Showing posts with label options. Show all posts
Showing posts with label options. Show all posts

Thursday, May 9, 2013

My mini-Berkshire strategy for selling insurance through puts and calls

I view myself as a mini Berkshire Hathaway. Every month, I get some cash flow that needs to be invested. My sources of cash flow include money I saved from my day job salary, dividends and some money from side hustles. I used to view my side hustle income as something that is similar to investing in newspapers, but lately the cashflow from it has been similar to what Buffett experienced for 20 years with the original textile mill. My investing portfolio portion is similar to the portfolios of securities that Berkshire owns. I view my salary income as businesses income, since I provide services to a large client, who is my employer.

These three sources of cashflow are exponentially increasing my dividend snowball, which is projected to exceed my expenses in five years. However, I have been missing the cost free insurance float, which Berkshire has leveraged for the past forty-fifty years. For the past four years I have tinkered with a strategy, that could essentially generate an additional cashflow for me to invest, by selling insurance. I went live with the strategy last month, and so far the results have been meeting my expectations.

The insurance I will be selling is mostly naked puts. You can read more about selling puts here and selling covered calls in previous articles I have written on the topic. With my strategy, I will be leveraging existing funds in one of my portfolios to sell naked puts. Before you start executing this strategy however, your broker needs to approve you for the highest level of option activity in a margin account. This could be a risky strategy, if you do not understand what you are getting into.

For my strategy, I plan on selling puts on S&P 500 ETF (SPY), which trade approximately 10 points below the current price and will expire within 4 – 6 weeks. I found that it would be easier to invest in an index ETF options because of high liquidity, elimination of specific stock risk and low bid/ask spreads. Please remember that these are approximations and not hard rules set in stone. I plan on making a trade once a month, although I keep my flexibility and not make trades depending on market conditions. I will exit options sold either if they expire worthless, I sell them or if I get assigned.

Some investors sell puts against stocks that they want to purchase, and this is a perfectly legitimate practice. For example, if McDonald’s (MCD) trades at $100/share, but I want to purchase it at $80, I could simply sell a put that expires in a few months. I can then collect the premium and if I get assigned I get a stock at a discount. If not, I collect the premium. The issue with this strategy is that that in a $60,000 - $120,000 portfolio, you are exposing yourself to too much individual security risk. In order to minimize that, I am focusing on the S&P 500 ETF (SPY).

I have designated approximately 25% of my account equity from one of my brokerage accounts as the portion that will be allocated to this strategy. My account is 100% invested in individual dividend stocks, and I am not adding any additional money to it as part of my strategy to protect myself against broker failures. As a result I am essentially playing with borrowed money.

Let’s assume that my account equity is $60,000. That means that I can sell puts worth up to $15,000. If SPY trades at $150 , I can sell one put contract for 100 shares, and immediately use the premium amount as I see fit. If SPY never falls below the strike price by the time it expires, I would have earned a premium and the liability involved with it will be terminated.

However, if the option falls in value after I sold it, and trades at a low price of say 10 -15 cents with more time to go till expiration, I would likely buy it back. I could then sell another option at a higher strike, or simply stay put.

The main risk with this strategy is if the market declines below the strike price, and stays there until option expiration date. The put price will increase dramatically, and by expiration date I will be assigned the underlying. However, using the example above, I would be essentially purchasing equities at a lower price than the cost at the time I entered into the options trade. I would essentially have to come up with $15,000 to purchase the underlying once it is assigned to me. In a margin account, I can take that 25% of equity and deploy it into the underlying on margin. I would have to pay margin interest to my broker for it, which could be expensive.

From there on, I have several options of what to do with the 100 shares of SPY for every naked put contract I have sold. I could either sell the shares in the market at a gain or loss, or I could sell covered calls at a strike that is at or above the price I paid for the shares. Since this is a trading strategy, I am not interested in buying on margin and keeping SPDR Trust (SPY) in this portfolio.

My take will be to sell covered calls on the assigned shares at or slightly above the price I paid for them. If I got assigned at $150/share, I would either sell a covered call expiring in 4 – 6 weeks with a strike 150 or strike 151. My goal is to dispose of the shares as soon as possible, because I am paying a margin interest on them. The goal is to not sell shares at a loss. If I were unfortunate enough to sell SPY at 150, and the price fell too much under that price, I would probably extend the maturity by a few more weeks.

The worst risk I can think of with this strategy however is if my portfolio decreased by 75%, and my options get assigned at a price that is substantially higher than current prices. If that $60,000 drops to $15,000 and I have to spend an additional $15,000 to purchase stock worth $3,750 I might be close to getting a margin call. The goal of investing is to minimize losses to principal that would result in a wipe-out of investor assets. I believe that by only allocating 25% of assets to this options strategy, I would have an adequate margin of safety that could provide some protection to principal. In addition, by using options that expire within a month or so, the risk of steep adverse declines are minimized. Stocks do fluctuate, but the likelihood of a 75% decline in one month is remote.

At the end of the day, this strategy would likely generate approximately $100 - $150/month in additional income for a portfolio valued at $60,000, if a conservative 25% allocation to the strategy is used. While this is a small stream of income, over time it can turn into a small fortune by the mere power of compounding. If you set aside $100/month and earn 7.50% annual total returns, you will have $17,793 in ten years.

