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.

Investors who bet on the direction of a stock typically initiate a long or short position and sell out-of-the-money puts or calls to hedge their bet. A covered call seller, for example, might buy a $100 stock and sell $110 strike price calls. The call premium provides a small cushion if the stock falls and some additional profit if the stock rises. Pure option traders take the opposite approach. They try to reduce their dependence on the direction of the stock and, instead, structure a trade that generates most of its profit from the option premium. An appropriate trade would be to buy the stock, as before, for $100 and sell $100 strike price calls. At-the-money calls are the logical choice because they have the most time premium and exhibit the fastest decay. The stock is held for many months with another batch of calls being sold at each expiration. Shorting the stock and selling at-the-money puts is an equally viable trade that performs slightly better in a bearish environment.

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At-the-money Trades

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

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

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.

Avoid Adjustments

Many investors adjust their trade after a large underlying price spike in either direction. They simply buy back the short option and sell a new put or call at the closest strike. Surprisingly, such adjustments tend not to improve the long term results. If the stock is far in-the-money, selling a new option removes most of the cushion against a retracement; on the other side, a new option locks in a loss by capping off any profit that might result from a reversal of the stock. Such retracements are often caused by profit taking after a rally, or a short squeeze following a sharp decline.

Resisting the temptation to adjust is especially important when the trade is profitable and the short options are far in-the-money. This situation is ideal because far in-the-money short options provide nearly 100% protection against a modest reversal of the stock and, if the stock remains beyond the strike price, 100% of the option premium will be captured as profit. In the case of a covered call, I often allow the stock to be called away at expiration and immediately launch a new trade the next day. The results presented in table 2 exactly mirror that scenario for six consecutive months of at-the-money covered calls on the SPDRs.

Jeff Augen is currently a private investor and writer,and has spent over a decade building a unique intellectual property portfolio of databases, algorithms, and associated software for technical analysis of derivatives prices. This work has been the subject of three books from Pearson Education (Financial Times Press): The Volatility Edge in Options Trading, The Option Trader’s Workbook, and Trading Options at Expiration.

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