Please note that this example is for educational purposes and uses a historical trade from April 2007

Another strategy utilized by investors is the Stock Collar. This strategy involves owning or purchasing 100 shares of a particular stock, buying a put option and selling a call option. An investor sells a call option to finance the “insurance” put option. While doing this does limit the downside, it also limits the upside potential. This strategy tends to be used less by money managers because of the possibility of missing a big positive move.

In Figure 4, the investor purchases 100 shares of Yahoo, Inc. (YHOO) on April 20, 2007, buys the July 2007 $25 put option, and sells the July 2007 $32.50 call option. From the breakdown of the trade in July 2007 at the maximum and minimum extremes, the positions could show a profit of 17.08% or a loss of 9.94%. This type of trade would be most suitable for trading a stock that an investor feels has a good probability of increasing in value, but about which he still holds some hesitations. The idea with this trade is to protect the position against strong negative moves, and instead of paying the put “insurance” premium out of pocket, the investor is simply financing that premium with a call sold for a premium. There are some money managers who use collars when trading indexes; they do this because the likelihood of an index increasing by 3% in a month is very unusual, but a drop of 5% or more is more likely.

A stock/option collar could have been used in the case of Martha Stewart. When she had received insider information that a drug was going to not be approved by the FDA, she then ordered her stockbroker to sell all of her Imclone shares. Although she was not guilty of insider trading, she was guilty of obstruction of justice, after lying to Federal investigators about her actions. Had she known that a news release was about to happen (and had not received the information from the CEO before news release), she could have purchased a collar or protective put to protect against the downside. She would have never run into the problem of selling the stock, had she used one of the options strategies introduced in this paper.

Figure 4

Please note that this example is for educational purposes and uses a historical trade from March 2007

A lesser-known strategy is the Protective Put strategy, which involves purchasing or holding a stock and buying a put option to protect against the downside. The strategy is the opposite of the Covered Call Strategy because the investor is limiting their downside and leaving the upside potential of the position. This type of protection does come at a cost, such as purchasing insurance against a loss; an individual must pay a premium in order to receive the protection. The amount of premium that an investor pays depends on the volatility within the individual stock, the higher the volatility of the stock, the more premium that an investor will have to pay for the “insurance”.

Figure 3 is a fictitious trade involving the purchasing or holding of 100 shares of Google, Inc (GOOG) on March 22, 2007. The reason for this hedge was Google planned to announce earnings after the bell on April 19, 2007, and to hedge against any downside risk the investor purchased a $470 put option, limiting the total risk of loss to $1,750 while maintaining the unlimited upside potential minus the $15.60 put option premium.

Figure 3

Please note that this example is for educational purposes and uses a historical trade from March 2007

Another way to play the income aspect of the Covered Call is through a strategy known as Cash-Secured Put Selling, which involves selling a put option, keeping the premium, and—if the option is exercised by the buyer—purchasing the 100 shares per contract. This might sound risky, but the idea is for the investor to keep enough cash in the account to purchase the shares should he receive an exercised notice. This strategy is ideal if used on a stock that an investor would not mind owning in their portfolio, should they receive an exercised notice.

In figure 2 below, the investor is taking a hypothetical trade in Cisco Systems (CSCO) on March 22, 2007. The investor sells the July 2007 $27.50 Put option at $1.42, which results in a cash premium received of $142 (representing a 5.44% return from the total cash requirements of $2,608). The trade is very similar to the Covered Call strategy and has the same Profit/Loss chart layout. The Cash-Secured Put Selling strategy is more appropriate on stocks that do not pay large dividends because, with it, the investor does not have the incentive to hold the shares to receive the dividend. Another nice feature of this strategy is the cash that the investor must keep on hand to secure the short put option can be invested in 90-Day T-Bills, which would provide the investor with some additional income. Another way an investor could utilize this approach is if he wanted to buy a stock at a lower price than what the stock is currently trading at. To do so the investor could decide to sell an in-the-money put option (which will most likely lead to the option being exercised). Therefore, instead of buying the stock outright, the investor would receive the premium today and as the option approaches expiration the investor would be required to purchase the underlying shares when the short option is exercised by the counter-party.

Please note that this example is for educational purposes and uses a historical trade from March 2007

The most popular options strategy among all investors today is Covered Call Writing. The basic idea of this strategy is to hold a stock with a near-term outlook that shows the stock will remain stagnant at its current price. In this situation, an investor could create a “synthetic” dividend by selling one call option and receiving the premium for every 100 shares of the stock that they own.

