $4.70
9/26/07 Roll Up Transaction -- STO 5 HON Oct 60s @ $1.10
10/20/07 Oct07 Option Expiration Date – HON closed below the strike price at $58.32
10/22/07 Covered Calls Continuation Transaction -- STO 5 Nov07 57.5 Calls @ $2.25
10/30/07 Roll Up Transaction -- (BTC) 5 HON Nov 57.5s @ $3.00
10/30/07 Roll Up Transaction -- (STO) 5 HON Nov 60s @ $1.25
The stock was trading at $59.83 when today's roll-up transaction was made.

The results-to-date through the completed Nov 57.5 covered calls and the status on the newly established Nov 60 covered calls position (including commissions) are each summarized below:

(a) Completed Covered Calls Transactions:
Original Stock Investment 9/10/07 – Purchased 500 shares HON @ $54.23
= $54.23*500 + $9.95 commission = ($27,124.95)
Change in Stock Value to Present ($59.83-$54.23)*500 = $2,800.00
Change in Options Value = 1st Options Write Income $886.30($1.80*500-$13.70 commission) minus 1st Options Buyback Cost $2,336.30($4.70*500+$13.70 commission) plus 2nd Options Write Income $536.30($1.10*500-$13.70) plus 3rd Options Write Income $1,111.30($2.25*500-$13.70) minus 2nd Options Buyback Cost $1,513.70($3.00*500+$13.70) = -$1,316.10($886.30-$2,336.30+$536.30+1,111.30-$1,513.70)

Net Change (+$2,800.00-$1,316.10) = $1,483.90

ANNUALIZED RETURN ON INVESTMENT:
(1,483.90/27,124.95)*(365/50 days) = 39.3%

(b) New Covered Call Position Established Today:
10/30/07 Retained 500 HON at $59.83 = ($29,915)
10/30/07 Sold 5 Nov07 60 Calls @ $1.25 = $611.30 ($1.25*500-$13.70 commission)

Annualized Return If Unchanged (ARIU) 42.3%
Annualized Return If Exercised (ARIE) 48.1%
Downside Breakeven Protection 2.1% =Avg. of .12%/day for 18 days until expiration which exceeds the minimum threshold of .06%/day for the covered calls advisor.

Friday, October 26, 2007

Roll Up Adjustment -- Merck

The Covered Calls Advisor Portfolio (CCAP) covered call position in Merck (MRK) was rolled up today (10/26/07) from the Nov 52.5 to the Nov 57.5. The transactions were as follows:

10/26/07 Buy-to-Close (BTC) 5 MRK Nov 52.5s @ $5.20
10/26/07 Sell-to-Open (STO) 5 MRK Nov 57.5s @ $1.30
Net Debit on Roll Up $3.90

The ‘net debit to strike price difference ratio’ was 78% [$3.90/($57.7-$52.5)]*100, which was slightly above this advisor’s desired threshold of rolling up when the ratio is <75%.

A summary of the MRK transactions so far is as follows:
Initial MRK Post:
9/7/07 Bought 500 MRK @ 49.97
9/7/07 Sold 5 MRK Oct07 50 Calls @ 1.85
Prior Roll Out Transaction:link
10/19/07 BTC 5 MRK Oct 50s @ $3.90
10/19/07 STO 5 MRK Oct 52.5s @ $2.40
Today:
10/26/07 BTC 5 MRK Nov 52.5s @ $5.20
10/26/07 STO 5 MRK Nov 57.5s @ $1.30
Note: MRK stock was trading at $57.40 today when the roll up transaction was executed.

The results-to-date through the completed Nov 52.5 covered calls and the status on the newly established Nov 57.5 covered calls position (including commissions) are each summarized below:

(a) Completed Covered Calls Transactions:
Original Stock Investment 9/7/07 – Purchased 500 shares MRK @ $49.97
= $49.97*500 + $9.95 commission = ($24,994.95)
Change in Stock Value ($57.40-$49.97)*500 = $3,715.00
Change in Options Value = 1st Options Write Income $911.30($1.85*500-$13.70 commission) minus 1st Options Buyback Cost $1,963.70($3.90*500+$13.70 commission) plus 2nd Options Write Income $1,186.30($2.40*500-$13.70) minus 2nd Options Buyback Cost $2,613.70($5.20*500+$13.70) = -$2,479.80($911.30-$1,963.70+$1,186.30-$2,613.70)

Net Change (+$3,715.00-$2,613.70) = $1,101.30

ANNUALIZED RETURN ON INVESTMENT:
(1,101.30/24,994.95)*(365/49 days) = 32.8%

(b) New Covered Call Position Established Today:
10/26/07 Retained 500 MRK at $57.40 = ($28,700)
10/26/07 Sold 5 Nov07 57.5 Calls @ $1.30 = $636.30 ($1.30*500-$13.70 commission)

Annualized Return If Unchanged (ARIU) 37.6%
Annualized Return If Exercised (ARIE) 40.5%
Downside Breakeven Protection 2.3% =Avg. of .10%/day for 22 days until expiration.

Wednesday, October 24, 2007

Buy Halliburton

The Covered Calls Advisor Portfolio (CCAP) established the following new covered call position:

10/24/07 Bought 700 HAL @ 40.01
10/24/07 Sold 7 HAL Nov07 40 Calls @ $1.25

Annualized Return If Unchanged: 47.1%
Annualized Return If Exercised: 47.1%
Downside Breakeven Protection: 3.1%

This position completes the establishing of positions for Nov07 covered calls. Approximately $9,600 cash (3.7% of total CCAP value) remains in CCAP to cover potential management of existing positions, such as roll ups.

Please click on the comments link below if you have any questions or feedback on the CCAP. Your comments are always appreciated.

Regards and Godspeed

Tuesday, October 23, 2007

Buy Accenture, iShares MSCI South Korea Index ETF, JP Morgan Chase, and Eli Lilly

Four new covered call positions were established today in the Covered Calls Advisor Portfolio(CCAP) as follows:

1. Accenture Ltd CL A Covered Calls Established

10/23/07 Bought 1000 ACN @ 39.48
10/23/07 Sold 10 ACN Nov07 40 Calls @ $1.05

Annualized Return If Unchanged: 38.8%
Annualized Return If Exercised: 58.1%
Downside Breakeven Protection: 2.7%


2. iShares MSCI South Korea Index ETF Covered Calls Established

10/23/07 Bought 800 EWY @ 68.40
10/23/07 Sold 8 EWY Nov07 70 Calls @ $1.90

Annualized Return If Unchanged: 39.0%
Annualized Return If Exercised: 71.8%
Downside Breakeven Protection: 2.8%


3. JP Morgan Chase Covered Calls Established

10/23/07 Bought 500 JPM @ 45.58
10/23/07 Sold 5 JPM Nov07 45 Calls @ $1.75

Annualized Return If Unchanged: 37.4%
Annualized Return If Exercised: 37.4%
Downside Breakeven Protection: 3.8%
Downside Maximum Return Protection 1.3% =[(45.58-45.00)/45.58]*100

4. Eli Lilly & Co. Covered Calls Established

10/23/07 Bought 500 LLY @ 56.48
10/23/07 Sold 5 LLY Nov07 55 Calls @ $2.95

Annualized Return If Unchanged: 49.0%
Annualized Return If Exercised: 49.0%
Downside Breakeven Protection: 5.2%
Downside Maximum Return Protection 2.6% =[(56.48-55.00)/56.48]*100

You'll notice that the first two positions are out-of-the-money (OTM) covered calls and the last two are in-the-money (ITM). An additional indicator termed 'downside maximum return protection' is included for any covered calls that are ITM when established. This represents the maximum percent that the stock price can fall by the expiration date and the maximum annualized ROI % will still be achieved.

