Rockin' and Rollin' -- When to 'Roll Up' a Covered Call Position

Once a covered call position is established, one approach to managing that position is to simply “do nothing” until the expiration date. At expiration, one of two possible events occurs: (1) The stock price is above the option’s strike price (in-the-money) and the stock is ‘called away’ or ‘assigned’ (i.e. sold); or (2) the stock price is below the strike price, so the option ‘expires’ worthless and the stock position is retained. A ‘do nothing’ approach is often the best method for a covered call position and is normally an appropriate decision for the majority of covered call positions. However, there are some circumstances when it is preferable to manage (i.e. modify) the position before the expiration date. This modification is an opportunity to further enhance the potential return on investment that would otherwise be achieved by simply holding the initial position until expiration.

First, let’s make sure we have a common understanding of exactly what a roll up is. Paul Kadavy gives a nice explanation in his book ‘Covered Call Writing With ETFs’ where he describes the process of rolling up: “to buy back the first call options and then write new calls with a higher strike price.” I would add a short phrase at the end of that definition, namely ‘with the same expiration month’.

Before examining a specific example of a roll up, let’s mention some other examples of covered calls position management before expiration. This will help us to understand the the roll up within a broader context of the numerous position management (prior to expiration) alternatives. On page 70 of ‘New Insights on Covered Call Writing’ by Lehman and McMillan, they succinctly define the relevant terms:
“Rolling: The process of closing the short call position in a covered write and opening (substituting) a different covered call position on the same stock.
Rolling Up: Substituting a call with a higher strike price.
Rolling Down: Substituting a call with a lower strike price.
Rolling Out: Substituting a call with a more distant expiration.”
An additional example would be ‘rolling up and out’, which would be the combination of simultaneously ‘rolling up’ and ‘rolling out’ -- for example, ‘rolling up and out’ from the XYZ Oct07 50s to the XYZ Nov07 55s. We will discuss these position management techniques in the future. For now, we will analyze only the rolling up case.

Let’s consider the Honeywell roll up done in the Covered Calls Advisor Portfolio as summarized in the previous post on this blog. In short, 500 shares of Honeywell (HON) were purchased on 9/10/07 at $54.23 and 5 Oct07 55 calls were sold at $1.80. When this covered call position was rolled up on 9/26/07, the stock had risen to $59.26 and the option to $4.70. Now the key question is: Should the existing position be kept until expiration or should it be rolled up to a higher strike price?

How should we analyze this decision? The key to understanding the answer is in the concept referred to as a ‘sunk cost’. A sunk cost is simply a cost that has already been incurred. It’s past. It’s history. So let’s consider our choices in the context of the HON example. First, disregard what happened between the time we initiated the covered call on 9/10/07 and today (we’ll pretend it’s now 9/26/07 for this example). The 68.5% annualized return achieved in the HON cc between 9/10 and 9/26 is now history; it’s a sunk cost (albeit a very profitable one). Nevertheless, what has already happened is meaningless in analyzing what we should do today (9/26) going forward.
Let’s compare two alternatives: (1) Do nothing. Keep the 500 HON shares and keep the 5 short Oct07 55s; or (2) Roll up. Keep the 500 HON shares and substitute 5 short Oct07 60 calls for the current 5 short Oct07 55 calls.
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 500 shares of HON at $59.26, would you prefer for the time period between now (9/26/07) and October expiration (10/20/07) to sell 5 Oct 55 options (priced at $4.70 on 9/26/07) or 5 Oct 60 options (priced at $1.10 on 9/26/07)? The primary factors for the two alternatives are as follows:
(1) For the Oct 55s:
Annualized Return If Unchanged (ARIU) = 11.3%
Annualized Return If Exercised (ARIE) = 11.3%
Downside Breakeven Protection = 7.9%
(2) For the Oct 60s:
Annualized Return If Unchanged (ARIU) = 28.2%
Annualized Return If Exercised (ARIE) = 47.2%
Downside Breakeven Protection = 1.9%
So which do you prefer? 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 16.9% higher (28.2%-11.3%)]; and (2) The per-day downside protection is >.06% [in this case it was .08% (1.9%/24 days until expiration)].
Your own criteria for an advantageous roll up might well be different than the 15% and .06% per day thresholds used by the Covered Calls Advisor.

Or perhaps your eyes are glazing over right now. You would really prefer an easier-to-apply guideline on when to roll up. If that is the case, I’d suggest using the ‘net debit to strike difference ratio’ as explained in the previous post on the HON roll up. There the guideline is: Roll up only if the ‘net debit to strike difference ratio’ is <75%. This analytical approach is definitely much less cumbersome than the more detailed approach described above, but it can be used with confidence since the resulting decision will be very comparable to that achieved by the more detailed method.

So, don’t be a ‘do nothing’. Start ‘Rockin and Rollin’ !!

