28280.Covered Calls And LEAPS A Wealth Option Guide For Generating Extraordinary Monthly Income

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Covered Calls

and LEAPS—

A Wealth

Option

ffirs.qxd 10/23/06 1:31 PM Page i

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ffirs.qxd 10/23/06 1:31 PM Page ii

Covered Calls

and LEAPS—

A Wealth

Option

A Guide for Generating

Extraordinary Monthly Income

JOSEPH HOOPER

AARON ZALEWSKI

John Wiley & Sons, Inc.

ffirs.qxd 10/23/06 1:31 PM Page iii

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Hooper, Joseph, 1943–

Covered calls—A wealth option : a guide for generating extraordinary

monthly income / Joseph Hooper And Aaron Zalewski.

p. cm.

Includes bibliographical references and index.

ISBN-13 978-0-470-04470-4 (cloth/dvd : alk. paper)

ISBN-10 0-470-04470-5 (cloth/dvd : alk. paper)

1. Options (Finance) 2. Stock options. I. Zalewski, Aaron, 1980–

II. Title. III. Title: Covered calls.

HG6024.A3H66 2006

332.63'2283—dc22

2006015461

Printed in the United States of America.

10987654321

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Contents

Foreword vii

Preface ix

CHAPTER 1 An Introduction to Options 1

PART I Covered Calls 21

CHAPTER 2 An Introduction to Covered Calls 23

CHAPTER 3 Entering New Covered Call Positions 33

CHAPTER 4 Management Rules 59

CHAPTER 5 Defensive Techniques 75

PART II Calendar LEAPS Spreads 115

CHAPTER 6 An Introduction to Calendar

LEAPS Spreads 117

CHAPTER 7 Entering New LEAPS Positions 123

CHAPTER 8 Management Rules 147

CHAPTER 9 Defensive Techniques 165

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CONCLUSION How to Move Forward 177

APPENDIX A Quick Reference Guide 179

APPENDIX B Foreign Exchange Risk 197

APPENDIX C Brokerages and Order Types 201

APPENDIX D Using ETFs and HOLDRs for

Diversification 205

APPENDIX E Compound Stock Earnings

Support Services 207

Glossary 211

Disclaimer and Legal Information 217

About the DVD 221

Index 223

vi Contents

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vii

Foreword

Brilliant book. Anyone who has read any of my work knows that I be-

lieve buying, holding, and praying is not an optimal financial strategy.

Joseph Hooper and Aaron Zalewski have done an excellent job mak-

ing a complex subject simple enough for someone like me to understand.

As most of us know, investors invest for two basic things: capital gains

and cash flow. Most people invest for capital gains, which is simply buying

something and hoping the price goes up. Investing for cash flow is invest-

ing for a steady stream of income. Of the two, investing for cash flow re-

quires the most skill. Anyone can deceive themselves by thinking, “The

price will go up in the future.” Or anyone can be suckered into a sales pitch

that goes: “Prices have gone up over the past five years...so you better

buy now.”

The reason I love this book is because the authors have made investing

for cash flow simple. I like the analogy in their Preface of planting trees and

growing a forest to be cut down as an example of investing for capital

gains versus planting fruit trees to harvest and replenish on a regular basis

as the example of investing for cash flow. Obviously, the more savvy in-

vestors invest for both capital gains and cash flow. They want a forest and

the fruit. They want money today and tomorrow.

Regardless, even if you never plan on investing in stocks or covered

calls, this is an excellent book for anyone who wants to look into the mind

of a professional investor. You see, the investment strategy discussed in

this book does not apply only to stocks. This investment strategy works for

real estate as well. Rarely do I buy a stock or piece of real estate without

first knowing that I will receive cash flow and capital gains. In other words,

this book is not about an asset class but more about a class of investor that

likes to win, not gamble.

OBERT

IYOSAKI

Author of Rich Dad, Poor Dad

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Preface

One can think of the accumulation of a stock portfolio through time as

the cultivation of a forest full of trees. Traditional Street mentality

encourages investors to plant trees throughout their working lives

and rely on appreciating markets to grow the forest over the long term.

Once our working lives are finished and active income ceases, the

Street then encourages investors to begin cutting down the forest to pro-

vide income in retirement. The hope is that the forest has grown large

enough over time to withstand the depletion in retirement. In our experi-

ence, this level of growth is a rarity for the average American.

What the Street has overlooked is that simple and very conservative

cultivation can transform the forest into an orchard of fruit-bearing trees.

Fruit-bearing trees generate cash income on a monthly basis. For investors

who want to grow their assets, rather than eating the fruit each month, the

fruit can be left to fall on fertile soils to grow more trees and thus to com-

pound the growth of the forest through time. For investors who are in re-

tirement, the fruit can be picked each month as cash income for living

expenses—without liquidating stocks in the portfolio and destroying the

forest that they depend on to live.

Correct application of the covered call technique is the vehicle by

which stocks are converted to cash flow generating assets.

OPTIONS ARE NOT JUST A

HIGH RISK/HIGH RETURN INSTRUMENT

Options are without doubt the most misunderstood, misrepresented, and

poorly implemented financial tool in the world. When asked about options,

most people (including those “in the know” like financial planners, stock-

brokers, and accountants) will tell you that “they’re high-risk, high-return

instruments.”

It is astonishing that even those who are financially educated seem un-

aware that options can be used to minimize or even eliminate risk in a

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stock portfolio. In fact, options were originally not devised for use as a

speculative instrument. They were originally used in the agricultural indus-

try to reduce risk by locking in future sales prices before harvest. Regard-

less of this original intent, options maintain the label of “high risk, high

return.”

The high-risk, high-return label derives its origins from the speculative

use of options. Speculators use options to bet on the direction of the mar-

kets for the potential of very high returns. However, with these high returns

come very high risk, and the vast majority of speculators fail over the long

term. If you ever attempt to speculate with options, there is a very high

chance that you, too, will be unsuccessful over the long term.

What evidence do we have that the vast majority of speculators fail over

the long term? Well, if just 10 percent of the world’s speculators were mak-

ing regular 50–100 percent returns per trade over the long term (as is the goal

of a speculator), then the world would be full of multi, multimillionaires who

made overnight fortunes trading options. Clearly, this is not the reality. How-

ever, this get-rich-quick ideal continues to be perpetuated by the endless

hope of investors seeking a quick and easy solution to their financial woes.

Options markets are a zero-sum game. Someone wins only when some-

one else loses. If most speculators lose in the long run, who are the win-

ners? Apart from the market makers and the small portion of speculators

who win over the long term, money flows each and every month into the

hands of option writers. Option writers are the people who are selling op-

tion contracts to the speculators.

What we want to teach you has nothing to do with the risky practice of

speculating with options—this is not high-risk, high-return trading. In fact,

covered calls are almost the complete opposite. In this book we show you

a way to use options to make consistent, steady profits that you can rely on

to pay your mortgage and put food on your table or to compound your in-

vestment capital through time into significant accumulations of wealth.

OSEPH

OOPER

ARON

ALEWSKI

xPreface

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CHAPTER 1

MARKET BASICS

This section is written specifically for the stock market novice. It is aimed

at those who have never bought a stock before or those who have very lit-

tle understanding of the most basic functions of stock and option markets.

What Is the Stock Market?

From the perspective of a private investor, the stock market provides a

venue for the buying and selling of stock of publicly listed companies. If

you want to buy fruit, you go to the fruit market. If you want to buy stocks,

you buy them through the stock market—it is as simple as that. Other com-

mon terms for the stock market include:

• Share market

• Equity market

• Simply “the market”

From the perspective of a company, listing on the stock market pro-

vides access to a large amount of investment capital that would not other-

wise be available to an unlisted company. The market provides companies

with the ability to seek investment funds from retail investors as well as in-

stitutional investors (fund managers, banks, etc.) who invest on behalf of

others. Access to this public market capital enables a listed company to sig-

nificantly extend its potential funding base upon which it can expand and

grow its business in the future.

An Introduction

to Options

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What Is a Share?

A share represents a portion of ownership of a company. Public companies

are very large and, in most instances, are not owned by just one person or

entity. Many thousands of different people or entities own stock in large

listed public companies.

A share literally entitles its owner to a portion of a company’s earnings

(as dividends) and a claim on the company’s assets in the event of bank-

ruptcy (priority given to creditors). Through the election of company di-

rectors, stockowners are also entitled to participate in deciding the future

direction of the company.

Most adults are already stockowners. Some of these stockowners are

active investors who buy and sell stocks based on their own research or on

the advice of their peers or professional advisers such as a stockbroker.

Other stockowners gain exposure to the stock market through mutual

funds where money is pooled and invested by a professional fund manager.

How Are Stocks Bought and Sold

on the Stock Market?

Think of the stock market like a fruit market. Let’s assume you want to buy

10 bananas. You need to go to the fruit market and see who is selling ba-

nanas and at what price. Store owners are entitled to sell their bananas at

whatever price they see fit. Obviously they don’t want to make the price too

high or their fruit won’t sell, or too low because then they are not making

as much money as they could.

You find three different stores selling bananas:

Asking Price, 10 Bananas

Store 1 $1.40

Store 2 $1.47

Store 3 $1.60

You obviously want to buy your bananas as cheaply as possible. If you

think $1.40 is reasonable, you might simply buy them from store 1 at that

price. If you are only prepared to pay $1.35, then you might “bid” to buy them

at $1.35. The manager at store 1 may agree to this price as it’s not far away

from his asking price. If you both agree on a price, the bananas will sell.

Buying stocks on the stock market works exactly the same way! Let’s

assume you want to buy 100 shares of General Electric (GE). You look up

the price at the stock market by calling your stockbroker (or going to your

broker’s online site). You are presented with the market for GE stock. It

looks Table 1.1.

2AN INTRODUCTION TO OPTIONS

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If you want to buy 100 shares, you need to buy them by reaching an

agreement on price from someone who wants to sell them. The sellers put

into the market how many shares they want to sell and at what price (the

“ask” price). You obviously want to buy the stock as cheaply as possible, so

the seller asking the lowest price is always at the top of the list. He or she

is offering 5,000 shares for sale at a price of $25.20.

You now have two options:

1. If you think $25.20 is a reasonable price, you can simply put in a bid to

buy 100 shares of GE at $25.20 and your order will be filled.

2. If you think $25.20 is not a reasonable price, you can put in a bid for less.

Let’s assume you think $25.10 is a reasonable price. You enter this bid

price into the market and the market will then look like Table 1.2. Your bid

is now at the top of the column because you are the current highest bidder.

If the seller at $25.20 (or any other seller) thinks that $25.10 is a reasonable

price, he or she may change the order to $25.10 and the stock will trade. Or

a new seller might come into the market enticed by your bid of $25.10 and

your stock may trade.

What Is a Stock Code or Symbol?

All stocks that trade on public markets are represented by an individual

stock code or symbol. No two stocks have the same stock code.

An Introduction to Options 3

TABLE 1.1 The Market for GE Stock

Buyers (Bid) Sellers (Ask)

Number of Shares Bid Price Ask Price Number of Shares

2,000 $25.00 $25.20 5,000

5,000 $24.80 $25.40 400

400 $24.20 $26.00 1,000

TABLE 1.2 Entering a Bid into the Market

Buyers (Bid) Sellers (Ask)

Number of Shares Bid Price Ask Price Number of Shares

100 $25.10 $25.20 5,000

2,000 $25.00 $25.40 400

5,000 $24.80 $26.00 1,000

400 $24.20

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While these terms can be used interchangeably, in the United States,

the term symbol is used. U.S. stock symbols consist of one letter to five

letters. For example, Citigroup is represented by the symbol C, Wal-Mart is

represented by the symbol WMT, and Shire Pharmaceuticals is represented

by the symbol SHPGY.

Option contracts in the United States are also represented by symbols/

tickers, which are generally five letters long. As with stocks, no two option

contracts have the same symbol.

What Makes Stock Prices Go Up and Down?

Many factors influence the price at which a company’s stock trades, the

most important factor being a company’s future earnings. Various funda-

mental factors combine to influence a company’s future earnings. You will

become very familiar with fundamental factors as they are of particular

interest to financial analysts and also gain significant exposure in the fi-

nancial press. Common fundamental factors that affect the future earnings

potential of a company include:

• Company-related issues such as increases or decreases in sales, in-

creases or decreases in the cost of doing business, and changes in asset

position, management team, business model, or perceived business risk.

• Industry-related issues such as the financial performance of competi-

tors or introduction of significant legislation.

• Economic-related issues such as the economic growth rate of econo-

mies in which the business operates, currency fluctuations, and inter-

est rate or inflation rate changes.

If a fundamental factor changes and causes the market to think that a com-

pany’s future earnings will be higher (lower) than previously expected, the

stock price will adjust upward (downward) accordingly.

Other influences on stock prices that you should be aware of are techni-

cal factors. Technical analysis is the study of stock price charts through time.

There are many investors and traders in the financial markets who make buy

and sell decisions based solely on technical analysis because they believe

that all fundamental factors are represented in the price charts they analyze.

We discuss both fundamental and technical factors in more depth later

in this book.

What Is a Stockbroker?

Stockbrokers provide access to the stock market by entering buy and sell

orders into the market on behalf of investors. Stockbrokers also hold ac-

counts on behalf of investors where electronic records of stocks, options,

and cash held are kept.

4AN INTRODUCTION TO OPTIONS

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A brokerage account is just like a bank account except it holds stocks

and options as well as cash. To set up a brokerage account, contact a bro-

ker (via phone or online), fill out the paperwork, and deposit money into

your account. For the type of investing you are going to be doing, it is best

to use a discount broker with the lowest possible transaction costs and fast

executions.

Do not use a boutique broker (one who provides advice), even if you cur-

rently use one. They are expensive and, from this point on, you will not need

their advice. You will make your own decisions and the returns you will gen-

erate may be many times what the best broker can do for you in the best year!

The brokerage industry is constantly evolving with new online players

entering the market and existing brokerage houses regularly making

changes to trading platforms and commission structures. The current in-

dustry best brokers for using the covered call technique can be found at

www.compoundstockearnings.com/brokers. We strongly advise you to use

one of these recommended brokers because trading platforms and trans-

action costs have a very dramatic effect on profitability.

What Are the Dow Jones Industrial Average,

S&P 500, and NASDAQ?

The Dow Jones Industrial Average (the Dow), S&P 500, and NASDAQ are

stock market indexes. A stock market index is used to represent the per-

formance of a group of stocks rather than just a single stock. Apart from

some exceptions (such as the Dow), indexes are generally constructed on

a market value weighted basis. Consequently, the movements of larger

companies have a greater impact on the performance of the index than do

movements of smaller companies.

Some of the world’s most significant stock market indexes are listed in

Table 1.3.

An Introduction to Options 5

TABLE 1.3 Major Stock Market Indexes

Index Name Market Composition

Dow Jones Industrial U.S.—NYSE 30 stocks on New York Stock Exchange

(Dow) (NYSE)

NASDAQ Composite U.S.—NASDAQ All NASDAQ stocks; heavy in technology

S&P/ASX 200 Australia 200 largest and most liquid companies

Financial Times Stock London 100 largest companies; often called

Exchange (FTSE) “Footsie”

DAX Germany 30 major companies

Hang Seng Hong Kong 33 largest companies

Nikkei Tokyo 225 largest companies

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OPTIONS BASICS

What Are Options and How Do They Trade?

An option is a financial instrument and contract. An option gives the holder

the right, but not the obligation, to buy or sell a financial asset at a certain

price up to a certain date. An important distinction is “the right, but not the

obligation.” The holder of the option does not have to exercise the right

under the contract if it is not in his or her favor to do so.

Options (like futures) are known as derivative securities simply be-

cause their value is derived from the value of other more basic variables.

For example, an IBM stock option is a derivative security because its value

depends on the price of IBM stock. The derivative asset is also referred to

as the underlying asset. In this case, the underlying asset is IBM stock.

Options are available on many financial assets including stocks, fu-

tures, and commodities. Most options are exchange traded, meaning they

are traded on public markets, just like stocks are traded on stock exchanges.

There are two basic types of stock options:

1. A call option gives the holder the right, but not the obligation, to buy a

stock at a certain price up to a certain date. Call options are used by

speculators who expect an increase in the price of the underlying

asset.

2. A put option gives the holder the right, but not the obligation, to sell a

stock at a certain price up to a certain date. Put options are used by

speculators who expect a decrease in the price of the underlying asset.

The covered call technique involves the use of call options only.

Options trade exactly the same way that stocks do. There are investors

who want to buy options and there are investors who want to sell, or write,

options. When these two investors reach an agreement on price, the con-

tract trades. This trade happens in exactly the same way as previously de-

scribed in the section on “how stocks are bought and sold on the stock

market.”

All exchange-traded options have certain standard characteristics.

Take this description of a contract as an example:

General Electric September 2005 $30.00 Call Option

Company name All exchange-traded options relate to a specific

publicly listed company (or financial asset). In

this case the contract relates to stock in Gen-

eral Electric (GE).

6AN INTRODUCTION TO OPTIONS

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Expiration date All options have an expiration date. In this case

the option expires in September 2005.

Strike or exercise All options have a specific strike or exercise

price price. These two terms are used interchange-

ably. If you own this contract you have the

right to buy GE stock at a price of $30.00.

Type All options are either a call option or a put

option. A call option provides the right to buy

the stock. A put option provides the right to

sell the stock. This contract is a call option.

If you owned the GE September 2005 $30.00 call option, you would have the

right, but not the obligation, to buy GE stock at $30.00 per share up to the

expiration date of September 2005.

Unlike stocks, options are referred to as contracts. In the United States,

a standard contract relates to 100 shares in the underlying stock—this num-

ber changes depending on which country the option is listed in. Thus, if you

buy four GE September 2005 $30 calls, you own four contracts. Each con-

tract relates to 100 shares, so in this instance, you own the right to buy 400

shares.

What Basic Options Terminology Do You

Need to Know?

Long and Short Positions An investor who has an overall buy posi-

tion in a stock or option contract is said to be long. If you currently do not

own GE stock and you purchase 500 GE shares, you are long 500 GE

shares. If you purchase four GE September 2005 $30 calls and have no

existing position in that contract, you are long four GE September 2005

$30 calls.

Conversely, an investor who has an overall sell position in an option

contract is said to be short. If you currently do not own GE stock and you

sell 400 GE shares, you are short 400 shares. If you sell three GE September

2005 $30 calls and have no existing position in that contract, you are said to

be short three September 2005 $30 calls.

Table 1.4 shows each position classified as either long or short. It

assumes that the investor has no existing position in any stock or option

contract.

Opening and Closing Transactions An opening transaction is one

where an option buyer or seller establishes a new position or increases an

existing position as either a buyer or a seller. For example, if John buys one

An Introduction to Options 7

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GE September 2005 $30 call, he is said to be “buying to open”—he has

opened a new position. John may also elect to sell one GE September 2005

$30 call. In this case he would be “selling to open” if he was not already long

in the identical contract. The effect of an opening transaction is that the

number of contracts the investor is exposed to is increased.

A closing transaction is one where an option buyer makes an offset-

ting sale of an identical option or an option seller makes an offsetting pur-

chase of an identical option. For example, if John is long one GE September

2005 $30 call and then sells one GE September 2005 $30 call, he would be

“selling to close” because he has now closed out his position in that option

contract and has no further rights or obligations under the contract. The ef-

fect of a closing transaction is that the number of contracts the investor is

exposed to is decreased.

Alternatively, if John holds a short position of one GE September 2005

$30 call and then buys one GE September 2005 $30 call, he would likewise

be “buying to close” because he has now closed out his position in that op-

tion contract and has no further rights or obligations under the contract.

Again, the effect of a closing transaction is that the number of contracts the

investor is exposed to is decreased.

Table 1.5 shows transactions categorized as either an opening or

closing.

The important concept to understand is that an option buyer or seller

can, at any time, close an open position by performing an equal and oppo-

site transaction with the identical contract. Whether the transaction is

closed for a profit or loss depends on the option’s price at the time that the

closing transaction is executed. This action is very similar to closing a tra-

ditional stock investment—the investor can sell the stock and close the po-

sition at any time, but whether the stock can be sold for a profit or loss

depends on the current market price at the time.

8AN INTRODUCTION TO OPTIONS

TABLE 1.4 Comparison of Long and

Short Positions

Position Long Short

Buy 300 GE shares X

Sell 12 WMT calls X

Buy 4 HD calls X

Buy 8 JPM calls X

Sell 1 CD call X

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In the Money, Out of the Money, and At the Money Option market

participants have coined the phrases in, out, and at the money to describe

an option’s strike price in relation to the stock price.

An in-the-money option is one that has intrinsic value, where the

owner of the option stands to profit by exercising his or her right under the

contract. For a call option to be in the money, the stock price must be

higher than the strike price. For example, a $15.00 call option is in the

money when the stock price is greater than $15.00.

An out-of-the-money option is one that has no intrinsic value, where

the owner of the option does not stand to profit by exercising his or her

right under the contract. For a call option to be out of the money, the stock

price must be lower than the strike price. For example, a $15.00 call option

is out of the money when the stock price is below $15.00.

An at-the-money option is one where the stock price is trading at or

very close to the exercise price. For example, a $15.00 call option would be

considered at the money if the stock price was $15.00. In practical terms,

market participants also describe an option as at the money when the stock

price is close to the exercise price of the option. So, if an option’s strike

price was $15.00 and the stock price was $14.80 to $15.20, it would be

deemed as being at the money.

Table 1.6 shows options classified as being either in, at, or out of the

money.

Physical Settlement Versus Cash Settlement There are two types

of settlement styles for exchange-traded options: physical settlement and

cash settlement. Physical-settlement options give the owner the right to re-

ceive physical delivery of the underlying asset when the option is exercised.

An Introduction to Options 9

TABLE 1.5 Classification of Transactions

Buy to Buy to Sell to Sell to

Current Position Next Transaction Open Close Open Close

Long 100 GE shares Buy 100 GE shares X

Long 100 GE shares Sell 100 GE shares X

Long 300 GE shares Buy 100 GE shares X

Short 200 GE shares Buy 200 GE shares X

No position Buy 2 GE calls X

No position Sell 2 GE calls X

Short 2 GE calls Buy 2 GE calls X

Long 2 GE calls Sell 2 GE calls X

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Cash-settlement options give the owner the right to receive a cash payment

based on the difference between the underlying asset price at the time of the

option’s exercise and the exercise price of the option. The majority of stock

options are physically settled while index options are cash settled.

American Versus European Expiration An American-style option

may be exercised at any time prior to its expiration. A European-style option

may be exercised only on its expiration date. The majority of stock options

traded on U.S. and international options exchanges are American-style

options. Our covered call technique involves the use of American-style op-

tions only.

Option Expiration Dates In the U.S. market, virtually all standardized

option contracts expire on the third Friday of each month; they do not ex-

pire on the last day of the month. For example, if you hold a November op-

tion contract, this contract will expire on the third Friday of November, not

at the end of November.

The Options Clearing Corporation The Options Clearing Corpora-

tion (OCC) guarantees that all market participants fulfill their obligations

under the terms of options contracts. This is a very important function of an

options market, particularly in terms of guaranteeing that options writers

are capable of fulfilling their potentially large exposures.

Apart from keeping a record of all short and long positions, the OCC

ensures that when purchasing an option the buyer must pay for it in full and

the writer of an option must maintain an adequately funded margin account

to cover his or her exposure at all times.

The clearinghouse allows the options market to function. Without it,

the risk of counterparties defaulting on their obligations under an option

contract would stifle the market.

Standardized Options and Option Chain Exchange-traded options

are almost always standardized. Standardized options have set parameters

10 AN INTRODUCTION TO OPTIONS

TABLE 1.6 Classification as In, At, or Out of the Money

Contract Stock Price In At Out

GE Jan 07 $35 Call $35.75 X

WMT Sep 05 $45 Call $48.20 X

C Jan 06 $50 Call $50.02 X

JPM Aug 05 $30 Call $24.10 X

HON Jan 07 $50 Call $40.45 X

ABT Sep 05 $45 Call $44.90 X

c01.qxd 10/23/06 2:22 PM Page 10

in terms of the amount of an underlying asset a contract relates to, the ex-

piration date, the exercise price, the multiplier, and the option style. In-

vestors cannot alter the standardized characteristics of an exchange-traded

option to suit their own needs—they must work within the standardized pa-

rameters provided by the options exchange. The most important function

of standardization is to assist in the formation of liquid secondary markets

where buyers of options can close out positions by selling an identical con-

tract and sellers/writers can close out positions by buying an identical

contract.

An option chain is a list of all standardized options available for a par-

ticular stock or index. Table 1.7 shows an option chain for the U.S.-listed

banking group JP Morgan. Take a moment to study it and note the different

strike prices and expiration dates available.

If you wanted to buy or sell a call option on JP Morgan, you would have

to select an option contract from this option chain. You are not able to se-

lect contract specifications that do not appear in the standardized option

chain. Note that for simplicity only call options appear on this option chain;

the same option chain is also available for put options.

How Do Speculators Use Options

to Trade the Market?

While we don’t use options to speculate on the future direction of a stock

or market, many investors do use options for this purpose. It is essential

that you understand how a speculative trade works in order for you to un-

derstand options markets.

Example of Using a Call Option to Speculate GE stock is cur-

rently trading at $30.00. John thinks GE stock is going to go up in the next

three months. It’s now June, so John decides to buy a September $30.00 call

option (note that he does not have to choose a strike price equal to the cur-

rent stock price). John now has the right, but not the obligation, to buy GE

stock at a price of $30.00 up to September. For this right John pays the pre-

mium of $1.00 per share. The premium is the price the option buyer pays

to the option seller.

So let’s assume John’s hunch is right. It’s now July and GE stock is

$35.00. John has the right to buy GE stock for only $30.00. He can exercise

this right, buy the stock at $30.00, and immediately sell it in the market for

$35.00 (the current stock price). John has paid a premium of $1.00 per share

for this right. His profit appears as follows:

Share sell price – Share buy price – Option price = Profit per share

$35.00 – $30.00 – $1.00 = $4.00

An Introduction to Options 11

c01.qxd 10/23/06 2:22 PM Page 11

12 AN INTRODUCTION TO OPTIONS

TABLE 1.7 JP Morgan Option Chain Example—Stock Price, $39.38

Bid Ask Bid Ask

Strike Symbol Price Price Delta Strike Symbol Price Price Delta

September Mar-05

27.50 JPMIY 11.80 12.00 1.00 27.50 JPMCY 11.90 12.10 0.98

30.00 JPMIF 9.30 9.50 1.00 30.00 JPMCF 9.50 9.70 0.97

32.50 JPMIZ 6.80 7.00 1.00 32.50 JPMCZ 7.20 7.40 0.92

35.00 JPMIG 4.40 4.50 1.00 35.00 JPMCG 5.20 5.30 0.81

37.50 JPMIU 1.95 2.05 0.91 37.50 JPMCU 3.30 3.50 0.63

40.00 JPMIH 0.30 0.35 0.33 40.00 JPMCH 1.90 2.05 0.44

42.50 JPMIV 0.00 0.05 — 42.50 JPMCV 0.90 1.05 0.26

45.00 JPMII 0.00 0.05 — 45.00 JPMCI 0.35 0.45 0.14

47.50 JPMIW 0.00 0.05 — 47.50 JPMCW 0.10 0.20 0.06

50.00 JPMIJ 0.00 0.05 — 50.00 JPMCJ 0.00 0.10 —

October Jan-06

27.50 JPMJY 11.90 12.00 1.00 20.00 WJPAD 19.30 19.50 0.95

30.00 JPMJF 9.40 9.50 1.00 25.00 WJPAE 14.40 14.60 0.94

32.50 JPMJZ 6.90 7.00 1.00 30.00 WJPAF 10.10 10.20 0.87

35.00 JPMJG 4.40 4.60 0.97 35.00 WJPAG 6.30 6.50 0.68

37.50 JPMJU 2.20 2.25 0.79 37.50 WJPAU 4.80 4.90 0.56

40.00 JPMJH 0.55 0.65 0.39 40.00 WJPAH 3.40 3.60 0.44

42.50 JPMJV 0.05 0.10 0.10 42.50 WJPAV 2.40 2.55 0.33

45.00 JPMJI 0.00 0.05 — 45.00 WJPAI 1.55 1.70 0.23

47.50 JPMJW 0.00 0.05 — 47.50 WJPAW 1.00 1.10 0.16

50.00 JPMJJ 0.00 0.05 — 50.00 WJPAJ 0.60 0.70 0.11

December Jan-07

30.00 JPMLF 9.40 9.60 0.99 25.00 VJPAE 14.40 14.90 0.88

32.50 JPMLZ 7.00 7.20 0.97 30.00 VJPAF 10.60 10.80 0.78

35.00 JPMLG 4.80 4.90 0.89 35.00 VJPAG 7.20 7.30 0.61

37.50 JPMLU 2.80 2.95 0.69 40.00 VJPAH 4.60 4.80 0.43

40.00 JPMLH 1.30 1.40 0.42 45.00 VJPAI 2.70 2.90 0.27

42.50 JPMLV 0.50 0.55 0.20 50.00 VJPAJ 1.50 1.60 0.16

45.00 JPMLI 0.10 0.15 0.07

47.50 JPMLW 0.00 0.10 —

Jan-05

25.00 JPMAE 14.30 14.50 0.99

30.00 JPMAF 9.40 9.60 0.98

32.50 JPMAZ 7.10 7.30 0.95

35.00 JPMAG 4.90 5.10 0.85

37.50 JPMAU 3.00 3.20 0.66

40.00 JPMAH 1.55 1.65 0.43

42.50 JPMAV 0.60 0.70 0.23

45.00 JPMAI 0.15 0.25 0.10

47.50 JPMAW 0.05 0.10 0.04

50.00 JPMAJ 0.00 0.05 —

c01.qxd 10/23/06 2:22 PM Page 12

So what would have happened if John’s hunch were wrong and GE

stock actually fell? John has the right, but not the obligation, to buy GE

stock at $30.00. If the stock is less than $30.00, he would not exercise this

right and would just let the option expire. If this were the case, he would

lose the $1.00 premium he paid for the contract. It is important to realize

that this $1.00 is the most John could possibly lose on this trade.

The maximum loss of an option buyer is the premium paid (the cost of

the option).

Example of Using a Put Option to Speculate A put option works

very similarly to a call option; however, investors buy a put option when

they think the price of a stock is going to fall. Let’s look at an example.

It’s now September and GE is trading at $35.00. John thinks that the

price of GE stock is going to fall. So he decides to buy a December $35.00

put option. He now has the right, but not the obligation, to sell GE stock at

a price of $35.00 up to December. For this right John pays, for example,

$1.00 per share.

The price of GE stock then falls to $30.00 per share. John has the right

to sell GE stock at $35.00. He would, therefore, go into the market and buy

GE stock for $30.00 and then exercise his right to sell GE stock at $35.00.

His profit would look like this:

Share sell price – Share buy price – Option price = Profit per share

$35.00 $30.00 $1.00 = $4.00

So what would have happened if John’s hunch were wrong and GE

stock actually rose? John has the right, but not the obligation, to sell GE

stock at $35.00. If the stock is more than $35.00, he would not take up this

right to sell and would just let the option expire. If this were the case, he

would lose the $1.00 he paid for the contract. It is important to realize that

this $1.00 is the most John could possibly lose on this trade.

Again, the maximum loss of an option buyer is the premium paid (the

cost of the option).

Options Trading in the Real World Now you understand the ratio-

nale and logic behind an options trade, but trading in the real world is a lit-

tle different!

In the real world, speculators very rarely exercise their option con-

tracts in order to take profits from a trade. Take the first example where

John has the right to buy GE stock at $30.00 and the stock is trading at

Premium: The price of an option; the amount of money the buyer pays for

the rights and the seller receives for the obligations granted by the contract.

Expressed on a per share basis.

An Introduction to Options 13

c01.qxd 10/23/06 2:22 PM Page 13

$35.00. If John wants to realize a profit on this trade, it is highly unlikely

that he would exercise this option. It is more profitable for John to just sell

his call option to someone else in the market (sell to close).

Remember, John paid $1.00 per share for the right to buy GE stock at

$30.00. If GE stock quickly jumped up to $35.00, he would actually be able

to sell his call option for around $6.00. This $6.00 market value comprises

$5.00 exercisable value and $1.00 of remaining time value. Both exercisable

(intrinsic) value and time value are discussed in detail later in “How Are

Option Prices Determined?”

John’s profit would look like this:

Option sell price – Option buy price = Profit per share

$6.00 – $1.00 = $5.00

So John would make $5.00 per share by selling the call option, compared to

only $4.00 per share if he exercised the call option, because exercising op-

tions results in a loss of time value (discussed in “How Are Option Prices

Determined?”). By exercising the option, John will realize the $5.00 exer-

cisable value in the contract ($35.00 stock price minus $30.00 strike price),

but will forgo the remaining time value in the contract ($1.00).

Due to this loss of time value, option traders very rarely exercise op-

tions in order to take profits from a trade! Options are traded just like

stocks, and profits and losses are made, for the most part, by buying and

selling the option itself, not by exercising it. So, it is important to remember:

Option traders very rarely exercise their options more than two

weeks before expiration. In practicality, the vast, vast majority of op-

tion contracts are exercised on the third Friday of expiration. Exer-

cising options early results in a loss of time value to the option buyer.

Instead, option traders simply buy and sell the option contract just

like buying and selling stocks.

Why Speculate with an Option Instead

of a Stock?

Why speculate with an option instead of a stock? The simple answer is

leverage. Options provide a much greater return potential than investing in

the stock itself (albeit with higher risk). If a stock moves up 5 percent, an

Time Value: The portion of an option’s price that exceeds the exercisable

value.

14 AN INTRODUCTION TO OPTIONS

c01.qxd 10/23/06 2:22 PM Page 14

investor will make more money if he has $10,000 invested in call options

rather than if he has $10,000 invested in stock itself.

Here’s an example. John thinks GE stock is going to rise by $2.00 and

wishes to invest $10,000 on his hunch. He has two alternatives:

1. Buy GE stock.

2. Buy call options on GE stock.

Let’s look at the two scenarios.

Scenario 1 GE stock is currently trading at $30.00. With his $10,000

John can buy 333 shares ($10,000/$30.00 per share). If GE goes up to $32.00

as he expects, John will make $2.00 per share profit, or a total of $666 on his

$10,000 investment. This is a return of 6.7 percent. Not bad.

Scenario 2 GE stock is currently trading at $30.00. With his $10,000

John decides to buy GE call options. He buys the $30.00 call option for

$1.00 per share. In the United States, each contract relates to 100 shares so

he can buy 100 contracts [$10,000/($1.00 per share ×100 shares per con-

tract)]. If GE stock increases by $2.00, his call option contract is likely to be

worth around $1.80 per share. John will make $0.80 per share ×100 shares

per contract ×100 contracts = $8,000. This is a return of 80 percent.

Table 1.8 gives a comparison of the two scenarios.

The preceding example shows that with the same dollar investment in

the same company and the same move in the stock price, John made an

extra 73 percent return on his investment and an extra $7,333 by buying GE

options rather than GE stock. This extra bang for your buck, known as

leverage, attracts speculators to the use of option contracts. Options are

leveraged instruments. But beware! The leverage works both ways. John

could have lost most, if not all, of his money if the stock price went down

$2.00 rather than up!

Leverage is why options are regarded by the vast majority as risky. Op-

tions are, without doubt, very risky when used to speculate. After all, can

An Introduction to Options 15

TABLE 1.8 Comparison of Investing in Stocks Versus Options

Type of Stock Total Number Sell

Scenario Investment Price Invested Price of Units Price Profit

A Shares $30.00 $10,000 $30.00 333 $32.00 $667

or 7%

B Options $30.00 $10,000 $ 1.00 100 $ 1.80 $8,000

or 80%

c01.qxd 10/23/06 2:22 PM Page 15

John, or you, or I see into the future and know which way a stock is going

to go? The answer is obviously no. GE could just as easily have gone down

and John could have lost most, if not all, of his $10,000 investment. We

never use an option for speculative purposes. Covered call writers sell op-

tions, rather than buy them.