Monday, October 22, 2007

Buy McDonald's

The Covered Calls Advisor Portfolio (CCAP) established the following new covered call position:

10/22/07 Bought 500 MCD @ 55.94
10/22/07 Sold 5 MCD Nov07 57.5 Calls @ $.70

Annualized Return If Unchanged: 55.94%
Annualized Return If Exercised: 94.4%
Downside Breakeven Protection: 1.3%

As you may recall, MCD goes ex-dividend on 11/13/07 with an annual dividend of $1.50 per share. Reference Link to McDonald's post. For clarification, this dividend is included in the annualized return %s above, but is excluded from the downside breakeven protection calculation.

Honeywell -- Continuation Transaction

The following transaction was made today to continue the covered calls written against the 500 shares on HON:

10/22/07 Covered Calls Continuation Transaction -- STO 5 Nov07 57.5 Calls @ $2.25


The Transactions History to date is as follows:

9/10/07 Initial Stock Position -- BTO 500 HON @ 54.23
9/10/07 Initial Call Option -- STO 5 HON Oct07 55 Calls @ 1.80
9/26/07 Roll Up Transaction -- BTC 5 HON Oct 55s @ $4.70
9/26/07 Roll Up Transaction -- STO 5 HON Oct 60s @ $1.10
10/20/07 Oct’07 Option Expiration Date – HON closed below the strike price at $58.32
10/22/07 Covered Calls Continuation Transaction -- STO 5 Nov07 57.5 Calls @ $2.25


The Performance Results potential (including commissions) if the current position is called is as follows:
Stock Purchase Cost: $27,124.95 ($54.23*500+$9.95 commissions)
Option Income: +$181.45 ($180*5-$470*5+$110*5+225*5-$43.55 commissions)
Capital Appreciation: $1,615.10 ($57.50*500-$9.95 -$27,124.95)
Net Profit: $1,796.55 ($181.45 + $1,615.10)


ANNUALIZED RETURN ON INVESTMENT IF CALLED:
(1,796.55/27,124.95)*(365/61 days) = 39.6%

United Health Group -- Closed

The initial UNH covered call position expired with the stock out-of-the-money. Today the 300 shares of stock were sold. It was decided not to continue with selling additional call options against the 300 shares owned because the potential annualized return-on-investment available for such a transaction did not exceed this advisor's threshold of >25% annualized return if stock price unchanged (ARIU).

1. United Health Group – Closed

Transactions History:
9/17/07 Bought 300 UNH @ 49.77
9/17/07 Sold 3 Oct07 50 Calls @ 1.50
10/22/07 Sold 300 UNH @ 47.26

Performance Results(including commissions):
Stock Purchase Cost: $14,940.95 ($49.77*300+$9.95 commissions)
Option Income: $437.80 ($1.50*300-$12.20 commissions)
Capital Appreciation: -$772.90 [($47.26*300-$9.95)-$14,940.95]
Net Profit or Loss: -$335.10 ($437.80-$772.90)

ANNUALIZED RETURN ON INVESTMENT:
(-335.10/14,940.95)*(365/35 days) = -23.4%

Sunday, October 21, 2007

October 2007 Expiration Transactions

The Covered Calls Advisor Portfolio (CCAP) contained 11 positions with Oct07 expirations with the following results:
- 8 positions closed in-the-money so the calls were exercised and the stock was called away. Details of each of these transactions are presented below.
- 1 position (MRK) was also in-the-money, but the October option was covered and a new Nov07 covered call position was established.
See MRK Roll Out link
- 2 positions (HON and UNH) ended out-of-the-money. Decisions will be made to either sell the stock, or to establish Nov07 covered call positions against these stock holdings. The related transactions will be made Monday morning and the actual transactions will be posted at that time.

The 8 closed positions and each of their annualized return-on-investment (ROI) %s are summarized as follows:
BMC Software -- 39.2%
Fluor -- 75.1%
Hewlett Packard -- 34.9%
iShares MSCI EAFE ETF -- 31.3%
Materials Select Sector SPDR ETF -- 35.8%
Nike -- 37.2%
Oil Service HOLDRS Trust ETF -- 42.7%
Travelers Cos. -- 44.6%

The transactions history and performance results for each of these 8 covered call positions is provided below:

1. BMC Software – Closed

Transactions History:
9/17/07 Initial Stock Position -- Bought(BTO)500 BMC @ 30.50
9/17/07 Initial Call Options -- Sold (STO) 5 Oct07 30 Calls @ 1.65
10/20/07 Option Exercised – STC 500 BMC @ $30.00

Performance Results(including commissions):
Stock Purchase Cost: $15,259.95 ($30.50*500+$9.95 commissions)
Option Income: $811.30 ($1.65*500-$13.70 commissions)
Capital Appreciation: -$269.90 [($30.00*500-$9.95)-$15,259.95]
Net Profit: $514.40 ($811.30-$269.90)

ANNUALIZED RETURN ON INVESTMENT:
(514.40/15,259.95)*(365/33 days) = 39.2%


2. FLR – Closed

Transactions History:
9/18/07 Initial Stock Position -- BTO 100 FLR @ $138.17
9/18/07 Initial Call Option -- STO 1 FLR Oct 140 @$4.90
10/2/07 Roll Up Transaction -- BTC 1 FLR Oct 140 @ $11.60
10/2/07 Roll Up Transaction -- STO 1 FLR Oct 150 @ $4.50
10/20/07 Option Exercised – STC 100 FLR @ $150.00

Performance Results(including commissions):
Stock Purchase Cost: $13,826.95 ($138.17*100+$9.95 commissions)
Option Income: -$249.85 ($490-$1160+$450-$29.85 commissions)
Capital Appreciation: $1,163.10 [($150.00*100-$9.95)-$13,826.95]
Net Profit: $913.25 ($1,163.10-$249.85)

ANNUALIZED RETURN ON INVESTMENT:
(913.25/13,862.95)*(365/32 days) = 75.1%


3. Hewlett Packard – Closed

Transactions History:
9/11/07 Initial Stock Position -- Bought 500 HPQ @ 49.78
9/11/07 Initial Call Options -- Sold 5 Oct07 50 Calls @ 1.75
10/20/07 Option Exercised – STC 500 HPQ @ $50.00

