Covered Call Covered Put

HOW TO USE THE ELLIOTT WAVE PRINCIPLE TO IMPROVE YOUR OPTIONS TRADING STRATEGIES

Range-Bound Strategies

Covered Call and Covered Put

EWI eCourse Book

How to Use the Elliott Wave Principle to Improve Your Options Trading Strategies Range-Bound Strategies — Covered Call and Covered Put By Wayne Gorman, Elliott Wave International Chapter 1 — Covered Call and Covered Put

Introduction This book introduces the standard textbook definitions of various options strategies and then explains how to apply them in the context of Elliott wave analysis, using real-world price charts. My name is Wayne Gorman, and I am Senior Tutorial Instructor at Elliott Wave International. I have over 25 years of experience in trading, forecasting, and portfolio management. I’ve been using the Wave Principle since 1986. In this volume, we will discuss range-bound strategies, including the covered call and covered put. We will review the basic description that you would see in most option textbooks and discuss how you can use Elliott wave to manage these strategies. As you proceed through the course, keep in mind the approach: Given any one of the strategies, I will show how you can best implement and manage it while using the Elliott Wave Principle. I don’t mean to imply that any of these strategies is better or worse than going outright long or short, or that you should use any of these strategies in particular. These all happen to be strategies that various option traders use. If you already feel comfortable using one or more of these strategies, then this course will show you how to use Elliott wave to improve upon how you implement and manage that strategy. Editor’s note: This webinar was originally presented live on October 29, 2008.

You’re reading the first chapter of Wayne Gorman’s 43-page eBook, How to Use the Elliott Wave Principle to Improve Your Options Trading Strategies — Volume 2: Range-Bound Strategies. For a limited time, EWI subscribers and Club members can purchase the entire eBook at a 30% discount. Go to: www.elliottwave.com/wave/RangeBoundStrategiesSpecial 1 To return to Club EWI for more free resources, go to: www.elliottwave.com/clublibrary © 2011 Elliott Wave International — www.elliottwave.com

Chapter 1 Covered Call and Covered Put

Figure 1-1 A covered call means that you are already long an asset. You then sell one out-of-the-money call and have a net debit if you include the cost of the asset. The outlook is neutral to moderately bullish and it’s a relatively short-term strategy — one month. The maximum risk is capped at the difference between the asset price paid and the stop price minus the call premium. When we go through the examples with covered calls or puts, I’m going to assume that you can put a stop on your long asset position, such as a futures position, to protect yourself. The maximum reward is capped at the difference between the call strike and the asset price paid plus the call premium. The breakeven is the asset price paid minus the call premium.

You’re reading the first chapter of Wayne Gorman’s 43-page eBook, How to Use the Elliott Wave Principle to Improve Your Options Trading Strategies — Volume 2: Range-Bound Strategies. For a limited time, EWI subscribers and Club members can purchase the entire eBook at a 30% discount. Go to: www.elliottwave.com/wave/RangeBoundStrategiesSpecial 2 To return to Club EWI for more free resources, go to: www.elliottwave.com/clublibrary © 2011 Elliott Wave International — www.elliottwave.com

Chapter 1 — Covered Call and Covered Put

Figure 1-2 The covered put is the counterpart of the covered call, or the mirror image on the short side. You are short an asset and sell one out-of-the-money put. You have a net debit (with the cost of the asset). The market outlook is neutral to moderately bearish, and it’s a relatively short-term strategy — one month. The maximum risk is capped at the difference between the asset price received and the stop price minus the put premium. The maximum reward is capped at the difference between the asset price received and the put strike plus the put premium. Breakeven is the asset price that you received on the short plus the put premium.

You’re reading the first chapter of Wayne Gorman’s 43-page eBook, How to Use the Elliott Wave Principle to Improve Your Options Trading Strategies — Volume 2: Range-Bound Strategies. For a limited time, EWI subscribers and Club members can purchase the entire eBook at a 30% discount. Go to: www.elliottwave.com/wave/RangeBoundStrategiesSpecial 3 To return to Club EWI for more free resources, go to: www.elliottwave.com/clublibrary © 2011 Elliott Wave International — www.elliottwave.com

Chapter 1 — Covered Call and Covered Put

Rely on Elliott wave rules and guidelines. *This represents entry point for both underlying asset and option at the same time or entry point for option when underlying asset position already exists.

