The Game of Covered Call Options Part Deux

Below is an excerpt from my upcoming third book My Happy Assets - Taking the Last Steps to Financial Independence.

If you like what you read, check out my first book, My Happy Assets at http://www.myhappyassets.com/ only $1.99 and the complete second book, Small Business Coffee Hour, Three Essential Ingredients for a Successful Business at http://www.smallbizcoffee.com/, only $1.99. Happy Reading!

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This is how covered calls work in a nut shell: you own 100 shares of a stock, let’s say Microsoft which you bought at $30. You sell 1 option contract against this stock giving someone the right to buy the stock for $30 at the end of the month. For selling this right, you receive a premium of $1.35 or one hundred and thirty-five dollars total since each contract represents 100 shares of stock.

Important Note: 1 option contract = 100 shares of stock.

The buyer of the option is banking that Microsoft stock will increase over the coming month and be worth more than the $30 strike price of the option contract. If it is, their contract will have value since for example, if the stock goes to $31, they now have the right to buy it at $30.

The seller of the option contract is focusing on the cash flow that the premium is delivering. In this case the seller received a 4.5% rate of return on their money or $135 for the $3,000 investment.

Of course, the risk in this whole deal is that the stock drops like a rock. Of course, if you are already invested in single stock, then you are already here. You could combine Buffettology, the Buffett style of investing in which you purchase fundamentally sound companies with strong, consistent earnings, with covered calls. If you apply the Buffett method correctly then your stocks should appreciate over time

even if “Mr. Market” goes haywire. Again, if you are already in single stocks then you are already here. The difference is that now you will be writing covered calls against your stocks which decreases your cost basis in the stock while delivering cash flow.

Of course if you are in mutual funds then you are not at the same risk platform that I am recommending here. You will see that the technique I follow recommends that you diversify across sectors in a maximum of 20 stocks. This can get you closer to “mutual-fund” like investments and not the complete riskiness of non-Buffett single stocks, but remember, you will not be completely here since mutual funds can potentially hold hundreds of stocks.

Still, if you already hold stocks then you are already invested in stocks nonetheless then covered call options will not be much of a leap. If anything, they should make perfect sense to the cash flow investor since writing covered call options will now allow you to generate monthly income, much like rental property. Remember, your stocks are like little duplexes and the income derived from them via covered calls will more than likely beat your current returns through dividends and capital which gains which probably cap out at 10%. If you are as good as Warren Buffett then you should be able to generate a rate of return of 24%. Our method purports to beat this through covered call cash flow.

The following 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 highly recommend you purchase this book and study this technique. Joe Hooper has been refining this methodology for over 30 years.

Where his method really excels is through the management of positions that “have not gone your way.” This is the whole crux of the plan because remember, the worst case scenario is that the stock drops like a stone. Hooper and Zalewski claim that through their system, you can continue to generate 3 to 6% a month in cash flow or 36% to 72% even if the stock drops. They have developed techniques, that will generate cash flow even if the stock is heading down.

The best analogy for this technique is found in rental property. If you have a four-plex that delivers $500 a month in cash at drops in price, say you purchased it for $150,000, the bottom drops out of the real estate market and it is now worth $75,000, but it still delivers the $500 a month in cash flow, would you sell it? If the $500 made your mortgage payment, would you sell the rental because the underlying asset price dropped in half?

The easy answer is no, correct? Many would argue that the real estate market is much less volatile than the stock market. Although recently, some real estate markets experienced drops of 50%, it is not likely that property is going to roller coaster like stock prices do. On average, property will make the slow climb at 4 to 6% a year. (can anyone say inflation?) Stocks on the other hand, are fairly manic depressive. Bad holiday retail season … market down. Decrease in the jobless number … market up … maybe, depending if analysts already factored this in. A company meets earnings … stock can decrease if analysts think they can’t do this again.

So you see, the market in many ways is ridiculous unlike, in theory, like the value of a piece of property which in general, in normal times, holds its value. The entire focus and the success of the Hooper/Zalewski plan relies on the ability to continue generating the same amount of cash flow regardless of the underlying value of the stock. This cash flow focus is the focus of our cash flow investing methodology which leads to financial independence.

Now Warren Buffett believes in ignoring the manic depressive nature of the market and buying into good companies with a solid history of earnings, a consumer monopoly or a toll bridge and the ability to reinvest those earnings and continue to compound them. Again, if you are an expert Buffett type investor, perhaps you just buy good companies that will increase in value over time and ignore the market.

I will go into detail on the individual decision points in the chart later but for now, here is the overview.

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

As presented by Hooper and Zalewski in their book Covered Calls and Leaps, a Wealth Option, here are the rules for entering a new Leaps position. Remember, Leap is just another word for long-term option, and while covered call writing delivers returns in the 4 - 6% a month range, Leaps can deliver returns in the upper single digits to low teens for an approximate return close to 100% a year.

