Section 1256 Contracts Marked to Market

Trading broad-based index options for taxable accounts can have some favorable consequences when paying federal income taxes. The IRS has a provision known as a Section 1256 Contracts Marked to Market. A section 1256 contract is any:

1. Regulated futures contract,
2. Foreign currency contract,
3. Non-equity option,
4. Dealer equity option,
5. Dealer securities futures contract.

Broad-based Index Options

The third item in this list, non-equity option, is of interest for trading index options. The IRS defines a non-equity option as “any listed option that is not an equity option.” According to the IRS, non-stock options include debt options, commodity futures options, currency options, and broad-based stock index options. A broad-based stock index is based upon the value of a group of diversified stocks or securities (ten or more). Standard and Poor’s 500 index is one example of a broad-based stock index.

60/40 Rule

Generally, capital gains from stock or stock option investments held less than one year are considered short-term and those held longer than one year are considered long-term. However, according to the IRS, under the marked to market system, 60% of a capital gain or loss may be treated as a long-term capital gain or loss and 40% may be treated as a short-term capital gain or loss, even if the position was held for less than a year. The ramification of this rule is that capital gains or losses considered to be long-term have lower marginal tax rates than short-term capital gains or losses, and index options on broad-based indexes qualifying under the 60/40 rule have a more favorable tax treatment over options on equities considered short-term investments.

Example

For example, for a short-term capital gain with a marginal tax rate of 35%, the marginal taxes on a $1,000 capital gain would be $350 and for a long-term capital gain with a marginal tax rate of 15%, the marginal taxes on $1,000 would be $150. Using the 60/40 rule, 60% of the capital gain, $600, would be taxed at 15% and 40% of the capital gain, $400, would be taxed at 35%, so the taxes paid under the 60/40 rule would be $90 for the portion considered long-term and $140 for the portion considered short-term for a total of $230 which is $120 less than if the total capital gain were considered short-term. The composite marginal tax rate for this example of the 60/40 rule is 23%, 12% less than the 35% rate for short-term capital gains and represents paying 34% less in income taxes.

Actual Broad-Based Index Spread Trade Example

To take advantage of trading option spreads for broad-based indexes investors must first make a profit. To aid investors in successfully trading broad-based index spreads, an actual broad-based index spread successfully traded is presented.

Trade Details

A bull-put credit spread was entered for PowerOptionsApplied’s Chromium TradeFolio™ on 8/5/2011 with the initial position and representative market bid/ask prices as shown below:

Market Return

Entering the position at market prices would have yielded a net credit of $0.05 calculated as $7.20-$7.15 for a potential return of 0.2%. The potential return is calculated as: [net credit*100%/(capital requirement – net credit)] = [$0.05*100%/(1095-1070) - $0.05]. With the capital requirement per share calculated as the difference between the strike prices for the options.

Midpoint Pricing

Option trades can often be filled at the midway point between the bid and ask prices with the calculation for the midway point for buying the $SPX 2011 Aug 1070 Put option calculated as $5.65+($7.15-$5.65)/2 = $5.65 + $0.75 or $6.40. Similarly, the midway point for selling the $SPX 2011 Aug 1095 Put option can be calculated as $7.20+($8.80-$7.20)/2 = $8.00.

The spread between the midpoints is then calculated as $8.0 – $6.4 which equals $1.60 with the potential return calculated as [$1.60*100%/(1095-1070) - $1.60] or 6.8%.

The trade was entered for a net credit of $1.50 and the trade was executed for a net credit of $2.20. This is a significant increase in net credit over the midpoint pricing and is atypical. The reason for the significant increase in net credit is a result of the price of the $SPX dropping significantly between the time the trade was selected and the time the trade was placed. The $2.20 net credit represented a potential return of 9.6%.

By attempting to enter a spread position using midpoint pricing, the potential return was significantly increased to 9.6% from the potential market-based return of 0.2%. The 0.2% potential return can be realized simply by entering a market order, but to get a position with the midpoint return of 6.8% requires entering the position with a net limit order.

As you can see, performing the vast array of the midpoint calculations is a lot of work. Granted some brokers provide midpoint pricing for each option, but not for the midpoint spread between the midpoint prices. PowerOptions new Mid-Point Spread Chain tool not only provides the midpoint pricing needed for spread trading but also provides other important information such as % out-of-the-money, potential return, annualized potential return and probability of success.