How Are Option Prices Determined?

As with determining the price at which a stock sells in the market, it is sup-

ply and demand that influence the price at which an option trades. An in-

vestor attempting to buy an option must do so from an investor wanting to

sell/write an option contract. Option market participants do, however, as-

sess distinct and constantly changing variables in order to determine the

price at which an option trades—its market value.

The liquidity of the options market is a significant contributor to the

consistency of bid and ask prices representing fair market value. In less liq-

uid markets—those with fewer participants, fewer market makers, and a

lower volume of options trades—it is more likely that bid and ask spreads

will be larger and that investors need to take more caution in assessing bid

and ask prices for fair market value. Your covered call activity will likely be

conducted in the options market of the United States, which is the world’s

largest and most liquid options market. As such, the bid and ask prices or

the market for contracts you trade will generally represent a reasonable ap-

proximation of fair market value.

Mathematical formulas such as the Black-Scholes and binomial pricing

models have been developed to calculate an option’s theoretical value. The

shortcomings of these models in terms of encompassing the scope of vari-

ables and uncertain outcomes of financial markets and their resulting de-

tachment from market reality have been well documented. Stock options’

market prices will inconsistently resemble the theoretical value as deter-

mined by models such as the Black-Scholes. As such, option traders and in-

vestors generally do not spend time calculating academic values for

contracts—the market is the primary driver of value determination.

What it all boils down to is this: If you’re investing in the U.S. market

(or a developed overseas market), it is highly likely that the prices at the bid

and ask are reasonable approximations of fair value.

That being said, six independent factors are very important when de-

termining the value of a stock option. It is essential for you to understand

these factors and how they interact and influence the price of an option

Liquidity: Market liquidity refers to the ability to quickly buy or sell a stock

or option without causing a significant movement in the price.

16 AN INTRODUCTION TO OPTIONS

c01.qxd 10/23/06 2:22 PM Page 16

contract. This knowledge will allow you to understand how the price of the

contract will change with changes in the underlying stock price, with lapses

in time, and so on. These six important factors are:

1. The current stock price.

2. The exercise price of the contract.

3. The time to expiration.

4. The volatility of the stock price.

5. Risk-free rate (interest rates).

6. Dividends expected on the stock during the life of the option.

To be successful in the business of writing covered calls, you need to

have a good understanding of factors 1, 2, and 3 and to a lesser extent, fac-

tor 4. Be aware of points 5 and 6; however, an in-depth understanding of

these factors is very academic and not essential to your success as an op-

tion writer.

Factor 1: The Current Stock Price As discussed previously, an in-

vestor who purchases a call option is speculating that the price of the un-

derlying stock is going to increase. The payoff to this investor will be the

difference between the exercise price and the stock price. This difference

is known as intrinsic value, which is simply what the option owner can

make if he or she exercises the option and sells the stock in the market.

That is, if he or she has the right to buy the stock at $35.00, and the stock

price is $40.00, the intrinsic value is $5.00. If the stock price moves up again

to $45.00, the intrinsic value is $10.00. It makes sense that an option con-

tract with $10.00 of intrinsic value should be worth more than a contract

with only $5.00 of intrinsic value.

Thus, call option prices increase as the stock price increases and more

intrinsic value is added to the contract. Put options are the opposite, so put

option prices increase as the stock price decreases. Table 1.9 shows the re-

lationship between option price and intrinsic value.

An Introduction to Options 17

TABLE 1.9 Intrinsic Value

Call Strike $35.00

Stock price $35.00 $40.00 $45.00

Call value $ 1.00 $ 5.60 $10.20

Put Strike $35.00

Stock price $25.00 $30.00 $35.00

Put value $10.20 $ 5.40 $ 1.10

c01.qxd 10/23/06 2:22 PM Page 17

Factor 2: The Exercise Price of the Contract The exercise price

of the contract has an influence on intrinsic value similar to changes in the

stock price. Let’s assume an investor has a $35.00 call option and the stock

price is currently $40.00. We now know that this contract has $5.00 worth

of intrinsic value. Let’s assume the same investor also has a $30.00 call op-

tion on the same stock. The $30.00 call option has $10.00 of intrinsic value

and obviously, then, it has to be worth more!

Thus, call options increase in price the lower the exercise price is. Put

options are the opposite, so they increase in price the higher the exercise

price is. Table 1.10 shows the relationship between option price and exer-

cise price.

Factor 3: The Time to Expiration Up to this point, we have dis-

cussed only intrinsic value. Hopefully, you have been looking at the pricing

examples provided for factors 1 and 2 and wondering why the option price

is greater than the intrinsic value. The option price is greater because the

other portion of value in an option contract is time value.

Intrinsic value + Time value = Option value

The longer an option has to expiration, the greater its time value. John

thinks GE stock is going to rise from the current price of $35.00. He decides

to buy a $35.00 strike call. Remember, John wants GE to increase in price

so that the intrinsic value of his contract will increase. If John has six

months until his contract expires, that gives him a lot of time for GE stock

to increase. However, if John purchases a contract with only one month to

expiration, he does not have much time for GE stock to move in his favor.

Thus, the more time a contract has to expiration, the more it is worth.

Each day that goes by, the price/value of each and every option contract de-

creases because there is less time to expiration. Options are, therefore,

known as decaying assets.

18 AN INTRODUCTION TO OPTIONS

TABLE 1.10 Exercise Price

Stock Price $35.00

Call strike price $35.00 $30.00 $25.00

Call value $ 1.10 $ 6.00 $10.40

Stock Price $35.00

Put strike price $35.00 $40.00 $45.00

Put value $ 1.00 $ 5.70 $10.60

c01.qxd 10/23/06 2:22 PM Page 18

Table 1.11 shows how time affects an option’s price (assume it is early

June).

A very important point to understand in options pricing is that time

decay is not linear! (See Figure 1.1.) Contracts that expire in one or two

months have a significantly higher level of time decay than contracts that

expire in one or two years. The majority of an option’s time value is lost

in the weeks leading up to expiration.

The covered-call method of investing actually utilizes the decay in time

value to your advantage. You will make money from the decay in the spec-

ulators’ assets.

Factor 4: The Volatility of the Stock Price Option contracts are

worth more on a stock that is volatile than on a stock that is less volatile.

Volatility is technically defined in terms of standard deviation; however,

for our purposes volatility can be thought of simply as a measure of how un-

certain we are about a stock’s future price movements. As volatility in-

creases, the chance that a stock will make a significant move upward or

downward increases.

If you were the owner of stock in a company, these two extreme out-

comes tend to offset one another. However, if you are the owner of a call or

a put, while your potential loss is limited to the amount invested, your po-

tential profit can be many times over your original investment from signifi-

cant price swings in the appropriate direction.

An Introduction to Options 19

TABLE 1.11 How Time Value Affects Options Price

Strike $35.00

Expiration date June July Sep Dec

Option price $0.50 $1.00 $1.30 $1.50

Price

Time

FIGURE 1.1 Example of the rapid decay of time value toward the end of an

option’s life.

c01.qxd 10/23/06 2:22 PM Page 19

So, all else being equal, a more volatile stock will have higher option

prices (see Table 1.12). Additionally, options prices will adjust upward or

downward to significant changes in a stock’s volatility levels.

Factor 5: Risk-Free Rate (Interest Rates) The effect of interest

rates on option prices is very academic and perhaps only meaningfully no-

ticeable over the longer term where significant interest rate changes occur.

Therefore, this brief discussion of that effect is included for completeness

rather than necessity. Understanding this effect will not have any signifi-

cant influence on your success as an option writer.

As interest rates increase, (1) the present value of future cash flows re-

ceived by the holder of the option decreases and (2) the expected growth

rate of stock prices tend to increase. In the case of calls, effect (1) tends to

decrease option prices and effect (2) tends to increase prices. In the case of

puts, both (1) and (2) have negative effects on prices.

Factor 6: Dividends Expected on the Stock During the Life of

the Option Dividends have the effect of reducing the stock price on the

ex-dividend date (the date the dividend on a stock is paid). The price re-

duction, in turn, decreases the value of call options and increases the value

of put options. A high proportion of companies you are likely to invest in

will pay dividends. Worrying about insignificant pricing influences such as

dividends creates headaches, not better returns. So forget about them, and

leave the squabbling to the academics.

20 AN INTRODUCTION TO OPTIONS

TABLE 1.12 Effect of Volatility on Price

Stock Price Call Strike Expiration Option Price

Stable stock $30.00 $30.00 Mar-06 $1.00

Volatile stock $30.00 $30.00 Mar-06 $1.30

c01.qxd 10/23/06 2:22 PM Page 20

PART I

Covered Calls

c02.qxd 10/23/06 2:21 PM Page 21

COVERED CALL PROCESS FLOWCHART

Enter New Position

1. Filter with CSE Screener

2. Upward or sideways current cycle

3. Bottom 25% of current cycle

Stock Decreases

1. Mid-month buyback rule or

2. Allow call to expire

Can we favorably CPR?

Wait for expiration of CPR

1. Were we called out?

Profitable buyback

on TSS call?

1. Close on delta or

2. Apply SSR

Reinvest and

compound

proceeds

Reinvest and

compound

proceeds

Stock Increases

1. Close on delta effect or

2. Get called out

Secondary Call Sales Rules

1. Near month call or

2. TSS For income

Yes

No Exit

TSS

Exit

Called Out

Near Month

Each step in the covered call investing process is shown in the flowchart

above—from entering new positions, to managing positions for income, to

advanced defensive techniques. Investors familiar with our covered call

method know that there is a specific technique to address every situation

that may occur in the markets. Each situation that can be presented to a

covered call investor can be handled through the use of a specific man-

agement technique. Part I of this book will elaborate, expand on, and

provide an example of each step presented in the covered call process

flowchart. You may wish to revisit the flowchart at the beginning of each

new topic so you can gain an understanding of where a particular rule or

technique is applied in the overall investment process.

c02.qxd 10/23/06 2:21 PM Page 22

CHAPTER 2

OPTION SELLERS/WRITERS

In Chapter 1 we discussed only the intentions of speculators who are buy-

ing options to bet on the movement of the market, buyers of calls who are

anticipating an upward move in the stock price, and buyers of puts who are

anticipating a downward move in the stock price. We also stated that for

every buyer of an option contract, there is also a seller/writer of that con-

tract (the terms seller and writer can be used interchangeably). So who are

the sellers of options and what are their objectives?

There are basically three types of sellers of options:

1. Sellers who are closing existing long positions.

2. Sellers who are opening short uncovered positions.

3. Sellers who are opening short covered positions.

Short Position: An overall sell position in a stock or option.

Long Position: An overall buy position in a stock or option.

An Introduction

to Covered Calls

c02.qxd 10/23/06 2:21 PM Page 23

Sellers Who Are Closing Existing Long Positions

Sellers who are closing existing long positions are generally traders who

are speculating in the market. Closing a long position is exactly the same

as someone who has bought stock and is now trying to sell it for a profit

or loss. The seller holds a long position (has bought an option) and is

now hoping to realize a profit or loss on the position by selling the option

to close.

For example, when GE stock was trading at $34.00, a speculator bought

to open a GE $35.00 call option for $1.00 in anticipation of the stock price

rising. Let’s assume the speculator correctly picked the direction of the

market and the stock price is now $36.00. This speculator can sell to close

the GE $35.00 call at $1.50 and realize a $0.50 profit. Alternatively, if the

price of GE stock declined, the speculator could sell this contract for some-

thing less than $1.00 and would realize a loss.

Sellers Who Are Opening Short Uncovered Positions

In most financial markets, you can sell something that you don’t already

own. Such a transaction is possible through short selling. The objective of

short selling is to buy the share or contract back (buy to close) at a lower

price than you sold it for. Let’s look at an example.

John sells a GE $35.00 call option for $1.20. He will immediately get the

$1.20 premium of the contract deposited in his brokerage account by the

option buyer. John wants the stock price to drop so that the call price also

drops and he can buy the contract back (buy to close) and make a profit.

Let’s assume the stock price drops and John buys the contract back (buy to

close) for $1.00. He has made the difference of $0.20.

This transaction is an example of selling an uncovered call. Selling an

uncovered call is simply selling a call option without owning the underlying

stock or another covering option, which prevents a loss if the stock price

increases (we discuss this in the following section, “Sellers Who Are Open-

ing Short Covered Positions”). If you sell a call option without owning the

underlying stock or another covering option you are said to be “uncovered”

or “naked.” Selling naked calls is one of the most risky activities any in-

vestor can do in the markets—the profit and loss potential is simply not

Buying to Close: Closing a short stock or option position.

Selling to Close: Closing a long stock or option position.

24 COVERED CALLS

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stacked in the naked seller’s favor. Let’s look at the example of John selling

a GE $35.00 call option for $1.20 and see what his profit and loss potential

looks like.

Profit Remember, John sold this option, so someone has the right, but

not the obligation, to buy GE stock from John for $35.00. When he sold the

contract, John received the premium of $1.20 from the option buyer. The

maximum possible profit that John can make from this trade is restricted to

the price he received for selling the option, which is $1.20. The best out-

come for John is that the stock price plummets, the call is way out of the

money, and the contract expires worthless. In this instance, he would keep

the $1.20 he sold the contract for. However, it is more likely that John will

buy the contract back at some time in the future for something less than he

sold it for. Remember, John has to buy the option back in order to close his

position. Otherwise, if the contract finishes in the money, the buyer will ex-

ercise his option and John may need to deliver GE stock.

Loss We understand now that the most John can make from this trade is

$1.20. But, believe it or not, he has the potential to lose an unlimited

amount of money, because the stock price can theoretically go up to

any value. Let’s assume GE stock goes up to $45.00. There are two scenar-

ios here:

1. The buyer of the option may exercise his or her contract and John will

need to deliver GE stock at $35.00. GE stock is available in the market

at $45.00. So John will have to take the $10.00 loss.

2. John sees the share price soaring and decides to cut his losses. He will

buy to close the contract so that he has no further obligation under the

contract. If the stock is at $45.00, he’ll have to pay around $11.00 to buy

back the call. In this case he would lose $1.20 – $11.00 = $9.80.

Summary In any case, John stands to make a maximum of $1.20 and lose

a potentially unlimited amount on this trade. Business and markets are all

about risk and return. You should now understand that selling naked calls

is a very bad business proposition. Even though people still sell naked calls,

our advice is that you do not ever, under any circumstances, sell naked

calls. Doing so is categorically the quickest and easiest way to lose your

money in the options markets.

Sellers Who Are Opening Short Covered Positions

Sellers who open short covered positions are executing covered calls.

These are the smart sellers and this is the sort of selling that will regularly

An Introduction to Covered Calls 25

c02.qxd 10/23/06 2:21 PM Page 25

put money into your account with very, very low risk. These types of sell-

ers are also selling option positions to open. However, the distinction is that

these sellers also own the underlying stock (or another option contract)

and are thus covered in the event the stock price increases.

Remember in the preceding example where John sold a $35.00 call op-

tion for $1.20? He made money when the stock price declined, as the option

expired worthless and he kept the premium. However, the problem with

this transaction was that, in the event the stock price increased, John stood

to experience a substantial loss. In the event the stock price increased to,

for example, $45.00, the speculator would exercise the call. John would be

forced to buy the stock at the current market price of $45.00, only to im-

mediately deliver the stock to the speculator at a price of $35.00—a $10.00

loss. This problem of suffering a large loss in the event the stock price in-

creases can be easily remedied by owning the underlying stock before sell-

ing the call option.

If John already owned GE stock before selling the call, he would not be

concerned about the stock price rising as he could simply deliver the stock

he already owned. John is therefore covered in the event the stock price

increases after selling the call—he will not be forced to buy the stock at

a higher price in the market and then immediately sell it at a loss to the

speculator.

So if John already owned the stock before selling the call, he would

make money if the stock price goes up, he would also keep the premium if

the stock price goes down. This is an example of selling a covered call,

which is discussed at length later in this book.

Selling or writing covered calls is perhaps the safest and most consis-

tent way to make money in the financial markets and also involves less risk

than owning stock. If you’re not convinced, here’s another example. Let’s

assume it is June and GE stock is trading at $34.50. John decides he’d like

to buy GE stock and sell a covered call against it. Let’s assume he elects to

sell the June $35.00 call and receives a premium of, for example, $0.70

straight into his brokerage account. There are two possible things that can

now happen to John.

1. He gets called out. Remember, John has sold a GE June $35.00 call. So

someone else has the right to buy his GE stock for $35.00 up until the

third Friday of June (remember that the third Friday of the month is the

expiration date for U.S. option contracts). Getting called out means

that the person who bought the GE June $35.00 contract has decided to

exercise the contract and wants to buy John’s stock, because GE stock

has gone up and it is worth more than $35.00. John is contractually ob-

ligated to oblige.

26 COVERED CALLS

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So John delivers (or sells) his stock at a price of $35.00 to the op-

tion buyer and this money gets deposited into his account. This trans-

action is good, because John only paid $34.50 for his stock and thus has

made $0.50 per share on the call out. John has also received a premium

of $0.70 from the option buyer, which he also gets to keep. So he’s

made a total of $1.20 per share in just one month! Based on a share

price of $34.50, that’s a monthly return of around 3.5 percent. If he

makes that return each month, he’ll make 41 percent on his money per

year (uncompounded). If he’s really smart and reinvests his earnings

and uses the power of compounding, his 3.5 percent per month turns

into an amazing 51 percent per year!

2. He doesn’t get called out. Again, John’s fate rests in the hands of the in-

vestor who bought the option he sold. If the stock price at the end of

the month is below the $35.00 strike price of the option, then it is not in

the option buyer’s interest to exercise the contract, so John won’t get

called out. In this situation, the contract would simply expire and John

would keep the $0.70 he received for selling the option. That’s a return

of 2.0 percent in a month or 24 percent per year (uncompounded).

John would be left with his GE stock at the end of June and would

simply sell another call for July and start all over again.

You should now be starting to realize the power of covered calls. You

should also be starting to understand that selling covered calls actually de-

creases the risk of stock ownership because you are continually generating

cash flow from your stock investment and effectively lowering your cost in

the stock.

Think of selling covered calls as investing in real estate. You are liter-

ally renting your stock out each month and getting cash flow in return.

Would you buy an investment property and not rent it out while you wait to

sell it? Of course not! You would be leaving thousands of dollars on the

table each month for no reason. Similarly, if you own stocks (which almost

everyone does) and are not selling covered calls against these stocks, you

are also leaving thousands of dollars on the table each month!

COVERED CALLS: THE RIGHT MIND-SET

To be a successful covered call writer, you must recognize from the out-

set what your objectives are and the mind-set you require in order to

achieve them.

An Introduction to Covered Calls 27

c02.qxd 10/23/06 2:21 PM Page 27

Compound Interest

Our objective is to generate consistent monthly cash flow from our assets.

We can then reinvest this cash flow each month to compound our invest-

ment capital and generate extraordinary long-term returns.

Compound interest is the way to accumulate wealth. Whether in busi-

ness, real estate, financial markets, or any other financial pursuit, com-

pounding your assets is the fastest way to make them grow. Don’t take our

word for it. Many years ago Albert Einstein was asked what he thought was

the human race’s greatest invention. His reply was “compound interest.” He

also regarded compounded interest as “the eighth wonder of the world.”

If you are not aware, there are two types of interest: simple and com-

pound. Simple interest allows you to earn money on your principal. Com-

pound interest allows you to earn money on your principal and your

interest. Table 2.1 gives the example of two bank accounts, each with a

starting balance of $10,000 and each earning 5 percent interest per year.

However, one account earns simple interest and the other, compound in-

terest. As you can see, the account that pays compound interest is worth

significantly more at the end of the 10-year period.

Now, in the context of covered calls, compounding is many times more

powerful. Remember, our objective is not to make 5 percent per year; our

objective is to generate monthly returns of 3–6 percent for covered call

transactions. We will then reinvest this return into new positions and com-

pound our returns on a monthly, not a yearly, basis. Let’s look at the

$10,000 bank account again, but this time let’s compound that account at a

28 COVERED CALLS

TABLE 2.1 Simple Versus Compound

Interest at 5 Percent Per Year

Simple Compound

Time Interest Interest

Start $10,000 $10,000

Year 1 10,500 10,500

Year 2 11,000 11,025

Year 3 11,500 11,576

Year 4 12,000 12,155

Year 5 12,500 12,763

Year 6 13,000 13,401

Year 7 13,500 14,071

Year 8 14,000 14,775

Year 9 14,500 15,513

Year 10 15,000 16,289

c02.qxd 10/23/06 2:21 PM Page 28

return of just 4 percent per month and see what it looks like after 10 years.

See Table 2.2

Wow, a $10,000 account has grown to over $1.1 million in 10 years! If

you had started with $50,000, you would have $5.5 million at the end of 10

years. This is the power of covered calls: We are compounding returns that

most investors get in a year on a monthly basis. Now, is this enough moti-

vation for you to gradually take control of your own financial future? We

should hope so!

Cash Flow Focus

We have established that generating monthly cash flow and compounding

this cash flow into much larger sums of money is our objective. To achieve

this objective as a covered call writer we prioritize cash flow over account

market value. To be successful in this technique, you must let go of the tra-

ditional benchmarks for measuring equity portfolio performance—particu-

larly in the short term.

The traditional benchmark that is used by the brokers and fund man-

agers to measure a portfolio’s performance is market value. Brokers and

fund managers report to you the market value of your portfolio on a regu-

lar basis. For instance, you may have started with $100,000, and the broker

bought you stock of this value. Now the combined value of your stocks has

gone up and your portfolio is worth $120,000. So the broker says you have

made $20,000 based on a current market valuation. While this valuation is

fine if you sell today, it is just a paper gain and, if the market turns down,

these gains can be easily lost because they have not been realized as cash.

An Introduction to Covered Calls 29

TABLE 2.2 Compound Interest at

4 Percent Per Month

Time Account Value

Start $ 10,000

Year 1 16,010

Year 2 25,633

Year 3 41,039

Year 4 65,705

Year 5 105,196

Year 6 168,423

Year 7 269,650

Year 8 431,718

Year 9 691,195

Year 10 1,106,626

c02.qxd 10/23/06 2:21 PM Page 29

A covered call writer should only be interested in cash. We do not care

if the stock we purchased for $10.00 is now worth only $8.00 or $5.00 in the

market. We understand and accept that stock prices of good companies go

up and down.

We do not care.

We care only about how much cash (premium income) we are able to

generate from a position. If you purchase a good company with real earn-

ings at a reasonable valuation and the stock falls, it is likely that eventually

the stock price will go back to where it was when you purchased it. Even if

it doesn’t, eventually we will make back all the money we invested in the

stock by selling calls against it. We never, ever, sell a stock for a loss.

This advice goes against all traditional measures of portfolio perfor-

mance and the “loser mentality” of “cutting your losses” that is instilled in

us by brokers to increase their own revenues. We look at stock investments

as you would an investment property. If you buy good property in a good

position, are you afraid of not getting your money back over the long term?

Do you get a weekly valuation of the property and stress if that valuation is

less than what you paid for the property? No. You take a long-term view, let

time run its course, and collect your rent each month. That is the mind-set

of a successful covered call writer.

The stock market is the only market in the world where investors have

developed a mind-set that it is acceptable, even advantageous, to sell a gen-

erally appreciating asset for a loss. You do not run out and sell your house

or an investment property for a loss because, at some point in time, the

market value happens to be down. You will only sell your investment prop-

erty because, at some point in time, it happens to be up in value and you are

getting a good price. We reiterate: The stock market is the only market in

the world where people voluntarily sell generally appreciating assets for a

loss because the market value just happens to be down at a particular point

in time. This is a destructive financial mentality based on ignorance and

fear, and it is perpetuated by the brokerage community to increase its own

revenues. We never sell a stock for a loss, and neither should you!

History indicates that the U.S. stock market (as measured by the S&P

500) has never failed to make new highs over the long term. Figure 2.1 is a

chart of the S&P 500, which measures the performance of the top 500 U.S.-

listed companies, from 1930 through 2004. It is clear that good companies

have historically increased in value over the long run. Over the short term,

however, stocks go up and down—that’s what they do. Accept this fact and

do not concern yourself with the daily or monthly fluctuations in the mar-

ket value of your portfolio. You must concern yourself only with generating

cash flow and compounding this cash flow. This is a concept that will take

time for you to gain confidence in. But history, and our experience, indi-

cates that it works.

30 COVERED CALLS

c02.qxd 10/23/06 2:21 PM Page 30

Growth Through Cash Flow Correct application of the covered call

technique provides portfolio growth through cash flow rather than specu-

lative appreciation. A cash return of 4 percent per month equates to 48 per-

cent cash return per year (uncompounded) or nearly 100 percent over two

years (uncompounded).

The initial capital investment can be entirely liquidated by premium in-

come in just two years. If the stocks have any value at all after two years,

the investor will be ahead. It is more likely that the stocks are around

breakeven, leaving the investor with his or her original capital investment

plus the premium income. Growth through cash flow, then, is another crit-

ical mind-set for the covered call writer.

The Impact of Cash Flow Focus on Short-Term Portfolio Market

Value Understanding the impact of cash flow–focused covered call in-

vesting on short-term portfolio market value is vitally important. Investors

new to the covered call technique often become discouraged when after the

first several months of covered call investing, the market value of their

portfolios remains relatively unchanged. Short-term stagnation of portfolio

market value is the nature of this technique and should be expected by all

investors.

Dozens of client testimonials and recorded interviews can be found at

www.compoundstockearnings.com/testimonials attesting to achieving con-

sistent cash returns between 4 percent and 6 percent per month using the

techniques outlined in this book.

An Introduction to Covered Calls 31

FIGURE 2.1 Value of the S&P 500 index from 1930 through 2004.

c02.qxd 10/23/06 2:21 PM Page 31

When using the covered call technique, growth in portfolio value

should not be expected in the initial months of the investment. In the early

stage of the investment, the “winning” stocks in the portfolio are capped at

around a 5 percent return (monthly), yet the “losing” stocks in the portfolio

(those that decrease in value) are held and can fall by more than that

amount. This condition initially has a negative effect on the portfolio’s mar-

ket value. It is then that the management and defensive techniques out-

lined in Chapters 4 and 5 of this book are applied to continue to generate

cash flow on these fallen positions. The overall portfolio market value then

begins to increase after a period of months when the cash flow generated

from all positions accumulates, compounds, and then outweighs the mar-

ket value losses of particular stocks in the portfolio.

The traditional use of the covered call technique does not generally

lead to portfolio growth as fallen stock positions become dormant and un-

productive due to a lack of management and defensive techniques (an in-

ability to continue to generate income on fallen stocks). The management

and defensive techniques outlined in this book are the difference between

great success and complete mediocrity in the business of covered calls.

We cannot overemphasize that it is important for investors to under-

stand and expect a lack of portfolio market value growth in the initial

months of using the technique. This initial lack of growth is the norm and

should not be a reason for discouragement. In our experience, portfolio

market value growth comes after a period of months when the cash flow

generated from all positions accumulates and begins to compound. Under-

standing this characteristic of the technique is essential so that we can re-

main focused on the long-term objective of consistently generating and

compounding cash flow.

Market Value: The value of the portfolio if it were immediately liquidated for

cash at current market prices.

32 COVERED CALLS

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CHAPTER 3

This chapter details the actual process of establishing covered call

positions.

SOME BASICS

Markets to Invest In

Choosing a market to invest in depends on your own personal objectives

and your country of residence. If you are a non-U.S. resident and have ex-

isting stock holdings in non-U.S. stocks or would like to invest only in your

country of residence for whatever reason (familiarity, etc.), then you are

able to write covered calls on your non-U.S. stocks. If, however, you have

new funds to commit to the market or you want to make a serious commit-

ment to the growth of your investment capital, you should invest in the U.S.

market.

Base your decision on what makes you more comfortable. Even if you

are a non-U.S. resident and decide to initially invest only in stocks listed in

your home country, it is likely (and advisable) that you will eventually move

all your covered call activity to the U.S. market. The U.S. market is incred-

ibly large and provides significantly more opportunity, lower transaction

costs, and much higher covered call returns. If you are committing new

capital to the market, it is strongly advisable to invest in the U.S. market.

Entering New

Covered Calls

Positions

c03.qxd 10/23/06 2:20 PM Page 33

Some advantages of writing covered calls in the United States include:

•More stocks to choose from. The United States boasts the largest and

most liquid stock and options market in the world. This allows U.S.

covered call investors to be very selective in their investment and stock

selection process, which, in turn, leads to a higher likelihood of posi-

tive investment outcomes.

•Higher monthly covered call yields. The U.S. market is significantly

more volatile than the majority of other developed foreign markets. As

volatile markets are positive for option prices, U.S. covered call in-

vestors will normally receive higher percentage returns (yields) on call

sales compared to other international markets.

•Access to information. There are some excellent information services

that allow U.S. covered call investors to research and filter all covered

call opportunities for the U.S. market. These services significantly as-

sist you in selecting companies based on the fundamental and technical

criteria you should use to select companies in which to invest (dis-

cussed later).

•U.S. option contracts relate to only 100 shares. Generally U.S. option

contracts relate to only 100 shares, whereas international option con-

tracts may relate to more than 100 shares. During your learning period,

you can invest a lot less money in a U.S. covered call transaction than

in some international markets (discussed in detail later).

•Lower transaction costs. Due to the size of the U.S. market and the

number of brokerage houses competing for your business, transaction

costs are significantly less in the United States compared to most de-

veloped overseas markets. You will, therefore, be able to invest at a

much lower rate of commission in the United States compared to most

international markets. Saving on commissions equates to higher profits.

Disadvantages of writing covered calls in the United States include:

•Limited market hours. While your covered call activity should only oc-

cupy a few hours of your time per month, if you choose to invest in the

United States you will need to work the hours when the U.S. market is

open. If you are outside the United States, the time difference between

your home country and the United States is a disadvantage for most

investors.

•Foreign exchange risk. If your country of residence is outside the

United States, it is likely that you will also need to manage foreign ex-

change risk as your profits will be made in U.S. dollars. While there are

techniques to use that will help manage this risk (see Appendix B), it is

an added consideration.

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Option Contract Sizes

It is important for you to understand that, in the United States, option con-

tracts generally relate to just 100 shares, while in foreign markets, option

contracts may relate to a different number of shares. For example, in Aus-

tralia, option contracts relate to 1,000 shares. The more shares an option

contract relates to, the more difficult it becomes for an investor to diversify

a portfolio with a smaller capital resource.

Using the example of Australia, because one option contract relates to

1,000 shares, an investor must have 1,000 shares to sell one covered call

contract. This requirement makes it very difficult for covered call writers in

Australia to build a diversified covered call portfolio with a smaller capital

resource. Let’s look at an example of one $0.50 call option sold on a $10.00

stock in both the U.S. and Australian markets.

Table 3.1 shows that if an investor wishes to write one covered call

contract on a $10.00 stock in the United States, the investor need only com-

mit US$1,000 to the stock purchase. However, if an investor wishes to write

one covered call contract on a $10.00 stock in Australia, the investor needs

to commit AU$10,000 (approximately US$7,500) to the stock purchase.

Thus there is a significant advantage of investing in the U.S. market,

particularly in terms of the following:

• Minimizing capital investment when learning the covered call technique.

• Gaining adequate levels of diversification with limited capital resources.

• Reinvesting monthly earnings into new covered call opportunities.

The Importance of Diversification

While you might start off with just one or two stocks during the learning pe-

riod, your eventual goal is to have a diversified portfolio of optionable

Entering New Covered Calls Positions 35

TABLE 3.1 Comparison of Option Contract Sizes

U.S. Australia

Shares bought 100 1,000

Stock price $10 $10

Capital invested $1,000 $10,000

Call contracts sold 1 1

Call sale price $0.50 $0.50

Cash inflow from call $50 $500

Uncalled return 5% 5%

c03.qxd 10/23/06 2:20 PM Page 35

stocks that you have selected because of high-yielding covered call oppor-

tunities. Investors should construct portfolios of between 10 and 20 stocks

regardless of which market they choose to invest in.

The importance of diversification cannot be stressed enough. Investors

must diversify their portfolios between different stocks and different in-

dustries—you must not find one or two or three high-yielding covered call

opportunities and put all your money into just a few positions. You must

spread risk across many different stocks in many different sectors. Diver-

sification is particularly easy to achieve in the U.S. market due to its size,

but is also achievable in foreign markets.

THE RULES FOR ENTERING NEW COVERED CALL

POSITIONS IN THE U.S. MARKET

If you have decided to invest in the U.S. market, you should invest a small

amount of money into two or three stocks while learning. To begin with,

only buy 100–200 shares and concentrate on stocks with relatively low

stock prices. By following these guidelines, investors can begin learning the

covered call technique with a capital commitment of as little as US$1,000 to

US$3,000. Once comfort is gained with the technique, investors can build a

diversified portfolio of U.S. covered calls with as little as US$10,000 to

US$15,000. The sky is the limit in terms of how much capital you can have

effectively invested in covered calls as the U.S. market is tremendously

large and liquid. And because of the large variety, investors can be very se-

lective when entering into new covered call positions.

The eight rules, then, for entering new covered call positions in the

U.S. market are:

1. You can only establish new positions on down market days. A down

market day is any time when the Dow and the NASDAQ are in the red

(trading lower than the close of the previous day).

2. You must always only sell the near month call when entering a

transaction.

3. Use the CSE Screener (discussed in the following section) to filter

through all available covered call opportunities on the U.S. market.

4. Select the highest-yielding opportunities presented by the CSE

Screener.

5. Ensure that the stock is an upward moving or sideways moving stock

(discussed in a later section, “Assessing Chart Positions for New Cov-

ered Call Positions”).

36 COVERED CALLS

c03.qxd 10/23/06 2:20 PM Page 36

6. Ensure that the stock adheres to the buying low rule for covered calls

(discussed later in this chapter).

7. Always give priority to maintaining acceptable levels of diversification

between stocks and industries—even if a stock you are already in-

vested in presents an excellent covered call opportunity.

8. Buy the stock first and then immediately sell the call. Do not hesitate.

If you buy the stock and wait for a better price for the call, you are no

better than a speculator, and you will get burned!

USING THE CSE SCREENER TO SELECT

U.S. COVERED CALLS

The CSE Screener is a proprietary covered call search and filter tool de-

signed, developed, and maintained by Compound Stock Earnings. The CSE

Screener allows investors to quickly and easily search the stock market

for the highest-returning covered call positions that meet specific funda-

mental and technical requirements. The tool is tailored to accommodate

the criteria and rules established in this book for selecting covered call

positions.

Anyone who purchases Covered Calls and LEAPS—A Wealth Option is

entitled to one month’s complimentary access to the Covered Call Toolbox

(which includes the CSE Screener) by going to www.compoundstock

earnings.com/freemonth. Thus readers can actually use the tools while

learning about them in this book.

Selection Parameters

Because the U.S. market is extremely large, you can be very selective in

terms of the quality of the companies in which you invest. You should use

the following eight parameters to filter U.S. covered call opportunities:

1. Uncalled return of minimum 4 percent.

2. Called return of minimum 4 percent.

3. Price-earnings ratio (PE) of 35 or less.

4. Market capitalization of US$500 million or more.

5. Average broker recommendation of 2.5 or less.

6. An aggregate of the brokers recommending the stock as “Strong Buy”

and “Buy” greater than the number of brokers recommending the stock

as “Hold.”

Entering New Covered Calls Positions 37

c03.qxd 10/23/06 2:20 PM Page 37

7. A consensus earnings per share (EPS) estimate for “Next Fiscal Year”

forecast to be greater than the consensus EPS estimate for “This Fiscal

Year.”

8. Stock trading less than 75 percent of its 52-week trading range.

Rationale Behind CSE Screener Filters

The return filters ensure that acceptable covered call yields are realized on

entering the transaction. A 4 percent uncalled and called return is the min-

imum acceptable return when entering a new covered call transaction. In

most instances, the CSE Screener will present transactions that yield re-

turns of 4–8 percent. You should select the transaction(s) with the highest

uncalled and called return.