Regards and Godspeed

Roll Up Adjustment -- Honeywell

The Covered Calls Advisor Portfolio (CCAP) covered call position in Honeywell(HON) was rolled up today (9/26/07) from the Oct 55s to the Oct 60s. A good-til-cancelled debit limit roll up order was placed at $3.60, and was executed as follows:

Buy-to-Close (BTC) 5 HON Oct 55s @ $4.70
Sell-to-Open (STO) 5 HON Oct 60s @ $1.10
Net Debit on Roll Up $3.60

The ‘net debit to strike price difference ratio’ was 72% [$3.60/($60-$55)], which meets this advisor’s threshold of rolling up only if the ratio is <75%.

A summary of the HON transactions so far is as follows:
Previously: Initial HON post
9/10/07 BTO 500 HON @ $54.23
9/10/07 STO 5 HON Oct 55s @$1.80
Today:
9/26/07 BTC 5 HON Oct 55s @ $4.70
9/26/07 STO 5 HON Oct 60s @ $1.10
Note: HON stock was trading at $59.26 today when the roll up transaction was executed.

The result for the completed Oct 55 covered call position and the status on the newly established Oct 60 covered call position (including commissions) are each summarized below:

(a) Completed Covered Call Position:
Original Stock Investment 9/10/07 – Purchased 500 shares @ $54.23 = ($27,124.95)
Change in Stock Value ($59.26-$54.23)*500 = $2,515.00
Change in Options Value ($913.70-$2,363.70) = -$1,450.00
Net Change ($2,515.00-$1,450.00) = $1,065.00
ANNUALIZED RETURN ON INVESTMENT:
(1,065.00/27,124.95)*(365/14 days) = 102.4%

(b) New Covered Call Position Established:
9/26/07 Retained 500 HON at $59.26 = ($29,630)
9/26/07 Sold 5 OCT07 60 Calls @ $1.10 = $564.95

Annualized Return If Unchanged (ARIU) 28.2%
Annualized Return If Exercised (ARIE) 47.2%
Downside Breakeven Protection 1.9%

Ten Factors to Consider when Analyzing a Potential Covered Call Investment

Too often we are prone to ask just two questions when we are analyzing a potential covered call (cc) position, namely:
1. Does it meet my minimum 'annualized return-on-investment %' threshold?
2. Does it provide adequate 'downside breakeven % protection'?

These questions are excellent to ask, but they should not be the sole factors considered when deciding whether or not to establish a particular covered call position.

For this advisor, the desired thresholds for these two factors are:
(1) >30% annualized return if the stock price is unchanged (ARIU) from its original purchase price; and
(2) >2.5% breakeven downside protection for near-month covered call positions.
Your own personal thresholds will likely differ from these, and that is fine; each investor will have his/her own risk tolerance level. Some investors are comfortable investing to achieve a somewhat lower return rate in order to obtain greater safety; while others seek higher returns and are willing to accept greater risk. That's all well and good. But regardless of your own personal risk/reward profile, it is essential that you consciously decide what your own risk level is; then, and only then, you should establish your personal thresholds for these two primary measures.

If we could only use two factors when analyzing potential covered call positions for investment, the two mentioned above would definitely be the ones to select. Fortunately however, there is no law that requires a limit of only two. These two should really serve only as the starting point in a total analysis of which specific covered call positions are worthy of a commitment of funds. Once it is determined that a particular cc option position meets the two basic thresholds, then this advisor suggests using eight additional factors to evaluate the relative value of a particular cc investment.

The eight additional factors considered by this covered calls advisor include:
1. Safety -- Downside protection is certainly one measure of safety, but there are others to consider. They include: days until expiration; days until next earnings release; the stock's historic volatility; dividend yield; financial liquidity as measured by the 'current ratio'; and financial leverage as measured by the 'debt/equity ratio'.
2. Profitability -- Two measures are determined here: free cash flow return on invested capital; and return on equity.
3. Stock Advisory Service's Ratings -- What is the overall rating of the company from the viewpoint of the two stock advisory services whose stock selection advice you prefer?
4. Value -- After the two primary factors (annualized ROI and breakeven downside protection), a particular company's valuation characteristics is the next most highly-weighted factor in this advisor's evaluation process. The measures used here include: volatility ratio (option's implied volatility divided by the stock's historic volatility); industry rating; price/earnings ratio; price/cash flow ratio; return on equity trend; and price/sales ratio.
5. Growth -- Three measures are used: price/earnings future growth rate; sustainable growth rate; and year-over-year cash flow per share growth.
6. Momentum -- Based on three measures of: stock price momentum; analysts' earnings estimates changes; and earnings surprises.
7. Management -- Currently uses the 'corporate governance quotients' both in comparison with its own industry and in comparison with all other companies.
8. Options Liquidity -- To ensure that there is adequate options liquidity to transact the option trades at a fair price. The option's 'open interest' as well as the bid/asked spreads are considered here.

Upon first reading, it is likely that these ten factors and all their related sub-factors will seem somewhat overwhelming. Well they are, at least for now. But over time, in-depth explanations of each of these items will be provided here. And as we are able to explore each of these factors more fully, their usefulness as an important part of developing and managing your own successful covered calls investing program will be demonstrated.
Looking forward to this journey with you.

