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Trading a Calendar Spread with LEAPS

Previously, we posted information on doing a covered call using a LEAPS option. Call calendar spreads are similar to a covered call. One part of the call calendar spread is buying a LEAPS call instead of owning the stock. Then, we can sell call options (like a covered call) with less time to expiration (the calendar part). For example, we can buy a call LEAPS with two years of time and sell a call option in the next month. It the strike price of the LEAPS is the same as the call sold, then you have created a call calendar spread. It the strike prices are different, then we have created a diagonalized calendar spread.

My preference is to buy a LEAPS that is in-the-money. This gives you a higher delta so you captured more of the stock price move. A good target is to buy a LEAPS call with a delta of 0.70 or higher. If the stock makes a strong up move, then you gain more profits in the LEAPS call. Also, ITM LEAPS give us more choices in what strike prices to sell the call. In comparison to a covered call with stock, we DO NOT want to e exercised in the LEAPS position. The reason is simply that we do not want to lose the time value of the LEAP call. You can buy an ATM or OTM LEAPS call, but your delta will be lower and it is more difficult to sell a call until the stock price moves up.

When I sell a call, I like to sell the shortest amount of time available because it will decay faster (more profit per day due to time decay) than a call with several months of time. I like to use the existing month and the next month for call sells. I like to sell an OTM call when holding a LEAPS because the call sold is all time value.

The bottomline: Your returns will be leveraged. For example, you may get a 3% return on a covered call but that same return will be 12% if your underlying is a LEAPS instead of stock. Since we are using LEAPS, if the short call strike price is above the stock then it will expire worthless. You can then sell a call against the LEAPS for the next month. If the stock price is greater than the short call, you can back back the short call or roll it up to a higher strike price.

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How to take Advantage of High Implied Volatility

Implied Volatility (IV) gets high when a company has some impending event that can move the stock price.  The impending event sometimes refers to the stock as being a special situation stock.  The impending event causes the option IV to change based on the likely stock price move.  Here are some causes that increase IV:
 

  • There is a pending event such as an earnings report, FDA ruling, etc.
  • A significant news event is pending on another company in the same industry
  • The company’s industry is more volatile due to expected changes
  • The stock has a higher level of volatility so its options are more expensive
  • An aberration occurs as there is no apparent reason for more expensive options.

When a stock is already moving its price, option premium will be high.  IV will simply reflect that volatility and potentially more volatility. Options are also more expensive when a stock is in a confirmed trend.  
 
Time value that is inflated due to spiking IV will collapse when the event causing the spike arrives.  You do not want to be long an option when IV collapse as you can lose money even if the stock price doesn’t fall.  In general, you want to buy low volatility and sell high volatility.

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To use high volatility to your advantage when you are Bullish:

  1. Buy stock as options are expensive;
  2. Write covered calls to collect higher premium;
  3. Sell naked or cash-covered puts for higher premiums;
  4. Write bull put spreads for higher credits.

If you are bearish with high volatility:

  1. Short the stock since puts are expensive;
  2. Sell naked calls;
  3. Write bear call spreads for credit.

How To Use Volatility in Selecting Covered Call Trades

If options were always fairly priced, then we would expect the option price to always imply a level of stock volatility that is more or less in line with historic volatility (HV).  But this not always the case.  For example, two stocks are trading at $20 each with current month calls at $20; one calls ask price is $1.00 while the other is at $2.00.  In comparison, one calls value is twice the others. Why? The difference is in implied volatility of the two stocks.

Implied volatility is the market’s perception of how volatile a stock will likely be in the future.  A covered call trader must understand how implied volatility affects their trading  decisions.  IV Can be the same as historical volatility, lower than historical or higher than historical.  What if an option has an implied volatility of 70% while the stock had a volatility of 25%?  The Black-Scholes calculation would tell us that the option is overpriced.

The key to covered writes: how implied volatility compares to historical volatility.  When option volatility (call IV) is lower than the 10-day/30-day historical volatility, then the call option is under priced.  For call writers, under priced options mean you are not being paid for the stock’s actual volatility.  However, if the calls IV is extremely higher than historical volatility, the market is expecting something to happen.  If after the event the IV collapses then the calls value will collapse.  But…

You should not chase the high IV because those stocks are too risky.  You should compare IV to both the 10-day and 30-day historical volatility.  This will tell you if the the IV is in line with HV.  Generally, you do not want IV to be significantly higher (10-15%) than either 10-day or 30-day historical volatility.