Uncalled and Called Returns There are two separate return calcula-

tions that you must compute and be aware of for every covered call trans-

action: the uncalled return and the called return.

The uncalled return is also known as the “percentage return” or “yield”

and is simply the premium you received on the call sale divided by the cost

of the stock. So if you sell a call for $1.00 and you paid $20.00 for the stock,

your uncalled return is 5 percent ($1.00/$20.00). The uncalled return is the

most important return in a covered call transaction because it represents

your return in the worst-case scenario and is the cash return in your hand

as soon as you sell the call.

The called return is the sum of the uncalled return plus the profit or

loss you make if your call is exercised (called out) divided by your cost in

the stock. If you are called out, you have to deliver the stock you own at the

exercise price of the call. For example, if you own a $19.50 stock and sell a

$20.00 call for $0.70 and are called out, your profit would look like this:

• You will deliver (sell) the stock at $20.00. You bought the stock for

$19.50. So you make $0.50.

• You also keep the $0.70 that you sold the call for.

• In total you make $0.50 + $0.70 = $1.20.

• Called return = $1.20/$19.50 = 6.15 percent.

PE Ratio A PE ratio of 35 or less ensures that the company you are in-

vesting in is historically profitable and its stock is not overly expensive

relative to the market. You want to be investing in solid, low-PE stocks.

High-PE stocks are often “priced to perfection” and their stock prices have

a long way to fall if the company does not perform as expected by the

market.

38 COVERED CALLS

c03.qxd 10/23/06 2:20 PM Page 38

Market Capitalization Market capitalization is a measure of the value

and size of a company. It is calculated by multiplying a company’s stock

price by the number of shares it has on issue. A market capitalization of $500

million or more ensures that the company is of a reasonable size. Investors

should give preference to companies with higher market capitalization.

Broker Recommendations An average broker recommendation of 2.5

or less ensures that the stock is rated at least an average of “buy” by the an-

alysts who cover it. This statement does not imply that we value or follow

the opinions of brokers. However, the brokerage community will be in the

markets promoting the stock and the masses will be providing buying sup-

port for the stock. More importantly, the stock is not likely to go out of busi-

ness in the short term.

The aggregate of the brokers recommending the stock as Strong Buy

and Buy must be greater than the number of brokers recommending the

stock as Hold. This criterion simply ensures that more brokers are positive

on the stock than are neutral.

Earnings per Share A forecast consensus EPS estimate for “Next Fis-

cal Year” greater than the consensus EPS estimate for “This Fiscal Year”

simply ensures that the brokers covering the stock believe that the com-

pany’s earnings will grow next fiscal year and helps prevent investors from

buying stocks that are going into a period of contracting earnings.

52-Week Trading Range Buying the stock at less than 75 percent of its

52-week range simply ensures that you are not paying a historically high

price for the stock.

52-Week Range: Refers to the lowest and highest price a company’s stock

has traded for during the past year.

Earnings per Share: A company’s earnings divided by the number of ordi-

nary shares.

Broker recommendations range from Strong Buy (1) to Strong Sell (5).

PE Ratio: A stock’s market price divided by its earnings per share. A PE ratio

of a stock is used to measure how cheap or expensive the stock price is.

Entering New Covered Calls Positions 39

c03.qxd 10/23/06 2:20 PM Page 39

Remember, you are a cash generator and compounder. All you are try-

ing to do when selecting a covered call opportunity is to make sure you get

a high uncalled and called return and that the company you invest in isn’t

going out of business in the near future. While it is nice if the stock goes up

and you are called out at the end of each month, you do not really care if it

goes down. You own stock in a fundamentally sound, profitable company

with a reasonable PE and significant broker support, and you have not paid

top dollar for the stock. Just worry about generating cash flow and let time

take care of the rest.

You should be concerned only with generating and compounding cash

flow. Compounding of the monthly cash return leads to portfolio growth.

Directions for Using the CSE Screener

To access the covered call search tools, you need to establish a username

and password from www.compoundstockearnings.com/freemonth. Then

do the following:

1. Go to www.compoundstockearnings.com/cctoolbox.

2. Enter your username and password.

3. Click Log On.

4. Click CSE Screener—Covered Calls.

The CSE Screener will automatically run the search for the best cov-

ered call positions using the eight criteria listed previously. It will then

search the entire market to find all the stocks that meet the stipulated fun-

damental and technical criteria. It examines the option chains on these

stocks to find positions with near month calls that provide both an uncalled

and called return of 4 percent or more. The CSE Screener then presents the

results of the search to the investor (see Figure 3.1).

The criteria for selecting covered call positions have remained sub-

stantially the same for many years. However, from time to time, the criteria

have been modified to adapt to the current conditions of the market. It is

very important for investors to understand that the objective of the criteria

will always remain the same: to find a low PE company of reasonable size

and with high broker support and forecast earnings growth that is not trad-

ing at yearly highs and that presents a very good covered call return in the

near month.

While this objective never changes, the market does. The market is not

static. PE ratios expand and contract with the performance of the market,

volatility increases and decreases affecting covered call premiums, strong

40 COVERED CALLS

c03.qxd 10/23/06 2:20 PM Page 40

market periods reduce the number of stocks trading below 75 percent of

the 52-week range, and so on. The market is constantly evolving, and occa-

sionally the criteria need to evolve to stay relevant to the condition of the

market. When such a change is needed, the authors adapt the default cri-

teria of the CSE Screener to keep investors in step with the current condi-

tions of the markets. Therefore, it is highly recommended that investors

simply use the default criteria of the CSE Screener when searching for new

positions.

Entering New Covered Calls Positions 41

FIGURE 3.1 Sample screenshot of the CSE Screener for covered calls.

c03.qxd 10/23/06 2:20 PM Page 41

USING PRICE CHARTS

Simply because the CSE Screener has presented a position does not auto-

matically qualify it as an acceptable investment. Revisit the “Rules for En-

tering New Covered Call Positions in the U.S. Market.” The present section

addresses in significant detail the two rules that relate to price charts:

• Ensure that the stock is an upward moving or sideways moving stock.

• Ensure that the stock adheres to the buying low rule for covered calls.

Judicious assessment of a stock’s price cycle is critical before a new cov-

ered call position is entered into. Investors who get caught up in hype and

buy when markets are going up or who panic and sell when markets are

going down are categorically the losing investors in the markets. You must

buy low and sell high: You must buy when markets are falling and sell when

markets are rising. If you were selling any product as a business venture,

you would be attempting to buy the product low and to sell it high. Finan-

cial markets are no different. The importance of these rules cannot be

stressed enough.

Identifying and Assessing Price Cycles

To implement these rules, you will need to recognize that virtually all

stocks move in distinct price cycles. Movements between parallel lines

characterize these cycles. What you want to do is identify a price channel

or a price cycle (these terms are used interchangeably). The way to identify

a price channel is to draw two lines (preferably parallel) connecting the

bottoms and the tops of a chart. The best source for free charts on the In-

ternet is www.bigcharts.com. If you select “Java Chart” and then check

“Draw Trendlines,” you will be able to draw cycles on the chart similar to

those in the following illustrations. You should always assess a stock using

a 12-month chart.

Figure 3.2 shows how stocks move. Almost all stocks cycle between

parallel lines. Perhaps the most costly misunderstanding among unedu-

cated investors is that stocks do not go straight up or straight down. A

stock that is cycling upwards or downwards also has upward and down-

ward movements within that cycle. Look at Figure 3.2. Regardless of the

trend of the stock, the stock is moving upwards and downwards within a

cycle. We repeat: Understanding this characteristic is vitally important.

Price Channel or Cycle: The price trend that a stock is trading in. Identified

by the trading range between two parallel lines.

42 COVERED CALLS

c03.qxd 10/23/06 2:20 PM Page 42

Stocks do not go straight up or straight down—they move up and down

within cycles characterized by parallel lines.

Upward Cycles In an upward cycle, the tops of the cycle are getting

higher and the bottoms are also getting higher. An upward cycle has higher

tops and higher bottoms. See Figure 3.3.

When we have an upward cycle, start by drawing a line connecting the

bottoms on the chart, because the buyers are in control of the market and

Entering New Covered Calls Positions 43

FIGURE 3.2 Example of how stocks cycle between parallel lines.

Upward cycle:

higher tops and

higher bottoms

FIGURE 3.3 Example of an upward cycle.

c03.qxd 10/23/06 2:20 PM Page 43

driving prices higher. Then attempt to identify the top of the cycle by draw-

ing a line that is parallel to the bottoms. Note: Assessing cycles is not an

exact science and absolute accuracy is not a contributing factor to the suc-

cess of our covered call technique.

Downward Cycles In a downward cycle, the tops of the cycle are get-

ting lower and the bottoms are also getting lower. A downward cycle has

lower tops and lower bottoms. See Figure 3.4.

When we have a downward cycle, start by drawing a line connecting

the tops on the chart, because the sellers are in control of the market and

driving prices lower. Then attempt to identify the bottom of the cycle by

drawing a line that is parallel to the tops. Again note that assessing cycles

is not an exact science and absolute accuracy is not a contributing factor to

the success of our covered call technique.

Horizontal Cycles In a horizontal cycle, the tops and bottoms are not

getting substantially higher or lower. A horizontal cycle has relatively sta-

ble tops and bottoms. The cycle highlighted in Figure 3.5 is a general hori-

zontal cycle (although it does have slight upward bias).

In a horizontal cycle, the market is in consolidation and it is not im-

portant which line is drawn first. Simply try to make the two lines parallel

remembering that assessing cycles is not an exact science and absolute

accuracy is not a contributing factor to the success of the covered call

technique.

44 COVERED CALLS

Downward cycle:

lower tops and

lower bottoms

FIGURE 3.4 Example of a downward cycle.

c03.qxd 10/23/06 2:20 PM Page 44

How to Look at a Price Chart

When an investor assesses a price chart, he or she must be able to answer

the following four questions:

1. What is the overall trend: upwards, downwards, or sideways?

2. What are the past cycles: upwards, downwards, or sideways?

3. What is the current cycle: upwards, downwards, or sideways?

4. Where are we in the current cycle: the bottom, middle, or top?

Step 1: Identify the Overall Trend A first glance at Figure 3.6 shows

that the overall trend for this stock is upward. We know this because in a

broad sense prices are increasing—significant tops and bottoms are getting

higher, so the chart is generally upward moving.

Step 2: Identify the Individual Cycles After identifying the overall

trend, we are then looking to identify the individual cycles. There is nor-

mally more than one cycle on any given chart of six months’ duration or

greater. Remember, cycles are characterized by movements between par-

allel lines. See Figure 3.7.

Step 3: Identify the Current Cycle After identifying the individual

cycles, we then want to classify the current cycle, that is, the cycle the

Entering New Covered Calls Positions 45

Horizontal cycle:

stable tops and

bottoms

FIGURE 3.5 Example of a horizontal cycle.

c03.qxd 10/23/06 2:20 PM Page 45

stock is trading in now. To do so we need to determine if the tops and bot-

toms of the current cycle are getting:

• Higher (upward cycle)

• Lower (downward cycle)

• Relatively stable (horizontal cycle)

46 COVERED CALLS

FIGURE 3.6 Identify this trend.

FIGURE 3.7 Identify the cycles.

c03.qxd 10/23/06 2:20 PM Page 46

Figure 3.8 shows that the current cycle of BP is horizontal with slight

upward bias. Understanding the direction of the current cycle is critical.

Step 4: Identify the Position in the Current Cycle After we have

identified the current cycle, in Figure 3.8 it is horizontal with slight upward

bias, we then want to understand the position of the stock in relation to the

current cycle. Is the stock at the top, middle, or bottom of the current

cycle? Where is the stock price in relation to the top and bottom lines of the

current cycle? In Figure 3.9 we can see that the stock price is at the top of

the current cycle.

Utilizing the Information So we now understand this chart of BP

(Figures 3.6 through 3.9). We know that BP is (1) in an overall upward

trend, (2) currently in a horizontal cycle with slight upward bias, and (3) at

the top of the current cycle.

The stock is at the top of the cycle—its bias is to head back down.

When a stock is in the high point of the current cycle, its bias is to go down.

When a stock is in the low point of the current cycle, its bias is to go up.

These facts are so basic and fundamental, yet they are ignored by most in-

vestors and that ignorance is the single biggest reason that investors lose in

the market. They are constantly on the wrong end of the cycle. They are

constantly chasing the trend and having it reverse on them. The mind-set of

a losing investor is to buy this stock right now, after all “it’s increased from

$60 to almost $70 in just one month and it’s in the press as a top performer

Entering New Covered Calls Positions 47

FIGURE 3.8 Identify the current cycle.

c03.qxd 10/23/06 2:20 PM Page 47

last month, it’s having a great run, so there must be further to go.” This is

the mind-set of the average losing investor. It should be abundantly clear

why this investor is an expert at picking stocks that then fall in the ensuing

weeks. This investor’s stock selection mentality always leads to purchasing

stocks at the top of the current cycle. The investor then panics when the

stock starts cycling down and sells out for a loss, only to see the stock go

back up a month later. The investor is completely ignorant to the fact that

stocks go up and down—that is what they do.

Let’s look at another example in Figure 3.10. We can quickly identify

that there is no distinct overall trend. However, we can identify three dis-

tinct price cycles. The stock is currently in an upward cycle and it is at the

very top of that cycle. The stock’s likely move over the short term is to head

back to the bottom of the rising cycle. The short-term bias for this stock

is down.

On occasion, you will find charts that are harder to identify and classify

in this fashion. If you do not understand a chart, do not invest in the stock.

Assessing Chart Positions for New

Covered Call Positions

The optimal outcome for covered call investors is that the stock price rises

after entering the transaction, they are called out at the end of the month,

48 COVERED CALLS

FIGURE 3.9 Identify the stock’s position in the current cycle.

c03.qxd 10/23/06 2:20 PM Page 48

and they then reinvest and compound their capital the following month. To

increase the likelihood of this outcome, investors should only invest in up-

ward moving or sideways moving stocks.

The CSE Screener filters stipulate that investments can only be made in

stocks that are trading less than 75 percent of their 52-week trading range.

This criterion commonly leads to stocks being presented by the CSE

Screener with three distinct stock price chart types:

1. Upward moving stocks

2. Downward moving stocks

3. Sideways moving stocks

Upward Moving Stocks In the context of covered calls, upward mov-

ing stocks can be of two types:

1. Stocks in a generally rising cycle.

2. Stocks that have had significant price declines in the preceding months

and are currently in an upward cycle. A stock is currently in an up-

ward cycle if it has (a) substantially broken through the upper line of

the declining price cycle and (b) established a new rising price cycle (a

cycle with higher tops and higher bottoms).

Entering New Covered Calls Positions 49

FIGURE 3.10 Assess this chart.

c03.qxd 10/23/06 2:20 PM Page 49

Type 1 upward moving stocks are generally upward moving within an

upward cycle. However, they are not trading at or near their highs for the

year. See Figures 3.11, 3.12, and 3.13 for examples.

Type 2 upward moving stocks have had significant price declines in the

preceding months and are now rising. The most important factors in

50 COVERED CALLS

FIGURE 3.11 Generally upward moving stock.

FIGURE 3.12 Generally upward moving stock.

c03.qxd 10/23/06 2:20 PM Page 50

determining whether the stock is now rising are if it has (a) substantially

broken through the upper line of the declining price cycle and (b) estab-

lished a new rising price cycle (a cycle with higher tops and higher bot-

toms). See Figures 3.14, 3.15, and 3.16 for examples.

Entering New Covered Calls Positions 51

FIGURE 3.13 Generally upward moving stock.

FIGURE 3.14 Current rising cycle outside of a declining cycle.

c03.qxd 10/23/06 2:20 PM Page 51

Downward Moving Stocks In the context of covered calls, downward

moving stocks are those that have had significant price declines in the pre-

ceding months and are continuing to decline. These stocks should be

avoided. They have not substantially broken through the upper line of the

declining price cycle and established a new rising price cycle (a cycle with

52 COVERED CALLS

FIGURE 3.15 Current rising cycle outside of a declining cycle.

FIGURE 3.16 Current rising cycle outside of a declining cycle.

c03.qxd 10/23/06 2:20 PM Page 52

Entering New Covered Calls Positions 53

FIGURE 3.17 Downward moving stock.

FIGURE 3.18 Downward moving stock.

higher tops and higher bottoms). See Figures 3.17 and 3.18 for examples of

downward moving stocks.

Sideways Moving Stocks Sideways moving stocks are suitable for

covered call investment and are characterized by predominantly stable

c03.qxd 10/23/06 2:20 PM Page 53

bottoms and tops; that is, the tops and bottoms of the cycle are getting nei-

ther higher nor lower. When a stock is sideways moving, the market is in

consolidation. See Figures 3.19 and 3.20 for examples.

54 COVERED CALLS

FIGURE 3.19 Sideways moving stock.

FIGURE 3.20 Sideways moving stock.

c03.qxd 10/23/06 2:20 PM Page 54

The Buying Low Rule for Covered Calls

The buying low rule for covered calls exists to ensure that new covered call

positions are only entered into in the lower portion of a stock’s current

price cycle. Investing in stocks that are in the lower portion of the current

price cycle increases the likelihood that the stock price will increase after

entering into a new position and, therefore, increases the likelihood of

being called out at the end of the option month. Being called out at the end

of the option month is a primary objective of covered call investing.

The buying low rule for covered calls includes two stipulations:

1. Invest in stocks that are upward moving or sideways moving.

2. Only invest in a stock when it is in the lower 25 percent of the current

price cycle. Investing in the lower 25 percent of the cycle makes it more

likely that the stock will move up after entering the transaction and,

therefore, increases the likelihood of being called out.

See Figures 3.21 and 3.22 for examples.

Entering New Covered Calls Positions 55

Only invest in new positions when the stock is trading at

or below 25% of the current price cycle.

FIGURE 3.21 Satisfying the buying low rule.

c03.qxd 10/23/06 2:20 PM Page 55

In contrast, the stock shown in Figure 3.23 does not qualify for invest-

ment. The current cycle is horizontal with upward bias, but the stock is

trading at about 75 percent of the cycle. The near-term bias is down. This

stock does not meet the buying low rule.

56 COVERED CALLS

Only invest in new positions when

the stock is trading at or below

25% of the current price cycle.

FIGURE 3.22 Satisfying the buying low rule.

Only invest in new positions when the stock is trading

at or below 25% of the current price cycle.

FIGURE 3.23 Buying low rule not satisfied.

c03.qxd 10/23/06 2:20 PM Page 56

INVESTING IN NON-U.S. MARKETS

Those electing to invest in non-U.S. markets must be aware of the limita-

tions of these markets compared to the U.S. markets. The primary draw-

backs of investing in markets outside the United States are the significantly

smaller numbers of optionable stocks in foreign markets, the lower option

premiums due to lower volatility levels, and the lack of tools such as the

CSE Screener to assist in finding and analyzing potential covered call

opportunities.

It is highly advisable that investors wanting to commit new funds to the

covered call technique do so in the U.S. market. However, if you already

own stocks in foreign markets and want to continue holding these stocks,

see if they are optionable and then start selling covered calls on them! You

are in a win-win situation; you have already assumed the risk of owning the

stock and can only benefit from selling the covered call.

If you don’t own any existing stocks and would like to start investing in

covered calls in a foreign market, the stocks you should focus on are those

with the most liquid options markets, those that provide consistent near

month call expirations, and those that provide superior yields.

A near month call is a call that expires in the current month—for ex-

ample, if we are in March, a near month call would expire at the end of

March. It is optimal for covered call writing that a stock always has a near

month call.

As the CSE Screener does not extend its services to foreign markets, if

you would like to start investing in covered calls in a foreign market, you

will need to conduct a reasonable amount of research before doing so. You

will need to understand:

• What stocks in the foreign market are optionable.

• What stocks in the foreign market have consistent near month call ex-

pirations.

• Which stocks have adequate volatility levels and, therefore, reasonable

covered call yields.

• How many shares each option contract relates to in the foreign market.

You must also recognize that it is unlikely that you will be able to find

covered call opportunities in foreign markets that meet the U.S. covered

call search criteria as previously discussed, because foreign markets are

smaller than the U.S. market and provide less variety and opportunity. You

may need to relax or even eliminate the fundamental and technical search

criteria discussed. Doing without these criteria is further reason why new

funds committed to the covered call technique should be committed in the

U.S. market.

Entering New Covered Calls Positions 57

c03.qxd 10/23/06 2:20 PM Page 57

If you still want to invest in covered calls in a foreign market, to begin

with, buy only enough stock to sell one covered option contract and con-

centrate on stocks with relatively low stock prices—this will minimize your

initial capital investment. Sell covered calls on just one or two stocks until

you have the confidence to commit more capital to the market.

If you find that the minimum investment in stock to sell one option con-

tract makes you uncomfortable due to its dollar value, or if this amount rep-

resents more than 10 percent of the capital you would like to ideally have

invested in covered calls (once you are comfortable with the technique),

then you should invest in the U.S. market because doing so will allow you

to gain acceptable levels of diversification with a smaller capital base (U.S.

option contracts generally relate to only 100 shares).

This being said, then, the six rules for entering new covered call posi-

tions in foreign markets are:

1. You can establish new positions only on down market days. A down mar-

ket day is a day when the major market average index for that market is

in the red (trading lower than the close of the previous trading day).

2. You must always only sell the near month call when entering a new

covered call position.

3. You should assess the universe of optionable stocks for the fundamen-

tal and technical data outlined in the U.S. covered call search criteria.

Preference should be given to stocks that more fully meet these criteria.

4. You should assess the universe of optionable stocks in the chosen

market for both uncalled and called returns and invest in the highest

yielding opportunities.

5. Always give priority to maintaining acceptable levels of diversifica-

tion—never have more than 10 percent of your investment capital in

any one stock. Preferably construct a portfolio of between 10 and 20

stocks.

6. Buy the stock first and then immediately sell the call. Do not hesitate.

If you buy the stock and wait for a better price for the call, you are no

better than a speculator, and you will get burned!

58 COVERED CALLS

c03.qxd 10/23/06 2:20 PM Page 58

CHAPTER 4

The difference between great success and complete mediocrity in the

business of writing covered calls is how well you can profitably man-

age your way out of a position that is not performing as you would

like. It would be fantastic if every time you entered into a transaction, you

were called out at the end of the month, got all your money back, and

started again. It would even be great if you didn’t get called out and were

able to sell the same strike price again in the near month and to maintain

both a good called and uncalled return. Unfortunately, such is not the real-

ity of this business.

Covered calls require management. You must manage positions for

consistent monthly income, regardless of market direction, to achieve port-

folio growth and compounding using this technique. This chapter highlights

the management techniques needed to achieve consistent monthly income

from a stock investment, regardless of market direction.

CLOSING POSITIONS ON THE DELTA EFFECT

Occasionally a stock’s price may increase significantly after a covered call

position has been established. This increase may allow investors to close

out the position for an overall transaction profit by buying back the short

call and selling the stock. The investor is able to achieve this profit because

the stock price generally increases more than the call price on a dollar-to-

dollar basis. This is known as the delta effect.

The delta of a stock option is the rate of change of the option price with

respect to the price of the underlying stock. It is a measure of how much an

Management

Rules

c04.qxd 10/23/06 2:18 PM Page 59

option’s price will increase or decrease for an incremental increase or de-

crease in the stock price.

Let’s look at an example of a call that has a delta of 0.60. This number

means that when the stock price changes by an amount, the option price

will change by 60 percent of that amount. For example, if the stock price in-

creases by $1.00, then the option will increase in price by $0.60 (60 percent

of the stock price’s increase). If the stock price increased just $0.50, then

the option price would increase by only $0.30 (60 percent of the stock price

increase).

The delta of the stock is always 1 or 100 percent; for a $1.00 move in the

stock price, the stock moves up, obviously, $1.00 or 100 percent of that

move. So, when a new covered call position is entered into and the stock

price increases significantly, the profit the investor can make by selling the

stock will almost always be larger than the loss realized by buying back the

call. Consequently, if the stock price moves up far enough after entering a

transaction, investors can close the position immediately with a profit and

then reinvest and compound the proceeds.

Let’s look at an example. John buys MDR stock at $20.00 and sells the

June $20.00 call for $1.00. You should understand that the delta of the stock

is always 1 and the delta of the call for the purposes of this example is 0.50.

If the stock price jumps up by, for example, $2.00 after entering this posi-

tion, the option price will only increase by $1.00 (50 percent of $2.00).

John’s position would look like this:

Profit on stock sale = $22.00 – $20.00 = $2.00

Loss on call buyback = $ 1.00 – $ 2.00 = –$1.00

Net Profit on transaction close = $ 2.00 – $ 1.00 = $1.00, or 5%

In this instance, it would be wise for John to simply close the transaction

and then reinvest and compound the proceeds. He would do so by simply

buying back the short call and then immediately selling the stock.

New covered call positions should be monitored for an opportunity to

close the position on the delta effect. Closing positions on the delta effect

occurs regularly when the stock price increases significantly after entering

a new position.

THE MID-MONTH RULE

Once you have entered into the covered call position, all you need to do is

have patience and wait for the option’s expiration at the end of the month.

However, you can decide to be a little more proactive during the month and

60 COVERED CALLS

c04.qxd 10/23/06 2:18 PM Page 60

utilize the mid-month rule, which can have the effect of significantly in-

creasing your returns on the position.

The mid-month technique involves buying back the short call for a

profit in the first two weeks of the month. The five rules for implementing

this technique are:

1. If you have sold a call for a 5 percent uncalled return or more, the mid-

month technique 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 percent for the month, then do so.

3. You then put in a good til canceled (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 ex-

piration, move to the secondary call sales rule.

Here’s an example of utilizing the mid-month rule. John selects a new

covered call position on MDR. He purchases the stock for $19.75 and sells

the one-month out $20.00 call option for $1.00. This transaction has gener-

ated a 5.1 percent uncalled return ($1.00/$19.75).

In assessing the chart, John has identified that the stock is an upward

moving stock and is in the lower 25 percent of the rising price cycle. If the

stock price falls after entering the position, he may be able to implement

the mid-month rule to enhance yield. John calculates that a 4 percent return

on this position would equate to about $0.80 (0.04 ×$19.75). So for John to

make a net 4 percent or $0.80 uncalled return on this position, he would

need to buy back the call at a price of $0.20 ($1.00 – $0.80).

John would then attempt to sell the same call again at a value greater

than what he bought it back for sometime before the end of the month. The

price at which he would resell the call depends on (1) the time left in the

option month and (2) the position of the stock in relation to its current

price cycle.

The price at which the call should be resold is based on judgment and

is a skill investors develop with time and experience. Less active investors

should simply put in a GTC order to resell the call for a price higher than

they bought it back for. More active investors should wait until the stock

Good til Canceled (GTC): An order to buy or sell a stock or option that re-

mains in effect until it is executed or canceled by the investor who placed it.

Management Rules 61

c04.qxd 10/23/06 2:18 PM Page 61

reaches 75 percent of the price cycle and then resell the call. This explana-

tion will be become more clear in the following section on secondary call

sales rules.

Remember, John would only buy back the call in the first two weeks of

the month. If he buys the call back later than this, then there is less than

two weeks left until the option expires. Due to accelerating time decay in

the last two weeks of an option’s life, it is unlikely that the price of the op-

tion will increase enough to make it worthwhile for John to sell it again.

By buying back the call, you are locking in a fantastic 4 percent return

for the month, but you are leaving a little bit of money on the table, in this

example, $0.20 or 1 percent. You are doing this because it is likely that,

sometime in the next two or three weeks before the option’s expiration, the

stock will jump up a little and allow you to resell the call for a greater value

than you bought it back for. Practitioners of this technique understand that

this is a regular occurrence. Remember, the covered call position was en-

tered into at the bottom 25 percent of a rising or sideways price cycle, and

the stock has obviously fallen further to allow the buyback of the call for a

profit. It is therefore highly likely that the stock price will then increase

back into its regular cycle, thus allowing the resale of the same call for

higher premium.

SECONDARY CALL SALES

A secondary call sale is any call sale that occurs after you have bought back

the original call or the original call has expired. At the end of the first

month, you either got called out or you didn’t. If you got called out, you now

have all your money back in your account and you are ready to start again.

Go back to the rules for entering new covered call positions provided in

Chapter 3. Enter these positions as quickly as possible. The longer you wait,

the more time value is eroding in the next month’s option contracts and the

lower your covered call yield will be. You need to assess how much cash

you have made during the month and try to reinvest it all so your money can

start compounding. Remember, compounding is the key.

If you didn’t get called out and you are investing in the U.S. market, you

have a nice 4–8 percent cash return sitting in your brokerage account in one

month. A 7 percent return would be a very good return for a mutual fund in

a year, and you have made that return in just one month! And if you have

several positions, your returns for the month may represent enough

cash for you to enter a whole new position and really have your money

compounding.

62 COVERED CALLS

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The Rules for Secondary Call Sales

If you were not called out, that means the call has expired worthless. You

now have a stock without a call and are ready to sell a call for the next

month. The rules for selling secondary calls are significantly different from

the rules for entering new covered call transactions. The six rules for sec-

ondary call sales are:

1. Secondary calls can only be sold when the markets are in the green

(higher than the close of the previous day). For the United States, the

markets are in the green when both the Dow Jones Industrial Average

and the NASDAQ are trading above the close of the previous day. For-

eign markets are in the green when the major market index for that

market is trading above the close of the previous day.

2. For the U.S. market, if you can sell a near month call where the un-

called and called returns are both greater than 4 percent, then do so.

For foreign markets, if you can sell a near month call where the un-

called and called returns are both greater than 1.5 percent, then do so.

3. If rule 2 isn’t applicable, you should use the TSS for income while being

sure to adhere to the selling high rule (both discussed in detail in the

following section). Move the expiration of the call out to the second to

last expiration and sell a call that provides an uncalled return of mini-

mum 10 percent. 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 percent for a TSS for income call

sale 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 de-

clines. You may select a lower strike price to allow an easier buyback

to the extent the strike price of the call selected plus the call’s bid price

is greater 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 percent net return can be realized or when the stock reaches

25 percent of the current cycle, whichever occurs first.

Implementing the Secondary Call Sales Rules

While the objective with covered calls is generally to sell a near month call

and have the time decay factor working strongly in your favor, this is often

not practically achievable. In situations where new covered call positions

Management Rules 63

c04.qxd 10/23/06 2:18 PM Page 63

are entered into and are not called out, it is often not possible to sell a near

month call where the uncalled and called returns are both greater than 4

percent (the preceding rule 2). For example, let’s assume it’s early May and

John selects a new covered call position on MDR. He purchases the stock

for $19.75 and sells the May $20.00 call for $1.00. If the stock finishes the op-

tion month at $18.00, the position will not be called out. John will keep

the $1.00 in premium and will be left to reassess a secondary call sale on

MDR. It’s now June and the near month option chain appears as shown in

Table 4.1.

We can see from Table 4.1 that John will not be able to sell the June

(near month) $20.00 call for an uncalled and called return of 4 percent or

greater (the preceding rule 2) as the premium for this call is just $0.20 or a

1 percent uncalled return. John could sell the June $17.50 call for an un-

called return of 6.1 percent, but the called return would be –5.3 percent

[($17.50 – $19.75 + $1.20)/$19.75]. That sale would violate rule 2, which stip-

ulates both the uncalled and called returns must be 4 percent or greater in

order to sell a near month call.

In this situation, John must use the TSS for income while being sure to

adhere to the selling high rule (the preceding rule 3).

64 COVERED CALLS

TABLE 4.1 MDR Near Month Option Chain

Strike Ticker Bid Price Ask Price Delta

June

7.50 JPMIY 10.60 10.70 1.00

10.00 JPMIF 8.10 8.20 1.00

12.50 JPMIZ 5.60 5.70 1.00

15.00 JPMIG 3.20 3.40 1.00

17.50 JPMIU 1.20 1.35 0.91

20.00 JPMIH 0.20 0.30 0.33

22.50 JPMIV 0.00 0.05 —

25.00 JPMII 0.00 0.05 —

27.50 JPMIW 0.00 0.05 —

30.00 JPMIJ 0.00 0.05 —

c04.qxd 10/23/06 2:18 PM Page 64

THE TETHERED SLINGSHOT FOR INCOME

AND THE SELLING HIGH RULE

The tethered slingshot (TSS) for income and the selling high rule are very

important techniques for the covered call writer as they allow consistent

generation of income in situations where the stock price is trading below

an investor’s cost in the stock.

The rules for the TSS for income are embedded in the preceding rules

for secondary call sales. These rules state that when a call cannot be sold

in the near month that provides both an uncalled and called return of 4 per-

cent or greater, the investor must use the TSS for income. The investor

should select the second to last expiration and sell a strike price call that re-

sults in an uncalled return of minimum 10 percent. Before this call can be

sold, the investor must ensure that the selling high rule has been satisfied.

The selling high rule relates to the timing of the TSS for income call sale—

it is very important that TSS for income calls are sold at the high point of

the price cycle.

The Selling High Rule

The selling high rule states that secondary call sales using the TSS for in-

come can only be made when a stock is in the upper 75 percent of its cur-

rent price cycle.

When a secondary call is sold using the TSS for income, the investor’s

objective must be to generate income and buy back the call (buy the call to

close) as soon as possible for a positive net return. To achieve a positive net

return on a buyback, one or both of the following circumstances must

occur: (1) The stock price must decrease in value and/or (2) time value

must diminish.

The selling high rule draws on point 1 by assisting the investor to iden-

tify when the stock is trading at the high point of its current price cycle.

This rule is essentially the opposite of the buying low rule for covered calls,

which ensures that you are buying into new positions when the market is

down and the stock is in the lower 25 percent of its price cycle. Conversely,

the selling high rule ensures that you are selling a secondary call when the

market is up and the stock is in the upper 75 percent of its price cycle. This

condition greatly increases the chances that the stock will fall and you will

be able to buy back the call for a profit.

TSS for Income: A covered call management technique used to generate in-

come when the stock price has declined after entry.

Management Rules 65

c04.qxd 10/23/06 2:18 PM Page 65

Remember, too, that decay in time value is also working significantly in

the covered call writer’s favor. This factor also greatly increases the op-

portunity for a profitable call buyback.

It is important to make the distinction that our objective is not specu-

lation when using the TSS for income and selling high rule. What we are

trying to do is sell in the vicinity of the top of the cycle and buy the call

back for a profit at lower stock prices in the near future. If you sell a call

and the stock keeps moving up, you do not take a loss on the call. Rather,

investors should have patience and wait for the stock price to come back

to the bottom of the cycle. Stocks cycle up and down—they do not go

straight up and they do not go straight down. If the stock doesn’t come

down to allow a profitable call buyback we can use other management

and defensive techniques, primarily exiting on the delta effect (see

earlier in this chapter) or the surrogate stock replacement (covered in

Chapter 5).

Patience and management are critical factors for success. You must

have patience to wait for the stock price to meet the selling high rule before

selling a TSS for income call. You must also have patience to wait for the

stock price to cycle down after selling a TSS for income call to allow a prof-

itable buyback. Patience is key.

It is very rare that a call will be sold and the very next day the stock cy-

cles down. It is not possible to pick the absolute top of the market and have

the call immediately fall in price—this is an unrealistic expectation. It is

much more common that over a period of one to four weeks after selling a

TSS for income call, the stock cycles down and allows a profitable buy-

back. During the period of waiting, patience is required. Novice investors

often panic when a TSS for income call cannot be immediately bought

back for a profit. Such immediacy is against the nature of this technique.

Again, when using the TSS for income and the selling high rule, patience

is key.

But what if we sell a TSS for income call at what we believe is the top

of the price cycle and the stock breaks cycle, shoots straight up, and never

trades at a lower price? This scenario is common and simply requires in-

vestors to implement one of many management strategies:

• Closing the position on the delta effect (discussed previously).

• Buying back the call profitably at higher stock prices due to the decay

in time value.

• Using the surrogate stock replacement to exit the position (discussed

in Chapter 5)

• Using the 20¢ rule or TSS for defense (Chapter 5).

