I’ve written many articles highlighting the advantages options trading and how this technique, when deployed in opportunistic or conservative scenarios on a consistent basis may augment overall portfolio returns while mitigating risk in a meaningful manner. Here, I’d like to focus on leveraging cash to engage in options trading, more specifically selling covered puts. Here, I’d like to cover my approach and results in layman's terms about strategy and empirical outcome with commentary.
In short, I’m committing cash to purchasing shares in the future at an agreed upon price while being paid a premium. Usually, this agreed upon price is significantly higher than it currently trades and when factoring in the premium income, the agreed upon price will be slightly lower than the current price. Put another way; I’m committing cash to buying shares in the future for less than the stock trades today. Therefore, the seller of the option contract (in this case me) believes the price will increase, and the buyer (stock owner) believes the price will fall. The stock owner (buyer) and is purchasing insurance in the event the stock falls (paying for the right to sell the stock at an agreed upon price and date). As the stock appreciates in value and approaches the agreed upon price within the contract time frame the shares will be kept by the owner (buyer), and I keep the premium. If the shares decrease in value, then the shares will be sold to me at the agreed upon price (less the premium). My objective is to leverage cash and generate income without owning the underlying shares of the company via options contracts.
Regarding leveraging cash in the form of covered puts, I always ask myself these questions:
1. Why buy a stock now when you can purchase the stock in the future at a lower price while being paid to do so?
2. Why buy stocks at all when you can make money on the underlying volatility without ever owning the shares?
3. Are the shares in question regarding a high-quality large-cap company that has witnessed a correction, pays a dividend, engages in share buybacks and possess an acquisitive mindset?
Timing the market has proven to be very difficult if not altogether impossible. However creating opportunities to lock-in downward movement in a given stock one is looking to own is possible. If a stock of interest has substantially fallen to at or near a 52-week low, then one has an option to “buy” the stock at an even lower price at a later date while collecting premium income in the process. Alternatively, it's also possible to make money on the option itself without owning any shares of the company via realizing options premium gains as the underlying stock appreciates in value off its lows. This is called a covered put option, covered in the sense that one has the cash to back the option contract. Leveraging covered put options in opportunistic scenarios may augment overall portfolio returns while mitigating risk when looking to initiate a future position in an individual stock. In the event of a covered put, this is accomplished by leveraging the cash one currently has by selling a put contract against the shares for a premium. It's also possible to make money on the option itself without owning any shares of the company via realizing options premium gains as the underlying stock appreciates in value.
Selling a put option will take on the obligation to purchase the shares of interest. For instance, he/she is taking on the obligation to buy the shares at $105 a month from now when the current price is $100. The seller of the put contract believes the shares will appreciate to or beyond the $105 level. In this case, the owner of the shares would not exercise the option and assign shares to the put seller if the shares appreciate to or beyond $105. Why sell the shares at $105 to the put option seller when the owner of the shares could sell them on the open market for a higher price than $105? In this case, the put option seller collects a premium from the put option buyer and still makes money without owning any shares. From the stock owner’s perspective, he/she is buying the right to sell the shares at $105 a month from now when the current price is $100. The buyer of the put contract believes the shares will fall below the $100 level. Thus the owner of the shares would exercise the option and assign shares to the put seller if the shares fall below $100. Why sell the shares below $100 on the open market when the owner can sell them to the put seller for $100? This is effectively an insurance policy against the shares falling. In this case, the put option seller collects a premium from the put option buyer and assigned shares that may be significantly lower than the market price. In this scenario, the premium paid to the option seller would be different between the current price and the agreed upon price plus a marginal amount ($105 - $100 = $5 in premium).
Variables in Covered Put Options
1. Strike price: Price at which you have an obligation to buy the stock (seller of the put option) or the price at which you the right to sell your stock (buyer of the put option).
2. Expiration date: Date on which the option expires.
3. Premium: Price one pays when he/she buys an option, and the price one receives when he/she sells an option.
4. Time premium: The further out the contract expires the greater the premium one will have to pay to secure a given strike price. The greater the volatility, the greater the time premium received for covered call writing.
5. Intrinsic value: The value of the underlying security on the open market, if the price moves above the strike price before expiration, the option will increase in lock-step.
When it comes to engaging in secured put selling (e.g. willing to buy shares at an agreed upon price by an agreed upon date while being paid a premium), I search for unique opportunities in high-quality names typically in the large-cap space that have sold off due to largely extraneous factors unrelated to the fundamentals of the company itself. Alternatively, I look for high-growth names that have momentum moving forward that the stock will likely continue. I focus on companies that are growing revenues, possess great growth potential, have an acquisitive mindset while returning value to shareholders via paying out dividends and buying back its shares. There are exceptions to this rule for high-growth stocks such as Netflix, Salesforce, and Facebook that can provide great returns in the options market after a double-digit sell-off or will continue its secular growth trend. Typically, I look for a correction in a given stock due in large part to extraneous factors (i.e. political backdrop, weak foreign data, currency issues, etc.) or a narrow earnings miss. This is often seen times, and recently stocks such as Nike, Target, Disney, Starbucks, Apple and CVS Health have declined dramatically. This is where I'm willing to "buy" high-quality names at 52-week lows via an option contract in hopes of a rebound to net a realized gain without owning the underlying stock. If assigned then I own a high-quality name which was purchased at a 52-week low.
