Citing a real world two-month trade example for support, Alan Ellman, of TheBlueCollarInvestor.com, addresses one way that options can help a trader stay in the game, even when market conditions are working against him.
Covered call writing and put-selling generate monthly cash flow with the inherent risk of share depreciation. One of the major advantages of these conservative strategies is that they can be tailored to all market environments. In today’s article, I will address one way to stay in the game even when market conditions are working against us as they have been recently with global economic concerns in China and Greece along with the technical breakdown last week at the New York Stock Exchange. Our goal is to achieve an annualized return of 10% per year in bear and volatile market conditions (and no this concept is not taken from the Bernie Madoff School of Sociopathic Investing).
Overall Concept
- We will initiate our trade by selling a deep out-of-the-money cash-secured put targeting a 1%, one-month return
- If that option expires worthless, we continue to sell similar put options
- If exercised, the stock is purchased at the discounted strike price less put premium as our cost basis
- Once shares are purchased, in-the-money covered calls are sold targeting a 1%, one-month time value return
- With both calls and puts we select as deep out- or in-the-money strikes as possible while still approaching our one-month option profit goal
- We will assume no greater than a 1-month price decline of 5%, so if the put is exercised, it will be purchased near market price
- In the event that share decline is catastrophic, use of our exit strategy arsenal is essential
Real-life Example
The challenge as I write this article is to find a security not reporting earnings prior to September 18, 2015 as I am crafting a two-month trade. Our Premium Watch List shows that Nike (NKE) is due to report on September 24, 2015 so that will represent our underlying security. The trades will initiate on July 9, 2015 and terminate on September 18, 2015. Here are the initial stats:
Entering the Trade
- NKE is currently priced at $110.42
- The out-of-the-money August 21, 2015 $105.00 put generates a premium of $0.99, near our 1% target
- The in-the-money $105.00 call generates $6.43 of which $1.01 is time value, meeting our 1% target goal
- We will make the assumption that strikes that are in-the-money strikes by $5.00 in future months will also return about 1% in time value with the understanding that stock implied volatility may change
Calculating the Out-of-the-Money Put
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Note the Following:
- NKE calculations are in the last column circled in red
- The return of the put option sale is 0.95% (green arrow)
- If exercised, our cost basis is $104.01, a discount of 5.81% from the price when the trade was initiated
Calculating the In-the-Money Call (In-the-Money by Approximately $5.00)
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Note the Following:
- The time value return by the strike about $5.00 in-the-money is 1%, meeting our target
- That profit is protected as long as NKE does not decline in value by more than 4.9%
- Our 10-week return in a bear market is 0.95% + 1.0% = 1.95% which annualized to our target of 10%
Discussion
This article was designed to show how flexible option-selling can be even in extreme bear and volatile markets. In order to accomplish this, certain assumptions were made with the understanding that there are a myriad of exceptions that may occur. The concepts behind these assumptions, however, are gold and can be applied in countless other scenarios.
By Alan Ellman of TheBlueCollarInvestor.com
