Comparing Covered Call Writing And Put Selling In Bear Markets

Calls and puts in bear market environments

 Facebook options chain

Bear market trade and calculations for covered call writing

We favor in-the-money strikes (ITM) which will generate time value returns that meet our goals along with downside protection of the option profit (different from breakeven). The deeper in-the-money we go, the greater our protection. With Facebook Inc (NASDAQ:FB) trading at $60.84, we will view the $57.50 ITM strike:

• Call premium = $5.45

• Intrinsic value of the premium = $3.34

• Time value of the premium = $2.11

• Initial profit = $211/$5750 per contract = 3.7% (the intrinsic value “buys down” our cost basis to the strike price)

• Annualized return = 31%

• Downside protection of the 3.7% = $3.34/$60.84 = 5.5%

• This means that we are guaranteed a 6-week return of 3.7% as long as share value does not decline by more than 5.5% by expiration Friday

• Breakeven = $60.84 – $5.45 = $55.39

Bear market trade and calculations for selling cash-secured puts

We favor out-of-the-money strikes which will generate more protection against share decline and less likelihood for share assignment (shares “put” or sold to us). The deeper out-of-the-money we go, the greater our protection. With FB trading at $60.84, we will view the $57.50 ITM strike. Note that we are using the same strike as for writing calls where the $57.50 strike is considered in-the-money. For selling puts, that same strike is considered out-of-the-money:

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•           Put premium = $2.13

•           Initial profit = $213/$5537  per contract = 3.8% (put premium decreases our cost basis)

•           Annualized return = 33%

•           Downside protection of the 3.8% = $3.34/$60.84 = 5.5%

•           This means that we are guaranteed a 6-week return of 3.8% as long as share value does not decline by more than 5.5% by expiration Friday

•           Breakeven = $57.50 – $2.13 = $55.37

Summary

In bear market environments we favor in-the-money call options for covered call writing and out-of-the-money put options when selling cash-secured puts. The returns will be similar when going a like amount in- and out-of-the-money.

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Market tone

Actions taken by the central banks in Europe, Japan and China have allayed many of the global-economic fears of our markets. Few would argue that our economy continues to expand at a moderate pace. This week’s reports support that position:

•  The Labor Department reported that 321,000 jobs were created in November, far surpassing the expectation of 228,000
• September and October jobs stats were revised upward by 44,000
• The unemployment rate remained unchanged at 5.8%
• The labor force participation rate also remained steady at 62.8%
• Hourly earnings for workers expanded by 0.4%/month, the best pace since June, 2013, causing the Fed to keep a close eye on inflation
• The US trade deficit decreased by 0.4% in October, but still wider than anticipated
• US worker productivity rose by 2.3% in the 3rd quarter, better than first reported by the Labor Department
• In October, construction spending increased by 1.1%, better than the 0,5% expected
• Construction spending increased by 3.3% year-over-year
• The Fed’s Beige Book confirmed that we have an improving jobs environment
• The ISM Non-Manufacturing Index rose to 59.3 in November, well above the 57.5 stat anticipated
• The ISM Manufacturing Index came in at 58.7, slightly better than the 58.3 projected by analysts (above 50 reflects expansion)

For the week, the S&P 500 rose by 0.4%, for a year-to-date return of 14%, including dividends.

Summary

IBD: Confirmed uptrend

GMI:6/6- Buy signal since market close of October 27, 2014

BCI: Moderately bullish favoring out-of-the-money strikes 2-to-1

Wishing you the best in investing,

Alan (alanatthebluecollarinvestor.com)

Original post

Written By: Dr. Alan Ellman