66 COVERED CALLS

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Applying the TSS for Income and

Selling High Rule

Remember, the selling high rule identifies the timing of a TSS for income

call sale. It identifies the point on the chart where a TSS for income call can

be sold. The selling high rule instructs to only sell a TSS for income call

when the stock price is in the upper 75 percent of the current price cycle.

Interpretation of the chart is vitally important. The figures in this section

show some examples of applying the TSS for income and the selling high

rule on various stocks.

Experience indicates that the selling high rule will be satisfied on

most stocks approximately once or twice a month over the long-term—

particularly when we assess shorter-term cycles (discussed in the next sec-

tion, “Safely Maximizing TSS for Income Call Sale Opportunities”). Look at

Figure 4.1. Assume we bought this stock some time in the past and it is cur-

rently trading below our cost. If we were assessing this chart today, it

would qualify under the selling high rule. At this point, we would immedi-

ately sell the TSS for income call. We do not care if it appears that the

stock has further to increase before it reaches the absolute top of the

cycle—this is speculation. We are not attempting to “pick the top.” We just

want to sell the TSS for income call in the high region of the price cycle.

Picking the absolute top is not reliably achievable and, further, does not

contribute to the success of this technique.

Management Rules 67

When the stock reaches 75% of the cycle, the selling

high rule has been satisfied. Sell TSS for income

call and wait for the stock to cycle down.

FIGURE 4.1 Satisfying the selling high rule.

c04.qxd 10/23/06 2:18 PM Page 67

Once the TSS for income call is sold, the investor then needs to have

patience and wait for the stock to cycle down. During this period of wait-

ing, the call may be unprofitable to buy back, as the stock price may in-

crease further. The investor must have patience and allow the stock to

cycle down or time value to erode in order to profitably buy back the call.

If the stock shoots straight up we may be able to exit on the delta effect

(discussed earlier in this chapter) or will use defensive techniques such as

the surrogate stock replacement (discussed in Chapter 5).

We can see from Figure 4.2 that there are always opportunities to con-

tinue generating net cash flow using the TSS for income—regardless of the

trend of the stock. However, patience is required to wait for the correct

point in the price cycle to sell the call. In the preceding example, we would

be waiting for the stock to reach 75 percent of the cycle before selling a TSS

for income call. As soon as the stock reaches 75 percent of the cycle, we

will immediately sell the call.

Safely Maximizing TSS for Income Call Sale

Opportunities—Understanding Cycles Within Cycles

When managing fallen positions using the TSS for income, it is important to

maximize call sale opportunities. Maximizing call sale opportunities

means taking advantage of as many movements within the price cycle as

possible. In the examples illustrated by Figures 4.1 and 4.2, we assessed the

selling high rule based on a 12-month chart. However, depending on the na-

68 COVERED CALLS

Selling high rule not satisfied. Have

patience and wait for the stock to

move back to the top of the cycle.

When the stock reaches 75% of

the cycle, immediately sell the

TSS for income call.

FIGURE 4.2 The selling high rule is not satisfied.

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ture of the stock, it is sometimes necessary to assess the selling high rule

based on shorter-term cycles. We can see in Figure 4.3, that if assessing the

cycles on a 12-month chart, only at approximately nine points would the

selling high rule be satisfied.

In order to maximize call sale opportunities when using the TSS for in-

come and selling high rule, investors must be cognizant of shorter-term cy-

cles. We can see from the chart in Figure 4.4 that this stock is cycling

upwards over the long-term; however, there are shorter-term cycles within

the long-term cycle—both upward and downward. Some (not all) of the

cycles are highlighted in Figure 4.4 for illustration purposes.

We can see in Figure 4.4 that many more opportunities exist to imple-

ment the TSS for income while adhering to the selling high rule when

Management Rules 69

FIGURE 4.3 Maximizing sale call opportunities.

FIGURE 4.4 Many points on the short-term downward cycle qualify under the

selling high rule.

c04.qxd 10/23/06 2:18 PM Page 69

assessing shorter-term cycles. There are many points on the short-term

downward cycle that qualify under the selling high rule. However, it is most

important to always understand the longer-term cycle and the position of

the stock in relation to that cycle.

We can see in the short-term downward cycle illustrated in Figure 4.5

that the top of this cycle is actually the bottom of the longer-term upward

cycle. This is a very common occurrence. In this instance a call should not

be sold because, in actuality, the stock is at the bottom of the longer-term

upward cycle. Its bias is, therefore, up.

In summary, maximizing call sale opportunities means taking advan-

tage of as many movements within the price cycle as possible. To do this,

investors must take advantage of short-term cycles while assessing the sell-

ing high rule. However, investors must not ignore the long-term cycle when

using the TSS for income and selling high rule. Do not sell a call at the bot-

tom of the long-term cycle. Always view the stock initially over a 12-month

time frame to understand the long-term cycle. Shorter-term cycles can then

be assessed. The top of a short-term cycle is often the bottom of the long-

term cycle.

SELLING CALLS ON EXISTING STOCK HOLDINGS

Investors new to the covered call technique often express concern about

being forced to profitably sell their stock in the event of a call out. This con-

70 COVERED CALLS

Top of short-term

cycle, but bottom of

long-term cycle.

FIGURE 4.5 A stock at the bottom of a longer-term upward cycle.

c04.qxd 10/23/06 2:18 PM Page 70

cern is particularly common with investors who are considering making

their first covered call transactions on existing stock holdings that have sig-

nificant unrealized capital gains.

If an investor wishes to be successful in the business of covered calls,

emotional attachments cannot be held toward any particular stock holding;

decisions must be made purely on economic considerations. However,

when learning the covered call technique, it is also important that investors

are comfortable with their level of financial commitment to the technique,

including the commitment to the taxman if significant unrealized capital

gains are realized through a call out.

This situation arises if you bought a stock for $15.00 and the stock is

now trading at, for example, $30.00. If you were not inclined to continue

holding the stock, the rules for selling covered calls on existing stock hold-

ings (detailed later in this section) would instruct you to sell a near month

call that will provide a good uncalled and called return. For purposes of il-

lustration, let’s assume you sold a $32.50 call. If you were then called out,

you would realize a capital gain of $17.50 ($32.50 – $15.00) on the stock.

Even though you can simply repurchase the stock after being called out for

around the same price as you sold it for and then resell another call, this re-

alization of capital gains liability understandably makes some investors ner-

vous when first starting to use the covered call technique.

One alternative for investors not wishing to risk being called out of a

particular stock holding is to not sell near month calls. Instead, simply use

the TSS for income and selling high rule. This strategy will dramatically de-

crease (but can never completely eliminate) the risk of being called out. It

is the preferred strategy for investors wishing not to be called out of a par-

ticular stock position. Investors following this technique should still make

themselves familiar with the defensive techniques for preventing a call out

(discussed in Chapter 5).

Once experience and comfort are gained with the technique, it is likely

that you will realize that the merits of consistent monthly cash flow out-

weigh the very small chance of a possible realization of a large capital gain

on a particular stock when using the TSS for income. However, if this does

concern you and if you wish to initiate selling covered calls on your exist-

ing portfolio, simply choose stocks in your portfolio that will not result in

significant tax liabilities in the event of a call out. It would also be advisable

that while familiarizing yourself with the technique, you do not sell calls on

stocks that will result in a negative called return. Instead, while learning the

technique, choose stocks in your portfolio that are trading close to or

slightly above the price you paid for them.

Management Rules 71

c04.qxd 10/23/06 2:18 PM Page 71

The Rules for Selling Calls on Existing

Stock Holdings

The four rules for selling covered calls on existing stock holdings are:

1. New calls may only be sold on up market days. For the U.S. market, an

up market day is when the Dow Jones Industrial Average and the NAS-

DAQ are in the green (trading higher than the close of the previous

day). For foreign markets, an up market day is when the major market

average index for that country is in the green (trading higher than the

close of the previous day).

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 market price of the stock is

lower than your 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 of minimum 2.0 percent for the U.S. market or minimum

1.0 percent for foreign markets, then do so. This minimum return re-

quirement is highly dependant on the volatility of the individual stock.

With experience, you will gain a greater understanding of what is a rea-

sonable uncalled and called return for your particular stock holdings.

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. These rules are detailed in the rules for sec-

ondary call sales listed earlier in the chapter.

What to Do When Called Out

If you plan to implement a covered call strategy over existing stock hold-

ings, the situation will arise when you are called out of such holdings and

left with excess capital to invest back into the market. If you wish to con-

tinue holding the stock you were called out of, you may simply construct a

new covered call position on that stock. When doing so, be sure that you

satisfy the buying low rule for covered calls. You must not construct a cov-

ered call position at the top end of the price cycle, even if it is on a stock

that you have just been called out of.

72 COVERED CALLS

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IMPLEMENTING A COVERED CALL STRATEGY

USING OTHER STOCK SELECTION METHODS

Many investors choose to implement a covered call strategy on stocks that

have been selected by a professional fund manager or broker. For example,

a fund manager or broker may suggest a diversified portfolio of stocks as an

attractive long-term investment. The investor educated in the covered call

technique may then simply choose to invest in these stocks yet add the

covered call strategy to enhance yield and reduce risk in the portfolio. The

most common strategy to implement in this instance is the TSS for income

while adhering to the selling high rule to allow yield enhancement to the

portfolio without having stocks called out on a regular basis.

While this is generally a very conservative strategy, investors should

understand that the covered call yields realized using this stock selection

method would be lower than the yields realized using the stock selection

methods outlined in this book. That being said, utilizing the covered call

strategy over a diversified portfolio of blue-chip stocks selected by a value-

(not growth) orientated broker or professional fund manager is the most

conservative and low-risk equity strategy available to investors.

It is important for those choosing to implement a covered call strategy

over such a portfolio that after being called out of a particular stock, in-

vestors do not construct a new covered call position on that particular

stock until the buying low rule for covered calls has been satisfied.

Management Rules 73

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c04.qxd 10/23/06 2:18 PM Page 74

CHAPTER 5

We have established that the difference between great success and

complete mediocrity in the business of writing covered calls is

management. Management primarily involves generating consis-

tent monthly income from a stock investment regardless of the direction or

trend of the stock.

With this chapter, we move on to defensive techniques, which are as

important as management techniques but used more sparingly. Defensive

techniques serve several very important functions, including:

• Identifying if a position is in danger of being unprofitably called out.

• Preventing an unprofitable call out while maintaining positive cash

flow.

• Remedying a TSS for income call sale that is not able to be bought back

for a profit.

• Reducing the profitable exit price of an underperforming position.

• Generating income on deeply depressed stock positions.

The defensive techniques presented in this chapter cover the entire

scope of worst-case scenarios that may be encountered by the covered call

investor. These techniques provide a so-called “light at the end of the tun-

nel” for poorly performing covered call positions and, when properly un-

derstood, provide investors with the confidence to implement the mind-set

of never selling a stock for a loss.

Defensive

Techniques

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76 COVERED CALLS

BASIC DEFENSIVE TECHNIQUES

The 20¢ Rule

You should recall that option contracts are rarely exercised until the last

two weeks before expiration because doing so results in a loss of time value

to the option buyer. In practically, the vast majority of option contracts are

exercised on the third Friday of expiration.

It is very rare that an option contract will be exercised before the last

two weeks of the option month, even if it is in the money. As such, defen-

sive measures to avoid an unprofitable call out need only be taken when the

option contract is within its last two weeks before expiration. If someone

does exercise on you early, you are unlucky and it will probably never hap-

pen again.

The 20¢ rule provides investors with a method to determine whether an

investment is in danger of being called out and if it is, therefore, necessary

to implement the tethered slingshot (TSS) for defense to prevent being

called out.

The 20¢ rule states that if you have a negative called return when an op-

tion contract has two weeks or less to expiration, take the strike price of

your call, add the cost of buying back that call (the ask price) and subtract

the market price of the stock. So:

20¢ rule = Call strike price + Call buyback price (ask) – Stock price

If the 20¢ rule value is equal to $0.20 or less, you are in the danger zone of

being called out and you need to take defensive action using the TSS for

defense.

The need for the 20¢ rule also arises when an investor has lowered the

strike price on a call sale and has a negative called return on a position.

While this situation arises very rarely when using the covered call tech-

niques presented in this book, it happens quite often when adopting tradi-

tional covered call methods, which instruct to sell near month calls with

lower strike prices in order to maintain yield. Regardless, awareness of

how to avoid an unprofitable call out is very important.

Let’s look at an example. Assume an investor buys a stock for $14.75

and sells the June $15.00 call for $0.80. In this example the return calcula-

tions would be:

Uncalled return = $0.80/$14.75 = 5.4%

Called return = ($0.80 + $15.00 – $14.75)/$14.75 = 7.1%

c05.qxd 10/23/06 2:15 PM Page 76

Defensive Techniques 77

The stock price then falls to $12.50 and the call expires worthless leav-

ing the investor with a return of 5.4 percent for the month. This investor

then elects to sell the July $12.50 strike. (Note that this would not be the

course of action if correctly following the secondary call sales rules—this

is for illustration purposes only. The correct course of action would be to

use the TSS for income [sell the second to last expiration of the option

chain and a call that allows for a minimum of 10 percent uncalled return

while adhering to the selling high rule].)

Let’s assume that the stock price now rises and the investor is unable

to buy back the near month $12.50 strike call back for a profit. The stock

price is now $13.30. As the stock price is now above the strike price of the

call sold, it may be in the interest of the option buyer to exercise his or her

option. The covered call writer may have to sell the stock at a loss. This in-

vestor may be in danger of being called out for a loss and needs to use the

20¢ rule for guidance. Thus:

20¢ rule = $12.50 + $0.85 (trading near intrinsic value) – $13.30

= $0.05

Since the 20¢ rule value is less than $0.20, this position is likely to be called

out and defensive action is necessary.

Remember, the 20¢ rule is only used in the last two weeks of the op-

tion month and only on positions with negative called return. You must

monitor such positions carefully during the last two weeks of the option

month to make sure you are not in danger of being called out unprof-

itably. If at any time during the last two weeks of the option month you

have sold a call that results in a negative called return and the 20¢ rule

equals $0.20 or less, you must immediately take defensive action using the

TSS for defense.

Tethered Slingshot for Defense

You should implement the TSS for defense immediately if the 20¢ rule has

indicated that you are in danger of being called out and that this call out will

be unprofitable.

The functions of the TSS are:

• Preventing an unprofitable call out.

• Generating additional covered call income.

• Allowing the investor to move the strike price of the call back to where

the called return is positive.

c05.qxd 10/23/06 2:15 PM Page 77

78 COVERED CALLS

The eight rules for using this technique are:

1. Implement the TSS for defense if the 20¢ rule indicates that you are in

danger of being called out and that 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 have now generated additional covered call income, as the price

you 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 tempo-

rary loss.

5. Buy back this new call when the net gain is at least equal to the tempo-

rary 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. You should now be patient and wait for an upswing in the stock price

that will allow you to sell a near month call for a minimum of 4 percent

uncalled and called return for the U.S. market and 1.5 percent for for-

eign markets that will allow a positive called return.

8. If the stock reaches 75 percent 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.

ADVANCED DEFENSIVE TECHNIQUES

The defensive techniques presented in this section are considered ad-

vanced because they draw on the use of debit spreads. A debit spread in-

volves selling a call option while using another long call option for cover,

rather than the stock. The general technique of using debit spreads is dis-

cussed in detail in Part II on calendar LEAPS spreads. Here we discuss how

to use debit spreads as a specific defensive tool for covered call investors.

These advanced defensive techniques are indispensable when using the

covered call technique.

Many brokers do not allow the use of debit spreads in a retirement ac-

count such as an IRA or 401k. It is important for investors to understand

that this is a software-related issue at the particular brokerage house rather

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Defensive Techniques 79

than a legal requirement that prevents the use of debit spreads in a retire-

ment account. To keep your business, many brokerage firms will tell you

debit spreads are “not allowed in a retirement account.” This is a mislead-

ing statement. Debit spreads are allowed in a retirement account; however,

most brokerage houses do not have the software to cater for them. For a

list of Compound Stock Earnings recommended brokers, including those

that allow debit spreads in a retirement account, go to www.compound

stockearnings.com/brokers.

Surrogate Stock Replacement

Surrogate stock replacement (SSR) is an invaluable covered call defensive

technique. The function of the SSR is to expedite the profitable close-out of

a covered call transaction where the following three conditions apply:

1. An investor has used the TSS for income on the position.

2. The stock has continued to move up after selling the TSS for income

call. The investor is therefore unable to 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 (buying back the call and selling the

stock) because doing so would result in an overall transaction loss. In

all instances this is due to the loss on buyback of the TSS for income

call exceeding the potential profit from selling the stock.

See, for example, the position shown in Table 5.1. This investor has a

$2.00 profit in the stock position; however, the position cannot be closed

due to a $4.50 loss on the TSS for income call. Closing the position would

result in an overall transaction loss of $2.50.

Given this scenario, if the investor does not implement the SSR, the

strategy going forward with this position would be to take one of the fol-

lowing two actions:

TABLE 5.1 Example Position Appropriate for Use of SSR

Entry Current Profit/

Position Price Price Loss

Long GE stock $35.00 $37.00 $2.00

Short Jan 2007 $30 call $ 5.00 $ 9.50 –$4.50

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80 COVERED CALLS

1. Wait for the stock price to move down or for time value to erode so the

investor can profitably buy back the TSS for income call.

2. Wait for a large increase in the stock price, which, in most cases, will

eventually lead to the position becoming profitable due to the delta

ratio.

The SSR serves the function of expediting the closeout of a TSS for in-

come call sale that has gone bad. This function is highly valuable to the

covered call investor because waiting for the conditions to arise to permit

either action (1) or (2) can, in many instances, take several months. During

this period of waiting for the position to improve through either a large in-

crease or decrease in the stock price, the capital invested in the position be-

comes dormant and unproductive. This period of waiting represents an

opportunity cost to the investor—the cost of returns that could have been

made if that capital were invested in productive positions.

When using the SSR, the objective is to restructure the position through

the following three actions:

1. Closing out the existing position by buying back the call and selling the

stock. In every case, this creates a temporary loss (the restructure

cost).

2. Purchasing a LEAPS or a longer-term call in place of the stock.

3. Selling a near month or two month out call that will provide a positive

called return on the entire transaction (including recuperating the re-

structure cost).

The ten rules for using the SSR technique are:

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.

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. There-

fore, if the position is closed out, a net loss for the investor would be

created.

LEAPS: Acronym for long-term equity anticipation securities. They are simply

long-term options. They have exactly the same standardized characteristics

as a normal option but with a long-term expiration. Contracts with one year

or more to expiration and a January 200x expiration are known as LEAPS.

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Defensive Techniques 81

4. Use the SSR Worksheet to calculate the net loss in closing the transac-

tion (the SSR Worksheet is part of the Covered Call Toolbox, one

month’s complementary access to which is available by going to

www.compoundstockearnings.com/freemonth). This net loss is the re-

structure cost.

5. Input various LEAPS contracts into the SSR Worksheet. The SSR usu-

ally 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 three or four contracts.

6. Input various near month and two month out call contracts into the

SSR Worksheet. Start two strikes out of the money and move into the

money two contracts.

7. The SSR should be executed if the SSR Worksheet presents a transac-

tion that has both an uncalled and called return of greater than 2 per-

cent. 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 neg-

ative. Optimally, the transaction should generate net cash.

9. If the transactions presented by the SSR Worksheet do not meet the re-

turn requirements or cash flow requirements in items (7) and (8), more

aggressive investors may choose to enter shorter-term calls into the

SSR Worksheet as an alternative to using a LEAPS. Aggressive in-

vestors 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

shorter-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 percent time value. This limit ensures that the in-

vestor 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.

in the event the stock begins trading down, the call will need to be

rolled out.

10. In the event the call that was shorted in the SSR restructure expires

worthless (the position was not called out), the position should be

managed like a regular LEAPS position (discussed in depth in Chapter

8) with the following exception:

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82 COVERED CALLS

(a) 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.

An Example of Implementing SSR Figure 5.1 shows the entry of a

covered call position on OVTI, at a price of $15.13, in the middle of June.

The stock then proceeded to fall, and the TSS for income was applied on

several occasions to maintain return on the position even though it was

depressed. In late October, a TSS for income call was sold in accordance

with the selling high rule. The call sold was the January 07 $12.50 at a price

of $2.85.

The stock then broke to the top of the declining price cycle and in-

creased strongly over the following month. During this time, the position

could not be closed for a profit, as the loss on buyback of the TSS for in-

come call was always in excess of the realizable profit on the stock. As is

sometimes the case, the delta ratio on the position was not acting as it

should. The position was then as depicted in Table 5.2.

It is clear that this position could not be closed for a profit, as the loss

on call buyback was greater than the profit when selling the stock. Without

using the SSR restructuring, the strategy going forward on this position

would be either to wait for a further increase in the stock price and an

Stock

purchased

here at $15.13.

Problem TSS for

income call

sold here.

FIGURE 5.1 History of a covered call position.

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Defensive Techniques 83

eventual exit on the delta effect (this would be difficult given that the call

is now very deep in the money and the delta is near 1) or to wait for a de-

cline in the stock price to allow a profitable buyback of the TSS for income

call. This position (Figure 5.2) is, therefore, an ideal candidate for the SSR

technique to be applied according to the following steps.

Step 1: Assess the restructure cost. The restructure cost is the tempo-

rary loss generated when the unproductive position is closed out or “re-

structured.” It is the same as the loss if the position is closed. In this

instance, the restructure cost is –$1.12. See Table 5.3.

TABLE 5.2 Data for Position Shown in

Figure 5.1

Current stock price $21.66

Cost in stock 15.13

–———

Profit on sale $ 6.53

Call sell price $ 2.85

Current call price 10.50

—–——

Loss on buyback –$ 7.65

Loss if position closed –$ 1.12

Stock

purchased

here at $15.13.

Problem TSS

for income call

sold here.

SSR

restructure

applied here.

FIGURE 5.2 Application of the SSR technique to the covered call position

depicted in Figure 5.1.

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84 COVERED CALLS

Step 2: Assess the option chain for an appropriate SSR. In this step,

we look at the at-the-money and in-the-money LEAPS contracts (second to

last expiration is the most likely to provide an acceptable transaction) and

match these contracts with a near month (ideally) or a two month out call.

This creates a LEAPS transaction with a short-term call sold against it.

The objective is to select a transaction that:

• Provides a positive called return—including recuperation of the re-

structure cost.

• Provides an acceptable uncalled return of greater than 3 percent.

• Is cash positive—meaning that the SSR will free up cash when exe-

cuted. This cash can then be reinvested into new positions.

To achieve these objectives, investors should use the SSR Worksheet

(part of the Covered Call Toolbox, one month’s complementary access

to which is available by going to www.compoundstockearnings.com/

freemonth). The SSR Worksheet allows investors to enter various LEAPS

and call combinations to find the optimal SSR for a position. It is very im-

portant that the position is constructed to provide a positive called return

including recuperation of the restructure cost. Otherwise, the call out will

be at a loss. The calculation of uncalled and called returns, including recu-

peration of the restructure cost, is performed by the SSR Worksheet.

Looking at the option chain and entering the appropriate LEAPS and

call contracts into the SSR Worksheet as instructed in the SSR rules pro-

duces the results as shown in Table 5.4. The SSR restructure that is optimal

for this particular transaction is highlighted. After closing out the existing

stock and TSS for income call position, the investor should immediately

buy the $15.00 January 2007 call for $8.60 and immediately sell the $25.00

January 2006 call for $0.60. This is the transaction that provides the best

TABLE 5.3 Assessing Restructure Cost

Current stock price $21.66

Cost in stock 15.13

–———

Profit on sale $ 6.53

Call sell price $ 2.85

Current call price 10.50

–———

Loss on buyback –$ 7.65

Restructure cost –$ 1.12

c05.qxd 10/23/06 2:15 PM Page 84

TABLE 5.4 Potential SSR Combinations

Ask Cash Bid Uncalled Called Bid Uncalled Called Bid Uncalled Called

Exp Strike Price Free Up Price Return Return Price Return Return Price Return Return

2007 $12.50 $10.40 5.0% 1.30 12.5% –2.1% 0.60 5.8% 15.2% 0.20 1.9% 35.4%

2007 15.00 8.60 16.9 1.30 15.1 –10.7 0.60 7.0 10.2 0.20 2.3 34.7

2007 17.50 7.00 27.5 1.30 18.6 –26.0 0.60 –8.6 –0.3 0.20 2.9 29.7

2007 20.00 5.60 36.7 1.30 23.2 –52.1 0.60 –10.7 –20.0 0.20 3.6 17.5

Sell Call Jan-06 $22.50 Sell Call Jan-06 $25.00 Sell Call Jan-06 $27.50Long Call Candidate

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86 COVERED CALLS

uncalled and called return and also frees up a high percentage of cash from

the position.

Shorting the $22.50 strike is not acceptable as doing so leads to nega-

tive called returns. Shorting the $27.50 strike is not optimal because it

would require a very large movement in the stock price to be called out. Ad-

ditionally, the uncalled return is very low (which is what the investor is

likely to receive at January expiration given the very out-of-the-money

$27.50 strike).

In regard to the long call selected, the optimal selection is to long the

January 07 $15.00 strike rather than the $12.50 strike as this frees up more

cash and provides a higher uncalled return when matched with the January

06 $25.00 strike.

Step 3: Execute the SSR. In this instance, the investor should close the

existing position, generating a restructure cost of –$1.12. The investor

should then long the January 2007 $15.00 at $8.60 and short the January

2006 (one month to expiration at time of execution) $25.00 at $0.60.

Executing this transaction will free 16.9 percent of the capital from the

position.

Note: The SSR Worksheet is designed to carry forward the restructure

cost when calculating the called return. The called return presented by the

SSR Worksheet includes recuperation of the restructure cost. This function

is very important to the success of the SSR. If the called return and re-

structure cost are not correctly accounted for, the position will be called

out at a loss.

If uncalled, the return on this position will be 7.0 percent (see Table

5.4), and if called the return will be 10.2 percent (see Table 5.4). The in-

vestor is now back into productive management of this position and has a

very high likelihood of exiting the entire position in one month’s time

through a call out. Remember, the cycle is now up, and that is why we are

unable to buy back the TSS for income call profitably.

If the stock price continues up and does not reach the strike of the

short call, the investor will keep the premium of the short call at expiration

and also benefit from capital appreciation of the LEAPS. This situation

often results in the investor being able to sell the LEAPS for an overall

transaction profit immediately following worthless expiration of the short

call. Exiting the position profitably does not specifically require a call out.

This is a very important characteristic of the SSR technique.

Step 4: Close the SSR and complete the transaction. In this particular

instance, the $25.00 January 2006 call expired worthless and the $15.00 Jan-

uary 2007 LEAPS was sold on the Monday following the third Friday. The

transaction was closed for an overall profit (Figure 5.3).

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Defensive Techniques 87

The profit on the transaction was as follows:

Profit from TSS for income call sales and buybacks

prior to SSR $1.80

Loss on restructure –$1.12

Profit from SSR $25.00 January 2006 call at expiration $0.60

Profit from sale of LEAPS on Monday following

January 2006 expiration $1.17

Total OVTI transaction profit at closeout $2.45

Profit on original $15.13 investment 16.2%

What if the SSR is uncalled and the LEAPS cannot be sold for an over-

all transaction profit? If the position is uncalled at January expiration and

the transaction still cannot be closed for an overall profit, the investor

should just resell the February 2006 $25.00 call provided that doing so re-

sults in a satisfactory uncalled return of 3 percent or more. If not, the posi-

tion should be managed to exit like a regular LEAPS transaction. The

process of managing a LEAPS transaction is discussed in Chapter 8.

Stock

purchased

here at $15.13.

Problem TSS

for income call

sold here.

SSR

restructure

applied here.

Transaction

profitably

closed here.

FIGURE 5.3 Completing the SSR transaction for the covered call position

depicted in Figure 5.1.

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88 COVERED CALLS

Cardiopulmonary Resuscitation

Cardiopulmonary resuscitation (CPR) is an advanced covered call defen-

sive technique that is used to literally resuscitate a fallen stock. The CPR

has two typical applications:

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 al-

lows 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 po-

sition. The CPR can effectively be applied where an underperforming

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 For any given stock position, the construction

of a CPR is accomplished as follows:

1. An investor holds a long position of 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 selected in step 2.

In the preceding example, the investor owns 100 shares of stock,

yet has sold two calls against the position. The stock holding covers

one of these calls and the second call is covered by the purchase of the

long call.

The CPR always follows this structure: The investor will always pur-

chase the number of call options that relates to his or her stock holding and

will always sell two times the number of call options that relates to his or

her stock holding. For example, (1) an investor holds a long position of 300

shares of stock; (2) the investor buys three near month (or two month out)

calls; and (3) the investor sells six near month (or two month out) calls with

a higher strike price than the call selected in (2).

This structure of selling two times the number of calls than the investor

purchases predominantly finances the purchase of the long call. This is an

important structural aspect of the technique and limits the downside of the

strategy in the event of an unfavorable stock price at expiration (discussed

later in this section).

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Defensive Techniques 89

Let’s look at the construction of a typical CPR on the stock FMD. The

objective of this example is to illustrate the structure of the CPR. The rules

for selecting expirations and strikes, timing, and pay-off scenarios are dis-

cussed later in this section.

Let’s assume it’s early January and John owns 100 shares of FMD at a

cost of $32.50. A typical CPR construction as previously described would

appear as follows:

1. John owns 100 shares of FMD at a cost of $32.50.

2. John buys one $25.00 January 06 call at $4.00.

3. John then sells two $30.00 January 06 calls at $1.50.

Understanding the Net Debit of a CPR Using the prices in the pre-

ceding example, John has outlaid $4.00 to purchase the $25.00 call, yet has

received $3.00 by the sale of two $30.00 calls. The net cash cost of this CPR

to John is $1.00 [$4.00 – (2 ×$1.50)]. This $1.00 net cost when constructing

a CPR is known as the net debit. The net debit should always be expressed

on a per share basis:

Net debit = Price of long call – (2 ×Price of short call)

It should now be clear that when an investor places a CPR, he or she is,

in effect, purchasing a near-term call to take advantage of a rising stock

price. This call, however, is being predominantly financed through the sale

of two calls at a higher strike price. This financing limits the downside in

case the stock price does not increase. If the stock price goes down signif-

icantly, the loss to the investor will be the $1.00 per share net debit rather

than the $4.00 per share cost of buying the short-term call on its own.

The net debit of the CPR is the maximum loss to the investor. How-

ever, the cost of this limited downside to the investor is that the investor’s

upside is now capped at the strike price of the short call ($30.00 in this

case). In the event that the stock price increases above the strike price of

the short call, the investor will be called out of the position (both the stock

position and the long option position) at the strike price of the short call.

In summary, the CPR provides very small downside to the investor. This

downside is equal to the net debit. However, this small downside comes at

a cost: The investor’s upside is capped at the strike price of the short call.

Understanding the Payoff from a CPR Now that the structure of the

CPR is understood, let’s examine the payoff from the strategy. The rules for

selecting expirations and strikes and timing are discussed later in this

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90 COVERED CALLS

section. Continuing with the preceding example of John owning 100 shares

of FMD at a cost of $32.50, a CPR would be constructed as follows:

1. John owns 100 shares of FMD at a cost of $32.50.

2. John buys one $25.00 January 06 call at $4.00 (near month).

3. John then sells two $30.00 January 06 calls at $1.50 (near month).

We now use the CPR Worksheet (part of the Covered Call Toolbox, one

month’s complementary access to which is available by going to www

.compoundstockearnings.com/freemonth) to understand the payoff from

the strategy at expiration of the long and short call options.

Table 5.5 shows the profit to the investor at various stock prices at ex-

piration. A CPR is an expiration-based strategy meaning that once a CPR

is constructed, it is generally held until expiration of the contracts. The

highlighted line in the table shows the payoff of the strategy at various

stock prices at expiration, represented as a percentage of the $32.50 in-

vestment in the stock.

CPR Is Unprofitable at Expiration We can see from Table 5.5 that if the

stock price finishes at $25.00 or below on the third Friday of January 2006,

the CPR will lose the investor 3.1 percent of his or her $32.50 investment in

the stock (a loss of $1.00). This loss is equal to the net debit and is com-

puted as follows:

Long $25.00 strike call:

• Cost is $4.00

• Expired worthless

• Loss of $4.00

Short 2 ×$30.00 strike call:

• Premium received is $3.00 ($1.50 ×2)

• Expired worthless

• Profit of $3.00

CPR return:

• Loss of $4.00 on long call

• Profit of $3.00 on short calls

• Net loss of $1.00

This $1.00 loss represents 3.1 percent of the $32.50 investment in the stock.

Regardless of how low the stock price goes, the investor’s maximum loss

for this CPR is capped at the net debit of $1.00 or 3.1 percent.

The maximum loss of all CPRs is equal to the net debit of the

transaction.

c05.qxd 10/23/06 2:15 PM Page 90

TABLE 5.5 Profit at Various Stock Prices at Expiration

Stock Price at Expiration

$24.00 $25.00 $26.00 $27.00 $28.00 $29.00 $30.00 $31.00 $32.00

Long $25 and Short $30

Will I get called out? No No No No No No Yes Yes Yes

Profit (loss) if called based on cost $ 1.50 $ 1.50 $ 1.50

How much did I get all up when called? $34.00 $34.00 $34.00

Current market price to repurchase $30.00 $31.00 $32.00

Cash return or called return % –3.1% –3.1% 0.0% 3.1% 6.2% 9.2% 4.6% 4.6% 4.6%

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92 COVERED CALLS

CPR Is Profitable at Expiration but Not Called Out We can also see from

Table 5.5 that this strategy becomes profitable at stock prices of $27.00 or

greater at expiration. If the stock finishes the option month at $27.00, the

profit from the CPR will be $1.00 or 3.1 percent of the $32.50 investment in

the stock. This profit is computed as follows:

Long $25.00 strike call:

• Cost is $4.00

• Sell for intrinsic value of $2.00 on third Friday

• Loss of $2.00

Short 2 ×$30.00 strike call:

• Premium received is $3.00 ($1.50 ×2)

• Expired worthless

• Profit of $3.00

CPR return:

• Loss of $2.00 on long call

• Profit of $3.00 on short calls

• Net profit of $1.00

This $1.00 profit represents 3.1 percent of the $32.50 investment in the

stock. In order to realize this profit, the investor must take the following

steps on the third Friday of expiration:

1. Buy back one of the short $30.00 calls. This buyback can normally be

executed for $0.05, as the call will expire worthless at the end of the

trading day. This buyback frees the long $25.00 call for sale, as it is no

longer needed to cover one of the short calls.

2. Sell the long $25.00 call. The sale price will be around the intrinsic

value of $2.00.

3. Allow the second call to expire worthless at the end of the trading day.

These three steps must be executed on the third Friday of expiration in

all CPRs when (a) the long call is in the money and (b) the short call is out

of the money (the CPR will not be called out). Following these steps allows

the investor to salvage the intrinsic value in the long call before that call ex-

pires worthless or the broker automatically exercises it.

CPR Is Called Out at Expiration In the event that the stock price finishes

above the strike price of the short call, the short calls will be exercised and

the position will be called out. This situation will generally occur only on

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Defensive Techniques 93

the third Friday of expiration. Using the preceding FMD example, if the

stock price is above $30.00 on the third Friday of January, the position will

be called out. John will be required to deliver 200 shares of FMD stock at a

price of $30.00. The following transactions will automatically occur in his

account as a result of the call out:

• John’s holding of 100 shares of FMD will be sold at the short call exer-

cise price of $30.00. John’s cost in FMD stock is $32.50, so he has sold

the stock for a loss of $2.50 per share.

• John will keep the $3.00 premium received for the short calls.

• John has an obligation to deliver an additional 100 shares of FMD stock

at $30.00 as he has sold two $30.00 calls. His broker will thus automat-

ically exercise John’s $25.00 strike call and he will buy 100 shares at

this price. The broker will then automatically sell this stock at the short

strike price of $30.00 to deliver John’s obligations from the $30.00 short

call. John has, therefore, purchased 100 FMD shares at $25.00 and im-

mediately sold these at the short strike price of $30.00. He has made

$5.00 profit per share on these 100 shares.

