The great unspoken irony of option trading is that the “good news” and the ‘bad news” are one and the same. Simply put, the good news is that there are many, many option trading strategies available, thus an individual can craft a position to match virtually any outlook for a given, stock, commodity or index. The bad news is that there are many, many option trading strategies available, thus it can be difficult for the uneducated trader to get a handle on things.
So the bottom line is that a little education can go a very long way. In reality, even a “complex” strategy can be fairly simple to use successfully once you understand the mechanics and the situation in which it is most useful. Let’s look at one for example of a strategy that I follow on a regular basis.
The Buy/Write Strategy
Most investors are used to buying something and holding it, whether it is a stock or a mutual. For people who are used to buying individual stocks, this strategy makes a lot of sense. There are essentially two approaches:
1. The Investment Approach – this involves selling (or “writing”) a “covered call” against a stock you already hold. The idea is that if the stock remains below the strike price of the option you sold, you get to keep the premium that you received when you wrote the call option. This affords you the opportunity to “generate income” from a stock holding even if the stock goes nowhere. Essentially, this should be done when:
a. You think the stock is likely to trade in a range for a period of time (perhaps following a sharp run up in the price of the stock).
b. You think the price of the stock may decline in the near-term but you want to hold the stock for the long-term.
c. The implied volatility for the options on that stock rises to a high level based on the historical range of implied volatilities for the options on that stock. When implied volatility is high it simply means that there is relatively more option premium built into the price of the option, thus selling options makes sense in order to capture that inflated premium.
2. The Trading Approach – this strategy is more commonly known as the “buy/write”, as it involves buying shares of stock and simultaneously writing a call against it. While it is technically cheaper in most cases to buy a lower strike price call option instead of the stock itself, the fact is that for investors new to options trading, this strategy is much more intuitive since they are used to buying stocks or at least understand the concept (up is good, down is bad).
The key to achieving success using the Trading Approach is to:
a. Find the right “setup”.
b. Generate an above average rate of return accompanied by an acceptable tradeoff between reward and risk.
c. Manage the position.
Based on a lot of research and a bit of experience I had a hand in developing an on-line service titled “Money Steps” – which focuses on the buy/write strategy and which came on line in October 2010. Tom Gentile recorded the course material on several short videos and I post three video update Case Studies a week. You can sign up for a free 30-day trial at www.moneysteps.com.au.
In terms of a setup, I prefer to look for stocks that have formed a solid base by carving out an objectively identifiable double or triple bottom. The low price achieved during the formation of this bottom serves as a useful “line in the sand.” We can then analyze the potential buy/writes using that stock (typically looking to sell the call whose strike price is closest to the stock price and that has at least 21 days left until expiration).
We can calculate the potential return if the stock stays above the “line in the sand” and the maximum risk if our stop-loss is hit (the stop-loss if placed a short distance below the “line in the sand”). If the total return is acceptable (say a minimum of 3% in 3-7 weeks) and the potential reward is acceptable relative to the potential risk (we prefer to see more upside potential than the expected loss if our stop-loss price is hit) then the trade can be recommended.
As long as the stock remains above the “line in the sand” an investor can make money by virtue of the fact that the option will decay in price as option expiration draws closer. Let’s look at an example.
Figure 1 displays HGSI after it has formed a multiple bottom.
Figure 1 – HGSI carves out a “line in the sand”
click to enlarge
We then assume that a trade is entered into which involves buying 200 shares of the stock and selling two slightly in-the-money call options. Figure 2 displays the “numbers” for the trade. Note that there is profit potential of 9.5% in 43 calendar days (even if the stock remains unchanged as we will see in Figure 3). Also the breakeven price is 11% below the current price for the stock.
Figure 2 – The “numbers” for the HGSI buy/write
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Figure 3 displays the risk curves for this position. Essentially, as time goes by the option loses its time premium in a process referred to as time decay. If the stock is at any price above $25 at the time of option expiration, the option will expire worthless and the trader will keep the entire premium received.
Figure 3 – The risk curves for the HGSI buy/write
click to enlarge
In a nutshell:
-The cost to enter this trade (buying 200 shares of stock and selling 2 call options) is $4,566.
-The profit potential is $434 or 9.5% in 43 calendar days.
-In this example we are suggesting a stop-loss $0.10 below the recent low at $23.46. In other words, if the stop-loss price is hit we will automatically sell the shares of stock, buy back the short calls and exit the entire position.
-If the stop-loss price of $23.46 is hit within the first two weeks of entry our dollar risk on the combined position is somewhere between $180 and $220. Thus, barring a huge gap down for the stock, we have a reward-to-risk ratio in excess of 2-to-1.
Figure 4 shows that the stock advanced between the time the position was entered and April option expiration. As a result, the position ultimately achieved the maximum profit potential of $434.
Figure 4 – HGSI rallies after the position is entered
click to enlarge
Opportunities abound in the world of options. The key to taking advantage of these opportunities is to become educated on when and how to use each particular strategy. Learning to use a strategy utilizing a step-by-step approach can improve your long-term likelihood of success. To learn more about the buy/write strategy please visit www.moneysteps.com.au.