Full Disclosure: Long MCD, Short SPY June 148 Puts

Relevant Articles:

The pros and cons of selling covered calls on dividend paying stocks
Covered Calls for additional income
An alternative strategy to covered calls
Build your own Berkshire with dividend paying stocks
Stress Testing Your Dividend Portfolio

Friday, October 16, 2009

Selling Options is no free lunch

Options are contracts that give their owners the right but not the obligation to buy (calls) or sell (puts) securities at a predetermined price (strike) at a predetermined period in the future.
If an investor is bullish on Microsoft (MSFT) when the stock is trading at $20/share, he/she could purchase calls and profit at options expirations week if the stock price increases above the strike price plus the price paid for the call. The options price consists of time value/time decay and an intrinsic value, which is the difference between the strike price and the current price of the security. Overall in quiet markets the time decay decreases the values of options. The time decay portion of the options price is sensitive to changes in volatility and could increase if volatility increases however.

Most investors believe that by selling covered calls or cash secured puts they could achieve additional income from the securities they own or plan to own. This additional return comes from taking on the additional risk of potentially exercising your options, which could hurt your total returns.

The S&P maintains two options indexes based off the S&P 500. One of them incorporates selling covered calls against the index, while the other incorporates selling naked puts against it.

The CBOE S&P 500 BuyWrite Index (BXM) is a benchmark index designed to track the performance of a hypothetical buy-write (covered calls) strategy on the S&P 500 Index. The methodology of the BXM Index is based on (1) buying an S&P 500 index portfolio, and (2) writing the near-term S&P 500 "covered" call option, generally on the third Friday of each month. The call is held until it is cash-settled on the 3rd Friday of the following month, at which time a new one-month call option is written.

Ibbotson Associates tested the strategy of selling covered calls against S&P 500 for the 16-year period between 1988 and 2006. According to the findings, the buy write index returned 11.77%, versus 11.67% for the S&P 500 index. The buy-write strategy managed to slightly outperform the broad market with lower volatility, as defined by standard deviations. The standard deviation for the buy write index was 9.29%, which was much lower than the 13.89% volatility of the S&P 500.

Overall for the past 23 years ending in March 2009, the buy-write index did manage to slightly outperform the S&P 500.

The covered calls strategy typically outperforms the underlying in flat and weak markets, while under performing the underlying in strong bull markets.

The chart below shows that as a percentage of the underlying value, premium income on covered calls has ranged between 0.5% to 4.50% and averaged close to 1.70%/month. Investors who dabble in options often see that they could purchase a stock at $20 and then sell a covered call at the next strike for $0.50, which represents a nice 2.50% return. Investors then start projecting and annualizing these kinds of returns. As evidenced by the first chart, these premiums are simply a compensation for foregoing any gains beyond the strike price, while fully participating in any declines in the underlying prices. They did not lead to the generations of any excess returns with any consistency relative to the cumulative performance of the S&P 500.

There are several funds which employ covered call techniques on S&P 500 index. One of the longest standing ones is S&P 500 Covered Call Fund Inc. (BEP). Over the past 4 years it has had a total return of almost zero, despite the fact that it keeps distributing $2 in dividends every year.

Thus on average, it is safe to assume that unless investors possess above average timing skills, selling covered calls is no free lunch, despite what gurus and self proclaimed experts claim this “safe” technique to be.

Full Disclosure: None

Thursday, April 9, 2009

Covered Call Options Strategy for cutting losses on USB

The current bear market has been a heaven for sellers of covered calls. I have mentioned earlier the pros and cons of selling covered calls. Typically I am not a big believer in cutting my profits and lowering my risk reward expectancy in exchange for the options premium. Furthermore I would hate to have a situation where a stock I like is called in and I would have to buy it back at higher levels.

Covered Calls do make sense to me however for a stock that has either not increased its dividend or for stocks in which I have a large paper loss.

Let us look into the first example, where one is sitting at a paper loss and they are willing to decrease it. The severity of the loss that would make you sell covered calls varies from individual to individual based off their risk tolerance. Let’s look at US Bancorp (USB) for example. The stock has been punished this year after losing more than half of its value year to date as investors are losing trust in the US financial system. In addition to that US Bancorp recently cut its dividends by 88%, which was a major red flag and a sell signal for me. If you are still holding on to that position however, waiting for the upturn in the company’s financial situation, selling covered calls against your position might be the only way to generate more income from the stock.

USB was largely trading in a range between $25 and $35 over the past five years, right before the financial crisis started. A dividend growth investor who dollar cost averaged their way into the stock over the past year could have easily bought the stock between $8 and $35/share. Since October 2008 USB shares have lost close to two thirds of their value. Assuming an average cost of $20, this investor would be sitting at a large paper loss at yesterday’s close at 14.45.

Assuming the investor still plans on holding on to the stock, while generating extra income, they could simply decide to sell a covered call with a strike of $20, and an expiration date that would generate some decent income. If called in, the investor would be obligated to sell his stock to the covered call buyer at the strike prie. This being the case, selling a covered call at prices below one’s cost basis would certainly bring losses if shares were called in.

Looking at different expirations for calls on USB stock with a strike price of $20, it seems that the highest prices could be obtained for calls that expire in January 2010 and January 2011. Selling the January 2010 call with a strike at $20, would generate about $210 for every 100 shares held before commission expenses. Selling the January 2011 call with a strike at $20 would generate $310 for every 100 shares held before commissions and other expenses. The first example would increase the yield on cost by almost 10%. The second example would lock in the obligation to sell at $20 by an extra year, but would bring incrementally a higher cash flow.

There have been many stocks which have lost a substantial amounts in short periods of time. If you are looking forward to increasing your income from stocks which have failed to increase their dividends or even worse have cut it, then selling covered calls could be a solution for you. Just like any other stategy however, learn as much as possible about it, before deciding if it is appropriate for you or not.

Full Disclosure: None

This article was included in the the Carnival of Personal Finance #201

Relevant Articles:

- The pros and cons of selling covered calls
- Covered Calls for additional income
- An alternative strategy to covered calls
- Dollar Cost Averaging

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