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Subject:  Alan Ellman's Covered Call Writing Date:  8/16/2019  7:38 AM
Author:  captainccs Number:  115487 of 115814

JabberStokky, thanks for bringing this interesting book to my attention. There is a multitude of things you can do with options, writing covered calls is just one of them but arguably it's the least risky way of trading options. There are two ways to approach writing covered calls, as a sideline to a regular investment portfolio to generate additional income or as the feature attraction of the portfolio. I started trading options as a sideline selling both calls and puts (Dec 2008). Puts turned out to be too risky so I stopped trading them. As I improved my Covered Call Selector it became the feature attraction of my portfolio (May 2019).

I'm very much in tune with Alan Ellman's methods and I picked up some pointers from his book but I find him still too complicated. It has to do with putting your trust on price. Markets are information systems and the information about the value of goods and services is transmitted via prices. If the quality is good, the price goes up. If there is an abundance of the product, the price goes down. If there is a cheaper or better substitute the price goes down while the substitute's price goes up. It's an absolute marvel! Yet price has acquired a bad reputation based on clueless but pithy sayings such as Oscar Wilde's "A cynic is a man who knows the price of everything and the value of nothing." Here at the Fool The BMW Method was sharply criticized by people who don't understand the value of prices. We all understand intrinsic value but no one is capable of calculating it. I've searched the Investor's Bible, a.k.a. Graham and Dodd's Security Analysis and The Intelligent Investor for the magic formula and it's nowhere to be found. But price is everywhere and it determines whether a trade happens or not.

Why the above digression? Because the lack of faith in price leads people to search for intrinsic value in complex ways, expert opinion, fundamental analysis, Fed meetings, POTUS tweets, the list is endless. But it's all already priced into the PRICE! Of course price is not the only thing you look at but these other views are mostly of a binary nature, trade/don't trade. They determine whether we are willing to accept the price. Our decision creates a feedback loop that affects the price. That's how we all vote to create the PRICE! The magic of markets, the world's oldest information system.

Alan Ellman's downside is that he is still looking for intrinsic value. My breakthrough was finding or inventing "dollars per day." I very much agree with Ellman's casino model. The seller of covered calls is playing house while the buyer is the gambler. The object of the house is to set a vigorish that guarantees that over the long run the house is profitable. There is a risk of going broke if the individual bets are too large which is the reason for house limits. Selling covered calls you control that limit.* The above explain why covered calls are a low risk proposition.

An interesting point made by Ellman is that a stock is nothing but an amount of money and holding on to it (anchoring) is not going to increase it or bring it back. Holding on to it just decreases the capital available to create trades. The logical conclusion is that any stock that is not worth writing a call on should be sold NOW!

One insight that I picked up from Ellman is that the best calls are at-the-money or in-the-money (thanks JabberStokky!). The premium is yours to keep but the price of the stock at expiration is uncertain. Your safest trades would all be assigned, you keep your premium and free the money for the next trade. At-the-money and in-the-money premiums are higher than out-of-the-money premiums providing more profit or protection in case of falling stocks. Depending on the stock and on market bull/bear sentiment one can choose on which side of at-the-money you want to be.

Ellman does not seem to have a Call Selector which is central to my covered call trading. One wants to sell the best calls, but how to find them? Calls are not easy to compare, there are a number of variables such as stock price, time to expiration, strike price, and premium to consider. My unifying metric is "dollars per day." Upload fifty to sixty option chains of preselected stocks and that's about 30,000 possible options. By adjusting various parameters the Call Selector whittles them down to a manageable number which one can then fine tune. BTW, last week's selection is useless today. Because expiration dates and strike prices are not continuous but discrete and variable increments the Call Selector has to be run before the market opens with enough time left over for the fine tuning. Even so, once the market opens, premiums jump up and down.

To conclude, I need to tweak the Call Selector with what I learned from Alan Ellman.

Denny Schlesinger

* The Kelly Criterion

Using the Kelly Criterion for Asset Allocation and Money Management
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