Time to Step Away

After nearly 20 years of running this blog and its accompanying discussion group, I've decided it's time to step away. I hope the information shared here over the years has been helpful.

Although this blog will no longer be update, the Groups.io discussion group will continue under a new moderator. If you wish to discuss covered calls, cash secured puts, wheel and other options strategies, then please join the group here.

Thank you to everyone who subscribed and for being part of this journey! Wishing you all the best!

On Hiatus

I'll be on hiatus until Dec, so there won't be any trades or reports until I return.

Does Selling Cash Secured Puts work in a Bear Market?

I get asked this question a lot. I posted this to my discussion group last week and thought I'd share it here also.

Many investing sites will tell you that selling cash secured puts (CSP's) requires a neutral-to-bullish market. That is mostly true, but CSP's also work in down-to-bearish markets.

I've been trading CSP's for more than 13 years, so I've seen my share of down markets, and still made money selling CSP's. If the right underlying, strike, and expiration are chosen, and if adjustments are made when necessary, CSP's can/will work under any market conditions.

The best underlying for CSP's in a down-to-bear market are the broad market ETF's, such as DIA, IWM, QQQ, & SPY. That's because they represent the overall market rather than an individual company's stock. Individual stocks can get hit harder than the overall market and take longer to recover. These ETF's have a long term upward bias, so they will eventually recover and reach new highs.

The best strike is one that has an 80% to 90% percent chance of expiring OTM. This puts the odds in your favor.

The best expiration is 1-2 weeks to give the market very little time to move against you and give you the ability to roll down/out quickly if needed.

Markets rarely go down in a straight line, there are ups and downs, even in a bear market. By keeping your strikes far OTM and your expirations short, you can take advantage of these ups and downs.

Beginning in Apr 2020, after the market crashed due to COVID, the market has been bullish until Jan 2022 when the current bear market started. Comparing the income I generated during the period between Jan-Jul in both 2020 & 2021 vs that same period this year, I generated almost the same amount of income under completely different market conditions.

So, yes CSP's can work in a bear market. This is why I never worry about market direction. I just stick to my trading plan.

How Cash Secured Puts Affect the Cash in Your Account

When you sell a put option there's a margin requirement, regardless of whether it's a Naked Put or Cash Secured Put, or if you're trading in a margin or non-margin account. The only difference is that in a non-margin account, like an IRA, the margin requirement for a Cash Secured Put is 100%, meaning that the full amount of cash required to buy the underlying at the strike price, if assigned, must be held in reserve.

When you trade Cash Secured Puts (CSP's) you have a Cash Balance and Option Buying Power (i.e. cash available to trade). Forgetting about premiums for a moment, when you sell a CSP, the Cash Balance doesn't change, however the Option Buying Power is reduced by the full amount of the strike sold. When you close a CSP (i.e. buy it back), the Cash Balance also doesn't change, however the Option Buying Power is increased by the full amount of the strike previously sold, since it's no longer required to secure the put. The premiums received or paid actually affect your Cash Balance.

In the following example, I used Thinkorswim's PaperMoney account to simulate a CSP trade. The initial Cash Balance and Option Buying power was $100,000.

After selling a CSP on SPY with a strike of 445, the Cash Balance was increased by the amount of premium received ($100,000 + $495.33 = $100,495.33), and the Option Buying Power was reduced by the amount required to secure the put ($100,495.33 - $44,500 = $55,995.33).

The CSP was then rolled out to a further expiration and rolled down to a lower strike of 435 for a net credit. The Cash Balance was increased by the credit received (100,495.33 + 130.67 = $100,626.00), and the Option Buying Power was also increased ($100,626.00 - $43,500.00 = $57,126.00), since the amount required to secure the new strike is lower than the amount required to secure the initial strike.

So, for CSP's, only the premiums received or paid affect your Cash Balance, and the sale or purchase of the CSP affects your margin requirement, which also affects your Option Buying Power. By rolling down you are reducing the amount of margin required, and thereby increasing your Option Buying Power.