Mid-Point Spread Chain
A partial screen capture from the PowerOptions Mid-Point Spread Chain unrelated to the position mentioned above is shown below:

For brevity, the call option spreads have been omitted. The parameters used for the screen capture above were:

• Spread width : 25
• Min Credit: greater than 0
• % Out Money Range: greater than 0
• Min % Return: greater than 5%
• % Probability Range: greater than 90%

As an example, the 1130/1155 bull-put credit spread has midpoint prices for the bid/ask of $2.22 and $3.70, respectively. The spread between the midpoints is $1.48 ($3.70-$2.22). The $1.48 represents a good starting point for the limit price for entering the position. As shown in the screen shot above, the short strike for the 1155 put option is 8.3% out-of-the-money, the potential return is 6.3%, the annualized potential return is 99.9% and the probability the position expires out-of-the-money is 96.5%.

PowerOptions’ Mid-Point Spread Chain takes care of the cumbersome calculations needed for entering spread trades and also for management of spread trades as shown in the following paragraphs.

Rolling a Position in Trouble

On 8/10/2011, the price of $SPX had dropped significantly and the August spread trade entered on 8/5/2011 for Chromium was in trouble as shown below:

Out-of-the-money spread trades can typically be rolled for a net credit, but once the trade transitions to in-the-money, rolling the position for a net credit is less likely. In order to prevent the position from going in-the-money, the August bull-put credit spread was rolled to a September bull-put credit with a lower short strike price. PowerOptions’ Mid-Point Spread Chain tool was used to evaluate and find the new position for potentially rolling as shown below:

To close the August spread required a net debit of $4.05 and entering the September spread position has the potential to generate a net credit of $5.10 with the combination of the two resulting in a potential net credit for rolling of $1.05 ($5.10-$4.05).

The position was entered at a net credit of $1.00 which was slightly lower than the midpoint calculation of $1.05.

Rolling a Position Again

The Chromium position was once again in trouble on 9/22/2011 as shown below:

Using PowerOptions’ Mid-Point Spread Chain tool, a candidate position for rolling was found. The September bull-put was rolled to an October bull-put for a net credit as shown below:

To close the September spread required a net debit of $4.60 and the October spread position had a potential net credit of $5.35 representing a potential net credit for rolling of $0.75. The order was placed with a net credit limit of $0.70 slightly lower than the midpoint value of $0.75 and was executed for $0.70.

Rolling Troubled Position for the Last Time

On 10/3/2011, the Chromium position was once again in trouble as shown below:

Using PowerOptions’ Mid-Point Spread Chain tool, a candidate position rolling was found. The October bull-put was rolled to a December bull-put for a net credit as shown below:

A suitable candidate for rolling to November was not found which is why the December position was selected.

To close the October spread required a net debit of $6.21 and to enter the December spread required a net credit of $7.26 based upon midpoint pricing with a resulting potential net credit of $1.05 ($7.26-$6.21). The roll order was placed with a net credit of $1.00 which was slightly lower than the midpoint calculation and was executed for a net credit of $1.05.

Trading Success

On December 17, 2011, the December put options expired worthless and the combination of the series of trades yielded a total net credit of $4.95 ($2.20+$1.00+$0.70+$1.05) for a return of 21.7% (not including brokerage fees and commissions). The return was calculated as $4.95*100%/($25-$2.2).

From start to finish, the position required 134 days to generate the 21.7% return which represented a 4.9% monthly return and a 59.1% annualized return.

Summary

Successful trading of option spreads for broad-based indexes can result in significant reduction in income taxes paid. Additionally, a significant amount of analysis is required for initial entry and management of spread trades using exchange bid/ask prices. The amount of effort required for spread trading can be significantly reduced through the use of tools such as PowerOptions’ Mid-Point Spread Chain which uses midpoint pricing for analysis, as option trades can often be executed at the midpoint between bid/ask.

Disclaimer

The information provided in this article is for informational purposes only. Power Financial Group, Inc. makes no claims as to the accuracy of the tax-related information included in this article and you should consult your tax advisor for more details.

The stock market can behave crazily at times as in the case of Technology Bubble, Lehman Brothers, Housing Bubble, Credit Crisis, Debt Ceiling, etc. Investors can be taken for very painful rides during market events such as these.

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(to view archived version of this presentation click the video below)

Insurance

An investor would not consider owning an expensive house or automobile and also not have it insured, however, the same investor may think nothing of putting his/her capital into the stock market – without any kind of insurance.

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But, where would an investor purchase insurance for their investment portfolio? The answer is the option market. The option market provides several methods for insuring an investment portfolio. Four of the methods discussed in this article include:

These four alternatives, individual, ETF, index and VIX, provide investors with a variety of ways for insuring their portfolios. Each approach has its positives and negatives, but all may be used for insuring an investment portfolio.

