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USING EQUITY OPTIONS TO REDUCE RISK AND INCREASE PROFITS

August 31, 2007
Dr. Paul Price

Dr. Paul Price

103 followers

TAKING THE PROFESSIONAL’S SIDE OF THE MARKET

INSIDE

  1. WHY OPTIONS?
  2. INVEST LIKE THE PROS
  3. PUT WRITING IN ACTION
  4. ROLLING OUT OPTIONS

WHY OPTIONS?

OPTIONS” is a “four letter word” to most investors. Based on most investors personal experiences this is not undeserved. The typical options novice begins by buying puts and calls and losing money. After a few such experiences many people give up on options and never return.

The first key point to remember is that almost all option buyers lose money!

The second key point is that “Options” is a zero sum game. For each dollar lost there is an equal dollar (less commissions) gain.

Thus if virtually all option buyers lose money, then they lose their money to the people who sold them the options. This is the key concept.

Be a seller, not a buyer, and the odds will be heavily in your favor. It’s similar to being “the house” at Las Vegas or Atlantic City but without their overhead expenses. While some gamblers can get lucky in the short run, over time the house advantage will prevail and the casino’s gross win percentages vary little from the statistically projected results. The same is true in options writing (or selling). The odds will always be in your favor if your strategy is sound and your pockets are relatively deep.

Option writing, done conservatively, is less risky than owning the same stocks outright. You will know your “worst case” scenario prior to establishing each position.

WHO BUYS OPTIONS?

  • Speculators
  • Gamblers
  • Hedgers

WHY BUY OPTIONS?

  • Limited Risk: Limited to a loss of 100% of your money!
  • Big Potential Gains: Unfortunately, they generally stay potential.
  • Small Capital requirements: This is one of the real lures.

WHO SELLS OPTIONS?

  • Professional floor traders. They’re very happy to accommodate the public’s demand
  • Mutual funds. (Mainly covered calls)
  • Astute individual investors. Like me and my clients!

WHY SELL OPTIONS?

  • High probability of success.
  • Increased income stream.
  • More conservative than outright buying of shares of the same stock.

INVEST LIKE THE PROS

My favorite strategy, Put Writing, first requires the identification of good underlying stocks. Choosing the proper stocks means selecting shares which will go up in value, stay the same, or at least not decline significantly over the term of the option period. This, obviously, is not a new concept. The difference here is that by writing at or below the market puts we can show gains even if the stock selected does not move up, or even goes down slightly. By lowering our break-even point to under the current market price, we have tremendously increased our chances of winning and reduced paper [or real] losses when positions move against us.

WHAT DOES A PUT WRITER WANT TO HAPPEN?

  • The seller of a put wants the stock in question to go above, or stay above, the strike price through the set expiration date.
  • Maximum profit equals the premium received upon sale of the option
  • Maximum risk is to purchase the required number of shares of the designated company at the strike price less the premium per share received.
  • Ideally, the put writer wants to collect as much premium as possible without ever being asked to purchase any shares. In many cases, but certainly not all, this is exactly what happens.

Just like the farmers who get paid NOT to grow crops, you can often be paid NOT to buy stock.

BENEFITS OF PUT WRITING

  • Either you get paid not to buy, or you own shares at a price you judged in advance to be very attractive.
  • It gives you the discipline to fight your emotions and buy when shares are cheap.
  • Put writing requires no initial cash outlay and it provides positive cash flow from the next business day. Used conservatively, option writing can be a better income vehicle that CD’s or bonds for clients who understand the process.
  • You have a high probability of profitability!
  • “Time”, the raw material you are selling, costs you nothing. “Time” is always on your side.
  • Many times you can be wrong and still make money.

RULES FOR WRITING PUTS:

  • Only write puts on stocks which represent good value.
  • Write only as many puts as you would be comfortable having exercised in a worst case.

PUT WRITING IN ACTION

STOCK TRADING BELOW STRIKE PRICE

ABC Corp. now sells for $19.
We can sell a March $20 put for $2.25 per share.
For selling the put we receive $225 per contract (less commission).
Our “break even” is reduced to $17.75 per share.

POSSIBLE SCENARIOS FOR ABC STOCK:

(ignoring commissions)

  • If ABC goes up to 20 or above: We win the maximum possible.
  • If ABC stays unchanged: We win paper gain of $1.25 per share.
  • IF ABC declines to $17.75: We break even.
  • If ABC falls below $17.75: Paper loss.

Please note that in the first three scenarios, with the stock going up to infinity, staying level or dropping up to 6.6% in value, the results to the option seller were highly profitable in most cases, and neutral at worst.