Why the Switch from Dividend Stocks to ETF's?

Some of you may be wondering why I decided to switch from trading individual dividend stocks to ETF's. Here are my reasons.

The switch occurred in 2020 due to the COVID-19 pandemic, which created an unstable economic environment. Individual stocks became too risky, since there was no way to tell how badly the companies would be impacted. So, that was the original reason to switch to ETF's. More diversification and less overall risk.

Since then, I found that trading ETF's was a lot less work.

With individual dividend stocks, the universe of potential stocks was in the hundreds. I had to develop and maintain customized software to download and analyze dividend stocks and their options, and then screen for potential trades. I also had to analyze each potential company's financial statements, and check each for news, ex-dividend, and earnings announcements occuring before expiration. This was a very time consuming process.

With ETF's, especially trading the major market ETF's like DIA, IWM, QQQ, SPY, and the XLx SPDR Sector ETF's, the universe is very small. There's no need for customized software, instead I use Thinkorswim scans to find potential trades. There's also no need to worry about earnings announcements, and only a few news worthy economic events that have the potential to move the market. These ETF's also provide less risk, since they're diversified, are extremely unlikely to fall to zero or go bankrupt, and have a long term bullish bias.

As I approach retirement at the end of July, making the switch to ETF's made even more sense. It takes a lot less time to establish and manage ETF positions, therefore providing me with more free time to enjoy my retirement. Will I ever return to trading individual dividend stocks? Maybe, if circumstances change, but until then, I'll continue trading ETF's as long as they continue to meet my income goals.

Seagulls and Jade Lizards

In this article I will show how to create Seagull and Jade Lizard positions. Each example will use SPY options expiring on 10/16/20, with prices as of 10/2/20.

A Seagull is a 3 legged option combination consisting of a Cash Secured Put and a Bull Call Debit Spread. The premium collected from the short put + the short call should be more than the premium paid for the long call. This results in a net credit and a risk free leg to the upside.

A Jade Lizard is a 3 legged option combination consisting of a Cash Secured Put and a Bear Call Credit Spread. The premium collected from the short put + the short call will be more than the premium paid for the long call. This results in a net credit and a risk free leg to the upside.

The following is a sample of a Seagull, a Jade Lizard, and a Combo of both, including risk graphs.

• Underlying: SPY
• Price: $333.84
• Expiration: Oct 16 2020

Seagull

• Entry: Sell the 319 Put + Buy the 334 Call + Sell the 336 Call
• Net Credit: $91
• Profit Zone 1: $91 (SPY between 319 & 334)
• Profit Zone 2: $291 (SPY above $336) 

Jade Lizard

• Entry: Sell the 319 Put + Sell the 342 Call + Buy the 343 Call
• Net Credit: $235
• Profit Zone 1: $235 (SPY between 319 & 342)
• Profit Zone 2: $135 (SPY above $343) 


 

Seagull-Jade Lizard Combo

• Net Credit: $326
• Profit Zone 1: $326 (SPY between $319 & $334)
• Profit Zone 2: $526 (SPY between $336 & $342)
• Profit Zone 3: $426 (SPY above $343) 


 

Covered Calls, Cash Secured Puts, and Bullish Seagulls

In this article I will show how to create Covered Call, Cash Secured Put, and Bullish Seagull positions.

Each example will use XLK options expiring on 9/11/20, with prices as of 8/14/20

Standard Covered Call

Formula = Long Stock + Short Call

First let's look at a risk graph for a Long Stock position. Here you can see that there is unlimited downside risk and unlimited upside potential. 

Selling an OTM call will create a Covered Call position, since the call is covered by the stock position. Here the downside risk remains the same, however the upside potential is capped by the strike price of the sold call. So for the benefit of the premium collected on the call, which reduces your cost basis, you give up some upside potential. 