Performance Results(including commissions):
Stock Purchase Cost: $24,899.95 ($49.78*500+$9.95 commissions)
Option Income: $861.30 ($1.75*500-$13.70 commissions)
Capital Appreciation: $90.10 [($50.00*500-$9.95)-$24,899.95]
Net Profit: $951.40 ($861.30+$90.10)

ANNUALIZED RETURN ON INVESTMENT:
(951.40/24,899.95)*(365/40 days) = 34.9%


4. iShares MSCI EAFE ETF – Closed

Transactions History:
9/11/07 Initial Stock Position -- BTO 400 EFA @ 77.75
9/11/07 Initial Call Options -- STO 4 Oct07 78 Calls @ 2.50
10/20/07 Option Exercised – STC 400 EFA @ $78.00

Performance Results(including commissions):
Stock Purchase Cost: $31,109.95 ($77.75*400+$9.95 commissions)
Option Income: $987.05 ($2.50*400-$12.95 commissions)
Capital Appreciation: $80.10 [($78.00*400-$9.95)-$31,109.95]
Net Profit: $1,067.15 ($987.05+$80.10)

ANNUALIZED RETURN ON INVESTMENT:
(1,067.15/31,109.95)*(365/40 days) = 31.3%


5. Materials Select Sector SPDR ETF – Closed

Transactions History:
9/12/07 Initial Stock Position -- BTO 200 XLB @ 38.84
9/12/07 Initial Call Options -- STO 2 Oct07 39 Calls @ 1.45
10/20/07 Option Exercised – STC 200 XLB @ $39.00

Performance Results(including commissions):
Stock Purchase Cost: $7,777.95 ($38.84*200+$9.95 commissions)
Option Income: $278.15 ($1.45*200-$11.85 commissions)
Capital Appreciation: $12.10 [($39.00*200-$9.95)-$7,777.95]
Net Profit: $290.25 ($278.15+$12.10)

ANNUALIZED RETURN ON INVESTMENT:
(290.25/7,777.95)*(365/38 days) = 39.2%


6. Nike Inc. – Closed

Transactions History:
9/7/07 Initial Stock Position -- BTO 500 NKE @ 54.83
9/7/07 Initial Call Options -- STO 5 NKE Oct07 55 Calls @ 2.30
10/20/07 Option Exercised – STC 500 NKE @ $55.00

Performance Results(including commissions):
Stock Purchase Cost: $27,424.95 ($54.83*500+$9.95 commissions)
Option Income: $1,136.30 ($2.30*500-$13.70 commissions)
Capital Appreciation: $65.10 [($55.00*500-$9.95)-$27,424.95]
Net Profit: $1,201.40 ($1,136.30+$65.10)

ANNUALIZED RETURN ON INVESTMENT:
(1,201.40/27,424.95)*(365/43 days) = 37.2%


7. Oil Service HOLDRS Trust ETF – Closed

Transactions History:
9/12/07 Initial Stock Position -- BTO 200 OIH @ 184.35
9/12/07 Initial Call Options -- STO 2 Oct07 185 Calls @ 7.70
10/20/07 Option Exercised – STC 200 OIH @ $185.00

Performance Results(including commissions):
Stock Purchase Cost: $36,879.95 ($184.35*200+$9.95 commissions)
Option Income: $1,528.15 ($7.70*200-$11.85 commissions)
Capital Appreciation: $110.10 [($185.00*200-$9.95)-$36,879.95]
Net Profit: $1,638.25 ($1,528.15+$110.10)

ANNUALIZED RETURN ON INVESTMENT:
(1,638.25/36,879.95)*(365/38 days) = 42.7%


8. Travelers Cos. – Closed

Transactions History:
9/10/07 Initial Stock Position --BTO 500 TRV @ 49.37
9/10/07 Initial Call Options -- STO 5 TRV Oct07 50 Calls @ 1.85
10/20/07 Option Exercised – STC 500 TRV @ $50.00

Performance Results(including commissions):
Stock Purchase Cost: $24,694.95 ($49.37*500+$9.95 commissions)
Option Income: $911.30 ($1.85*500-$13.70 commissions)
Capital Appreciation: $295.10 [($50.00*500-$9.95)-$24,694.95]
Net Profit: $1,206.40 ($911.30+$295.10)

ANNUALIZED RETURN ON INVESTMENT:
(1,206.40/24,694.95)*(365/40 days) = 44.6%


The performance of the overall Covered Calls Advisor Portfolio (CCAP) as measured by the total portfolio value will be posted on this site monthly on the last day of each calendar month. The initial posting for the monthly overall CCAP performance results will therefore be on October 31, 2007.

Regards and Godspeed

Saturday, October 20, 2007

Covered Calls Selection Process

A previous article Stock Selection 101 described the Covered Calls Advisor's stock selection process. This article picks up where that article left off by describing the process used for systematically narrowing the initial list of 200-300 stock purchase candidates to a final list of 10-20 covered call positions to be added to the Covered Calls Advisor Portfolio (CCAP).

This advisor normally writes near-month covered calls on stocks whose next earnings release is sometime after the next expiration date. Since we have just completed the Oct07 expiration, we first look to eliminate from the preliminary list of 200-300 stocks, those stocks that do have an earnings release between now and Nov07 options expiration on Nov.17th. As noted in a previous post, it is desirable for the covered call writer to avoid the uncertainty along with the accompanying erratic price moves that are often associated with earnings surprises -- so we consciously avoid owning stocks when they are releasing earnings results. November is one of four expiration months (February, May, and August are the other three) when most companies will be releasing their quarterly earnings. This is true since for most companies, their fiscal year coincides with the calendar year so their quarters conclude at the end of March, June, September, and December. And since quarterly earnings are normally reported between 3 and 6 weeks after the end of a quarter, the majority of earnings releases will occur in the expiration monthly periods of Feb,May,Aug,and Nov. So, our initial screen eliminating all earnings reporting stocks from the 287 initial stock candidates identified for November expiration leaves us with only 113 remaining stock purchase candidates.

The second screen further eliminates any of the 113 stocks for which no options are traded or where the options open interest is very low(less than 150). This month that is 15 stocks, so after the options liquidity screen for November, there are now 98 (113-15) stocks remaining on the list. The third screen eliminates stocks that are, from this advisor's experience, either too volatile to be warranted as covered call investment candidates; or on the other hand too stable to generate adequate annualized return on investments -- thus equities are eliminated from further consideration that have historic volatilities below 20 or above 43. For Nov07 expirations, this volatility screen eliminates 29 additional stocks, so there remains only 69 (98-29) stock candidates for establishing covered call positions.

So now only 69 stocks remain for consideration as potential candidates for our Nov07 covered call selections. This is fewer than is normally the case; but again, that's what happens with so many earnings releases during Feb,May,Aug,and Nov expiration months. The fourth and final screen provides a list of those covered call positions (using all 69 potential stocks remaining) that meet the following criteria:
1. Common Price >$9.90
2. Open Interest >150
3. Annualized Return If Unchanged (ARIU) >25%
4. Expiration Date = 11/17/07
5. Call Option Overpriced by more than 0%
6. Stock Price between 3.5% below and 2% above strike price.
7. Historic Volatility of stock between 20% and 43%.
8. Option Bid Price >= .40
9. Downside Breakeven Protection >2.0%
The Value Line Daily Options Screener is used to conduct this screen. The 69 stock symbols were keyed and run through this screener. A total of 32 positions were identified that met all of the nine criteria listed above.

