Even Better then Covered Calls
History suggests that long-term success in the options market is an uncommon achievement for retail traders. There are a variety of reasons for this disparity, however the most obvious cause is poor strategy selection. The majority of popular techniques are based on forecasting the future price of an issue, but determining market direction requires expertise in a number of skills; charting with technical trend and momentum indicators; the use of contrarian systems including sentiment indexes and put/call ratios; and valuation systems such as fundamental analysis. With all of the complexity involved in directional trading, are there any methods that offer the average investor a reasonable opportunity to profit in a comfortable, low maintenance strategy?
Many experts believe that writing covered-calls fits this description quite effectively. An option strategy that includes stock ownership appears much easier to manage (than directional trading) on a day-today basis and it offers a favorable balance of risk versus profit potential for those who attempt to predict market movement. The combined stock/option position is more conservative than just buying stock, due to the fact that a “premium” is collected for the sold call, which lowers the break-even price of each share. This concept of “selling future potential” is very attractive to the investor who is willing to limit his upside in exchange for some downside protection.
But, what if I told you there was a strategy equal in risk to covered-calls, but with far better profit potential. Would you find that hard to believe? Read on...
Selling Insurance on Stocks
Owning publicly-traded stock is by far the most popular method of investing. But, we all know the stock market is difficult, if not impossible, to forecast. At the same time, statistics suggest that stock prices generally move in a predictable manner – that is, they typically remain in a specific range for a given period of time. In addition, share values have historically increased over time with the stock market enjoying a compounded average annual change of nearly 5% over the past century. With this knowledge in mind, would-be stock owners can establish a conservative option-based portfolio with the sale of cash-secured puts.
The strategy is very simple. A trader who writes (sells) a cash-secured put assumes an obligation to purchase the equivalent number of underlying shares at the strike price of the (short) option. The put writer collects and keeps the money from the sale of the put, regardless of the future price of the stock. If the stock price is below the sold strike price at option expiration, the put will be assigned, and the investor will be required to purchase the underlying issue.
New traders often wonder who is buying these puts. The answer, of course, is other option traders. Some are bought by speculators who are hoping for future declines in the underlying, but most puts are purchased by fund managers and individual investors who own the stock and want to protect their portfolios from catastrophic losses. Remember, when you sell a put you are essentially acting as an insurance company. You agree to buy the stock at a predetermined price for a specific period of time. For this pro- 1 tection, the option buyer must pay a premium, in cash. It's a mutually beneficial relationship; the owner of the stock is willing to compensate you for providing insurance against future declines in its market value.
Strategy Basics: Making the Trade
A put option gives the buyer the right, but not the obligation, to sell stock for a specific price for a given amount of time. In contrast, a put seller has the obligation to purchase stock if the option is exercised. The purchase of a put is considered a “bearish” strategy, thus the sale of a put is generally used when the investor is “bullish” on a particular issue. Traders who sell cashsecured puts typically hope to achieve one of two objectives:
Short put options provide income when they expire without assignment. If the option is assigned, the money received from the sale of the put will reduce the cost basis of the stock –hopefully to a level below its market value. If the underlying issue declines substantially, the position will incur a loss as cost of the stock will be more than the current share price.
Let's use a popular “premium-selling” stock as an example. Suppose Yahoo! (NASDAQ:YHOO) is trading near $38. A front-month put option (30 days of time value) with a strike price of $32.50 would sell for about $40.00 per contract. Thus, a trade involving the sale of 5 put option contracts would generate approximately $200 cash before commission costs. The initial margin (collateral) requirement is roughly $1000 per contract, so the position would yield a 4% return for one month if successful. Again, here are the specifics of the trade:
YHOO “Cash-Secured” Puts
YHOO @ $38.00
Sell (5) JAN-$32.50 puts for $0.40 each (X 100) = $200.00
Collateral Requirement = [40% X $38.00 + 0.40 - (38 - 32.5)] X 5 = $5050.00
Return On Investment = $200.00 / $5050.00 = 4%
The maximum profit of 4% or $0.40 (per contract) is achieved as long as the stock price remains above $32.50. That means the share value of YHOO can decline 15%, to $32.10, before the position begins to lose money. For stocks in a bullish trend, that is a lot of downside margin.