Synthetic Covered Call

Formula = Synthetic Long Stock (Long Call + Short Put) + Short Call

Using options only, you can create a Synthetic Long Stock position by buying a call and selling a put at the same strike. This has the same risk profile as Long Stock, but at a lower cost, and in some cases at no cost or a net credit. 

Selling an OTM call will create a Synthetic Covered Call position, since the short call is covered by the long call (i.e Bull Call Spread). Again, downside risk remains the same, and upside potential is capped. However, this trade is less capital intensive than a Standard Covered Call. 

Cash Secured Put

Formula = Short Put

Instead of creating either variation of Covered Calls, you could just sell an OTM Cash Secured Put to replicate the risk profile. This is the simplest option (pun intended).

Bullish Seagull

Formula = Short Put + Long Call + Short Call

Formula = Synthetic Long Stock Split Strike (Long Call + Short Put) + Short Call

Formula = Cash Secured Put (Short Put) + Bull Call Spread (Long Call + Short Call)

In the Synthetic Long Stock position example above, the call/put were bought/sold at the same strike. However, you can buy/sell at different strikes, which creates a Synthetic Long Stock Split Strike position. This position is less aggressive and has more downside protection, but at a cost (i.e. net debit vs net credit). 

Selling an OTM call will create a Bullish Seagull, which I described here. 

Conclusion

There are many ways of combining options to create positions with similar risk profiles. I encourage you to try this for yourself and see what you can come up with.

I hope you found this useful.

Bullish Seagulls - Giving Your Cash Secured Put Wings

For the past month I've been experimenting with a new variation of the Cash Secured Put strategy by combining it with a Bull Call Spread. This strategy is called a Bullish Seagull (named for the shape of the risk graph). 

A Cash Secured Put (Short Put) consists of selling an OTM put for a net credit. At expiration, if the stock remains above the put strike, it expires and the maximum profit is the premium received. If the stock is below the put strike, it can either be rolled out, rolled down and out, or assigned to purchase the stock at a discount. Selling a Cash Secured Put gives up any upside if the stock continues to rise.

A Bull Call Spread (Long Call + Short Call) consists of buying an ATM or slightly OTM call and selling an OTM call at a higher strike for a net debit. At expiration, if the stock is above both call strikes, they are automatically exercised/assigned for the maximum profit (difference in the strikes - the premium paid). If the stock is in between the call strikes, the ITM call can be sold, possibly for a profit, and the OTM call will expire. If the stock is below both call strikes, they expire and the maximum loss is the premium paid.

Combining both strategies creates a Bullish Seagull (Short Put + Long Call + Short Call). When this is sold for a net credit, it's similar to a Cash Secured Put but with the potential for additional profit on the upside. The credit received is less than just selling the put, but it also pays for the Bull Call Spread, making that a free trade. At expiration, if the stock remains above the put strike and below both call strikes, then all options expire and the maximum profit is the premium received. If the stock is in between the call strikes, the ITM call can be sold, possibly for a profit, and the OTM call and OTM put will expire. If the stock is above both call strikes, they are automatically exercised/assigned for the maximum profit (difference in the strikes + the premium received) and the OTM put will expire. So it's the best of both worlds.

My criteria for entering a Bullish Seagull.

1. Find a stock that's in a solid uptrend (e.g. XLK).
2. Look to sell an OTM put below a support level with an 80% probability of expiring OTM.
3. Look to buy an ATM/OTM call with a delta around 50.
4. Look to sell an OTM call 1-5 strikes above the call to buy. This determines the maximum profit to the upside.
5. The trade must result in a net credit to insure a minimum profit.

Trade management is similar to a Cash Secured Put.

1. If the put strike is in danger of being breached, roll the put for a net credit to the next expiration and possibly down in strike.
2. If the long call is ITM near expiration but the short call is OTM, buy back the short call for $.10 or less and let the long call run, then sell it on expiration day.
3. If both calls are ITM at expiration, the broker will automatically exercise the long call (buy stock) and assign the short call (sell stock). This results in the maximum profit.
4. If all options are OTM at expiration let them expire and keep the premium received. This results in the minimum profit.

