Monthly Archives: November 2011

Index Call Option Spreads for Income

Index Call Spreads

This strategy can be used to enhance returns on a stock portfolio. The first step is to look at the portfolio and determine which index it correlates most closely to. A mostly technology stock portfolio may correlate most closely to the NASDAQ, or the QQQQ ETF. A portfolio of foreign stock might have the closest correlation the EAFE or the EFA ETF. For our example we’ll assume that the investor has a $260,000 portfolio that is highly correlated to the S&P 500. The ETF for the S&P 500 is the SPY. The next step is to determine how many option contracts represent the value of the portfolio. As of the writing of this book the SPY is trading at about $130 so 20 contracts ((20 X100) X $130) = $260,000. The next step is the sell a credit spread on the SPY. If we sell the 133 X 134 spread we receive a credit of 0.25 cents or $500. The maximum risk on the spread is the amount of the spread minus the credit or 0.75 cents or $1,500. If the SPY stays below 133 we keep all of the credit. If the S&P declines, the portfolio will decline and we’ll still keep the credit for additional income or an offset to the decline. If the SPY rises above 134 at expiration we’ll have our maximum loss on the spread, but it will be offset by the gain in the portfolio. Say the SPY is at 135 at option expiration. We’ll have a loss of $1,500 in the call spread, but if the portfolio is 95% correlated to the S&P 500, we’ll have a gain of 3.85% on the SPY. Assuming the portfolio has a 95% correlation to the S&P 500 that translates to a gain of over $9,500 in the portfolio. Using this strategy consistently the investor will have profits on the spread when the market is flat, declines or rises slightly. When the market makes a large gain, the investor will have a loss on the spread that is offset by the gain in the portfolio. Strike prices for the spread can be selected using out of the money options that have a low probability of loss. Remember when a loss does occur it is offset. Over time there should be more winning months than losing months based on lognormal distribution of market returns and the strategy will have a positive expected return.

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Synthetic Long Stock ~ Call and Put Options

Synthetic Long Stock

Options can be used to create positions that act like the underlying investment. Every underlying, option and complex option position has a synthetic equivalent. In other words the tactical option investor can put together option positions that will act in a similar fashion to another option or underlying position. We’ll start with a simple one the synthetic long stock position. A synthetic long stock position will act like owning a long position in an underlying investment whether it’s an individual stock or an ETF. A synthetic long stock consists of a short put combined with a long call. Remember we used the long call position when we wanted to participate in the upside of the market and have limited exposure to the downside. We used the short naked put position to accumulate shares of stock. The naked put has profit potential limited to the premium received for the put if the market makes a large move to the upside the investor does not participate. The long call will participate in a large upside move, but will decay over time if the market is flat, and of course will decline in value if the market goes down. The synthetic long stock is generally put on for a credit when the investor is willing to take on the full risk of stock ownership. They can also be put on for a debit. The short put is sold and the long call is purchased. The tactical option investor is targeting an underlying that they are willing to own if it goes below the strike price of the put, but also wants exposure to the upside to participate in gains if the underlying makes a large upside move. For example say we want a long position in the S&P 500 index. We could purchase 100 shares of SPY for about $13,400. Or, we could sell a LEAP put and buy a LEAP call that expires in about one year, January 2012. The 130 put is currently priced at $8.15 and the 135 call is priced at $8.05. This trade would be opened for a net credit of .10 or $10 for one contract. The margin requirement would be 20% of 130 or $2,600. That means that the difference between the cost of the 100 shares of SPY and the margin requirement for the synthetic long stock position, the $10,800, could be invested in a safe interest bearing Treasury bond for the duration of the trade. It provides for a better use of capital. If the SPY is below in a year we’ll purchase the shares at 130 plus our credit for a net cost of $129.90. Between 130 and 135 we’ll keep the $10. Above 135 we keep the initial credit plus any price above 135. If the S&P has a 10% gain for the year. It would close at $147.95. The profit from the synthetic would be $1,305, which is a 50% gain on the margin requirement, plus the interest on the $10,800 which was set aside in a treasury obligation. At today’s low interest rates the return on the bond is not that much, but in a higher rate environment it can add up. If rates were at 5% the return would be $540 at 1% the return is only $108. The key point is that a 10% move in the market gave us a 50% gain on the margin requirement and the risk is the same. If you just bought the 100 shares outright and paid $13,400 you’d still have a nice gain of $1,395 or 10%.