For example, Figure 1 below is a fictitious trade involving the purchasing or holding of AT&T (T) at $39.19 on March 22, 2007 and the selling of a $40 July 2007 Call Option, paying the investor a premium of $1.15 or $115 for the entire option. The figure also illustrates the amount of gain or loss at different stock prices. This analysis does not take into account the $.355 dividend paid in July, but if it were included, it would be an additional $35.50 at each profit/loss breakdown.

Figure 1
Covered Call Writing provides the investor the ability to create cash flow by selling options and keeping the premiums. In the example above, the selling of the option creates a “synthetic” dividend of 2.93% for a four month holding period, or an annualized ”synthetic” dividend of 8.79%, in addition to any actual cash dividends that the company pays on their shares. However, there are two main downsides to this strategy. The first is that keeping the money invested in a not-so-promising stock for an extended period leaves the investor open to losses from holding a losing security. The second drawback is that this strategy caps the upside that an investor can experience from holding the stock. If the security would experience a sudden growth, the investor would not benefit because he would have to sell at the strike price of the call option.

One of the most exciting financial instruments available comes in the form of derivatives. The versatility of derivatives, allows for many different investment goals to be reached. Derivatives are growing in popularity and are quickly emerging as an essential financial investment tool. One of those derivatives is Futures, which are a financial contract obligating the buyer to purchase an asset (or the seller to sell an asset), such as a physical commodity or a financial instrument, at a predetermined future date and price. Futures are most common among institutional investors and large firms because of the high risk that comes with trading the volatile futures market. Another growing derivative is Swaps, which is an exchange of streams of payments over time according to specified terms. Although both of these are growing derivative fields, this focus is solely on another type of derivative, options.

A stock option is a privilege sold by one party to another, which gives the buyer the right, but not the obligation, to buy (call) or sell (put) a stock at an agreed-upon price within a certain period or on a specific date. An option is a contract for 100 shares of an underlying security at a particular strike price, which is the price per share for which an option holder upon exercise of the option contract may purchase underlying stock. While the 100-share contract size seems quite small, it does limit the use of options in a portfolio to individuals and managers that have the purchasing power for at least 100 shares of a particular stock.

A common misconception with the option market is that it is very risky and volatile, capable of causing fortunes to erode in one swift blow. This, however, is due to the speculative aspects, to which only a small minority of traders is actually attracted. These two markets can give the trader the ability to minimize risk and to create lower volatility returns, which is the opposite effect of the commonly accepted opinions as mentioned above. In my paper, I will describe how investors can utilize options to manage risk and create predictable future returns.

Over the course of the next few posts, TheFinancialWhiz.Com will examine various options trading strategies that can be used by investors to lower the risk of a particular position or overall portfolio. The strategies that will be covered are:

• Covered Call Writing
• Cash Secured Put Writing
• Protective Put
• Stock Option Collar

For questions regarding any of the strategies or explanations of options strategies not covered, please feel free to comment or email me. Happy Trading!

Marek over at Stokblogs.com wrote a post about a trade involving Chesapeake Energy (CHK). He looked into utilizing a stock option collar on the position, which from my previous post, “Option Collars – Low-Risk, Low-Cost, Market Perform Trading Strategy.” can be explained as holding a stock long, selling an out-of-the-money call option (covered call) and buying an at- or near-the-money put option (protective put). The idea is to use the call premium to finance the downside insurance (cost of the put premium). Below are some graphics with a more detailed breakdown of the CHK trade that Marek described in his post:

The graphic above illustrates the possible outcomes of the CHK trade. It shows that the investor is risking, at maximum, $100 to make up to $900. The total requirement of this trade is $3,600 (100 shares of CHK at $34.60 + Cost of Put Option $4.80 per share – Premium from Call Option $3.40 per share). Therefore, the investor stands to make 25% total profit from this trade if CHK is trading above $45.00 ($900 divided by $3,600), while the maximum downside risk is 2.77% ($100 divided by $3,600). The 25% profit sounds great, but the investor must remember that this trade is long-term because the options contracts used expire in 2010, which is about 2.5 years from now. Taking the 25% total profit and divide it by 2.5 years shows an annualized return of 10%. Furthermore, Chesapeake Energy pays an .8% dividend per year, which would add to that annualized return.