Examples of closed Bullish Seagulls

XLK Seagull #1

If all options are OTM at expiration.

Stock	Strikes	ExpDate	Days	Margin	P/L	ROI	AROI
XLK	98/103/105	7/10/2020	14	$9,800.00	$33.06	0.34%	8.80%

If both call options are ITM at expiration.

Stock	Strikes	ExpDate	Days	Margin	P/L	ROI	AROI
XLK	98/103/105	7/10/2020	14	$9,800.00	$233.06	2.38%	62.00%

Result: Both calls were ITM and automatically exercised/assigned for max profit. Short put expired OTM.

XLK Seagull #2

If all options are OTM at expiration.

Stock	Strikes	ExpDate	Days	Margin	P/L	ROI	AROI
XLK	104/108/110	7/24/20	17	$20,800.00	$105.15	0.51%	10.85%

If both call options are ITM at expiration.

Stock	Strikes	ExpDate	Days	Margin	P/L	ROI	AROI
XLK	104/108/110	7/24/20	17	$20,800.00	$505.15	2.43%	52.14%

Result: All options expired OTM. Profit was credit received.

XLK Seagull #3

If all options are OTM at expiration.

Stock	Strikes	ExpDate	Days	Margin	P/L	ROI	AROI
XLK	102/107/109	7/31/20	15	$20,400.00	$112.97	0.55%	13.48%

If both call options are ITM at expiration.

Stock	Strikes	ExpDate	Days	Margin	P/L	ROI	AROI
XLK	102/107/109	7/31/20	15	$20,400.00	$512.97	2.51%	61.19%

Result: Both calls were ITM and automatically exercised/assigned for max profit. Short put expired OTM.

XLK Seagull #4

If all options are OTM at expiration.

Stock	Strikes	ExpDate	Days	Margin	P/L	ROI	AROI
XLK	103/107/108.5	8/7/2020	15	$20,600.00	$121.73	0.59%	14.38%

If both call options are ITM at expiration.

Stock	Strikes	ExpDate	Days	Margin	P/L	ROI	AROI
XLK	103/107/108.5	8/7/2020	15	$20,600.00	$421.73	2.05%	49.82%

Result: Both calls were ITM and automatically exercised/assigned for max profit. Short put expired OTM.

Total profit on all 4 trades was $1,272.91 in 42 days (6/26/20 - 8/7/20) vs $975.26 had I just sold CSP's at the same strike, an increase in profit of $297.65. Not bad!

Hope you find this new strategy useful.

Goodbye Interactive Brokers! Hello TD Ameritrade!

After 15 years of trading options at Interactive Brokers (IB) I've decided to transfer my account to TD Ameritrade (TD). The primary reason I chose IB was due to their low commissions. However, TD lowered their commissions last year making them comparable to IB. TD's Thinkorswim (TOS) trading platform, which I prefer to IB's Trader Workstation, is the primary reason for the transfer.

I'm looking forward to trading on TOS and have already setup my charts and custom indicators. TOS also has an Excel Real-time Data (RTD) function, which I'm using to update my spreadsheets, and an API which I plan to use to write some custom code.

IB has been good to me over the years and saved me a ton of money on commissions, but it's time to move on.

New Discussion Group

After 13 years on Yahoo Groups, the JustCoveredCalls (JCC) group has moved to Groups.io as JustCoveredCallsPlus (JCC+).

Here's the link to the new group: justcoveredcallsplus

To Subscribe: justcoveredcallsplus+subscribe@groups.io

Name Change

I decide to change the name of this blog from "My Covered Call Blog" to "Covered Calls and Cash Secured Puts", which is a more appropriate name.