 

The rules are as follows:

  • If IV is higher than HV – then an event is projected such as news, earnings, etc. Find another stock to write calls on;
  • If IV is lower than HV – then the option is likely under priced so you should Find another call write trade;
  • If IV is in line with HV – then this is a good trade if stock volatility is below 40%.

For conservative covered calls, you want stock volatility below 40%.  Any stock with a volatility above 60% is too risky for a covered call trade.  

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How to Use LEAPS as Stock Replacement

Some investors are getting started with a small account.  However, these investors want to make some extra cash to pay some bills or to build up their capital.  They can sell calls on lower priced stocks as it takes less capital to purchase 100 shares of stock.  This is not the only way to achieve income on a smaller portfolio.  They can use LEAPS (long-term equity anticipation securities) as a stock replacement in covered call trades.

Just like a covered call trade, LEAPS (yes it always has an “S” which stands for security) can be purchased instead of the underlying stock which a call can be sold against to provide income.  LEAPS are similar to options except they have a longer time to expiration.  LEAPS usually expire from 1 to 3 years from the time of purchase.  The tradeoff is that you can purchase a LEAPS with 1-3 years of time at a lower cost than purchasing the stock.

The risk profile is very similar between a stock purchase or a LEAPS.  If you buy a stock for $50 then your risk is $50.  The same is true for a LEAPS.  If you buy a LEAPS contract for $20 then your risk is $20.  In both cases, your total investment amount is at risk.  The big difference is that LEAPS have an expiration date while stocks do not.  Since LEAPS have an expiration date, they can be purchased at a lower price than the underlying stock.

When you purchase a LEAPS contract, you control 100 shares of the underlying stock.  Just like a option call, LEAPS give you the right, but not an obligation, to purchase the stock at any time before expiration at the strike price you purchased.

For example, Pepsi (PEP) is trading at around $69.00 at this time.  Your cost to purchase 100 shares of UA will be $6,900.  You can purchase a Jan 2013 call at the $70 strike price for $4.35 per contract. This LEAPS will cost a total of $435.00.  This is a significant difference in the initial investment that is at risk.  The January 2013 call has 556 days until expiration.  You now have the right to purchase 100 shares of Pepsi stock at $70.00 anytime over the next 556 days.

To complete a covered call on PEP, you can sell one August 2011, 38 days til expiration, call at $0.84 per contract.  This is $84.00 in income for a total investment of $435.00.  This is a static return of 19.31% over 38 days.  This is extreme leverage that LEAPS offer to the investor.  If you purchased the stock instead of a LEAPS, your return would be 1.22% because your investment would be $6,900.  Also, your risk would be $6,900 for the stock versus just $435.00 for the LEAPS.

The bottom line: LEAPS lower your total investment compared to the underlying stock and leverage your total return potential.  This is great for those wanting income when investing with a small portfolio or those wanting to leverage their return.

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Real Estate Monthly Passive Income

For investors seeking consistent monthly income along with using passive vehicles, look at stocks with monthly dividends. Imagine, having multiple monthly income streams such as 10 or more stocks paying you each month. Then, add covered call investments from Get Rich Investments to live the life your desire.

Realty Income Corp styles itself as “the Monthly Dividend Company,” and frankly, this conservative retail real estate investment trust (REIT) deserves the title of king of the monthly dividend stocks. Realty Income has paid its investors like clockwork for 559 consecutive months and even raised its dividend for 77 consecutive quarters.

It has a yield of 3.9%, a stock is always going to be considered more risky than a bond, but Realty Income is about as close to a bond as you can realistically get in the stock market. Its cash flows are backed by long-term leases to high-quality tenants. Its properties are generally high-traffic retail sites that are mostly recession proof and “Amazon.com proof.”

We see total revenue growth of approximately 7% in 2019, moderating to 5% to 7% in 2020 driven by acquisitions, rising rents and stable occupancy. Occupancy at the end of Q4 2018 was 98.6%, near the highest occupancy rate within the past 10 years and up from 98.4% in the prior year. We estimate occupancy to remain near its historical average of 98% due to the desirable locations and non-discretionary retailer demand.

