Recap on How to Rent Your Stocks Out for Cash Flow - Covered Calls

The below chart is the Covered Call Process Flowchart as presented by Joseph Hooper and Aaron Zalewski in their book Covered Calls and Leaps - A Wealth Option.

I will go into detail on the individual decision points at a later point but for now, here is the overview.

You enter into a new position following a certain set of rules. (to be covered.) Ensure that the stock is in the bottom 25% of its current price cycle. If the stock increases in price, you either get called out (sell the stock and keep the premium) or you close on the delta effect. (the stock price increases greater than the option buyback cost and you can now buy the call back and sell the stock for a profit.) At this point, you can now follow the rules to enter a new position.

If the stock price drops, you potentially enter territory where you can not sell a call at a profitable called return. (your cost basis is higher than a profitable strike price call.) If you can sell a call for a called and uncalled return of 4%, then go ahead and do so following the rules of a secondary call sell. (covered later) If you cannot, then you need to enter a defensive technique called the Tethered Slingshot or TSS.

In the TSS technique, if you are in danger of being called away for a loss, you buy back the call and then immediately turnaround and sell a call at the second to last expiration date at the same strike price for a minimum 10% uncalled return with the intention of buying the call back once the stock cycles down. The idea is, you sell the TSS when the stock is at 75% of its current cycle and then wait for it to drop down and buy it back for a positive return. The initial buyback creates a temporary loss but the sell of the second to last expiration will cover this loss and the buyback will help to generate a profit.

If your stock does not have a call on it and you cannot profitably sell a call for a 4% called and uncalled return, then you simply enter the TSS technique while adhering to the 75% rule - sell the second to last expiration for a minimum 10% uncalled return (using the higher of the market value or your cost in the stock), wait for the call to cycle down and buy it back for a profit.

If the stock does not cycle down, if instead it shoots up, then you should look to close on the delta effect (the sell of the stock will reap a greater reward than the cost of the buy back of the option) or look to the Surrogate Stock Replacement technique which I will cover in a subsequent post along with the CPR technique.

All of the preceding information can be found in Joseph Hooper and Aaron Zalewski's book Covered Calls and Leaps - A Wealth Option, a great book you should buy.

From Hooper and Zalewski, Covered Calls and Leaps

1. You can only establish new positions on down market days.
2. You must always only sell the near month call when entering a transaction.
3. Using the CSE screener to filter through all available covered call opportunities.
4. Select the highest yielding opportunities presented by the CSE screener.
5. Ensure the stock is an upward moving or sideways moving stock.
6. Ensure that the stock adheres to the buying low rule for covered calls.
7. Always give priority to maintaining acceptable levels of diversification between stocks and industries.
8. Buy the stock first and then immediately sell the call.

Now, just what does the CSE screen filter on? Here it is:

1. Uncalled return minimum of 4%.
2. Called return minimum of 4%.
3. PE <= 35.
4. Market Cap of $500 million or more.
5. Average broker recommendation of <= 2.5 (1 is a strong buy)
6. Aggregate of brokers recommending a "strong buy" or "buy."
7. Consensus EPS estimated for next year to be greater than this year.
8. Stock trading less than 75% of its 52 week trading range.

And there you have it ... the steps for entering a new covered call position as well as the screen.

Before entering into a stock position in order to write a covered call, it is important to understand the overall, individual and current cycles of the stock. The bottom line is that stocks go up, down and sometimes trend sideways. Before you invest it is important to understand and take advantage of the current stock cycle.

In relation to writing covered calls, you want to ensure the stock is an upward moving or sideways moving trend and that it meets the buying low rule for covered calls. (you want to make sure the stock price is 25% or below of its current cycle.) To identify the overall trend, look at a one-year chart and draw trend-lines. Trend-lines are simply a way to visually detail the overall price movement of the stock. For an up-trending stock, start by drawing the bottom line touching the average low points. For a down-trending stock, connect the tops first.

