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TRADERS´STRATEGIES
Selling Naked Puts and Covered Calls
How to Make Volatility Produce Income for You
With the economy in the state that it is, it is essential for many traders and investors to generate income. With volatility currently being moderate to high,
there is a good opportunity to make money selling options. That is, as traders and investors are currently displaying fear, volatility rises. A good measure
of volatility is found in the Volatility Index, known as the VIX. We will be discussing the VIX further down in this article.
o Generally speaking, when the VIX is high, option prices are
high, and that means it is time to be an option seller. Handin-hand with high option prices are many shares selling
below the liquidation value of the company’s assets. The
combination of the two, present us with an opportunity to
buy first-class company shares at bargain prices. Take for
example company ZZZ (Figure 1).
An Income Generation Strategy
In this article I will be presenting you with a simple income
F1) Company ZZZs Share Prices at $16.92
generating strategy. What makes at least ½ of the strategy
work is the fact that great companies are selling at ridiculously
low prices – often below their net liquidation value. And due
to high volatility, option premiums are high, especially Put
premiums.
In Figure 1, ZZZ has fallen from over $45/share to $16.02/
share, a substantial drop in value. But as I wrote this article, a
$15 put option was selling for $3.40. It means that if you sold
the put and ZZZ’s price dropped to $15, you would have to
buy 100 shares of ZZZ at a price of $15.
However, you received $340 in option premium (100
shares x $3.40). Each option represents 100 shares of stock.
The numbers looked like this:
100 shares x $15.00 =
Less
$1500
$ 340
$1160
But, would you want to own ZZZ – is it a good buy at net
$1160? ZZZ was worth over $20 in cash on hand plus
inventory. But ZZZ also owns a lot of property, which is not
even in the $20 figure. ZZZ’s value really seems to be solid.
There Is More to Know
ZZZ has fallen from over $45/share to $16.02/share, a substantial drop in value. But as I wrote this article, a $15 put
option was selling for a whopping $3.40.
Source: TRADERS´ graphic
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October 2010 | www.tradersonline-mag.com
In order for you to have to cough up the money to buy
ZZZ, it would have to close at Option Expiration at a price
below $15. In other words, if ZZZ Closed right at $15 or
above, the option would expire worthless and you would
get to keep the $340, and sell yet another Put. But let’s
say ZZZ Closed at a price below $15. As long as it did not
reach $11.60, you would still be ahead. In other words, ZZZ
would have to drop another 23 percent for you to be in
loss position.
TRADERS´STRATEGIES
But We Are Not Done yet!
The reason we are not done is that as soon as the option
was “put” to you at $15, you would then own 100 shares
of ZZZ. The action you would take immediately would be
to sell a Call.
We can only guess at which price ZZZ would be
when you had to buy the shares, but the most immediate
probable action would be to sell a $15 Call.
The premium you receive from the Call further lessens
any pain from owning the shares. And there is still one
additional thing to consider – the dividend!
Let’s assume you now own 100 shares of ZZZ. You
paid out $1500 for those shares. But you received $340 in
Put premium, which is money in your account. Let’s also
assume that all you received from selling a $15 Call was
$170, or half of what you received from selling the Put. You
now have $510 in your account – all of which came from
option premium.
The last time ZZZ paid a dividend, they paid out $0.68.
If they pay out that amount again, you will receive another
peice, giving you $510 premium + $68 in dividends, or
$578 to the good. All of this can be applied against the
$1500 you paid for the shares. So although your cost basis
for the shares was $1500, you also have profited by owning
ZZZ. You have earned over 38 percent on your original
investment, and if you want to, you can take that money
out for your own use.
F2) Company YYY with Shares at $8.70
Buy shares for $8.70, sell $9 call for $1.50.
Source: TRADERS` graphic
The VIX
The VIX index is a widely recognized measure of volatility. As
I wrote this article the VIX was over 30. Anything over 25 is
considered to be good for selling options. The VIX measures
fear in the market. I have seen it run as high as 90, at which
October 2010 | www.tradersonline-mag.com
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TRADERS´STRATEGIES
point selling options is better than just about anything you
can imagine.
