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Covered Call Strategies – Expiration Writing

There are many variations of the covered call trade.  The classic covered call is to select the trade, buy the stock and sell the ATM call.  In addition, there are a number of strategies that are variations of the classic call based on different trading ideas.  One covered call variation is expiration writing.

The investor will scan for short-term writes in the last two weeks of the current option cycle.  The trader is looking for stocks with high premium and high return on funds invested.  To get high returns over such a short time period usually indicates a high implied volatility and increased risk.  When IV is higher than actual volatility, then there is usually a pending event so you must research these trades very thoroughly.

One safer way to do this is to find a stock with higher volatility due to an event planned in advance.  Examine the stock to see when the event date is scheduled.  If the event will occur after the current expiration date, then you can trade in the current month calls.  The reason for this is that event volatility may increase premiums across both the current month and the next month option cycles.  This is a cool trick that most covered call writers had not heard of before.

This is not a risk free trade but it works if you are right about the timing of the event expiration being after the current month.  The key is to actually confirm the event date and not speculating about when it will occur.  Do not just go by the high volatility in two month alone as this does not indicate the event date.  If the IV is in line with the historical volatility, it may be a great covered call write anyway.

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Trading a Calendar Spread with LEAPS

Previously, we posted information on doing a covered call using a LEAPS option. Call calendar spreads are similar to a covered call. One part of the call calendar spread is buying a LEAPS call instead of owning the stock. Then, we can sell call options (like a covered call) with less time to expiration (the calendar part). For example, we can buy a call LEAPS with two years of time and sell a call option in the next month. It the strike price of the LEAPS is the same as the call sold, then you have created a call calendar spread. It the strike prices are different, then we have created a diagonalized calendar spread.

My preference is to buy a LEAPS that is in-the-money. This gives you a higher delta so you captured more of the stock price move. A good target is to buy a LEAPS call with a delta of 0.70 or higher. If the stock makes a strong up move, then you gain more profits in the LEAPS call. Also, ITM LEAPS give us more choices in what strike prices to sell the call. In comparison to a covered call with stock, we DO NOT want to e exercised in the LEAPS position. The reason is simply that we do not want to lose the time value of the LEAP call. You can buy an ATM or OTM LEAPS call, but your delta will be lower and it is more difficult to sell a call until the stock price moves up.

When I sell a call, I like to sell the shortest amount of time available because it will decay faster (more profit per day due to time decay) than a call with several months of time. I like to use the existing month and the next month for call sells. I like to sell an OTM call when holding a LEAPS because the call sold is all time value.

The bottomline: Your returns will be leveraged. For example, you may get a 3% return on a covered call but that same return will be 12% if your underlying is a LEAPS instead of stock. Since we are using LEAPS, if the short call strike price is above the stock then it will expire worthless. You can then sell a call against the LEAPS for the next month. If the stock price is greater than the short call, you can back back the short call or roll it up to a higher strike price.

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How to Get More Protection from Stock Price Declines

In a flat to bullish market, most call writers will sell an at-the-money call on the stock they own.  the rationale for selling an ATM call is that they have the highest premium in terms of time value.  Of course, the option seller can sell at any strike price.  What should the call seller do in a market driven by fear such as potential debt defaults, FED changes, financial chaos, etc.?  The smart call writer will change their strike price to get more downside protection.

Suppose you want to write a call on a stock that you are concerned about a potential price drop,  you can look to write an in-the-money call.  The stock is trading at $7.80 per share.  You can write the $7.50 call for $0.90.  This call has a $0.30 intrinsic value so you are getting $0.60 in time value. As long as the stock is above $7.50 at expiration you keep the $0.60 in time value and the $0.30 intrinsic value.  Now you have created a situation where you still make money if the stock declines by 3.85%.

Let’s try another example.  The stock is trading at $136.00 per share.  You can sell the 135 call for $10.25; the 130 for $13.15; the 125 for $16.40; the 120 for 20.05.  You can go down to the 120 call strike to produce a 13% downside protection.   Yet you still get a $4.05 time value premium that is almost a 3% return.  Now you have created a situation where you still make money if the stock declines 13%.

Considering an average volatility, this is a great way to protect yourself for an anticipated price downturn.   While selling ITM calls does not usually realize a return as high as selling ATM calls, it does have the benefit of creating more downside protection for the stock price to fall and still return a profit.  You should only sell ITM calls if you are willing to let the stock be called away.

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How To Create Your Own High Yield Cash Machine

Many investors look to their portfolios for income.  To get current income, these investors should look for high yield investments.  High-yielding investments can be a little confusing if you just search for the biggest yields.  This article will share some guidelines to creating a cash machine for high income.