Regards and Godspeed

Run With Nike

They say ‘sometimes it’s better to be lucky than good.’ That is certainly the case with my current Covered Calls Advisor Portfolio (CCAP) position in Nike.

After the market closed yesterday (Thursday), Nike announced 1st quarter ’08 earnings and they were awesome. Both top line (revenue) and bottom line (earnings) exceeded Wall Street expectations with revenue 11% above last year and earnings up 24%. Earnings were actually up by 51% when including a one-time tax benefit.

So why do I say ‘lucky’? Well, the truth of the matter is that I didn’t follow my own preferred method. I like to write near-month covered calls on companies that do not report earnings during that month -- I’ll explain the reasons why I prefer this method in detail in a post on this site at a later date. But for now suffice it to say that if I had focused on the fact that Nike was releasing their earnings prior to the Oct ’07 expiration date, then I would not have established the Nike position in the first place. So again, as they say: ‘Sometimes it’s better to be lucky than good.’

As I write this at Noon (Eastern Standard Time) on Friday, the market seems to have greeted this news in a positive, although somewhat muted way. The overall market, as measured by the Russell 3000, is up by .6% today while NKE is up 1.2% to $59.00. I’ll be considering the possibility of rolling up my Oct 55 call to either Oct 57.5 or Oct 60, but I will wait until Monday or Tuesday of next week to decide, which will allow a little more time for investors to more fully digest the earnings report and for the stock to reach a more normalized post-earnings level before deciding on the best action, if any, to take.

Further encouragement to us Nike investors was seen in the newly-presented objective stated by CEO Mark Parker on the conference call: ‘$23 billion in annual revenue by 2011’. From the $16.3 billion achieved in fiscal 2007, this would be a 9.0% compounded annual increase in revenues, which is consistent with, but also more specific than the previously stated objective of ‘high single-digit growth in revenue’. The increasing specificity by the CEO as well as the fact that he is willing to announce publicly a long-range target are both positive signs – first, in his confidence in the company’s ability to continue and accelerate their growth; and second, his willingness to set a long-range (2011) performance target. These types of actions by a CEO are very encouraging signs for us investors. Yet another encouraging sign was the recent blockbuster opening of Nike’s first store in Beijing, which initiates their China roll out plans. Also, the timing couldn’t be more fortuitous since we are now less than 1 year from the 2008 Summer Olympics in Beijing, a tremendous worldwide showcase for Nike footwear and apparel. It will take years for Nike to establish similar brand recognition and loyalty worldwide like they have established in the U.S.; but in this advisor’s opinion, chances are good that they will accomplish just that.

So, Run with Nike!

Developing Your Investing 'Themes'

Each month during the week of options expiration, which is actually right now for Sept ’07 expirations, this advisor develops a short list of ‘Themes’. These themes are the Big Picture ideas that aid in maintaining a broad perspective when making decisions regarding which types of investments are most likely to outperform in the near-term future.

Now, for positions being established for future expiration months, the five themes of the Covered Calls Advisor are:
1. Sector Weightings:
· Overweight – Energy; Healthcare; Industrials
· Marketweight – Materials; Technology
· Underweight – Consumer Discretionary; Consumer Staples; Finance; Telecom; Utilities

2. Emphasize large-cap companies.

3. Emphasize companies with a large international exposure.

4. Emphasize companies that will benefit directly from high energy costs; especially in the oil services industry.

5. Mitigate risk caused by the slowdown in the U.S. economy:
· Focus on companies less exposed to the effects caused by high energy and other high commodity costs.
· Identify companies with more defensively-oriented characteristics (such as healthcare) and that are less dependent on increases in consumer spending.

In looking at the 11 positions in the current CCAP, you will notice that these themes are reflected in the Oct ’07 portfolio selections. The first two themes listed above relate directly to the topics of sector diversification and asset allocation respectively. Additional information and details related to the importance of these tools and how to use them in developing your own portfolio will be discussed further in subsequent posts on this site.

It is very important to commit your themes to writing each month (via either pen and paper or typing them into your computer). The source for your beliefs about what your investing themes should be is a culmination of all the information you have read, heard, and analyzed about current economic and political conditions. They will guide your decision making when it comes down to making choices between specific investment alternatives. And this statement is critically important: ‘Don’t expect to be correct all the time with your themes’ – learn to accept the fact that you will often be wrong. The good news here is that you can still be a market-beating covered calls investor without also having to be a great economic prognosicator. But don’t let errors you make in your written themes discourage you or deter you from continuing to write down your themes each month. The simple fact that you are taking the time to write down your themes every month will force you to think, … and then think again, … and then to think some more about what you believe about the market and, more importantly, why you believe it to be true at that particular moment in time. Writing down your monthly themes is not necessarily a ‘fun’ thing to do. Hmmmm... on second thought, it really is a 'fun' thing because it provides you an opportunity to make your own predictions of the near-term future (excuse this rather weak analogy, but it's somewhat similar in concept to filling out your weekly picks for the football pool). Nevertheless, rather than 'fun' it is actually a ‘discipline’ that will help you to gradually become a more informed, thoughtful, perceptive, and ultimately more successful covered calls investor.

