Using Puts and SelectSector SPDRs to Create an Ultra-Conservative Option-Selling Strategy

09/09/2015 8:00 am EST

Focus: OPTIONS

Alan Ellman

President, The Blue Collar Investor Corp.

Options expert Alan Ellman, of TheBlueCollarInvestor.com, illustrates how selling out-of-the-money puts and using top-performing SelectSector SPDRs can be combined to design an extremely defensive option-selling strategy in a volatile market environment like this one that traders are currently experiencing.

When we sell an out-of-the-money cash-secured put we are agreeing to purchase that security at a price lower than its current market value. In a bear or volatile market environment this can be a sensible approach to generating monthly income while still emphasizing capital preservation. Our breakeven becomes the strike price minus the put premium. If a stock was selling for $52.00 and we sold the $50.00 out-of-the-money put for $2.00, our breakeven would be $48.00.

The SelectSector SPDRs are exchange-traded funds that divide the S&P 500 into nine sector index funds. We can choose the current top-performing sectors and then sell out-of-the-money puts on those ETFs that are currently in favor. Since ETFs in general, and especially those associated with the S&P 500, have lower option premiums, we must lower our goal expectations in exchange for the protective nature of this strategy. 10% – 12% annually would be a reasonable objective. The screenshot below depicts the top-performers as of July 28, 2015, a screenshot I took prior to the current market decline:

chart
Click to Enlarge

Note the following 3-month performances

  • S&P 500 (SPY)—(-)0.59%
  • XLY—+ 3.26%
  • XLV—+ 3.75%
  • XLP—+ 3.05%
  • XLF—+ 3.53%

31-day returns

We first access an options chain and then feed the information into the BCI Put Calculator:

chart
Click to Enlarge

Note the following % discount if exercised (black arrow) and annualized returns (red arrow)

  • XLY—2.61% (10.89%)
  • XLV—2.76% (11.65%)
  • XLP—1.38% (13.34%)
  • XLF—3.07% (10.67%)

Steps After Exercise or Non-exercise

If the option expires worthless (share price remains above the strike price), we continue to write out-of-the-money puts looking to generate 1% per month. If the option is exercised and we buy the underlying ETF(s) at the discounted price, we can then either write an in-the-money covered call or sell the security and replace it with a better-performer.

NEXT PAGE: Discussion and DOL’s Proposal

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Discussion

Option-selling strategies can be crafted to accommodate market conditions and personal risk-tolerance. In bear or volatile market conditions combining out-of-the-money cash-secured puts and SelectSector SPDRs is one way to develop a defensive option-selling blueprint.

Department of Labor Proposed Laws Relating to Options in IRA Accounts

Some of our members have become aware of and are concerned regarding laws recently proposed by the Department of Labor regarding the use of options in IRA accounts. Many of our members currently use options in these accounts and have expressed concern to me.

I have contacted the CBOE, contacts I have at FINRA, and a few Financial Advisors familiar with the situation and here is what I can report at this time:

  • DOL’s proposal wouldn’t preclude covered call writing in self-directed IRAs
  • The proposal essentially would require those advising holders of 401(k) plan accounts, individual retirement accounts (IRAs), and other self-directed retirement plan accounts to act as fiduciaries
  • The fiduciary standard is the applicable standard for Investment Advisory-based accounts. For brokerage accounts, the standard is not as stringent
  • The impact of the proposal would be on the brokerage side
  • The rule would not prohibit covered call writing in self-directed IRAs, but may prohibit advisors from charging for covered call writing-based recommendations
  • The rule would permit brokerage account advisors to charge for recommendations in connection with the purchase or sale of an “asset” for an IRA. Regarding the definition of an “asset,” the proposal, in its current state, specifically excludes options-based recommendations, meaning an advisor would not be able to charge for recommending writing calls
  • It appears more about precluding charges for options based advice—vis a vis IRAs—and not about precluding the strategy itself
  • The OCC formally commented on the DOL proposal. I think you will find the OCC’s submission useful. You can find it here: https://www.moneyshow.com

If you want contact your political reps on this issue, here is a link created by TD Ameritrade:

The information I have received thus far indicates that we will still be able to write calls in our IRAs. The proposed laws seem geared to assuring the advisers adhere to the fiduciary responsibilities they are legally bound to. Any additional insurances or costs to advisers and brokers may, however, eventually be passed onto us. I will update our members as I learn more on this topic.

By Alan Ellman of TheBlueCollarInvestor.com

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