Next, draw a parallel line, on the top for the up-trend and the bottom for the down trend. This will give you the price channel. Do this for the overall trend, typically a year, individual cycles throughout the year, which can vary-time-wise, and the current, which will be the most recent cycle. You next want to divide your channel into quadrants so you can identify when the stock is at 25% and 75% of the price in the cycle.

Before you can enter a new position and sell a call, the stock must be at the 25% or lower level. This measure is used in order to provide the benefit of riding the stock up, resulting in a potential call out at the end of the month. Additionally, knowing the stock's placement in the current cycle will be important for additional management and defensive techniques I will describe later.

Let's take a look at what happens if there is increase in the price of the stock we have written a covered call against. This is represented in the CSE flowchart (Hooper and Zalewski) in the second box underneath and to the right of "Enter New Position." It is labeled "Stock Increases" and contains two possibilities; 1.) Close on the Delta Effect or 2.) Get Called Out

Let's look at number two first, get called out. According to Hooper and Zalewski, getting called out is one of the primary aims of covered call writing. Getting called out means your stock appreciated in value to the stock price, you keep the premium received when you wrote the option and you profited by the gain in the position which will be the difference in the strike price and your purchase price. If you are following the rules as previously noted, you will at a minimum receive a 4% called return.

Closing on the Delta Effect

The Delta of an option is simply the percentage increase in the option relative to the stock price. For instance, if an option has a .60 delta, for every dollar the stock increases in value the option will go up by 60 cents. What this means for you, the covered call option writer, is that there may be an opportunity to close out the position early by buying the call back early and selling the stock for a profit. If you can get a minimum of 4%, then do it. You can determine your profit by calculating the following formula.

Sell Price of the Stock - The Original Buy Price of the Stock + The Premium Received From the Call Write - The Buy Back Price of the Option (the Ask Price)

The calculation of this formula results in the net profit on the transaction close.

For example, let's say Bill buys APOL at $30 and sells a June $30 call for $1.00. The delta of the call for this example is .50. If the stock price jumps $3.00 after entering the position, the option price will only jump by $1.50. The sell of the position will look like this.

Sell Price of the Stock $33

- Original Buy Price $30

+ Premium Received $1.00

- Buyback of Option $2.00

Net Profit $2.00 or 6.7%.

As you can see in the flow chart, if Bill closes the position on the Delta effect (the stock price has increased significantly in relation to the option price), he has closed out his position by buying back the call and selling the stock and now moves to "Entering a New Position" and the accompanying rules.

If you keep a close eye on your covered call options, you might be presented with an opportunity to buy back the short call for a profit in the first 2 weeks and close out the position. If within the first two weeks of the month you are able to buy back the call and lock in an uncalled return of 4% for the month, then follow these rules as presented by Hooper and Zalewski in their book, Covered Calls and Leaps:

Five Rules for the Mid-Month Buy-Back

1. If you sold a call for a 5% uncalled return or more, than the mid-month may be considered.
2. If within the first two weeks of the month you are able to buy back the call and lock in an uncalled return of 4% for the month, then do so.
3. You then put in a good 'til cancelled (GTC) order to sell the same call for more than you bought it back for.
4. If the GTC order executes, wait until the end of the month to see if you will be called out.
5. If the GTC order does not execute or if the position is uncalled at expiration, move to the secondary call sales rules. (presented later.)

Good to Cancelled: an order to buy or sell a stock or option that remains in

effect until executed or cancelled by the investor.

It's important to remember that you should only consider the mid-month buy-back in the first two weeks of the month. Only buy back the call in the first two weeks of the month.

In our flowchart, provided by Hooper and Zalewski, the Mid-Month Buy-Back Rule falls beneath and to the left of the "Enter New Position" entry point in a decision box titled "Stock Decreases."

Any call sale that occurs after you have bought back the original call or the original call has expired is considered a secondary call sale. In the flow chart below, as presented by Hooper and Zalewski in their book,Covered Calls and Leaps, the secondary call sale rules fall under the "Stock Decreases" channel. For now, I am skipping CPR. Don't worry, you can still utilize the tool without CPR at this point.