Regards and Godspeed

Covered Calls Advisor Portfolio -- Initial Positions Completed

The establishing of initial positions in the Covered Calls Advisor Portfolio (CCAP) is now completed. The total initial capital investment in the account is $250,000. All trades were made in a CBOE Virtual Trader account powered by Options Xpress.

The worksheet below shows the 11 covered call positions now in the portfolio. The total cost of purchasing these positions (including commissions) was $240,051.40, so there is an additional $9,948.60 in cash in the account for a starting total investment of $250,000.



From this initial stake of $250,000, this CCAP will be managed on an ongoing basis with the primary objective being to achieve market-beating returns. All transactions will be documented on this blog site the same day they are made and financial tracking results will be posted at the close of each calendar month beginning next month (October '07). Note: There will be no cash deposits or withdrawals made with CCAP (except for any dividends earned on stocks held in the account), so monitoring portfolio results compared with the original $250,000 investment will be very straightforward.

Readers: Your thoughts and ideas are always welcome here -- simply click on the 'Comments' link below; or if you prefer greater confidentiality email the Covered Calls Advisor at partlow@cox.net

Regards and Godspeed

Stock Selection 101

Deciding which equities to buy is the single most important decision for the stock market investor. It is also the single most important decision for us covered call investors. So this article is devoted to presenting the approach to stock selection favored by the Covered Calls Advisor. To convey the preferred approach, consider the following hypothetical, but instructive Q&A session between a covered calls investor and the Covered Calls Advisor. Try to place yourself in the position of the covered call investor who is asking the questions in this discussion.

Question 1: Where should I get my ideas for which stocks to buy?
Answer: First, the approach used by most people in identifying what they will buy is often by what I like to call a ‘whimsical’ means. Perhaps they hear that a particular brokerage firm is recommending Company X; or they’ve read an article in a magazine or newspaper that describes an interesting development in Company Y; or a friend recommends ‘getting into’ Company Z. These are absolutely the wrong approaches to stock selection; and I used the term ‘they’ on purpose rather than ‘you’ since ‘you, the reader’ don’t use this ‘whimsical’ approach. Well you don’t, do you?
This advisor advocates using a top-down approach wherein a wide universe of equities (approximately 5,000) are all considered and are relatively quickly narrowed down to a more manageable number (about 250) of good candidates for potential purchase.

Question 2: How can I possibly hope to analyze 5,000+ investment opportunities to identify the ones that are the best buy candidates?
Answer: Not surprisingly, the answer is that you can’t do it alone. Fortunately, there are myriad stock advisory companies that have numerous research analysts and high-powered number-crunchers (i.e. computers) that work full-time at analyzing which companies should be included on their ‘Buy’ list.

Question 3: Then which stock advisory companies should I use to help me narrow the field from 5,000 to 250 potential purchase candidates?
Answer: This advisor recommends that you use two stock advisory services to help with this narrowing process. And this advisor is not going to tell you which two are the best for you. Why? Because ultimately, it is your choice and only you know the style of investment analysis that is most appealing to you. You will need to do some research on your own in this regard to identify the two services in which you have a good comfort-level with the approach they use in making their investment recommendations. Moreover, if you make your own choices regarding the two particular services, you will likely be more motivated to work diligently to make sure your own personal choices work successfully for you as you are managing your own covered call investments.

Question 4: What factors should I consider in identifying the services that are right for me?
Answer: Two basic factors: (1) First, make sure the services you evaluate have a performance history of at least 5 years. Also, make certain that they have beaten the performance results of a stock market benchmark (such as the S&P 500 or the Russell 3000) during the most recent 5-year period. You might be surprised to know that about three-fourths of advisory firms will fail in this critical measure and thus they can be readily eliminated from your further consideration; and (2) Learn as much as you can regarding the detailed methodology used by the firm in making their Buy, Sell, and Hold evaluations to see if you agree fully with their approach. It is much easier to get this methodology information from some firms compared with others since they all consider their methods as proprietary; and that’s okay. However, this advisor has found that the firms that are the most forthright in providing substantial detail about their stock evaluation methods tend to have the most thoroughly developed strategies and usually achieve the best long-term results.

Question 5: Why 2 services?
Answer: This may sound trite, but the short answer is simply ‘two heads are better than one’. In addition, the practical reality of the matter is that most comprehensive stock advisory services have several hundred stocks rated ‘Buy’ and a method is needed by the individual investor to reduce the huge number of ‘Buy’ ratings to a more manageable number. By identifying those stocks that are rated ‘Buy’ by both of your two favorite stock advisory services, your list of potential investments is narrowed considerably, from 5,000+ down to around 200-300 possibilities.

