Using Options To Improve Investment Returns

Trading options can be highly risky, but if used properly they can improve your investment returns, especially in a sideways to down trending market.

I generally prefer to invest in large-cap high dividend paying stocks from all sectors. Rather than just buy and hold the stock to collect the dividends, I prefer to use options to improve my returns. I always enter every investment position by selling a cash-secured put option in the stock I wish to invest in. This allows me to collect option premium before entering any position.

Comparison: Buying 100 shares of stock XYZ v. selling 1 cash-secured put in XYZ.

Stock XYZ is currently trading at $68 as of Aug 5, 2011. The stock has an ex-dividend date of Sept 1, with a payout of $0.50/sh. We want to potentially get in the stock before the ex-dividend date so that we can collect the dividend. Let's look at 2 options:

1. Buy 100 shares of XYZ stock @ 68/sh.

2. Sell a Aug 20, 65 strike put in XYZ for 1.08. Based on the current option chain for XYZ:

Strike    Bid      Ask
62.5      0.59     0.62
65.0      1.07     1.10
67.5      1.89     1.94

I would choose to sell the 65 strike put, but it depends on how bullish you are on the stock. If you don't see much downside risk then selling the 67.5 strike put would be a viable option.

Now let's look at some possible outcomes approximately 1 month later ~ Sept 5:

Outcome #1: Stock is trading higher ~ $75/sh.

Option #1: You are rich, with a gain of ~ $700.00 + $50.00 in dividends.

Option #2: The 65 strike put expired worthless. You made ~$100 from selling the put.

Clearly Option #1 was the best choice for this outcome.

Outcome #2: Stock is trading pretty much where you bought it ~ $68/sh.

Option #1: You made $50.00 in dividends.

Option #2: The 65 strike put expired worthless. You made ~$100 from selling the put.

Here Option #2 is the slightly better option. You didn't get to collect the dividend, but the option premium you collected more than made up for the missed dividend.

Outcome #3: Stock tanks and is trading ~ $60/sh.

Option #1: You are in pain. Including the $50.00 dividend, you are down $750.00 on your investment.

Option #2: You are in slightly less pain. The put option was assigned, so you collected the $100 premium, plus the $50.00 dividend, so you are down $650.00 on your investment.

Here Option #2 is the better option. The option premium you collected from selling the put helps to offset your losses in the stock.

In summary, selling a cash-secured put is a good investment strategy in flat or down trending markets. The drawback of selling a put is that you may miss a big move up in the underlying stock.

Now let's take a look at what we can do should Outcome #3 above occur:

Option #1: Hold onto the stock and hope for it to recover.

Option #2: Sell a Sep 17, covered call in XYZ.

For Option #2, let's assume we are able to sell a Sep 17, 65 strike call for ~ 1.10, which would give us about $100 after comissions.

Now let's look at some possible outcomes approximately 1 month later ~ Oct 5:

Outcome #1: Stock is trading higher ~ $75/sh.

Option #1: You are rich, with a gain of ~ $700 + $50 in dividends.

Option #2: The 65 strike call was assigned. You made ~$100 from selling the put, ~ $100 from selling the call and $50 in dividends for a total gain of ~ $250.

Clearly Option #1 was the best choice for this outcome.

Outcome #2: Stock rallies back to where you bought it ~ $68/sh.

Option #1: You made $50.00 in dividends.

Option #2: The 65 strike call was assigned. You made ~$100 from selling the put, ~ $100 from selling the call and $50 in dividends for a total gain of ~ $250..

Here Option #2 is the better option. The stock didn't move in 2 months time, but you collected $200 in option premium and $50 in dividends.

Outcome #3: Stock is still trading ~ $60/sh.

Option #1: You are still in pain. Including the $50 dividend, you are still down $750 on your initial investment.

Option #2: You are in slightly less pain. The initial put option was assigned, so you collected the $100 premium, plus the $50.00 dividend. The call option expired worthless, so you collected another $100 in option premium. You are now down $550.00 on your initial investment.