We raise our target price by $8 to $73, equal to 22.4x our 2019 FFO per share estimate of $3.26, and above the peer average of 15.5x. We start 2020’s FFO estimate at $3.40. O reported Q4 FFO of $0.73 vs. $0.61, $0.01 below consensus. Year-end occupancy increased to 98.6% from 98.4% in the prior year while rents under lease were up 0.8% for Q4 and up 0.9% for the year, which we find acceptable given O’s tenants are under triple-net leases. We continue to believe O will execute well and stick to its core competencies. We like that O has taken advantage of its current stock price and a favorable market, raising $539 million in Q4 from sale of common stock, a prudent move to help fund future acquisitions. We think long-term investors will continue to benefit from O’s predictable cash flow, but we reiterate our Hold opinion on valuation. O usually trades at a 20% premium-to-net asset value (NAV), but at its current 40% premium we would wait for a more attractive opportunity to buy.

 

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Using Put-Call Ratios in Covered Call Trades

The Put-call ratio is a market sentiment statistic that has been around for quite some time and are followed by option traders.  This stat is based on open interest for each option strike price.  A put-call ratio is the number of put contracts divided by the number of call contracts open.  An increasing ratio is a clear indication that investors are starting to move toward instruments that gain when prices decline rather than when they rise. Since the number of call options is found in the denominator of the ratio, a reduction in the number of traded calls will result in an increase in the value of the ratio. This is significant because the market is indicating that it is starting to dampen its bullish outlook.

You can use these ratios when considering the strike price of the option that you are considering selling.  If there are more open calls than puts, you sell the strike price higher than current stock price as the indicator is showing a bullish sign.  If there are more puts, you should sell the stock price lower than the current stock price as this indicates a potential bearish move.  The ratios are influenced by option speculators who are gamblers, not stupid, very wise and putting up real dollars to back their options.

The put-call ratio is a true indicator of option market sentiment.  You can rely on the put-call ratio continuously because it is very reliable.  Recall that the idea of contrarian sentiment analysis is to measure the pulse of the speculative option crowd, who are wrong more than they are right. We should therefore be looking at the equity-only ratio for a purer measure of the speculative trader. In addition, the critical threshold levels should be dynamic, chosen from the previous 52-week highs and lows of the series, adjusting for trends in the data.

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How to Manage Risk with a Covered Call & Leap Strategy

When entering a covered write with a LEAP, the investor hopes that the short-term call written against the LEAPS will expire worthless.  The investor can then “roll” the short-term call to further-out months with the goal of collecting additional premium month after month.

There are three risks with covered call – LEAP strategy:

  • Stock price decline
  • Assignment (creates a short stock position)
  • Stock price rise can reduce profit

Managing actions should be planned in advance.

If the price falls too fast you have these options:

  1. Close position and realize the loss.
  2. Roll Down and Out by covering (buying back) short call and then selling lower strike call with later expiration date.
  3. Maintain position – hope for price rise.  Let short Call expire and keep LEAPS Call.

 

What if the short call is assigned when stock price rises above call strike price?  Here are some options:

  1. Close the whole position
  2. Buy stock (to cover): stay long LEAPS Call
  3. Buy stock (to cover) & sell another Short-term Call (now have a new LEAPS covered call).

If the stock price rises too much, your profits will be reduced.  Why are profits reduced if the stock price rises too much?

It’s called the “effective price” concept.  If a call is exercised, then stock is purchased.  The effective purchase price of the stock is the strike price plus the call premium.  For example:

Buy a 50 Call @ $3.00

If the call is exercised:

The total cost of the stock is $50 + $3 = $53

$53 is the effective price.

The following example shows how to calculate effective price:

Stock XYZ @ $53.80

Long 1 XYZ 18-month 45 Call @ $10.60

Short 1 XYZ 60-day 55 Call @ $1.25

Strike  +   Call Px  =   Eff Px

55 Call           55      +     1.25     =  56.25 Sell

LEAPS Call   45      +     10.60 = 55.60 Buy

Maximum Profit = +0.65

 Profit at expiration of short call can be higher if there is time premium in the LEAPS call.

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8 Ways to Profit from Covered Call Trades

The covered call trade has always been known as an income strategy as you receive premium for selling calls against your stock.  This is the most popular rationale for implementing this type of tradings.  However, there are many more dimensions that can be coupled with covered call trading to further enhance the potential for profits.  Here is a list of 7 methods to more profits writing covered call trades.