To reach this point, you previously established a new covered call position and were not called out and did not close on the delta effect. If you used the mid-month buyback rule, you bought the stock back in the first two weeks in to lock in a 4% and placed a GTC order to sell the same call at a higher price. If you were called out, you follow the stock increases channel and go back to the rules for entering a new stock position. If you were not called out, or your call expired, both as a result of the stock staying flat or decreasing in price, you follow the rules for a secondary call sale.

Here are the rules as presented by Hooper and Zalewski in their book, Covered Calls and Leaps.

1. Secondary calls can only be sold when the markets are in the green (higher than the close of the close of the previous day).
2. For U.S. options, if you can sell a near month call where the uncalled and called returns are both > 4%, then do so.
3. If rule 2 doesn't work, use a TSS for income (covered later) while adhering to the selling high rule. In order to do this, move the expiration of the call out to the second to last expiration and sell a call that provides an uncalled return minimum of 10%. Do not sell the last expiration of the option series. This must be kept in reserve for defensive techniques.
4. The minimum uncalled return of 10% for a TSS for income is based on your purchase price of the stock or the current market value, whichever is higher.
5. The greater the uncalled return generated on the TSS for income call sale, the quicker the call will be bought back as the stock price declines. You may select a lower strike price to allow an easier buyback to the extent that the strike price of the call selected plus the call's bid price is > than the current price of the stock.
6. Once a TSS for income call is sold, it should be bought to close at any time a 5% net return can be realized or when the stock reaches 25% of the current cycle, whichever comes first.

Selling High Rule: TSS for income calls must be sold at the high point of the price cycle. This is the point at which the stock price is 75% or greater of the current price cycle. You close out your current position, (buy the call back which creates a temporary loss) and then sell the second to last expiration (which eliminates the temporary loss and generates a profit) and then wait for the stock to cycle down so you can profitably close out the position.

If the stock shoots up, you can potentially exit on the delta effect (the income you will receive from the sale of the price of the stock will be greater than the cost to buy back the option) or you can resort to another, advanced defensive technique, the Surrogate Stock Replacement or SSR which will be covered later.

The bottom line is that you are maximizing call sale opportunities. You are taking advantage of as many movements within the price cycle as possible.

TSS for Income: A covered call management technique used to generate income when the stock price has declined after entry.

As presented by Hooper and Zalewski in their book Covered Calls and Leaps, here are the rules for selling calls on existing stock holdings.

1. New calls may only be sold on up market days.
2. If the market price of the stock is higher than your cost in the stock, both the called and uncalled return calculations should be based on the current market price of the stock. If the current market price of the stock is lower than you cost in the stock, all return calculations should be based on your cost in the stock.
3. If you have no desire to keep the stock, your objective should be to sell a near month call that will provide a satisfactory uncalled and called return. If you can sell a near month call with a resulting uncalled and called return minimum of 2%, then do so.
4. If you cannot satisfy rule 3 or you do not want to be called out of the stock holding, then use the TSS for income while being sure to adhere to the selling high rule.

This rule is a defensive measure that can be used when the option contract is within the last two weeks before expiration. Along with a holistic covered call investing methodology, this rule is presented in Hooper and Zalewski's book Covered Calls and Leaps.

The 20 Cent Rule: If you have a negative called return when an option contract has 2 weeks or less to expiration, take the strike price of your call, add the cost of buying that call back (the ask price) and subtract the market price of the stock:

Call Strike Price + Call Buyback Price - Stock Price

If the resulting value from this formula is $.20 or less, then you are in danger of being called out and need to take defense ... using the TSS for defense.

