By Chris Ebert
Stock options are not only useful tools for managing the risk of a trade; they can also be analyzed in ways that can help determine the appropriate times to place a trade. This week's focus is on Starbucks (SBUX) options.
How it works
The theory goes like this: If it is not possible to profit from selling covered calls on a stock, then it is not a good time to own shares of that stock. Simple enough, right? If covered calls are poor trades, then certainly owning the stock outright, without the benefit of collecting the premiums from selling calls, is even worse.
Perhaps more importantly, if covered calls are profitable trades, it is generally a good time to own shares of the underlying stock, even when the stock price is declining. Stock prices rarely go up or down in a straight line. In order to fully realize the profit potential of a trade, it therefore becomes necessary to hold onto a position that temporarily moves in an unfavorable direction. While there are many forms of technical analysis that can help determine whether or not a move is temporary, an analysis of covered calls is often all that is necessary.
At-the-money covered calls opened 7 days prior to expiration are a good indicator of a short-term trend, but their performance fluctuates too much to make them a reliable. Those opened 28 days before expiration are much less sensitive to false signals, but they remain vulnerable to minor corrections that are unlikely to affect the long-term trend. Even so, poor performance over the 28-day time frame is a warning for traders to pay close attention to the stock.
At-the-money covered calls opened with 112 days to expiration are very reliable predictors of a long-term trend. When they are profitable, the trend is almost always up, even in the face of significant corrections that cause the 28-day and 7-day trades to suffer losses. A trader has a high probability of catching the majority of a trend by:
- Waiting for 112 day covered calls to show a profit before buying stock, and
- Selling or shorting only when 112 day covered calls result in a loss.
Starbucks shares have plunged recently. Undoubtedly, some traders are looking for an opportunity to buy at a bargain price. But is now the time?
The SBUX 112-day covered call analysis has been very effective at predicting the trend over the past two years, with only one false signal. A trader who used this form of analysis would have:
- Bought shares at $25 the week of August 30, 2010
- Sold at $26 the week of October 4, 2010
- Bought at $27 the week of October 11, 2010
- Sold at $52 the week of July 16, 2012 (just $10 shy of the recent $62 high)
In order for the 112-day covered call analysis to return a "buy" signal in the next few weeks, one of the following levels of SBUX shares would need to be exceeded:
- $58 the week of July 30
- $55 the week of August 6
- $54 the week of August 13
- $52 the weeks of August 20 and 27
These levels are not meant for bargain hunters, only those who are interested in going long when trader's emotions, as portrayed by the performance of covered calls, would suggest it is safe to do so.
Why it works
Traders have emotions. Different forms of technical analysis are aimed at revealing those emotions. Whether it is the use of candlestick patterns, simple moving averages, Ichimoku clouds or Fibonacci retracements, the goal is the same; to learn how other traders feel, or are likely to feel in the future.
Every form of technical analysis has its advantages and limitations, and covered call analysis is no exception. However, covered calls provide a view of the trend that is adjusted for changes in volatility - a property that tends to make them less arbitrary than other indicators. A Fibonacci trader may swear by a 0.618 retracement as a trading signal, just as one using moving averages may swear by a loss of the 200 sma or the 5 ema. But in reality, as effective as those numbers might be, they are still somewhat arbitrary. Even the trader using Bollinger bands or Elliott waves must concede that no matter how well-considered, the time frame of the analysis is ultimately arbitrary.
As mentioned earlier, covered call analysis is not perfect. There is a choice to make regarding the expiration date of the options to be studied, and that choice adds an arbitrary aspect. However, the performance of such trades tends to have very little dependence on time frame when the time to expiration is longer than one month. The performance of a 112-day covered call is not likely to differ significantly from one opened 80 days prior to expiration, or 100 days or 120 days. So although the choice of the 112-day time frame as a "buy" and "sell" indicator is arbitrary, the effect of that arbitrariness is very minor.
While that may seem like a very complex reason for why covered call analysis is effective, the most compelling argument may be found by answering this question: "If I owned a stock and could consistently sell covered calls, a few months out, and receive a profit every time, would I sell the stock?"
Option position returns are extrapolated from historical data that, while reliable, cannot be guaranteed accurate. It is not possible to match the exact performances shown, because the strike prices and expiration dates used in the calculations will not always be available in actual trading.
The preceding is a post by Christopher Ebert, who uses his engineering background to mix and match options as a means of preserving portfolio wealth while outpacing inflation. He studies options daily, trades options almost exclusively, and enjoys sharing his experiences. He recently co-published the book "Show Me Your Options".
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