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I'm still learning about options trading. I've been analyzing several strategies, and up to this point, I've only found one that seems to fit my risk/reward profile. Selling deep in-the-money covered calls. Here's my basic strategy, and the analysis I've done so far.

Select stocks from a pool of value stocks that have been beaten up. (I used the CANSLIM value screen) I perused the list for companies I recognized, and selected a set of companies that covered several industries. I then looked at the November options (about 6 weeks out) and analyzed selling the deepest in-the-money options. AEO is one candidate.

Buy at Current Price: $13.22
Sell Nov 7.50 Call: $6.00 (BxA = 5.8x6.4)
Net Debit: $7.24/share
This represents a 3.6% gain if the option is exercised, and the strike price is 45% below the current price of the stock, and 40% below the 52 week low. Now, I know 3.6% isn't a huge gain, but since it's realized in 6 weeks, that translates to an annual return over 20%. That sure beats any trading I've done in the past.

As long as this is done with stocks that I believe have value, why would this be a poor strategy? I realize I'm giving up the gains if it moves up, but I'll happily take a 3% return in 2 months to have such a large margin of protection to the down-side. In the worst case, the option expires below the strike price, so I'm left holding a stock that I believed had value at $13 for $7.24. Compared to just purchasing the stock, it seems like a good idea. Also on the plus side, if the stock does move down, the option becomes more liquid, so I have an opportunity to exit the position and limit my losses if necessary.

Is there anyone out there that's tried implementing this type strategy? This seems to good to be true, so I need someone to point out what I'm missing. BTW, this would be done with TradeKing (very low commissions) and in a IRA account, so the tax implications aren't a factor.

Thanks all!
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<<As long as this is done with stocks that I believe have value, why would this be a poor strategy?>>

I prefer selling puts of the same strike, since it involves fewer commissions and is much less likely to get exercised. Selling a put is identical to buying stock and selling a call.

But I like the concept of harvesting time decay, especially now with implied volatility so high.

Jim
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I've been analyzing several strategies, and up to this point, I've only found one that seems to fit my risk/reward profile. Selling deep in-the-money covered calls.

It's mostly dependent on what you expect the stock to do. If you're selling deep ITM, you're fairly bearish on the stock -- because you're willing to part with it for a very small premium.

Many "income" covered call sellers will go for the ATM option -- because it typically has the highest premium.

For example, you cited a 3.6% gain (if exercised) for the Nov $7.50 call. But if you did an ATM call, you could get a 7.2% gain on the Oct $12.50 call. That is, double the return in half the time. But you get less downside protection...

And, BTW, I would always calculate your returns on the bid price, not on the last closing price. In your example, that extra 20 cents cuts your net earnings per share from 26 cents down to 6 cents -- a HUGE difference. Especially since you will most certainly have transaction costs related to having the stock called.

I have a spreadsheet I use to do the calculations, after pulling in the data from the web. Here's what I get for the November expiration:

Call Options Bid RIE RIU mRIE mRIU
AEO Nov 2008 7.50 $5.00 -0.1% -0.1% -0.1% -0.1%
AEO Nov 2008 10.0 $3.10 6.3% 6.3% 4.1% 4.1%
AEO Nov 2008 12.5 $1.60 14.6% 14.6% 9.5% 9.5%
AEO Nov 2008 15.0 $0.65 26.5% 5.5% 17.0% 3.6%
AEO Nov 2008 17.5 $0.25 42.7% 2.0% 26.8% 1.4%
AEO Nov 2008 20.0 $0.05 60.5% 0.4% 37.1% 0.3%

Or the October calls:

Call Options Bid RIE RIU mRIE mRIU
AEO Oct 2008 10.0 $2.60 0.9% 0.9% 2.7% 2.7%
AEO Oct 2008 12.5 $0.85 7.2% 7.2% 23.2% 23.2%
AEO Oct 2008 15.0 $0.15 21.4% 1.2% 78.7% 3.7%
AEO Oct 2008 17.5 $0.05 40.4% 0.4% 77.1% 1.2%

Note the "sweet" spots for the monthly return-if-price-unchanged are the at-the-money calls in both cases.
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<<Note the "sweet" spots for the monthly return-if-price-unchanged are the at-the-money calls in both cases.>>

True, but an unchanged price is a big "if." Normally, I like to write out-of-the-money (OTM) puts instead of at-the-money (ATM) to give myself some cushion in case the underlying price falls.

But . . .

With the VIX over 50 and many stock prices much lower than their intrinsic values due to panic selling, I am much more willing to sell ATM puts.

Jim
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Jim do you prefer selling puts or credit put spreads?
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I prefer selling puts of the same strike, since it involves fewer commissions and is much less likely to get exercised. Selling a put is identical to buying stock and selling a call.

