Using Technical Indicators To Assist With Strike Selection
Dr. Alan Ellman | Jun 04, 2017 02:04AM ET
When selling covered call or put options, strike price selection is one of the three required skills. Here are the main factors we evaluate when determining which strike price to select:
- Overall market assessment
- Personal risk tolerance
- Return goals
- Technical price chart
In this article, we will focus in on the technical parameters that will guide us to the strike price that will offer the greatest chance of successful covered call trades. To highlight the relationship between price chart patterns and strike price selection, we will use real-life examples for NVIDIA Corporation (NASDAQ:NVDA) and Charles Schwab (NYSE:SCHW). Charts and calculations were created the weekend prior to the start of the January 2017 monthly contracts. At the time, NVDA had a bullish technical chart pattern while SCHW had a mixed technical chart.
BCI guidelines for the relationship between chart patterns and call strike selection
We will favor in-the-money call strikes that meet our goals when charts show mixed indicators. We will assume a goal for initial returns of 2% – 4% per month.
NVDA: Bullish chart pattern
Get The News You Want
NVDA Technical Chart: 12/2016
SCHW: Mixed chart pattern
SCHW: Mixed technical Chart Pattern
Calculations based on technical analysis
The option chains for the two securities where analyzed specifically looking for out-of-the-money strikes for NVDA and in-the-money strikes for SCHW that generated an initial time value 1-month return of 2% – 4%. The information was entered into the multiple tab of the Ellman Calculator:
Calculating Initial Returns for NVDA and SCHW
Note the following:
- Yellow field: The time value return for both options did meet our goals of 2% – 4%
- Brown field: The out-of-the-money $105.00 strike for NVDA offered the opportunity of an additional 4.6%, 1-month return if share price moved up to the strike by expiration resulting in a potential 7.1%, 1-month return
- Purple field: The in-the-money $38.00 strike for SCHW offered a 2.1% downside protection of the 2.6%, initial return. I view this as an insurance policy on the initial profit paid for by the option buyer, not by us.
Discussion
There are several factors that guide us in strike price selection and technical analysis must be part of that evaluation process. Bullish chart patterns guide us to out-of-the-money call strikes while mixed chart patterns encourage in-the-money strikes.
Market tone
Global stocks extended gains this week mainly due to moderate global growth and subdued inflation data. All three major US indices set all-time highs. Oil continued its decline with West Texas Intermediate crude falling to $47.35 a barrel from $48.95 a week ago. Volatility, as measured by the Chicago Board Options Exchange Volatility Index (VIX), remained historically low, falling to 9.76 from 10.8 last week. This week’s reports and international news of importance:
- The May employment report was a disappointment with 138,000 new jobs were added last month, while revisions to March and April data trimmed 66,000 from previous totals. Economists had expected a rise of 184,000 nonfarm payrolls
- Wage gains were steady at 2.5% versus a year ago
- A bright spot in the report was the continued fall in the unemployment rate, which moved down to a 16-year low of 4.3%. While weaker than expected, the data likely won’t discourage the US Federal Reserve from hiking rates later this month
- German chancellor Angela Merkel said the times when Europe could rely on others were over. She said while friendly relations with the US and UK are needed, she added that “we have to fight for our own future ourselves”. The German federal election takes place on September 24th
- European Central Bank president Mario Draghi downplayed the probability of any change in policy at next week’s rate-setting meeting. Economic growth is improving but inflation remains muted the central banker said, adding that the economy still requires substantial stimulus
- Saying he was elected to represent the voters of Pittsburgh, not Paris, US president Donald Trump this week announced that the United States would pull out of the Paris climate deal
- Optimism weakened in a few districts, the Fed reported in its Beige Book. Seven of the 12 Fed districts reported growth as “modest” since the last report on April 19th, while four reported “moderate” growth and one district — New York— was flat. Markets still expect the Fed to hike rates later this month, but with inflation pressures moderating, future rate hikes are less certain than they were earlier in the year
- While manufacturing in the US and China moderated slightly in May, Europe continues to show strength. The eurozone manufacturing purchasing managers’ index firmed to 57.0 from 56.7 in April, the highest in six years
- With 492 of the members of the S&P 500 Index reporting, earnings are expected to have increased 15.4% in the first quarter versus the same quarter a year ago
- Excluding the energy sector, earnings rose 11.1%
- Revenues are up 7.3%, and up 5.4% excluding energy
THE WEEK AHEAD
MONDAY, JUNE 5th
- Productivity (revision) Q1
- Markit services PMI (final) May
- ISM non-manufacturing index May
- Factory orders April
TUESDAY, June 6th
- Job openings April
WEDNESDAY, June 7th
- Consumer credit April
THURSDAY, JUNE 8th
- Weekly jobless claims 5/27
FRIDAY, JUNE 9th
- Wholesale inventories April
For the week, the S&P 500 moved higher by 0.95% for a year-to-date return of 8.92%.
Summary
IBD: Market in a confirmed uptrend
GMI : 6/6- Buy signal since market close of April 21, 2017
BCI: I am fully invested in the stock portion of my portfolio currently holding an equal number of in-the-money and out-of-the-money strikes
WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US
The 6-month charts point to a moderately bullish outlook. In the past six months, the S&P 500 was up 12% while the VIX (9.76) moved down by 31%.
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