However, let’s make some rules now:
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Sell Puts whenever the VIX is 30 or above, which means
share prices are falling.
Find a dividend paying stock that you would not mind
owning and holding at a heavily discounted price.
Check liabilities vs. assets to be sure company is not
likely to go broke. If the company has debt make sure
operating cash flow is sufficient to cover the debt
payment.
Find dividend paying stocks (for example at www.
nextrend.com, it is free).
Sell one Put for every 100 shares that you are willing to
buy.
Collect premium for the Put which reduces your
investment in the shares.
If on option expiration day, shares are below the strike
price of the Put, we buy the shares, and immediately sell
Calls above our net investment cost.
For option prices, visit http://finance.yahoo.com or any
other website containing this information – usually, this
service should be for free.
Whenever You Own Shares and Have
Sold a Call above the Price of the Shares You Own
You have a Covered Call, sometimes called “Covered Write.”
In the case of ending up with a covered Call following the
naked Put strategy with ZZZ, we backed into the covered
Call position. However, we can also begin a position as a
covered Call.
Generally speaking, in a rising market, a way to generate
a nice income from it is to forgo capital gains, in favor of
generating steady income along with a small capital gain.
In my opinion a good way to do that considering current
market conditions is to create covered Call positions during
market rallies.
Let’s say that with prices at $8.70 you buy 100 shares of
company YYY and sell a $9.00 Call for $1.50. Let’s also say
the chart looks like Figure 2.
Joe Ross
Joe Ross, trader, author, and educator is one of the most
eclectic traders in the business. His over ﬁve decades in the
markets include position trading of shares, futures, and
options. Ross day trades stock indices, currencies, and forex.
He trades futures spreads and options on stocks, and futures,
and has written books about it all– twelve to be exact. Ross
has written countless articles for many trade journals and
magazines and has appeared on TV ﬁnancial programs, as
well as ﬁnancial programs on Radio. Moreover, he produces a
trading newsletter called Chart Scan™.
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October 2010 | www.tradersonline-mag.com
Your Position Looks like This
You own shares at $8.70 x 100
You are short one $9 Call option for $1.50
Cash Position
= $870
= $150
= $720
If prices at option expiration are at $9 or less, you get to
keep the premium of $150, and sell another option (Naked
Put if the VIX is 30 or more, if the VIX is less than 30 sell a
Covered Call). If prices are above $9 at option expiration, you
get to keep the premium + you make the difference between
$8.70 and $9. You make an additional $30. The shares will
have been “called” away from you. You will no longer have
those shares, but will be free to sell another option (Naked
Put, or covered Call depending on the value of the VIX.)
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You will not be in a cash loss position until prices close
below $7.20. But even if you are, you may still receive a
dividend, and at the lower prices you may choose to sell
another Call, since the original Call you wrote will have
expired worthless.
Some traders choose to exit the entire position if they
are experiencing a 25 percent loss in the price of the
shares.
Is There a Way to Lose?
There is only one way you can possibly lose using this
strategy. The company would have to go out of business,
and all shareholders lose.
Otherwise, your position is one of the following:
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You own shares in the company, which you bought at a
discount.
If the company pays dividends you get to collect them.
Or, you no longer own shares but have pocketed the
Put or Call premium, which in many cases can be done
repeatedly until such time as the shares are called away
from you.
Conclusion
There is a time to be an option seller and a time to be an
option buyer. Right now with the VIX above 25, it is time to
be a seller.
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Coca Cola (KO)
Exxon Mobile (XOM)
Intel (INTC)
McDonalds (MCD)
Microsoft (MSFT)
Procter and Gamble (PG)
Walmart (WMT)
Above is a list of great world-dominator companies that
can be bought inexpensively even without option premium.
But with option premium available on these companies, plus
the fact that these companies pay dividends, it is hard to not
take advantage of the current situation. n