Question 6: If 2 services are good, then aren’t 3 even better? Or 4? Or …?
Answer: It is counterintuitive, but more than 2 is not necessary. In fact, it is actually counterproductive. Remember, ultimately we are seeking 10-20 covered call positions for our portfolio. Phase I is what is being described in this article, namely how to select stocks that will be included in our Phase II analysis. The Phase II analysis takes the 200-300 stocks identified in Phase I and then analyzes them in conjunction with the call options for those stocks to identify the 10-20 best-ranked covered call investment opportunities.
200-300 stocks may seem like a large number to evaluate, but this advisor has found that this range of candidates is actually an ideal number (neither too few nor too many), so adding a 3rd advisory service and selecting only those stocks rated ‘Buy’ by all 3 services decreases the number of stock selection candidates to around 45-75, far too few in this advisor’s opinion. Fortunately, with the use of covered calls screening software, the task of evaluating 200-300 stocks is simplified immensely. This reason alone makes 2 services the right choice. But in addition, from a practical viewpoint, 3 services simply take too much time to administer; not to mention the additional costs of maintaining the extra subscription. It’s good for you to conduct thorough analyses; but it’s nice to keep the process as simple as possible as well. Two services seem to provide just the right balance.


Question 7: Which services do you use?
Answer: The diagram below shows the 2 services used by the Covered Calls Advisor. There are currently 287 stocks with ‘Buy’ recommendations from both services. The Covered Calls Advisor’s brokerage account is with Charles Schwab. Schwab was selected because in a study conducted by Zack’s Investment Research for Barron’s, the stock selections made by Schwab Equity Ratings were ranked first in comparison with other major brokerage firms over the most recent 5-year period. The second service used is MarketGrader.com. They also have an excellent long-term record, and they were recently selected by Barron’s to provide the stock selections for the newly formed Barron’s 400 index, through which Barron’s plans to achieve a market-beating performance. Barron’s has been tracking the performance of independent stock advisors for years, and it is a tremendous vote of confidence in MarketGrader.com for Barron’s to put their reputation for excellence on the line and to contract with MarketGrader.com for their stock selection services. I also really like the detailed descriptions and methodology descriptions provided by both services; and although both companies methods incorporate both fundamental and growth components, the fundamentals definitely predominate -- which is fine with me!
However, remember the advice provided in answer to question #3: Do your own research and select the companies that match your own investing approach and philosophy. In short, perform your own due diligence. In addition to the 2 services used by the Covered Calls Advisor, others you might consider while conducting your own review might include Argus, Investors Business Daily, Morningstar, The Oxford Club, Standard & Poor’s, StockScouter, Value Line, and Zacks.



Question 8: Okay. So now we have a list of about 200-300 stocks (currently 287). So how does the Covered Calls Advisor narrow the 287 down further to the 10-20 covered call positions to be established?
Answer: Stay tuned. This will be the topic of another blog post coming in the near future.

Regards and Godspeed

Buy Fluor

The Covered Calls Advisor Portfolio (CCAP) established a new covered call position today as follows:

9/18/07 Bought 100 FLR @ 138.17
09/18/07 Sold 1 Oct07 140 Call @ 4.90
Annualized Return If Unchanged: 40.5%
Annualized Return If Exercised: 55.6%
Downside Breakeven Protection: 3.5%

Remember, it's Fluor not Flour.
Flour makes bread and cake.
Fluor makes petrochemical and other infrastructure facilities.

Buy BMC Software and UnitedHealth Group

The Covered Calls Advisor Portfolio (CCAP) established two new covered call positions today as follows:

9/17/07 Bought 500 BMC @ 30.50
9/17/07 Sold 5 Oct07 30 Calls @ 1.65
Annualized Return If Unchanged: 41.7%
Annualized Return If Exercised: 41.7%
Downside Breakeven Protection: 5.4%
Maximum Profit Downside Protection: 1.6%


9/17/07 Bought 300 UNH @ 49.77
9/17/07 Sold 3 Oct07 50 Calls @ 1.50
Annualized Return If Unchanged: 33.3%
Annualized Return If Exercised: 38.4%
Downside Breakeven Protection: 3.0%

Are You Ready For Some Covered Calls?

On Monday Night Football, ESPN has Hank Williams, Jr. again this year singing “Are You Ready For Some Football?”
Here, we ask a similar, but really very different question: “Are You Ready For Some Covered Calls?”

Are you currently investing in covered calls as part of your investment portfolio? If so, think back to when you made your first covered call trade. What made you decide that you were ready for covered calls? If you’re anything like me, you sort of slowly ‘eased in’ to covered calls. In my case, at my first job after college, I was working in the same office with two other young fellows who, along with me, were interested in stock investing. We did the work we were supposed to be doing, but we also managed to intersperse our assigned tasks with the equivalent of about 2 hours per day of stock market conversations. So, because of my natural interest in investing, but perhaps also because I wanted to hold up my end of the conversations, I began to read everything I could get my hands on in the local public library about the stock market. It took me about 2 years to gain enough confidence (and more importantly to save enough money), to open a brokerage account (anybody remember a company named Johnston, Lemon?) and to buy my first stock (anybody remember a company named Gulf & Western?). For the next 3 years I continued to slowly add more stocks to my account. Then, during a bear market period, I decided it would be wise to sell some options against my stock holdings in order to obtain some additional income and to get some downside protection. Little did I know then that I was beginning to use a strategy that would ultimately become the cornerstone of my investing approach.