SPY Synthetic Long Stock

P/L Graph for SPY Synthetic Long Stock

 

 

Understanding Call and Put Options

Understanding options

            What is an option? An option is a contract written on an underlying investment vehicle. There are options on stocks, futures, indexes and exchange traded funds. We are going to focus on stock and ETF options. There are two types of option contracts, call and put. There are also two parties to each contract, the buyer of the option also known as the holder and the seller of the option who is also known as the writer. The holder of a call option has the right but not the obligation to purchase the underlying. The writer of a call has the obligation to sell the underlying. The holder of a put has the right to sell the underlying, while the writer of a put has the obligation to purchase the underlying. In market jargon if you buy an option you are considered to be long that option contract. Similarly if you sell an option you are considered to be short that option contract. If you sell and are short the option you can be either covered or uncovered. The market term for uncovered option positions is naked. So if you sell a call on a stock where you already own the underlying you are considered to be covered and that is known as a covered call. If you sell a call and do not own the underlying then you are short a naked call and the risk is potentially unlimited. Remember if you buy a call you have the right to buy the underlying stock at the strike price of your call contract. If you sell a call you are required to deliver the underlying stock at the strike price of the call contract. If you sell a naked call and the stock price rises dramatically due to a merger announcement or new product announcement the losses can be severe. If you have seen options literature that suggests you can have 90% winners that is the kind of risk they are taking on. There are always option contracts available that have a 90% probability of being out of the money at expiration. It’s the 10% that end up in the money that create substantial losses. Tactical option investors who use options to manage and enhance returns on stock and ETF portfolios control risk at all times. We do not use positions ever that have unlimited risk even if the probability of success is very high. When we employ option positions it is to enhance the performance of our portfolio and we are always aware of the risk we have at all times and only use option positions that have a defined risk. There are only two types of option contracts, call and put but they can be put together in numerous ways to create complex positions based on one’s outlook for the market. There are spreads, straddles, strangles, butterflies, condors and more. Later on we’ll discuss the various strategies, how they relate to market conditions and how they can be strategically employed along with an existing portfolio.

The Covered Call – How to Sell a Call

The covered call is one of the most common option market strategies employed by individual investors. The call writing strategy can lower risk and produce income at the same time. The investor will sell a call on her stock position for immediate income. The call money shows up in the account right away. The covered call writer is moderately bullish to neutral in her market opinion and is willing to sacrifice some upside gain in order to collect the premium from the sale of the call contract. The risk of the underlying stock position is reduced by the amount of the call premium or call money received. Call premium from the short call is received into the investors account as immediate income. For example an investor may buy 100 shares XYZ stock at $25.00 and subsequently sell 1 October $30 call at $1.25.  At expiration if XYZ is above $30, the investor will have the stock called away.  When below $30, at expiration the investor will keep the shares, any gain between $25 and $30, and the call premium of $1.25. Her cost basis in the stock is now also reduced to $23.75, the initial price of the stock minus the premium received for the call.

Numerous academic studies have been done on the covered call strategy also known as the buy write strategy and one of the conclusions drawn from them is that covered call writing can not only enhance portfolio return, but the strategy has been shown to provide those returns with lower risk. The portfolio volatility  can be significantly reduced by employing a covered call writing strategy. Since the delta of an at the money option is 50 and the delta of the underlying fund is 100, if an investor sells an at the money option, the position delta is reduced to 50, so that position has about half the risk of the underlying position as long as the option stays at the money, as long as the price of the underlying does not move very much. Another Greek that the covered call writer wants to monitor closely is the theta, or rate of decay. The theta tells the option writer how much money she’ll earn daily just through price erosion. At the money options will have the highest theta. Shorter term option contracts will  have a higher theta than loner term option contracts.

Say for example that an investor sells a slightly out of the money option for $2 at the beginning of the month, not the first calendar day of the month, but the first Monday following the third Saturday of the month. If the underlying price stays steady or declines slightly in the last week of the option’s life it may be only worth 5 cents. Since the option’s theta is now only 5 cents and the investor has already earned $1.95 in profit, it may make sense to buy that option back and sell the following months slightly out of the money option and try to increase the theta of the holding. In other words attempt to increase the daily income earned through option decay. Calls can be written on index options as well as on individual stocks and that is a good way to lower risk by avoiding what is known as company specific risk.

Profit Loss Graph for a Covered Call

SPY Covered Call P/L Graph