Figure 1-3 Here are the optimal Elliott wave characteristics for using the covered call and covered put. First is function. In a covered call or covered put, we’re looking for reactionary waves or countertrend (sideways) moves. Contracting and barrier triangles are the best structures for these strategies, because they are sideways patterns that trade in a narrow range. Ideally, place your strike price at a level that you achieve both the maximum premium and earn the most on your long position. In a covered call, you’ll receive less premium if you set your strike price too high, and, if the underlying price falls short of that strike price, you will not have optimized the trade. If you set the strike too low, you’ll get more premium, but will lose opportunity on the long side if the underlying price goes up past the strike. Ideally, you want the price of the underlying asset to go right to your strike price at expiration. To optimize both of these dimensions, a structure that trades in a narrow range, such as a contracting triangle, will allow you to pinpoint the proper strike. Notice that I underlined “4 of Impulse Wave” for the wave position. That is because wave 4 of an impulse wave is where you will see the most triangles. You’ll often see triangles in wave B of a zigzag and wave X. Wave Y and wave Z are in parenthesis because they can be sideways moves, but they are not officially countertrend. Wave Y can be a triangle in a double three combination. If there is a triple three combination, then wave Z can be a triangle. We are looking for triangles at a relatively low wave degree, not triangles that span years. If the triangle is of larger degree, you’d trade the impulse waves within the triangle. The entry point for the strategy is at the end of wave a within wave 4 of an impulse wave, or wave a within a B triangle of a zigzag. Letters with circles around them are Elliott wave labels. I’m using them to better clarify the optimal wave position. You’re reading the first chapter of Wayne Gorman’s 43-page eBook, How to Use the Elliott Wave Principle to Improve Your Options Trading Strategies — Volume 2: Range-Bound Strategies. For a limited time, EWI subscribers and Club members can purchase the entire eBook at a 30% discount. Go to: www.elliottwave.com/wave/RangeBoundStrategiesSpecial 4 To return to Club EWI for more free resources, go to: www.elliottwave.com/clublibrary © 2011 Elliott Wave International — www.elliottwave.com

Chapter 1 — Covered Call and Covered Put

For covered calls you want the market to be in a triangle pattern during the correction, but in an uptrend at the next higher degree. For a covered put, the main trend should be down. Next is the wave prior to entry point at next lower degree. Wave a should be finished. An impulse or diagonal wave (c) of wave a should have ended. And, of course, we always rely on Elliott wave rules and guidelines for these strategies. Let’s start the first trading example. In each of these chapters, I will only cover one strategy with a trading example, since the other one is just a mirror image

Figure1-4 The trading scenario in the LME 3-month Aluminum will start on March 26, 2008, which is the date at the far right of this weekly bar chart. A triangle ended cycle wave IV in 2003. We can count waves 1, 2, 3, and 4, and now we’re in Primary wave 5, which is part of the big upsurge that occurred in commodities in early 2008.

Figure 1-5 Before you enter a trade, you need to know the potential for Primary wave 5 to the upside. One Fibonacci guideline is that wave 5 is often equal to the net distance traveled of waves 1 through 3 multiplied by a Fibonacci ratio. Taking that distance and multiplying it by a Fibonacci ratio of .382 gives us one possible end point at 3164.83. The market already traveled to 3300.00, so, unless it’s going to be a truncated fifth wave, it looks like wave 5 will be longer than implied by that ratio analysis. Now we’ll multiply the net distance traveled of waves 1 through 3 by .618. That gives a target of 3631.17 for the endpoint for wave 5. You’re reading the first chapter of Wayne Gorman’s 43-page eBook, How to Use the Elliott Wave Principle to Improve Your Options Trading Strategies — Volume 2: Range-Bound Strategies. For a limited time, EWI subscribers and Club members can purchase the entire eBook at a 30% discount. Go to: www.elliottwave.com/wave/RangeBoundStrategiesSpecial 5 To return to Club EWI for more free resources, go to: www.elliottwave.com/clublibrary © 2011 Elliott Wave International — www.elliottwave.com

Chapter 1 — Covered Call and Covered Put

Figure 1-6 March 26 is the last bar on this daily chart of Aluminum. Wave 5 of (C) of 4 has a truncated fifth: wave (C) ended a little bit higher than the low before it. We can count Intermediate waves (1), (2) and (3). Notice the question mark at the next low. It looks like wave (4), but there is a bit of a “role reversal” here. Usually wave (2) makes a deep retracement of wave (1) and wave (4) is shallow and sideways. The opposite appears to have occurred. Wave (2) is a shallow running flat, and the supposed wave (4) is extremely deep. The large wave (4) over a short period of time tells us that maybe this is not all of wave (4). Since wave four normally makes a shallow and often sideways .382 retracement at its termination point, perhaps the low is actually wave A of (4), and the structure will continue sideways for waves B, C, D, and E, forming a contracting triangle.