The Tethered Slingshot With the 20 Cent Rule

1. Implement the TSS for defense if the 20 Cent Rule indicates that you are in danger of being called out and this call out will be unprofitable.
2. Immediately buy back the existing call (this results in a temporary loss.)
3. Select the same call strike price but move the expiration date out to the second to last expiration.
4. You now have generated additional covered call income as the price your received for selling the TSS for defense call is always higher than the cost of buying back the near month. You no longer have a temporary loss.
5. Buy back this new call when the net gain is at least equal to the temporary loss generated in rule 2.
6. You now have a stock with no call obligation, did not get called out, and made additional income every step of the way.
7. Now wait for an upswing in stock price that will allow 4% called/uncalled return.
8. If the stock reaches 75% of the price cycle and does not allow for application of rule 7, go back to the rules for secondary call sales given in Chapter 4.

The following information is detailed in Hooper and Zalewski's book, Covered Calls and Leaps.

Debit Spread: selling a call option while using another long call for cover rather than the stock.

Surrogate Stock Replacement (SSR)

This expedites the profitable close-out of a covered call transaction where the following three details apply:

1. An investor has used the TSS on the position.
2. The stock has continued to move up after selling the TSS for income and now the investor cannot buy back the TSS for income call due to this buyback being unprofitable.
3. The investor now has a profit in the stock position but is prevented from closing the entire transaction because it will result in an overall loss.

In the case where the TSS is failing (the stock is still going up), an investor can:

1. Wait longer to see if the price erodes and lead to a profitable buyback of the call.
2. Wait for a large increase in the stock price and close on the delta effect. (stock price increases greater than the option buyback price.)

Implementing the SSR

In using the SSR, the objective is to restructure the position through the following three actions:

1. Close out the existing position by buying back the call and selling the stock. This will result in a temporary loss.
2. Purchase a LEAP or in other words, a longer-term call in place of the stock.
3. Sell a near month or two month out call that will provide a positive called return on the entire transaction.

LEAPS - option contracts with one year or more to expiration and a January 200x expiration.

There are 10 rules for using the SSR. I will cover these in the next posting. For now, here is a preview of the CPR technique again, as detailed in Hooper and Zalewski's book Covered Calls and Leaps.

CPR (Cardiopulmonary Resuscitation)

There are two applications for the CPR:

1. To dramatically expedited the closing of a new covered call position where the stock price has suffered an immediate decline after entering the transaction. The CPR provides this ability as in many cases it allows the investor to lower the strike price of the short call in the near month yet continue to maintain a positive called return.
2. To generate income and reduce the cost basis in a deeply depressed position. The CPR can effectively be applied where an under-performing stock is now in an upward cycle but the cycle's depth is too shallow to effectively use the TSS for income.

As promised, here are the 10 rules for using the SSR covered call defensive technique as presented by Hooper and Zalewski in their book, Covered Calls and Leaps.

1. The SSR is to be used on a covered call position where an investor has an open TSS for income call.
2. The investor has a profit in the stock position. (The stock is worth more than you paid for it.)
3. The position cannot be closed for a profit as the loss on buyback of the call is greater than the potential profit from selling the stock. Therefore, if the position is closed out, a net loss is created.
4. Use the SSR worksheet to calculate the net loss in closing the transaction. (part of the Covered Call Toolbox provided one month's free at www.compoundstockearnings.com)
5. Input various LEAPs contracts into the SSR worksheet. The SSR usually works better when using the second to last expiration LEAPs rather than the furthest out LEAPs contract. Start one strike price out of the money and move into the money 3 or 4 contracts.
6. Input various near month and 2 month out call contracts into the SSR worksheet. Start 2 strikes out of the money and move into the money 2 contracts.
7. The SSR should be executed if the SSR worksheet presents a transaction that has both an uncalled return and called return of greater than 2%. Preference should be given to the SSR transaction with the highest returns. Preference should also be given to selling the near month call.
8. It is also preferable that the SSR be cash flow positive. Investors with excess capital may still choose to execute the SSR if it is cash flow negative. Optimally, the transaction should generate net cash.
9. If the transactions presented by the SSR worksheet do not meet the return requirement of cash flow requirments in 7 and 8, more aggressive investors may choose to enter shorter-term calls into the SRR worksheet as an alternative to using a LEAPs. Aggressive investors may buy a shorter term call to construct a SSR if the shorter term call provides an SSR that meets rules 7 and 8.