I suspect that many of you could craft a similar story that describes how you also ‘eased in’ to covered call investing. But this article is really intended to primarily serve as advice to those who are interested in the possibility of investing in covered calls, but who are not yet comfortable with making the decision to ‘jump in’ (or at least ‘ease in’).
How much do you really need to know about covered calls before you make your first investment? A flippant answer would be ‘as much as possible.’ But really, how much is enough? To assist you in answering that question for yourself, I've devised a simple test that will help you assess if you are ready. In this regard, understanding key terminology of covered call option writing is a good indicator of your own knowledge and readiness. If you can provide a short explanation of what each of the following four terms are, then you are probably prepared to begin -- the four terms are: (1) Annualized Return If Exercised, (2) Downside Protection, (3) Open Interest, and (4) Implied Volatility. Don’t be concerned right now if you are clueless about the meaning of these terms. In fact, I strongly suspect that there are several people that will read this who are already active covered call investors and who will have to admit that they can’t really explain the meaning of these terms either. So rather than becoming discouraged, instead challenge yourself to find a knowledgeable person, or a website, or a book (or preferably all three) where you can learn these important covered call terms as you prepare for your first covered call investment.

I’d like to issue a caveat to you regarding this terminology test. It is meant to be a convenient way to get a relatively quick assessment of your covered call investing readiness. But no simple test or guideline can tell you precisely when is the right time for you. Only you can make that determination for yourself. In this advisor’s recent article http://tinyurl.com/yrlb4u there is a short description of the importance of using your own ‘gut feeling’ as a portion of determining your outlook for the short-term direction of the overall stock market. Using your gut instinct is also a very valid approach when it comes to deciding when you are ready to start investing with covered calls. You will have your own personal sense of when it is the right time for you to begin (‘ease in’ if you will). My advice to you is to ‘trust your own instincts’ -- they'll help you to sense when you have reached that comfort level wherein it will just seem right to begin. You will always have some apprehensions, but once begun, covered calls investing will likely prove to be both an interesting and profitable adventure for you. So, the sooner you prepare yourself to the point where you're ready to begin, the better.

Right about now you're probably asking yourself: "Well, what should I do now? Where do I begin?" As part of your covered calls education, there is a book that I strongly commend to your careful reading. In this advisor’s opinion, it is the single best book now available for learning about covered call investing (including the four terms above and many more). It is ‘New Insights On Covered Call Writing’ by Lehman and McMillan. http://tinyurl.com/yo5keu It is very worthwhile reading for the novice and experienced investor alike because it explains both basic information as well as key strategic concepts; and fortunately it is presented in a very clear writing style. Please check it out – and if you’ve already read it, then follow my lead and read it once again. As covered call investors, the more we read the more knowledge we gain and the better and more savvy we become in our investing decisions.

If you have any specific questions about this article, or anything else related to covered calls, please post a ‘comment’ at the link below. Also, if you are not already a member of the Yahoo Groups ‘justcoveredcalls’ on-line discussion group, then consider joining now. The posts made on that site are generally both interesting and educational; and there are several knowledgeable, successful, and helpful covered call writers there who are more than willing to respond to any of your comments and questions.

Regards and Godspeed to All

Buy Oil Service HOLDRS ETF and Materials Select Sector SPDR ETF

The Covered Calls Advisor Portfolio (CCAP) established two new covered call positions today as follows:

9/12/07 Bought 200 OIH @ 184.35
9/12/07 Sold 2 Oct07 185 Calls @ 7.70

Annualized Return If Unchanged: 40.1%
Annualized Return If Exercised: 43.5%
Downside Breakeven Protection: 4.2%


9/12/07 Bought 200 XLB @ 38.84
9/12/07 Sold 2 Oct07 39 Calls @ 1.45

Annualized Return If Unchanged: 35.8%
Annualized Return If Exercised: 39.8%
Downside Breakeven Protection: 3.7%

Developing an Overall Stock Market Outlook

Are you bullish, bearish, or neutral in your near-term stock market outlook? Your answer is a very important one because it greatly influences your specific investment decisions -- and it should. But how did you develop your current market outlook anyway? To stimulate your thinking in this regard, the Covered Calls Advisor summarizes the five key metrics currently used to arrive at its Overall Stock Market Outlook. Ultimately, the overall outlook is categorized as either Very Bearish, Bearish, Slightly Bearish, Neutral, Slightly Bullish, Bullish, or Very Bullish.