Figure 1 – Empirical covered put contracts over the previous nine months with a 76% win rate
The above recent trades are long-term covered puts that I sold over the previous nine months with a 78% win rate. Again, what I'm essentially saying is that I'm willing to buy the shares at an agreed-upon price (strike price) by an agreed upon date (expiration) while being paid a premium to do so. I offer commentary below for the trades without touching on the fundamental analyses as this is out of scope for this piece. I’ll highlight my strategy for a few trades and the remaining trades follow suit and are an iterative process.
1. Nike example above; the stock had sold off from the high $60s to the low $50s, and I wanted to take advantage of this sell-off via a covered put with a strike price of $60. Nike remained stuck in the low $50s despite strong quarterly earnings. At this point, the contract was at near parity with the premium received, and I was assigned shares at $60 less the premium of $8.40 for an effective purchase price of $51.60. No net realized gain was obtained however I now own a high-quality company at prices not seen since in over 20-plus months. I added to a long-term position and decreased my average share price in the process. The stock now trades near $60 thus an unrealized 16% gain on the shares. I’ve also leveraged these shares and have sold/closed four covered call contracts to net $1.21 in income with a pending fifth covered call contract. Taking the four covered calls into consideration, the $1.21 in income decreased my assigned price to $50.39 per share all while collecting the dividend as well.
2. Disney example above; the stock had sold off from the low $120s to the high $90s, and I took advantage of this sell-off via a covered put with a strike price of $100. Disney propelled higher and broke through the strike price to the mid $100s. At this point, the contract was near worthless, and I decided to buy-to-close the contract at $1.08 to capture ~90% of the contract value. Net realized gain was $818 or a yield or 8.2% ($8.18/$10,000 leveraged or earmarked to potentially purchase the shares). This gain was realized over the course of roughly seven weeks utilizing cash on hand and never owning the underlying shares of Disney.
3. Target example above; same scenario as my Netflix position except the fact that Target is a well-established large-cap stock with a dividend yield and thus premium yields are usually less lucrative for these types of stocks. Despite the less lucrative premiums, the same principles apply. The stock had sold off from the mid $80s to the mid $60s, and I took advantage of this sell-off via a covered put with a strike price of $72.50. Target blew away the numbers and the stock were propelled higher and broke through the strike price to the high $70s. At this point, the contract was near worthless, and I decided to buy-to-close the contract at $0.67 to capture ~90% of the contract value. Net realized gain was $549 or a yield or 7.6% ($5.49/$7,250 leveraged or earmarked to potentially purchase the shares). This gain was realized over the course of roughly four weeks utilizing cash on hand and never owning the underlying shares of Target.
Target assignment - Target missed earnings and the stock sold off thus my covered put was assigned to me at an effective purchase price of $63.54 which was near a 52-week at the time. The stock traded at ~$55 a share at the time of assignment. I lowered my average share price after this assignment to $67.55 from $73.00 or a 7.5% reduction in my average share price. Similar to Nike, I will wait for a rebound off these lows while collecting a 3.55% dividend yield along with an aggressive share buyback program.
Facebook was an exception to the ideal scenario of identifying stocks that have witnessed a correction. Facebook’s earnings momentum is extremely strong and looking at projected EPS and revenue numbers I felt comfortable engaging in this type of trade. Facebook easily broke through the strike of $140. Thus I closed out this position to net $731 or a 5.2% realized gain on cash leveraged.
Occasionally the option buyer will assign shares at a loss and in this case, I usually immediately relinquish the shares or hold on for a brief period before selling the assigned shares at a slight profit. This was the case with Bank of America and Exxon Mobile contracts. When subtracting the premium income from the strike price that shares were assigned, my realized purchased price was less than the price the shares traded on the open market. This gives me an opportunity to sell the assigned shares at a profit on the open market.
When it comes to engaging in covered put selling (e.g. willing to buy shares at an agreed upon price by an agreed upon date while being paid a premium), I search for unique opportunities in high-quality names typically in the large-cap space that have sold off due to largely extraneous factors unrelated to the fundamentals of the company itself. Based on empirical data, I’ve been able to net realized gains utilizing cash-on-hand without owning any shares of the underlying company. If the shares do not appreciate, the contract is worthless, and shares are assigned. I always choose a high-quality company when engaging in covered puts in the event the shares are assigned. Over the course of the previous nine months, I’ve had a 78% contract win percentage while capturing over 50% of gross premiums received. This covered put technique, when deployed in opportunistic or conservative scenarios may augment overall portfolio returns while mitigating risk in a meaningful manner.
INO.com Contributor - Biotech
Disclosure: The author currently holds shares of NKE, FB, TGT, DIS, CVS and GILD and the author is long all these holdings. The author has no business relationship with any companies mentioned in this article. He is not a professional financial advisor or tax professional. This article reflects his own opinions. This article is not intended to be a recommendation to buy or sell any stock or ETF mentioned. Kiedrowski is an individual investor who analyzes investment strategies and disseminates analyses. Kiedrowski encourages all investors to conduct their own research and due diligence prior to investing. Please feel free to comment and provide feedback, the author values all responses. The author is the founder of stockoptionsdad.com a venue created to share investing ideas and strategies with an emphasis on options trading.
Originally published in partnership with INO.com