New 15-15 Positions

After a discussion on my JustCoveredCalls Yahoo group last week, I established 4 new positions on ANF, BTU, CNX, & SCHN (see Trades below). The criteria used is a minimum of 15% downside protection and 15% annualized return. I added additional criteria to further qualify the positions. The following is the selection criteria:

• All dividend paying companies.
• Covered by Morningstar and Value Line Daily Options Survey.
• Current price below M* Fair Value.
• CSP strike below or within $5 above the M* Consider Buy Price.
• CSP downside protection of 15% or greater.
• CSP annualized return of 15% or greater.

If these positions work out well, I'll probably continue to establish a limited number of these positions in my portfolio, but the bulk of my portfolio will continue to follow the criteria documented in my trading plan.

The Definition of Risk

Many people define risk in terms of price volatility and/or price movement. They believe a stock is risky if its price swings are wide or declining, and believe a stock is less risky if its price swings are narrow or rising.

My opinion differs greatly from the above. From my perspective, risk doesn't equate to volatility or price movement, it equates to what Ben Graham called a "permanent loss of capital". And by "permanent", I don't mean the day-to-day fluctuations in the mark-to-market value, I mean "permanent", as in "realized loss".

I use three categories of risk when analyzing a company for potential investment:

• Fundamental Risk
• Valuation Risk
• Cash Flow Risk

Fundamental Risk is the risk associated with the company financials, such as revenues, expenses, debt, cash flow, etc. and requires thorough analysis of the financial statements. You wouldn't buy a used car these days without checking the CarFax, and neither should you buy a stock without checking the financial statements. To minimize fundamental risk, I look for wide or narrow moat companies that are financially stable, have sustainable revenues and a history of generating positive free cash flow.

Valuation Risk is the risk associated with the fair value of the company vs its current market price. If a stock is overpriced in relation to its fair value, there's a greater risk of loss. On the other hand, if a stock is undervalued in relation to its fair value, there's a greater potential for gain, and the more undervalued the better. As Buffett said "If you buy a dollar for 60 cents, it's riskier than if you buy a dollar for 40 cents, but the expectation for reward is higher in the later case". In other words, risk/reward are not always correlated. Sometimes, less risk means greater reward. To minimize valuation risk, I look for companies that are trading at a discount to fair value, and always with a Margin of Safety between 20-40% lower than fair value, just in case the fair value estimate is wrong or changes due to fundamentals.

Cash Flow Risk is the risk associated with investor cash flow, meaning cash flow generated as a result of an investment in a given company. This usually means dividends received, but for a CC/CSP portfolio, it also means premiums from the sale of call and put options. To minimize cash flow risk, I look for companies with a history of consecutive dividend increases. For a CC/CSP portfolio, I look for stocks with good option liquidity and premiums that meet my cash flow requirements.

If a company passes all three risk assessments, then I consider it low risk. I'll allocate up to a maximum 10% of working capital per company, but will leg in with smaller positions of at least 1%. I normally establish an initial position by selling a CSP 20-40% below fair value. In order to get assigned, the stock has to decline in price. So, where those who define risk as volatility or declining price will avoid this stock, I'm happy to take assignment and then sell a call at or above the purchase price. If the company still passes all three risk assessments, I'll even sell another CSP at a lower strike and greater discount to fair value. This second CSP is even less risky than the first (i.e. a dollar for 40 cents vs 60 cents). I'll repeat this up to 10% of working capital per company. Currently, my average position size is around 3%, with the max between 5-6%.

So, that's my definition of risk. What's yours?

Today's New Positions

I established 6 new CSP positions today. AVP & LOW declined today providing an opportunity to sell CSP's at my target buy price, which is about 30% below my fair value estimate.

Since I was holding over 78% in cash, I decided to sell some deep OTM CSP's on TLT for May expiration. TLT hasn't closed below $88 in several years so I sold 4 different strikes at $85, $86, $87, & $88. With the market overvalued, by the metrics I follow, if there's a correction, TLT should rise as investors flee to the safety of US Treasuries. If that occurs, these puts should expire in May, and free up the cash to pick up any new opportunities that arise.