The 10% return might not sound amazing, and it sure won’t make a person rich quickly, but the experts expect that the domestic equity markets will return about 7% per year over the long term. The CHK collar trade is enticing because it gives the investor the opportunity to participate in the growth of a great company as well as the opportunity to beat the overall market return with much less risk. Just think if an investor used collars at the end of the bubble; he would have been able to preserve his capital and salvage value of now defunct dot com companies (by exercising the protective put option).

Please note: This analysis does not take into account taxes and commission. This is meant for illustrative purposes and is not meant to be used as professional investment advice.

Technorati Tags: Chesapeake Energy, CHK, stocks, options, trading, stock market, collar, investment, investing

This trading strategy is very similar to the Put Option Dividend Strategy, but this strategy can be applied to stocks that don’t pay dividends, which provides some versatility and diversification. It would also keep transaction costs low as opposed to the Put Option Dividend Strategy with Covered Calls Strategy, which requires more options to be sold instead of one long-term option. The ideal situation would be to combine the two approaches into companies that you feel are fundamentally sound, and you will have a market-beating, low risk portfolio of stocks that generate returns greater than or equal to the market.

The stock I would like to use as an example of this strategy is Google (GOOG). While the ability of you or I to purchase 100 shares of Google may be extremely limited because of its current trading price of $452.96 for a total cost of $45,296.00, it does represent a prime example of this type of strategy.

Today (March 9, 2007) we purchased the following position:

Total cost of the position is $45,316

Below is a graph of the possible outcomes from this transaction.

As you can see from the above possible outcomes, this trade is fairly low risk and provides a decent return in the market should Google (GOOG) perform. Should Google reach $540 by January 16, 2009, you would realize the full return from this strategy. The $8,684 provides for a total return of 19.16%, which if annualized to the trade, would mean a total annual return of approximately 10.45%. While the risk for the trade is -.38%, for a risk to return ratio of 1 to 27.5 (meaning we are risking $1 for a potential return of $27.50), giving us a great potential return for relatively no risk.

There is a risk associated with the Time Value of Money, meaning that you are tying your money in this trade for 2 years, when it could have been sitting in a bank account or treasury bill earning 5% per annum in interest. If you take into account a 4% interest rate that you could have been earning in a bank account, you potentially give up approximately $1,812.64 in interest payments a year. The risk to reward ratio then becomes 1 to 2.20 ($1 risk to potentially gain $2.20), which I would consider still a good trade off since the outcome is previously known, unlike investing in individual stocks unhedged where you are risking a lot for hopefully a positive potential payoff.

It is advisable to anyone who might consider this strategy to use it against a portfolio of stocks and preferably alongside the Put Option Dividend with Covered Call strategy because it would create a low risk portfolio that is capable of generating a consistent and predicable return.

This analysis did not take into account taxes or commissions. If you have any questions please feel free to comment below and I will be sure to answer them as soon as possible.

This is a list of stocks that fit the profile of the Put Option Dividend Strategy (with Covered Calls).  They pay a dividend that is more or just about equal to their put premiums.  This list is very concentrated in Financial, Utility, and Telecommunication companies, but that is due to their steady, predictable cash flows which can be used to pay dividends.

BMY – Bristol Myers Squibb
WB – Wachovia Bank
C – Citigroup
UST – UST Inc.
PTR – PetroChina
NCC – National City
FITB – Fifth Third Bank
VZ – Verizon Communications
SO – Southern Company
DUK – Duke Energy
ED – Cons Edison
T – AT&T
MRK – Merck
MO – Altria Group

Check back soon for additional companies that will be added..

While this strategy can leave the investor slightly unprotected against the downside (or upside) depending on how the strategy is used, it can provide returns that are less volatile and will outperform in a flat or falling market.  The idea here is to expand on a typical covered call trading, holding long shares and selling calls against that position (1 call for every 100 shares).  This strategy is suggested to be used with index funds that follow the broad market indexes, to avoid individual firm risk.  Lets take a look at how this strategy can be used.

Portfolio 1 – All Stock
SPY – $101,346- 700 shares

Portfolio 2 – Using LEAPS
7 SPY December 2008 $120 Call – Total Cost: $23,310
$78,036 in cash

While purchasing the call option does entail an additional cost because of the premium, which is $8.49 per share, or a 5.9% premium to the current price, it does allow us to gain a full allocation to the index with about a 5th of the actual cost.