Each of these 32 positions will be entered into an 'Analysis Sheet' to identify the highest ranking covered call positions to be selected. Along with the overall rankings generated from the 'Analysis Sheets', additional consideration is given to ensure that adequate portfolio diversification as well as consistency with the overall investing 'themes' is achieved in the CCAP. The 'Analysis Sheet' includes all of the detailed factors this advisor includes in evaluating each covered call investment under consideration. A preview of these factors was provided in an earlier post 10 Factors link. Presentation of a sample 'Analysis Sheet' will be provided in a post at a later date.

Regards and Godspeed

Friday, October 19, 2007

Roll Ups Revisited – Fluor and Honeywell

For October expirations, two of eleven positions established in the Covered Calls Advisor Portfolio (CCAP) were rolled up from their initial strike price to a higher strike price. This article shows the trade history and the results to date for those two holdings, which were FLR and HON.

1. FLR – Closed

Since FLR was trading above the $150 strike price at the close on Friday 10/19, one call was exercised and the 100 shares of FLR were called away at the strike price of $150. The trading history, including the roll up transaction, was as follows:
9/18/07 Initial Stock Position -- BTO 100 FLR @ $138.17
9/18/07 Initial Call Option -- STO 1 FLR Oct 140 @$4.90
10/2/07 Roll Up Transaction -- BTC 1 FLR Oct 140 @ $11.60
10/2/07 Roll Up Transaction -- STO 1 FLR Oct 150 @ $4.50
10/20/07 Option Exercised – STC 100 FLR @ $150.00

The performance results (including commissions) are as follows:
Stock Purchase Cost: $13,826.95 ($138.17*100+$9.95 commissions)
Option Income: -$249.85 ($490-$1160+$450-$29.85 commissions)
Capital Appreciation: $1,163.10 [($150.00*100-$9.95)-$13,826.95]
Net Profit: $913.25 ($1,163.10-$249.85)

ANNUALIZED RETURN ON INVESTMENT:
(913.25/13,862.95)*(365/32 days) = 75.1%

Two important observations here:
(a) This result demonstrates the advantage of rolling up to a higher strike price when the underlying stock has increased substantially in price. When the initial covered call position was taken in FLR Initial FLR position,the maximum annualized return on investment was 55.6%. By transacting the mid-month roll up, the overall annualized ROI achieved increased by 19.5 percentage points from 55.6% to 75.1%. Remember: It is this advisor's strategy to consider roll ups only when there is a potential increase of at least 15 percentage points in the annualized ROI. Of course, the ability to achieve this higher return is dependent on the underlying stock’s ability to retain its price increase and to close at or above the higher strike price on the expiration date. In the 2nd example presented below with HON, an increased return was not achieved since the stock closed well below the higher strike price.
(b) This FLR example also demonstrates that covered call writing does not have to be, as it is frequently and erroneously portrayed, solely an income producing strategy. To take full advantage of the profit making potential of covered calls, both income and capital appreciation factors should be analyzed as to their respective potential contributions to the overall ROI performance in the covered call decision-making process.

2. HON – Interim Position

Like Fluor, the initial Oct’07 covered call position in Honeywell was rolled up to a higher strike price during the past month. Unlike FLR, HON did not close in-the-money but rather out-of-the-money. The trading history, including the roll up transaction, to date is as follows:
9/10/07 Initial Stock Position -- BTO 500 HON @ 54.23
9/10/07 Initial Call Option -- STO 5 HON Oct07 55 Calls @ 1.80
9/26/07 Roll Up Transaction -- BTC 5 HON Oct 55s @ $4.70
9/26/07 Roll Up Transaction -- STO 5 HON Oct 60s @ $1.10
10/20/07 Oct’07 Option Expiration Date – HON closed at $58.32

The performance results to date (including commissions) are as follows:
Stock Purchase Cost: $27,124.95 ($54.23*500+$9.95 commissions)
Option Income: -$929.85 ($180*5-$470*5+$110*5-$29.85 commissions)
Capital Appreciation: $2,035.05 ($58.32*500-$27,124.95)
Net Profit: $1,105.20 ($2,035.05 - $929.85)

ANNUALIZED RETURN ON INVESTMENT:
(1,105.20/27,124.95)*(365/40 days) = 37.2%

Although an excellent annualized ROI of 37.2% has been achieved to date, the analysis performed when the initial position was established Initial HON position demonstrates that a greater result would have been achieved if the roll up had not been transacted. In that case, the Oct 55 option would have been exercised, the stock called away, and the annualized ROI achieved would have been 43.2%. But again, 37.2% is still great and a decision will be made during the next 2 days concerning whether on Monday morning to sell the HON stock; or retain the HON stock and sell Nov’07 options against it. Regardless of the decision, an article will be posted on Monday after the transaction is completed.

Regards and Godspeed

Roll Out -- Merck

With MRK at 53.79 this afternoon, the Covered Calls Advisor Portfolio Oct 50 position was in-the-money. It was decided to keep the MRK stock and roll out to a Nov 52.5 covered call position as follows:

Previously: Initial MRK Post
9/7/07 Bought 500 MRK @ 49.97
9/7/07 Sold 5 MRK Oct07 50 Calls @ 1.85
Today:
10/19/07 BTC 5 MRK Oct 50 @ $3.90
10/19/07 STO 5 MRK Oct 52.5 @ $2.40
Note: MRK stock was trading at $53.79 today when the roll out transaction was executed.

The result for the completed Oct 50 covered call position and the status on the newly established Nov 52.5 covered call position (including commissions) are each summarized below:

(a) Completed Covered Call Position:
Original Stock Investment 9/07/07 – Purchased 500 shares @ $49.97
= $49.97*500 + $9.95 commission = ($24,994.95)
Change in Stock Value ($53.79-$49.97)*500 = $1,910.00
Change in Options Value = Original Income of $911.30 ($1.85*500-$13.70 commission)minus Option Buyback Cost $1,963.70 ($3.90*500+$13.70 commission) = -$1,052.40 ($911.30-$1,963.70)
Overall Net Change ($1,910.00-$1,052.40) = $857.60
ANNUALIZED RETURN ON INVESTMENT:
(857.60/24,994.95)*(365/42 days) = 29.8%

(b) New Covered Call Position Established:
10/19/07 Retained 500 MRK at $53.79 = ($26,895)
10/19/07 Sold 5 NOV07 52.5 Calls @ $2.40 = $1,186.30 ($2.40*500-$13.70 commission)

Annualized Return If Unchanged (ARIU) 26.0%
Annualized Return If Exercised (ARIE) 26.0%
Downside Breakeven Protection 4.5%
Downside Maximum Return Protection 2.4% =[(53.79-52.50)/53.79]*100

Saturday, October 13, 2007

Special Situation: Capturing McDonald's Dividend

McDonald's is one of only a few domestic companies that pays an annual (not quarterly) dividend. A dividend of $1.50 per share goes ex-dividend on November 13, 2007.