As a result of today's trades, I'm currently 54% invested and 46% in cash, with 14 open positions, 4 CC positions and 10 CSP positions.

Today's Closed Positions

Today I decided to close 5 CSP positions, which actually expired on Mar expiration, and the cash to secure the puts was returned on 3/18. So, technically, these positions were already closed, as far as my broker was concerned.

However, I was waiting to decide whether to continue with these positions, by selling the same strike puts, or to close them out. Since the market has continued to rise and the puts were getting further OTM, I decided to just close these positions today.

The date of closure is 3/18, since, as stated above, these were technically closed positions, which were returned to cash on 3/18.

With the rising market, which is overvalued by the metrics I follow (see Market Valuation Meters on the right), it's getting harder to find good opportunities. As a result, I'm currently 22% invested and 78% in cash, with 8 open positions, 4 CC positions and 4 CSP positions.

How to Determine the Value of a Stock

For the past several years I've used Morningstar's Premium service for stock valuation. Morningstar uses a Discounted Cash Flow model to determine Fair Value (i.e. intrinsic value), which can get quite complex. In his book, The Intelligent Investor, Benjamin Graham describes a simpler formula to determine intrinsic value.

Formula: V = EPS x (8.5 + 2G) * (4.4 / Y)

where:

• V: Intrinsic Value
  
• EPS: the company’s last 12-month earnings per share
  
• 8.5: the constant represents the appropriate P/E ratio for a no-growth company as proposed by Graham
  
• G: the company’s future long-term (five years) earnings growth estimate
  
• 4.4: the average yield of high-grade corporate bonds in 1962, when this model was introduced
  
• Y: the current yield on AAA corporate bonds
  

I use the modified formula from Old School Value, which uses a P/E of 7 for a no-growth company and a multiplier of 1.5G rather than 2G, since these are more conservative.

Modified Formula: V = EPS x (7 + 1.5G) * (4.4 / Y)

The original formula uses the last 12-month EPS (TTM), however, like Old School Value, I normalize EPS over a 10 year period, which estimates future EPS for the next 5 years, using a linear forecast based on the previous 10 years, and then takes the median of the previous 5 years and next 5 years to arrive at a normalized EPS. For estimated future 5yr growth rate I use 3 different sources, 1) Yahoo Finance, 2) Morningstar, and 3) MSN Money. I found that each site has a different 5yr estimate, so I use an average of these estimates.

Determining intrinsic value, no matter which method/formula is used, relies on estimating earnings and earnings growth, which is nothing more than an educated guess, so it's important to discount whatever valuation you determine. This is a Graham concept known as Margin of Safety. Purchasing stocks with a sufficient Margin of Safety below Fair Value helps to protect against being wrong on the earnings estimates/growth. How much of a Margin of Safety to require depends on your confidence level in the company and the estimates you use. I typically use a Margin of Safety range between 20%-40% below Fair Value.

Once I have all the input parameters I plug them into my spreadsheet, which is a modified version of the one at Old School Value, and calculate the Fair Value and Target Buy Price. I then compare the results to Morningstar's valuation.

Let's look at an example for Abbott Laboratories (ABT) using the modified Graham Formula:

Input	Value
10yr Normalized Earnings	$3.75
Average 5yr Growth Rate	9.29%
20yr AAA Corp Bond Rate	5.44%
Desired Margin of Safety	20%
Results	Value
Fair Value	$64.00
Target Buy Price	$51.00

To compare the Graham Formula to Morningstar's valuation I input Morningstar's Fair Value and Target Buy Price and solve for the implied 5yr growth rate. Here's the same example using Morningstar's Fair Value:

Input	Value
M* Fair Value	$68.00
M* Target Buy Price	$54.00
M* Margin of Safety	20%
10yr Normalized Earnings	$3.75
20yr AAA Corp Bond Rate	5.44%
Results	Value
Implied 5yr Growth Rate	10.28%

As you can see, both valuations are very close, with only a 1% difference in the 5yr growth rate.