Of course, there is still considerable risk in the trade because you have agreed, through the sale of the put options, purchase the stock at $32.50, regardless of how far it might fall. Once the sold strike ($32.50) is breached, losses can become substantial when compared to the potential profit, so it's crucial to:
Despite the unique risk/reward ratio, there are a number of advantages to this strategy. First, the sale of cash-secured puts can be funded with the collateral value of a brokerage account. There is no upfront expense, but rather a commitment to “make good” on the obligation of the (short options in the) trade should the stock fail to perform as expected. In addition, the insurance “premium” is paid in the initial trade, so the incoming funds can be put to work immediately in other positions, further improving the potential return on investment. Finally, a successful outcome occurs when the options expire without assignment, so there are no closing transactions – the (short) puts are simply removed from your account at the end of the expiration period.
Buying Stocks at a Discount
In the previous example, an investor who was interested in purchasing Yahoo! (NASDAQ:YHOO) would pay $38.00 per share in the open market. As an alternative to outright stock ownership, he could write put options at the $37.50 strike for approximately $175 per contract. The potential return on investment would be nearly 11% for a 30-day period with a cost basis of $35.25. The maximum profit of 4% or $0.40 (per contract) is achieved as long as the stock price remains above $32.50. That means the share value of YHOO can decline 15%, to $32.10, before the position begins to lose money. For stocks in a bullish trend, that is a lot of downside margin. Of course, this approach would not guarantee a long position in the underlying issue – YHOO's share value would have to fall below $37.50 for that to occur – but an 11% profit, in exchange for the obligation to buy YHOO near $35, is certainly a viable option-based substitute for a conservative stock portfolio.
After the stock is purchased, the sale of covered- calls can reduce the overall cost of the position. Investors who participate in this strategy generally use out-of-the-money calls to reduce the chance of having their short positions exercised (in which case delivery of the underlying issue would be required). The problem with this technique is that when one sells an out-of-money option, the overall position tends to reflect more of the result of the stock price movement and less of the benefits of writing the call. This dilemma occurs because the premium from the out-of-the-money call is relatively small and the overall position is very susceptible to loss if the underlying stock declines. Conservative traders may find that a better alternative is to commit half of the position to in-the-money options and the other half to out-of-the-money options. By spreading the options among different strike prices, the call writer can acquire more favorable return potential as well as establishing adequate downside protection.
Investors who have large positions in a specific stock can choose even greater diversification by spreading the sold calls over time as well as different strike prices. One can gain several benefits by writing a portion of the calls near-term and the remaining calls further in the future. In the event of large, unexpected move in the stock, the combination of time frames in each position reduce the need to make immediate adjustments. This type of activity may include buying-back one written call and selling another or simply having the stock called away, but with a mixture of sold options, all of the different positions will not need to be adjusted at the same time. Another advantage to this technique is that the level of option premiums may become more favorable than when the original series of calls were written. At worst, only one group of options would be sold when the premiums are small and hopefully they would increase in value before the next expiration period. This type of diversification will also allow you to establish various positions at different strike prices, smoothing the portfolio balance as the market fluctuates cyclically. It also prevents all of one's stock from being committed at a single price.
Some Notable Advantages
One benefit of selling options, as opposed to buying them, is the concept of time decay: the timevalue or excess “premium” in an option's value declines as it approaches expiration. Unlike stocks, where an investor can hold on to a stagnant issue indefinitely in the hope that it will rebound, the value of an option eventually falls to parity if the underlying stock fails to move in the correct direction. This premium erosion allows a put writer to profit without having to correctly predict the future movement of the underlying issue, as long as it remains above the strike price of the sold option. In contrast to most option-buying techniques, short term selling strategies that use out-of-the-money strikes have a high probability of success because the time value of an option, which decays at a predictable rate, falls very rapidly in the final month of the expiration period. Another advantage of this technique stems from the nature of option pricing. The methods used to value options are very complex, involving computerized models that evaluate historical data. But, the calculations are based upon the assumption that all stock price movement is “random.” Clearly, there are always a number of stocks moving in well-defined price trends, as opposed to moving randomly, and if you can identify those issues whose price trends are likely to continue, you can achieve an edge against the option-pricing model. Much of our effort at the OW is devoted to finding stocks that will remain in such trends, so our subscribers can profit from selling options with premiums that do not accurately reflect the (limited) potential for assignment.