The Rules for Entering a New Leaps Position

1. You can only establish new positions on down market days. A down market day is any time the Dow and NASDAQ are in the red.
2. Use the CSE screener, provided by Hooper and Zalewski at www.compoundstockearnings.com, to filter all stocks in the market for the fundamental criteria for LEAPs investments.
3. You must follow the rules for correctly constructing a LEAPs position (discussed later). These rules are imbedded in the CSE screener.
4. Ensure that the stock adheres to the buying low rule for LEAPS (discussed later).
5. Always give priority to maintaining acceptable levels of diversification between stocks and industries (invest across the 13 varying sectors) - even if a stock you are already invested in presents an excellent opportunity.
6. Buy the LEAPs first and then immediately sell the call. Do not hesitate.

Again, the previous information is presented in Hooper and Zalewski's bookCovered Calls and Leaps a Wealth Option ... an invaluable resource for anyone who wants to be financially independent.

Below is the LEAPs investing flowchart as presented by Hooper and Zalewski in their book,Covered Calls and LEAPs, A Wealth Option. While covered calls in the book are designed to deliver returns of 3 to 6% per month or approximately 50% a year, LEAPs investing is designed to deliver monthly returns in the high single digits to low teens. What this means is that an investor can expect returns of approximately 100% per year or a payback period of 1 year. An investment of $50,000 results in income of $50,000 per year. An investment of $100,000 results in income of $100,000 per year.

Does this sound too good to be true? Some things that sound too good to be true are true. In order to separate the wheat from the chaff, you have to do your homework, stick your toe in the water and find out. Nothing great ever happens until you take action. Ready, fire, aim. If it doesn't work, readjust your aim.

As presented by Hooper and Zalewski in their book, Covered Calls and LEAPs a Wealth Option, here is the detail of the Buying Low Rule for LEAPs, used in conjunction with the rules for entering a new LEAPs position. Remember, LEAPs can potentially result in returns of 100% per year, meaning a $50,000 investment can replace a $50,000 income.

1. Investment in new LEAPS positions can only be made when a stock's overall or current cycle is increasing or horizontal.

2. Investment in new LEAPS positions can only be made when a stock is in the lower 25 percent of its overall or current price cycle.

3. A stock's current price cycle must have a minimum of $1.50 of price between the upper and lower lines for a position to be eligible for investment. This third rule ensures that there is enough potential upward movement in the stock price to exit the position.

As pointed out by Hooper and Zalewski in their book, Covered Calls and Leaps a Wealth Option,"there are two distinct occasions when the bottom 25 percent of a current rising or horizontal cycle is, in fact, a very poor place to construct a position."

1. The Bottom of a Current Rising Cycle That Is Part of a Longer-Term Downward Cycle
2. Current Cycles That Are Close to the Yearly High

As it relates to point one, always check the long term cycle. The stock could in fact be in a prolonged downward cycle and therefore, not an optimal investment. Make sure to check the one-year price chart, draw in the trend lines, top first and then bottom for a downward trend, in order to verify the cycle. A stock typically has broken out of a downward cycle when it has substantially broken the top downward trend line and continued up for a number of months ... at least three typically.

Number two essentially means do not buy a stock that has ascended in a straight stair fashion to its yearly high. If it has gone straight up and you are now close to a 52 week high, look elsewhere.

Again, all of this is covered in a great book on option writing, Covered Calls and LEAPS, a Wealth Option.

According to Hooper and Zalewski in their book Covered Calls and LEAPS a Wealth Option, one can identify a change in cycle by identifying when the following two events occur, indicating a change from a declining cycle to a rising cycle.

1. A higher bottom or bottoms, which may occur within the declining price cycle.
2. A break through of the top line of the declining price cycle.

According to the authors, "the first buy point of a new price cycle is literally the first point in a new cycle at which the buying low rule is satisfied" and "the first buy point of a new cycle is always preceded by a minimum of tow tops and a minimum of one bottom." The second top is higher than the first.

This is merely the first spot an investor can enter the new LEAPs position. You can also enter the position after the trend has been well established but this serves as an indicator at a minimum of when the first buy point occurs.

Okay, here is how Hooper and Zalewski tell you how to construct a LEAPS position in their bookCovered Calls and LEAPS a Wealth Option. I highly recommend you purchase this book if you are serious about generating cash flow into your income column and reaching financial independence.

Selecting a LEAPS

• Select a LEAPS that is one strike in the money.
• Do not select a LEAPS that is more than $10.00 in price. This will create leverage for you and let you manage the position better in the event of a market downturn.
• The LEAPS selected must have a minimum 12 months to expiration with preference given to the longest-term available.