1. Earnings Yield and Bond Yield Spread --This is the Covered Calls Advisor's single favorite indicator. It is calculated as the difference between the S&P 500 Earnings Yield and the 10-Year Treasury Bond Yield where the earnings yield is simply the inverse of the P/E Ratio. The current trailing twelve months(ttm) P/E for the S&P 500 is 17.1, so its earnings yield is 1/17.1 = 5.35%. The current yield on 10-Year U.S. Treasury Bonds is 4.37%. Thus, the current 'Earnings Yield and Bond Yield Spread' is +0.98% (5.35%-4.37%), for which the chart below shows to be a slightly bullish indicator.
To appreciate why this 0.98% spread is slightly bullish for stocks, please consider this question: Would you prefer to invest in bonds at 4.37% or companies that generate an average after-tax earnings yield of 5.35%?
Unless and until the 'Earnings Yield and Bond Yield Spread' narrows to a point where the yields are much closer to each other, stocks will remain as the preferred investment. This is true regardless of the type of investor you are -- an individual investor; a large hedge fund manager; or even a corporate CEO or CFO who are deciding whether to buy back their own company shares, or whether to merge with or acquire an attractively-priced company.

Earnings Yield and Bond Yield Spread:
>+2.5% is Very Bullish
+1.5% to +2.5% is Bullish
+0.5% to +1.5% is Slightly Bullish
-0.2% to +0.5% is Neutral
-1.0% to -0.2% is Slightly Bearish
-2.0% to -1.0% is Bearish
<-2.0% is Very Bearish

2. Inflation -- Inflation has always been and will remain a critically important factor in evaluating the economy's ability to sustain and support adequate growth. Several measures of inflation are widely reported, including the Producers Price Index (PPI), the Consumers Price Index (CPI), and Personal Consumption Expenditures (PCE). This advisor's preference is to look at the 1-Year PCE, a rate calculated by the Federal Reserve from data supplied by the Department of Commerce's Bureau of Economic Analysis. Currently, the 1-Year PCE inflation is at 2.1%, a bullish indicator:

< 2.0% is Very Bullish
2.0 to 3.0% is Bullish
3.0 to 4.5% is Slightly Bullish
4.5 to 5.0% is Neutral
5.0 to 6.0% is Slightly Bearish
6.0 to 7.0% is Bearish
>7.0% is Very Bearish

3. Current Versus Expected P/E Ratios -- Historically in the U.S. stock markets, inflation and P/E ratios have usually been inversely related. That is, when inflation has been high (say >6%) P/E ratios have been low (below 10 on average). Conversely, low inflation (say <2.5%) has normally been accompanied by relatively high (above 18) P/E ratios. Where are we now? As stated above, the S&P 500 P/E is now at 17.1 and inflation, as measured by the One-Year PCE is 2.1%. During the past half century, when inflation is below 2.5%, the average P/E exceeds 18 and has often been in the 20s. Given the current 2.1% inflation rate, the 'Expected P/E Ratio' of around 20 is now 16.4% (20-17.1/17.1) higher than the Current P/E. This does not imply that the market is precisely 16.4% undervalued, but it is nevertheless a bullish signal:

Current Versus Expected P/E Ratios:
>+30% is Very Bullish
+15% to +30% is Bullish
+5% to +15% is Slightly Bullish
-3% to +5% is Neutral
-7% to -3% is Slightly Bearish
-15% to -7% is Bearish
<-15% is Very Bearish

4. Price Momentum -- This is simply a measure of the extent to which the overall market is higher or lower than 9 months ago. I like to use the Russell 3000 as a total market benchmark and the relevant ranges are:

>+18% is Very Bullish
+10% to +18% is Bullish
+4% to +10% is Slightly Bullish
-2% to +4% is Neutral
-5% to -2% is Slightly Bearish
-10% to -5% is Bearish
< -10% is Very Bearish

The Russell 3000 (symbol RUA) closed yesterday at 850.82 and it closed on the same day 9 months ago at 821.21. This is a 3.5% increase which provides a neutral reading from the chart above.

5. Gut Feeling -- Each of the four metrics described above are highly quantitative and objective in their measurement. However, successful investing is as much an art as it is a science. Some consideration for the investor's own vision of the market's near-term outlook is appropriate. Actually, it is much more than appropriate; it is essential! Let's term the investor's own sense of the market's near-term direction as his/her 'gut feeling'.
This Covered Call Advisor's gut feeling right now is neutral in the sense that there are roughly equal measures of both negative and positive factors. The primary 'positive' is the market's modest pricing relative to historic valuations -- this is demonstrated by the bullish indicators in metrics 1-3 above. This, however, is countered by 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. This discomfort is manifest in the more than doubling of the Volatility Index (VIX) in recent weeks, as well as the seemingly daily 100+ point market swings -- sometimes up and sometimes down. Until a greater measure of market stability is achieved, a neutral investing posture seems to be the most prudent rating at this time for the 'gut feeling' indicator.

In summary, the current outlook for each of the five market indicators is:
Earnings Yield and Bond Yield Spread -- Slightly Bullish
Inflation -- Bullish
Current Versus Expected P/E Ratios -- Bullish
Price Momentum -- Neutral
Gut Feeling -- Neutral
Two bullish, one slightly bullish, and two neutral indicators. All things considered, let's call it a Slightly Bullish Overall Market Outlook.

The use of these five indicators to determine an overall stock market outlook at any given time is definitely a work in progress. These measures will continue to be modified and improved upon over time.

