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Negotiating The High Seas With Options

By Len Yates

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)
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),
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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