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Today's Featured Article
The Standard & Poor's 500 is a basket of 500 solid mid cap or large cap corporations. It is weighted by market value and its performance is representative of the stock market as a whole. A well-diversified stock portfolio would be highly correlated to the S&P 500; which means a rise or fall in the S&P 500 would mirror a similar percentage rise or fall in a stock portfolio.
Options on the S&P 500 are very liquid and traded heavily in the March quarterly cycle. Expiring on the third Friday of March, June, September and December, these options can be used to receive extra income while lessening overall market risk.
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For example, let's take a million dollar stock portfolio that is representative of the S&P 500. By selling the September 1015 call for 7.50 points and buying the September 1045 call for 3.50 points you receive a net of 4 points* This is a short bull call spread or more commonly known as a credit spread. Each point in the S&P 500 is worth $250. By collecting 4 points you receive a premium of $1,000 per spread.* Any rally at all by expiration would increase the value of your overall portfolio regardless of the amount. On a million dollar portfolio I would recommend 10 spreads. Although this is not considered a hedge it will lessen your overall portfolio
risk by the $10,000 collected if the market goes down or remains at the current level of 920. In fact, if the market on expiration (September 18th) has risen 10% from 920 to 1012, not only should your stock portfolio increase from $1,000,000 to $1,100,000 but the call spread is still out of the money and the $10,000 is retained. Your total risk on the option can never be more than $65,000 = 30 x $250 x 10, minus the $10,000 you received. The good news is the only way this can happen is if the market goes up 13.5% in the next 80 days and then your stock portfolio should increase from 1,000,000 to 1,135.000.
By doing this each quarter it is easy to see that $40,000 of extra income can be received during a calendar year. Since the position is hedged by the underlying stock portfolio no adjustments need to be made during the life of the trade. If the market goes down you will have retained the $10,000 of premium. An unchanged market will also enable you to retain the $10,000.
If the market makes a significant move higher any loss in the call spread will be more than offset by the rise in the value of your stock portfolio.
Another way of receiving extra income is by selling call options every other month. An example would be to sell the August 965 calls. These options are 5% out of the money and bring a premium of 14 points or $3500 of income. At the current market level of 920 you are controlling 920 x $250 = $230,000 worth of stock. This is significantly less than the $1,000,000 your portfolio represents.
By selling a naked call every other month you can expect to take in $21,000 worth of premium in a calendar year. I would sell 2 of the calls and take in $42,000 of premium and control $460,000 of stock, still less than the $1,000,000 portfolio.
In the first example, (quarterly income) involving a credit spread your potential loss on the option is predetermined. In this example (bi-monthly income) your potential loss on the option is unlimited. It is naked. However, since you own a million dollar portfolio that is highly correlated with the S&P 500 any loss in the naked calls is more than offset by the rise in the stock portfolio.
*Excluding commission and fees.
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Let's examine what would happen if in the two month time frame the market would explode up 20%. At first blush one would think that being short a naked call would be a disaster; upon further review such is not the case. From the current level of 920 a 20% rise would represent a market level of 1104. At 1104 the 965 call you received $3,500 for would be worth 1104 - 965 = 139 x $250 = $69,500. However, the value of your stock portfolio would be worth $1,200,000. This more than offsets the value of the option.
Unlike the first example involving a spread, the naked call could and probably should be adjusted prior to going in the money. One of the many advantages of commodity options is the amount of ways traders have at their disposal to adjust an existing position. The proper adjustment is made based on a number of factors: time till expiration, percentage out of the money, volatility of the underlying market, valuation of the option and of course anticipation of market direction.
Based on the aforementioned factors we could roll the option to a higher strike price and or roll the option to a longer term. In all likelihood we would be able to roll the option from a September 965 call to an out of the month October call probably also 5% away from the market at inception.
Including the original 5% move from 920 to 965 in order for the October call to get in the money an additional 5% move would have to occur. Which in turn would be a 10% gain to the value of your stocks.
People for years have been writing calls on stocks they own, called covered calls. These covered calls are protected by the underlying stock. When you have a diversified portfolio that moves in tandem with the S&P 500, a similar approach should be taken. Even though writing S&P 500 calls is considered naked, the writer may be protected by owing the underlying stocks.
Call writing, whether in the form of spreads or naked, can be a continuous source of extra income. The more volatile and the more uncertain things remain, generally speaking the richer option premiums become. And I know we all could use the extra income.
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About the Author
Mr. Ed Carr
graduated from Allegheny College with a Bachelor of Science in Economics. He continued his education by obtaining a Masters in Business Administration in Finance from Fairleigh Dickinson University. His initial career foray was as an account executive of a large commodities brokerage firm. In five years he was ranked as a top producer and was promoted to management. Shortly thereafter he was recruited by a major brokerage firm and became their Vice President.
In 1987 he put his experience to use and founded Carr Investments Incorporated. Carr Investments had professionally handled thousands of clients worldwide for ten years. In 1998 the assets of Carr Investments were acquired by Trader's Edge Inc. Mr. Carr took over the role of President and Jonathan Lubow as Vice President.
His vast experience has enabled him to market four unique ways of trading options that have been utilized by many firms, as well as individuals. Mr. Carr has appeared as a guest on several investment shows and given numerous seminars and lectures to professional investors, corporations and individuals throughout North and South America. Mr. Carr has been married for over twenty-five years, has four children and resides in Morris County New Jersey.
Ed is also a contributor to Optionsscholar. |
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Special Message from Our Author
COMPLIMENTARY Booklet: Smart Trading Techniques
Trader's Edge is offering a complimentary booklet, Smart Trading Techniques: How to Profit from Time Value Decay Writing S&P 500 Credit Spreads. John Summa, a well-known options trader and advisor, shares his time-value-friendly strategy for trading options on the S&P 500 futures. Why not put his experience to work in your portfolio? Get your copy now! |
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