November 28th, 2014
by Russ Allen, Online Trading Academy Instructor
Recently I've written about hedging strategies that use options. One of the strategies I've described was buying put options as insurance. Another was selling covered call options against the stock position, to reduce its cost and therefore its risk. Yet another was to combine those two strategies, in what is known as a collar.
All of these methods assume that we want to continue to own the stock. Today we'll take a different tack, which involves selling the stock to take profits now, and making a plan to re-purchase it at a discount later.
If we think the stock has had about as much of a run as it's going to get for now, we can simply sell it and bank the profits. A bird in the hand has been kept from flying away, to stretch a metaphor.
But we can set a trap for more birds. If we can identify a lower price at which we would like to buy back in to the stock, we can use options as a way to be paid for waiting for the stock to reach it.
Here is a chart of TLT, the exchange-traded fund that owns long-term U.S. Treasury bonds.
TLT has had a very good run over the last year, rising over 14% while also paying dividends of around 3%. Not bad for something as prosaic as government bonds. But let's suppose we think it is likely to fall from here, back toward its long-term trend, and to pull back to around $114-115. (This is not a recommendation. We're just supposin' here).
If that is our opinion, we could sell TLT now and bank our gain. We could then put in an order to buy it back at a limit price of $115. If it were to drop that low, our order would be filled and we'd be back in the game. If TLT holds at its long-term trend and begins to rise again, we'll be aboard for another up cycle.
We could do a little better than just hoping to buy TLT at $115 though. We could get paid for being willing to buy it.
This would be accomplished by selling cash-secured put options on TLT. Looking at the available put options, we can see that there is a bid of $1.17 per share for the January put options at the 116 strike price. These expire on January 16, 58 days from now. We can sell these puts (it's also called "writing" the puts, because we are creating them and then selling them to someone else), and receive $1.17 per share, or $117 for a hundred shares.
To be allowed to do this, we have to have the money in our brokerage account with which to buy the stock - $116 per share, or $11,600 for 100 shares. This is earmarked for the possible purchase of the TLT stock, but until then, it's still our money. In exchange for receiving the $1.17 per share, we have taken on the obligation to buy the stock at $116, but only if the stock is actually cheaper than that when the options expire in 58 days.
If TLT is at a price below $116 at that time, then the actual re-purchasing of the TLT stock will happen. If that is the case, the $11,600 will be removed from our account, and 100 shares of TLT stock will be put into it. Our net cost will be the $116 per share that we will then have paid, less the $1.17 per share that we will have earlier received for selling the puts. The net cost will be $116.00 - $1.17, or $114.83 per share. This is is in the $114-115 area that we identified on the chart as a good buy price.
What if TLT does not drop as low as $116? In that case, we will not be required to buy the stock. Our obligation to do so will expire with the options on January 16. But even though we would then end up not buying the stock, we would still have gotten paid to be willing to buy it: we will still keep the $1.17 that we took in for selling the put options.
So here are the possible scenarios. Remember that in all cases, we are assuming that we started out by selling a 100-share TLT position that we had earlier owned, at the current price of $11,876, and had that much money in our pockets. Of that amount, $11,600 has to be reserved in case we are required to buy the stock.
- TLT goes up from here. We do not make any money on that, because we sold our previous position. But we do keep the $117 as a return on the $11,600 investment that has been tied up for 58 days. That works out to an annual rate of return of about 6%.
- TLT goes sideways, or down a little, but not below $116. Same as number 1 - we make $117.
- TLT goes below $116, but no lower than $114.83. We still have a profit on the put sale, because we now own TLT at a net cost of $114.83, and it is worth more than that.
- TLT drops below $114.83. We would have an unrealized loss, to the extent that the drop was lower than that price.
After the January expiration, we can repeat the process each month, collecting money for selling puts while waiting for the stock to drop into whatever buy zone we determine at that time. If our timing is good, we can significantly increase our returns by taking profits at high prices and then buying back at discounted prices. The option premiums we collect are icing on the cake.
In our classes, we cover both the market timing aspects and the option strategies in depth. Sign up for a free class and learn how it's done.