Selecting the Call

• Sell a call as soon as you buy the LEAP. Hesitation is for the weak and the speculator.
• Select a call that results in a positive called return ... you can find this by adding the cost of the LEAPS to the LEAPS strike price. This will give you the approximate strike price of the call.
• The call expiration cannot be equal to the LEAPS expiration.
• The combine delta ratio of the LEAP and call must be 1.90 or more. This will allow you to potentially close out on the delta effect. (this is the rate of change of the option price with respect to the underlying stock. At a 1.9, the LEAPS price will increase much faster than the cost of buying back the call.

The Delta equation in this context is as follows:

Delta ratio = LEAPS delta/Call delta

In order to complete the construction, use Hooper and Zalewski's propreitary screener located at www.compoundstockearnings.com, ensure the underlying stock position is an overall or current upward or horizontal cycle and that it meets the buying low rule.

Hooper and Zalewski in their book Covered Calls and LEAPS a Wealth Option, detail the management techniques necessary to maintain high returns. While covered calls are intended to deliver returns in the area of 4% a month or 48% a year, LEAPS are designed to deliver returns in the range of high single digits to the lower teens. What this means is that one can potentially reach returns of 100% a year. A 50,000 dollar a year income can be replace with a $50,000 investment. Sound to good to be true? If something sounds too good to be true, then it is worth checking out.

The LEAPS Management Rules of Hooper and Zalewski

• The 10 Cent Rule
• The Delta Low Bridge Technique
• The 5% Buyback Rules

The 10 Cent Rule and Delta Low Bridge are applicable in a situation where the stock price has increased. If the bid price of the LEAPS increases to 10 cents above your cost in the LEAPS you buy back the short call at market price. You then add the cost of the buyback to your cost in the LEAPS and add 5%. If the LEAPS sells then you will have generated a return of 5% in a short period of time.

Under the Delta Low Bridge, you close out the entire transaction when you can realize a 5% return. The Delta is working in your favor because the construction of the LEAPS calls for a position with a delta of 1.90. When the stock price increases the LEAPS will increase at a much faster clip. When you close out using the Delta Low Bridge, you back the short call for a loss and then sell the LEAP in order to generate an overall profit. Thus, you must make sure to generate a minimum 5% return when you buy back the call and sell the LEAP.

For example, let's say you purchase a LEAPS for $10 and sell a call for a premium of $.90. The stock then goes up and thus the LEAP goes up to let's say a price of $12.00. For example sake, let's say the call has gone up to a $1.20. You can now buy the call back to close for a loss of $.30 and then sell the LEAPS for a gain of $2.00. $2.00 - .$30 = $1.70. $1.70/$10.00 = 17%.

You now have your money back and are ready to enter a new position following the rules.

In the case where the stock price drops, you can utilize the 5% Rule. Buy back the call for a net uncalled profit of 5% if market prices drop. You then add 5% to the cost of the LEAPS and put in a GTC order to sell at this price. If the LEAPS sells, you will have locked in a 10% return. To calculate the initial 5% return, you simply multiply your cost in the LEAPS by 5% and then subtract this number from the premium you received on the short call. This will be your call buyback price and you can enter a GTC order to automatically buy at this price. This will ensure that the call is bought back if the stock drops and allow you to not have to micro-monitor for this event.

Hooper and Zalewski provide a LEAPS screening tool at www.compoundstockearnings.com in the covered call toolbox. This screener includes a DLB index and ranks the positions lowest to highest according to percent increase for call out and is a very useful tool for this type of investing.

If you were not able to sell your initial LEAP for cost plus 5% then you should follow the rules for secondary call sales as detailed by Hooper and Zalewski in their book, Covered Calls and LEAPS, a Wealth Option.

1. A secondary call can only be sold when the markets are in the green.
2. It can only be sold after implementing either the 10 cent rule or the 5% buyback rule.
3. A secondary call cannot be sold if the mkt. bid price of the LEAPS is within 10% of your GTC sale price.
4. A secondary call can only be sold with the formalized seven day rule has been satisfied.
5. A secondary call sale should generate a minimum of 10 percent uncalled return.
6. The aim is to buy back the call for a net uncalled return of 5%.
7. It is preferable to select the same call strike price as the strike price used when the position was established.
8. Preference should always be given to a shorter term call if this provides the minimum uncalled return requirement of 10 percent.
9. If a min. 10% uncalled return with the same strike cannot be maintained, drop the strike one increment toward in the money.
10. Continue to drop to generate yield up to the point that the call strike price is equal to the LEAPS strike price.
11. If the 10% cannot be generated then the LEAPS should be repositioned.