STOCK TRADING ABOVE STRIKE PRICE

XYZ Corp. now sells for $11 per share.
We can sell a December $10 put for $1 per share.
For selling the put we receive $100 per contract (less commission).
Our “break even” is reduced to $9 per share.
Possible scenarios for XYZ stock:

(ignoring commissions)

  • If XYZ goes up: We win the maximum possible.
  • If XYZ stays unchanged: We win the maximum possible.
  • If XYZ declines to $10: We win the maximum possible.
  • If XYZ declines to $9: We break even.
  • IF XYZ falls below $9: Paper loss.

In the last two situations we could either purchase the shares at a net of $9 per share and wait for a price rebound or we could close the options (if they have not yet been exercised).

Please note that in the above scenarios, with the stock going up to infinity, staying level or dropping up to 18% in value, the results to the option seller were highly profitable in most cases and neutral at worst.

This certainly covers the most likely events to occur if the underlying stock was chosen well.

Assuming they had not been exercised previously we could “ROLL OUT” these puts to a later expiration date to allow more time for the shares to come up in price.

“ROLLING OUT” OPTIONS”

When share prices go down despite our projections, we will need to attend to put options which are (hopefully) temporarily unprofitable. By rolling out put options we obtain more time for the shares to pick up and achieve out price objectives. Best of all, in most cases we also get paid extra for trying again. Where else in life do you not only get a second, third, or forth chance to succeed, but also profit financially from having missed on previous efforts?

HERE’S AN EXAMPLEOF A “ROLL OUT”:

When XYZ was selling at $11 per share we sold 10 contracts of the December $10 Puts for $1 per share. We received $1000 (less commissions) into our account and had an obligation to purchase 1000 shares of XYZ at $10 per share through the third week of December.

Shortly before expiration XYZ shares are at $8.75. If we have not been “PUT” yet, we can close out our December puts by buying them back at the current market price. The market price with little time left until expiration will be the intrinsic value plus a small time premium in most cases. This would typically be $1.375 per share in this case ($1.25 of intrinsic value plus a 12.5 cent time premium.)

To finish the “Roll Out” we will (simultaneously, in most cases) sell 10 new $10 puts on XYZ for a later month. A June $10 XYZ put would typically bring in around $2 per share or $2000 (less commissions) for out 10 puts.

Our obligation after all this is done is to purchase the same 1000 shares of XYZ at $10 per share. The only difference is that the option period extends through the third Friday in June, rather than December.

LET’S RECAP:

Sold 10 puts: Collected $1000
Obligated to buy 1000 shares XYZ at $10 per share, Dec. Expiration

Bought 10 puts: Paid $1375
Canceled obligation to buy XYZ shares in Dec.

Net Dollars: (-$375)
No obligation to buy XYZ shares.

Sold 10 puts: Collected $2000
Obligated to buy 1000 shares of XYZ at $10 per share, June Expiration

Net Dollars: +$1625

At the completion of the rollout the obligation is the same as it was to start: Buy 1000 shares of XYZ at $10 per share. However, if by June, the shares have recovered to above $10 (as we expect) we will now have a profit of $1625 instead of the $1000 profit which would have been realized if the options had expired in December. If, by June, the shares remain below $10, or if they are “PUT” to us earlier, we have lowered our bread even point from $9 originally, to $8.375 per share.

 

About the author:

Dr. Paul Price
GuruFocus - Stock Picks and Market Insight of Gurus

Rating: 3.9/5 (9 votes)

Comments

billytickets
Billytickets - 7 years ago
Well done Paul.Suppose I think JNJ will not go under 60 or 55 .Walk me through how much the puts on JNJ cost and how much money i would need to have to buy JNJ in case the price fell
musto
Musto - 7 years ago
Obviously, you've mastered how to write options and make money with it too.

I personally find the whole thing waay too cumbersome to make decent returns.

My past returns from plain vanilla equity purchases are very satisfactory, and

I don't need to do half as much work as required for writing options.


Dr. Paul Price
Dr. Paul Price premium member - 7 years ago
Billy,

As of Friday's close [Aug. 31st] you could sell a Jan. 2009 $60 put on JNJ and get paid $3.80 per share. Thus, your breakeven point would be a worst case buy at $56.20 net cost per share. If you wrote [sold] the $65 strike puts for Jan. 2009 you would receive $6.10 for a net worst case buy at $58.90 /share.

Going out to 2010 you would get paid $5.10 for the $60's or $10 for the $70 puts. You get the use of the money from the next business day and you only need to have 'buying power' to cover the potential purchase - not necessarily the cash to pay. It's rare that you get put early on LEAP options with 1 or more years to go till expiration as any holders of the options can make more by selling their puts than by exercising them [in most cases]. With a deep in the money sale like the 2010 $70 puts you can make the first $10 of upside without putting up an cash and you earn interest on the money received while you are short the puts. Instead of paying margin interest you earn credit interest.

