Monthly Archives: December 2011

Using Call and Put Options to Build Stock and ETF Positions

Using Call and Put Options to Pay for Stock and ETF Positions

Is anyone a long term investor anymore? I don’t mean people who hold trades for more than fifteen minutes. This is a strategy for investors who indentify a stock or ETF that they want to own for several years, then use call and put option selling to generate sufficient cash flow over time to completely pay for the holding, once the position has been paid for it can then be held indefinitely.

Here’s how it works, the first step is to decide on the stock or ETF that you want to accumulate a long term position in. I’ll leave that up to the reader and focus on explaining how we are going to pay for that position. For the sake of explanation, I am going to use the Silver ETF, SLV, this is not a recommendation to purchase SLV, it is merely being chosen for explanatory purposes.

The strategy consists of three distinct phases. The first phase is the accumulation phase, where we sell puts and calls until the desired size position is accumulated. The second phase starts once we’ve accumulated enough shares, now we just sell calls until we have paid for the cost of the position. The third phase is the holding phase where we have paid for our shares and we are holding for long term capital appreciation. In this writing we’ll focus on building the position, not on defending it once it’s built or taking profits down the road.

Our hypothetical investor has decided to build a 1000 share position in SLV. She starts the process by selling two out of the money front month SLV puts. Two things can happen here, either the puts will expire worthless or the SLV will get put to her. If the puts expire worthless, we keep track of the profit earned to pay for the position and repeat the process next month. If the stock gets put to us, we take delivery of the stock and we now have 200 shares. Once we get assigned, we now own 200 shares and we will sell 2 puts and 2 calls both out of the money. Now, three possible scenarios can unfold. One is that both options expire worthless and we keep track of our profit and repeat until we either get assigned or one goes in the money. The next scenario is that we get assigned another 200 shares and the call expires worthless. Now we will own 400 shares, and we’ll repeat the process again next month. If the call goes into the money prior to expiration, since we want to accumulate shares, not liquidate them, we’ll roll those calls for a credit into the next expiration.

Once we’ve met our goal for accumulation, 1000 shares, by repeating the process of selling puts and calls, we’ll stop selling the puts and just sell calls until we have collected sufficient premium to pay for the total cost of the position. Then our purchase price for the position has been returned to us and we can hold that investment as long as we wish.

Looking at actual prices of SLV as of this writing, by selling the first strike out of the money on the calls and puts would generate $1.70. SLV is trading at $26.10. $1.70 is 6.5% of the price of SLV. If you could collect that much premium each month it would only take 16 months to pay off the position if the price remained static, which it won’t, if the price were static you wouldn’t get any option premium, volatility is a factor which helps determine the option price. Volatile stocks will have higher premiums than less volatile stocks. Because prices are obviously not static, it’s impossible to determine in advance how long it will take to build and pay off your position, but a good rule of thumb for an issue with good option premiums should be 2 to 3 years. Hypothetically say you already owned 1000 shares of SLV and that your cost was $26.00 per share. The next month’s first strike out of the money calls are at $0.72 cents, if you could collect that much each month just from the calls it would take 36 months or 3 years to pay off your position.

The reality of building positions this way is that some months you’ll have stock getting put to you, some months you’ll be rolling calls up and out for a credit and some months both sides will expire worthless and you’ll keep the credit. You’ll need to keep track of every trade, including the costs and keep with the strategy until your stock is paid for.

Using Call and Put Options to Pay for Stock and ETF Positions

Is anyone a long term investor anymore? I don’t mean people who hold trades for more than fifteen minutes. This is a strategy for investors who indentify a stock or ETF that they want to own for several years, then use call and put option selling to generate sufficient cash flow over time to completely pay for the holding, once the position has been paid for it can then be held indefinitely.

Here’s how it works, the first step is to decide on the stock or ETF that you want to accumulate a long term position in. I’ll leave that up to the reader and focus on explaining how we are going to pay for that position. For the sake of explanation, I am going to use the Silver ETF, SLV, this is not a recommendation to purchase SLV, it is merely being chosen for explanatory purposes.