Note: Although this discussion has focused solely on the U.S. stock market, similar measures can and will be developed for various international markets as well.

As always, I value your thoughts and insights highly, and would appreciate you sharing any 'comments' at the link shown below.

Regards and Godspeed to All

Buy Hewlett Packard and iSHARES MSCI EAFE ETF

The Covered Calls Advisor Portfolio (CCAP) established two new covered call positions today as follows:

9/11/07 Bought 500 HPQ @ 49.78
9/11/07 Sold 5 Oct07 50 Calls @ 1.75

Annualized Return If Unchanged: 32.1%
Annualized Return If Exercised: 36.1%
Downside Breakeven Protection: 3.5%


9/11/07 Bought 400 EFA @ 77.75
9/11/07 Sold 4 Oct07 78 Calls @ 2.50

Annualized Return If Unchanged: 30.1%
Annualized Return If Exercised: 33.1%
Downside Breakeven Protection: 3.2%

Buy Honeywell and Travelers

The Covered Calls Advisor Portfolio (CCAP) established two new covered call positions:

9/10/07 Bought 500 HON @ 54.23
9/10/07 Sold 5 HON Oct07 55 Calls @ 1.80

Annualized Return If Unchanged: 30.3%
Annualized Return If Exercised: 43.2%
Downside Breakeven Protection: 3.3%


9/10/07 Bought 500 TRV @ 49.37
9/10/07 Sold 5 TRV Oct07 50 Calls @ 1.85

Annualized Return If Unchanged: 34.2%
Annualized Return If Exercised: 45.8%
Downside Breakeven Protection: 3.7%

4 Steps for Establishing a Great Covered Calls Portfolio

Step 1. The Big Picture - It's important to have a personal outlook for the overall stock market. Are you bullish, bearish, or neutral for the near-term future of the market? This outlook must not be obtained quickly or emotionally. Rather, our outlook should result from: (1)avid reading of high-quality financial resources; and (2) from applying a disciplined ratings process that includes several macroeconomic, momentum, value, and growth factors. My current outlook will always be shown as the top information element in the right column of this blog --
For now, "The Covered Calls Advisor Says: The Current Overall Stock Market Outlook is : SLIGHTLY BULLISH. The Corresponding Investing Strategy is: SELL SLIGHTLY OUT-OF-THE-MONEY COVERED CALLS."
Generally speaking, covered call positions should be established that are consistent with your overall market perspective, namely:
Bullish -- Plan to sell primarily Out-of-the-Money(OTM) Calls
Neutral -- Plan to sell primarily At-the-Money(ATM) Calls
Bearish -- Plan to sell primarily In-the-Money(ITM) Calls

Step 2. Stock Selection - Stock Selection is Job #1 for the stock market investor, and it's also the most important decision for us covered call investors. Consequently, there will be a lot of information provided in future posts describing how this Advisor analyzes and selects stocks for inclusion in a covered call portfolio.

Step 3. Analyzing the Covered Call Investment - Once good stock investment candidates are identified, it is essential to perform additional analysis to determine which covered call option positions available will provide the best combination of both attractive return-on-investment potential as well as sufficient downside protection.

Step 4. Portfolio Diversification - Last, but certainly not least, is to ensure that the total portfolio of covered call positions is adequately diversified. The three components of diversification are: (1) Asset Allocation, (2) Sector Diversification, and (3) Individual Position Concentration.

There will be many future posts that will explore detailed aspects of each of these 4 steps with the intention of assisting you in refining and improving your own covered call investing decisions.

Buy Merck and Nike

The Covered Calls Advisor Portfolio (CCAP) is initiated today with two new covered call positions:

9/7/07 Bought 500 MRK @ 49.97
9/7/07 Sold 5 MRK Oct07 50 Calls @ 1.85

Annualized Return If Unchanged: 31.4%
Annualized Return If Exercised: 31.9%
Downside Breakeven Protection: 3.7%


9/7/07 Bought 500 NKE @ 54.83
9/7/07 Sold 5 NKE Oct07 55 Calls @ 2.30

Annualized Return If Unchanged: 35.6%
Annualized Return If Exercised: 38.2%
Downside Breakeven Protection: 4.2%

It is expected that the CCAP will normally contain between 15-20 positions on an ongoing basis. Additional covered call positions will be established during the next two weeks and every transaction will be posted to this blog on the same day they are established.

Welcome Everyone!

This 'Covered Calls Advisor' site is devoted exclusively to investing with covered call options. The objective of this advisor is to explore and explain all aspects of a successful covered call investing program. Covered calls offer an excellent avenue for obtaining market-beating results while at the same time offering the added benefit of doing so with less overall portfolio risk.

A primary feature of this site will be the Covered Calls Advisor Portfolio (CCAP). All transactions in this portfolio will be presented herein. This approach will enable this advisor to explain both basic and advanced approaches to managing our covered call investments. The initial CCAP is coming soon.

I have found covered calls to be both fun and profitable. I welcome the opportunity to share this exciting journey with you. Let the fun begin!