Figure 1-7 Let’s look at some Fibonacci relationships. Aluminum has gone way past the .618 retracement to almost halfway between the .618 and .786 retracement of wave (3), implying that wave (4) is either finished or has reached its maximum price retracement and may go sideways to use up time.

You’re reading the first chapter of Wayne Gorman’s 43-page eBook, How to Use the Elliott Wave Principle to Improve Your Options Trading Strategies — Volume 2: Range-Bound Strategies. For a limited time, EWI subscribers and Club members can purchase the entire eBook at a 30% discount. Go to: www.elliottwave.com/wave/RangeBoundStrategiesSpecial 6 To return to Club EWI for more free resources, go to: www.elliottwave.com/clublibrary © 2011 Elliott Wave International — www.elliottwave.com

Chapter 1 — Covered Call and Covered Put

Figure 1-8 This chart examines the C wave of wave (4). Using a Fibonacci expansion of wave A (the blue circle at the 3058 low) to estimate the length of wave C relative to wave A, wave C is almost two times the length of wave A, which is rather large. This implies that this zigzag may be finished.

Figure 1-9 The green arrows on the chart reveal key possibilities. We could be wrong about the uptrend at the next higher time frame. Perhaps Aluminum did turn and the count is wrong. Maybe there are five waves up to the top, and the move is over. But the main trend has been up, so we’re going to discount that particular scenario. It really comes down to three scenarios all pointing to the upside, which I will explain next. We’re going to assume that the market’s still bullish because that’s the main trend at next higher degree.

You’re reading the first chapter of Wayne Gorman’s 43-page eBook, How to Use the Elliott Wave Principle to Improve Your Options Trading Strategies — Volume 2: Range-Bound Strategies. For a limited time, EWI subscribers and Club members can purchase the entire eBook at a 30% discount. Go to: www.elliottwave.com/wave/RangeBoundStrategiesSpecial 7 To return to Club EWI for more free resources, go to: www.elliottwave.com/clublibrary © 2011 Elliott Wave International — www.elliottwave.com

Chapter 1 — Covered Call and Covered Put

Figure 1-10 One possibility is that Aluminum makes a triangle. This chart is a depiction of that triangle. It could also make a flat, meaning that the move to the recent low is wave A, and then it will go up in wave B and come back down in wave C. Perhaps wave (4) has ended; however, fourth waves usually make shallow retracements at their termination points (which would be true if it turns out to be a triangle). In any case, either the market is going up in wave (5) or it’s going up in wave B of a flat or it’s going up in wave B of a triangle. Figure 1-11 Let’s look at some Fibonacci relationships. If it makes a triangle, it probably would end right in the middle of the price range, making a .382 retracement. When you see large A waves like this that happen over a short period of time, you have to consider this possibility. Another thing I want to point out is that it’s important to first identify a zigzag for wave A within wave (4) (or whatever the wave is at next higher degree). If it’s not a three-wave structure — if this were truly a five-wave structure — then the next structure at higher degree would be a zigzag, probably for all of wave (4), and the structure would not travel sideways. Zigzags (covered in Volume 1) make sharp corrections and are not for sideways strategies such as the ones we are going through in this volume. If the first structure is three waves for wave A, you can start to narrow down the possibilities. You know that a flat is a 3-3-5, and a triangle is a 3-3-3-3-3. With some strategies, you can start taking action right after the initial zigzag or A wave, if you have strong evidence that wave A is over. With other strategies, you might have to wait for wave C before you even know that you’re in a triangle. You’re reading the first chapter of Wayne Gorman’s 43-page eBook, How to Use the Elliott Wave Principle to Improve Your Options Trading Strategies — Volume 2: Range-Bound Strategies. For a limited time, EWI subscribers and Club members can purchase the entire eBook at a 30% discount. Go to: www.elliottwave.com/wave/RangeBoundStrategiesSpecial 8 To return to Club EWI for more free resources, go to: www.elliottwave.com/clublibrary © 2011 Elliott Wave International — www.elliottwave.com

Chapter 1 — Covered Call and Covered Put

Figure 1-12 At this point, I don’t think we can assume that wave (4) is over. I’m going to temporarily call this low wave A of (4). No matter what happens, the next move has to be up unless we’re just totally wrong about the wave count. This market will either move up in wave (5), up in wave B of a flat, or up in wave B of a triangle. If it’s a contracting triangle (the shallowest move at termination), wave B will go up and probably retrace about .618 or .786 of wave A. We’re going to take it step by step. The trend is up, so we are going to go long. The question is, do we sell calls against our position? And, if we do sell some calls, where do we put the strike? We want to keep it short in terms of expiration because we want to be outright long eventually, since we will go up in wave (5). We’re going to sell some calls in the area between 3073.83 and 3146.91 and see what unfolds. We’re trying to get the best of both worlds, i.e., earn premium on our calls and also profit from our long asset position. If the market indeed should start to go sideways, at least we made some money on the short calls while we’re waiting to earn on the long position. If the market does skyrocket up, then we have an opportunity loss if it blasts through the call strike. But we’re placing the strike price high enough in case it does travel up a considerable amount.