But I like the concept of harvesting time decay, especially now with implied volatility so high.

Jim
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<<Jim do you prefer selling puts or credit put spreads?>>

I sell puts on stocks if I wouldn't mind owning the stock, but I sell put spreads on indices that I don't ever want to own.

Jim
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it's all i do now, and a very good strategy. and with the option premiums high these days, it is more profitable as well.
i try to search for scenarios that give me 25% down protection and a return of 4 to 6%. Since the market has dropped so much recently, it has actually reduced my cost basis on 4 of my stocks to almost zero. Meaning, i now own those free and clear and can either sell more calls in the coming months, or let em run when the market catches its breath and gets rolling again. they are a long term investment for me. one thing to watch for is not to get exercised. it triggers a capital gain. if you get percentage goal before expiration, don't wait, roll out to the next month to avoid assignment. If you are careful, you should be able to get over 30-50% a year returns.
Sam
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Selling deep ITM covered calls is identical to selling naked OTM puts, which I like very much in this high volatility environment, so it is a good strategy. I prefer selling naked OTM puts, however, because it entails fewer commissions and there is less likelihood of the short put getting assigned.

Jim
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isn't that 30 - 50% a year return actually negated in a bear market, when stocks just continue to drop? you haven't accounted for the returns / or repair strategy for when you are actually assigned / called, and the stock keeps dropping...

playing devil's advocate on this interesting strat
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not really, it's figured in. gains are usually much larger than 30-50% a year on the winners. the downside cushion is large enough and except for recently, you should fair well.

as for the assignment, you've received the premium already, gains locked in and stock called away. nothing to do. risk is over. buy it again if you want and sell the next month out call.

if the stock drops too quickly before the expiration, i often buy back the call and sell a lower strike call, to help save the position. you will make less, and sometimes nothing on it. it doesn't happen often, to me anyway.
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<< Selling deep ITM covered calls is identical to selling naked OTM puts, which I like very much in this high volatility environment, so it is a good strategy. I prefer selling naked OTM puts, however, because it entails fewer commissions and there is less likelihood of the short put getting assigned. >>

So if one were willing to accept small, yet consistent returns, annually, wouldn't selling FOTM Puts (potentially Leaps) be a pretty consistent and profitable strategy?

Again, taking SPY, the furthest for Dec 2009 is the 60 Put, at around $4. Selling it (and sorry, I use $30 as a basis as if I were to be assigned on margin), is over 30%, with a very unlikely chance of being assigned, and also, I wouldn't mind owning SPY at 60 - 4 !!

If the stock rallies, I can also buy it back and roll up...

Comments?
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correction, 13%, not 30%, typo
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<<So if one were willing to accept small, yet consistent returns, annually, wouldn't selling FOTM Puts (potentially Leaps) be a pretty consistent and profitable strategy?>>

Yes, but I wouldn't sell LEAPs because the time decay is too slow. I like to buy long-term and sell short-term.


<<sorry, I use $30 as a basis as if I were to be assigned on margin>>

You should be sorry because your profit calculation is bogus. As I explained in a previous post, going on margin does NOT reduce your cost basis. In reality, both your profit potential and risk are doubled under 50% margin, so the potential return on investment remains the same.

Jim
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it sounds like a lot of risk for such a small return. you will be scrambling if the market moves on you. i wouldn't bother. remember the most time premium you can take in is in the current month. use it to your advantage.
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<< it sounds like a lot of risk for such a small return. you will be scrambling if the market moves on you. i wouldn't bother. remember the most time premium you can take in is in the current month. use it to your advantage. >>

I wouldn't be scrambling, I'd be happy to own the stock SPY (I am adamant about the S&P 500 for super long term)

still bad?
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<< You should be sorry because your profit calculation is bogus. As I explained in a previous post, going on margin does NOT reduce your cost basis. In reality, both your profit potential and risk are doubled under 50% margin, so the potential return on investment remains the same. >>

I use the 50% because almost all the time, it is more than the margin requirement as well - thus my profit on using less capital is higher, but I see your point that the profit potential remains the same, cause of the formula used to calculate profit you explained earlier.
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I guess there are many ways to look at profit, but with selling naked or cash-covered puts, I prefer to look at the amount at risk as the denominator.

If you sell a SPY 60 LEAP put for 4.00, your max gain would be



$4.00
----- = 4/56 = 7.1%
$60-$4


You may think, what are the chances that it will decline 33% from its current $90-ish to below $60?

Try this gedankenexperiment. It's Oct 2007 and SPY is at $150; you don't know about the nearly 50% decline that is coming. Would you sell a $100 LEAP put for $7 (same max 7%-ish return)?

Just some food for thought...

Adenovir
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<< You may think, what are the chances that it will decline 33% from its current $90-ish to below $60?