In their book Covered Calls and LEAPS a Wealth, Hooper and Zalewski detail how to invest in LEAPS in order to generate returns in the high single digits to low teens. They go into detail on how to manage your position in the event that it is not called out. One of the rules is to only sell a secondary call on the LEAP if the Formalized Seven-Day Rule is met. Here are the details of the Formalized Seven-Day Rule:

1. The rule is essentially the selling high rule that was discussed for covered calls - secondary call sales can only be made when a stock is in the upper 75% of its current price cycle. What this means is that you take the stock's price chart, draw upper and lower trendlines around its current channel and then divide the range into quarters. Again, you only sell secondary calls when the stock is in the upper 75% of its price. The intention of this rule is to allow the stock price to drop and allow for profitable buyback.
2. A rising price cycle must have a minimum of $1.50 of price between the upper and lower lines of its price cycle.

If the stock shoots up instead of dropping as anticipated, you may be able to profitably exit on the delta effect, buy back the call profitably due to time decay or use another advanced technique to manage the position such as the Surrogate LEAPS Replacement.

There is one exception to the rule ... on a declining cycle, only buy back the call when the stock reaches the bottom 25% of its price cycle.

This is when you want to sell a secondary call. The first sell point of a new cycle is always preceded by a minimum of two bottoms and one top according to Hooper and Zalewski in their book,Covered Calls and LEAPS, a Wealth Option.

In a rising cycle you will see a break through of the top of a declining cycle. You will see higher bottoms. The first sell point is preceded by a minimum of two bottoms and one top. In a declining cycle, you will see the break through of the bottom of a rising cycle and then the first sell point is preceded by a minimum of two bottoms and one top.

It is very important to pay attention to these indicators when selling secondary calls under the LEAPS technique since you are leveraged in the positions and optimization is therefore highly important.

According to Hooper and Zalewski, in their book Covered Calls and LEAPS A Wealth Option, there are five defensive techniques to manage a LEAPS that has not sold for a profit.

1. SLR
2. Average down
3. Reposition
4. Close on delta
5. Roll out

The SLR or Surrogate LEAPS Replacement is used when 3 conditions exist:

1. An investor has sold a secondary call and the stock price has moved up, not allowing that call to be bought back for a profit.
2. The investor can sell the LEAPS for a 5 percent or better profit but is prevented from closing the transaction as doing so would result in an overall negative return due to the buyback cost of the call.
3. The stock is in the upper 75% of its current cycle.

Here's how to implement the SSR:

If the stock price is in the upper 75% of the cycle and you are able to sell the original LEAPS for a return of 5% or more, the SLR can be considered.

Select the same expiration date, move the strike price up one or two increments (preferably not equal to the strike price of the call) Buy this LEAPS and then immediately sell the LEAPS you own.

Two scenarios take place after you implement this:

1. Stock price continues up and you may be able to sell the LEAPS for a 5% profit and then buy another LEAPS.
2. Stock price declines and you may be able to buy back the call when you can exit a the cost you sold it for.

In their book Covered Calls and LEAPS, a Wealth Option, Hooper and Zalewski detail a number of defensive rules to manage a LEAPS position gone awry including how to average down a position.

The Averaging Down Rules

1. If the market price of a LEAPS drops significantly to a point where you are able to buy the same LEAPS contract you already own for 15% or less of the price you paid for it, then do so.
2. You should buy the number of contracts that brings your average cost to a price equal to two times the average down price.
3. The 5% return calculation for subsequent secondary call sales should be based on the original contract cost, not on the average cost of contracts. So, for a buyback on a secondary call sale on a $5.00 LEAPS, you should still attempt to realize a net return of $.25.
4. Sell the LEAPS at the new average cost plus 5%, not the original cost. So, for the preceding example, you should sell the LEAPS for $1.50 plus 5%.

Hooper and Zalewski detail how to manage a LEAPS that has not sold for profit in their book,Covered Calls and LEAPS a Wealth Option. Here are two of the techniques:

Repositioning a LEAPS

In order to generate a 10% minimum return you occasionally have to sell a call with a strike price less than the LEAPS. If this is the case, you should reposition your LEAPS. This simply means selling the LEAPS you currently own and purchasing a LEAPS with the same expiration one or two strike prices deeper in the money. Try not to violate the $10.00 adjusted cost rule ... if you do, will be more difficult to manage the call position.

Repositioning has the effect of creating more management depth.

Rolling Out

Rolling out ensures that you keep time decay in your LEAPS at a minimum by ensuring that there is always at least one year of time value left in the LEAPS.

If the LEAPS has less than one year to expiration, follow these guidelines to roll out:

1. It must be conducted on a down day.
2. If it allows, select the same strike price and the furthest out date possible providing that the adjusted cost does not exceed $10.00.
3. If this LEAPS leads to an adjusted cost of more than $10.00, select the next highest strike price. Continue to raise the strike until the adjusted cost does not exceed $10.00.

Adjusted cost is a measure of the new cost of your LEAPS after you have rolled out.

Adjusted cost = cost of original - sell price of original + cost of new LEAPS

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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