The Covered Calls Advisor recommends considering taking a position in the nearest out-of-the-money (OTM) covered call for Nov'07. The stock closed Friday at $57.02 with the Nov 57.5 at $1.30 bid. At these prices, some key stats on a covered call position would be:
Annualized Return if Stock Price Unchanged (ARIU) = 54.3%
Annualized Return if Exercised (ARIE) =63.6%
Downside Breakeven Protection = 2.3% Note: Not great, but at .07% per day (2.3%/33 days) it exceeds this advisor's minimum threshold of .06% per day.
Overall, excellent return potential for a relatively low volatility stock.

Are you concerned about having the stock called away if the stock price is above $57.50 on or before Nov 12th if the holder of the option decides to exercise early to obtain the stock and capture the dividend?
Don't be! In that instance, we have still benefited from the capital appreciation and will have achieved a 40.7% annualized return.

You might want to wait until after McDonald's officially releases their 3rd quarter earnings this Friday, 10/19/07, although they just released preliminary earnings per share of $.83 which was $.05 above consensus estimates and revenue also exceeded expectations -- the stock reacted favorably to this news on Friday. If you decide to wait until after earnings release to take a position, the stock may have risen above the $57.50 strike price. That's OK -- in that case simply evaluate the possibility of selling the $60 strike price instead.

The Covered Calls Advisor Portfolio has not yet taken a position in McDonald's and may or may not ultimately do so. But I do intend to wait until after next Friday's official earnings release and re-evaluate at that time and then make a decision.

Regards and Godspeed,

A Tribute to Coach Wooden

Sunday, October 14, 2007 is the 97th birthday of Coach John Wooden. Coach has had a great influence on me despite the fact that I have never played basketball on his team or even met him face-to-face. Sure, I’m a basketball fan and his coaching accomplishments are legendary – in fact many consider him as the best coach of all time. But his greater influence to me is as a premier role model in his beliefs and personal character.

During the summer after my sophomore year in high school, I attended the week-long Pocono Mountain Basketball Camp in Pennsylvania. The highlight of that experience was the appearance of Coach Wooden after dinner Friday night and the talk he gave to us on his ‘Pyramid of Success’. He has long defined success by saying: “Success is peace of mind which is a direct result of self-satisfaction in knowing you made the effort to do the best of which you are capable." He explained the pyramid to us in some detail that evening; and yes, he described how it related to playing basketball. But the primary focus of the pyramid really had little to do with basketball, but everything to do with how to live our lives. Even to this day, I have a framed ‘Pyramid of Success’ as signed by ‘John Wooden’ as the sole item hanging in front of me above my computer desk.

McDonald’s has developed a website dedicated to Coach Wooden as a tribute to him. I sincerely hope you will spend 15 or 20 minutes there. I especially recommend you spend time in the links for The Pyramid of Success and also Favorite Maxims (especially his Seven Point Creed). Enjoy:
Coach Wooden link

Since this site is devoted to covered calls investing, I’ve developed the following as a personal tribute to Coach:

Stock Selection is the foundation.The diversification triumverate of asset allocation, sector diversification, and position sizing is at the central core. Covered call position selection is at the pinnacle. These components act together to enable success for the covered calls investor.



Making the effort to do the best of which I am capable,

Regards and Godspeed

Friday, October 12, 2007

Reminder: Begin Writing Your Monthly Themes

A prior post (Investing Themes link) presented a case to encourage every covered call investor to develop a written list of his/her investing ‘themes’ that would help to provide overall guidance in making stock selection decisions, and to do so during the week prior to options expiration each month. Therefore, the time to begin with a first draft of your current investing themes is NOW. Don’t expect your first draft to be a finely crafted list. Remember, it’s only a first draft (a rough draft) of those investing themes that you want to emphasize for your portfolio holdings in the near-term future. If you write your first draft sometime during this weekend (Note: you might want to plan to write your first draft during the weekend prior to options expiration Friday every month), then you can spend a few minutes from time to time during the remainder of this upcoming week thinking about, modifying, and fine tuning your themes.

To assist you in initiating the process of writing down your investing themes monthly, the current themes of the Covered Calls Advisor are presented below. You are welcome to use them as a guideline for developing your own themes. But please, whatever your themes are, write them down! Trust me – don’t take a shortcut here and simply think about your themes. Again, write them down! As the months go by, you’ll be pleasantly surprised at how much the process of committing your ideas to paper will help you to clarify your thinking when it comes to making your stock selection decisions.

The Covered Calls Advisors current investing themes are:
1. Sector Weightings:
· Overweight – Health Care; Industrials; Technology
· Marketweight – Materials; Energy; Consumer Staples; Telecom
· Underweight – Consumer Discretionary; Finance; Utilities
2. Emphasize large-cap companies.
3. Emphasize domestic companies that have a large international exposure.
4. Overweight international equities – especially big Europe (i.e. United Kingdom, Germany and France); South Korea; and Taiwan.
5. Emphasize companies whose exposure to high energy and other commodity costs is minimal.
6. Mitigate risk caused by the slowdown in the U.S. economy. Identify companies with more defensively-oriented characteristics (such as health care) and that are less dependent on increases in consumer spending.

The time is now! Get that pen and paper (or turn on your Microsoft Word program) and begin to write your first draft of your own current investing themes.

Regards and Godspeed


Thursday, October 11, 2007

Keep or Sell?

Expiration Friday for October is now exactly one week away. Let’s consider the following question: How should we decide which stocks currently owned in our covered calls portfolio should be kept and which ones should be sold? This article describes the decision-making process used by the Covered Calls Advisor to answer this question.

While the decision to sell an existing underlying stock can of course be made at any time, the overwhelming majority of the keep or sell decisions made by us covered call investors are normally made near the monthly options expiration dates. The easiest approach to the keep or sell decision faced by us covered call investors as an expiration Friday approaches is to simply do nothing. And unfortunately, since it is the easiest approach, it is too often the approach used by many covered call investors. With this approach, the following will automatically occur:
1. Almost all in-the-money (ITM) positions will be called away (a.k.a. ‘assigned’ or ‘exercised’) and the underlying stock will be sold for the strike price value; and
2. For all out-of-the-money (OTM) positions, the options will expire worthless and the underlying stock is retained in the portfolio.

This do-nothing approach is absolutely NOT the technique recommended by this advisor. It definitely flies in the face of good common sense when you think about it, since the end result of this do-nothing approach is that those stocks are sold which have actually been the strongest performers in the portfolio (the winners if you will); and those stocks that have been the weakest performers (i.e. the losers) are the ones that are retained. This is exactly the opposite of what we would normally be inclined to do if we simply owned the stocks and were not facing an imminent options expiration date.