Put options for stock enable insuring a single investment against a loss. ETF put options can provide insurance for a sector of stock investments or a broad market of stock investments. Index put options and VIX call options can provide insurance for a broad market of stock investments.

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Individual Put Options

Put options for individual stocks provide the highest level of protection, but also come with the largest cost. This cost can include higher brokerage fees as well as the associated “cost” for insuring the investment. The cost for insuring an individual stock varies depending upon the “level” of insurance, but typically costs around 1.5% per month or 18% per year. This means in an up market, an investor would have to make at least 18% on an investment just to make a profit. Individual put option insurance can be entered for weekly (in some cases), monthly, quarterly and yearly increments. In general, individual put options further out-in-time provide the cheapest insurance based upon cost-per-day, but require the largest upfront capital and/or cost.

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ETF Put Options

ETF put options enable an investor to insure a sector of stock investments. For example, a portfolio with a large portion in oil and gas related companies may be insured using an oil and gas oriented ETF. Using ETF put options for insurance enables an investor to focus on a particular sector and not be significantly hurt if the sector takes a hit. However, a problem with an individual stock and not associated with sector as a whole can cause some pain for a portfolio insured with ETF put options. However, by using the conventional approach of diversification, a hit from a single investment can be reduced. Similar to individual put options, ETF put options further out-in-time provide the cheapest insurance based upon cost-per-day, but require the largest upfront capital and/or cost.

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Index Put Options

Index put options can insure a broad-based portfolio of investments. If the whole market takes a hit, index put options can provide insurance. However, similar to ETF put options, a problem with an individual stock not associated with the market as a whole can cause some pain. Diversification, as discussed in the previous paragraph, can help reduce problems with a single investment. Similar to individual put options and ETF put options, index put options further out-in-time provide the cheapest insurance based upon cost-per-day, but require the largest upfront cost

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VIX Call Options

The VIX index represents a measure of the implied volatility of S&P 500 index options. The VIX moves counter to the stock market, if the stock market moves down significantly, the VIX moves upward significantly. VIX call options provide insurance for a broad-based portfolio, similar to index put options, however, when the market has a lot of “fear”, VIX call options can provide some very serious protection for a small amount of capital. As an example, a broad-based investment portfolio can be insured with VIX call options for about 0.5% per month. Based on this example, a $100,000 broad-based portfolio of stocks can be insured with VIX call options for $500 per month. However, insuring with VIX call options require monthly purchases of the options, as VIX call options further out in time do not move very much as compared to the stock market. Purchasing VIX call options with a short time-to-expiration is preferable, as the shorter timeframe VIX call options move more dramatically when the market makes a significant movement. The graph below illustrates the contrary movement of the VIX as compared to the S&P500 index (SPX):

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As can be observed, the VIX moves contrary to the stock market. When the market moves up, the VIX moves downward. When the market moves down, the VIX moves up. Purchasing a long call option provides a hedge mechanism for alleviating pain when the market takes a very large drop.

Investment Insurance is Expensive

Investment insurance by itself presents a problem, as it is expensive. As a conservative example, insuring with VIX call options can require as much as 0.5% to 1% of a portfolio per month or 6% to 12% per year. So, a $100,000 portfolio requires from $500 to $1000 per month to insure with VIX call options. Individual stock put option insurance is typically more expensive than VIX call options with a cost in the neighborhood of 1.5% per month.

The long-term return of the stock market is in the range of 8-10% per year, so a buy-and-hold investment approach attempting to use insurance for protection does not bode very well for realizing a profit after paying for the insurance. For example, a portfolio returning 8% per year with an insurance cost of 6% per year leaves only a 2% margin for profit.

Income Methods to Pay for Investment Insurance

With the stock market being too volatile and insurance being too expensive, what is the answer? One approach is to purchase insurance and pay for the insurance with income methods. Another approach is to invest with option income methods and use a portion of the income from the income methods to pay for investment insurance.

As a reference, some examples of income methods include:

The Covered Call income method will be discussed in more detail later in this article. The Naked Put strategy has a similar risk/reward profile as the Covered Call, but does not involve purchase of stock and therefore does not participate in receiving dividends. Investing in Spreads is a highly leveraged strategy and is not discussed in this article, but in general, it is recommend to overly weight a portfolio with Spreads, as Spread positions can be very dangerous and can result in a large loss in highly volatile markets.

Purchase Insurance then Pay for Insurance

Purchasing insurance followed by paying for the insurance with income methods can be performed via the Married Put position. A Married Put combines purchase of a stock with purchase of a put option. The shares of the stock are insured by the put option. The put option provides a guaranteed exit.