• John will then lose the $4.00 premium he paid for the long call option,

as this call has now been exercised.

• Adding these figures, John’s overall profit on call out is $1.50 or 4.6 per-

cent of his $32.50 investment in the stock. This profit is computed as

follows:

(a) Loss of $2.50 per share on the stock sale plus

(b) Profit of $3.00 per share from short call premium plus

at $30.00 plus

(d) Loss of $4.00 per share from the exercised long option equals

(e) Overall transaction return of $1.50 per share or 4.6 percent of the

$32.50 investment in the stock.

We now understand that this CPR will be called out for a return of 4.6

percent if the stock price is above $30.00 at expiration. Importantly, re-

gardless of how high the stock price is at expiration, John’s called return is

capped at 4.6 percent. He will receive the same called return regardless of

how high above $30.00 the stock price is at expiration because his upside in

the transaction has been capped by the sale of the $30.00 call option.

Understanding the CPR Worksheet Now that we understand the

basic structure of the CPR, let’s look at entering this particular transaction

into the CPR Worksheet. The CPR Worksheet is part of the Covered Call

Toolbox (one month’s complementary access to which is available by going

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94 COVERED CALLS

to www.compoundstockearnings.com/freemonth). The CPR Worksheet al-

lows investors to quickly and accurately perform the following three tasks

automatically:

1. Assess various strike prices and expirations to find the optimal CPR for

a given position.

2. Calculate the net debit of the transaction.

3. Understand the profit and loss of the CPR at various stock prices at

expiration.

We continue with the preceding example of assessing a CPR on FMD

stock, which an investor owns at a cost of $32.50. The first step in assess-

ing a CPR on this position is to enter the position details into the CPR Work-

sheet as indicated by the highlighted cells thereon.

CPR Worksheet Inputs The inputs for our example as shown in Table 5.6

are:

• The stock code is FMD.

• The purchase price is the investor’s cost of 32.50.

• The net premium to date is $0.00. For simplicity, we have assumed the

investor has not made any income from call sales and buybacks. Im-

portantly this figure is net premium. Net premium is cumulative call

premium from closed positions only. When assessing a CPR you must

not include the premium from an open call position. If an investor

wishes to construct a CPR, the stock must not have an open call posi-

tion. Any open call positions will first need to be closed. The profit or

TABLE 5.6 CPR Worksheet Inputs

Inputs

Stock FMD

Purchase price $32.50

Net premium to date $ 0.00 0.0%

P&L analysis—start price $24.00

P&L analysis—$ increment $ 1.00

CPR potential strikes $25.00 $30.00 $35.00

Bid or ask Ask Bid Ask Bid

Option price $ 4.00 $1.50 $1.65 $ 0.30

Net debit CPR with $25 and $30 $ 1.00 3.6%

Net debit CPR with $30 and $35 $ 1.05 3.2%

Ask Bid Ask Bid

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Defensive Techniques 95

loss on closure should be included in total net premium to date on the

position.

• The P&L analysis—start price is $24.00.

• The P&L analysis—$ increment is $1.00.

• The CPR potential strikes are $25.00, $30.00, and $35.00. The potential

strikes were selected arbitrarily from the option chain. In general, the

strikes that most often construct effective CPRs are in the range of two

strikes in the money to two strikes out of the money. This is explained

in more detail later in this chapter.

• The option prices entered are the relevant bid and the ask prices for the

near month or near month + 1 contract. The CPR should always be con-

structed with the near month call if this call provides the desired return

outcome. If it does not, the CPR can be constructed with near month +

1 contracts. This, again, is discussed in more detail later in this chapter.

Using the inputs provided, the CPR Worksheet then calculates the net debit

for the two possible CPRs on this position.

Understanding the CPR Worksheet Outputs Once the details of a partic-

ular position and the potential CPR strikes and market prices have been

entered, the CPR Worksheet will produce the profit and loss from the par-

ticular CPR at various stock prices at expiration.

Table 5.7 shows the profit and loss scenarios for two different CPRs

that have been generated by the CPR worksheet:

1. Long $25.00 and short $30.00

2. Long $30.00 and short $35.00

The investor then needs to assess both potential CPRs to select the best

construction for the position. We achieve this by looking in Table 5.7 and

comparing the rows “Cash Return or Called Return %” for each CPR. We

can see that the $25.00 and $30.00 CPR becomes profitable with stock

prices at expiration above $27.00 and that a profitable call out of 4.6 percent

will occur at stock prices at expiration (one or two months away) of $30.00

and above (remember, the cost in the stock is $32.50). The maximum loss

on this CPR is the net debit, which is 3.1 percent.

Alternatively, if the $30.00 and $35.00 strike CPR is selected, the CPR

will become profitable at stock prices at expiration of $32.00 and above,

and a positive called return of 19.8 percent will result with stock prices

greater than $35.00 at expiration. We can see that this CPR needs a greater

increase in the stock price in order to become profitable and provides more

upside to the investor due to the higher strike price. Again, the maximum

loss of this CPR is the net debit, which is 3.2 percent.

c05.qxd 10/23/06 2:15 PM Page 95

TABLE 5.7 Stock Breakeven Analysis

Stock Price at Expiration

$25.00 $26.00 $27.00 $28.00 $29.00 $30.00 $31.00 $32.00 $33.00 $34.00 $35.00

Long $25 and Short $30

Will I get called out? No No No No No Yes Yes Yes Yes Yes Yes

Profit (loss) if called based on adj. cost $ 1.50 $ 1.50 $ 1.50 $ 1.50 $ 1.50 $ 1.50

Do I need to rebuy stock? No No No No No No No No No No No

How much did I get all up when called? $34.00 $34.00 $34.00 $34.00 $34.00 $34.00

Current market price to repurchase $30.00 $31.00 $32.00 $33.00 $34.00 $35.00

Reduction in cost/cash return $ 1.50 $ 1.50 $ 1.50 $ 1.50 $ 1.50 $ 1.50

Cash return or called return $ –$ 1.00 $ 0.00 $ 1.00 $ 2.00 $ 3.00

Cash return or called return $ –$ 1.00 $ 0.00 $ 1.00 $ 2.00 $ 3.00 $ 1.50 $ 1.50 $ 1.50 $ 1.50 $ 1.50 $ 1.50

Cash return or called return % –3.1% 0.0% 3.1% 6.2% 9.2% 4.6% 4.6% 4.6% 4.6% 4.6% 4.6%

Adjusted cost $33.50 $32.50 $31.50 $30.50 $29.50 $28.50 $29.50 $30.50 $31.50 $32.50 $33.50

Profit or loss if immediately sell stock –$ 8.50 –$ 6.50 –$ 4.50 –$ 2.50 –$ 0.50 $ 1.50 $ 1.50 $ 1.50 $ 1.50 $ 1.50 $ 1.50

Long $30 and Short $35

Will I get called out? No No No No No No No No No No Yes

Profit (loss) if called based on adj. cost $ 6.45

Do I need to rebuy stock? No No No No No No No No No No No

How much did I get all up when called? $38.95

Current market price to repurchase $35.00

Reduction in cost/cash return $ 6.45

Cash return or called return $ –$ 1.05 –$ 1.05 –$ 1.05 –$ 1.05 –$ 1.05 –$ 1.05 –$ 0.05 $ 0.95 $ 1.95 $ 2.95

Cash return or called return $ –$ 1.05 –$ 1.05 –$ 1.05 –$ 1.05 –$ 1.05 –$ 1.05 –$ 0.05 $ 0.95 $ 1.95 $ 2.95 $ 6.45

Cash return or called return % –3.2% –3.2% –3.2% –3.2% –3.2% –3.2% –0.2% 2.9% 6.0% 9.1% 19.8%

Adjusted cost $33.55 $33.55 $33.55 $33.55 $33.55 $33.55 $32.55 $31.55 $30.55 $29.55 $28.55

Profit or loss if immediately sell stock –$ 8.55 –$ 7.55 –$ 6.55 –$ 5.55 –$ 4.55 –$ 3.55 –$ 1.55 $ 0.45 $ 2.45 $ 4.45 $ 6.45

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Defensive Techniques 97

For this particular position, at this moment in time, the CPR should be

constructed using the $25.00 and $30.00 strike. While both positions will

provide a positive called return, the $25.00 and $30.00 strike CPR:

• Becomes profitable at stock prices above $27.00 versus $32.00 for the

higher strike CPR. (See the “Cash Return or Called Return %” row in

Table 5.7.)

• Will allow the investor to exit the position through a call out at a price

of $30.00 versus an exit price of $32.00 for the higher strike CPR. Note:

A call out will occur for the $30.00 and $35.00 CPR at a price of $35.00;

however, the position will be able to be profitably closed at a stock

price at expiration of $32.00 or greater because the CPR, at a stock

price of $32.00 at expiration, generates uncalled return of $0.95. This

uncalled return lowers the investor’s cost in the stock to $31.55

($32.50 – $0.95). The investor can then sell the stock at the current mar-

ket price of $32.00 to realize a net return of $0.45 ($32.00 – $31.55) or

2.9 percent.

• Provides much lower likelihood of losing the net debit of the transac-

tion as this occurs at stock price of $25.00 and below versus $30.00 and

below for the higher strike CPR.

To summarize, the $25.00 and $30.00 CPR is superior as it will pro-

vide higher levels of profit at lower stock prices; will allow the investor

to exit the entire position at a significantly lower stock price at expiration;

and provides less likelihood of the investor realizing a loss equal to the

net debit.

In all instances where both potential CPRs provide a positive called re-

turn, the CPR that provides the lowest profitable exit price should be used.

The objective of a CPR that has a positive called return is to exit the posi-

tion profitably at the lowest possible stock price at expiration. We discuss

later in this chapter the objectives of a CPR that does not provide a prof-

itable called return.

Applying the CPR Technique The CPR has two typical applications:

1. To dramatically expedite the closing of a new covered call position where

the stock price has suffered a decline after entering the transaction.

2. To generate income and reduce the cost basis in a depressed position

where the cycle of the stock is now increasing but this cycle is too

shallow to effectively use the TSS for income.

Using the CPR to Expedite the Close of a New Covered Call Position

Using the CPR to expedite the close of a new covered call position is its

c05.qxd 10/23/06 2:15 PM Page 97

98 COVERED CALLS

most significant function. When the stock price falls after entering a new

covered call position, correct use of the CPR allows an investor, in most in-

stances, to lower the strike price of the near month call yet maintain a pos-

itive called return. This stance greatly increases the likelihood that the

position will be called out for a profit. Take the following simplified exam-

ple for illustration of this function:

• Stock is purchased in January at $34.00 and the January $35.00 strike

call is sold for $1.50.

• Stock price falls sharply to $30.00 and the call can now be bought to

close for $0.80, leaving a profit of $0.70, or 2.0 percent.

• Immediately apply CPR with January expirations at strikes of $25.00

and $30.00.

• Yield enhancement in the form of uncalled return will occur at stock

prices greater than $27.00 at expiration.

• Profitable call out will now occur at a stock price of $30.00 rather than

the original call sale strike of $35.00, resulting in a 15 percent reduction

in the profitable call out price. This reduction is very significant.

We can see, then, that the CPR was used as a defensive measure on a

new covered call position immediately following a large decline in the

stock price. The CPR had the effect of enhancing uncalled return at stock

prices higher than $27.00 and, more important, lowering the profitable call

out price from a $35.00 strike to $30.00. This defensive outcome is regularly

achievable using the CPR technique on newly established covered call po-

sitions that fall.

The following example illustrates the complete process of using the

CPR to expedite the close of a covered call position on a fallen stock.

Step 1: Enter a new covered call position. In mid-December (Figure

5.4), a new covered call position was identified and executed as follows:

• BTO 500 FMD @ $33.33

• STO 5 FMD $35.00 Jan 06 calls @ $1.35

The stock met the fundamental requirements for investment, was an up-

ward moving stock, and was in the bottom 25 percent of the rising price

cycle. A few days after entering the position, the stock fell 16 percent to

$28.00. This is an ideal time to assess a potential CPR to expedite the close

of this fallen position (Figure 5.5).

Step 2: Assess the potential CPR and execute if acceptable. We now

hold a covered call position on FMD, which, in all likelihood, will not be

called out at the end of the month due to the call being sold at a strike of

c05.qxd 10/23/06 2:15 PM Page 98

$35.00 and the current stock price being around $28.00. However, we do

have a profit in the call due to the fall in the stock. This profit is significantly

to our advantage when we construct the CPR. Without the profit in the buy-

back of the call, the CPR may not be able to be structured with a positive

called return.

We then enter the details of the position and the option contracts we

may use into the CPR Worksheet as shown in Table 5.8.

Defensive Techniques 99

Positioned constructed here:

BTO FMD @ $33.33

STO Jan 06 $35.00 @ $1.35

Assess potential CPR.

FIGURE 5.5 When to assess the need for CPR.

Positioned constructed here:

BTO FMD @ $33.33

STO Jan 06 $35.00 @ $1.35

FIGURE 5.4 Entering a covered call on FMD.

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100 COVERED CALLS

In this instance, the option expiration selected is January. January is the

same month as the original call sold when entering the position. It is our pref-

erence to use the January expiration; however, February can be used in the

event that a CPR cannot be favorably constructed with January expirations.

Favorable construction in this regard is a CPR with a positive called return.

You will also notice that net premium to date has been entered into the

CPR Worksheet as $0.95. If we wish to construct this CPR, we will need to

buy to close the open January 06 $35 call, which we originally sold for

$1.35. The ask price for this contract when assessing the CPR was $0.40.

Buying back the call at this price will realize net premium of $0.95. The net

premium we receive when buying back the call is critical to the CPR con-

struction having adequate called return.

The CPR Worksheet produces the output as shown in Table 5.9. We can

see that both CPRs will provide a positive called return. From previous dis-

cussion, we know that when assessing two CPRs that both have positive

called returns, the CPR with the lowest strike prices should always be se-

lected. The reasons for this choice have been explained previously and are

not repeated here. As such, we will immediately apply the CPR with $25.00

and $30.00 strikes to this stock. The process is as follows:

• Buy back five January 06 $35.00 calls at $0.40 for a gain of $0.95, or 2.9

percent.

• BTO 5 Jan 06 $25.00 calls at $4.00.

• STO 10 Jan 06 $30.00 calls at $1.40.

• The net debit is $1.20, or 3.6 percent.

We have now executed the CPR (see Figure 5.6).

TABLE 5.8 CPR Worksheet Inputs Pertaining to Figure 5.5

Inputs

Stock FMD

Purchase price $33.33

Net premium to date $ 0.95 2.9%

P&L analysis—start price $25.00

P&L analysis—$ increment $ 1.00

CPR potential strikes $25.00 $30.00 $35.00

Bid or ask Ask Bid Ask Bid

Option price $ 4.00 $1.40 $1.45 $ 0.30

Net debit CPR with $25 and $30 $ 1.20 3.6%

Net debit CPR with $30 and $35 $ 0.85 2.6%

Ask Bid Ask Bid

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101

TABLE 5.9 Stock Breakeven Analysis Pertaining to Figure 5.5

Stock Price at Expiration

$25.00 $26.00 $27.00 $28.00 $29.00 $30.00 $31.00 $32.00 $33.00 $34.00 $35.00

Long $25 and Short $30

Will I get called out? No No No No No Yes Yes Yes Yes Yes Yes

Profit (loss) if called based on adj. cost $ 1.42 $ 1.42 $ 1.42 $ 1.42 $ 1.42 $ 1.42

Do I need to rebuy stock? No No No No No No No No No No No

How much did I get all up when called? $33.80 $33.80 $33.80 $33.80 $33.80 $33.80

Current market price to repurchase $30.00 $31.00 $32.00 $33.00 $34.00 $35.00

Called return $ 1.42 $ 1.42 $ 1.42 $ 1.42 $ 1.42 $ 1.42

Uncalled return $ –$ 0.25 $ 0.75 $ 1.75 $ 2.75 $ 3.75

Uncalled or called return $ –$ 0.25 $ 0.75 $ 1.75 $ 2.75 $ 3.75 $ 1.42 $ 1.42 $ 1.42 $ 1.42 $ 1.42 $ 1.42

Uncalled or called return % –0.8% 2.3% 5.3% 8.3% 11.3% 4.3% 4.3% 4.3% 4.3% 4.3% 4.3%

Adjusted cost $33.58 $32.58 $31.58 $30.58 $29.58 $28.58 $29.58 $30.58 $31.58 $32.58 $33.58

Profit or loss if immediately sell stock –$ 8.58 –$ 6.58 –$ 4.58 –$ 2.58 –$ 0.58 $ 1.42 $ 1.42 $ 1.42 $ 1.42 $ 1.42 $ 1.42

Long $30 and Short $35

Will I get called out? No No No No No No No No No No Yes

Profit (loss) if called based on adj. cost $ 6.77

Do I need to rebuy stock? No No No No No No No No No No No

How much did I get all up when called? $39.15

Current market price to repurchase $35.00

Called return $ 6.77

Uncalled return $ $ 0.10 $ 0.10 $ 0.10 $ 0.10 $ 0.10 $ 0.10 $ 1.10 $ 2.10 $ 3.10 $ 4.10

Uncalled or called return $ $ 0.10 $ 0.10 $ 0.10 $ 0.10 $ 0.10 $ 0.10 $ 1.10 $ 2.10 $ 3.10 $ 4.10 $ 6.77

Uncalled or called return % 0.3% 0.3% 0.3% 0.3% 0.3% 0.3% 3.3% 6.3% 9.3% 12.3% 20.3%

Adjusted cost $33.23 $33.23 $33.23 $33.23 $33.23 $33.23 $32.23 $31.23 $30.23 $29.23 $28.23

Profit or loss if immediately sell stock –$ 8.23 –$ 7.23 –$ 6.23 –$ 5.23 –$ 4.23 –$ 3.23 –$ 1.23 $ 0.77 $ 2.77 $ 4.77 $ 6.77

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102 COVERED CALLS

Step 3: Wait for expiration Friday of the calls. Our profit and loss on

the position at January expiration is shown in Table 5.10.

It is very important to understand that the returns presented by the

CPR Worksheet include the net premium to date. Therefore, all cash re-

turns and called returns in the Worksheet include the $0.95 already made in

net premium.

For example, this position will be called out at stock prices above

$30.00. The return on call out will be a total transaction return of 4.3 per-

cent. The called return is not 4.3 percent plus the 2.9 percent already real-

ized in net premium. Additionally, at a stock price at expiration of $27.00,

the cash return will be 5.3 percent. This is the total transaction cash return

and includes the net premium to date of 2.9 percent. All returns presented

by the CPR Worksheet are overall transaction returns and include any net

premium to date.

If the stock finishes the option month above $30.00, we will be called

out for an overall transaction return of 4.3 percent. Originally, our prof-

itable call out strike was $35.00 so we have drastically lowered the prof-

itable exit price of this position. This is the most important aspect of the

CPR technique. The technique is designed to profitably expedite the close

out of an underperforming covered call position through lowering of the

strike price while maintaining a positive transaction called return.

If the stock finishes the option month between $25.00 and $30.00, the

position will not be called out, yet the investor will be left with a cash return

Positioned constructed here:

BTO FMD @ $33.33

STO Jan 06 $35.00 @ $1.35

Position called out at

$30.00 on the third Friday

for a return of 4.3%.

BTC call and execute CPR.

BTC FMD Jan 06 $35.00 calls @ $0.40

BTO FMD Jan 06 $25.00 calls @ $4.00

STO 2 ¥ FMD Jan 06 $30.00 calls @ $1.40

FIGURE 5.6 Using CPR to profitably close out of an underperforming covered

call position.

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103

Stock Price at Expiration

$25.50 $26.00 $26.50 $27.00 $27.50 $28.00 $28.50 $29.00 $29.50 $30.00 $30.50

Long $25 and Short $30

Will I get called out? No No No No No No No No No Yes Yes

Profit (loss) if called based on adj. cost $ 1.42 $ 1.42

Do I need to rebuy stock? No No No No No No No No No No No

How much did I get all up when called? $33.80 $33.80

Current market price to repurchase $30.00 $30.50

Called return $ 1.42 $ 1.42

Uncalled return $ $ 0.25 $ 0.75 $ 1.25 $ 1.75 $ 2.25 $ 2.75 $ 3.25 $ 3.75 $ 4.25

Uncalled or called return $ $ 0.25 $ 0.75 $ 1.25 $ 1.75 $ 2.25 $ 2.75 $ 3.25 $ 3.75 $ 4.25 $ 1.42 $ 1.42

Uncalled or called return % 0.8% 2.3% 3.8% 5.3% 6.8% 8.3% 9.8% 11.3% 12.8% 4.3% 4.3%

Adjusted cost $33.08 $32.58 $32.08 $31.58 $31.08 $30.58 $30.08 $29.58 $29.08 $28.58 $28.08

Profit or loss if immediately sell stock –$ 7.58 –$ 6.58 –$ 5.58 –$ 4.58 –$ 3.58 –$ 2.58 –$ 1.58 –$ 0.58 $ 0.42 $ 1.42 $ 1.42

TABLE 5.10 Stock Breakeven Analysis

Inputs

Stock FMD

Purchase price $33.33

Net premium to date $ 0.95 2.9%

P&L analysis—start price $25.50

P&L analysis—$ increment $ 1.00

CPR potential strikes $25.00 $30.00 $35.00

Bid or ask Ask Bid Ask Bid

Option price $ 4.00 $1.40 $1.45 $ 0.30

Net debit CPR with $25 and $30 $ 1.20 3.6%

Net debit CPR with $30 and $35 $ 0.85 2.6%

Ask Bid Ask Bid

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104 COVERED CALLS

from the CPR. To realize this return, on the third Friday, the investor will

need to buy back 5 of the 10 short $30.00 calls and then sell all 5 long $25.00

calls. This process will allow the investor to realize the intrinsic value in the

long option before it expires or is exercised automatically by the broker.

This process is discussed in detail in the earlier section, “CPR Is Profitable

at Expiration but Not Called Out.”

If the stock finishes the option month below $25.00, we will lose the

net debit of the transaction or 3.6 percent. This loss will be compensated

for by the 2.9 percent profit realized from net premium to date. As such, the

maximum negative net cash return for the month will be just 0.8 percent. As

you can see, there is very small downside to the correct application of the

CPR technique. See Table 5.11.

What if the CPR Worksheet does not produce a CPR with a positive

called return? If the CPR Worksheet does not produce a transaction with a

positive called return using near month or near month + 1 expirations or, in

assessing the cycle of the stock, the higher strike price CPR seems to re-

quire an unrealistically large movement in the stock price to become prof-

itable, we will simply wait for a further increase in the stock price, which

will improve the profitability of the potential CPRs.

If at any time an investor is waiting for an improvement in a CPR return

before executing the CPR and a call can be sold that meets the secondary

call sale rules such as a TSS for income, then these rules should be imme-

diately followed.

Using the CPR Where the Called Return Is Negative Another useful func-

tion of the CPR technique is to generate income and reduce the cost basis

on a deeply depressed position. The CPR can effectively be applied where

a stock is now in an upward cycle but the cycle’s depth is too shallow to ef-

fectively use the TSS for income. A cycle with such characteristics is often

evident in a stock that has suffered one of the following fates:

• A quick and sharp price decline that is normally the result of a negative

news or earnings announcement causing the stock to consolidate in a

gradual upward moving or sideways moving cycle.

• A long and protracted decline over a period of months and the stock is

now upward moving or sideways moving.

In most instances where the CPR is applied on a deeply depressed

stock, an effective CPR cannot be constructed with a positive called return.

The investor will, therefore, construct a CPR with a profitable range of

stock prices at expiration. If the stock price is below this range at expira-

tion, the investor will lose the net debit. If the stock breaks cycle, begins a

more aggressive upward cycle, and is above the profitable range, this action

can result in the CPR being unprofitable.

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105

TABLE 5.11 Stock Breakeven Analysis

Stock Price at Expiration

$24.00 $24.50 $25.00 $25.50 $26.00 $26.50 $27.00 $27.50 $28.00 $28.50 $29.00

Long $25 and Short $30

Will I get called out? No No No No No No No No No No No

Profit (loss) if called based on adj. cost

Do I need to rebuy stock? No No No No No No No No No No No

How much did I get all up when called?

Current market price to repurchase

Called return

Uncalled return $ –$ 0.25 –$ 0.25 –$ 0.25 $ 0.25 $ 0.75 $ 1.25 $ 1.75 $ 2.25 $ 2.75 $ 3.25 $ 3.75

Uncalled or called return $ –$ 0.25 –$ 0.25 –$ 0.25 $ 0.25 $ 0.75 $ 1.25 $ 1.75 $ 2.25 $ 2.75 $ 3.25 $ 3.75

Uncalled or called return % –0.8% –0.8% –0.8% 0.8% 2.3% 3.8% 5.3% 6.8% 8.3% 9.8% 11.3%

Adjusted cost $33.58 $33.58 $33.58 $33.08 $32.58 $32.08 $31.58 $31.08 $30.58 $30.08 $29.58

Profit or loss if immediately sell stock –$ 9.58 –$ 9.08 –$ 8.58 –$ 7.58 –$ 6.58 –$ 5.58 –$ 4.58 –$ 3.58 –$ 2.58 –$ 1.58 –$ 0.58

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106 COVERED CALLS

Let’s look at an example of implementing the CPR on a deeply de-

pressed stock. Let’s assume we own 500 shares of DRL at a cost of $20.00.

Step 1: Assess the cycle of the stock you wish to CPR. When a stock is

trading deeply below an investor’s cost, it is unlikely that a CPR can be con-

structed using near month or near month + 1 expirations that has a positive

called return. If a CPR has a negative called return, it can only be con-

structed when (1) the stock is in a current upward cycle and (2) the distance

between the upper and lower lines of the price cycle is $1.50 or less. If the

cycle of the stock does not comply with both (1) and (2), then it is more ad-

vantageous for the investor to use the TSS for income on the position.

We can see from Figure 5.7 that DRL is currently stabilizing from se-

vere price declines in the preceding months. DRL qualifies for CPR as it is

both an up cycling stock (the bottoms and tops of the current cycle are get-

ting higher) and the current cycle has less than $1.50 of price depth. We

can, therefore, assume that the CPR technique can be used on this stock at

this point in time rather than the TSS for income.

Step 2: Input the position data into the CPR Worksheet. For the pur-

pose of this example, the January 06 expirations were used. At the time of

writing, the January contract had 40 days to expiration. See Table 5.12.

Note that in this instance, the net premium to date is set at $0.00.

When assessing a CPR that will not result in a positive called return, the

net premium should always be set to $0.00 regardless of the income earned

on the position in the past. We use $0.00 because we are attempting to

generate additional income on the position and need to understand the

FIGURE 5.7 A depressed stock that qualifies for CPR.

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Defensive Techniques 107

profitability of the CPR as an independent strategy. We are not looking to

the CPR as a tool to lower the exit price of the stock, as we would if the

called return were positive.

Step 3: Assess the CPR Worksheet outputs. The CPR worksheet pro-

vides the profit and loss of the two potential CPRs. See Table 5.13. The

stock price at time of writing was $11.60. The optimal CPR for this position

is the $10.00 and $12.50 CPR. This CPR will provide an enhancement to re-

turn at stock prices between $11.00 and $14.00 at expiration. This result

compares to the $12.50 and $15.00 CPR that does not become profitable

until the stock price reaches $13.00—a required increase of 12.1 percent in

a month.

If the stock finishes the option month above $12.50 but less than

$14.00, the investor will be called out. This call out will be at a loss, but will

still result in the investor earning an uncalled return on the position.

We see from Table 5.14 that if the investor is called out, the loss on call

out will be $5.90. This loss on call out is calculated as the total capital re-

ceived on call out ($14.10) minus the cost in the stock ($20.00).

In situations where the investor is called out in a CPR and that call out

will be unprofitable, the investor will need to rebuy the stock on the Mon-

day following expiration as the position is yet to be closed for an overall

transaction profit. The difference between the total capital received on call

out and the current market price to repurchase is the called return in a CPR

where the call out is unprofitable versus the investor’s overall cost.

Let’s look at an example using Table 5.14 and assuming a stock price at

expiration of $13.00. In this scenario, the investor will be called out on the

third Friday. Total capital received will be $14.10. If the stock price at ex-

piration is $13.00, the investor will be able to repurchase the stock on the

TABLE 5.12 CPR Worksheet Inputs

Inputs

Stock FMD

Purchase price $20.00

Net premium to date $ 0.00 0.0%

P&L analysis—start price $ 9.50

P&L analysis—$ increment $ 0.50

CPR potential strikes $10.00 $12.50 $15.00

Bid or ask Ask Bid Ask Bid

Option price $ 2.00 $0.55 $0.60 $ 0.10

Net debit CPR with $10 and $12.50 $ 0.90 4.5%

Net debit CPR with $12.50 and $15 $ 0.40 2.0%

Ask Bid Ask Bid

c05.qxd 10/23/06 2:15 PM Page 107

108

TABLE 5.13 Stock Breakeven Analysis

Stock Price at Expiration

$ 9.50 $10.00 $10.50 $11.00 $11.50 $12.00 $12.50 $13.00 $13.50 $14.00 $14.50 $15.00

Long $10 and Short $12.50

Will I get called out? No No No No No No Yes Yes Yes Yes Yes Yes

Profit (loss) if called based

on adj. cost –$ 5.90 –$ 5.90 –$ 5.90 –$ 5.90 –$ 5.90 –$ 5.90

Do I need to rebuy stock? No No No No No No Yes Yes Yes Yes Yes Yes

How much did I get all up

when called? $14.10 $14.10 $14.10 $14.10 $14.10 $14.10

Current market price to

repurchase $12.50 $13.00 $13.50 $14.00 $14.50 $15.00

Called return $ 1.60 $ 1.10 $ 0.60 $ 0.10 –$ 0.40 –$ 0.90

Uncalled return $ –$ 0.90 –$ 0.90 –$ 0.40 $ 0.10 $ 0.60 $ 1.10

Uncalled or called

return $ –$ 0.90 –$ 0.90 –$ 0.40 $ 0.10 $ 0.60 $ 1.10 $ 1.60 $ 1.10 $ 0.60 $ 0.10 –$ 0.40 –$ 0.90

Uncalled or called

return % –4.5% –4.5% –2.0% 0.5% 3.0% 5.5% 8.0% 5.5% 3.0% 0.5% –2.0% –4.5%

Adjusted cost $20.90 $20.90 $20.40 $19.90 $19.40 $18.90 $18.40 $18.90 $19.40 $19.90 $20.40 $20.90

Profit or loss if

immediately sell

stock –$11.40 –$10.90 –$ 9.90 –$ 8.90 –$ 7.90 –$ 6.90 –$ 5.90 –$ 5.90 –$ 5.90 –$ 5.90 –$ 5.90 –$ 5.90

c05.qxd 10/23/06 2:15 PM Page 108

109

Long $12.50 and Short $15

Will I get called out? No No No No No No No No No No No Yes

Profit (loss) if called based

on adj. cost –$ 2.90

Do I need to rebuy stock? No No No No No No No No No No No Yes

How much did I get all up

when called? $17.10

Current market price to

repurchase $15.00

Called return $ 2.10

Uncalled return $ –$ 0.40 –$ 0.40 –$ 0.40 –$ 0.40 –$ 0.40 –$ 0.40 –$ 0.40 $ 0.10 $ 0.60 $ 1.10 $ 1.60

Uncalled or called

return $ –$ 0.40 –$ 0.40 –$ 0.40 –$ 0.40 –$ 0.40 –$ 0.40 –$ 0.40 $ 0.10 $ 0.60 $ 1.10 $ 1.60 $ 2.10

Uncalled or called

return % –2.0% –2.0% –2.0% –2.0% –2.0% –2.0% –2.0% 0.5% 3.0% 5.5% 8.0% 10.5%

Adjusted cost $20.40 $20.40 $20.40 $20.40 $20.40 $20.40 $20.40 $19.90 $19.40 $18.90 $18.40 $17.90

Profit or loss if

immediately sell

stock –$10.90 –$10.40 –$ 9.90 –$ 9.40 –$ 8.90 –$ 8.40 –$ 7.90 –$ 6.90 –$ 5.90 –$ 4.90 –$ 3.90 –$ 2.90

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110

TABLE 5.14 Stock Breakeven Analysis

Stock Price at Expiration

$12.00 $12.50 $13.00 $13.50 $14.00 $14.50 $15.00 $15.50 $16.00

Long $10 and Short $12.50

Will I get called out? No Yes Yes Yes Yes Yes Yes Yes Yes

Profit (loss) if called based on adj. cost –$ 5.90 –$ 5.90 –$ 5.90 –$ 5.90 –$ 5.90 –$ 5.90 –$ 5.90 –$ 5.90

Do I need to rebuy stock? No Yes Yes Yes Yes Yes Yes Yes Yes

How much did I get all up when called? $14.10 $14.10 $14.10 $14.10 $14.10 $14.10 $14.10 $14.10

Current market price to repurchase $12.50 $13.00 $13.50 $14.00 $14.50 $15.00 $15.50 $16.00

Called return $ 1.60 $ 1.10 $ 0.60 $ 0.10 –$ 0.40 –$ 0.90 –$ 1.40 –$ 1.90

Uncalled return $ $ 1.10

Uncalled or called return $ $ 1.10 $ 1.60 $ 1.10 $ 0.60 $ 0.10 –$ 0.40 –$ 0.90 –$ 1.40 –$ 1.90

Uncalled or called return % 5.5% 8.0% 5.5% 3.0% 0.5% –2.0% –4.5% –7.0% –9.5%

Adjusted cost $18.90 $18.40 $18.90 $19.40 $19.90 $20.40 $20.90 $21.40 $21.90

Profit or loss if immediately sell stock –$ 6.90 –$ 5.90 –$ 5.90 –$ 5.90 –$ 5.90 –$ 5.90 –$ 5.90 –$ 5.90 –$ 5.90

c05.qxd 10/23/06 2:15 PM Page 110

Defensive Techniques 111

Monday following the third Friday for around the $13.00. This $13.00

amount is less than the $14.10 total capital received on call out. In this in-

stance, the investor will repurchase the stock for $13.00, yet the investor

has just been called out for a total of $14.10, which is a $1.10 difference.

The investor has generated a return of $14.10 – $13.00 = $1.10, or 5.5

percent. This $1.10 return is, in effect, uncalled return, or “free net cash re-

turn”; it is the same as the uncalled return received on a profitable call buy-

back or call expiration. It can be used to invest in other positions or to

reduce the cost basis or amortize the investment in the stock.

If the stock finishes the option month between $10.00 and $12.50, the

position will not be called out. The investor will need to take action to re-

alize the uncalled return or minimize the loss of the CPR. See Table 5.15.

As previously outlined, when the long call of the CPR finishes in the

money and the short call finishes out of the money, the investor must take

action on the third Friday of expiration to realize the intrinsic value in the

contract before it expires or is automatically exercised by the broker. This

process is discussed in detail in the preceding material and will involve the

investor taking the following steps on the third Friday of expiration:

1. Buy back half the short calls at around to $0.05 (they will expire worth-

less at the end of the day).

2. Sell the entire holding of long calls. This price realized will be around

intrinsic value.

3. Allow the other half of the short calls to expire worthless at the end of

the trading day.

Following this process when there is intrinsic value in the long call yet the

short calls are out of the money ensures that the uncalled return will be re-

alized or the loss on the CPR will be minimized.

We can see from Table 5.15 that any stock price at expiration greater

than $10.00 and less than $12.50 will require this action. Importantly, at a

stock price of $10.50 at expiration, this action will still need to be taken.

The result will be a loss on the CPR of 2.0 percent, rather than a loss of the

entire net debit of 4.5 percent.

If the stock finishes the option month below $10.00, then both calls

will expire worthless leaving the investor with a loss equal to the net debit

of 4.5 percent. Regardless of how low the stock price goes, this is the max-

imum loss of the CPR.