If buying a short term call:

a) Preference must be given to the longest term call that meets rules 7 and 8.

b) An investor must not purchase a call when that call's price consists of more than 15% time value. This limit ensures that the investor is purchasing primarily intrinsic value. (exercisable value) and will not be affected greatly by time decay in the event that the position is not exited quickly.

c) When purchasing a shorter term call, investors must be aware that in the event the stock begins trading down, the call will need to be called out.

10. In the event that the call was shorted and the SSR restructure expires worthless, the position should be managed like a regular LEAPs position with the following exception:

The investor should always give preference to selling a near month call if that call will provide a positive called and uncalled return. Remember, the objective of the SSR is not to manage the position for income, but to exit the unproductive position as soon as possible.

As detailed in Hooper and Zalewski's book, Covered Calls and Leaps, what follows is a defensive technique used to resuscitate a fallen stock, the Cardiopulmonary Resuscitation Technique otherwise known as CPR. (see the flowchart below)

Two applications of the CPR technique:

1. To dramatically expedite the closing of a new covered call position where the stock price has suffered an immediate decline after entering the transaction. The CPR provides this ability as in many cases, it allows the investor to lower the strike price of the short call in the near month, yet continue to maintain a positive called return.
2. To generate income and reduce the cost basis in a deeply depressed position. The CPR can effectively be applied where an under-performing stock is now in an upward cycle but the cycle's depth is too shallow to effectively use the TSS for income.

The Structure of a CPR

1. An investor holds a long position of 100 shares of stock.
2. The investor buys one near month (or 2 month out) call.
3. The investor sells 2 near month (or 2 month out) calls with a higher strike price than the call selected in step 2.

The Structure of a CPR (as presented in Hooper and Zalewski's book, Covered Calls and Leaps)

1. An investor holds a long position of 100 shares of stock.
2. The investor buys one near month (or 2 month out) call.
3. The investor sells 2 near month (or 2 month out) calls with a higher strike price than the call selected in step 2.

The CPR will always follow the above structure.

The investor will always purchase the number of call options that relates to his or her stock holding and will always sell 2 times the number of call options that relates to his or her stock holdings.

example:

Dale holds 300 stocks at $32.50

He then buys 3 near month (or 2 month out) calls at $25 strike at $4.00 and

He sells 6 near month (or 2 month out) calls with a higher strike price than the call selected in 2 ... a $30 strike at $1.50.

Again, the CPR as presented by Hooper and Zalewski in their book, Covered Calls and Leaps, is used when the stock price is depressed and in a new cycle, but the cycle depth is too shallow to apply the TSS technique.

Example:

1. John owns 100 shares of FMD at a cost of $32.58.
2. He buys one $25 Jan 06 call at $4.00
3. He sells 2 $30 Jan 06 calls at $1.50.

The Net Debit of a CPR

Net debit = Price of a long call - (2 x Price of the Short Call)

$4.00 - ( 2 x $1.50) = - $1.00

$1.00 is the net debit.

$1.00 is the maximum loss to the investor.

Just to recap ...

The Cardiopulmonary Resuscitation Technique is used to:

1. Dramatically expedite the closing of a new covered call position where the stock price has suffered an immediate decline after entering the transaction. The CPR provides this ability as in many cases, it allows the investor to lower the strike price of the short call in the near month, yet continue to maintain a positive called return.
2. To generate income and reduce the cost basis in a deeply depressed position. The CPR can effectively be applied where an under performing stock is now in an upward cycle but the cycle's depth is too shallow to effectively use the TSS for income.

Construction:

1. An investor holds a long position - 100 shares of stock.
2. The investor buys one near month (or two month out) call.
3. The investor sells two near month (or two month out) calls with a higher strike price than the call in number 2.

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