An example of a 5-line setup for Married Put position is shown below:

Insurance for Single Stock is Very Expensive

The Married Put position is a limited risk position with unlimited upside, however the insurance provided for protection is expensive. In the case of the ABX example, the insurance costs about 1% per month. However, income methods can be used to reduce and/or eliminate the cost of the insurance. It is also possible to realize a position which is “Bulletproof” meaning a position guaranteeing an exit price higher than the initial cost basis. For example, the initial cost basis for the ABX position was $57.81, so bulletproofing the ABX position would result in an exit price greater than the initial cost basis of $57.81. The chart below illustrates a profit/loss diagram for the initial ABX position:

Bulletproof

As an example scenario for ABX, consider the possibility of selling a Sep 55 call option for $3.00 after the price of ABX increases to $55. Selling the call option against the stock is known as a Covered Call position and the Covered Call position combined with the put option results in a Collar position. The Covered Call and Collar positions are discussed in more detail later in this article.

Selling the Sep 55 call option reduces the risk to -$0.19 as the total cost for the ABX position has been reduced to $54.81 with a guaranteed exit price of $55 – the position has been made Bulletproof – meaning it cannot result in a loss as compared to the initial investment! A profit/loss chart for the modified ABX position is shown below:

The details for the Married put with Income strategy can be found in “The Blueprint” – additional details can be found at www.RadioActiveTrading.com. A free “Sketch” can be downloaded at RadioActiveTrading outlining one of the ten income methods discussed in “The Blueprint”.

Pro’s of the Married Put with Income Strategy are:

Con’s of the Married Put with Income Strategy are:

Covered Call

The Covered Call investment strategy is one of the most well-known and most popular stock option strategies. Many stock option investors start with Covered Call investments and then learn more advanced stock option investing strategies.

A Covered Call position may be entered by purchasing a stock and selling a call option against the stock. A Covered Call position may also be entered by selling a call option against an existing stock position.

A Covered Call position can be considered analogous to purchasing a house and leasing the house out with an option to purchase.

A profit/loss diagram for a Covered Call position is shown below:

As illustrated in the profit/loss chart shown above, a Covered Call position has some downside protection, so the price of the stock can drop with the position remaining profitable.

Covered Call Can be Managed

A negative of the Covered Call strategy is its limited upside potential and its exposure to a very large loss. However, application of management techniques for the Covered Call strategy increases the cap associated with the upside potential. Covered Call positions can be rolled up, down, and/or out-in-time for increasing upside potential. An example of a managed Covered Call position is shown below:

Collar

A Covered Call position can be converted to a Collar position with the purchase of a put option. A Collar is analogous to purchasing a house, leasing the house out with an option to purchase and purchasing insurance for protection.

A profit/loss diagram for a Collar position is shown below:

As can be seen, the Collar position has limited upside and downside.

Example Covered Call Trade

An example for the PowerOptionsApplied Titanium TradeFolio^TM will be presented illustrating the management of a Covered Call position. Titanium is a newsletter publishing Covered Call positions for stocks with 2-8 new positions entered per month with an average number of twenty positions open at a time.

PowerOptions

Titanium uses its sister company, PowerOptions (www.PowerOpt.com), for finding and managing Covered Call positions. Typically positions published by Titanium are: included in S&P 500, in an up-trend and have recently taken a dip

PowerOptions’ tools enable searching for positions meeting the three criteria mentioned above. Positions in an up-trend are found by searching for positions with a 100 day moving average greater than the 200 day moving average. Positions which have also taken a dip are found using Bollinger Band constraints.

A position for Kohl’s (KSS) was found using PowerOptions on 1/10/2011. The price of Kohl’s stock was also close to its 200 day moving average and its previous support level, two other desirable conditions for entering a Covered Call.

A profit/loss diagram for the published KSS Covered Call position is shown below:

Kohl’s stock was purchased for $52.03 and a 2011 Feb 52.50 call option was sold against the stock for $1.37.

The unchanged potential return for the Kohl’s Covered Call position was 2.7%, the assigned potential return was 3.6% and the time-to-expiration was 40 days. The unchanged potential return of 2.7% represents the potential return if the price of Kohl’s stock was at the price of entry, $52.03, at expiration. The assigned potential return of 3.6% represents the potential return if the price of Kohl’s is greater than the strike price of the call option, $52.50, at expiration, resulting in the assignment or calling away of the stock.