If the stock finishes the option month above $14.00, the investor will

be called out for a loss and will not be able to repurchase the stock for less

than the $14.10 received at call out. See Table 5.16. In this instance, the in-

vestor will need to repurchase the stock at the higher market price and add

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112

TABLE 5.15 Stock Breakeven Analysis

Stock Price at Expiration

$10.00 $10.50 $11.00 $11.50 $12.00 $12.50 $13.00 $13.50 $14.00

Long $10 and Short $12.50

Will I get called out? No No No No No Yes Yes Yes Yes

Profit (loss) if called based on adj. cost –$ 5.90 –$ 5.90 –$ 5.90 –$ 5.90

Do I need to rebuy stock? No No No No No Yes Yes Yes Yes

How much did I get all up when called? $14.10 $14.10 $14.10 $14.10

Current market price to repurchase $12.50 $13.00 $13.50 $14.00

Called return $ 1.60 $ 1.10 $ 0.60 $ 0.10

Uncalled return $ –$ 0.90 –$ 0.40 $ 0.10 $ 0.60 $ 1.10

Uncalled or called return $ –$ 0.90 –$ 0.40 $ 0.10 $ 0.60 $ 1.10 $ 1.60 $ 1.10 $ 0.60 $ 0.10

Uncalled or called return % –4.5% –2.0% 0.5% 3.0% 5.5% 8.0% 5.5% 3.0% 0.5%

Adjusted cost $20.90 $20.40 $19.90 $19.40 $18.90 $18.40 $18.90 $19.40 $19.90

Profit or loss if immediately sell stock –$10.90 –$ 9.90 –$ 8.90 –$ 7.90 –$ 6.90 –$ 5.90 –$ 5.90 –$ 5.90 –$ 5.90

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113

TABLE 5.16 Stock Breakeven Analysis

Stock Price at Expiration

$13.00 $13.50 $14.00 $14.50 $15.00 $15.50 $16.00 $16.50 $17.00

Long $10 and Short $12.50

Will I get called out? Yes Yes Yes Yes Yes Yes Yes Yes Yes

Profit (loss) if called based on adj.

cost –$ 5.90 –$ 5.90 –$ 5.90 –$ 5.90 –$ 5.90 –$ 5.90 –$ 5.90 –$ 5.90 –$ 5.90

Do I need to rebuy stock? Yes Yes Yes Yes Yes Yes Yes Yes Yes

How much did I get all up when

called? $14.10 $14.10 $14.10 $14.10 $14.10 $14.10 $14.10 $14.10 $14.10

Current market price to repurchase $13.00 $13.50 $14.00 $14.50 $15.00 $15.50 $16.00 $16.50 $17.00

Called return $ 1.10 $ 0.60 $ 0.10 –$ 0.40 –$ 0.90 –$ 1.40 –$ 1.90 –$ 2.40 –$ 2.90

Uncalled return $

Uncalled or called return $ $ 1.10 $ 0.60 $ 0.10 –$ 0.40 –$ 0.90 –$ 1.40 –$ 1.90 –$ 2.40 –$ 2.90

Uncalled or called return % 5.5% 3.0% 0.5% –2.0% –4.5% –7.0% –9.5% –12.0% –14.5%

Adjusted cost $18.90 $19.40 $19.90 $20.40 $20.90 $21.40 $21.90 $22.40 $22.90

Profit or loss if immediately sell stock –$ 5.90 –$ 5.90 –$ 5.90 –$ 5.90 –$ 5.90 –$ 5.90 –$ 5.90 –$ 5.90 –$ 5.90

c05.qxd 10/23/06 2:16 PM Page 113

114 COVERED CALLS

this expense to the overall cost of the position. Importantly, CPRs are con-

structed with near month or near month + 1 expirations and on stocks with

very little depth in the cycle. Extremely dramatic stock price movements are

unlikely. In the preceding example, DRL’s stock price at execution of the

CPR was $11.60. The CPR becomes unprofitable at stock price of $14.00

and higher and thus would require an increase of 20.7 percent [($14.00 –

$11.60)/$11.60)] in one month for the CPR to become profitable. This is a

very dramatic and highly improbable increase given the cycle of the stock.

More importantly, an increase in the stock price of this magnitude (20+

percent) in such a short period (one month) would normally indicate that

some fundamental changes have occurred that have increased the market’s

forecast for the company’s future earnings. It is therefore likely that the

stock price will continue to increase, and the position will no longer be

underperforming.

c05.qxd 10/23/06 2:16 PM Page 114

PART II

Calendar LEAPS

Spreads

c06.qxd 10/23/06 2:14 PM Page 115

CALENDAR LEAPS SPREAD PROCESS FLOWCHART

Enter New LEAPS Position

1. CSE Screener filter

2. Satisfy buying low rule

3. Construct LEAPS position

Buy Back Call and Set GTC on LEAPS

1. 10¢ Buyback rule or

2. 5% Buyback rule

Close Transaction or Buy Back Call

1. 5% Close on delta or

2. 5% Buyback rule

Did LEAPS sell for cost + 5%? Reinvest and

compound

proceeds

Managing LEAPS That Have Not Sold for Profit

1. Secondary call sale rules

2. Formalized seven-day rule

3. Delta effect

Defensive Techniques

1. SLR

2. Average down

3. Reposition

4. Close on delta

5. Roll out

Yes

10¢ Rule DLB

Buy Back Buy Back

Each step in the calendar LEAPS spread investing process is shown in the

flowchart above—from entering new positions, to managing positions for in-

come, to LEAPS defensive techniques. As with covered calls, investors who

are accomplished with our LEAPS method understand that there is a specific

technique to address every situation that may occur in the markets. However,

when contrasted to covered calls, there are significantly more management

and defensive techniques in LEAPS investing. Further, the addition of leverage

to the strategy makes LEAPS much more responsive to management when

compared to traditional covered calls. Part II of this book will elaborate on,

expand on, and provide an example of each step presented in the calendar

LEAPS spread process flowchart. You may wish to revisit this flowchart at the

beginning of each new topic so you can gain an understanding of where a par-

ticular rule or technique is applied in the overall investment process.

c06.qxd 10/23/06 2:14 PM Page 116

117

CHAPTER 6

As noted in Chapter 5, LEAPS stands for long-term equity anticipation

security. Despite this complicated name, LEAPS are just long-term

options. They are exactly the same as normal options, but allow in-

vestors to establish positions with expirations of up to three years.

The use of calendar LEAPS spreads is a technique similar to, yet more

sophisticated than, traditional covered calls. The mind-set for using the

technique remains the same as for using covered calls (see Chapter 2).

However, it is a technique to be used only by investors who have developed

a consistent track record of success with the covered call technique. The

LEAPS technique requires a greater time commitment than covered calls,

but provides the potential for higher returns because the compounding ef-

fect is magnified many times over. It is, therefore, ideally suited to those

who aspire to eventually make a full-time career out of the markets or those

who have more time to commit to their investments.

Calendar LEAPS spreads are most easily performed in the U.S. market.

If you wish to use them from outside the United States, you will have to sac-

rifice by adapting to working for reasonable lengths of time at unusual

hours. However, the potential returns from this technique for experienced

investors certainly justify such a sacrifice.

In our experience, portfolio growth is much more quickly achieved

using the LEAPS technique when compared to traditional covered calls.

An Introduction

to Calendar

LEAPS Spreads

c06.qxd 10/23/06 2:14 PM Page 117

ADVANTAGES OF THE LEAPS TECHNIQUE

In a calendar LEAPS spread, we buy a LEAPS for cover rather than buying

a stock. The advantages of this technique over writing covered calls are nu-

merous and include the following:

• Investors are able to use higher-priced stocks (many of which are the

bluest of blue chip). Investors would not normally be able to use these

higher-priced stocks with the covered call technique because the un-

called and called returns would not be high enough.

• Investors are able to utilize the leverage offered by options, as they can

control stock using LEAPS with a much lower capital outlay and at

much lower prices compared to investing in the stock. Thus the ability

to completely amortize (reduce) the cost of a position is dramatically

increased when using the calendar LEAPS technique because, rather

than paying, for example, $30.00 for a stock, an investor will purchase

a LEAPS contract for $10.00 or less (when following the rules outlined

in this book). When the same calls are sold against this much cheaper

LEAPS, the cost is amortized to zero many times faster.

• Investors are able to much more directly take advantage of upward

movements in the stock price. Where they would normally have to wait

for the end of the month to be called out, calendar LEAPS spreads

allow investors to close out the transaction immediately if the stock

price increases, thus allowing much greater compounding of the asset

base.

• Investors are able to be much more proactive in the management

process when the position is not performing well. This ability assists in

maintaining high returns regardless of the direction of the market.

• Because of leverage, investors are effectively able to have the benefits

of investing on margin without the detractions of margin (margin calls,

etc).

The most significant advantage of LEAPS over covered calls is that

they enable experienced investors to close out a transaction potentially

many times per month. This capability allows much higher returns and far

superior compounding of an investor’s asset base.

Growth Through Cash Flow

Correct application of the LEAPS technique provides portfolio growth

through cash flow rather than speculative appreciation. When using cov-

118 CALENDAR LEAPS SPREADS

c06.qxd 10/23/06 2:14 PM Page 118

ered calls, our objective is a cash return of around 4 percent per month,

which equates to 48 percent cash return per year (uncompounded) or

nearly 100 percent over two years (uncompounded). When using the

LEAPS technique, our return objectives are much higher; we aim to achieve

consistent monthly cash returns in the high single digits to low teens.

Being Prepared for Extreme Fluctuations

in Position Market Value

As previously stated, the calendar LEAPS spreads technique is an advanced

covered call technique. Only investors who have developed a consistent

track record of success with the covered call technique should use LEAPS.

Having such a track record is necessary because of the extreme fluctuation

in position market value while managing calendar LEAPS spread positions

for cash flow until a profitable exit is realized. Investors must understand

that LEAPS are leveraged instruments and their market value fluctuates sig-

nificantly on a daily basis.

Take the two positions shown in Table 6.1 as an example of leverage.

Investors A and B both create a position in JPM at the same time. Investor

A purchases the stock at $30.00, while investor B purchases a JPM LEAPS

for $6.00. Remember, these two purchases are made at the same time—the

JPM stock price is $30.00. The stock then declines 10 percent. Investor A

has suffered a 10 percent market value decline in the value of his position.

However, investor B, who purchased a JPM LEAPS, has suffered a 35 per-

cent market value decline in the value of his position. This is a significant

market value decline and is the result of leverage.

Experienced investors who are familiar with the covered call technique

understand the mind-set required to never sell a position for a loss and, in-

stead, to continue to generate and compound cash flow from a fallen posi-

tion. Those experienced with the correct application of the covered call

technique understand that stock prices of good companies go up and down

and that cash flow can be consistently generated regardless of market

An Introduction to Calendar LEAPS Spreads 119

TABLE 6.1 An Example of Leverage

Asset Asset Stock Asset Asset

Investor Purchased Price Declines Price Decline

A JPM Stock $30.00 10% $27.00 10%

B JPM LEAPS $ 6.00 10% $ 3.90 35%

c06.qxd 10/23/06 2:14 PM Page 119

direction. For those unaccustomed to the technique, “never selling a posi-

tion for a loss” is merely a catch phrase, and many investors find this tem-

porary market value loss too large a psychological hurdle. Experienced

LEAPS investors understand that correct management of a position leads

to the complete amortization of the position, in most instances, in less than

one year. Investors using the LEAPS technique must understand and accept

market value fluctuations. They must remain focused on the primary ob-

jective: consistently generating and compounding cash flow.

USING LEAPS FOR COVER

A covered call is defined as selling a call when holding the underlying stock

or another covering option on the same stock. In Chapter 2, “An Introduc-

tion to Covered Calls,” we explained selling a covered call and being cov-

ered by the stock. This section explains how to be covered by owning a

long-term option (LEAPS).

The rules for constructing and managing LEAPS positions are dis-

cussed in subsequent chapters, but, for now, let’s gain an understanding of

how to be covered by a LEAPS instead of a stock. Here is an example.

Citigroup stock is currently trading at $46.00. Let’s assume we purchase

a Citigroup January 2007 $40.00 LEAPS for $8.00 (remember, this is just a

normal option with a very long expiration). We then go ahead and sell a

December 2004 $47.50 call for $1.40. Our position is as follows.

Long Jan 2007 $40.00 Call at $8.00

Short Dec 2004 $47.50 Call at $1.40

There are two separate return calculations that you must compute and

be aware of for every LEAPS transaction: the uncalled return and the called

return.

The uncalled return is also known as the “percentage return,” “down-

side protection,” or “yield” and is simply the premium you received on the

call sale divided by the cost of the LEAPS. So in our example we purchased

a LEAPS for $8.00 and sold a call for $1.40. The uncalled return in this in-

stance is $1.40/$8.00 = 17.50 percent, which is a very large return and is the

result of leverage working in our favor.

The called return is the return the investor realizes in the event that the

short call is exercised or called out. The formula for calculating the called

return is:

Called return = Strike call – Strike LEAPS – LEAPS price + Call price

120 CALENDAR LEAPS SPREADS

c06.qxd 10/23/06 2:14 PM Page 120

To calculate the called return, you must understand what happens in the

event of a call out. Using our example:

• If we are called out, we have the obligation to deliver Citigroup stock at

a price of $47.50. As we own the LEAPS, we have the right to buy Citi-

group stock at a price of $40.00.

• In the event of a call out, our broker will automatically exercise the

LEAPS on our behalf. We will thus automatically buy the stock at a

price of $40.00 and sell the stock at a price of $47.50. We have recov-

ered $7.50 of our capital investment on the stock sale.

• As with covered calls, we get to keep the $1.40 that we sold the call for.

Our total return of capital would, therefore, be:

Return of capital = Strike call – Strike LEAPS + Call price

= $47.50 – $40.00 + $1.40

= $8.90

Remember, we invested $8.00 in this transaction, so the called return would

be $8.90 - $8.00 = $0.90 or 11.3 percent ($0.90/$8.00)

Again, the formula for calculating the called return is:

Called return = Strike call – Strike LEAPS – LEAPS price + Call price

In this instance, then:

Called return = $47.50 – $40.00 – $8.00 + $1.40

= $0.90, or 11.3% ($0.90/$8.00)

So we now know how we can substitute the stock with a LEAPS and

still sell a covered call.

An Introduction to Calendar LEAPS Spreads 121

c06.qxd 10/23/06 2:14 PM Page 121

c06.qxd 10/23/06 2:14 PM Page 122

123

CHAPTER 7

SOME BASICS

Markets to Invest In

Unlike traditional covered calls, LEAPS investors are restricted to the U.S.

market. Only the U.S. option market has adequate size and liquidity to ef-

fectively implement a calendar LEAPS strategy.

If you wish to utilize these techniques from outside the U.S., you will

have to adapt to working for reasonable lengths of time at unusual hours.

This is a sacrifice; however, the potential returns from this technique for

experienced investors certainly justify such a sacrifice. You will also need

to be cognizant of foreign exchange risk (see Appendix B).

The Importance of Diversification

Our objective with LEAPS is to construct a well-diversified portfolio of 15

to 20 positions. One significant advantage of LEAPS over conventional cov-

ered calls is that you are able to invest in the bluest of blue-chip stocks—

including those that are generally excluded to covered call investors due to

their high stock prices and subsequent low yields.

You must construct a portfolio with a broad representation of indus-

tries. You should also construct your portfolio using only large capitaliza-

tion stocks (those with a market capitalization greater than US$5 billion)

from the Dow Jones Industrial Average, the S&P 500, and the NASDAQ.

These are the bluest of blue-chip companies available for public invest-

ment anywhere in the world. Apart from rare instances (Enron, WorldCom,

Entering New

LEAPS Positions

c07.qxd 10/23/06 2:12 PM Page 123

etc.) it is very uncommon for these companies go out of business—and

that is the only time we ever lose money on a properly constructed position.

Your portfolio should include companies from the industries listed in

Table 7.1. As you can see, there are eleven individual sectors. You should

try to include about two stocks from each of these sectors in the construc-

tion of your LEAPS portfolio.

The importance of diversification cannot be stressed enough. Investors

must spread risk between various stocks in different industries. Given the

low price of LEAPS contracts (the contracts that investors will purchase

following the rules in this book are usually priced between $4.00 and

$10.00), a portfolio of 15 LEAPS positions can be constructed with as little

as $6,000.

THE RULES FOR ENTERING

NEW LEAPS POSITIONS

A new calendar LEAPS position involves buying a LEAPS and selling a call.

The six rules for entering into new LEAPS positions are:

1. You can only establish new positions on down market days. A down

market day is any time when the Dow and the NASDAQ are in the red

(trading lower than the close of the previous day).

124 CALENDAR LEAPS SPREADS

TABLE 7.1 Industries Suitable for LEAPS Investing

Sector Example of Industry

Financial Banks, insurance companies, investment services

Health care Biotechnology and drugs, health care facilities, major

drugs

Consumer noncyclical Beverages, food, household products

Consumer cyclical Apparel, footwear, autos

Basic materials Chemical manufacturing, paper products, plastic and

rubber

Technology Computer equipment, semiconductors, software

Transportation Air, railroads, trucking

Capital goods Aerospace and defense, construction services and

machinery

Utilities Electrical, natural gas, water

Energy Coal, oil and gas, services and equipment

Services Advertising, broadcasting and cable, retail

c07.qxd 10/23/06 2:12 PM Page 124

2. Use the CSE Screener to filter all stocks in the market for the funda-

mental criteria (see the following section) for LEAPS investments.

3. You must follow the rules for correctly constructing a LEAPS position

(discussed later in this chapter). These rules are imbedded in the CSE

Screener.

4. Ensure that the stock adheres to the buying low rule for LEAPS (dis-

cussed later in this chapter).

5. Always give priority to maintaining acceptable levels of diversification

between stocks and industries—even if a stock you are already in-

vested in presents an excellent opportunity.

6. Buy the LEAPS first and then immediately sell the call. Do not hesitate.

If you buy the LEAPS and wait for a better price for the call, you are no

better than a speculator, and you will get burned!

USING THE CSE SCREENER TO FILTER

LEAPS INVESTMENTS

The first step in the LEAPS process investment flowchart (Figure A.2 on

page 190) is to use the CSE Screener to identify a potential LEAPS invest-

ment. The CSE Screener is a proprietary covered call and LEAPS search

and filter tool designed, developed, and maintained by Compound Stock

Earnings. The CSE Screener allows investors to quickly and easily search

the stock market for the highest returning covered call or LEAPS positions

that meet specific fundamental, technical, and construction requirements.

The tool is tailored to accommodate the criteria and rules established in

this book for selecting LEAPS positions.

Anyone who purchases Covered Calls and LEAPS—A Wealth Option is

entitled to one month’s complimentary access to the Covered Call Toolbox

(which includes the CSE Screener) by going to www.compoundstockearn

ings.com/freemonth. Thus readers can actually use the tools while learning

about them in this book.

Selection Parameters

The eight parameters you should use to filter LEAPS positions are:

1. Uncalled return of minimum 10 percent.

2. Called return of greater than 0 percent

3. Price-earnings ratio (PE) of 70 or less.

4. Market capitalization of US$5 billion or more.

Entering New LEAPS Positions 125

c07.qxd 10/23/06 2:12 PM Page 125

5. Stock price between $25.00 and $100.00.

6. Average broker recommendation of 2.5 or less.

7. An aggregate of the brokers recommending the stock as “Strong Buy”

and “Buy” greater than the number of brokers recommending the stock

as “Hold.”

8. A consensus earnings per share (EPS) estimate for “Next Fiscal Year”

forecast to be greater than the consensus EPS estimate for “This Fiscal

Year.”

Rationale Behind CSE Screener LEAPS Filters

The fundamental filters for LEAPS and covered calls are slightly different.

The LEAPS technique provides the opportunity to exit positions much

faster than traditional covered calls, and the companies in which we invest

are inherently lower risk due to their larger size, established positions in

the market place, very high levels of broker coverage, and increased visi-

bility of earnings. As such, it is necessary to alter the selection criteria for

LEAPS investments.

Uncalled and Called Returns The uncalled return filter of 10 percent

or greater ensures we are entering a transaction with adequate return to

correctly manage the position. The uncalled return is vitally important as it

affects our ability to buy back the call for a profit under a scenario of a

small stock price decline after entering the transaction. This scenario is dis-

cussed in Chapter 8.

The called return filter of 0 percent or greater simply ensures we are en-

tering a transaction that will provide a positive return if called out. While our

objective when entering a LEAPS position is not to be called out, and the

calls sold are not near month, which all but eliminates the chance of a call

out, a position should never be constructed where a loss will be realized on

call out. When assessing two positions with different called returns, in-

vestors should not view the position with a higher called return more favor-

ably. The only consideration is if the position has a positive called return.

PE Ratio The PE ratio filter of 70 or less reflects the fact that with

LEAPS investing, we are dealing with the bluest of blue-chip companies.

We thus allow a higher PE ratio than with traditional covered calls. Unlike

covered calls, LEAPS allow investment in much higher priced stocks due to

the leverage offered by buying the LEAPS rather than the stock itself.

126 CALENDAR LEAPS SPREADS

c07.qxd 10/23/06 2:13 PM Page 126

Market Capitalization The market capitalization filter of $5 billion or

greater ensures that we are investing in a company of significant size, with

substantial earnings. A company is generally considered blue chip when it

has a market capitalization of $5 billion or greater. LEAPS investors should

construct positions on qualifying companies from the Dow Jones Industrial

Average, the S&P 500, and the NASDAQ. These are the bluest of blue-chip

companies available for public investment anywhere in the world.

Stock Price We also now only select stocks that are priced between

$25.00 and $100.00. We do not invest in stocks under $25.00 as lower priced

stocks limit leverage in the LEAPS position and also the application of the

formalized seven-day rule, which is discussed in Chapter 8. Stocks with

prices over $100.00 are also excluded because they are inherently more

risky for this technique due to limiting the application of the formalized

seven-day rule.

Broker Recommendations An average broker recommendation of 2.5

or less ensures that the stock is rated at least an average of “buy” by the an-

alysts who cover it. This statement does not imply that we value or follow

the opinions of brokers. However, the brokerage community will be in the

markets promoting the stock and the masses will be providing buying sup-

port for the stock. More importantly, the stock is not likely to go out of busi-

ness in the short term.

The aggregate of the brokers recommending the stock as Strong Buy

and Buy must be greater than the number of brokers recommending the

stock as Hold. This criterion simply ensures that more brokers are positive

on the stock than are neutral.

Earnings per Share A forecast consensus EPS estimate for “Next Fis-

cal Year” greater than the consensus EPS estimate for “This Fiscal Year”

simply ensures that the brokers covering the stock believe that the com-

pany’s earnings will grow next fiscal year and helps prevent investors from

buying stocks that are going into a period of contracting earnings.

Readers familiar with the traditional covered call technique will notice

that with LEAPS investing, we drop the 75 percent of the 52-week trading

range. This omission reflects the more short-term nature of LEAPS invest-

ments compared to covered calls. It is not necessary to hold a LEAPS in-

vestment to wait for a call out at the end of the month. A LEAPS position

can be quickly and profitably closed out with a very small increase in the

underlying stock price.

Entering New LEAPS Positions 127

c07.qxd 10/23/06 2:13 PM Page 127

Directions for Using the CSE Screener

To access the covered call search tools, you need to establish a username

and password from www.compoundstockearnings.com/freemonth. Then

do the following:

1. Go to www.compoundstockearnings.com/cctoolbox.

2. Enter your username and password.

3. Click Log On.

4. Click CSE Screener—LEAPS.

The CSE Screener will search the entire market to find all the stocks

that meet the stipulated fundamental and technical criteria. It then looks

at the option chains on these stocks and correctly constructs LEAPS

positions using the position construction rules outlined later in this

chapter.

Correct construction is absolutely critical. Without correct construc-

tion, it is highly unlikely that the investor will be able to exit the position

quickly and profitably with a small increase in the stock price. Additionally,

management for cash flow will be very difficult if the entry position is in-

correctly constructed.

The CSE Screener then presents a list of potential positions to the in-

vestor. All positions meet the fundamental requirements listed previously

(PE ratio, market capitalization, broker rating, etc.) and are correctly con-

structed to expedite a profitable close out and assist management for cash

flow.

Figure 7.1 is a typical screenshot of the CSE Screener for LEAPS trans-

actions. Each position presented by the screener meets both the funda-

mental and construction criteria outlined in this book.

Remember, The CSE Screener only filters for fundamental criteria and

correctly constructs the position. You must ensure that companies meet the

technical criteria (upward or sideways moving stock and adherence to the

buying low rule discussed in the next section) before entering the position.

The fundamental and construction criteria for selecting LEAPS posi-

tions have remained substantially the same for many years. However, from

time to time, the criteria have been modified to adapt to the current condi-

tions of the market. When such a change is needed, the authors adapt the

default criteria of the CSE Screener to keep investors in step with the cur-

rent conditions of the markets. Therefore, it is highly recommended that in-

vestors simply use the default criteria of the CSE Screener when searching

for new positions.

128 CALENDAR LEAPS SPREADS

c07.qxd 10/23/06 2:13 PM Page 128

USING PRICE CHARTS WITH THE

LEAPS TECHNIQUE

Simply because the CSE Screener has presented a position does not auto-

matically qualify it as an acceptable investment. Revisit the “Rules for En-

tering New LEAPS Positions” listed earlier. At this point we just want to

emphasize the rule that relates to price charts:

• Ensure that the stock adheres to the buying low rule for LEAPS.

Before entering a new LEAPS position, investors must assess the stock’s

chart. Correct assessment of the price chart is absolutely critical to opti-

mizing returns when using the LEAPS technique. Investors who get caught

up in hype and buy when markets are going up or who panic and sell when

Entering New LEAPS Positions 129

FIGURE 7.1 Sample screenshot of the CSE Screener for LEAPS transactions.

c07.qxd 10/23/06 2:13 PM Page 129

markets are going down are categorically the losing investors in the mar-

kets. You must buy low and sell high: You must buy when markets are

falling and sell when markets are rising. If you were selling any product as

a business venture, you would be attempting to buy the product low and to

sell it high. Financial markets are no different. The importance of this rule

cannot be stressed enough.

The detailed information provided in the “Using Price Charts” section

in Chapter 3 also applies to entering a LEAPS position. Review the mater-

ial therein about identifying and assessing price cycles and how to look at

a price chart. And remember: If you do not understand a chart, do not invest

in the stock.

THE BUYING LOW RULE FOR LEAPS

The second step in the LEAPS investment process flowchart (Figure A.2 on

page 190) is to satisfy the buying low rule. The buying low rule defines the

point in the stock’s price cycle at which an investor can enter into new po-

sitions. It attempts to ensure that investors are buying when prices are low.

The three components of the rule are:

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 at minimum $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 up-

ward movement in the stock price to exit the position.

By ensuring that you enter into new positions on stocks whose general

or current cycle is either increasing or horizontal and the stock is trading in

the lower end of the cycle, the buying low rule provides you with greater

probability that the stock price will increase and allow you to close out the

transaction.

Implementing the Buying Low Rule

Figures 7.2 through 7.14 provide examples of implementing the buying low

rule. Study each of these carefully. Turnover of capital (meaning the quick

and profitable exit of positions) is critical to your success as a LEAPS in-

vestor. Correct assessment of the price chart expedites the profitable exit

130 CALENDAR LEAPS SPREADS

c07.qxd 10/23/06 2:13 PM Page 130

of LEAPS positions. Incorrect assessment of the price chart leads to in-

creasing the number of positions that require management for income.

Bottom 25 Percent of an Overall Rising or Horizontal Cycle

We can see in Figure 7.2 that the overall trend for HON is rising because

the significant bottoms and tops on the chart are getting higher. We can

also see that there is around $5.00 of price depth in the cycle (~$38.50 –

~$33.50). HON is also reaching the bottom 25 percent of the overall rising

cycle (indicated by the stock’s movement below the bold line drawn on the

chart). This is the safest and most profitable chart position for a new

LEAPS investment. Given the position on the chart, it would be ideal to con-

struct a LEAPS position on HON now.

Investing at or below the bottom 25 percent of an overall rising or hor-

izontal cycle is ideal for LEAPS positions.

Let’s look at another example in Figure 7.3. To assist us in identifying

when the stock is trading in the lower 25 percent of its price cycle, we draw

in a 50 percent line directly in the middle of the upper and lower lines

(should be parallel). We can see from the chart in Figure 7.3 that the over-

all trend for PG is horizontal with slight upward bias, because the signifi-

cant bottoms and tops on the chart are generally stable with slight upward

bias. We can also see that there is around $7.00 of price depth in the cycle

(~$58.00 – ~$51.00). Again, this is the safest and most profitable chart po-

sition for a new LEAPS investment. Given the position on the chart, it

would be ideal to construct a LEAPS position on PG now.

Entering New LEAPS Positions 131

Only invest in new positions when the stock is trading

at or below 25% of the generally rising price cycle.

FIGURE 7.2 Identifying the bottom 25 percent of an overall rising cycle.

c07.qxd 10/23/06 2:13 PM Page 131

132 CALENDAR LEAPS SPREADS

Only invest in new positions when the stock is trading at

or below 25% of a current rising or horizontal price cycle.

FIGURE 7.4 Identifying the bottom 25 percent of a current rising cycle.

Only invest in new positions when the stock is trading

at or below 25% of a generally horizontal price cycle.

FIGURE 7.3 Identifying the bottom 25 percent of a horizontal cycle.

c07.qxd 10/23/06 2:13 PM Page 132

Entering New LEAPS Positions 133

Investing at or below the bottom 25 percent of an overall rising or hor-

izontal cycle is ideal for LEAPS positions.

Bottom 25 Percent of a Current Rising Cycle When the stock

drops into the lower 25 percent of the price channel (below the bolded

line), it qualifies under the buying low rule. We can see that Figure 7.4 dif-

fers significantly from the preceding examples. In contrast, this stock is not

in an overall rising cycle, but the current cycle is rising. This chart is also

optimal for constructing new LEAPS positions.

Investing at or below the bottom 25 percent of a current rising cycle is

ideal for LEAPS positions.

We can see that Figure 7.5 also differs significantly from the preceding

examples. In this case, the current cycle is horizontal with slight upward

bias. Again, this chart is optimal for constructing new LEAPs positions.

When Constructing a Position at the Bottom 25 Percent

of a Current Rising or Horizontal Cycle Is a Poor Choice

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 posi-

tion. The following examples apply to chart interpretation for both cov-

ered call and LEAPS positions.

Only invest in new positions when the

stock is trading at or below 25% of a

current rising or horizontal price cycle.

FIGURE 7.5 Identifying the bottom 25 percent of a current cycle that is

horizontal with a slight upward bias.

c07.qxd 10/23/06 2:13 PM Page 133

1. Bottom of a Current Rising Cycle That Is Part of a Longer-

Term Downward Cycle Perhaps the most common chart misinterpre-

tation made by novice investors is not recognizing that a current rising

cycle is part of a longer-term downward cycle. This is the result of an in-

vestor ignoring the longer-term cycle of the stock. This shortsightedness

leads investors to construct positions in a short-term upward cycle that is

merely the continuation of a longer-term downward cycle.

Study Figure 7.6. We can see that while BSX is in a current rising cycle,

the overall cycle is down. Now compare Figure 7.6 to Figure 7.7. Notice in

Figure 7.7 that the top of the declining price cycle has been substantially

broken by the current rising cycle. This differs from Figure 7.6 where the

current rising cycle was still trading within the declining price cycle.

Do not invest in a stock where the current rising cycle has not sub-

stantially broken through the top of the overall declining price cycle. This

occurrence is critically important to prevent misinterpretation of the cur-

rent cycle of the stock.

Let’s look at another example. Study Figure 7.8. Again, we can see that

the current rising cycle is actually a part of the long-term declining cycle.

LEAPS positions should not be constructed at the bottom of such a cycle.

2. Current Cycles That Are Close to the Yearly High Another

common chart misinterpretation by novice investors is investing at the bot-

tom of current cycles that are very close the yearly high for the stock. This

134 CALENDAR LEAPS SPREADS

The rising current price cycle is actually a part

of the declining longer-term price cycle.

FIGURE 7.6 A rising current cycle that is part of a long-term downward cycle.

c07.qxd 10/23/06 2:13 PM Page 134

Entering New LEAPS Positions 135

The current rising cycle has substantially broken

through the top of the declining price cycle.

FIGURE 7.7 Evidence that the overall cycle is increasing.

The rising current cycle is actually a part of the

declining longer-term price cycle.

FIGURE 7.8 Another rising current cycle that is part of a long-term

declining cycle.

c07.qxd 10/23/06 2:13 PM Page 135

point, in many instances, is a “greed trap,” where investors see a stock con-

tinually rising over a yearly time frame and they are entering into new po-

sitions very near to the yearly high for a stock. While this strategy is fine if

the stock continues its strength, eventually it will turn around. Investors

who consistently enter new positions near the yearly high will accumulate

a portfolio of underperforming positions that require management for in-

come. When a stock breaks cycle after making a yearly high, it may be

months or even years before the stock price ever trades higher than this

major yearly high. Very few stocks can consistently make yearly highs

month after month. All stocks eventually cycle down.

Remember, our objective when using the buying low rule is to buy

when markets are falling and to enter a position at the lower point of the

market. We do not want to be caught up in the hype of the losing investors

who consistently buy stocks at the high end of the market. At this point, it

is important to think about what the term “buying low” actually means.

“Buying low” means entering into a position at an inexpensive price relative

to the market. Relativity is the key word. We want to enter into new posi-

tions at a relatively inexpensive price compared to what other investors

have recently paid for the stock. Relativity is the key.

See, for example, Figures 7.9 and 7.10. Figure 7.9 shows entering a new

position in the lower 25 percent of an overall rising cycle. Figure 7.10 high-

lights the entry point from Figure 7.9, the point where we are comfortable

constructing a new LEAPS position if we were assessing this chart today.

This point is the lower 25 percent of the overall rising cycle. Notice that

many investors have recently paid prices significantly higher than our entry

price. Relatively speaking, our entry price is inexpensive.

Similarly, Figure 7.11, on Dell, shows entering a new position under the

buying low rule at the bottom of a current horizontal cycle. Notice in Figure

7.12 that the vast majority of investors have recently paid prices signifi-

cantly higher than our entry price. Again, relatively speaking, our entry

price is inexpensive.

Now that we more fully understand the concept of buying low, let’s ad-

dress the common mistake of investing at the bottom of a current rising

cycle that is very close to the yearly high for a stock. Take Figure 7.13 as an

example. It is clear that this stock is both in an overall upward cycle and

within the bottom 25 percent of this cycle. Why then, is this a very poor

place to construct a new LEAPS position? See Figure 7.14 for the answer.

We can see very clearly from Figure 7.14 that while the stock is gener-

ally rising over a yearly time frame and is at the bottom of a current rising

cycle, we are paying almost the yearly high for the stock. Very few investors

136 CALENDAR LEAPS SPREADS

c07.qxd 10/23/06 2:13 PM Page 136

Entering New LEAPS Positions 137

Only invest in new positions when the stock is trading at

or below 25% of a generally horizontal price cycle.

FIGURE 7.9 Entering a new position in the lower 25 percent of an overall

rising cycle.

Many investors have paid higher prices for the

stock compared to our entry price.

FIGURE 7.10 Relative entry price.

c07.qxd 10/23/06 2:13 PM Page 137

have recently purchased the stock at higher prices. We are, in actuality,

buying high, rather than low. We are getting caught up in the hype and ex-

uberance of a strongly appreciating stock price.

This is a very poor place to construct a LEAPS position. Sure, the stock

may continue its strong run upwards and we may quickly exit the position.

However, in the event that the stock does turn around and makes a signifi-

138 CALENDAR LEAPS SPREADS

Only invest in new positions when the

stock is trading at or below 25% of a

current horizontal price cycle.

FIGURE 7.11 Entering a new position at the bottom of a current

horizontal cycle.

The majority of investors have paid higher prices

for the stock compared to our entry price.

