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.

20 Jan 2011

Market Overview:

The S&P finally had its long awaited pullback today. We shall see if we get some follow through to the downside tomorrow. There's a lot of support at SPY = 128 as that coincides with the 10-day SMA. Below that there will be more strong support at SPY = 127, which coincides with the 20-day SMA. It's options expiration week so that will probably add to the volatility.

SPY Options Trading:

I got out of my large long Feb 127 put position today for a modest gain. I'm still holding 22 Jan 2011 126 calls and 22 Jan 2011 129 calls short. My plan right now is to hold these calls short until expiration. If we can get a pullback to 127 then I'll look to close out the 126 call position and at the same time sell some weekly 126 puts. If we make another run to 129, I may look to start building another Feb put position.

Key Levels in the SPY:

Resistance: 128.50, 128.75 (5-day SMA), 129.20, 129.50

Support: 128 (10-day SMA), 127.50, 127 (20-day SMA)

Individual Stock Trading:

The Ag space had a big sell-off today on news that Cargill is selling its 64% stake in Mosaic (MOS). If there is continued selling tomorrow I'll look to try and capitalize on the volatility by selling weekly OTM puts in one more of the following Ag stocks: POT, MOS, AGU

Trading Log for Jan 2011

18 Jan 2011

Market Overview:
It just keeps going up. I'm not sure how long this can last. I was expecting a pullback last week. It didn't happen and I got hammered. I expect it to be a volatile week as earnings season gets into full swing. For Tuesday, I think the market will reverse on whichever way it opens. If we gap up on the open, then I think it corrects back down towards Friday's close. A gap down will likely see "bargain hunters" come in and start buying.

SPY Options Trading:
I got crushed on my short weekly 128 calls position last week. I'm still holding 22 Jan 2011 126 calls short. I'm way down on that position. If the options don't get assigned before expiration, then I'll look to close out my position if SPY retests 128. I piled into long Feb 127 puts on Friday. I kept buying more as the market kept rising. My plan with these is to "go to war" with the market. If the market goes up, I'll buy more. I think (hope) that the market will pullback at some time between now and expiration.

Key Levels in the SPY:
Resistance: 129.33
Support: 129, 128.80, 128.60, 128.20, 128

Individual Stock Trading:
GLD -
If gold continues to sell-off this week I will look to sell some weekly GLD 130 puts. There should be strong resistance at 130.

AAPL -
AAPL reports earnings after the bell on Tuesday. I expect them to completely blow out earnings. However, the stock has had a huge run ahead of earnings, therefore I think the upside is limited. If I have enough capital to do so, I will look to sell weekly 355 or 360 calls on Tuesday.

13 Jan 2011

Market Overview:

I was completely wrong about the break of the SPY 126.15-127.80 range. The market gapped up today and it didn't look back. Just about every individual stock I look at is showing overbought conditions, particularly the financials and the ags. I think we'll see a pullback to at least SPY=128 before the end of the week. If not, I will get hammered.

SPY Options Trading:

I sold to open more weekly 128 calls on the pop today. I was way too early with the selling and I now find myself down big. I also started buying Feb 126 puts today as I'm trying to dig myself out of hole. I'm looking, better to say hoping, for a pullback to 128 tomorrow. If that happens then I'll look to close out my SPY put position.

Key Levels in the SPY:

Resistance: 128.72

Support: 128.30, 128, 127.50

12 Jan 2011

Market Overview:

The market remains stuck in a pretty tight range as rallies are sold and pullbacks are bought. The SPY has been trapped between 126.15-127.80 since the start of the new year. I'm still expecting the break of this range to be to the downside.

SPY Options Trading:

I sold to open weekly 128 calls on the pop this morning. I'm thinking the market stays capped below 128 for the rest of the week. I wouldn't be surprised if we see a false break to the upside. If that happens I'll probably try to sell more calls. I will most likely only look to sell weekly puts if we see a major selloff.

Key Levels in the SPY:

Resistance: 127.50, 127.75

Support: 127, 126.50, 126.15

Individual Stock Trading:

USO -

If we see a pop in USO after the oil inventory report tomorrow I will look to short it. I don't think the economy can support oil around $95/barrel yet. I'll look to short USO around 39.50 with a stop at 40.50 and a target of around 37.