Let's do another example, this time for Lowes (LOW) using the modified Graham Formula:

Input	Value
10yr Normalized Earnings	$1.94
Average 5yr Growth Rate	14.60%
20yr AAA Corp Bond Rate	5.44%
Desired Margin of Safety	30%
Results	Value
Fair Value	$45.00
Target Buy Price	$32.00

Here's the same example using the Morningstar's Fair Value:

Input	Value
M* Fair Value	$36.00
M* Target Buy Price	$25.00
M* Margin of Safety	30%
10yr Normalized Earnings	$3.75
20yr AAA Corp Bond Rate	5.44%
Results	Value
Implied 5yr Growth Rate	10.68%

Here you can see that there's almost a $10 difference in Fair Value and a 4% difference in the 5yr growth rate. That's still pretty close. One way to deal with differences is to use an average of both results which would be:

Results	Value
Average Fair Value	$41.00
Average Target Buy Price	$33.00
Average 5yr Growth Rate	12.64%

Now let's look at Pfizer (PFE), where the valuations are very different. Here's the modified Graham Formula:

Input	Value
10yr Normalized Earnings	$1.22
Average 5yr Growth Rate	2.38%
20yr AAA Corp Bond Rate	5.44%
Desired Margin of Safety	30%
Results	Value
Fair Value	$10.00
Target Buy Price	$7.00

Here's the same example using the Morningstar's Fair Value:

Input	Value
M* Fair Value	$26.00
M* Target Buy Price	$18.00
M* Margin of Safety	30%
10yr Normalized Earnings	$1.22
20yr AAA Corp Bond Rate	5.44%
Results	Value
Implied 5yr Growth Rate	12.84%

Morningstar's implied 5yr growth rate is about 10 times greater than the average 5yr estimates. That's a very big difference. Either Morningstar overestimated the growth rate or the analysts underestimated it. Again, you can use the average of both results:

Results	Value
Average Fair Value	$18.00
Average Target Buy Price	$13.00
Average 5yr Growth Rate	7.63%

So, there you have it. A fairly simple way to determine stock valuation and target buy price thanks to Ben Graham. It may not be an exact science, but it's definitely worth the effort.

Covered Calls and Cash Secured Puts on the Same Stock

Someone posted the following comment yesterday.

"Is there anything bad about selling CC and CSP for the same stock, at the same time?"

Here's my response:

There's nothing wrong with selling a Covered Call (CC) and Cash Secured Put (CSP) on the same stock, at the same time. Two caveats though 1) you should want to own the stock at both prices and 2) you should be careful not to exceed your asset allocation for a given stock. You can think of selling a CSP as a way to average down if the stock declines. But, as always, the key is company selection. Make sure you only sell CC's and CSP's on companies you'd be happy to own for the long term.

Here's how I use CC's and CSP's.

If the stock is priced at or below my target price, which is anywhere from 20-50% below Morningstar fair value estimate, I'll buy the stock and sell an OTM call (CC). I'll also look to sell a CSP further below my purchase price if I can get a return greater than the yield on 10 Year US Treasuries.

If the stock is priced above my target price, I'll sell a CSP near my target price. If assigned on the CSP I'll sell an OTM call (CC), and look to sell another CSP below my purchase price as above.

I currently have 13 CC's and have sold CSP's on 8 of them, and I have 12 CSP's with no CC position (33 positions in total). I manage each position separately even if assigned on the CSP.

I've added the following data to all of the positions I post here, including new positions and adjustments. I updated all the trade positions I did this week to include this data.

• Dividend Champions Status =
  
• Years of Consecutive Dividend Increases =
  
• Years of Positive Free Cash Flow (last 10 years) =
  
• Discount to Morningstar's Fair Value Estimate =
  

The discount to M* fair value is calculated against my cost basis (i.e. purchase price or CSP strike), not the current stock price.

For example, here's the data for the Monsanto CSP I established yesterday.