Covered Call vs. Collar

As a hypothetical comparison, entering a Collar for Kohl’s can also be analyzed. For example, the KSS 2011 Feb 50 put option could have been purchased on 1/10/2011 for $0.75. The Collar position would then have had an unchanged potential return of 1.2%, an assigned potential return of 2.1% and a maximum risk of 2.7%. Purchasing the put option for insurance limits the downside for the position to 2.7%, but does so at a cost of 1.5% of potential return. A comparison of the Covered Call position versus the hypothetical Collar position is shown in the table below:

Rolling Covered Call

On 2/17/2011 very little time value was left for the Kohl’s covered call position and the position was rolled to a new position. Time value represents a premium over the intrinsic or current exercise value. The details for rolling the position are shown below:

By rolling the position from February to March the new assigned potential return was 5.4%. As a bonus, on 3/7/2011 Kohl’s paid a dividend of $0.25 per share increasing the assigned potential return to 5.9%.

On 3/18/2011, the price of KSS was at $52.77, so the March 52.50 call option was in the money and the KSS stock was assigned or called away. The table below compares the return for the covered call position versus a buy-and-hold long position in KSS:

Covered Call Outperformed Long Position

As you can see, the Covered Call strategy outperformed the buy-and-hold strategy by 4%. This is not always the case, sometimes the Covered Call position outperforms a buy-and-hold stock, and sometimes the buy-and-hold long stock outperforms the Covered Call. The real advantage of using the Covered Call strategy is that income generated from selling the call option can be used to purchase insurance for insuring a single position and/or for insuring a portfolio.

Income investing with insurance provides income with less volatility, so investors can invest with less fear.

Investors seeking to learn income investing with insurance can get started with a free 14-day trial to PowerOptions at www.PowerOpt.com. PowerOptions provides education and tools for income investing with insurance. PowerOptions also provides tools for analyzing, finding and managing income generating investments.

Investors seeking to follow the experts for income investing with insurance can get started with a subscription to a free newsletter at www.PowerOptionsApplied.com.

Safety Net

Safety Net is included with a subscription to the free PowerOptionsApplied newsletter. Safety Net is provided to help investors insure their income generating portfolios against a large market crash. The table below compares some hypothetical best-case returns for insuring with SPY put options versus VIX call options (used by the Safety Net):

As can be observed, VIX call options significantly outperformed the SPY put options in three of the four examples Lehman Credit Crisis part I, Lehman Credit Crisis part II and the Flash Crash. However, in the recent market drop associated with the Debt Ceiling political maneuvering, the SPY put options outperformed the VIX call options.

Hypothetically, an investor purchasing the VIX Oct 60 call option on 9/22/2008 and selling the VIX Oct 60 call option on 10/17/2008 would have experienced a return of 11700%. For example, for a portfolio of $100,000 and using 0.5% or $500 of the portfolio for insurance would have realized a gain of $58,000. A diversified portfolio of S&P500 stocks would have dropped around $23,000 over the same time period. So instead of the portfolio being down $23,000, the portfolio would actually have realized a gain of $35,000 ($58,000 – $23,000) due to the VIX Oct 60 call options.

A difficulty with purchasing insurance using VIX call options is determining which VIX call option to purchase. The best return was generated for a VIX call option selected 26 strikes out-of-the-money, however selecting a VIX call option 26 strikes out-of-the-money only works well when the market is really volatile and fearful. In general, its best to purchase short-term VIX call options with a time-to-expiration of less than 30-40 days and 4 to 8 strikes out-of-the-money. An investor might also consider using half of their insurance allocation for purchasing VIX call options 4 to 8 strikes out-of-the-money and half of the allocation for purchasing VIX call options about 20 strikes out-of-the-money.

If after reading this, you think income investing with insurance is for you then check out our websites at: www.PowerOpt.com, www.PowerOptionsApplied.com and RadioActiveTrading.com. Don’t forget to sign up for the free 14-day trial to PowerOptions, the free newsletter to PowerOptionsApplied and get the FREE “Sketch” at RadioActiveTrading.com.

Technorati Tags: portfolio, diversification, stocks, Technology Bubble, Lehman Brothers, Housing Bubble, Credit Crisis, Debt Ceiling, Investors, insurance, KSS, Kohls Corp.

But before considering the Greeks, it’s a good idea to consider the support and resistance for a stock, index or ETF.

For example, consider entering a position for Chevron (CVX) with the graph as shown below:

For those of you who don’t already know, Chevron is in the oil and gas business and was formerly known as Chevron Texaco.

As observed from the graph, Chevron’s stock price was on an upward trend for several months, then entered a trading range with support around $97 and resistance around $110, as shown by the graph below:

A support level is a price at which a stock stopped dropping for a prior drop in price and resistance level is a price at which a stock ceased increasing for a prior increase in price.

