Category Archives: Bullish Option Strategies

Breakout in Natural Gas

The chart below shows today’s breakout in natural gas. UNG is up over 30% year to date. Today’s price move shown in the red bars is over two standard deviations. The bottom line on the chart is the ratio of the implied volatility to the statistical volatility, IV/SV ratio. I have talked about nat gas on my radio show, Ken’s Bulls and Bears report quite a bit this year and have been recommending it as a long position. $UNG is a part of my ETF covered call model portfolio.

UNG 04-18-2013

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.

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

 

 

Bull Put Spread ~ Put Options

Bull Put Spread

Put Spreads can be used when an investor is willing to accumulate stock, but have downside protection in case the underlying stock breaks below a pre-determined level. The strategy is called the bull put spread.

What you do is sell out of the money put options, but purchase further out of the money put options for downside protection in case the stock breaks down. For example if XYZ is trading at $25, the investor sells 1 $20 put option and buys one $15 put option for a net credit of $1.  If the stock stays above $20, the investor will keep the credit. If it goes below $20, the stock will be put to the investor, but the investor has downside protection at $15 so the maximum potential loss is capped at $4.

SPY Credit Put Spread

P/L Graph for SPY Bull Put Spread

Limiting risk with call options ~ How to Trade

The long call option is probably one of the simplest option positions to understand. The purchaser of a call is considered to be long a call option. The long call gives the investor exposure to the upside of the market while the risk is limited to the premium paid for the option. Long calls will have a positive delta and a negative theta. LEAPS or long term equity anticipation securities can be purchased up to three years out. If you are bullish on the market for example, but concerned about global events like
sovereign debt defaults, war or terrorism you could purchase a LEAP on an index like the S&P 500, if the market rises you’ll participate. In the event an unexpected event occurs and the market takes a big hit, your risk is controlled because what you have paid for the option is much less than if you had purchased the index fund outright. Considerations to be made when purchasing a long call include the price of the underlying, the implied volatility of the option, the strike price, expiration, delta and the theta or decay factor of the option. Remember the rate of decay accelerates rapidly in the final weeks prior to expiration. Investors buying call options as a limited risk stock substitute should use longer dated contracts to give the underlying more time to make the anticipated move and to minimize the negative effects of time decay. The options delta is also a primary factor to consider. The at the money call with have a delta near 50 which means that the option will move half of what the underlying does. Out of the money calls have lower deltas as they move out of the money, they also have lower prices which equates to less capital at risk but you also need a larger price movement in the underlying to profit. The delta is roughly equal to the probability of the option being in the money at expiration, so a call with a low delta, say a 25 delta call, will only have a 25% probability of being in the money at expiration. An in the money option will have a higher delta, but will also have a higher price meaning more
capital at risk. An in the money call with a 75 delta will have a 75% chance of being in the money at expiration. If the price of the underlying rises, that call’s delta will change at a rate given by the gamma and will go to 100 if the option goes deeper into the money. Generally tactical option investors buy high delta in the money calls as a stock or ETF substitute that have a high
probability of success. When buying deep in the money calls however, it almost never makes sense to pay more for the call than you would to purchase the underlying on margin or 50% of the price of the underlying.

SPY Long Call

SPY Long Call

The naked put, selling puts to accumulate stock

The uncovered or naked put is sold when an investor wants to produce income and is willing to accumulate shares of stock. The key difference between an investor and a speculator when it comes to naked put selling is that the investor is targeting a stock or ETF for a long term buy and has set a price that he is willing to purchase that stock at. The speculator is trying to profit by selling the put and hopes it will either expire worthless or he can buy it back later for a profit.  The investor is satisfied with either outcome having the put expire worthless or getting assigned and purchasing the underlying shares at pre-determined price. Income is produced by selling out of the money put options at a price lower than the current price of a stock, when the investor would be willing to buy the stock at that price.  For example, if XYZ stock is trading at $25, the investor is willing to purchase XYZ at $20. Therefore, she sells a $20 put for $1.  If the stock stays above $20, the investor retains premium. If the stock goes below $20, it will be put to the investor at $20.  However, the investor already has collected $1 in premium so her cost basis is $19.  There are many sources that consider naked put selling to be a risky strategy. However, selling an uncovered put is not as risky as outright stock ownership. If an investor owns a stock that goes to 0, like General Motors, the investor has a total loss. If the same investor sold a put and was assigned on that put to purchase those GM shares, the investor would have retained the put premium even though the shares eventually went to zero. Naked put selling is riskier to the brokerage house because they fear that the investor may not meet the margin call if shares are put to her. If the investor utilizes proper position sizing relative to her portfolio and is using the strategy for stock accumulation uncovered put selling is not a high risk strategy and in fact has the same risk profile as the covered call strategy which is generally considered to be low risk. When stock prices decline, implied volatility has a tendency to rise making the options more expensive. If you’re targeting an entry price for a stock and see it decline rapidly, check the option quotes for a rise in the implied volatility and high prices for out of the money puts. When bad news comes out on a stock that you want to own, that can be a good time for selling out of the money puts. Say you’re willing to accumulate 1000 shares of XYZ over time. You could sell 10 out of the money puts and wait for the shares to get put to you or you could use a fraction of the total, say 2 puts per month and repeat the process until you’ve accumulated the full 1000 shares. When selling naked puts we target investments to accumulate, a price below the current market that we’re willing to buy them at and try to find puts that are relatively expensive. If you’re accumulating shares of a stock, puts will have a tendency to be priced high every quarter prior to the earnings release. This can create an opportunity for the put seller as the implied volatility rises to account for a substantial move in the stock. Out of the money puts can have a higher price at this time and provide an attractive entry point. For investors wishing to accumulate shares in a commodity based ETF such as USO, the oil ETF, the volatility can be higher before the weekly release of the petroleum report. Stock index ETFs can have higher implied volatility prior to major releases of
economic data like the monthly employment numbers or scheduled Federal Reserve meetings. When selling a put you can use the delta to approximate the probability of getting assigned at expiration. An at the money put will have a 50 delta, so if you sell an at the money put you have a 50/50 chance of ending up owning the shares. The at the money puts also have a relatively high premium and will have high theta. As the puts move out of the money the delta is lower so the probability of getting assigned also gets lower as you move out of the money. If you sell 20 delta puts the premium may not be that high, but you’ll only get assigned 20% of the time and your entry price into the underlying will be substantially below the current market price.  If you are targeting individual equities with this strategy, you will only get assigned when the stock drops significantly, and you may decide you don’t want to own that stock anymore. It’s very critical to be sure you’re willing to purchase a stock when selling puts. When the strategy is used to accumulate ETF shares in a broad based index like the S&P 500 for example, by selling far out of the money puts on the index, you’ll only buy shares on dips and it can be a good dollar cost averaging strategy for share accumulation in an index fund.

P/L Graph for SPY Naked Put

SPY Short Put