Here Option #2 is the better option. The option premium you collected from selling the put and selling the call helps to offset your losses in the stock.

In summary, selling a covered call is a good investment strategy in flat or down trending markets. The covered call gives you some protection to a down move in the underlying stock. Like selling a put, the drawback of selling a call is that you may miss a big move up in the underlying stock.

I would be happy to help anyone get started using this investment strategy. If you have any comments or questions, please leave them below.

Update

Over the past 6 months my trading has generally been going well. I hit a huge speed bump at the end of June and the beginning of July when I kept piling on short as the market surged higher. I went from being way up for the year to down. Lucky for me the market reversed during the second week of July and I have since nearly gotten back to where I was before I fumbled. Trading is a tough business. Just when you think you have it figured out it punches you in the face. I think getting my ass handed to me for a couple weeks was good for me. It's taught me that no matter how much you think you have a safe trading plan you are just one wrong decision away from losing it all. You have to be mentally tough, stick to the plan and always use stop losses.

My workload at my day job has never been higher, so I do not plan to be able to update this blog frequently. I'll be sharing my current investment strategy in an upcoming post, so stay tuned.

On Hiatus

Due to a recent illness and an increase in work load at my day job I will no longer be updating this blog regularly. I hope to be able to return to blogging one day. Until then, I will be providing my trade ideas and positions as I have time on twitter.

31 Jan 2011

Market Overview:

Friday saw the first big sell-off in the markets in over 2 months as news of the growing political unrest in Egypt hit the wire. For the first time since Nov 30 the S&P closed below its 10-day SMA. This upcoming week will be driven by how the crisis unfolds in Egypt. I suspect most other market news will simply be ignored. I'm expecting the sell-off to initially continue on Monday then for the market to stabilize above S&P 1250.

SPY Options Trading:

If we open down big on Monday I will look to sell weekly 124 or 125 puts in SPY. I think SPY will find support around its 50-day SMA (~ 125) this week.

Key Levels in the SPY:

Resistance: 128.15 (~ 20-day SMA), 128.85 (~ 10 day SMA), 129.25

Support: 127.20, 126.25, 125 (~ 50-day SMA)

Individual Stock Trading:

GLD -

I got stopped out of my short GLD put position last Thursday. It sure looked like gold was on its way down, then the Egypt news hit and changed everything. I think that downward bias returns this week, so I'm going to look to fade this rally in gold. I suspect gold will open higher this evening and thus GLD will open higher tomorrow morning. I'm going to look to sell weekly GLD 132 or 133 calls on strength Monday morning. There should be some resistance in GLD around the 132.50 level.

USO -

I expect oil to continue higher this week. There will be a lot of volatility so I may look to sell some weekly options in USO. If oil gets back to $95/barrel, then I'll look to sell some weekly USO 40 calls.

26 Jan 2011

Market Overview:
It was a volatile day with a lot of ups and downs. The market bounced off the low of the day around 3 pm and rallied to close basically flat. We closed above the 10-day SMA once again to keep the streak alive.

Tomorrow the Fed announces. The Fed statement will be key. I suspect they will just say they are going to keep the party going with QE2. If so, this will likely give the market and commodities a quick boost and the dollar a punch in the face.

SPY Options Trading:
I'm still short the 28 Jan 2011 130 calls. If we get a big bounce after the Fed announcement tomorrow I may look to add to this position. If we happen to get a big sell-off tomorrow I will look to sell some weekly 126 puts on a test of the 20-day SMA (~ 127.70)

Key Levels in the SPY:
Resistance: 129.50
Support: 129, 128.80(2-day SMA), 128.50(5 & 10-day SMA), 128.20, 127.70 (~20-day SMA)

Individual Stock Trading:
USO -
Oil continues to pullback. I'm targeting crude = $85 as a place to get long. I think that works out to USO around 36. If we get a sell-off in oil after the inventory report tomorrow I'll look to get long USO around 36, with a stop around 35 and a target of 38.

