# Trading Options on the SPYs

Two Possible Approaches to Covered Option Trades

Covered calls (long stock/short call) and covered puts (short stock/short put) are among the simplest and most popular structured trades. There are two distinctly different approaches: The first involves betting on the direction of a stock and selling options as a hedge. The second generates profit from the option sale and uses the stock as a hedge. Our discussion will focus on the second approach which nearly always generates more profit over extended periods of time.

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The advantage of this approach can be illustrated with sequential monthly sales of at-the-money options on the S&P 500 using options on^SPY^. The two year time frame that began in January 2008 and ended in January 2009 serves as a stringent test because the market fell 51% then rallied 65%. During these two years, the average price for SPY was \$108.45, average volatility was 32%, and current month at-the-money puts averaged \$3.98. Two years of sequential put sales would, therefore, have generated \$95.52 of option premium – virtually the entire value of the underlying stock.

However, the profit from selling sequential covered options must be calculated on a monthly basis because, in any given month, the maximum profit is capped by the value of the option. Suppose, for example, the stock fell \$10 the first month and recovered by rising \$10 the next. Selling \$4 of puts each month would cap our gain in the first month at \$4, and limit our loss to \$6 in month #2. Since our net stock position ended flat, we would have a net loss of \$2. Stated differently, we sold \$8 of puts over two months, bought back the first month’s options \$10 in-the-money, and were flat on the stock. We would, therefore, realize a net loss of \$2.

Table 1 depicts actual results for at-the-money covered put sales on SPY during the six months ending at the January 16, 2010 expiration. Sequential at-the-money put sales reduced a \$19.51 loss on the underlying stock trade to just \$4.44. This result reveals the power of the trade. An investor who made a wrong-way bet by structuring a short position and holding it through a 6 month, 21% rally, was able to limit the loss to just 4.7%. A rally of this magnitude is unusual, and most investors would not have remained short the entire time.

Table 1. Six month covered put trade on SPY

 Expir. Stock Start Stock End Strike Put Net Aug 94.13 102.97 94 2.73 -6.11 Sep 102.97 106.72 102 2.40 -1.35 Oct 106.72 108.89 106 2.50 0.33 Nov 108.89 109.43 108 2.39 1.85 Dec 109.43 110.21 109 2.46 1.68 Jan 110.21 113.64 110 2.59 -0.84 total -\$4.44

Conversely, structuring the trade as a sequence of covered calls yields 95% of the profit of the rally while providing \$18.46 (19.6%) of downward protection from the sale of options. Results for this trade are presented in table 2.

Table 2. Six month covered call trade on SPY

 Expir. Stock Start Stock End Strike Call Net Aug 94.13 102.97 95 2.48 3.35 Sep 102.97 106.72 103 2.94 2.97 Oct 106.72 108.89 107 2.80 3.08 Nov 108.89 109.43 109 2.88 2.99 Dec 109.43 110.21 110 2.49 3.06 Jan 110.21 113.64 111 2.41 3.20 total \$18.65

Net values for each month are calculated by adding the profit in the stock trade to the credit from the option sale and subtracting the cost of buying back in-the-money options. The results are surprising considering the magnitude of the rally and the use of at-the-money options.