STOCK INVESTMENT THE OPTIMUM APPROACH Ė USE OF OPTIONS TO ADD TO RETURNS

Options have become increasingly popular in recent years. While there are many strategies and rationales for trading options, their use in the context of the dividend-based, minimum risk approach being touted is somewhat limited. There are many excellent resources available for options education, so I wonít attempt that here, I will assume the reader has a basic understanding of how options work.

I only sell options. This approach always has time on my side. A given option loses value every day. Since in my case I will always have already sold, time is working to reduce the value of any option trade I have entered, which is a good thing if I ever feel the need to buy it back. Of course, under my rules, that will seldom happen, as I will explain in a moment.

First consider "covered" calls. This is a common strategy followed by stock investors. The concept is you own the stock and sell a call, usually with a strike price above the current market, and collect the call premium plus continue to collect the dividends. After the call expires worthless, repeat the process. It sounds too easy, and in fact it isnít that cut and dried. One article I read on Seeking Alpha challenged the basic premise that this was "free money", and cited statistics to show that covered call sellers frequently give up big gains on their stocks to pocket tiny premiums, and most sellers would be better off not using them. I donít doubt for a second that this is true in many if not most cases. If an investor "goes overboard" and sells calls against nearly all positions owned indiscriminately, chances are the results will be as the article suggested. I have a number of caveats to offer to try to avoid this scenario. First, there are some quality holdings I just donít want to risk losing, so I just wonít sell calls against them. An example is Johnson and Johnson (JNJ). For other stocks, the only time I even consider calls is when the market is really "frothy", a stock is making new highs and has advanced into the pre-determined full-value range, and I could consider selling, but I donít really want to sell. Yet, I hate to waste this advance, because I believe the stock will probably pull back soon, retracing a good portion of the gain. I will consider a call sale as an alternative to selling the stock. I then check to see what calls are available. One requirement is I donít want to go too far out in time, ideally only 3 or 4 months, and at most only 6 to 7 months. I also want a strike price above the current market, ideally by $2 to $3 dollars, which I really donít believe will be reached, but if it is reached, I would be happy to sell. And finally, I need for the call premium to be at least $1.00 or more, to yield enough cash to make the trade worth taking. If all conditions are met, I will enter a limit order to sell the call, usually trying for a little more than the quoted prices. Once Iím in, I consider that Iím committed, that the stock has been "pre-sold" at the strike price, and any dividends I collect during the term of the option contract are just "gravy". I therefore have mentally let go of the stock. The worst thing that can happen, at least as far as the option trade is concerned, is the stock rockets on up beyond any level imaginable, the stock is sold by assignment, and I suffer at least mentally from knowing the lost opportunity cost of the gain forfeited. Yet I am placated by the knowledge that, absent the option, I would probably have sold anyway before it reached the heights it later attained. The best outcome is the stock stays about where it was when I sold the option throughout the optionís life, or declines only a little, and the option expires worthless. Another negative outcome that can occur is the stock declines catastrophically and I have to buy back the option before I can sell the stock to limit further losses. This outcome really isnít bad from the standpoint of the option trade, since I will make money on the option trade, although probably not much compared to the loss on the stock, assuming the decline is below my cost basis. Consider that the decline would have happened whether or not I sold the option, and Iím not going to sell quickly anyway under my approach, so the extra time to buy back the option is not a big deal. And even if I buy back the option and sell the stock for a loss, I will be a little better off by having sold the option initially, since I will at least make money on the option trade.

Now, I know I said I was committed to riding out the option until expiration, but a couple of situations may cause me to buy back the option before expiration. If the stock declines quite a lot, and the option loses most of itís value, yet there is a month or more still to go, I sometimes consider buying it back instead of waiting for expiration. Even though at that point it looks like the option will very likely expire worthless, a lot can change over the course of a month or two. If I have made 90%, why not take it and avoid any risk of the stock reversing while Iím waiting for that last 10%? My rule of thumb is I will consider buying back the option if it can be purchased for 10 cents or less, yielding a 90% profit before commissions. Of course, the option buy back commission, which is avoided if the option is held to expiration, must also be considered when making a decision. The other situation where I might buy the option back is if, on expiration Friday, the stock is fluctuating up and down near the strike price, or is only a little above it, and Iíve had a change of heart about letting the shares go. I will consider a buy back if I can still exit the option trade with at least some profit and thus not lose the shares from assignment.

If an option is available that is attractive but I have less than 100 shares, I sometimes consider buying at the current inflated price (in my estimation) enough to get to 100 shares, then immediately sell the option. This would only be considered if I was originally close to having 100, say 75 or more, so a relatively small per cent of my total position would be acquired at the high price. This is a more aggressive strategy than I prefer to follow, but worth considering sometimes.

With these parameters, opportunities to sell calls are infrequent, but when all the pieces fall into place, it really does seem like "free money".

The only other option strategy I follow is selling cash-covered puts. I only use this strategy in extreme cases, and I seldom have more than one or two put trades on at any given time. In fact, I have never had more than two on at one time. Selling a put should only be considered when the market has declined quite a lot, yet few purchase opportunities are presenting themselves. A desired stock that is not owned may be down somewhat, but still not where you want to buy. If a put can be sold with a strike several dollars lower, where you would buy if you could, and the put price is $2.00 or better, a put sale could be considered. Keep in mind that if exercise occurs, you will be buying a full position at once, not over a minimum of 3 purchases, if 100 shares represents a full position for you. This risk can be considered to be mitigated somewhat by the effective low price considering the strike price and the put premium. Note that the cash that would be needed upon assignment is locked up for the duration of the put (in IRAís at least). One positive feature of this strategy is this cash will still bear interest in your brokerage account until it is used to buy the stock, which will only occur upon assignment. Unfortunately, this isnít worth much today (October 2011), but it may become relevant at some time in the future. I have sold puts for $3 or even $4. After about 10 or so trades, I have never been assigned on a put position. Under this put strategy, only two things can occur, both good Ė the put expires worthless and you keep the premium, or the put is exercised and you acquire the stock at a substantial discount from the price the stock was at when the option trade was entered, and the effective price is even better when you consider the put premium retained. So why not do more put sells since this works so well? It ties up a lot of cash, and you donít collect dividends on stocks you donít own.

I post all option trades to the to the Daily Journal, both buys and sells, just like I do for stock trades. I also post option trades to the Excel worksheets discussed in the prior essay. Although I enter stock trades on the active positions section in Excel in date sequence (with the caveat that additional adds to a position are posted next to the prior trades of that position), I post covered calls on the active positions in Excel just after the purchase entries for the stock in question. When an option trade is closed out, I initially post it on the Daily Journal in the same manner as I post the results of a stock sale, noting the gain/loss, and later I enter all relevant values on the Excel closed trades section. Also, to stay on top of options activity further, I maintain a separate log of options trades, with all relevant transaction details, plus I note the price of the underlying stock as it stood when the position was opened and again when it was closed. I use the option log to continually evaluate the cumulative results of option trading, including the opportunity cost of forfeited gains, to be sure it is beneficial in the aggregate.

I close this section with a final thought. Options selling is probably as close as you can get to "free money" in the market, but be well aware of the obligation assumed when an option contract is sold, and donít enter the contract in the first place if honoring the contractual obligation will cause you distress.