A “Real” High Yield Investment:

  • Pays dividends yields of 5% to 20% annual
  • Highly liquid vehicles that can be bought or sold through discount or online brokers
  • Less volatility than the average large cap stock portfolio
  • Drives dividends from cash-flow, not debt payments
  • Pays dividends monthly and/or quarterly

There are so many investment categories that offer high yield securities.  Here is a list of high yield investments:

  • Business Development Companies (BDCs)
  • Canadian Royalty Trusts
  • Closed End Funds
  • Convertible Securities
  • Corporate Bonds
  • Emerging Market Debt
  • Exchange Traded Funds (ETFs)
  • Exchange Traded Notes (ETNs)
  • Grantor Trusts
  • Master Limited Partnerships (MLPs)
  • Oil/Shipping Tanker Stocks
  • Option Income Funds
  • Preferred Stocks
  • Real Estate Investment Trusts (REITs)
  • Structured Products (i.e. STRIDES)

 While do you want to buy high yielding investments?  The five keys to the cash machine high income investment strategy are as follows:

  1. It pays a double-digit yield
  2. It’s highly diversified
  3. It’s highly liquid
  4. It’s flexible
  5. It offers upside appreciation with less volatility than common stocks

 To build your own cash machine portfolio you must do the following:  

  • Desire to build income portfolio
  • Look for securities paying yields of 5% to 20%
  • Invest in asset classes with strong fundamentals in pockets of economic strength
  • Rotate in and out of sectors of strength
  • Target capital appreciation of 10% to 15% per year

The bottom line is that all income investors should have at least a portion of their income in a cash machine with high yield investments.

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Using a Protective Put to Prevent Investment Losses

At Get Rich Investments, we create investing strategies to capture monthly income. This may take the form of covered call trades, cash-secured put trades, CEFs for monthly dividends and other strategies. However, as the market volatility increases such as we have experienced lately, investors get worried about protecting their capital. We do have an answer which is an effective strategy. It is called a protective put trade to protect against losses during a price decline. We like to also combine the protective put with our covered call strategy to have our income and protect our capital at the same time.

Please don’t take my word for it , here is how our friends at Fidelity Investments describe using a protective put.

There are two types of options: calls and puts. The buyer of a call has the right to buy a stock at a set price until the option contract expires. The buyer of a put has the right to sell a stock at a set price until the contract expires.

If you own an underlying stock or other security, a protective put position involves purchasing put options, on a share-for-share basis, on the same stock. This is in contrast to a covered call which involves selling a call on a stock you own. Options traders who are more comfortable with call options can think of purchasing a put to protect a long stock position much like a synthetic long call.

The primary benefit of a protective put strategy is it helps protect against losses during a price decline in the underlying asset, while still allowing for capital appreciation if the stock increases in value. Of course, there is a cost to any protection: in the case of a protective put, it is the price of the option. Essentially, if the stock goes up, you have unlimited profit potential (less the cost of the put options), and if the stock goes down, the put goes up in value to offset losses on the stock.

Let’s highlight how the protective put works. Assume you purchased 100 shares of XYZ Company at $50 per share six months ago. The cost of this trade was $5,000 ($50 share price multiplied by 100 shares).

The stock is now trading at $65 per share, and you think it might go to $70. However, you are concerned about the global economy and how any broad market weakness might impact the stock.

A protective put allows you to maintain ownership of the stock so that it can potentially reach your $70 price target, while protecting you in case the market weakens and the stock price decreases as a result.

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When the stock is trading at $65, suppose you decide to purchase the 62 XYZ Company October put option contract (i.e. the underlying asset is XYZ Company stock, the exercise price is $62, and the expiration month is October) at $3 per contract (this is the option price, also known as the premium) for a total cost of $300 ($3 per contract multiplied by 100 shares that the option contract controls).

If XYZ continues to go up in value, your underlying stock position increases commensurately and the put option is out of the money (meaning it is declining in value as the stock rises). For instance, if at the expiration of the put contract the stock reaches your $70 price target, you might then choose to sell the stock for a pretax profit of $1,700 ($2,000 profit on the underlying stock less the $300 cost of the option) and the option would expire worthless.

Alternatively, if your fears about the economy were realized and the stock was adversely impacted as a result, your capital gains would be protected against a decline by the put. Here’s how.

Assume the stock declined from $65 to $55 just prior to expiration of the option. Without the protective put, if you sold the stock at $55, your pretax profit would be just $500 ($5,500 less $5,000). If you purchased the 62 XYZ October put, and then sold the stock by exercising the option, your pretax profit would be $900. You would sell the stock at the exercise price of $62. Thus, the profit with the purchased put is $900, which is equal to the $500 profit on the underlying stock, plus the $700 in-the-money put profit, less the $300 cost of the option. That compares with a profit of $500 without it.

As you can see in this example, although the profits are reduced when the stock goes up in value, the protective put limits the risk to the unrealized gains during a decline.

We continue to identify winning option trades to generate income and to exit early as the stock bullish patterns moves prices higher.

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