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Over the past year, I have occasionally suggested the use of covered strangles -- long the stock, short strangles bracketing the share price -- as a way to reduce risk and/or increase return. The thinking is that it is good practice to get paid for doing what you want to do anyway, which is to buy low and sell high. Furthermore, the stock can't go in two directions at once, so one of the options sold will be profitable.

This essay reviews the results achieved on stocks that I wrote up on Seeking Alpha and mentioned with regard to the strategy, finding that it occasionally disappoints when large price moves occur, but provides a good risk/return profile when properly employed.

The stocks involved:

Company

Symbol

Date of article

Price when written up

Recent Price

Carbo Ceramics

CRR

7/10/2009

34.99

74.00

Lufkin Industries

LUFK

1/2/2009

35.69

87.50

Haynes International

HAYN

9/25/2009

32.08

36.19

Carpenter Technology

CRS

9/25/2009

23.91

36.94

Humana

HUM

3/23/2009

24.43

45.65

Positions of this type are opening gambits, and it is often desirable to adjust as time passes and share prices change. In presenting the results, I utilize my actual trades and returns on stocks involved, under the belief that options traders, by nature active, would monitor and adjust along similar lines.

There are a number of questions that come up repetitiously when computing the rate of return on strategies of this type, which include the sale of a put. These were discussed in my article on Haynes International and rather than repeat the material here is a link. Bearing in mind that I am computing the XIRR (internal rate of return) on the basis that the puts sold were cash secured, and that the annualized returns shown are based on compound interest, here is a table of results: (Click to enlarge)



The picks were good. Under XIRR, the options column reflects the results of the spreadsheet function applied to my actual trades; the shares column does the same computation on hypothetical trades of an equivalent amount of shares on the same dates, for comparative purposes.

The strategy underperformed compared to just plain buying the shares, when the capital required to support the short puts is factored into the return computation. The XIRR ratio compares the returns for options with the hypothetical returns on shares. The $_Efficiency, by which I mean the extent to which the options strategy captured the dollar profits that were available by buying the shares, was good. The XIRR ratio reflects the low returns on the cash assumed to have been segregated to support the puts.

The covered strangle will do well in a choppy sideways market, particularly if volatility is high, as it was during much of the period. However, it is not going to look good in a rapidly rising market. Selling puts is not the same as buying the shares, and it will not reliably get you in at the bottom, as Warren Buffett has pointed out.

Carbo Ceramics (CRR) is the prime example of the drawbacks of this strategy. No sooner was the covered strangle in place than the shares took off like a rocket, never looking back. Just plain buying the shares resulted in a large, quick profit. After reviewing my article and the comments, which included a discussion of the 29% short interest that was outstanding at the time, it is clear that this case was controversial and a large move was to be expected, one way or the other.

On the other hand, Haynes International (HAYN) illustrates the benefits of the strategy. The stock headed down before it went back up, resulting in being assigned on the puts, buying low. After about six months it started to move, not too rapidly. In this case, the investor was paid to wait, forced to buy low, and is enjoying a good return on a low risk strategy, having captured all of the available price movement.

Summary

When the puts sold are adequately secured by cash, this strategy is low risk, basically amounting to deploying half your capital and holding the rest in reserve in order to buy on the dips, meanwhile selling strangles for income. It will out-perform a moderate market, but under-performs a strong upward chart. If the cases are selected with an eye on margin of security, the downside is quite manageable.

I have typically used this strategy in cases where I had a combination of value – tangible book as margin of security – and volatility – high options premiums available. When that combination, attractive as it is, comes up, the investor will do well to study the situation carefully, as a large move may be in the offing, and more aggressive strategies may be called for.

Disclosure: Long CRS and HAYN, no position in other stocks mentioned

Source: Options Strategy Review: Covered Strangles