10 Jan 2011

Market Overview:

The market shook off a slightly worse than expected jobs report on Friday and managed to finish the day nearly flat. The market will likely move based on three news generating events this week:

1. The beginning of earnings season.

2. Macroeconomic data released on Wed-Fri.

3. A renewal of fears about the European sovereign debt crisis.

I think this will be the week we see a reversal of the uptrend in the market. After an early pop on Monday last week, the market failed to move higher as volume remained relatively high. To me this churn represents bulls using up their ammunition. I expect the market to find a reason to selloff this week.

SPY Options Trading:

Thankfully, my weekly options expired worthless last week. I'm still holding the 22 Jan 2011 126 calls short in expectation of a pullback to at least 125 before expiration. Since I have a bearish bias for the upcoming week, I will look to sell weekly 128 or 129 calls on any rally. To the downside, I will look to sell 124 or 123 puts if there is a major selloff.

Key Levels in the SPY:

Resistance: 127.50, 127.75, 128

Support: 127, 126.50, 126.15, 126, 125.50

Individual Stock Trading:

NFLX -

NFLX is still stuck in a tight range between 175-185. There is a convergence of SMAs around 180. The 2, 5, 10, 20 and 50 day SMA are all near 180. I'm expecting this stock to make a big move in the near future. I will attempt to play it in the direction of the break. I'd prefer it to break higher as I think that would give the biggest gains as the shorts are squeezed.

RIMM -

After a break higher RIMM has struggled to move higher the past 2 trading days. It looks like the rally is failing, thus I will look to fad an opening pop on Monday. I'll look to short RIMM around 63, with a stop of 65 and a target of 57.

FDX -

FDX is still trapped between 92-94. Like NFLX, I'm looking to play this one in the direction of its break from the trading range.

My updated trading log for the month is below.

7 Jan 2011

Market Overview:

The market rally temporarily ran out of steam today. The employment report and Bernanke's testimony before congress will be the big market movers tomorrow. Here's what I'm thinking on the jobs report:

Much better than expected: Market initially rallies then sells off as the dollar strengthens.

Much worse than expected: Market initially tanks then rallies as the dollar weakens.

Pretty much in line: Market slowly grinds higher.

Bernanke will probably say he's going to keep QE2 going and promise low interest rates forever, so that will likely provide a positive boost to stocks, but the employment number will be the big deal tomorrow.

SPY Option Trading:

I still have my open sells on the weekly 128 calls and weekly 125 puts. I'm hoping to keep SPY below 128 tomorrow and have all my weekly options expire worthless. I'm still holding the 22 Jan 2011 126 calls short as still expect a pullback to at least the 125 level before expiration.

Key Levels in the SPY:

Resistance: 127.50, 127.75, 128 (pre-market high this morning)

Support: 127.20, 127, 5-day SMA (~ 126.85 right now), 126.50, 126.25

Individual Stock Trading:

CHK:

CHK has rallied quite a bit since the middle of December. Today it put up a shooting star candle as it failed to hold above 27. This makes for an obvious stop on a short trade. If I have enough capital I will look to short CHK around current levels (~ 26.75) with a stop at 27.50 (above today's high) and a target around 25 (a potential area of support).

NFLX:

I'm still keeping an eye on NFLX, waiting for it to break out of the 175-185 trading range.

FDX:

FDX is another stock stuck in a trading range (92-94). I'll be looking to play it in the direction of the break.

See my trading log below for my current open and closed positions for the month.

6 Jan 2011

Market Overview:

The ADP employment report came out unbelievably better than expected today. This turned the market around from being down to setting new highs. Weekly jobless claims and chain-store sales will be released tomorrow. A lot of the individual stocks I follow are showing overbought conditions, as is the SPY, so I'm expecting it to be a struggle to go higher from here.

SPY Option Trading:

I started the day worrying about the weekly 125 puts I sold yesterday and ended the day adding to my short weekly 128 call position and worrying about that. I have now used up all my bullets. I got nothing left. If this market breaks above 128, then I'm going to get hit with a margin call, at which point I will probably roll out of this week's SPY call options and roll into next week's. If we happen to get a pretty good pullback tomorrow I will look to sell some weekly 126 puts as I still have the margin to do that.