Trading spreads for stocks in a trading range can be very tricky, as the stock’s price can trend up for a while, then trend down for a while, etc. It’s very easy to get on the wrong side of a spread when a stock is in a trading range.

The price of Chevron is trading in the middle between it’s support and resistance levels, so entering either a bullish position with a bull-put credit spread or entering a bearish position with a bear-call credit spread could result in a lot of management if the position goes against you, or worse result in a loss.

Sometimes the best trade to make is not to enter a trade at all, and with Chevron’s stock price trading near the middle between its resistance and support, the best trade in this case may also be not entering a trade and waiting for a better entry point.

For example, an option investor might wait until the price of CVX dropped to the neighborhood of the lower resistance price of $97 and enter a bull-put credit spread, or wait until the price of CVX increased to around the upper resistance value of $110 and enter a bear-call credit spread.

So, a better place to start than with the Greeks when considering a stock option spread trade is to consider the stock’s support and resistance levels.

OK, time for the sales pitch, you can learn how to trade options for your own account with PowerOptions or you can follow the option trading pros at PowerOptionsApplied.com for those of you that want to track and trade the experts recommendations.

Most Well Known Stock Option Strategy

The Covered Call strategy is the most well known stock option investing strategy. The Covered Call strategy is easy to implement and is less risky than many other stock option strategies. Entering a Covered Call position entails purchasing a stock and selling a call option against the purchased stock. The Covered Call position can return a higher return than experienced by the plain-old long stock position, and the converse is also true, the long stock position can return a higher return than the Covered Call position. A typical potential return for a Covered Call position is around 2-3% over a timeframe of one month.

Managed vs. Unmanaged

The Covered Call position is commonly referred to as having limited upside, which is true for an unmanaged Covered Call position, but for a managed Covered Call position, the upside is not limited, as the position can be continually rolled for realizing increased return.

Downside Protection

The Covered Call position has a nice characteristic in that it has downside protection, i.e. the long stock for the position can decrease in price, however, the Covered Call position can still return a profit.

Legging-in

Another twist for the Covered Call strategy is legging-into a position. For this scenario, the long stock is purchased and the call option is sold against the stock at a later date following an increase in the price of the stock. Typically, the legged-in call option is sold at-the-money. At-the-money refers to the price of the stock and the strike price of the option at approximately the same price. For example, a stock could be purchased at $50 and when the price of the stock reached $55, a call option with a $55 strike could then be sold against the stock. Legging-in allows an investor to participate in the appreciation in the price of the stock and also generate income from selling options against the stock.

Out-of-the-Money

A similar strategy to legging-in is entering an out-of-the-money Covered Call position. For an out-of-the-money Covered Call, the call option is sold simultaneously to the purchase of the stock, but the strike price of the call option is greater in price than the underlying stock price. An out-of-the-money Covered Call enables an investor to realize profit for the increase in the price of the stock and also for income from selling call options against the stock. In comparison, the income generated from the option for the out-of-the-money Covered Call is less than the income generated from legging-into an at-the-money Covered Call.

Collar

A Collar strategy takes the Covered Call method step further with the purchase of a put option for protection or insurance. A put option can be thought of as insurance for stocks, if a stock drops in price, the put option can insure against a large loss. The problem with a collar strategy is the put options are generally very expensive and eat into the potential income for a Covered Call. Whereas a Covered Call position may have a potential return of 2-3%, a Collar on the other hand may have a potential return of 1%-2%. Even after purchasing the protective put option, a Collar position can potentially sustain a double-digit percentage loss.

Covered Call on the Dips

Entering a Covered Call on the dips for blue chip companies can act to mimic a Collar position without having to pay for the protective put option. The idea is to enter a Covered Call or purchase a blue-chip stock with the intent of legging-into a Covered Call at a point in time where the price of the blue-chip stock has “dipped”. The position is not protected by a put option, but at some point potential buyers of a blue-chip stock will step up and purchase the stock thereby putting a bottom under the stock. An added bonus is to enter a position for a blue-chip stock paying a nice dividend, as potential buyers are more prone to step up and purchase a dividend stock when the dividend yield becomes attractive, i.e. the lower the stock price goes, the higher the dividend yield realized and the more prone an investor is to purchase the stock for the dividiends.

Example

As an example, we will consider a Covered Call position for Kohl’s (KSS) entered for the PowerOptionsApplied Titanium TradeFolio^TM on 1/10/2011. Titanium publishes Covered Call positions for blue-chip (very large) companies, which have taken a “dip”. At the time of entry, Kohl’s did not pay a dividend, but in the month of February following entry of the Covered Call position, Kohl’s announced they would pay a dividend.