GLD -
I sold some weekly 129 GLD puts today as GLD tested 129. GLD bounced around noon and closed over 130. I'll be using that 129 level as my stop in this position now. If we go back down there again, that's bad news for me.

NFLX -
Earnings are tomorrow after the bell. I have no intention of playing this stock ahead of earnings. I think NFLX is setting up for a fall though. A lot of these high multiple stocks have sold off even after good earnings. I expect the same from NFLX. I expect them to beat, the stock to briefly pop and then sell-off. I will likely be too chicken to play it though.

25 Jan 2011

Market Overview:

The market rallied broadly today. The Dow was still showing relative strength to smaller caps. AAPL rallied and that helped bring the Nasdaq higher.

SPY Options Trading:

I sold short some 28 Jan 2011 130 calls on the market strength today. I may have been a little early with this trade. I still think the market is due for a larger pullback. We haven't closed below the 10-day SMA since Nov 30. That's one hell of a run. If we rally further tomorrow I will look to start buying some Feb puts. The 129.50 level is my target for initiating put buying.

Key Levels in the SPY:

Resistance: 129.50

Support: 129, 128.75, 128.35 (10-day SMA), 127.50 (20-day SMA)

Individual Stock Trading:

AMZN -

I closed out my short AMZN put position today for a moderate loss. The stock looks sick as it broke and closed below its 50-day SMA, even after a late-day rally. Earnings will be released Thursday and I'd rather not gamble on that. I think they will beat big, but I'm not sure how the stock will react. I would guess that it will initially pop and then sell-off.

GLD -

I'm still stalking GLD. I'm looking for a test of 130 at which point I will look to sell some weekly 129 puts.

FCX -

FCX has failed three consecutive trading days at its 50-day SMA. I think this sets up a nice try at a short. I'll look to short FCX around 110, with a stop of 112 and a target of 100 or below.

Jan 2011 Trading Log

24 Jan 2011

Market Overview:
The market is giving me mixed signals. DIA and SPY are still looking relatively strong, but QQQQ and IWM are showing significant weakness. Generally, the bigger the market cap, the better the stock did this past weak.

There are a boatload of earnings reports this week and those along with the Fed announcement on Wednesday will likely make this a volatile week of trading. The 20-day SMA on SPY (~ 127.30) will be a critical level this week. We tested that level last week and bounced. If we break through there then we will probably test the strong support ~ 126. To keep the uptrend going we will want to break and close above 130 this week.

SPY Options Trading:
Last week I got out of my short 22 Jan 2011 126 call position at nearly break even and made a nice gain on my short 22 Jan 2011 129 call position which expired worthless. This week I'll be looking to sell weekly 130 calls on strength and weekly 125 or 126 puts on weakness.

Key Levels in the SPY:
Resistance: 128.50, 128.70 (5-day SMA), 129.15, 129.50
Support: 128, 127.30 (20-day SMA), 126

Individual Stock Trading:
AMZN -
I sold some 28 Jan 2011 175 puts on Friday as AMZN approached its 50-day SMA. I'm looking for AMZN to bounce here ahead of earnings. If we get a good bounce I may look to turn this position into a strangle by selling some weekly calls.

GLD -
GLD is approaching strong support at 130. I'll be looking to sell weekly 129 or 130 puts on further weakness. I suspect GLD will see some strength after the Fed announcement, which is likely to be dovish (it usually is) and further weaken the dollar.

I think this recent weakness in gold is due to inflation fears. I think gold is actually not a good thing to own during inflation. During inflation you want to own something that has a high yield to keep up with the inflation. Gold yields 0%, thus if the price of gold is not rising at the same rate as inflation you will lose value in real dollars.

AAPL -
AAPL is approaching its 50-day SMA (~323) and strong support at 320. I will be looking to sell some weekly 315 or 320 puts on further weakness this week.

GE -
GE popped on positive earnings report on Friday. If we get a pullback to the 19.50 level I will look to get long with a stop of 18.90 and a target of 21 or above.