Hazards & Consequences
Many investors avoid selling “naked” puts because of the large downside risk; a stock can always fall to zero. However, these same investors are usually willing to buy stock and hold it through a lengthy decline, far beyond a point at which it should have been sold in the name of prudent money management. The key to success with this technique is understanding its unique drawbacks and learning to implement the strategy correctly, in the appropriate market conditions.
From a risk versus reward standpoint, writing deep-out-of-the-money options is based on a high probability of achieving a limited profit. But, as with any “premium-selling” strategy, there will always be a few unexpected losers that create draw-downs far in excess of the profits from winning plays. With that reality in mind, one requirement for success is to prevent the majority of losing positions from being “catastrophic” to your portfolio. The best way to accomplish that task is through diversity, both in the number of contracts per position and in the market sectors/industry groups selected for each position. Another prerequisite to achieving consistent profits with this type of (high probability/low profit) approach is to understand the statistical nature of the strategy, which suggests that careful play selection and diligent position management can produce (over time) a reasonable return on investment.
Despite the mathematically high success rate, this technique is not for everyone and most professional traders admit it is one of the most difficult strategies to master (due to human emotions) in the options market. That's why it is so important to have an exit strategy in place for those few occasions when the underlying stock moves beyond the sold strike price. This plan must be simple enough to implement while monitoring a portfolio of plays in a volatile market and it must be useful in a variety of situations. Remember, it takes a number of winners to offset the big losers, so there simply can't be many big losers. A sound exit strategy will help you avoid exposing your portfolio to excessive losses and that's critical because the science of successful trading is far less dependent on making profits, but rather on avoiding undue outflows.
Margin Requirements & Target Returns
Our goal with this strategy is to generate $400 of income each month using a level II brokerage account with an average balance of $10,000. The account can be funded with cash or equity as long as the minimum margin requirement (a deposit in your brokerage account designed to guarantee that you will cover any written options in the event they are exercised) is maintained for the short option positions. Although our margin/ROI calculations are based on the widely used regulations at the Chicago Board Options Exchange, higher collateral requirements may be imposed either generally or in individual cases by various firms. We suggest that you discuss this strategy and the necessary adjustment techniques with your broker before entering any positions.
A portfolio of conservative cash-secured puts, when prudently selected and diligently managed, can easily achieve a 3-5% monthly (annualized) return. However, most of the positions will provide a slightly larger percentage profit in order to offset the few losing trades. Using this approach, the selection process can focus on "out-of-the-money" positions with a very high probability of success, sometimes as high as 90% – which corresponds roughly to the 2nd standard deviation of a normal distribution. (The market almost always trades within the 2nd standard deviation of a normal distribution). Of course, it would be great if every portfolio play was a “winner” but since that isn't possible, the best course of action is to choose trades that offer a favorable balance between probability of profit and potential downside risk. In those rare cases where things go awry, it's often possible to turn losing plays into winning ones by “rolling” into new positions or purchasing the stock for the sale of covered-calls.
Option Investor Inc is neither a registered Investment Advisor nor a Broker/Dealer. Readers are advised that all information is issued solely for informational purposes and is not to be construed as an offer to sell or the solicitation of an offer to buy, nor is it to be construed as a recommendation to buy, hold or sell (short or otherwise) any security. All opinions, analyses and information included herein are based on sources believed to be reliable and written in good faith, but no representation or warranty of any kind, expressed or implied, is made including but not limited to any representation or warranty concerning accuracy, completeness, correctness, timeliness or appropriateness. In addition, we do not necessarily update such opinions, analysis or information. Owners, employees and writers may have long or short positions in the securities that are discussed.
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