Figure 1-13 The option data on the LME was spotty, and I wasn’t confident about it. So, I decided to keep the charts on the LME three-month Aluminum basis, which is in U.S. dollars per ton, because most people are familiar with it. But, I would trade the futures and options on the CMX or the NYMEX/COMEX. I’ve put the equivalent futures prices on the chart so you can follow the discussion better. We’re buying the May futures at 131.00. The futures have a different basis. The futures are based You’re reading the first chapter of Wayne Gorman’s 43-page eBook, How to Use the Elliott Wave Principle to Improve Your Options Trading Strategies — Volume 2: Range-Bound Strategies. For a limited time, EWI subscribers and Club members can purchase the entire eBook at a 30% discount. Go to: www.elliottwave.com/wave/RangeBoundStrategiesSpecial 9 To return to Club EWI for more free resources, go to: www.elliottwave.com/clublibrary © 2011 Elliott Wave International — www.elliottwave.com

Chapter 1 — Covered Call and Covered Put

on U.S. dollars per pound, not per ton. And they’re not on a three-month forward basis. The contract size is 44,000 pounds, so one point is one cent, so it’s $440.00 a point. We’re buying the May futures at 131.00, which is the level on March 26 (labeled “Buy” in green). We’re going to put the stop at 126.00, which is below the wave A low of 126.25 in futures. We’re going to sell the May 2008 140.00 calls at .75. They expire on April 25, which is about one month forward. The May futures expire May 28. The maximum risk is 4.25 points, the maximum reward is 9.75 points, and the breakeven is at 130.25.

Figure 1-14 Here we are on April 28. The May 140 calls expired out of the money, since the price never got up that high. We made a 5.5 point total profit, 4.75 points on our futures contract when it settled at 135.75, and the .75 premium we earned for selling the calls. We earned some premium, and now we have a lot more information. There is a three-wave move up, which I’ve labeled wave B, and then there is a bit of consolidation. Maybe the market’s going into wave C. We can pretty much eliminate wave (5) in progress. It does not look like an impulse wave to the upside, but rather a big three for wave B, then another three that hasn’t finished yet. There are two possibilities at this point: It could be a flat, meaning that it will still move higher in wave B, or it could be a triangle. However, the odds of this being a flat are diminished because we would have expected the B wave to have gone up closer to the start of wave A. Keep in mind that the B wave has to retrace at least ninety percent of wave A in a flat, which it hasn’t done yet. Let’s put on another covered call. We have to wait for wave C to the downside — a three-wave structure that does not go past wave A. If we see three three-wave structures, that presents strong evidence that there is a triangle in progress.

You’re reading the first chapter of Wayne Gorman’s 43-page eBook, How to Use the Elliott Wave Principle to Improve Your Options Trading Strategies — Volume 2: Range-Bound Strategies. For a limited time, EWI subscribers and Club members can purchase the entire eBook at a 30% discount. Go to: www.elliottwave.com/wave/RangeBoundStrategiesSpecial 10 To return to Club EWI for more free resources, go to: www.elliottwave.com/clublibrary © 2011 Elliott Wave International — www.elliottwave.com

Chapter 1 — Covered Call and Covered Put

Figure 1-15 In a triangle, alternate waves (meaning A and C, B and D, C and E) are often related to each other by the Fibonacci ratio of .618. In other words, we often see that wave C will be equal to .618 of wave A. So, we’ll measure the length of wave A (notice the start and end icons) and multiply that by .618. Then we’ll expand that distance from the end of wave B, which gives us 2846.17 in the LME 90-day forward price, which is 129.19 in futures. Our strategy is to wait and see if we get three waves down for wave C. There’s no reason to go long at this point. The best time is at the end of wave C.

Figure 1-16 The updated chart reveals that wave C has gone slightly past the .618 retracement.