Since the result of this do-nothing approach is inherently counterintuitive and clearly undesirable, then what does constitute a desirable approach? First, plan to evaluate each and every stock in the portfolio to make an assessment of whether to keep or sell that stock, based on an objective set of pre-defined criteria. For the Covered Calls Advisor, the keep or sell decision-making process is as follows:
1. During the week prior to expiration each month, make a list of all covered call stocks that have options written against them for that particular month.
2. Plan to sell (either on expiration Friday or early the following Monday) those stocks for which any one of the following criteria is met:
· The stock rating as provided by either of the two stock advisory services you follow has been reduced below a ‘buy’ rating; or
· The consensus analysts’ future earnings estimates (see Reuters Research) for the company have been reduced since the stock was initially purchased; or
· There is an earnings release scheduled between this month’s expiration date and prior to next month’s options expiration date; or
· The annualized return if unchanged % (ARIU) for establishing next month’s covered call position does not meet or exceed a 25%+ threshold.
3. Process any transactions necessary in order to: (a) keep those stocks for writing additional covered calls for the next month that meet all criteria listed in #2 above; and (b) sell those stocks that fail to meet any one of the criteria listed in #2 above.

The requirements listed in #2 above are very restrictive – so much so that it has been this advisor’s experience that it is not uncommon for only 20% to 25% of stocks to be retained from one expiration month to the next. But don’t be concerned about the relatively high turnover – over a period of time you’ll see that it is actually quite preferable to other alternatives.

So how does this approach apply to the eleven positions currently in the Covered Calls Advisor Portfolio? As of right now, only two of these stocks (BMC and TRV) have earnings releases scheduled for the period between October expiration (10/22/07) and November expiration (11/17/07) and so they will definitely be eliminated from the ongoing CCAP. However, all eleven positions will be re-evaluated next Friday (on the expiration date itself) to make the final keep or sell decision based on using all four of the analysis criteria for each stock owned.

Regards and Godspeed

Wednesday, October 10, 2007

Using ONLY Annualized Return on Investment %

Let me state my position on this topic as directly and forcefully as I can: "When evaluating the return on any potential investment (and that definitely includes all potential covered call investments), always calculate the annualized ROI %."
For covered call investments, the formula for calculating the annualized return on investment if the stock price is unchanged at expiration compared with its price when the covered call position was established (annualized return if unchanged; or ARIU) is:
ARIU= ($ option premium/$ original investment)*(365 days/# days until expiration)*100
For example, American Express(AXP) closed today at $61.89. If we purchased 100 shares at $61.89 and sold 1 NOV'07 62.5 call at its bid price of $2.00, the corresponding annualized ROI % calculation (excluding commissions) would be:
ARIU = ($200/$6189)*(365/37)*100 = 31.9%

The importance of always calculating the annualized ROI % cannot be over-emphasized. In short, it is the only way an investment return should be considered in relation to its potential as an investment. In addition to its usefulness in evaluating potential positions, it is also the method by which any investment return result should be measured; both when an existing position is finished as well as for some specified duration of time, such as at the end of each month. Some of you are now thinking 'Yes, of course. Why does he even need to spend the time to emphasize such a fundamental principle?' -- and if you already use this approach, then good for you. However, this advisor has simply seen far to many instances when financial analysts and investors have used other measures (i.e. different than annualized ROI %) to analyze investment returns; and erroneous measures often and readily lead to erroneous conclusions regarding which covered call investment alternative provides the highest return.

Two examples of incorrect, but frequently used approaches by investors in looking at the relative attractiveness of the returns on potential investments are: '$ returns' and '% absolute returns'. Unfortunately, many investors focus on one or both of these measures while totally neglecting the preferred measure of annualized ROI %. The chart below presents these three return measures for evaluating AXP covered call choices for the 62.5 strike price and for four different expiration months (Oct'07, Nov'07, Jan'08, and Apr'08).



In looking at the chart, which of the four expiration months provides the highest return? If you said "October 07", then congratulations!
But let's explore this a little further. As an example, if Investor A is primarily interested simply in $s returned, then the $490 for the Apr'08 covered call seems like the best alternative. If Investor B is somewhat more savvy than Investor A and calculates a ROI %, but calculates simply the absolute ROI % ($ option premium)/$ original investment), then the 7.9% return for the Apr'08 covered call would again seem to be the best choice.

The misguided approach used by both Investor A and Investor B will invariably lead them to the wrong selection if one of their primary objectives is to maximize the return on their investment. The Oct'07 covered call annualized return of 49.1% actually provides the highest return opportunity of the four expiration months analyzed in this example. The essential fact is that always calculating the annualized ROI % is the best method for providing an apples-to-apples comparison of investment alternatives with varying time horizons. I feel fortunate for having gained an appreciation for this approach many years ago from an excellent Engineering Economics professor in a course taken during my sophomore year at N.C. State -- it has benefited me greatly throughout both my professional and investing careers.

So, do you agree that you should always calculate the annualized ROI %?
I know, some of you are now saying "yeah, I agree with that; but a complete analysis of a potential covered call position must consider more than simply which alternative will provide the highest annualized ROI %!"
My response to that is "Yes. Absolutely! But analyzing the potential return on any investment is critically important (Job #1 so to speak); so using the correct analytical approach is key."
You might add: "What about investing safety, such as how much downside protection I should obtain? And don't the longer-term expirations usually provide more downside protection?"
My answer to that would be "sometimes yes and sometimes no".
But that's a topic for a later date.

Regards and Godspeed

Sunday, October 7, 2007

U.S. Market Meter Changes From Slightly Bullish to Bullish

The Covered Calls Advisor conducts weekly reviews of the five key metrics used to determine its U.S. Market Meter Indicator. The Meter was initiated on September 11, 2007 with a 'Slightly Bullish' reading. Today the indicator has been upgraded from Slightly Bullish to Bullish.

The five metrics were described in detail in a Sept 11 post -- Link.
The current readings for the five metrics are:
1. Earnings and Bond Yield Spread:
5.52%-4.64%=+.88% is Slightly Bullish.
2. Inflation: 2.1% is Bullish.
3. Current Versus Expected P/E Ratio:
(20.0-18.12)/18.12=+10.4% is Slightly Bullish.
4. Price Momentum:
(903.36-817.20)/817.20=+10.5% is Bullish.
5. Covered Calls Advisor's Gut Feel: Bullish.

Three bullish and two slightly bullish indicators. Hence, the overall weighting has shifted to a bullish outlook, which is now reflected on the 'U.S. Market Meter' Indicator at the top of the right-hand column of this blog. The meter also states the recommended investing strategy for this assessment: "The Covered Calls Advisor says: The Current Overall Stock Market Outlook is: BULLISH. The Corresponding Investing Strategy is: SELL MODERATELY OUT-OF-THE-MONEY COVERED CALLS."

By 'moderately out-of-the-money', this advisor means that the covered call positions in a portfolio of near-month covered calls should now be established on-average between 1.5% and 3.0% below the strike price.

Since this advisor's gut feeling was the deciding factor in determining that the overall rating would now change to bullish, a short explanation of this bullish gut feeling is appropriate. Previously, this advisor stated that the primary factor preventing a bullish gut feeling sentiment was "investors' discomfort regarding the current decline in the rate of economic growth and, more specifically, whether a recession can be avoided and the desired soft-landing achieved." Since that concern, the Fed made their .5% reduction and thereby demonstrated to this observer that they are committed to providing sufficient liquidity as necessary to minimize the probability of a U.S. recession. Historic studies have repeatedly demonstrated that the stock market is bullish during the first six months after an initial Fed rate cut if a recession is, in fact, avoided. This outcome now seems likely.