We then will look to sell covered call against our positions, which would mean that we will be selling 7 out of the money call options.  For the position we will be looking at selling 7 $147 March 2007 Call options currently trading at $1.00.  By taking this position we will be receiving $700 in premiums.  We will assume that we will be able to receive a similar premium on the sold options every two months, so we will be receiving an approximate $4,200 a year or $8,400 for the two years that you hold the position.  This would mean that for the approximate $100,000 position, you will be receiving 4.2% a year return by selling the call options against your position, which retain about 2% of upside potential per month. 

With the LEAPs portfolio, you have approximately $78,036 in cash, plus an allocation to $100,000 of the S&P 500 index.  The S&P 500 index allocation will be similar to the returns as experienced above, because the deep in-the-money call option will move point for point with the underlying stock.  Now the difference comes with the extra $78,036 in cash, to make the example easier we will invest it all into 3-month T-Bills currently yielding 5.16% a year.  This will add an additional $4,026 in cash per year.  Taking the $4,026 gained from the T-Bill investment and the $4,200 in cash received from selling the covered calls, you are receiving about $8,226 or 8.23% a year on the $100,000 LEAPs portfolio.  This is double the amount you would be receiving from just the $100,000 portfolio invested fully in the S&P 500 index fund.

I didn’t forget about the premium to the current stock price that you had to pay for the LEAP call option, but one year of premiums or one year of T-Bill payments will pay for the additional premium you owed. 

This strategy puts less money at risk than a traditional investment portfolio, and if you put that extra ~$75,000 of cash into bonds, you can potentially increase your returns and hedge against a market downturn, since bonds tend to move opposite of stocks.  This strategy can give a $75,000 allocation to bonds and a $100,000 allocation to stocks, which is deemed to be very conservative, all of this on a total investment of $100,000 using the LEAP option strategy.  This strategy also can handle a 50% decline in stocks, such that was experience after 1999, if the S&P 500 were to experience this sort of decline in the next two years, the all index portfolio would now be worth approximately $50,000 plus any premiums, while the LEAP option strategy would be worth approximately $75,000 plus any interest and premiums received.

This strategy can also be applied to the index if you expect it to go down, all you would do is use Put options instead of the call options.

Another strategy that can be used by investors is one that has a high probability of success and a low probability of loss.  This strategy is to provide consistent returns and is not speculative by any means and will not produce outsized returns.  The premise of the investment strategy is to hold long 100 shares of stock of a particular security and selling a deep in the money call option in the hopes of being assigned.  The investor will weigh risk/return on a particular stock and this strategy should be used in a diversified manor to provide more consistency to weigh out any outlier security that does not perform as to expectations.

To get a better idea of how this strategy works, we will apply it to Advanced Micro Devices (AMD), which has recently been under pressure from its larger rival Intel.  It is currently trading at $15.69 a share and we will be looking at going long 100 shares of stock.  Which would give us a total cost of $1,569.  Because we like the company and feel the future is promising for the company we are comfortable with the position that was initiated, however, we still aren’t 100% comfortable that they will be able to act on their future plans.  We will then sell 1 call option against that position, but instead of selling one at a higher price, we will sell one that is far in the money.  We identify the January 2008 $10 call option currently trading at $6.60.  By selling the call option we will receive $660 from the premium, thus lowering our initial position cost to $909.  We are protected from any losses down to $9.09 per share.  This is how the trade would look at different price levels in January 2008:
$0.00 – -$909
$2.50 (-84.00%) - -$659
$5.00 (-68.13%) -$409
$7.50 (-52.20%) -$159
$10.00 (-33.27%) +$91
$20.00 (+27.47) +$91

While it might seem that you are making a risky bet on the stock by risking $909 to make $91, if has, in fact, a high probability of being a profitable trade.  That $91 represents a 10% return should the stock be trading above $10 one year from now in January 2008.  This means that the stock can drop 33% from its current level and you will still profit.

This strategy can, at times, generate negative returns especially in declining markets and company fundamentals, so this strategy would require some analysis to be done by the investor.  This strategy can also be combined with dividend paying stocks, which in this strategy will provide some additional returns and will lower the cost basis of the trade.  The effects of purchasing your shares on margin and selling call options against those shares will be analyzed in an upcoming post.

The effects of taxes and commission was not taken into account in this example.