The stock chart for KSS at entry on 1/10/2011 is shown below:

As can be seen from the stock chart for KSS, the price of KSS was near the 200-day moving average, near the lower Bollinger band and also near the previous support level for the stock occurring in November of 2011. The lower Bollinger band can be a good indicator for the recovery of a stock, as a stock will often recover after touching, crossing or coming near the lower Bollinger band. Previous support level is a good indication of where investors were willing to step up and purchase a stock during its last dip and is a good indicator that investors may be willing to once again step up and purchase the stock around the same price point.

At entry, the price of KSS was $52.03 and the option sold was a KSS 2011 FEB 52.50 call option at a price of $1.37.

A profit/loss chart for the initial KSS Covered Call position is shown below:

At entry, the unchanged potential return for the position was 2.7% with an assigned potential return of 3.6%. Unchanged potential represents the return a position would realize at options expiration if the price of the stock were unchanged from the price at entry. Assigned potential return represents the return a position would realize at options expiration if the price of the stock were greater than the strike price of the call option.

On 2/17/2011, the time value for the KSS 2011 FEB 52.50 call option was very small, so the KSS 2011 FEB 52.50 was rolled to a KSS 2011 MAR 52.50 call option for a net credit of $0.90. Time value represents the difference between an option’s value and its intrinsic value. For Covered Call investing, time value can be used as a gauge for the remaining potential profit available for a position.

The total net credit received for KSS was $1.37+$0.90 or $2.27 with a resulting assigned potential return of 5.4%.

On 3/18/2011 at March option expiration, the price of KSS was at $52.77, so the KSS 2011 MAR 52.50 call option was exercised with the KSS stock being called away from the account. As a bonus, KSS paid a dividend of $0.25 per share on 3/7/2011. The realized return for the KSS Covered Call including the dividend was 5.9%. An investor simply purchasing a long position in KSS and receiving the dividend would have realized a return of 1.9%. The comparison for the Covered Call versus a long stock position is shown below:

The Covered Call position had another advantage over the long stock, as the Covered Call position had downside protection, so as long as KSS did not drop more than the initial net credit of $1.37, the Covered Call position would have realized a profit.

The return for the PowerOptionsApplied Titanium TradeFolio^TM over the last year employing Covered Calls for blue chips on the dips realized a whopping return of 25% which is very good considering the S&P 500 had a return of about 15% over the same time period.

The Titanium TradeFolio^TM publishes Covered Call positions for blue-chip (or very large) companies, which have taken a dip. Titanium had a success rate of 90% over the last year with many of Titanium’s positions paying a dividend. The positions for Titanium are continually monitored for news which might have a negative impact. For example, some of Titanium’s losing positions were exited early as a result of bad news associated with the company. Particularly, during the oil spill in the Gulf of Mexico and the tsunami/nuclear disaster in Japan positions were exited early. In each case of exiting a position for a loss, the loss for the Covered Call position was less than for a long position in the stock, as the Covered Call positions had downside protection.

Titanium offers a diversified portfolio of Covered Call positions, typically twenty positions open at any given time. Titanium adds two-to-eight new potentially profitable positions every month.

As an added bonus, subscribers to Titanium can add “insurance” with the “Safety Net”. Safety Net purchases VIX call options for insurance, as the VIX moves counter to the movement of the stock market. So, as the stock market drops, the VIX and its call options increase in price. Insuring with VIX call options can protect a portfolio cheaper than using index put options, for example.

Titanium also offers auto-trading with select brokers so investors don’t have to enter or manage the published trades, everything is automatically handled by the broker.

Titanium offers a 30-day free-trial subscription to Titanium. If you are not happy with Titanium within the first 30 days, just let us know and we will refund your subscription. You can view information regarding Titanium, as well as other products, at this link. Better yet, get start today and subscribe to Titanium today here: SUBSCRIBE to Titanium

Below is a snipped from email we received from one of our customers concerning the performance of our products:

Subscribe now, and you too can experience the benefits of Titanium — SUBSCRIBE to Titanium

1. “What is the expected monthly return for covered calls, vertical spreads, diagonal spreads and the RadioActive Trading Techniques?”

a. This leads to a conversation at the 30 minute mark: “One of your competitors claims they make monthly returns of 3-6% for covered calls; 6-10% for diagonal spreads and higher for vertical spreads…”

(To view the video, select below)

2. Mr. Chupka’s general thoughts on using Greeks for adjusting positions.

3. Discussion on using Bollinger Bands and RSI in the Search Tools.

4. We take a brief look at a comparison of a Weekly All Call Condor versus the parity Weekly Iron Condor on a standard ETF.