FIGURE 7.12 Relative entry price.

c07.qxd 10/23/06 2:13 PM Page 138

cant change in trend, it is very unlikely that there will be higher prices for

the stock for months, if not years. As such, we will be forced into a pro-

tracted period of management for income on this position (management for

income is discussed in depth in Chapter 8). While there are numerous man-

agement rules and techniques that allow the continued generation of in-

come from a position regardless of market direction, having to rely on

Entering New LEAPS Positions 139

FIGURE 7.13 A stock in an upward cycle and within the bottom 25 percent of

the cycle.

The vast majority of investors have paid lower

prices for the stock compared to our entry price.

FIGURE 7.14 A current rising cycle that is actually very close to the yearly high.

c07.qxd 10/23/06 2:13 PM Page 139

management for cash flow is not the optimal outcome. The optimal out-

come for LEAPS investors is to quickly enter and exit LEAPS transactions.

The regular reinvestment of capital plus cash returns allows for fast and

dramatic compounding of the asset base.

Whenever entering a new position, investors should ask themselves:

“Am I paying a relatively cheap or expensive price? Have many investors

recently purchased the stock at a higher price than my entry price?” As

we have just seen, the answers will reveal the suitability of entering the

position.

Identifying a Change in the Cycle and the

First Buy Point

We now understand that new LEAPS positions can only be constructed at

the bottom 25 percent of an overall or currently rising or horizontal cycle.

Therefore, two very important skills are needed:

1. Knowing how to identify a change in cycle.

2. Knowing how to identify the first buy point of a new price cycle.

How to Identify a Change in Cycle This topic applies equally to cov-

ered call and LEAPS techniques. However, it is discussed in this section

rather than in Part I, Covered Calls, since it is an advanced charting tech-

nique. Investors using both techniques can use this to understand a change

in cycle from declining to rising and to, consequently, identify the first

buy point of a new rising cycle. In each and every change in cycle from de-

clining to rising, two chart events occur. These events do not necessarily

occur in the same order for each individual change in cycle and they do

not guarantee a change in cycle; however, both events do occur each and

every time a cycle actually changes direction. Therefore, investors should

be watching cycles for these events—and when they unfold, they warn of a

potential change in cycle. Because we are talking about entering into new

positions, we are assessing a change from a declining to a rising cycle.

The two chart events that occur in each and every change of trend

from a declining to a rising cycle are:

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.

Without these two events occurring, a change of cycle direction cannot

take place. Therefore, watching for and identifying these events as they

140 CALENDAR LEAPS SPREADS

c07.qxd 10/23/06 2:13 PM Page 140

occur is an excellent early warning to watch for a change of cycle direction.

See the examples in Figures 7.15 and 7.16.

Now that we know that when following a declining cycle, higher bot-

toms and a break to the top of the declining cycle provide a red flag that the

cycle may, in fact, be about the change, we need to know how to identify

the first buy point of a new, rising cycle.

Entering New LEAPS Positions 141

1. Higher bottom; in this instance,

within the declining price cycle

2. Break through the top of the

declining price cycle

FIGURE 7.15 Identifying a change in cycle.

1. Higher bottoms; in this instance,

within the declining price cycle

2. Break through the top of the

declining price cycle

FIGURE 7.16 Another example of identifying a change in cycle.

c07.qxd 10/23/06 2:13 PM Page 141

How to Identify the First Buy Point of a New Price Cycle The

most difficult part of the buying low rule for LEAPS is identifying the first

buy point of a new price cycle. The first buy point of a new price cycle is lit-

erally the first point in a new cycle at which the buying low rule is satisfied.

This definition does not mean that new positions can only be constructed

at the first buy point; however, the first buy point provides confirmation of

a new rising cycle.

The first buy point of a new cycle is always preceded by a minimum of

two tops and a minimum of one bottom. The second top must be higher than

the first; otherwise the cycle is declining and is ineligible for investment.

Study Figure 7.17. We can see that the first buy point of a new cycle is

always preceeded by a mimimum of two tops (the second top being higher

than the first) and a minimum of one bottom. The first buy point can then

easily be estimated by first connecting the higher tops, identifiying the first

bottom of the cycle, and then extrapolating a bottom parallel line from this

bottom. Remember, when attempting to identify the first buy point, the sec-

ond bottom of the cycle is yet to form—the bottom line must be estimated

by drawing a parallel line from the first bottom.

Remember, this technique is only a tool for identifying the first buy

point of a new cycle. It is not necessary to only enter new positions at the

first buy point. It is completely reasonsable to enter into new positions

after the current rising cycle is well established (after it has made several

higher bottoms and tops).

142 CALENDAR LEAPS SPREADS

2. Minimum of one bottom.

Draw bottom line parallel to tops. 3. First buy point; 25%

of current rising cycle.

1. Minimum of two tops. Second top is

a higher top. Draw top trend line.

FIGURE 7.17 Identifying the first buy point of a new price cycle.

c07.qxd 10/23/06 2:13 PM Page 142

CONSTRUCTING A LEAPS POSITION

Now that we understand how to use the CSE Screener to identify a poten-

tial LEAPS position and how to qualify a stock using the buying low rule,

we are ready to discuss position construction. The CSE Screener only pre-

sents positions that follow the correct construction rules as outlined in this

section, which is a significant advantage to investors, as position construc-

tion has already been performed. However, it is essential that investors un-

derstand the fundamental rules and reasoning behind the construction of a

position. So let’s look at the rules for constructing a LEAPS position.

Selecting a LEAPS

• You must select a LEAPS that is one strike price in the money. The rea-

son for this requirement relates to the delta ratio, which is discussed

later in this chapter.

• You may not select a LEAPS that costs more than $10.00; the less it

costs, the better. Low cost is necessary to generate leverage. Also, the

higher the cost of your LEAPS, the more difficult the position will be to

manage in a market downturn.

• The LEAPS selected must have at minimum 12 months to expiration,

with the longest-term LEAPS available always given preference.

Selecting the Call

• You must sell a call as soon as you buy a LEAPS. If you wait to get a

higher price for the call, you are no better than a speculator and you

will get burned!

• You must select a call that results in a positive called return. To make

this selection, take the LEAPS strike price and add the cost of the

LEAPS and you will arrive at an approximate strike price for the call.

• The call expiration that you select must not be equal to the expiration

of the LEAPS. The shortest-term call that meets the requirements for a

correct construction should be selected to allow management depth

(discussed later).

• The call selected must combine with the LEAPS selected to have a

delta ratio (see next section) of 1.90 or more.

Let’s look at an example of constructing a calendar LEAPS Spread on

JP Morgan (JPM). For the purpose of this example, assume that the fun-

damental and buying low rule requirements have been met and that the

CSE Screener is not being used. Remember, the CSE Screener will not

present a position for investment unless it meets the construction rules.

However, it is essential that investors understand these rules and the logic

behind them.

Entering New LEAPS Positions 143

c07.qxd 10/23/06 2:13 PM Page 143

Refer back to Table 1.7 (on page 12), which shows an option chain for

JPM. (Option chains on U.S. stock are available as part of the Compound

Stock Earnings Covered Call Toolbox.) An option chain is just a list of all

available option contracts on a particular stock and the prices the contracts

are trading in the market.

To construct a LEAPS Position on JPM according to the rules, we need

to select a LEAPS that is (1) one strike price in the money; (2) not more

than $10.00 in value; and (3) the longest-term LEAPS available in the option

chain.

The first step is to go out to the longest-term LEAPS available. From

the option chain shown as Table 1.7, the longest-term LEAPS available is

the January 2007. We then need to find the January 2007 LEAPS that is

one strike price in the money. As JPM is trading at $39.38, the $35.00

strike is one strike price in the money. We need to invest in a LEAPS that

costs no more than $10.00. We can buy the January 2007 $35.00 for $7.30.

(If the January 2007 $35.00 were more than $10.00, we would simply disre-

gard this position and identify a new stock for investment. However, it is

not necessary to do so in this instance, as we have met the selection crite-

ria.) We will try to construct a spread using the January 2007 $35.00 for

$7.30.

We now need to select a call to sell against this LEAPS. From the rules

we know that we must select a call that (1) results in a positive called re-

turn and (2) a minimum uncalled return of 10 percent; (3) whose expiration

is not equal to the expiration of the LEAPS selected (the shortest-term call

that allows a correct construction should be selected); and (4) has a delta

ratio of 1.90 at a minimum.

Next we need to select the call strike price. Remember, our goal is to

ensure that we create a position with a positive called return and an

uncalled return of minimum 10 percent. We estimate the correct call strike

price that will provide a positive called return by adding the LEAPS

strike price of $35.00 to the cost of the LEAPS. So we add $35.00 to $7.30 for

a total of $42.30. We should thus attempt to sell a $42.50 call for a mini-

mum uncalled return of 10 percent. The cost of the LEAPS is $7.30, so we

need to sell a call for $0.73 or more (10 percent or more). We look at the op-

tion chain (Table 1.7) for a $42.50 strike call that we can sell for $0.73 or

more.

We see that the shortest-term $42.50 strike call that we can sell for

$0.73 or more is the March 2005. This call would meet the rules previously

outlined because (1) it results in a positive called return; (2) it is the near-

est month that allows for a minimum 10 percent uncalled return (the Janu-

ary 2005 $42.50 is trading at $0.60 and will not provide a 10 percent return);

and (3) the call expiration that we selected is not equal to the expiration of

the LEAPS selected.

144 CALENDAR LEAPS SPREADS

c07.qxd 10/23/06 2:13 PM Page 144

Finally, we need to assess the delta ratio. The rationale and importance

of the delta ratio is discussed in the following section, but for now you only

need to know how to calculate it per the following equation:

Delta ratio = LEAPS delta/Call delta

So for our example:

Delta ratio = 0.61/0.26

= 2.34

Now have met all criteria for entering into a new position, which is as

follows:

Buy LEAPS Jan 07 $35.00 for $7.30 delta of 0.61

Sell call Mar 05 $42.50 for $0.90 delta of 0.26

Uncalled return $0.90/$7.30 = 12.3%

Called return $42.50 – $35.00 – $7.30 + $0.90

= $1.10 or 15.1%

The Delta Ratio

As noted earlier in the book, the delta of a stock option is the rate of change

of the option price with respect to the price of the underlying stock. It is a

measure of how much an option’s price will increase or decrease for an in-

cremental increase or decrease in the stock price.

Let’s look at an example of a call that has a delta of 0.60. This number

means that when the stock price changes by an amount, the option price

will change by 60 percent of that amount. For example, if the stock price in-

creases by $1.00, then the option will increase in price by $0.60 (60 percent

of the stock price’s increase). If the stock price increased just $0.50, then

the option price would increase by only $0.30 (60 percent of the stock price

increase).

The delta ratio is a measure of the interaction between the LEAPS delta

and the call delta and is represented by the following formula:

Delta ratio = LEAPS delta/Call delta

A position with a delta ratio of 1.90 or more ensures that, when the stock

price rises, the LEAPS price increases much faster than the cost of buying

back the call. This high delta ratio will assist greatly in the closing of a

transaction when the stock price continues to rise after entering a new po-

sition. The delta ratio also assists in closing positions on the delta effect

when performing a secondary call sale. (Secondary call sales are discussed

in Chapter 8.)

Entering New LEAPS Positions 145

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Completing the Construction

Remember, the CSE Screener will only present positions that meet the pre-

ceding construction rules. Consequently, we needn’t go through the con-

struction process on each position. We only need to do the following three

things:

1. Use the CSE Screener to identify positions that meet the fundamental

criteria and can be correctly constructed.

2. Ensure that the position is on a stock with an overall or current upward

or horizontal cycle.

3. Ensure the position meets the buying low rule.

Assuming that the portfolio diversification rules are also met, we can

then enter the position.

146 CALENDAR LEAPS SPREADS

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147

CHAPTER 8

After entering new LEAPS positions, you need to know the rules for

managing these positions in the event that the stock price initially in-

creases or decreases. You also need to know how to manage a po-

sition for cash flow until you completely amortize the cost of the LEAPS in

the event the stock price never increases to a point where you can exit the

transaction (refer to Figure A.2 on page 190). Correct management is the

difference between great success and complete mediocrity in the business

of both covered calls and LEAPS.

THE 10¢ AND 5% BUYBACK RULES

With an established position in the LEAPS and the call, there are two

possibilities:

1. The stock price increases and triggers the 10¢ buyback rule.

2. The stock price decreases and triggers the 5% buyback rule.

These rules are intended to expedite the closing of the transaction so you

can get your capital back and reinvest it to compound your assets.

You must understand that your objective with LEAPS spreads is not the

same as with covered calls. With LEAPS spreads your objective is always to

exit the entire spread as soon as possible for a 5 percent profit on the whole

Management

Rules

c08.qxd 10/23/06 2:11 PM Page 147

transaction. Unlike covered calls, it is not necessary to hold the position

until the expiration of the short call. The position can be very quickly

closed for a profit if the stock price increases by a small amount after en-

tering the transaction.

The 10¢ Buyback Rule

The objective of the 10¢ buyback rule is to allow the buyback of the call if

the stock price moves up after entering the position and then to sell the

LEAPS for a profit if the stock price continues to move up. Application of

this rule facilitates the timely close of the transaction by preventing the call

price from increasing as the LEAPS price is increasing. Remember, the

LEAPS position is constructed at the bottom 25 percent of a rising or hori-

zontal cycle where the bias for the stock is to move up after entering the

transaction.

The 10¢ buyback rule instructs investors to do two things:

1. Buy back the call at market if the bid price of the LEAPS moves to 10¢

above your cost in the LEAPS.

2. Then add the cost of the call buyback to your cost in the LEAPS, add 5

percent to that total, and put in a good til canceled (GTC) order to sell

the LEAPS at this price.

For example, if your cost in a LEAPS is $7.30, you would buy back the call

if the market bid price of the LEAPS reaches $7.40. This is a very important

point: We are referring to the market bid price of the LEAPS, not the ask

price or the last price.

When you buy back a call under the 10¢ buyback rule, it usually in-

volves a loss on buyback of $0.20 to $0.40. Let’s assume the call buyback

creates a loss of $0.30. Continuing with our example, you would calculate

your GTC sell order for the LEAPS as follows:

GTC sell order = (LEAPS cost + Loss on buyback) ×1.05

= ($7.30 + $0.30) ×1.05

= $7.98

So you would set your GTC order at $8.00. If this stock moves up a lit-

tle further, this order will execute, you will have your money back in your

account plus your 5 percent return, and you will be ready to reinvest your

money and compound your assets. If the order does not execute, you will

148 CALENDAR LEAPS SPREADS

c08.qxd 10/23/06 2:11 PM Page 148

have the option of selling another call. This option is discussed in the later

section on secondary call sales.

The 5% Buyback Rule

The 10¢ buyback rule applies in the event the stock price initially increases

after entering the transaction. Conversely, the 5% buyback rule allows you

to take advantage of a downward movement in the stock price after estab-

lishing a new position by taking the following two steps:

1. Buy back the call for a net uncalled return of 5 percent if market prices

decline.

2. Then add 5 percent to the cost of the LEAPS and place a GTC order to

sell the LEAPS at this price.

Let’s continue with the preceding example in which you have a LEAPS

that cost $7.30 and a call you sold for $0.90. If there were a drop in the stock

price, you would buy back the call at a price of $0.55 to leave a net return

of $0.35, or a 4.8 percent gain ($0.35/$7.30). You would then put in a GTC to

sell the LEAPS at a price of $7.70 ($7.30 x 1.05) for an additional gain of 5.5

percent. If this stock went back up and this order executed, a total net gain

of 10.3 percent would result.

Based on the example given here, if the 10¢ buyback rule were trig-

gered, you would attempt to sell the LEAPS for $8.00 for a total transaction

gain of 5 percent. However, if the 5% buyback rule were triggered, you

would sell the LEAPS for $7.70 for a total transaction gain of 10 percent.

Thus you can see that it is often more advantageous for the stock price to

drop after initially entering a transaction! This advantage is another unique

aspect of the LEAPS technique. It is the reason why we do not attempt to

pick the bottom of the market. Entering a position at or around 25 percent

of the cycle often leads to the stock initially falling before it cycles back up.

An initial fall is a significant advantage in a LEAPS position as it can result

in double the return and a lower exit price.

If you buy back the call for a profit and your order to sell the LEAPS at

cost plus 5 percent does not execute, then what? Well, you have locked in

a great 5 percent return over just a few days and you then assess the possi-

bility of selling another call. This activity is discussed in detail in the later

section on secondary call sales rules.

Management Rules 149

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150 CALENDAR LEAPS SPREADS

THE DELTA LOW BRIDGE

The delta low bridge (DLB) is an alternative technique to the 10¢ rule LEAPS

technique. The primary difference between the two techniques is:

• DLB investors do not buy back the short call under the 10¢ rule if the

stock price rises after entering a transaction.

Instead, if the stock price rises after entering the transaction, DLB investors

exit the entire transaction on the delta effect. Exiting the transaction on the

delta effect involves buying back the call and immediately selling the

LEAPS when a 5 percent net return can be realized. This technique thus

provides DLB investors with greater downside protection because they are

not exposed to a downturn in the market after buying back the call and

waiting for the stock price to increase and the LEAPS to sell.

If the stock price declines after entering the transaction, as with 10¢

rule transactions, DLB investors will also buy back the initial call for a

profit of 5 percent and then sell the LEAPS for cost plus 5 percent.

Closing a Transaction Using the Delta Effect

As previously discussed (in Chapter 7), the delta of a stock option is the

rate of change of the option price with respect to the price of the underly-

ing stock. It is a measure of how much an option’s price will increase or de-

crease for an incremental increase or decrease in the stock price.

Recall from the position construction rules that LEAPS transactions

must be established with a minimum delta ratio of 1.90. In a correctly con-

structed LEAPS position, the LEAPS delta is always significantly higher

than the call delta. As such the value of the LEAPS increases much faster

than the buyback cost of the call. This is a critical factor for DLB investors

who rely on the LEAPS increasing in value much faster than the buyback

cost of the call in order to exit the transaction.

Closing a transaction on the delta effect means waiting for a point

where the buyback cost of the call is exceeded by the profit available when

selling the LEAPS. Take the following position as an example:

• BTO GE $35.00 Jan 2007 LEAPS @ $5.00; delta of 0.60

• STO GE $40.00 Dec 2005 Call @ $0.50; delta of 0.30

Closing this position on the delta effect when the stock price increases

would involve immediately buying back the call and selling the LEAPS

when a 5 percent net return could be realized. For example, suppose the

c08.qxd 10/23/06 2:11 PM Page 150

stock price increases after entering this transaction and the current market

prices of the LEAPS and call are as follows:

• GE $35.00 Jan 2007 LEAPS @ $5.00; current bid price $5.60

• GE $40.00 Dec 2005 Call @ $0.50; current ask price $0.80

This position could be closed on the delta effect to realize a $0.60 profit on

the LEAPS and a $0.30 loss on the call. The overall profit would therefore

be $0.30, or 6.0 percent ($0.30/$5.00) of the invested value of the LEAPS.

Such a situation is common for the LEAPS investor using the DLB tech-

nique. The call is never bought back for a loss under the 10¢ rule; rather, the

delta effect is relied on to provide a profitable exit.

The DLB Rules

The process of investing with the DLB technique is similar to that for nor-

mal LEAPS transactions. Investors still go through the regular LEAPS in-

vestment process previously outlined in Chapter 7, including:

• Using The CSE Screener to meet fundamental and construction

requirements.

• Ensuring the stock is in an overall or current rising or horizontal cycle.

• Ensuring the stock meets the buying low rule.

Once these actions have been accomplished, DLB investors must perform

one additional activity to ensure a realistic position is being entered into:

• Assessing the stock chart for the upward price move required to exit

the DLB transaction.

As DLB transactions require exit on the delta effect, they generally need a

larger movement in the stock price to close the transaction for cost plus 5

percent than is required for 10¢ rule transactions.

When assessing a particular position as a DLB, it is important to look at

the “DLB Close @” column of the CSE Screener. This column tells the in-

vestor at what stock price a particular LEAPS construction will close on the

delta effect for a 5 percent return. This is a very valuable component of the

tool and allows a realistic position to be entered into. The “DLB Close @”

column is highlighted in Figure 8.1.

The position shown on HD in Figure 8.1 would close out on the delta ef-

fect for a 5 percent return when the stock price increases to $42.78, which is

a 2.4 percent increase from the current stock price of $41.55. Remember,

all LEAPS positions are constructed at the lower 25 percent of an overall or

Management Rules 151

c08.qxd 10/23/06 2:11 PM Page 151

current rising or horizontal cycle, so the bias is the for the stock price to in-

crease in the short term. However, investors must ensure that a particular

DLB position will close out on the delta effect by the time the stock reaches

75 percent of the cycle. The assessment of the stock price at which the posi-

tion will close is critical to the timely exit of the position. Let’s assess the

HD price chart shown as Figure 8.2 and make a judgment on this particular

position.

We can see from the “DLB Close @” column in Figure 8.1 that this par-

ticular position will close out on the delta effect for a 5 percent return when

the stock price reaches $42.78. This point is well before the stock reaches

75 percent of the current rising cycle; actually, the position will close out

before the stock reaches 50 percent of the cycle. As such, this position

meets the requirements and is an acceptable investment. If the stock price

needs to increase more than 75 percent of the current cycle, the position is

152 CALENDAR LEAPS SPREADS

FIGURE 8.1 The “DLB Close @” column tells the investor at what stock price a

particular LEAPS construction will close on the delta effect for a 5 percent return.

c08.qxd 10/23/06 2:11 PM Page 152

Management Rules 153

This DLB position will close out at $42.78,

a price that is actually below 50% of the

cycle. This is an acceptable DLB position.

FIGURE 8.2 Price chart showing an acceptable DLB position.

not optimal, and we would simply select and qualify another position. As an

alternative, we may choose to enter this position as a 10¢ rule transaction,

which does not depend on the delta effect to exit.

Understanding the DLB Index

Another very important function of the CSE Screener is the ability to filter

the market for LEAPS investments that have a high DLB index. The DLB

index is a calculation for any given LEAPS position of the percentage the

stock price must rise in order for the position to exit on the delta effect with

a 5 percent return. For example, a position with a DLB index of 3.5 percent

will close out on the delta effect for a 5 percent return when the underlying

stock price increases by 3.5 percent. A position with a DLB index of 2.0 per-

cent will close out on the delta effect for a 5 percent return when the un-

derlying stock price increases by 2.0 percent.

Obviously, the most desirable DLB transactions are those that close out

with the smallest increase in the underlying stock price. The CSE Screener

can be used to effectively identify the best DLB positions (those with the

lowest DLB index). See Figure 8.3. The default search criteria of the CSE

Screener automatically ranks the positions in relation to their DLB index.

The positions with the lowest DLB index are presented at the top of the re-

sults table. Investors choosing to use the DLB technique can simply start at

the top of the list to identify positions with the lowest DLB index, qualify

positions under the buying low rule, and then, finally, ensure that the re-

quired stock price increase is within 75 percent of the cycle.

c08.qxd 10/23/06 2:11 PM Page 153

SECONDARY CALL SALES: MANAGING LEAPS

THAT HAVE NOT SOLD FOR A PROFIT

Remember, the objective is to consistently generate and compound cash

flow regardless of the direction of the market. This section explains how

we accomplish this objective through secondary call sales. A secondary call

sale is any call sale that occurs after you have bought back the original

call you sold when constructing a position. You need to use the secondary

call sale rules on positions where the stock price has not increased enough

to sell your LEAPS for cost plus 5 percent after buying back the short call.

LEAPS Secondary Call Sales Rules

The objective when selling a secondary call on a LEAPS is to buy back that

call as soon as possible for at least a 5 percent net return. The methods and

timing of secondary call sales are discussed in depth later in this section,

154 CALENDAR LEAPS SPREADS

FIGURE 8.3 CSE Screener ranks positions by DLB index.

c08.qxd 10/23/06 2:11 PM Page 154

but for now you must gain an understanding of the rules for selecting strike

prices and expirations for secondary call sales—this function is not per-

formed buy the CSE Screener.

The underlying function of the rules for selecting strike prices and ex-

pirations on a secondary call sale is to ensure, if possible, that you sell a

secondary call that is both (1) the same strike price as the original call se-

lected when constructing the position and (2) the shortest expiration pos-

sible that allows the minimum required return. The eleven rules are:

1. A secondary call can only be sold when the markets are in the green

(trading higher than the close of the previous day). The markets are in

the green any time when both the Dow Jones Industrial Average and

the NASDAQ are trading above the close of the previous day.

2. A secondary call can only be sold after implementing either the 10¢ or

5% buyback rule.

3. A secondary call cannot be sold if the market bid price of the LEAPS is

within 10 percent of your GTC sale price.

4. A secondary call can only be sold when the formalized seven-day rule

has been satisfied (discussed in depth later in this section).

5. A secondary call sale should generate a minimum 10 percent uncalled

return.

6. The aim is to buy back the call for a net uncalled return of 5 percent.

7. It is preferable to select the same call strike price as the strike price

used when the position was established. Simply move the expiration

date out in order to maintain a minimum 10 percent uncalled return

using the same strike price. This move ensures that the delta ratio re-

mains intact. A call may be sold up to but not exceeding the expiration

date of the LEAPS.

8. Preference should always be given to a shorter-term call if this call pro-

vides the minimum uncalled return requirement of 10 percent (time

value erodes more quickly in the investor’s favor).

9. If a minimum 10 percent uncalled return with the same strike price

cannot be maintained, drop the strike price one increment toward in

the money. Preference should always be given to a shorter-term call if

this provides the minimum uncalled return requirement of 10 percent.

10. Continue to drop the strike price to generate yield up to the point that

the call strike price is equal to the LEAPS strike price. Do not sell a call

with a strike price lower than the strike of the LEAPS.

11. In the event that a 10 percent uncalled return cannot be generated with-

out violating rule 10, the LEAPS should be repositioned (discussed in

Chapter 9).

Management Rules 155

c08.qxd 10/23/06 2:11 PM Page 155

Example of Selecting a Strike and Expiration for a Secondary

Call Sale Let’s assume some time ago you entered into the following

position on JP Morgan (JPM):

• BTO Jan 2007 $45.00 @ $6.50

• STO Jan 2006 $50.00 @ $1.50

After entering the position, the stock price declined and the call was bought

back for $1.20 for an uncalled return of 4.6 percent. Subsequently, the stock

price broke cycle and began cycling down. You are thus unable to sell the

LEAPS for cost plus 5 percent and are now assessing a secondary call sale.

When selecting a call from the option chain, the LEAPS secondary call

sales rules stipulate that:

• The bid price of the LEAPS must not be within 10 percent of the GTC

sale price of the LEAPS.

• The call selected must generate a minimum 10 percent uncalled return.

• It is preferable to select the same call strike price as the strike price

used when the position was established. If this call will not generate

the uncalled return requirement, move the expiration date out to a

maximum of the expiration of the LEAPS contract. Preference is al-

ways given to the shorter-term contract that provides the minimum un-

called return of 10 percent.

• If a minimum 10 percent uncalled return with the same strike price

cannot be maintained, drop the strike price one increment toward in

the money. Preference is always to sell the shortest-term call that pro-

vides the minimum uncalled return requirement of 10 percent.

Assume that the market is in the green and that the formalized seven-

day rule (FSDR) has been met. (The FSDR governs the point in the price

cycle where a secondary call can be sold and is covered in detail in the next

section). Let’s assess the option chain for JPM (Table 8.1) to find a call that

meets the preceding requirements.

Because the stock price has declined since entering the position, the

LEAPS originally purchased for $6.50 is now trading for $2.70 to $2.90. The

original call sold was the January 2006 $50.00 at $1.50. This call is now trad-

ing for $0.60 to $0.70.

The first preference is to sell the original call sold when entering the

transaction, if this call will provide a minimum 10 percent uncalled return

on the position, or a minimum $0.65. We can see from the option chain that

this call can only be sold for $0.60, which is less than the required minimum

uncalled return of $0.65. You need to increase yield on the call sale. The

preference is to maintain the same strike price, yet move the expiration of

156 CALENDAR LEAPS SPREADS

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Management Rules 157

TABLE 8.1 JP Morgan Option Chain Example

Bid Ask Bid Ask

Strike Ticker Price Price Delta Strike Ticker Price Price Delta

September Mar-05

27.50 JPMIY 11.80 12.00 1.00 27.50 JPMCY 11.90 12.10 0.98

30.00 JPMIF 9.30 9.50 1.00 30.00 JPMCF 9.50 9.70 0.97

32.50 JPMIZ 6.80 7.00 1.00 32.50 JPMCZ 7.20 7.40 0.92

35.00 JPMIG 4.40 4.50 1.00 35.00 JPMCG 5.20 5.30 0.81

37.50 JPMIU 1.95 2.05 0.91 37.50 JPMCU 3.30 3.50 0.63

40.00 JPMIH 0.30 0.35 0.33 40.00 JPMCH 1.90 2.05 0.44

42.50 JPMIV 0.00 0.05 — 42.50 JPMCV 0.90 1.05 0.26

45.00 JPMII 0.00 0.05 — 45.00 JPMCI 0.35 0.45 0.14

47.50 JPMIW 0.00 0.05 — 47.50 JPMCW 0.10 0.20 0.06

50.00 JPMIJ 0.00 0.05 — 50.00 JPMCJ 0.00 0.10 —

October Jan-06

27.50 JPMJY 11.90 12.00 1.00 20.00 WJPAD 19.30 19.50 0.95

30.00 JPMJF 9.40 9.50 1.00 25.00 WJPAE 14.40 14.60 0.94

32.50 JPMJZ 6.90 7.00 1.00 30.00 WJPAF 10.10 10.20 0.87

35.00 JPMJG 4.40 4.60 0.97 35.00 WJPAG 6.30 6.50 0.68

37.50 JPMJU 2.20 2.25 0.79 37.50 WJPAU 4.80 4.90 0.56

40.00 JPMJH 0.55 0.65 0.39 40.00 WJPAH 3.40 3.60 0.44

42.50 JPMJV 0.05 0.10 0.10 42.50 WJPAV 2.40 2.55 0.33

45.00 JPMJI 0.00 0.05 — 45.00 WJPAI 1.55 1.70 0.23

47.50 JPMJW 0.00 0.05 — 47.50 WJPAW 1.00 1.10 0.16

50.00 JPMJJ 0.00 0.05 — 50.00 WJPAJ 0.60 0.70 0.11

December Jan-07

30.00 JPMLF 9.40 9.60 0.99 25.00 VJPAE 14.40 14.90 0.88

32.50 JPMLZ 7.00 7.20 0.97 30.00 VJPAF 10.60 10.80 0.78

35.00 JPMLG 4.80 4.90 0.89 35.00 VJPAG 7.20 7.30 0.61

37.50 JPMLU 2.80 2.95 0.69 40.00 VJPAH 4.60 4.80 0.43

40.00 JPMLH 1.30 1.40 0.42 45.00 VJPAI 2.70 2.90 0.27

42.50 JPMLV 0.50 0.55 0.20 50.00 VJPAJ 1.50 1.60 0.16

45.00 JPMLI 0.10 0.15 0.07

47.50 JPMLW 0.00 0.10 —

Jan-05

25.00 JPMAE 14.30 14.50 0.99

30.00 JPMAF 9.40 9.60 0.98

32.50 JPMAZ 7.10 7.30 0.95

35.00 JPMAG 4.90 5.10 0.85

37.50 JPMAU 3.00 3.20 0.66

40.00 JPMAH 1.55 1.65 0.43

42.50 JPMAV 0.60 0.70 0.23

45.00 JPMAI 0.15 0.25 0.10

47.50 JPMAW 0.05 0.10 0.04

50.00 JPMAJ 0.00 0.05 —

c08.qxd 10/23/06 2:11 PM Page 157

the call out to generate yield. In this instance, the only option is to move to

the January 2007 expiration. We know that you must attempt to sell a call

with the same strike price as the original call sold, if this call provides the

minimum uncalled return of 10 percent. In this instance the January 2007

$50.00 is selling for $1.50, well in excess of your minimum uncalled return

requirement of $0.65. This is the call you would sell.

In the event that the January 2007 $50.00 did not provide an uncalled re-

turn of minimum 10 percent, you would drop the strike price one increment

and sell the shortest-term call that provides an uncalled return of 10 percent

or greater. This process can be continued up to, but not exceeding, the

strike price of the LEAPS. If, in order to generate an uncalled return of min-

imum 10 percent, you need to sell a call with a strike less than the strike of

the LEAPS, the LEAPS needs to be repositioned. Repositioning of a LEAPS

is discussed in detail in Chapter 9.

The Formalized Seven-Day Rule

Now that we have covered how to select the strike price and expiration for

a secondary call sale, in this section we discuss an equally important aspect

of secondary call sales: timing. Timing relates to where on the price chart a

secondary call sale is executed. Timing is critical to the ability of an in-

vestor to continually generate cash flow from a position, regardless of mar-

ket direction.

Readers familiar with covered calls will realize that the FSDR is essen-

tially the selling high rule for covered calls applied to the LEAPS technique.

While the concept remains the same, the one very significant advantage of

applying this technique to a LEAPS position compared to a traditional stock

position is leverage. When applying the FSDR on LEAPS, buyback returns

can be realized with much smaller movements in the underlying stock

price, because the profitable buyback amount is so much smaller due to a

smaller dollar investment in the LEAPS contract versus the stock. For ex-

ample, a 5 percent net return on a $5.00 LEAPS is just $0.25, whereas a 5

percent net return on a $30.00 stock is $1.50. Much smaller movements in

the underlying stock price allow for profitable call sales and buybacks. It

follows, then, that very small cycles of the stock price can and should be

utilized to sell and profitably buy back a call when managing a LEAPS po-

sition. The need to pay close attention to stock price cycles is part of the

reason why LEAPS require a much greater time commitment to manage-

ment than do covered calls. However, the greater time commitment is com-

pensated for by much higher returns when used by experienced investors.

To achieve a profitable buyback on a call using the FSDR technique we

need one or both of the following to occur: (1) The stock price must drop

sometime in the future or (2) time value must diminish.

158 CALENDAR LEAPS SPREADS

c08.qxd 10/23/06 2:11 PM Page 158

The FSDR concentrates on point 1 by identifying when a stock is in the

high region of its price cycle. This rule is essentially the opposite of the buy-

ing low rule that ensures you are buying into new positions when the mar-

ket is down and a stock is in the lower 25 percent of its cycle. Conversely,

the FSDR ensures that you are selling a secondary call when the market is

up and the stock is in the upper 75 percent of its current cycle. This condi-

tion greatly increases the chances that the stock will fall and you will be

able to buy back the call for a profit.

It is important to make the distinction that our objective is not specu-

lation. What we are trying to do is simply buy low and sell high or sell high

and buy low, as the case may be. If you sell a call and the stock keeps mov-

ing up, you may be able to close the position on the delta effect (previously

discussed) or implement other defensive strategies such as the surrogate

LEAPS replacement technique (see Chapter 9).

The FSDR encompasses two components:

1. Secondary call sales can only be made when a stock is in the upper 75

percent of its current price cycle.

2. A rising price cycle must have a minimum of $1.50 of price between the

upper and lower lines of its price cycle.

By ensuring that you sell secondary calls at the high end of the price cycle,

it is more likely that the stock will decline and you will be able to buy the

call back for a profit. Remember, the decay in time value is also working

significantly in the covered call writer’s favor. This factor also greatly in-

creases the opportunity for a profitable call buyback.

It is important to make the distinction that our objective is not specu-

lation when using the FSDR. What we are trying to do is sell in the vicinity

of the top of the cycle and buy the call back for a profit at lower stock

prices in the near future. If you sell a call and the stock keeps moving up,

you do not take a loss on the call. Rather, investors should have patience

and wait for the stock price to come back to the bottom of the cycle. Stocks

cycle up and down—they do not go straight up and they do not go straight

down. If the stock doesn’t come down to allow a profitable call buyback we

can use other management and defensive techniques (see Chapter 9).

Patience and management are critical factors for success. You must have

patience to wait for the stock price to meet the FSDR before selling the sec-

ondary call. You must also have patience to wait for the stock price to cycle

down after selling the call to allow a profitable buyback. Patience is key.