This is a great way to have the benefits of leverage without the cost of borrowing money.

Dr. Paul Price
Dr. Paul Price premium member - 7 years ago
When you exercise a put option you receive the difference between the 'strike price' and the current market price [less commissions]. Example:

If XYZ is selling at $8 share and you own a $10 put you can buy XYZ on the open market and then 'put' it to the option seller at $10 netting the $2 /share difference. In most cases, though, the option would be priced with a built in 'time premium' reflecting the value of the remaining days, weeks or months until expiration. If this example's option had a few months before expiration it would probably be priced with a bid of at least $2.50 a share.

Using [exercising] the $10 put would net the owner of the put just the $2 /share difference between the market price and the strike price. Selling [closing out] the put option would result in a net gain to the owner of the option of $2.50 /share. That 50 cents /share extra profit is what makes the early exercise so unlikely.

You are at significant risk of early exercise on puts only when the 'time premium' is trivial enough to make selling the option a less profitable choice.
KevinEnyeart
KevinEnyeart - 7 years ago
What broker do you use to sell puts? I have a Scottrade account. Scottrade does not allow selling to open put options. I would like to use this stategy to collect income and (in the event the put is exercised) get into a long position at a lower cost. What broker would you recommend for this type of trading? Obviously, low commissions are important to me, one of the reasons I have the Scottrade account.
Dr. Paul Price
Dr. Paul Price premium member - 7 years ago
I think almost all brokers allow for selling of naked puts but you need to apply for permision to do that type of trading. See if you can add that to your 'trading permissions'. If they don't offer it to you try InteractiveBrokers.com. I use them and they only charge 75 cents per contract with a $1 minimum and 1/2 cent per share for stock trading.
Dr. Paul Price
Dr. Paul Price premium member - 7 years ago
If you see a stock with big upside you should consider selling [writing] in the money puts so you can benefit from the move up to the strike price. This works especially well when LEAP puts for 2009 & 2010 are available as you have 1.4 to 2.4 years of growth to help achieve your target price. Writing at the money or out of the money is a useful technique if you see mild upside but little downside. Then you can get paid well even if the underlying shares stay even or just climb modestly.
armeetofo
Armeetofo - 7 years ago
i'm not a full time investor, i update my porfolio once a quarter, what should i do?
Dr. Paul Price
Dr. Paul Price premium member - 7 years ago
The beauty of being a put seller [rather than a buyer] is that you don't have to monitor your holdings constantly. You know the worst case before you begin. At worst- you'd have to buy a set number of shares of a stock you liked, at a price you thought was cheap, sometime between when you sold the puts and their expiration date.

Your risk is lower than if you had simply bought shares of that same stock the day you sold the puts. If a stock was $20/share on the starting date then if it went to zero [worst case scenario] you'd lose $20 /share. If you sold a $20 put for $2 and the shares went to zero you'd lose $18 /share.

Any stock you buy can go down but selling puts gives you a lower break-even price and less absolute risk if you are wrong on the shares' direction. You also can do better than the straight purchaser of the same stock if the shares decline slightly or if they stay flat from when you first started.

Example: Shares are $20 at inception and still $20 six months later. The stockholder has no gain or loss [not counting dividends if applicable]. The put writer from our example would have a $2 per share gain [plus any interest earned on the premium collected from the option sale]. If these shares had declined to $19 by the end of the six months the buyer of shares would have a $1 [or 5%] paper loss. The put seller would have a $1 /share gain [as his break-even would be $18 /share].
kfh227
Kfh227 premium member - 7 years ago
This all looks good. I'll re-read it all later tonight (I'm at work).

My comments are on thie following ....

RULES FOR WRITING PUTS:

1) Only write puts on stocks which represent good value.

2) Write only as many puts as you would be comfortable having exercised in a worst case.


To add to (1). I try to only do options so if the stock is assigned I get a 3%+ yield (in most cases). That way, if I am assigned the stock actually pays a good amount of the interest expense should one have to use margin. And when looking at yield, keep a close eye on payout ratio! Even great stocks have to cut their dividends on occasion (like CAG)

In regards to (2), I try to keep the number of puts limited such that should any single assignment occur, that my portfolio will not grow more than 15% in size. 10% is a better number, but I use 15%.

To tie 1 and 2 together, if you maintain a 3%+ portfolio yield, any margin interest from a single assignement should be handled by the dividends you are currently receiving.