5. How to exercise / assign a Married Put position that is In-the-Money at expiration.

6. “Would you use a Long Call or a Naked Put position to potentially buy shares of stock?”

7. “What is your preferred strategy using Weekly options for high probability; low risk trades?”

8. Brief review of the Stock Repair tool on PowerOptions to help repair stocks that have declined in price.

C’mon, you know what those problems are…

1) the riskiness of sitting on a stock that’s kinda volatile (the SEXIEST
premiums come from the more volatile stocks)… and
2) almost as frustrating… the fact that if you DO pick a runaway winner of
a stock, that selling covered calls puts a CAP on what you can make.

That’s kind of BACKWARDS from the old trader’s maxim: cut your losers short
and let your winners run. Selling covered calls generally makes for a structure
that goes against that simple idea.

Imagine if you could reverse that situation and truly cut your losers short
and let your winners run. Imagine if it were possible for you to have very
little AT RISK, in case you are wrong about a stock… then STILL take income from
selling calls against it… and if the stock takes off to the moon, you get
to take the ride with it! This video shows the coveted “Money Net”… a spread
trade that takes in premium but poses ZERO RISK.

- Discussed the functionality of the Strategy Search Summary Tool to evaluate opportunities in different strategies one stock at a time.

- Basic discussion on Weekly options

- Concepts on protecting and managing a Naked Put trade, using the PowerOptions Portfolio tools as a guide (detailed information can be found in the PowerOptions book: Naked Puts – Power Strategies for Consistent Profits)

- Trading the Married Put / RadioActive Trading techniques in a bearish or declining market, including how to use the PowerOptions Search Tool to find Married Puts on Inverse ETFs.

- Evaluating the math behind ‘Income Method #6′, one of the 10 Income Methods used in the RadioActive Trading techniques which are fully detailed in The Blueprint.?

A: As you know, historical stock volatility can be measured in many ways: 20-day volatility, 50-day volatility, 100-day volatility, etc.

Rather than use the historical trading range of the stock to measure volatility, investors will use the SIV. The SIV is the average Implied Volatilities for calls and puts for the near months expiration’s. This gives the investor an idea of the average value of the near term ITM – OTM calls and puts on the stock.

This is a very useful measure to use during an earnings season. For example, you may be tracking an option that you are looking to sell which has an Implied Volatility (IV) of 0.65. The underlying security might not have had a lot of movement recently, so the 50-day Historical Volatility (HV) might be right around 0.50.

When you compare the IV / HV ratio, to see if the option is under or overvalued, you would have: 0.65 / 0.50 = 1.30. This means that the option would be considered 30% overvalued compared to the Historical Volatility.

However, although the stock has not fluctuated in price recently we are nearing an earnings event, so the near term options will be inflated. Although it appears the option is overvalued compared to the Historical Stock Volatility, if we compared to IV to the SIV we might have:

IV / SIV = 0.65 / 0.68 = 0.96

This means that the particular option we were researching is actually 4% undervalued, compared with the average Stock Implied Volatility (SIV). So, the option is inflated compared to the Historical Volatility, but not as inflated as the other options around it in the same expiration cycle.

(click below to view video)

During this Open Discussion – Q&A session, we begin by reviewing some of the basic concepts from Part I:

1. What 3 criteria are used to enforce the 3 Core Principles of RadioActive Trading
2. Setting up the criteria for certain searches such as Dividend Stocks and ETFs for RPMs
3. General functionality of the Search Tool

This 15 minute review is followed by specific questions posed by attendees regarding the various criteria and techniques. The questions and answers include, but are not limited to:

1. Measures of certain criteria
2. Implied Volatility (IV), Implied Volatility vs. Historical Volatility (IV/HV) and % Implied Volatility Range
3. Using the Bollinger Band Criteria for RPMs
4. Use of the % Probability Above
5. How to narrow Search Results
6. Evaluating multiple strike prices on the same stock

Other concepts that are discussed during the presentation:

1. A teaser for Part III – Analyzing the Search results
2. Evaluating Call Premium when opening an RPM
3. Comparison of using an ITM Long Strangle (Buy a Long term ITM Call in lieu of stock + ITM Long Put) versus the RadioActive Profit Machine setup.

Part III of this ongoing series, Researching and Analyzing the Search Results, will be held on Tuesday, February 8th at 9 PM Eastern Time. You can register for that webinar here: sign-up for webinar.

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