It is very rare that a call will be sold and the very next day the stock cycles

down. It is not possible to pick the absolute top of the market and have the call

immediately fall in price—this is an unrealistic expectation. It is much more

common that over a period of one to four weeks after selling a secondary call,

Management Rules 159

c08.qxd 10/23/06 2:11 PM Page 159

the stock cycles down and allows a profitable buyback. During the period of

waiting, patience is required. Novice investors often panic when an FSDR call

cannot be immediately bought back for a profit. Such immediacy is against the

nature of this technique. Again, when using the FSDR, patience is key.

But what if we sell an FSDR call at what we believe is the top of the

price cycle and the stock breaks cycle, shoots straight up, and never trades

at a lower price? This scenario is common and simply requires investors to

implement one of many management strategies:

• Closing the position on the delta effect.

• Buying back the call profitably at higher stock prices due to the decay

in time value.

• Using the surrogate LEAPS replacement to exit the position (discussed

in Chapter 9).

Applying the FSDR Remember, the FSDR identifies the timing of a sec-

ondary call sale. It identifies the point on the chart where a secondary call

can be sold. The FSDR instructs to only sell a secondary call when the

stock price is in the upper 75 percent of the price cycle (Figure 8.4). This

section illustrates the practical application of this technique. Interpretation

of the chart is vitally important.

160 CALENDAR LEAPS SPREADS

When the stock reaches 75% of the cycle, the FSDR

has been satisfied. We will sell a secondary call and

wait for the stock to cycle down.

FIGURE 8.4 The FSDR instructs to only sell a secondary call when the stock

price is in the upper 75 percent of the price cycle.

c08.qxd 10/23/06 2:11 PM Page 160

Readers should revisit “Using Price Charts,” discussed in Chapter 3.

The FSDR is essentially the selling high rule for covered calls when applied

to LEAPS. The commentary and examples provided for the selling high rule

apply equally to the FSDR.

Identifying the First Sell Point of a New Price Cycle This topic

applies equally to covered call and LEAPS techniques. However, it is dis-

cussed in this section rather than in Part I, Covered Calls, since it is an ad-

vanced technique for optimizing the management of positions. This level of

optimization is not critical to the success of the covered call strategy, yet it

will most definitely increase returns of that strategy. When using the LEAPS

technique, however, we are leveraged, and aggressive management of un-

derperforming positions is critical to the success of the strategy.

The most difficult task regarding the FSDR is identifying the first sell

point of a new price cycle. While it is not critical to enter new positions at

the first buy point, identifying the first sell point of a new cycle is much

more important. The reason for its importance is that when assessing an

FSDR, the investor is already in a management situation on the particular

position and needs to maximize call sales to maximize the cash flow from

that position. Consistently missing the first sell point of a new cycle means

an investor is consistently missing an opportunity to generate cash flow, re-

duce cost base in the position, and compound the asset base.

When assessing the first buy point, we do so from the perspective of

entering into new positions after the current cycle has changed from de-

clining to increasing. In identifying the first sell point, many of the princi-

pals of identifying a change in cycle remain the same as those for

identifying the first buy point, so now is a good time to revisit the section

“Identifying the First Buy Point” in Chapter 7. In using the FSDR, however,

we are discussing management of positions in any cycle and how to iden-

tify the first sell point of a new cycle, whether it is increasing or declining.

When managing a position for income where the current cycle is de-

clining, we should be watching for higher bottoms and a break to the top of

the declining cycle to indicate a potential change of cycle direction, as

shown in Figure 8.5. When managing a position for income where the cur-

rent cycle is rising, we should be watching for lower tops and a break to the

bottom of the declining cycle to indicate a potential change of cycle direc-

tion, as shown in Figure 8.6.

Once we have spotted a potential change in cycle, whether increasing

or declining, we can identify the first sell point of a new cycle as follows:

• The first sell point of a new cycle is always preceded by a minimum of

two bottoms and one top.

Management Rules 161

c08.qxd 10/23/06 2:12 PM Page 161

See Figure 8.7 for an example of identifying the first sell point of a new

rising cycle. As previously noted, the first sell point of a new cycle is always

preceeded by a mimimum of two bottoms and a minimum of one top. So we

first connect the two bottoms, then identifiy the first top of the cycle, and

then extrapolate a top parallel line from this top. Remember, when at-

tempting to identify the first sell point, the second top of the cycle is yet to

162 CALENDAR LEAPS SPREADS

1. Lower top; in this

instance, within the

rising price cycle

2. Break through the bottom of

the rising price cycle

FIGURE 8.6 Break through bottom of a rising cycle.

1. Higher bottom; in this instance,

within the declining price cycle

2. Break through the top of the

declining price cycle

FIGURE 8.5 Break through top of a declining cycle.

c08.qxd 10/23/06 2:12 PM Page 162

form—the top line must be estimated by drawing a parallel line from the

first top.

An example of identifying the first sell point of a new declining cycle is

shown in Figure 8.8. Since the first sell point of a new cycle is always pre-

ceeded by a mimimum of two bottoms and a minimum of one top we first

connect the two bottoms, then identifiy the first top of the cycle, and then

Management Rules 163

First sell point is preceded

by minimum of two

bottoms and one top.

FIGURE 8.7 Identifying the first sell point of a new rising cycle.

First sell point is preceded

by minimum of two

bottoms and one top.

FIGURE 8.8 Identifying the first sell point of a new declining cycle.

c08.qxd 10/23/06 2:12 PM Page 163

extrapolate a top parallel line from this top. Remember, when attempting to

identify the first sell point, the second top of the cycle is yet to form—the

top line must be estimated by drawing a parallel line from the first top.

Exception to FSDR—Declining Cycles The FSDR is applicable to

stocks regardless of whether the stock price is rising, falling, or going side-

ways. The rules for applying the FSDR remain substantially the same re-

gardless of the direction of the cycle. However, one very important

exception to the FSDR exists for falling stocks, and it is known as the 25%

buyback rule.

When implementing the FSDR on a declining cycle, investors should

not aim for a net buyback return of 5 percent. Instead, for larger buyback

returns, investors should only buy back the call when the stock reaches the

bottom 25 percent of the cycle. The 25% buyback rule leverages off the fact

that the current cycle is declining. As such, it is wise to take full advantage

of this declining stock price in order to enhance returns.

164 CALENDAR LEAPS SPREADS

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165

CHAPTER 9

In the preceding chapters we discuss in detail the process of entering

new LEAPS positions, the buyback and close out rules, and managing

unproductive positions for consistent cash flow regardless of market di-

rection. Now we present the defensive techniques available to LEAPS in-

vestors (refer to Figure A.2).

The flexibility of LEAPS allows investors a significant array of defen-

sive techniques. These techniques can be used to effectively manage any

poorly performing LEAPS position to an eventual profitable exit. They vary

in nature and are used for the following purposes:

• To prevent an unprofitable callout.

• To reduce capital in an underperforming position.

• To reduce the average LEAPS cost in an underperforming position.

• To allow continued call sales on a LEAPS that has fallen significantly.

• To prevent high levels of time decay in a LEAPS.

When learning the defensive techniques, it is important to remember

the three primary objectives of LEAPS investing:

1. Closing the transaction as quickly as possible for a profit.

2. Generating consistent income on underperforming positions.

3. Reinvesting and compounding these proceeds.

The defensive techniques exist to quicken the realization of these objec-

tives and allow faster compounding of the asset base.

Defensive

Techniques

c09.qxd 10/23/06 2:10 PM Page 165

SURROGATE LEAPS REPLACEMENT

The surrogate LEAPS replacement (SLR) is a highly valuable defensive

technique that is very regularly applied by LEAPS investors. The SLR is

used when an investor sells a call under the FSDR and the stock price con-

tinues to move up, preventing a profitable call buyback. It allows investors

to reduce capital in the position and realize profits on a LEAPS by taking

advantage of a rising stock price—without unprofitably buying back the

short call.

The SLR is very effective when the stock price has not moved up

enough to exit the entire position on the delta effect or the position has a

poor delta ratio due to incorrect construction. Thus, it is to be used when

the following three 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 percent of its current cycle.

Take the position shown in Table 9.1 as an example. We can see that

this investor has a LEAPS with a cost of $5.00 and has sold a call for $1.00.

Since selling the call, the underlying stock price has increased. As such, the

call has not been able to be bought back for a profit and is now trading at

$3.00. As the stock price has increased, so has the value of the investor’s

LEAPS. The investor now has a $1.50 profit in the LEAPS but is prevented

from realizing this profit because of the larger loss on the call. The loss on

the call is preventing the transaction from being closed out; even through

the investor has a large profit in the LEAPS. This is an ideal situation in

which to use the SLR.

166 CALENDAR LEAPS SPREADS

TABLE 9.1 Sample Position Suitable for SLR

Contract Entry Price Current Price Profit (Loss)

LEAPS $5.00 $6.50 $1.50

Call $1.00 $3.00 ($2.00)

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The SLR Rules

There are two basic rules for using the SLR:

1. If the stock price is in the upper 75 percent of the cycle and you are

able to sell the original LEAPS for a return of 5 percent or more, then

the SLR can be considered.

2. Select the same expiration date; however, 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.

Once you have taken action based on these rules, there are two distinct

scenarios:

1. Stock price continues up. In this scenario you should take advantage of

the rising stock price. If you are able to sell the SLR LEAPS for a 5 per-

cent profit, then do so. After selling this LEAPS, you must immediately

buy another LEAPS. Simply move the strike price up one increment.

You have now performed a second SLR. Continue to take 5 percent

profits and SLR the LEAPS to the extent that the strike price of your

LEAPS is not higher than the strike price of the call. You can SLR up to

the point that the LEAPS and the call have an identical strike price.

2. Stock price declines. In this scenario you should buy back the prob-

lematic call, but only when you can exit the call at approximately the

cost you sold it for. Once you have bought back the call, go back to the

FSDR.

Following the rules for this technique achieves several important

objectives:

• Investors can take advantage of the high point of the price cycle and re-

alize a profit on the LEAPS.

• Investors can continually reduce the capital invested in the position by

selecting a higher strike price LEAPS. Excess capital can then be rein-

vested into new positions.

• If the stock price rises, investors can profit from continued strength in

the stock by selling LEAPS for 5 percent profits.

• If the stock price declines, investors can exit a problematic call.

• After buying back the call, investors have the potential to exit the entire

position on the next high point of the price cycle.

Defensive Techniques 167

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Applying the SLR

Here is a detailed example of implementing the SLR in five steps.

Step 1: Enter new position. Figure 9.1 shows the entry into a new po-

sition at the bottom of a current horizontal cycle. The stock then broke

cycle, allowing the call to be bought back to lock in a 5 percent uncalled

return.

Step 2: Sell a call at top of cycle, which then becomes problematic.

After buying back the initial call, our interpretation of the chart as shown in

Figure 9.2 is that the stock was in a current declining cycle. A secondary

call was sold at the top of this declining cycle. The stock immediately broke

to the top of the declining cycle. The call could not be bought back for a

profit.

Step 3: LEAPS becomes profitable, so perform an SLR. The stock

price continues to increase after selling the call, as shown in Figure 9.3. It

increases to a point where we have a 5 percent or greater return if we sold

the LEAPS. At this point, we immediately SLR. We move the strike up one

or two increments (two in this case) and buy the Jan 2007 $35.00 @ $3.00.

We then sell the current LEAPS to take a profit of $0.40. We have taken

profits and reduced capital in the underperforming position by over 50 per-

cent. This capital should be immediately invested elsewhere. We would

then generally place a GTC to buy back the problematic call at cost ($0.80).

Step 4: Stock price declines and the GTC to buy back the call executes.

The GTC order to buy the call at cost executes (see Figure 9.4). In this in-

168 CALENDAR LEAPS SPREADS

1. Position constructed here:

BTO Jan 2007 $30.00 @ $6.00

STO Jan 2006 $37.50 @ $1.20

2. BTC call here:

BTC Jan 2006 $37.50 @ $0.90

5% Uncalled return realized

FIGURE 9.1 Entering a new position at the bottom of a current horizontal cycle.

c09.qxd 10/23/06 2:10 PM Page 168

stance, the call was held for a period of approximately three weeks. It is im-

portant during this time to have patience and wait for time to take its

course and for the stock price to fluctuate, allowing the buyback.

Most importantly, during this period of waiting, the SLR has freed the

majority of our capital from the position. This capital is now invested in

Defensive Techniques 169

2. Problem call sold here:

STO Jan 2007 $37.50 @ $0.80

FIGURE 9.2 A problematic secondary call sale.

3. SLR here:

STC Jan 2007 $30.00 @ $6.40

BTO Jan 2007 $35.00 @ $3.00

LEAPS was purchased here for $6.00.

FIGURE 9.3 Performing an SLR when the LEAPS becomes profitable.

c09.qxd 10/23/06 2:10 PM Page 169

new productive positions and has been reinvested many times over during

the three-week period.

If the stock price continues to move up and does not allow a profitable

call buyback, when we are able to sell the current LEAPS for a 5 percent or

greater return and the stock is at 75 percent of the current cycle, we will

SLR again. We will continue to SLR until the strike price of the LEAPS is

equal to the strike price of the call. When the strike prices are equal, we are

“against the wall” and can no longer SLR. By this time, we have taken sev-

eral profits from the LEAPS and have taken out the vast majority of the cap-

ital from the position. We will then simply wait for the stock price to

decline and time value to erode the buyback cost of the call until it can be

bought back at breakeven. Stocks go up and down, but they do not go

straight up or straight down.

Step 5: Sell SLR LEAPS for cost plus 5 percent. As shown in Figure 9.5,

we complete the transaction by selling the SLR LEAPS for cost plus 5 per-

cent. The total profit on the transaction is as follows:

• $0.30 from buyback of original call.

• $0.40 from sale of original LEAPS.

• $0.15 from sale of SLR LEAPS.

• Total = $0.85, or 14.1 percent on original cost of $6.00.

Remember, $3.40 or 57 percent of the $6.00 of capital committed to this

position was removed by the SLR. The entire position was open for ap-

170 CALENDAR LEAPS SPREADS

4. BTC call here:

BTC Jan 2007 $37.50 @ $0.80

Call was sold here for $0.80.

FIGURE 9.4 Stock price declines and the GTC to buy back the call executes.

c09.qxd 10/23/06 2:10 PM Page 170

proximately one month; however, for three weeks of this month, only $3.00

of capital was committed. This figure effectively brings the return up to

around 30 percent on the committed capital of $3.00. This adjustment high-

lights the value of the SLR technique: Capital can be effectively removed

from an underperforming position and committed elsewhere into new, pro-

ductive positions.

One significant point of note is the secondary call sale that may have

been executed at the top of the current horizontal cycle. If this call were ex-

ecuted, the position would not be able to be closed, and we would have ap-

plied the SLR again. However, this call should not have been sold.

According to the LEAPS secondary call sales rules, a secondary call cannot

be sold if the market bid price of the LEAPS is within 10 percent of the GTC

sell price. This limitation prevents calls from being sold against positions

that are close to an exit. As it is impossible to pick the absolute top of the

market, when a call is sold on a position that is close to exit, more often

than not, it becomes a hindrance to the position being profitably closed out.

AVERAGING DOWN

Many investment methodologies promote the technique of dollar cost aver-

aging. Dollar cost averaging involves purchasing a certain amount of a stock

or fund at regular intervals over time. For example, instead of investing

$10,000 in a stock today, invest $2,500 at the end of each quarter over a year.

Defensive Techniques 171

Sell secondary call here?

5. Sell SLR LEAPS for cost +5%.

STC Jan 2007 $30.00 @ $3.15

FIGURE 9.5 Completing the SLR LEAPS transaction.

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A modified version of this technique is a valuable defensive technique

for LEAPS investors. Occasionally, a LEAPS price will drop significantly

over a long period of time. These circumstances may allow you to take ad-

vantage of a highly depressed LEAPS price by averaging down.

The four rules for averaging down a LEAPS position are:

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 per-

cent or less of the price you paid for it, then do so. For example, if you

own a LEAPS at a cost of $5.00, you would average that position down

if you could buy additional contracts at a price of $0.75 (the “average

down price”).

2. You should buy the number of contracts that brings your average cost

(see explanation in “Calculating Adjusted Cost and Average Cost” in

the section on rolling out that follows) to a price equal to two times the

average down price. For example, if you own a LEAPS at a cost of

$5.00, you would average that position down if you could buy addi-

tional contracts at a price of $0.75 (the average down price). You

should buy the number of contracts that brings your average cost to a

value of $1.50 (two times the average down price of $0.75).

3. The 5 percent 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 $0.25.

4. Sell the LEAPS at the new average cost plus 5 percent, not the original

cost. So, for the preceding example, you should sell the LEAPS for

$1.50 plus 5 percent.

Averaging down allows investors to do the following:

• Significantly reduce their average cost in the LEAPS for a relatively

small additional capital outlay.

• Significantly increase their LEAPS contracts for a relatively small ad-

ditional capital outlay.

• Generate significantly higher percentage returns on secondary call

sales.

• Exit the position at average cost rather than original cost. This feature

has the effect of enabling investors to exit the position at much lower

stock prices and, therefore, much quicker.

172 CALENDAR LEAPS SPREADS

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REPOSITIONING A LEAPS

In the rules for selling secondary calls we established that (1) you cannot

sell a call on a LEAPS with a strike price less than the LEAPS and (2) you

cannot sell a call on a LEAPS with an expiration longer than the LEAPS.

On rare occasions, a stock may decline significantly to a level where

you can no longer sell a call on a position for a minimum 10 percent return

without breaching the preceding two rules. If this situation occurs, you

must reposition your LEAPS in order to continue generating cash flow from

this position.

Repositioning a LEAPS 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.

Again, you must try not to violate the $10.00 adjusted cost rule; how-

ever, on some occasions it may be necessary to do so. If you do violate the

$10.00 rule, managing the position with secondary call sales will be more

difficult.

Repositioning a LEAPS has the effect of creating more management

depth by allowing you to sell lower strike prices that previously would have

violated the rule regarding not selling a call on a LEAPS with a strike price

less than the LEAPS.

ROLLING OUT

One great advantage of the LEAPS technique is that time is always working

more for you than against you. You always sell a call that has a far greater

theta, or rate of time decay, than the LEAPS you own. To keep time on

your side, it is imperative that each year you go through a process called

rolling out.

As a guide, a one strike price in the money LEAPS with about two years

to expiration has a theta value of around –0.003, which means that the

LEAPS loses $0.0030 in value each day, or $0.09 per month.

A one strike price in the money LEAPS with a half a year to expiration

has a theta value of around –.0042, meaning that the LEAPS loses $0.0042 in

value each day, or $0.13 per month.

The objective is to always keep time decay of your LEAPS to a mini-

mum. Rolling out allows you to accomplish this objective by ensuring that

there is always at least one year of time value left in the LEAPS.

Defensive Techniques 173

c09.qxd 10/23/06 2:10 PM Page 173

The Rollout Rules

If an investor is holding a LEAPS that has less than one year to expiration,

he or she must sell it and buy another LEAPS relating to the same company.

Three guidelines must be followed:

1. A rollout must be conducted on a down day.

2. If your capital position allows, select the same strike price and the fur-

thest out date possible providing that the adjusted cost (discussed later

in this section) does not exceed $10.00.

3. If this LEAPS leads to an adjusted cost of more than $10.00 (or if your

capital position does not allow you to select the same strike), select the

next highest strike price. Continue to raise the strike price until the ad-

justed cost does not exceed $10.00. Preference is always given to main-

taining the lowest strike price possible.

Note that if you raise the strike price of the LEAPS, you will generally

have a lower delta value on the LEAPS. This causes a lower delta ratio

when selling calls against the LEAPS and also means the stock price must

travel higher for you to exit the position at cost plus 5 percent.

Calculating Adjusted Cost and Average Cost

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

rolled out. As an example of how it is calculated, suppose the following

conditions exist:

• You hold a Jan 2006 $35.00 LEAPS on JPM at a cost of $5.00.

• You have not been able to exit the position for cost plus 5 percent, but

you have been selling and buying back calls to generate cash flow.

• It is now January 2005, and you need to roll out the LEAPS.

• You sell your Jan 2006 $35 LEAPS on JPM for $3.50.

• You buy the Jan 2007 $35 LEAPS on JPM for $8.00.

You figure the adjusted cost as follows:

Adjusted cost = Cost of original – Sell price of original + Cost of new LEAPS

= $5.00 – $3.50 + $8.00

= $9.50

You now must use the adjusted cost of $9.50 for all return calculations.

A net 5 percent return on a secondary call sales and buyback is now $9.50

×0.05 = $0.48. Do not use the original cost of your LEAPS as you now have

174 CALENDAR LEAPS SPREADS

c09.qxd 10/23/06 2:10 PM Page 174

more capital invested in the position! When selling the LEAPS, also use the

adjusted cost of $9.50 plus 5 percent.

Average cost is a measure of new cost of your LEAPS after you have av-

eraged down. Let’s use another example to show how this factor is calcu-

lated. Suppose the following:

• You hold 10 Jan 2006 $35.00 LEAPS at a cost of $5.00.

• You have not been able to exit the position for cost plus 5 percent, but

you have been selling and buying back calls to generate cash flow.

• Following the averaging down rules, you purchase another 46 contracts

of the Jan 2006 $35.00 LEAPS on JPM. You purchase this number of

contracts as this is the number that will allow you to reduce your aver-

age cost down to $1.50 (two times the average down price).

The number of contracts needed to be purchased to reduce the average

cost to two times the average down price varies for each position. The

number needs to be estimated at first, and then investors can use the fol-

lowing formula to test the accuracy of the estimate. Adjust the number of

contracts upwards or downwards as appropriate, until the result of the fol-

lowing formula equals two times the average down price.

Adjusted cost = [(No. original contracts ×Cost of original contracts)

+ (No. new contracts ×Cost of new contracts)]/(# Original contracts

+ No. new contracts)

= [(10 ×$5.00) + (46 ×$0.75)]/(10 + 46)

= $1.50

When selling the LEAPS, use the adjusted cost of $1.50 plus 5 percent.

However, when performing a secondary call sale, use the original cost of

$5.00 when calculating net buyback amounts. For example, a call buyback

for a secondary call sale will net a minimum $0.25 or (5 percent of the $5.00

original cost) even though the adjusted cost in this position is now only

$1.50. Just one management move with a net buyback return of $0.25 will

now allow you to net a return of 16.70 percent.

Thus you can see how averaging down allows realization of much

higher returns on an underperforming position.

Defensive Techniques 175

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c09.qxd 10/23/06 2:10 PM Page 176

177

CONCLUSION

Since Compound Stock Earnings was founded in 1999, thousands of in-

vestors have been taught the techniques outlined in this book and are

now successfully managing their own investments using covered

calls. Once comfort and familiarity are gained with the technique, these in-

vestors consistently generate monthly returns from their stock investments

equivalent to an annual mutual fund return.

This chapter is intended to provide some guidance to those who wish

to follow the path of thousands of successful Compound Stock Earnings

clients who are now safely and very successfully managing their own stock

portfolios.

1. Reread this book until you are confident in your full and compre-

hensive understanding of the concepts and techniques of covered call in-

vesting described herein. You should not consider beginning investing if

there are any gaps or uncertainties in your understanding. You must be

comfortable and confident with every concept before placing your hard-

earned money at risk.

2. Investigate the support services offered by Compound Stock Earn-

ings such as the 2-Day Intensive Seminar or Covered Call/LEAPS Selec-

tions (see Appendix E) and decide which, if any, will enhance your learning

and progression. We have found that most investors do not require any sup-

port services over the long term, but these services are invaluable to those

who are learning the technique.

3. The importance of capital management cannot be overstated for

learning investors. Do not invest a significant amount of money while learn-

How to Move

Forward

bafter.qxd 10/23/06 2:28 PM Page 177

ing the covered call technique. A “significant amount” of money varies for

each individual investor. A good “learning stake” is 10–20 percent of the

value of your current stock portfolio; or if you do not have a stock portfo-

lio, 10–20 percent of your annual salary. If an investor is gripped with the

fear of losing money, it is very difficult to make rational and logical deci-

sions. The learning process is greatly assisted when a smaller amount of

capital is at stake.

4. When you are ready to commit funds to the technique, we strongly

recommended that all investors begin investing with covered calls and not

LEAPS. Covered call investing is a superior technique for the learning in-

vestor as it is far less complicated and inherently less risky than LEAPS.

5. Invest using the covered call technique with a small learning stake

for a minimum of six months before considering progressing to LEAPS.

This period will allow you to accumulate some profits in your account, be-

come proficient in both up and down markets, learn from a few mistakes

(you cannot develop a new skill without making them), gain some confi-

dence, and gain greater insight into the operation of the markets.

6. Once you have developed a consistent track record of generating re-

turns over a six-month period with covered calls, you are then ready to con-

sider progressing to LEAPS if you wish. Investors should understand that

LEAPS investing is a higher risk/higher return strategy when compared to

covered calls, and it requires much greater time commitment. A good way

to start learning the practical application of the technique is to follow the

transactions, management moves, and close-outs being executed by the au-

thors in the Compound Stock Earnings Covered Call/LEAPS Selections ser-

vice by going to www.compoundstockearnings.com/services.htm.

7. Many investors choose to continue solely with covered call invest-

ing, as they are happy with the returns generated and the low time input re-

quired. If you would like to progress to LEAPS investing, do so gradually.

Take 10 percent of your portfolio and place these funds into LEAPS invest-

ments for a month or two. Then move another 10 percent to LEAPS invest-

ments if you achieve acceptable returns.

8. Do not move more than 20 percent of your portfolio into LEAPS in-

vestments until you have a consistent track record over six months of gen-

erating returns higher than those realized with your covered call investing.

9. Remember, investing is a long-term wealth-building proposition.

Treating it as such and taking the time to learn will greatly increase the like-

lihood of achieving the desired successful outcomes. Any endeavor worth

succeeding in requires aptitude, patience, and perseverance. Investing is no

different!

178 Conclusion

bafter.qxd 10/23/06 2:28 PM Page 178

179

APPENDIX A

This appendix is best used as a reference. It should not be read to the

exclusion of the rest of the book.

COVERED CALLS

Refer to the accompanying flowchart (Figure A.1) that depicts each step in

the covered call investment process.

The Rules for Entering New Covered Call

Positions in the U.S. Market

A new covered call position involves buying a stock and selling a covered

call. The U.S. market has thousands of optionable stocks; therefore in-

vestors can be very selective when entering into new covered call posi-

tions. The eight rules are as follows:

1. You can only establish new positions on down market days. A down

market day is any time when the Dow and the NASDAQ are in the red

(trading lower than the close of the previous day).

2. You must always only sell the near month call when entering a

transaction.

3. Use the CSE Screener to filter through all available covered call op-

portunities on the U.S. market.

Quick Reference

Guide

bapp.qxd 10/23/06 2:26 PM Page 179

180 Appendix A

Enter New Position

1. Filter with CSE Screener

2. Upward or sideways current cycle

3. Bottom 25% of current cycle

Stock Decreases

1. Mid-month buyback rule or

2. Allow call to expire

Can we favorably CPR?

Wait for expiration of CPR

1. Were we called out?

Profitable buyback

on TSS call?

1. Close on delta or

2. Apply SSR

Reinvest and

compound

proceeds

Reinvest and

compound

proceeds

Stock Increases

1. Close on delta effect or

2. Get called out

Secondary Call Sales Rules

1. Near month call or

2. TSS For income

Yes

No Exit

TSS

Exit

Called Out

Near Month

FIGURE A.1 Covered call process flowchart.

bapp.qxd 10/23/06 2:26 PM Page 180

4. Select the highest-yielding opportunities presented by the CSE Screener.

5. Ensure that 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—even if a stock you are already in-

vested in presents an excellent covered call opportunity.

8. Buy the stock first and then immediately sell the call. Do not hesitate.

If you buy the stock and wait for a better price for the call, you are no

better than a speculator, and you will get burned!

Using the CSE Screener to Select

U.S. Covered Calls

The CSE Screener is a proprietary covered call search and filter tool de-

signed, developed, and maintained by Compound Stock Earnings. The CSE

Screener allows investors to quickly and easily search the stock market for

the highest returning covered call positions that meet specific fundamental

and technical requirements. The tool is tailored to accommodate the criteria

and rules established in this book for selecting covered call positions.

Anyone who purchases Covered Calls and LEAPS—A Wealth Option is

entitled to one month’s complimentary access to the Covered Call Toolbox

(which includes the CSE Screener) by going to www.compoundstockearn

ings.com/freemonth. Thus readers can actually use the tools while learning

about them in this book.

Because the U.S. market is extremely large, you can be very selective in

terms of the quality of the companies in which you invest. You should use

the following eight parameters to filter U.S. covered call opportunities:

1. Uncalled return of minimum 4 percent.

2. Called return of minimum 4 percent.

3. Price-earnings ratio (PE) of 35 or less.

4. Market capitalization of US$500 million or more.

5. Average broker recommendation of 2.5 or less.

6. An aggregate of the brokers recommending the stock as “Strong Buy”

and “Buy” greater than the number of brokers recommending the stock

as “Hold.”

7. A consensus earnings per share (EPS) estimate for “Next Fiscal Year”

forecast to be greater than the consensus EPS estimate for “This Fiscal

Year.”

8. Stock trading less than 75 percent of its 52-week trading range.

Appendix A 181

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How to Look at a Price Chart

When an investor assesses a price chart, he or she must be able to answer

the following four questions:

1. What is the overall trend: upwards, downwards, or sideways?

2. What are the past cycles: upwards, downwards, or sideways?

3. What is the current cycle: upwards, downwards, or sideways?

4. Where are we in the current cycle: the bottom, middle, or top?

Identifying Upward, Downward, and Sideways

Moving Stocks in the Context of Covered Calls

Upward moving stocks can be of two types:

1. Stocks in a generally rising cycle.

2. Stocks that have had significant price declines in the preceding months

and are currently in an upward cycle. A stock is currently in an up-

ward cycle if it has (a) substantially broken through the upper line of

the declining price cycle and (b) established a new rising price cycle (a

cycle with higher tops and higher bottoms).

Downward moving stocks are those that have had significant price de-

clines in the preceding months and are continuing to decline. These stocks

should be avoided. They have not substantially broken through the upper

line of the declining price cycle and established a new rising price cycle (a

cycle with higher tops and higher bottoms).

Sideways moving stocks are suitable for covered call investment and

are characterized by predominantly stable bottoms and tops; that is, the

tops and bottoms of the cycle are getting neither higher nor lower.

The Buying Low Rule for Covered Calls

The buying low rule for covered calls exists to ensure that new covered call

positions are only entered into in the lower portion of a stock’s current

price cycle. Investing in stocks that are in the lower portion of the current

price cycle increases the likelihood that the stock price will increase after

entering into a new position, and therefore, increases the likelihood of

being called out at the end of the option month. Being called out at the end

of the option month is a primary objective of covered call investing.

The buying low rule for covered calls includes two stipulations:

1. Invest in stocks that are upward moving or sideways moving.

182 Appendix A

bapp.qxd 10/23/06 2:26 PM Page 182

2. Only invest in a stock when it is in the lower 25 percent of the current

price cycle. Investing in the lower 25 percent of the cycle makes it more

likely that the stock will move up after entering the transaction and,

therefore, increases the likelihood of being called out.

The Rules for Investing in Non-U.S. Markets

1. You can establish new positions only on down market days. A down mar-

ket day is a day when the major market average index for that market is

in the red (trading lower than the close of the previous trading day).

2. You must always only sell the near month call when entering a new

covered call position.

3. You should assess the universe of optionable stocks for the fundamen-

tal and technical data outlined in the U.S. covered call search criteria.

Preference should be given to stocks that more fully meet these

criteria.

4. You should assess the universe of optionable stocks in the chosen mar-

ket for both uncalled and called returns and invest in the highest yield-

ing opportunities.

5. Always give priority to maintaining acceptable levels of diversifica-

tion—never have more than 10 percent of your investment capital in any

one stock. Preferably construct a portfolio of between 10 and 20 stocks.

6. Buy the stock first and then immediately sell the call. Do not hesitate.

If you buy the stock and wait for a better price for the call, you are no

better than a speculator, and you will get burned!

The Mid-Month Rule

Once you have entered into the covered call position or sold a secondary

call, all you need to do is have patience and wait for the option’s expiration

at the end of the month. However, you can decide to be a little more proac-

tive during the month and utilize the mid-month rule, which can have the ef-

fect of significantly increasing your returns on the position.

The mid-month technique involves buying back the short call for a

profit in the first two weeks of the month. The five rules for implementing

this technique are:

1. If you have sold a call for a 5 percent uncalled return or more, the mid-

month technique 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 percent for the month, then do so.

Appendix A 183

bapp.qxd 10/23/06 2:26 PM Page 183

3. You then put in a good til canceled (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 ex-

piration, move to the secondary call sales rule.

The Rules for Secondary Call Sales

A secondary call sale is any call sale that occurs after you have bought

back the original call or the original call has expired. The six applicable

rules are:

1. Secondary calls can only be sold when the markets are in the green

(higher than the close of the previous day). For the United States,

the markets are in the green when both the Dow Jones Industrial

Average and the NASDAQ are trading above the close of the previous

day. Foreign markets are in the green when the major market index for

that market is trading above the close of the previous day.

2. For the U.S. market, if you can sell a near month call where the un-

called and called returns are both greater than 4 percent, then do

so. For foreign markets, if you can sell a near month call where the

uncalled and called returns are both greater than 1.5 percent, then do

so.

3. If rule 2 isn’t applicable, you should use the TSS for income while

being sure to adhere to the selling high rule. Move the expiration of

the call out to the second to last expiration and sell a call that provides

an uncalled return of minimum 10 percent. Do not sell the last expira-

tion of the option series. This must be kept in reserve for defensive

techniques.

4. The minimum uncalled return of 10 percent for a TSS for income call

sale 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 de-

clines. You may select a lower strike price to allow an easier buyback

to the extent the strike price of the call selected plus the call’s bid price

is greater 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 percent net return can be realized or when the stock reaches

25 percent of the current cycle, whichever occurs first.

184 Appendix A

bapp.qxd 10/23/06 2:26 PM Page 184

The Tethered Slingshot for Income

and the Selling High Rule

The tethered slingshot (TSS) for income and the selling high rule are very

important techniques for the covered call writer as they allow consistent

generation of income in situations where the stock price is trading below

an investor’s cost in the stock.

The rules for the TSS for income are embedded in the preceding rules

for secondary call sales. These rules state that when a call cannot be sold in

the near month that provides both an uncalled and called return of 4 percent

or greater, the investor must use the TSS for income. The investor should se-

lect the second to last expiration and a strike price call that results in an un-

called return of minimum 10 percent. Before this call can be sold, the

investor must ensure that the selling high rule has been satisfied. The selling

high rule relates to the timing of the TSS for income call sale—it is very im-

portant that TSS for income calls are sold at the high point of the price cycle.

The selling high rule states that secondary call sales using the TSS for

income can only be made when a stock is in the upper 75 percent of its cur-

rent price cycle.

Safely Maximizing TSS for Income Call Sale Opportunities—

Understanding Cycles Within Cycles

Maximizing call sale opportunities means taking advantage of as many

movements within the price cycle as possible. To do this, investors must

take advantage of short-term cycles while assessing the selling high rule.

However, investors must not ignore the long-term cycle when using the TSS

for income and selling high rule. Do not sell a call at the bottom of the long-

term cycle. Always view the stock initially over a 12-month time frame to un-

derstand the long-term cycle. Shorter-term cycles can then be assessed. The

top of a short-term cycle is often the bottom of the long-term cycle.

The Rules for Selling Calls on Existing

Stock Holdings

1. New calls may only be sold on up market days. For the U.S. market,

an up market day is when the Dow Jones Industrial Average and the

NASDAQ are in the green (trading higher than the close of the previous

day). For foreign markets, an up market day is when the major market

average index for that country is in the green (trading higher than the

close of the previous day).

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 market price of the stock is

Appendix A 185

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