• Dividend Champions Status = Contender
  
  
• Years of Consecutive Dividend Increases = 10
  
• Years of Positive Free Cash Flow (last 10 years) = 9
  
• Discount to Morningstar's Fair Value Estimate = 29.58%
  

My target buy price is 30% below M* fair value, so I sold a Jan 50 Put, which is close to my target buy price.

If assigned in Jan I'll look to sell a 50 or higher Call, and sell a 45 or lower CSP.

This is the method I developed while on vacation for 5 weeks back in June and I've been using it ever since with good success. Since I'm limiting all of my positions to solid dividend paying companies I also sleep better at night with his strategy.

Changes to Open Positions

In addition to the new financial statements and updated trading plan, I also have some changes to my current open positions.

Back in April, I replaced several of my holdings with companies that are members of the Dividend Champions, which is more in line with my new trading plan. At that time, I also used an alternative, and somewhat controversial, accounting method, of consolidating the positions using the original cost basis of the old positions, rather than starting with the new cost basis. I did this so I could track the Cash Return on Invested Capital (CROIC) using my existing spreadsheets at that time. However, with my new financial statements and data from IB, this alternative accounting method is no longer necessary.

So, I've modified the consolidated positions to reflect their actual cost basis at the time they were established in April/May, rather than the consolidated cost basis I used before. As a result, these positions have a much lower cost basis. The loss on the original positions were/are already reflected in the Net Asset Value (NAV) of my portfolio, so there's no change there.

Another change I made was to breakup positions in the same underlying by their cost basis. Each time the cost basis changed, either through the purchase of additional shares or the sale or change in strike of a cash secured put, I separated it into a new position, and in some cases closed the old position.

From now on, whenever additional shares are purchased or additional cash secured puts are sold or change strikes, on the same underlying, a new position will be established. This will limit each position to a single cost basis, which will make it easier to manage and easier to track annualized return.

Managing each position by cost basis also allows me to sell different strikes on the same underlying, since I'll have a different break even price for each position. Of course I've always had that ability, but it was harder to track as a single position.

Over the next week or so, I'll be posting all the modifications to my open positions, in addition to the closed positions that resulted from the cost basis conversion.

This may seem like a lot of changes in such a short amount of time, but I've been planning this for 5 weeks while I was on vacation. It really gave me time to think and reevaluate my investment strategy.

The biggest impact came when I re-read "F Wall Street" and "The Essays of Warren Buffet". Those two books made me refocus on value investing, the importance of cash flow and the importance of net asset value. I was already focused on the first two, but less focused on the later. I paid more attention to generating income and not enough attention to capital appreciation. But I'm refocused now and these changes will help me achieve my goals. It's never to late to re-evaluate! :)

Posting of Returns Will Be Further Delayed

I'm in the process of changing how I track and report returns, so the returns for June and July will be further delayed.

I'm developing a new spreadsheet which will contain two financial statements, 1) Statement of Net Asset Value, and 2) Statement of Cash Flows. All the data will be obtained from the Interactive Brokers Activity Statement. This will make it easier to track my progress against two metrics, 1) Return on Assets (ROA) and 2) Cash Return on Invested Capital (CROIC).

These statements will use standard accounting practices and will be similar to those of other investment companies. I studied the financial statements for several covered call funds and used them as a model.

I'll only be able to create these new reports for 2010 and beyond. Unfortunately I can't go back any further since my IB account had multiple portfolios, in addition to my CC portfolio, until then end of 2008, which was the reason I didn't use the IB Activity Statements in the past. Also, some of the 2009 data is no longer available.

While I might lose some historical data, I think this is the best approach going forward. It will be much easier to maintain, since IB will provide all the data, and I think it will be easier for myself and others to track my progress.

When I'm ready I'll post a more complete explanation on what I'm doing and why, as well as post the new statements for 2010.

Back From Vacation

I'm back from a 5 week vacation and have some catching up to do. I'll post the returns for June and July expiration sometime this weekend.