You’re reading the first chapter of Wayne Gorman’s 43-page eBook, How to Use the Elliott Wave Principle to Improve Your Options Trading Strategies — Volume 2: Range-Bound Strategies. For a limited time, EWI subscribers and Club members can purchase the entire eBook at a 30% discount. Go to: www.elliottwave.com/wave/RangeBoundStrategiesSpecial 11 To return to Club EWI for more free resources, go to: www.elliottwave.com/clublibrary © 2011 Elliott Wave International — www.elliottwave.com

Chapter 1 — Covered Call and Covered Put

Figure 1-17 The arrows depict what we would expect if wave C does indeed end here. Now we’re going to do the same type of trade as before. We’re going to go long and sell calls against our position, and we’re expecting waves D and E to unfold. Our best estimate for the end of the triangle is somewhere in the middle of the range. Now you can see even more clearly than before the semblance of a triangle forming, so we have a lot of confidence to put on this trade.

Figure 1-18 We’re going to do another covered call. The current date is May 1. We’re going to buy the June futures at 128. They expire June 26. We’re going to sell the June 135 calls, which expire May 27. That gives us a premium of .90. Again, we’re going to put a stop on our futures contract at 126, right below the wave A low. Wave C should not go below wave A; otherwise, the triangle is invalid. Our maximum risk is 1.1, our maximum reward is 7.9, and our breakeven is 127.10. Again, those are all in futures terms not the U.S. dollars per ton LME terms. Note that we’re selling the calls in the middle of the range at 135.00. Why? This is because the optimum trade is that the price of the underlying Aluminum futures will go right to the strike at expiration. If the market blows through it, we’ll still achieve our maximum reward, but we will have misjudged the optimal strike price.

You’re reading the first chapter of Wayne Gorman’s 43-page eBook, How to Use the Elliott Wave Principle to Improve Your Options Trading Strategies — Volume 2: Range-Bound Strategies. For a limited time, EWI subscribers and Club members can purchase the entire eBook at a 30% discount. Go to: www.elliottwave.com/wave/RangeBoundStrategiesSpecial 12 To return to Club EWI for more free resources, go to: www.elliottwave.com/clublibrary © 2011 Elliott Wave International — www.elliottwave.com

Chapter 1 — Covered Call and Covered Put

Figure 1-19 The market traveled up into a possible wave D, and then traveled down into the May 27 expiration date. It closed at 135.75, so our options expired slightly in the money. We’re going to close out the futures right now. I labeled this peak as wave D. The June calls expired in the money at .75, but we made a nice profit on futures so we still achieved a profit of 7.9. We earned from 128.00 to 135.75 on the futures, gave back 0.75 on the calls that expired in the money, and received a premium of 0.90. We’re coming to the end of the triangle, so there is no incentive to sell calls anymore; we want to be long for the big thrust out of the triangle in wave (5) of 5. Figure 1-20 Here we see the aftermath of the trade. Wave E traveled right down to the A-C trendline, and then the market thrust out of the triangle to complete wave (5). Wave (5) of 5 actually went up to 3375.00, which is a new high; Primary wave 3 ended at 3300. If we were just trading futures, we would have gone long for the thrust out of the triangle.

Summary The key is to take it step by step. Within this wave (4), the first step was to determine if there was some kind of zigzag. And then we had to decide, is it all of wave (4) or part of wave (4)? But when you looked at all the possibilities, you realized that three out of the four pointed up. And then we kept looking for more zigzag patterns to form a triangle to eliminate the possibility of a flat. (Remember that the C wave of a flat is a five-wave structure, so a five-wave structure would have eliminated the triangle possibility.) You’re reading the first chapter of Wayne Gorman’s 43-page eBook, How to Use the Elliott Wave Principle to Improve Your Options Trading Strategies — Volume 2: Range-Bound Strategies. For a limited time, EWI subscribers and Club members can purchase the entire eBook at a 30% discount. Go to: www.elliottwave.com/wave/RangeBoundStrategiesSpecial 13 To return to Club EWI for more free resources, go to: www.elliottwave.com/clublibrary © 2011 Elliott Wave International — www.elliottwave.com

Want to Learn More? Get 30 Additional Pages Filled With More Options Strategies

You’ve just read the first chapter of Wayne Gorman’s 43-page eBook, How to Use the Elliott Wave Principle to Improve Your Options Trading Strategies — Volume 2: Range-Bound Strategies. For a limited time, EWI Subscribers and Club members can purchase the entire eBook at a 30% discount. Range-Bound Strategies introduces you to the textbook definitions of various options strategies and then uses real-world price charts to explain how you can apply these strategies in the context of Elliott wave analysis. You’ll learn: • The following options strategies: the covered call, covered put, bear call spread, bull put spread, long butterfly and long condor. • For each strategy, which Elliott wave structure provides the best opportunity for a successful trade • Where to set entry, price target and exit levels • How to determine whether to hold the position until expiration • How you can use Elliott wave to manage these strategies. • And much more!

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