Try this gedankenexperiment. It's Oct 2007 and SPY is at $150; you don't know about the nearly 50% decline that is coming. Would you sell a $100 LEAP put for $7 (same max 7%-ish return)?

Adenovir >>

Most definitely, as my strategy is that if I am put the stock at a significantly lower price, I am very willing to accept that, and subsequently sell a covered call, or sell out of the position, and sell another current ATM Put. My whole strategy revolves around SPY, and the fact, pretty much a fact, that it cannot go to zero, is representative of the S&P 500, and thus is a great long term play, whether 2 years or 20 years.

I wholeheartedly agree that this is far more risky on an individual company / stock.
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I wouldn't be scrambling, I'd be happy to own the stock SPY (I am adamant about the S&P 500 for super long term)

still bad?


Yes, just as bad.

Your feelings about "happy to own...at ..." is nothing but a rationalization to make you feel good about a losing trade.

Feelings are not tools of cognition. Hope is not a method.
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Part of my strategy is accepting assignment of SPY. Nothing to do with feelings, I believe in SPY for the very long term.
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"Part of my strategy is accepting assignment of SPY. Nothing to do with feelings, I believe in SPY for the very long term. "

You can achieve similar profits without the need to accept assignment by simply buying the equivalent call spread - at the correct price.

If you are more comfortable selling puts, then go for it.

Mark
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Alex Jacobson of the ISE wrote an article on the relative attractiveness of credit and debit vertical spreads:

www.ise.com/assets/files//Hidden_Costs_Of_Credit_Spreads.pdf...


Jim
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<< You can achieve similar profits without the need to accept assignment by simply buying the equivalent call spread - at the correct price.

If you are more comfortable selling puts, then go for it.

Mark >>

Can you give an example? Naked Puts are equivalent to Covered Calls, not spreads, so in what scenario are you suggesting a call or put spread to achieve the same as a naked put?

Thanks
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"Can you give an example? Naked Puts are equivalent to Covered Calls, not spreads, so in what scenario are you suggesting a call or put spread to achieve the same as a naked put?"

I apologize. I thought the discussion concerned selling put spreads, with the short leg being significantly ITM (your SPY 60/140)

There is no call spread that's equivalent to a naked put. [But, buying a very deep ITM call instead of buying stock (and writing a cal) is very similar to the covered call.]

Mark
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<< I apologize. I thought the discussion concerned selling put spreads, with the short leg being significantly ITM (your SPY 60/140)

There is no call spread that's equivalent to a naked put. [But, buying a very deep ITM call instead of buying stock (and writing a cal) is very similar to the covered call.]

Mark >>

Yes, the LEAPS naked put versus bull call or put spread with a leg DITM has been my battle, but I believe the naked put is a more conservative strategy, which can still be profitable, and protects more of my downside, giving me more time to recover if I am assigned the stock, versus losing all the call premium if timing is bad

by the way, how do you italicize the responses here?
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TYPE: before and after.

Can also use for bold.

Mark
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That didn't work too well, it doesn't show me the actual text :)
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"That didn't work too well, it doesn't show me the actual text :) "



You type ''

Next you insert the text you want to italicize.

Then you type '<i/>'
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Sorry: at the end you type: ''
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<<Try this gedankenexperiment. It's Oct 2007 and SPY is at $150; you don't know about the nearly 50% decline that is coming. Would you sell a $100 LEAP put for $7 (same max 7%-ish return)?

Just some food for thought...

Adenovir >>


Suppose I did sell sell exactly above.

I deposit 100/2 - 7, or $4300 in cash into my margin account.

Stock is now 85, I am most likely assigned? With $5000 in the margin account, I own the stock at 93 and am not on an immediate margin call?

I immediately sell out the stock, my net position for the 8 point loss (93 - 85) is $5000 minus $800, or $4200?

Stock (150 down to 85) loses 43%, and this trade loses $100??
I must be wrong in my second calculation?
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<< Stock is now 85, I am most likely assigned? With $5000 in the margin account, I own the stock at 93 and am not on an immediate margin call?

I immediately sell out the stock, my net position for the 8 point loss (93 - 85) is $5000 minus $800, or $4200? >>


I think I need to correct myself here:

Stock is now 85, I am most likely assigned? With $5000 in the margin account, I own the stock at the strike, 100

I immediately sell out the stock, my net position (100 - 85) is $5000 minus $1500 or $4300 - $800 = $3500?

Stock (150 down to 85) loses 43%, and this trade loses $800/$4300 = 19%??

So if the analysis is correct, to answer the original question, would I sell the 100 strike put for 7, when SPY was trading at 150? the answer is still yes, as I would lose less than owning the stock still?

Help on my calculations appreciated please
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