New Options Strategy

There’s been two new options strategies that I’ve been toying with.

Both involve variants on buying stock and selling covered calls.

For the beginning options trader, each options contract consists of 100 shares. As an example, I current have a little over 400 shares of GE in my account. On Friday (9/18), I could have sold 4 contracts of GE with a strike price of 25.5 and an expiration of 10/30/2015 and receive $171. I’d get to keep any dividends received until then. At any point, should the price of GE stock reach 25.5 (or above), my 400 shares could get called away, meaning that I’d be forced to sell them at the agreed upon strike price of 25.5. The risk is that GE could reach 26 and I’d still be forced to sell them at 25.5 each. That fact is precisely why someone gave my $171.

However, with the stock price of GE currently at 24.83, I’d effectively lock in a gain of 2.7% over that 41 day period to 10/30/2015. And, I’d get to keep the entire $171, netting $270 in profit or 5.35%.

I’m going to move to 200 shares for the following examples (you’ll see why in a moment):

1) Imagine that on Friday I had purchased 200 shares of GE at 24.83, costing $4,966 and then immediately sold 2 contracts, collecting $83. This a called a buy-write. Buy the shares and then immediately sell a covered call. If GE went above 25.5 by 10/30/2015, I’d get the $83 plus sell GE at 25.5/share, making $134 (stock gain) + $83 (options premium) + $21 (dividend). (For the dividend, I just figured what the dividend would have been over a 41 day period assuming the annual dividend was divided evenly each day.) The total profit over a 41 day period would be $238, or 4.8%. If the stock price stayed below 25.5, the profit would be $83 (1.7%). I could then sell another covered call expiring at a later time.

2) Another way to do a buy-write is to buy an in-the-money LEAPS and then sell covered calls against this. A LEAPS is a Long term Equity AnticiPation Security. For a nearly equivalent amount of money I can buy 5 LEAPS contracts in GE at a strike price of 15 and an expiration of 1/20/2017. This is termed deep-in-the-money and would cost $1,010 per contract. 500 shares would run $5050. As you can see, I can control many more shares of GE using LEAPS. The reason for using a deep-in-the-money LEAPS is that it has a high delta (or 0.93) meaning that if GE rises from the current price of 24.83 to 25.5 (0.67), the LEAPS would rise almost 1-to-1. This effectively can act as a surrogate for owning the shares outright but with significantly less capital for an equal number of shares or significantly more shares for an equal dollar amount. In the current example, I can control and sell covered calls on 200 shares of GE if owning the stock outright or on 500 shares of GE if using the deep-in-the-money LEAPS.

The beauty of using 500 shares is that you can then sell more covered calls. Had I purchased 5 LEAPS of GE, as above, it would have cost me $5050. I could then have sold 5 covered calls at the same premium and expiration. Had GE stayed below 25.5, I would have kept my LEAPS and made $215 in options premium or just under 4.3%. I could then sell more covered calls with a later expiration on the same LEAPS. Had GE gone above 25.5, I would have collected (for each contract) the difference in the spread ($25.5 – $15 = $10.5) + the short option premium = $0.43 for a total of $10.93. Once the cost of the long call is subtracted ($10.10), the profit is $0.83 per share or $83 per contract. The profit would be $83/$1010 or 8.2%. For 5 contracts that would come out to a profit of $415.

Another benefit of using LEAPS as a stock surrogate for covered call writing is that I pay much less in commissions for options than stocks. I have a deal for $1 per contract with a $5 minimum versus $8.95 per equity trade.

A downside to this options strategy is that should the stock price drop, I may not be able to sell covered calls any longer for a profit (considering the decreased value of the LEAPS) and would not be able to collect dividends as I wait for the price to appreciate to the point where the covered call premium would again be worth it.

An excellent description of this strategy is available here: LEAPS As Stock Surrogates And Covered Call Writing

Another good site walking you through a similar trade on Intel is available here (and is actually the same author as above): Covered Call Writing with LEAPS

Finally, a short article “How I Trade Diagonal Spreads!” which discusses some of the risks of this strategy.

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4 Responses

  1. DivHut says:

    This is getting a little too complex for me. I really need to study up on options and longer term LEAPs. I still am interested in writing covered calls or writing puts for stock I do not mind purchasing all in the hopes of generating extra premium income. Suffice it to say, I’m still not comfortable trying options. One day I know I’ll dip my toe. Thanks for sharing and trying to explain to me what your new strategies are.
    DivHut recently posted…Recent Stock Purchase III September 2015My Profile

    • scott says:

      It is getting a little confusing, but once you break it down to just puts and calls, it starts to make more sense. I’m basically using the deep-in-the-money LEAPS as a stock substitute and then selling calls against it. I haven’t done any of these trades yet, but I’ll update the blog with my experiences once I do.

      Now is a great time to write puts for stocks that you might want to own. Volatility is high (which increases premium) and since a lot of stocks are down, you can get an even better discount if you do get assigned. Best to just go ahead and try it. The worst is that the stock drops below your strike and you buy it at a worse price than you could in the open market. But, you had wanted to buy the stock anyway so it really isn’t a loss AND you get to get the premium.

      There are paper trading services you can play with as well to try it out. Check out the Papertrading link above to see some of the different options.

  2. Nice job. Great to see another DGI investor taking advantage of the gains options offer. Best of luck to you.
    Investment Hunting recently posted…June 2015 Options TradesMy Profile

    • scott says:

      Thanks! Options offer a lot of advantages and can be used to supplement a dividend generating portfolio. I look forward to using them more in the not too distant future.

      Thanks for visiting!

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