The strategy consists of three distinct phases. The first phase is the accumulation phase, where we sell puts and calls until the desired size position is accumulated. The second phase starts once we’ve accumulated enough shares, now we just sell calls until we have paid for the cost of the position. The third phase is the holding phase where we have paid for our shares and we are holding for long term capital appreciation. In this writing we’ll focus on building the position, not on defending it once it’s built or taking profits down the road.

Our hypothetical investor has decided to build a 1000 share position in SLV. She starts the process by selling two out of the money front month SLV puts. Two things can happen here, either the puts will expire worthless or the SLV will get put to her. If the puts expire worthless, we keep track of the profit earned to pay for the position and repeat the process next month. If the stock gets put to us, we take delivery of the stock and we now have 200 shares. Once we get assigned, we now own 200 shares and we will sell 2 puts and 2 calls both out of the money. Now, three possible scenarios can unfold. One is that both options expire worthless and we keep track of our profit and repeat until we either get assigned or one goes in the money. The next scenario is that we get assigned another 200 shares and the call expires worthless. Now we will own 400 shares, and we’ll repeat the process again next month. If the call goes into the money prior to expiration, since we want to accumulate shares, not liquidate them, we’ll roll those calls for a credit into the next expiration.

Once we’ve met our goal for accumulation, 1000 shares, by repeating the process of selling puts and calls, we’ll stop selling the puts and just sell calls until we have collected sufficient premium to pay for the total cost of the position. Then our purchase price for the position has been returned to us and we can hold that investment as long as we wish.

Looking at actual prices of SLV as of this writing, by selling the first strike out of the money on the calls and puts would generate $1.70. SLV is trading at $26.10. $1.70 is 6.5% of the price of SLV. If you could collect that much premium each month it would only take 16 months to pay off the position if the price remained static, which it won’t, if the price were static you wouldn’t get any option premium, volatility is a factor which helps determine the option price. Volatile stocks will have higher premiums than less volatile stocks. Because prices are obviously not static, it’s impossible to determine in advance how long it will take to build and pay off your position, but a good rule of thumb for an issue with good option premiums should be 2 to 3 years. Hypothetically say you already owned 1000 shares of SLV and that your cost was $26.00 per share. The next month’s first strike out of the money calls are at $0.72 cents, if you could collect that much each month just from the calls it would take 36 months or 3 years to pay off your position.

The reality of building positions this way is that some months you’ll have stock getting put to you, some months you’ll be rolling calls up and out for a credit and some months both sides will expire worthless and you’ll keep the credit. You’ll need to keep track of every trade, including the costs and keep with the strategy until your stock is paid for.

Forecasting Volatility

Forecasting volatility; With all of the different types of volatility, you may find yourself wondering how and why one should have a forecast of future historical or implied volatility. Most investors spend their time trying to forecast the direction of the market or of an individual stock. Followers of the buy and hold “random walk” theory know that the market has a strong upside bias over long time periods and will buy low cost index funds and hold them indefinitely. Most investors will buy a stock thinking that over time it will appreciate in price and maybe pay some nice dividends along the way. Technical analysts will devote time to studying charts, looking at things like moving averages, stochastics and other indicators to attempt to forecast a future price or at least the direction of the price in the future. Fundamental analysts will study earnings reports, the trend of the reported earnings and use things like PE multiples and book values to determine the future value of a stock. Most investors devote the vast majority of their analytical efforts in studying company reports or charts of past price action to determine the future price of a stock or index. So why would anyone be interested in forecasting the future volatility of a stock?

The first reason is that the volatility of a stock or index generally has an inverse relationship to its price. That is because prices have a tendency to fall faster than they rise. So, if the volatility is increasing, the price is usually declining and if the volatility is falling, the price is generally rising. So, if we could forecast volatility accurately, that would also tell us something about the likely future direction of the stock. There is a great deal of statistical evidence that stock prices do follow a random walk. In other words the current price reflects all of the known information about the company and there is no correlation between past prices and prices in the future.

