Negotiating The High Seas With Options

I was just thinking the other day about how stormy the markets are these days, and in my mind the connection was made to the movie “The Perfect Storm.” Later that very day, the January issue of Futures magazine landed on my desk and the headline was “The Perfect Economic Storm?”

It’s a horrendous bear market. Stock investors are clearly not making money.

However, is it possible to protect those stocks, and even make money, using options? What is the best way to use options in a market like this? Good questions. With implied volatilities (IVs) at all-time high levels, option buyers have got to know that they’re playing with fire. When the market quiets down (and sooner or later is has to), IVs (and all options prices) are going to come down.

So how can the options trader position himself so that the coming IV decline works in his favor? In a word, by finding ways to sell options.

Covered Writing

The first and most obvious (safest) way to sell options is “covered writing” – in which you either sell calls against your existing stock holdings, or buy new stock holdings and sell calls against them. These are “covered” calls, because you own the underlying. Extravagant premiums may be collected right now by selling calls. Still, the drawback to covered writing is that if the stock falls a lot further, beyond a certain point your short calls do not help to cushion the fall. Also, should a decent rally develop, your upside potential is capped by the short calls.  

Naked put writing

Another way of selling options, very popular with well-heeled investors, is to sell naked puts on stocks the investor wouldn’t mind owning. Typically, at-the-money or just out-of-the-money puts are sold. Then if the stock stays around the current price, or advances, the investor keeps the (currently generous) options proceeds after the option expires worthless. If the stock declines, the investor eventually gets assigned shares. In that case, the cost basis for his shares is the put strike price minus the options proceeds.

For example, at the time of this writing, (CSCO | Quote | Chart | News | PowerRating) is trading at 42. A 3-month far out-of-the-money put with a strike price of 35 can be sold for 3 3/4 ($375 each). The $375 is yours to keep, no matter what. Worse case, you’ll end up paying $3,500 for 100 shares of stock. Subtract the $375, and your effective basis is $3,125, or a price of 31 1/4 per share. Not a bad deal!

The only drawback to this strategy is that if the stock moves higher after you sell the naked puts, such that you’re never assigned, then since you don’t own the shares you won’t participate in the rally. Thus, selling naked puts cannot be counted on to get you into the best performing stocks. In fact, it may tend to get you into less than the best performing stocks. (Well, at least ones that decline first before moving up.)  

Are you looking for sideways movement in the Nasdaq this year?

A beautiful strategy for this scenario is a combination of the above two strategies. When you add a naked put sale to a covered write, you get what is called a covered combo. I have written about the covered combo more than once before. And even though I may have been too early, as it turns out, recommending specific covered combo’s in November and December, the covered combo is still a fantastic strategy to use at these extreme volatility levels.

In this example covered combo in Texas Instruments (TXN | Quote | Chart | News | PowerRating), with the stock at 48, you’re paying an effective price of only 36 per share. The prospective yield on this 106-day investment, if the stock holds up, is 61% (211% annualized). Wow!  

Spreads

Another way of selling options is to use spreads for your directional trading instead of outright option buying. While this may not allow you to benefit from the coming IV decline, at least the effect of the decline is neutralized. In fact, if you’ll use credit spreads rather than debit spreads, you may actually be able to put a potential IV decline in your favor (a little bit). That would because the more pricey short leg of the spread ought to decline faster when IV drops.

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