In addition, it is noted that we are currently in a bull market that began on 10/9/02 and in which we have so far had a 100.5% increase as measured by the S&P 500. (Note: A bull market is defined as a rally exceeding +20% after a period of a 20+% decline).

Prior to this one, there have been five bull markets since 1970. This advisor analyzed the Earnings Yield to Bond Yield Spread at the end of each of these bull markets and discovered that these bull markets did not end until the Earnings Yield was more than 1% lower than the 10-Yr Treasury Bond Yield. In fact, the actual yield differences at the end of these five bull markets were -1.29%, -2.06%, -4.27%, -3.24%, and -1.39%. In comparison, as shown in #1 above, the current yield spread is +.88%. In this advisor's opinion, this bodes well for the likelihood of a continuation of the current bull market.

Regards and Godspeed

Saturday, October 6, 2007

The Answer Is: Between 7 and 25

So then: What is the Question?
Perhaps you might think the question is: How many different jobs am I likely to have in my lifetime? Or how about: How many houses will I look at before I buy one? These are both questions that could reasonably precede the answer "between 7 and 25". However, the question the Covered Calls Advisor is looking for is: How many covered call positions should I have in my portfolio?

This advisor intends to maintain between 7 and 25 covered call positions in the Covered Calls Advisor Portfolio (CCAP). It is recommended that you also consider the advantages of maintaining between 7 and 25 positions in your own portfolio.

To specify why 7 to 25 is the recommended range, let’s consider two questions:
(1) What are the fewest number of covered call positions I should own?; and
(2) What are the largest number of covered call positions I should own?

The first question above is one that I often receive. On the one hand, people usually want to be adequately diversified, but on the other hand they have limited resources to invest. Although there are some very successful investors that do not practice diversification (for example Warren Buffett and Ken Heebner), the overwhelming majority of successful investors and financial advisors do recommend diversification, as do I. So the first question really becomes: What are the fewest number of covered call positions needed to be adequately diversified?

There are three primary components related to diversification: Asset Allocation, Sector Diversification, and Position Sizing -- Each of these will be discussed in greater depth in future postings. For now, this advisor will simply present my own guidelines for diversification:
(a) Asset Allocation
Domestic Equities – 70% (roughly 40% large cap and 30% mid/small cap)
International Equities – 25%
Fixed Income – 0%
Cash – 5%
Note: This advisor maintains an aggressive investing approach. You might be more conservative in your own portfolio with a lower percentage of equities and a higher percentage of fixed income and cash.
(b) Sector Diversification - Invest in at least five of the six sectors listed below:
Consumer (includes both Consumer Staples and Consumer Discretionary)
Energy (including Materials)
Financial
Health Care
Industrial (including Telecom and Utilities)
Information Technology
(c) Position Sizing – No single position more than 20% of total. This is the same guideline used by this advisor’s broker, Charles Schwab & Co.

So again, what is the recommended minimum number of positions?
To diversify across all sectors shown above, a minimum of six positions would need to be established. And to achieve a 25% allocation in international, without exceeding the maximum 20% position size for each position, a minimum of two international positions would be required for a total of 8 covered call positions. The Covered Calls Advisor recommends that you be invested in at least 5 of the 6 sectors listed above at all times. So although not recommended, it is acceptable to not be invested in one of the six sectors at any given time if you feel strongly that a particular sector will under-perform the others in the near future. Therefore, the recommended minimum is 7 positions (5 different sectors plus 2 international). This can be achieved while still honoring the max 20% limit for any single position).

The second question above is as important as the first:
What is the maximum number of positions I should own? The short answer is: ‘no more than you can continually monitor without feeling overburdened by the research and recordkeeping’. The second part of this statement, ‘without feeling overburdened by the research and recordkeeping’, is the most important. To be a successful investor in the long-run, which is our primary objective, we need to feel both mentally stimulated as well as to receive enjoyment from the research we are undertaking; but without feeling burdened by it.

Now for the first part, ‘no more than you can continually monitor’. What does ‘continually monitor’ mean? There are four primary aspects to ‘continually monitoring’ a portfolio:
(a) Read all news on the companies – Preferably daily, but at least once a week.
(b) Monitor prices – Preferably daily, but at least weekly.
(c) Listen to earnings conference calls – Quarterly.
(d) Maintain a good understanding of all positions currently held in your portfolio – That is, you should be able to name every equity held in your portfolio from memory without having to look them up; and be able to provide a clear and concise rationale for each position (4 to 6 sentences) as to why it is now a good covered call investment opportunity.

For this advisor, 25 is the upper limit for being able to perform all four of the ‘monitoring’ tasks above and also ‘without feeling overburdened’. However, while 25 is the max for this advisor, it can also be stated that my most common range is from 10 to 20 total covered call positions at any given time. That is my ‘comfort zone’ so to speak; that is, where I feel I am achieving both very good diversification while simultaneously maintaining a good handle on key information about each of the companies -- and most importantly, really enjoying the whole process! The max number for you might be different; perhaps 10, or 20, or even 30 – and that’s fine! Find your own personal ‘comfort zone’.

Regards and Godspeed

Wednesday, October 3, 2007

Defining Two Important Covered Call Terms

In a previous post (’Ten Factors’ link), ten factors were identified that are used by this Covered Calls Advisor to analyze potential covered call positions for investment worthiness. Of these ten however, two primary factors were identified as being particularly important to us covered call investors:
1. Annualized Return-On-Investment(ROI) %
2. Downside Breakeven Protection %

To understand these two terms, we will first describe and show the formulas for how they are calculated. Then we will further clarify ‘how-to’ calculate them by performing the calculations using a specific example (Hewlett Packard).

1. Annualized ROI % - Two percentages are calculated here that are relevant to the covered call selection process:
(a) Annualized Return If Unchanged (ARIU) – more fully described as the annualized return-on-investment % if the stock price is unchanged at expiration compared with its current price. The formula is:

ARIU= ($ option premium/$ original investment)*(365 days/# days until expiration)*100

(b) Annualized Return If Exercised (ARIE) – more fully described as the annualized return-on-investment % if the stock price is above the option strike price at expiration and is therefore exercised (Note: other synonymous terms for ‘exercised’ are ‘assigned’ and ‘called’). This is the best-case scenario wherein the maximum return potential for the covered call position is achieved. The HPQ example below shows that the percentages for ARIU and ARIE are identical for a covered call position that is in-the-money (ITM) when originally established. However, the ARIE percentage will be higher than the ARIU if the stock is out-of-the-money (OTM) when the covered call position is established. In this OTM instance, the formula is:

ARIE = [((option strike price – current stock price + option bid price)/current stock price)*(365 / # days until expiration)]*100

2. Downside Breakeven Protection (DBP) % -- This measure shows what % the current stock price would have to fall by the expiration date to reach a breakeven point (i.e. $0 profit and $0 loss) on the total covered call position. The formula is simply:

DBP=($ option premium/$ stock price)*100

Note: Commissions should normally be included in the calculations above, but are excluded here to make the formulas somewhat easier to understand.

