After witnessing first hand the market crashes of 2000 and 2008, and realizing the stock market has returned nothing over the last 10 years, many investors are looking for solutions beyond the buy and hold strategy that worked for nearly 20 years prior to the tech bust! The rollercoaster ride has produced many upset stomachs and the remedy of "don't worry it will come back" prescribed by many advisors isn't curing the ailment. Sitting on the sidelines, or having a large portion of cash equivalents, seems to be the solution for many investors. With interest rates at historic lows, this puts portfolio growth on hold for most. It's not as if they aren't interested in investing for the long term; many are perplexed with when or what to invest in. At Volt, we have seen a lot of investors in this situation and we've developed a strategy that aims to maintain their cash position and produce returns that are significantly higher than current yields. We do this by using high probability options strategies that adhere to a disciplined, systematic approach to increasing returns in portfolios.
Options 101
Most have heard of a Call and Put option. Before we touch on how our strategy works we thought it would make sense to define the dynamics of each of these option contracts. If you are not familiar with what an option is, how they work, or just need a refresher; check out this Investopedia.com page as it does a good job going over the basics.
Call Option - The buyer of a call option purchases the right to purchase a stock at a set price within a set amount of time. The seller has the obligation to sell that stock to the buyer for the agreed upon price and time-frame.
Put Option - The buyer of a put option purchases the right to sell stock at a set price within a set amount of time. The seller of that option has the obligation to buy that stock from the buyer at the agreed upon price during the given time-frame.
Studies have shown that the seller of the option has a higher probability of success: This chart helps visualize this relationship.
How does the strategy work?
As you can imagine our strategy focuses on the higher probability side of the equation when dealing with options. Our ultimate goal is to be sellers of options contracts and collect premiums on behalf of our clients increasing the return they are experiencing within their portfolio. Here are a few examples of how we do this:
Cash Covered Put Writing - Refer back to the definition above on the relationship between the buyer and the seller of the Put. When identifying stocks that could be candidates for Put Writing, we are looking for fundamentally sound businesses that through our research process, we believe it's price will stay neutral or increase in value during the option contract time period; say 30 days until it expires. As an example, if XYZ stock is currently trading at $28 per share we may look at a Put option with a "strike price" of $25. When looking at the Put we find that it has a "premium" of $.50 per contract. Each contract represents 100 shares of stock so this would equate to $50 if looking at 1 contract. If our research is complete and we feel confident that this is a sound trade, we would SELL the Put and collect the premium. The important concept to grasp is "collecting the premium". Once the trade is done the premium collected goes directly in the clients account and becomes a realized gain once the trade is closed out or it expires worthless (after 30 days in this example). The ultimate goal is to have the contract expire and move on to the next months trade. Here is what this would look like if we sold 10 contracts with the next month's expiration.
Sell to Open 10 contracts of the XYZ September $25 Put contracts @ $.50 per contract. This would generate $500 of premium collected.
Here are the possible outcomes:
1. If XYZ's stock closes at $25 or higher on the expiration day, the $500 becomes a realized gain and the contracts expire. This is what we want!
2. If XYZ's stock closes below $25 on expiration day, we have two choices:
-close out the option contract by buying it back
-allow the stock to be assigned to us at $25 per share
Outcome 1 is simple, we collect the premium and look for the next candidate to do the same thing. With Scenario 2 we can "buy-back" the Put contract typically for a loss on the trade or let the stock get assigned to us (meaning we buy it at $25 per share) which, many times, is what we prefer to do. Remember the goal is to stay in a cash or liquid position so our goal is to get out of this stock as soon as possible. The beauty of options is there are many different strategies for many different situations and we can customize HOW we use them for each client's unique situation. Our goal, if owning the stock, is to engineer a gain when this situation happens because not all trades work out the way we expect and we will periodically get assigned stock! In contrast, if someone owned the stock outright and it decreased in value from $28 per share to $24.50 per share, that would be a decrease of $3500 or 12.5%(1000 shares - $3.5 per share) vs. being even in our example ($.50 premium collected x 1000 shares = $500 - exercise price of stock $25 = total cost of $24.50 per share). This is why, in general, we look at strike prices that are typically 5% or more from the current price of the stock. This presents us with a high probability of success in the trade. What we would typically do in this situation is immediately Sell a Covered Call that expires the next month. Many are familiar with a covered call as it is the opposite of the Put trade. As the seller we are obligated to sell the stock at a given price (strike price) within a certain time-frame. Here is how it would look for our situation:
Sell to Open 10 contracts of the XYZ October $25 Call contracts @ $.50 per contract. This would generate $500 of additional premium collected for the trade.
Here are the possible outcomes:
1. If XYZ closes above $25 at expiration we would end up selling the stock at $25 per share with an overall gain of 4% from the trades (not counting trade commissions).
2. If XYZ closes below $25:
-we can retain the stock and sell another call
-simply sell the stock
At this point we hope you understand the basic concept of what we are trying to achieve. These are just a few examples of the options strategies that we use when working with clients. In some cases we will also use Credit Call and Put Spreads as well as the infamous "Iron Condor". As with all option trading strategies, its important to understand the risks with the strategy you employ. In the above example, the original Put that we sold is in essence a synthetic buy order to purchase the stock at a certain point. Many investors use this if they would like to buy the stock if it went down to a certain price point. They are actually getting paid to place the buy order! The ultimate risk in this strategy is similar to owning the actual stock, it could hypothetically go to zero! This is where risk management of the portfolio comes in. We will typically look for multiple stocks each month to spread "single stock risk" out. Most important is identifying quality businesses that present an 80% or higher probability of success and if the trade went against us, we wouldn't mind holding the stock in the short-run.
As the markets and economy continue to muddle forward, our strategies at Volt are designed to position our clients for success in these types of market conditions. As you can see with this particular strategy we take an active role in attaining return, rather than just hoping and waiting for the market to go up. If you would like to explore how we could apply this or any of our other strategies to your portfolio, please reach out to us. Thanks for reading.
*Important Disclaimer
This document is not intended as an offer or solicitation. Investors should consult their own attorneys and tax advisors about the legal and tax issues concerning options transactions. Options are subject to complex risks and trading is not suitable for all investors. For more information on the risks of trading option, a copy of the Characteristics and Risks of Standardized Options may be requested