  1. Selling the classic covered call against stock you own.  You make money with the time decay of the short call.  usually you sell the near month or next month out so you can continue to compound your money.
  2. You can use LEAPs as stock replacement to leverage a covered call trade which will increase potential profit returns.  Click here  for a recent article on this topic.
  3.  You can sell out-of-the-money (OTM) calls as your short call.  Here you get the call premium and potential for a capital gain as the OTM call offers some upside profits for the stock price to increase.
  4. You can make more money on a short call when volatility collaspse early in the trade and you close the trade.  We have all been in covered call trades when after a few days the call option loses value and you find yourself in a very profitable trade.  You can close this short call to lock in profits.
  5. You can trade the short call as the stock price changes.  For example, if the stock price decreases, you can close the short option early for a profit.  Then, the call can be written again when the stock prices snaps back to higher levels.  This is similar to channeling stocks by trading the short call against stock price changes.
  6. You can roll up or roll out the short calls to a higher strike price or to a later expiration month.  This allows you to squeeze extra profits out of a stock price rise.
  7. You can add option legs to a short call to create spread positions such as a bull or bear call spread.  This is good to take profits from a rising covered call trade or a falling stock price.
  8. You can add a long protective put to the covered call position as it will increase in value as the stock price decreases.  This is usually utilized as protection against stock declines but can create more income when a stock price declines while you are holding a covered call position.

It is not necessary to use all of these methods when trading covered calls.  It will be advantageous to the income trader to use more than one method to make money income from selling premiums.  In addition, some of these methods can be used to enhance and/or protect your monthly income.

Adding these methods does require more monitoring or your covered call positions.  The advantage is that it adds more potential for profits compared to the classic covered call trade.  It really comes down to how active you want to be in your income trading each month.

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8 Tips to Becoming a Millionaire

We at Get Rich already know the path to wealth is having multiple streams of income that we create each month using covered call trades and monthly income dividend stocks.  This article from Entrepreneur magazine captures the tips we live by each day.

See the full article here

Millionaire. It’s a title that plenty of us would love to have. But, is that actually feasible?

Believe it or not, becoming a millionaire is a goal that can be achieved this year. In my life, I have been a millionaire several times. Most of the time before my 30s, however, I gambled my money away on cars, homes and a lifestyle I had no reason to be living.

Despite the chance that you too will blow millions, the process for you or anyone to become a millionaire has been consistent over the years. If you follow these eight valuable pieces of advice, I can guarantee that eventually you will become a millionaire. Here’s to making this happen this year!

Develop a written financial plan.

One of the main reasons why someone can never become a millionaire is that they haven’t written a financial plan. Developing a financial plan forces you to take action, instead of just talk. It also guides you in making the right decisions in order to achieve all of your dreams and goals.

Financial planner Scott D. Hedgcock said that, “When planning for a more secure future there are two inputs that are indispensable: how much money you have and how much money you spend.

Increase your streams of income.

After studying the very wealthy for five years, author Thomas Corley discovered that 65 percent of self-made millionaires he studied had three streams, 45 percent had four streams and 29 percent had five or more streams. This could include starting a side business, working part time, making investments and renting out everything from your home to your car to household items.

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Options Basics – How to Use Volatility in Covered Call Trades

There are two types of volatility used in security analysis: historical volatility measures the past price movements and implied volatility that indicates the potential level of future volatility a security is implying.

Historical volatility (HV) is the price changes of a security over a period of time so it is really a standard deviation calculation.  This means it is how much a stock price has moved over time usually expressed as a 10-day or 30-day volatility.  For example, a stock with a volatility of 70% is high and should be considered quite volatile.  This is not the type of stock to write a covered call on.  In contrast, a stock with a volatility of 20% is a low volatility stock and selectable for a covered call.

The stock’s volatility can help us forecast short-term price ranges and the relative value for an option price.  The option premiums of highly volatile stocks will have a high value while a low volatility stock will have a much lower premium.  An options premium will be influenced by the probability the stock price will move above or below the various strike prices.  Of course, the excitement of high premiums leads to some investors falling into the premium trap by chasing highly volatile stocks that impose a significant risk to loss of capital.

Another thing to keep in mind is the stock volatility as a confirmation of the stock chart.  Suppose you are looking at a stock chart that seems to be in a trading price range that is stable.  The 30-day historical volatility is 72%.  Is this a good stock candidate for a covered write?  The correct answer is no if you are seeking a conservative covered call investment.  Compare the 72% volatility to a stock with a 30 day HV of 25% which is lower than the S&P 500 at the same time.  I would select the stock with a 25% 30 day volatility for a more conservative covered call investment.

The bottom line is that adding volatiliy to your covered call selection process will increase your chances of morw winning trades and a more consistant income stream.  There will be several more posts about volatility in covered call investing in the coming days.

Get new trades for cash-secured puts and CC trades.

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