Now we’ll use a specific option chain for Hewlett Packard (HPQ) to show how the calculations are made in a specific circumstance. The pertinent information for the two closest strike prices are:

Hewlett Packard(HPQ) Current Price = $50.42
Oct07 50 Bid Price = $1.65
Oct07 52.5 Bid Price = $.40

Example 1: Sell In-the-Money (ITM) Covered Call:
On 10/3/07: Buy 100 HPQ @ $50.42 = $5,042
Sell to Open (STO) 1 Oct 50 @ $1.65 = $165

ARIU = +52.4% = [($165-($5,042-$5,000))/$5,042]*(365/17 days)
ARIE = +52.4% -- Same as ARIU since ITM
DBP = (1.65/50.42)*100 = 3.3%


Example 2: Sell Out-of-the-Money (OTM) Covered Call:
On 10/3/07: Buy 100 HPQ @ $50.42 = $5,042
Sell to Open (STO) 1 Oct 52.5 @ $.40 = $40

ARIU = +17.0% = ($40/$5,042)*365/17 days)*100
ARIE = +105.5% = ((52.5-50.42+.40)/50.42)*365/17 days)*100
DBP = (.40/50.42)*100 = 0.8%

Notice the inverse relationship between these two key factors – annualized ROI % and downside breakeven protection %. When both factors are considered together, they demonstrate the essence of the risk-reward principle. That is, in order to achieve greater potential reward (17.0% and 105.5% in example #2 above), we need to be willing to accept greater risk (i.e. less downside breakeven protection; only 0.8% in example #2 above). Conversely, we can achieve less risk (for example 3.3% downside breakeven protection in example #1 above) but with less maximum potential reward (+52.4% in example #1 above). Ultimately, each of us covered call investors must find our own personal risk/reward comfort level and make our covered call investment decisions accordingly.

For this covered calls advisor, a minimum threshold of +30.0% ARIU and >.06% per-day DBP is required. Example #1 above exceeds these criteria (52.4% ARIU and .19% (3.3%/17 days) per-day DBP; so this position would be a viable candidate for further analysis as a possible covered call investment (remember, this advisor analyzes eight additional factors before determining whether a particular covered call position is a buy). In Example #2 above, the covered call position does not meet the minimum threshold criteria and therefore would not be given additional consideration. As implied earlier, your thresholds might be different from that of the Covered Calls Advisor since they are dependent on your own personal risk tolerance. If you’re more cautious, then your ARIU minimum would be lower and your DBP threshold higher. Conversely, if you are more risk tolerant you might have a somewhat higher ARIU minimum but with an accompanying DBP threshold even lower than this advisor’s .06% per-day minimum.

These concepts might be somewhat confusing at this moment, but please persevere. If necessary, re-read the article above to gain a better understanding of its contents; or click on the ‘Comment’ link below to provide a specific comment or ask a question.

Regards and Godspeed

Tuesday, October 2, 2007

Roll Up Adjustment -- Fluor

The Covered Calls Advisor Portfolio (CCAP) covered call position in Fluor (FLR) was rolled up today (10/02/07) from the Oct 140 to the Oct 150. A good-til-cancelled debit limit roll up order was placed at $7.10, and was executed as follows:

Buy-to-Close (BTC) FLR Oct 140 @ $11.60
Sell-to-Open (STO) FLR Oct 150 @ $4.50
Net Debit on Roll Up $7.10

The ‘net debit to strike price difference ratio’ was 71% [$7.10/($150-$140)], which meets this advisor’s threshold of rolling up only if the ratio is <75%.

A summary of the FLR transactions so far is as follows:
Previously: Initial FLR post
9/18/07 BTO 100 FLR @ $138.17
9/18/07 STO 1 FLR Oct 140 @$4.90
Today:
10/2/07 BTC 1 FLR Oct 140 @ $11.60
10/2/07 STO 1 FLR Oct 150 @ $4.50
Note: FLR stock was trading at $150.16 today when the roll up transaction was executed.

The result for the completed Oct 140 covered call position and the status on the newly established Oct 150 covered call position (including commissions) are each summarized below:

(a) Completed Covered Call Position:
Original Stock Investment 9/18/07 – Purchased 100 shares @ $138.17
= $138.17*100 + $9.95 commission = ($13,826.95)
Change in Stock Value ($150.16-$138.17)*100 = $1,199.00
Change in Options Value = Original Income of $478.30($4.90*100-$10.70 commission)minus Option Buyback Cost $1,170.70($11.60*100+$10.70 commission) = -$692.40 ($478.30-$1,170.70)
Net Change ($1,199.00-$692.40) = $506.60
ANNUALIZED RETURN ON INVESTMENT:
(506.60/13,826.95)*(365/14 days) = 95.5%

(b) New Covered Call Position Established:
10/02/07 Retained 100 FLR at $150.16 = ($15,016)
10/02/07 Sold 1 OCT07 150 Call @ $4.50 = $439.30 ($4.50*100-$10.70 commission)

Annualized Return If Unchanged (ARIU) 58.6%
Annualized Return If Exercised (ARIE) 58.6%
Downside Breakeven Protection 3.0%

In the prior post on this blog titled ‘Rockin’ and Rollin’ – When to ‘Roll Up’ a Covered Call Position’, a specific methodology (more detailed than the ‘net debit to strike price difference’ method is provided for comparison purposes on two possible roll up decision alternatives: (1) maintain the existing position and do nothing; or (2) roll up to a higher strike price. Here’s an excerpt from that post as it pertains to the present Fluor holding:

Here’s the key: Analyze the two option position alternatives as if you don’t already have a short options position.Given that you already own 100 shares of FLR now valued at $150.16, would you prefer for the time period between now (10/02/07) and October expiration (10/20/07) to sell 1 Oct 140 option (priced at $11.60 on 10/02/07) or 1 Oct 150 option (priced at $4.50 on 10/02/07)? The primary factors for the two alternatives are as follows:
(1) Keep the covered call Oct 140 position for the remaining 18 days until October expiration:
Annualized Return If Unchanged (ARIU) = 19.4%
Annualized Return If Exercised (ARIE) = 19.4%
Downside Breakeven Protection = 7.7%
(2) Switch to a covered call Oct 150 position for the remaining 18 days until October expiration:
Annualized Return If Unchanged (ARIU) = 58.6%
Annualized Return If Exercised (ARIE) = 58.6%
Downside Breakeven Protection = 3.0%

As also described in the prior blog post, this advisor’s own personal guideline is to roll up to the higher strike price if two conditions are met: (1) The ARIU is more than 15% greater for the new position [in this case it was 39.2% higher (58.6%-19.4%)]; and (2) The per-day downside protection is >.06% [in this case it was .17% (3.0%/18 days until expiration)]. Since both criteria were met, the decision was made to roll up the covered call position.