And with puts, I have to stress, only do this with companies you have an almost certainty that they will be around 20+ years down the road. The JNJs, GEs and BACs of the world.
kfh227
Kfh227 premium member - 7 years ago
Regarding “ROLLING OUT OPTIONS”

I do this on occasion. When you close a naked put position at a loss and then roll into a later expiration, the wash sale rule does apply from all that I can understand. The ride on the ups and downs is still significantly similar.

Just wanted to add this to the discussion as it is very important to pay attention to when tax season rolls around.
lzou
Lzou - 7 years ago
Dr.

I read through the thread a couple of time. It is detailed and very useful information. Thanks for sharing this strategy. I wonder whether you have any suggestions on writing call options like covered call. I felt it will cap the growth potential. Thanks
Dr. Paul Price
Dr. Paul Price premium member - 7 years ago
You should write covered calls when the strike price [plus the premimum received] gets you to a level where you think the stock is at or above your target price. If you get called you sell at a good level. If your calls expire you've made extra income that can be pretty substantial percentage-wise. Since you can often sell calls 2 -3 times a year on the same shares [if your calls expire] the income from these sales usually far exceeds the dividend yield and can add tremendously to your total return on the position.
buffetteer17
Buffetteer17 premium member - 7 years ago
"You should write covered calls when ... you think the stock is at or above your target price."

I don't get it. Why not just sell the stock?
Dr. Paul Price
Dr. Paul Price premium member - 7 years ago
If your target price is $30 and the stock is $26 or $27 writing a $30 call for $2 /share would mean selling at $32 [the $30 price plus the $2 premium] if the option is exercised versus just exiting at the $26 or $27 current quote. An extra $4 - 6 is quite a lot more percentage wise than just selling outright. The $2 premium received comes to you whether or not the shares actually rise to $30 and thus provides about 7 - 8% immediate income and risk-reduction as soon as you sell the call.
lzou
Lzou - 7 years ago
Dr.

Thanks for your suggestion. Sound very practical way by writing out-of-money covered call. So, sound like you suggest to use short expiration to day so that we can write the covered call 2-3 times in a year. Great strategy. I guess you don't prefer to buying options then

Thanks again!
blakeday
Blakeday - 7 years ago
stockdox99: That's assuming the stock doesn't go down from your target price. If that happens, you'll wish you had sold.
Dr. Paul Price
Dr. Paul Price premium member - 7 years ago
Buying options is a losers game. Read my original post for the reasons why.
buffetteer17
Buffetteer17 premium member - 7 years ago
Say your target is 30 and the stock is at 35, and you believe the stock is overpriced.

Scenario 1. You were right and the price falls to 25.

-you sold 36 calls for 2, and then sold the stock for 25: income = 27

-you sold the stock: income = 35

Scenario 2. You were wrong and the price rises to 45.

-you sold 36 calls for 2, and the stock got called: income = 38

-you sold the stock: income = 35

Now, you have to believe that scenario 1 is the more likely one, else why would you think the stock is overpriced? In scenaro 1 you did 8 worse than simply selling, and in scenario 2 you did 3 better than simply selling. That is to say your expected loss is bigger and your expected gain is smaller using the call option strategy, compared to simply selling the stock. That does not compute for me.
Dr. Paul Price
Dr. Paul Price premium member - 7 years ago
Buffetteer,

If any stock is OVERPRICED you should either sell it outright or write in-the-money calls to protect against downside. I NEVER recommended selling calls above the market on overpriced shares.

My wording about selling calls said to write calls if the combination of the strike price plus the option premium would take you to fair value or above. It never said to sell callls if the shares were already at or above fair value. You need to read what's on the page- not what you interpret it to be.
buffetteer17
Buffetteer17 premium member - 7 years ago
My apology for misunderstanding your point.
mayankc
Mayankc - 7 years ago
very useful and well expalined

you have discussed the strike prices; how about the optimum strike month? or it is not that important since you have a defensive roll out technique?

also, if the stock price rises quickly should you cover and sell a put for a higher strike price so that your money is not locked for the period of the contract?
Dr. Paul Price
Dr. Paul Price premium member - 7 years ago
There is no one best time period to write options for unless you can clearly see the future. I tend to sell for at least 6 months [and even up to 2 - 3 years out] because I have much more confidence in the long term prospects for my shares than in their short term movements. Also, by writing for longer time periods, you take in more up-front dollars per share and thus lower your break-even point on an absolute basis. Tax-wise it is also a bonus as options become taxable events only after they are closed-out or they expire. If you sell a January 2009 option now and leave it alone until expiration you will not pay taxes on your gain [if things work out as expected] until you file your 2009 tax return in April of 2010. That's a nice legal tax-deferment of over 2.5 years plus you earn interest on the premium dollars received from the next business day after the sale of the options.

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