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 defnitions 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. Ive 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 dont 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.
Editors note: This webinar was originally presented live on October 29, 2008.
1
Youre reading the frst chapter of Wayne Gormans 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
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 its 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, Im
going to assume that you can put a stop on your long asset position, such as a futures position, to protect your-
self. 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.
2
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 its 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.
3
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, were looking for reactionary waves or countertrend (side-
ways) 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, youll 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, youll 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. Youll 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 offcially 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, youd 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. Im using them to better clarify the optimal wave position.
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.
4
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 fnished. 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.
Lets start the frst 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 were 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. Tak-
ing that distance and multiplying it by a
Fibonacci ratio of .382 gives us one pos-
sible end point at 3164.83. The market
already traveled to 3300.00, so, unless
its going to be a truncated ffth wave, it
looks like wave 5 will be longer than
implied by that ratio analysis.
Now well 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.
5
Figure 1-6
March 26 is the last bar on this daily
chart of Aluminum. Wave 5 of (C) of
4 has a truncated ffth: 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 fat, 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
Lets look at some Fibonacci relation-
ships. 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 fnished or has reached its maxi-
mum price retracement and may go
sideways to use up time.
6
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 fnished.
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 fve
waves up to the top, and the move is
over. But the main trend has been up, so
were going to discount that particular
scenario.
It really comes down to three scenarios
all pointing to the upside, which I will
explain next. Were going to assume
that the markets still bullish because
thats the main trend at next higher
degree.
7
Figure 1-10
One possibility is that Aluminum makes
a triangle. This chart is a depiction of
that triangle. It could also make a fat,
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 its going up in wave
B of a fat or its going up in wave B
of a triangle.
Figure 1-11
Lets look at some Fibonacci relation-
ships. 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
its important to frst identify a zigzag
for wave A within wave (4) (or what-
ever the wave is at next higher degree).
If its not a three-wave structure if
this were truly a fve-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 frst structure is three waves for wave A, you can start to narrow down the possibilities. You know that
a fat 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 youre in a triangle.
8
Figure 1-12
At this point, I dont think we can as-
sume that wave (4) is over. Im going
to temporarily call this low wave A of
(4). No matter what happens, the next
move has to be up unless were just to-
tally wrong about the wave count. This
market will either move up in wave (5),
up in wave B of a fat, or up in wave B
of a triangle.
If its a contracting triangle (the shal-
lowest move at termination), wave B
will go up and probably retrace about
.618 or .786 of wave A.
Were 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).
Were going to sell some calls in the area between 3073.83 and 3146.91 and see what unfolds. Were trying to
get the best of both worlds, i.e., earn premium on our calls and also proft 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 were wait-
ing 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 were 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 wasnt confdent 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.
Ive put the equivalent futures prices
on the chart so you can follow the dis-
cussion better. Were buying the May
futures at 131.00. The futures have a
different basis. The futures are based
9
on U.S. dollars per pound, not per ton. And theyre not on a three-month forward basis. The contract size is
44,000 pounds, so one point is one cent, so its $440.00 a point.
Were buying the May futures at 131.00, which is the level on March 26 (labeled Buy in green). Were going
to put the stop at 126.00, which is below the wave A low of 126.25 in futures. Were 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 proft, 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 Ive
labeled wave B, and then there is a bit
of consolidation. Maybe the markets
going into wave C. We can pretty much
eliminate wave (5) in progress. It does
not look like an impulse wave to the up-
side, but rather a big three for wave B,
then another three that hasnt fnished
yet. There are two possibilities at this
point: It could be a fat, meaning that it
will still move higher in wave B, or it
could be a triangle.
However, the odds of this being a fat 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 fat, which it hasnt done yet. Lets 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.
10
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, well measure the length of
wave A (notice the start and end icons)
and multiply that by .618. Then well
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. Theres 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 retrace-
ment.
11
Figure 1-17
The arrows depict what we would ex-
pect if wave C does indeed end here.
Now were going to do the same type
of trade as before. Were going to go
long and sell calls against our position,
and were 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 confdence to put on this trade.
Figure 1-18
Were going to do another covered call.
The current date is May 1. Were going
to buy the June futures at 128. They
expire June 26. Were going to sell the
June 135 calls, which expire May 27.
That gives us a premium of .90. Again,
were 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 were 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, well still achieve our maximum reward, but we will have
misjudged the optimal strike price.
12
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 ex-
pired slightly in the money. Were go-
ing 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 proft on futures so we
still achieved a proft 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.
Were 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 frst step was to deter-
mine 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 pos-
sibility of a fat. (Remember that the C wave of a fat is a fve-wave structure, so a fve-wave structure would
have eliminated the triangle possibility.)
13
Want to Learn More?
Get 30 Additional Pages Filled With More Options Strategies
Youve just read the frst chapter of Wayne Gormans
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
defnitions 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.
Youll learn:
The following options strategies: the covered call, covered
put, bear call spread, bull put spread, long butterfy 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!
Continue your options strategies education:
www.elliottwave.com/wave/RangeBoundStrategiesSpecial

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HOW TO USE

THE ELLIOTT WAVE PRINCIPLE

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