Key Levels in the SPY:

Resistance: 127.73 (Today's High)

Support: 127.50, 127, 5-day SMA (~ 126.60 right now), 126.50, 126.25

Individual Stock Trading:

RIMM:

RIMM played out just like I expected. I couldn't play it though because all my capital was tied up in short SPY call options. Pity the fool.

NFLX:

Since about 1 Dec 2010 NFLX has been trading very similar to RIMM. Both stocks hit highs on 1 Dec 2010 and have since pulled back. I'm not saying NFLX is going to break out to the upside like RIMM, but it looks like NFLX is starting to get trapped in a tight range between 175-185, near its 20 and 50 day SMAs. I would play this, like I wanted to play RIMM, by waiting for the big volume break out of this range, either to the upside or to downside and then play it in the direction of the break.

See my trading log below for my current open and closed positions for the month.

5 Jan 2011

Market Overview:

The market is sending me mixed signals. On the one hand the Dow and S&P finished strong today, while on the other, the Russell 2000 tanked hard and had a weak bounce into the close. Oil also got punched in the face today. We will get some preliminary job data and the ISM Non-Mfg index tomorrow so maybe that will determine the market's next move.

SPY Option Trading:

I got lucky to sell some weekly puts near the market bottom today. That was my only move. I will likely sit tight with my weekly SPY options for the remainder of the week unless we get a big move. If we get a big move to the upside then I will look to sell some more weekly 128 calls. If we get a big move to the downside then I will look to sell some weekly 124 puts.

Key Levels in the SPY:

Resistance: 127, 127.50

Support: 126.50, 126.25, 126, 125.50, 125

Individual Stock Trading:

RIMM:

I tried shorting RIMM at 59.50 right after the open, but my order never hit. It looks like RIMM is trapped among a bunch of SMAs (20, 50 and 200) so I think the best thing to do now is just sit back and wait for it to make a big volume break, either to the upside or to the downside, and then play it in the direction of the break.

See my trading log below for my current open and closed positions for the month.

4 Jan 2011

SPY Option Trading:

I got PUNKED trying to short the SPY on Monday. I put on a bad trade early when I sold the weekly (7 Jan 2011) SPY 127 puts. I tried to close out of this trade and rotate into SPY 128 calls but I ended up closing the trade right near the highs for the day, so I only was able to sell 1 additional SPY 128 call.

I'll be looking to sell more weekly SPY 128 calls on a pop tomorrow. To the downside we should have support at 126 now, so I'll be looking to sell some weekly 125 calls on a pullback,

Individual Stock Trading:

RIMM:

I didn't pull the trigger on RIMM again today. It turns out that the RIMM rally failed at the 20-day SMA and now the stock looks like a good setup for shorting. I'll be looking to short RIMM in the 59-59.25 area tomorrow with a stop at 60.50 and a target of 55.

See my trading log for below for my current open and closed positions for the month.

3 Jan 2011

Market Overview:

As the new year begins it looks like the market wants to go higher. We may see a repeat of January 2010. Last year we had a nice rally the first week in January when everyone was expecting a pullback. This squeezed out the remaining shorts. The market did eventually rollover later in the month.

I'm seeing a lot of individual stocks in a consolidation pattern. AAPL, RIMM, AMZN, SNDK for example. If these stocks break higher then they will likely take the broad market with them.

SPY Option Trading:

Despite my short-term bullish thinking, I'm currently short the SPY via selling naked 22 Jan 2011 SPY 126 calls. I'll be looking to sell some weekly (7 Jan 2011) SPY 127 calls on a pop this week. To the downside we should have support at 125 and then 124 in SPY. I'll be looking to sell weekly SPY 123 or 124 puts on a pullback this week.

Individual Stock Trading:

USO:

If we get another rally in oil this week I will look to short USO. This short is mainly a fundamental play. I don't think the economy will be able to support oil prices at > $90 barrel for long. I'll look to short USO around 39.50, with a stop of 40.50 and a target of 37.50.

RIMM:

RIMM is trapped between its 50-day and 200-day SMA. I still like RIMM to pop higher here. Admittedly, I should have pulled the trigger on this trade last week. I will look to get long if RIMM breaks above 58.50, with a stop of around 57 and a target of 65.