A Joke from Berkshire's 2009 annual report

Customer: Thanks for putting me in XYZ stock at 5. I hear it’s up to 18.

Broker: Yes, and that’s just the beginning. In fact, the company is doing so well now, that it’s an even better buy at 18 than it was when you made your purchase.

Customer: Damn, I knew I should have waited.

Selling Premium, Naked

Naked premium selling involves selling simple calls or puts without having a position in the underlying asset or without hedging with additional option positions.

A typical example is selling SPY $117 March CALLS, currently trading for $.47 or selling SPY $111 March PUTS, currently trading for $.48. The maximum profit for both examples is the received premium. For the CALLS break-even is at 117.47 at opex; for the PUTS – break-even is at 110.52. The maximum loss is unlimited for the CALLs as theoretically SPY could rise to infinity in the next two weeks (I know it sounds ridiculous, but just pointing out the risks). The maximum loss for the PUTs is $110.52 per share as theoretically SPY could go to zero in the next two weeks.

Selling naked calls is an alternative to shorting. For example you might want to short certain stock, but there are no shares available to borrow or/and the IV of the Calls is elevated and you want to take an advantage of potential volatility crash;

Selling naked puts is an alternative to going long. For example you might want to go long certain stock, because it has declined significantly and for a “stupid” reason over the past month, but you are not sure how far the decline will go and you would like to take advantage of the elevated IV of the option. During severe and fast declines, options’ IV tend to increase significantly as fear has risen.

The general rule is to sell premium when you expect it to decline due to a move in the underlying asset, IV crash and time depreciation.

Premium sellers play the role of insurers. They offer the right to buy from them (via selling calls) or to sell to them (via selling puts).

Selling front month naked options is usually done to take advantage of elevated IV and accelerating time depreciation. Find an overextended stock with liquid options; stock that has declined significantly over the past few weeks.  You would like to own at this level, but you are not sure if the decline will continue and how far it will go. Sell front month OTM puts to collect premium. If the underlying continues to decline, you will enter at much lower price in a stock that you would like to own at these levels. If the stock reverses up, you will keep a hefty premium as the IV will crash and theta and delta will be on your side.

Selling naked LEAPS (long-term options, typically having 12 months + till expiration).  You find an overextended stock, to the upside or to the downside. If you sell front month OTM calls or puts, you won’t receive too much of a premium as there is not much time left till expiration. You are also not sure how far the selected stocks will go. In short-term perspective, irrationality reigns and anything can happen. Selling OTM LEAPS solves that problem. You receive a hefty time premium and in the same time you give the stock enough time to catch up with its fundamentals. In the mean time you could use the received premium to invest in other ideas.

Selling OTM LEAPS is one of  Warren Buffett favorite strategies. After all he is in the insurance business. He likes to sell premium when there is fear in the market. In 2007 and 2008 he sold long-term  index derivatives for $2.5 billion, betting that in the long-term  the stock market tends to increase in value. Selling long-term puts of companies that he plans to acquire is also often practiced.

Covered call

Covered call is a position in which you simultaneously buy the underlying stock and sell a call option against it. Its main purpose is to collect premium and have some cushion in case the underlying declines in value.

A typical example of a covered call is buying 100 shares of DOW, currently at $30.00, and selling against them 1 DOW April $32 Call, currently trading at .53 (or 1.75% of the underlying price). Against every hundred shares that you own, you can sell one call.  The best case scenario is DOW closes a little bit above 32 and you keep the premium + you make $2. If it closes at let say 31.50, you still keep the premium, keep your shares and you make 1.50 from the move in the stock. Break-even of this covered call is at 29.43, because you are keeping the premium no matter what. Anything below 29.43 is a loss.

Under what circumstances is a good idea to initiate a covered call?

I believe it is a good strategy for people’s IRA. Let say you own a relatively low beta stock that pays a nice annual dividend. (stocks like PM, DOW, KO…). The stock is in your long-term core holdings. A covered call strategy will let you decrease your cost basis. Every month, you are going to sell 5% OTM Call options against your equity and collect a premium. Typically 5% OTM calls with 4 weeks to expiration are traded anywhere between 0.5% and 2% of the stock’s price, depending on volatility. For the purposes of the post, we’ll work with 1%. Every month, no matter what happens with the stock you will collect about 1% premium. If the stock doesn’t change its value, in the end of the year you will have 12% from selling premium + the dividend that the stock pays.

A downside of this strategy could be a missed opportunity if the underlying stock rises significantly above the strike of the sold OTM call. For example if in the next 6 weeks DOW goes up to 38, you will miss on the profit from 32 to 38, because you sold a $32 strike call. This is why, the covered call is an appropriate strategy for low beta stocks that pay nice sized dividends.

Recently some bank executives have used covered calls to get paid. They received bonuses in company’s shares, without being able to sell them in the next 2 years. Guess what? They still got paid by selling ATM and slightly OTM Calls expiring in 2 years against their stocks. Certainly the received premium is much less than the current stock price, but if you need your money now and can’t sell stocks, covered calls is one way to solve the problem.

If DOW is in your long-term holding, it means that you will be willing to add to your position on dips. An alternative to waiting for dips could be selling 5% OTM PUT options and collecting premium against it. In the case with DOW, currently trading at 30.00, you could sell April $28 PUTS for about .70 (or 2.3% of the stocks’ price). Typically 5% OTM puts with 4 weeks to expiration are traded for about .5% – 2% of the price of the underlying asset. You could sell 5% OTM PUTs every month and collect let say 1% premium. If the stock doesn’t experience tremendous volatility during the year, in the end you would have 12% gain only from selling premium via PUT options. If your stock drops to below the strike of your PUT, you will get exercised and you would have to buy shares at the strike at which  each option was sold. For example, if DOW declines to 26 you will be exercised and you’ll have to buy it at $28, because you sold April $28 PUTs.

What will happen if you combine the two strategies and every month you sell 5% OTM Calls and 5% OTM Puts against your equity. Assuming your stock’s price starts and closes the year at approximately the same price, you have guaranteed minimum 24% income from premium + the dividend it pays. (broker’s commissions are not taken into account. The lower your capital and the more often you trade, the bigger the negative impact of commissions on your return).