The second reason is because volatility can be possible to forecast. When analyzing volatility we do find that there is a serial correlation between returns. Volatility has a tendency to manifest itself in clusters. If you look at a chart of price of a stock it goes up or down and may show signs of trending predominately in one direction or another, but the price movements are random. If you study a chart of the volatility of a stock you’ll immediately notice that there are distinct periods of high and low volatility and that the periods of high volatility are followed by periods of lower volatility and that the periods of low volatility are interrupted by high volatility periods. There’s a simple reason for the clustering of volatility. In the absence of significant news a stock may quietly drift higher for a long period of time. If some news like a potential lawsuit, a product recall, or a new product announcement by a competitor comes out, the stock may sell off quite rapidly until the news is fully digested by the investing public. These short term sell offs can be considered to be buying opportunities for investors wishing to accumulate shares of the stock. When we chart the volatility of the stock these news events will show brief spikes in the volatility that typically persist for short periods of time, then return to normal. At times like this the future price direction may not be simple to forecast, but the volatility can be because it is a very good assumption that the volatility will eventually revert to the mean or return to a more normal level. The tactical option investor will utilize periods of high volatility to produce more income or do some share accumulation.

 

Option volatility and stock market volatility

Understanding Stock Market Volatility

I think that it’s important for option investors to have some understanding of basic statistics, especially standard deviation and lognormal distributions. Many option traders use volatility trading, that is they don’t trade by forecasting the direction of a stock price movement, but trade based on a forecast of the volatility. I closely monitor the volatility or standard deviation of the equities and ETFs that I trade.  Basically, there are different types of option volatility that we evaluate. Historical volatility is the standard deviation of the past history of the underlying.  Future volatility is what the volatility will be going forward, typically the period that is the life of the option contract. If the underlying has been through a period of low volatility you may expect it to rise, if it’s been through a period of very high volatility you may anticipate the volatility will quiet down for awhile and consider limited risk strategies that will capitalize on lowering volatility.  The option investor will study the historical volatility to help determine what may happen with the future volatility. Another type of volatility is forecast volatility which is a forecast of what the future volatility might be. GARCH (generalized auto-regressive conditional heteroskesdasticity) models and GARCH variants can be useful tools for volatility forecasting. These three types of volatility are all related to the underlying instrument, the stock or ETF.  Another type of volatility is related to the option contract and is determined by consensus of all of the participants in the market place and is derived from the Black-Scholes options pricing model and that is the implied volatility. When looking at a quote of an option price, check the implied volatility of the option compared to the historical volatility of the underlying. Is it significantly higher or lower? If it is, check the news wire and see if there’s a reason for the pricing. If the implied volatility is high and you’re looking at a stock check to see when the next earnings release date is or if there’s a major product announcement or lawsuit pending. When I am considering entering an option position, I’ll check the implied volatility of the options under consideration. I’ll pay close attention to the relationship between the implied volatility of the option and the historical volatility of the underlying investment. I’ll consider the current standard deviation plus some longer term history of the range and trend of the volatility. In addition to looking at the current implied volatility of the option, I’ll also look the longer term history of the implied volatility of the options. I guess we could call that the historical implied volatility. Since the implied volatility is the current volatility priced into an option, when you trade an option you are essentially making a forecast of the future implied volatility. If you think that the implied volatility is too low and will rise you should consider a strategy that will profit from rising volatility, like a long straddle if you want to be direction neutral or delta neutral. If you believe that the implied volatility is too high and that the volatility will decline in the future you should use a position that will profit from falling implied volatility like a credit spread or iron condor or iron butterfly.

Implied volatility is the one element of the Black Scholes model that must be estimated. Implied volatility can be derived from the formula using the current market price. Options that have a high implied volatility will be expensive and options that have a low implied volatility will be considered cheap. In general we want to sell something that’s expensive and buy something that’s relatively cheap.  So if we’re bullish on a stock and believe that the stock price is reasonable, we’re willing to own it and we think that the option price is high due to the implied volatility, we may think it’s a good time to sell a put. If you’re bearish on a stock, believe that it is overvalued and think that the options are cheap due to low implied volatility an investor may wish to purchase a put. Conversely if you’re bullish and think the implied volatility is low you may want to buy a call. If you’re bearish and think that implied volatility is high you may want to sell a call.