It's Amazing What A Stock Market Rally Can Do

by: SA Editor Rocco Pendola

On Monday, I published a sample portfolio: The Short Portfolio That Wants to Be Long. Comprised of short put options, I had two main intents for the portfolio.

First and foremost, it would generate income from the hefty premiums generated by writing put options on several big-name stocks, including a few volatile high-flyers. Second, it could accomplish the goal of getting you long on stocks that you would not mind owning on a pullback, which, in at least a few cases looks somewhat unlikely.

As I have illustrated with my $10,000 portfolio, the last few weeks provide an excellent environment for selling puts and collecting premiums on established names. With all of this volatility, you have been able to sit back, wait for a rally -- head fake or not -- and then decide, should I close out the position for a profit or ride it out longer, maybe all the way until expiration. And all the while, assuming you picked the right strikes on stocks you would love to own and you have sufficient account equity to back up the trade, you could remain calm, cool and collected about the prospects of getting put shares.

Consider the illustrations of this technique I put forth on Monday:

If you have $10,000 in cash ...
  • Sell Tiffany (NYSE:TIF) Sept $57.50 put for $3.50.
  • Sell Johnson Controls (NYSE:JCI) Sept $28 put for $1.35.
  • Requires $8,550 to secure the puts. $1,450 cash balance + $485 premium income.
If you have $50,000 in cash, consider all of the above plus ...
  • Sell Apple (NASDAQ:AAPL) Sept $360 put for $15.75.
  • Sell Lululemon (NASDAQ:LULU) Sept $43.75 put for $3.40.
  • Requires $48,925 to secure the puts. $1,075 cash balance + $2,400 premium income.
If you have $100,000 in cash, consider all of the above plus ...
  • Sell (NASDAQ:AMZN) Sept $175 put for $8.45.
  • Sell Chipotle (NYSE:CMG) Sept $280 put for $13.30.
  • Requires $94,425 to secure the puts. $5,575 cash balance + 4,575 premium income.

The following chart shows the value of each of the above-referenced put options, as of Tuesday's close, with your gross profit had you closed out the position at Tuesday's closing price (I use the closing midpoint on all contracts). It also shows the effective price (strike minus premium received) you would pay for the shares if, and this is a big if, you end up getting assigned on or before options expiration day in September (all puts are September options). Of course, the final column assumes you did not close the trade.

Basically, this chart illustrates a crossroads: Do I close out the position(s) for quick profits OR do I hang on to the puts, let time decay go to work and run the "risk" of getting put shares I went into the trade with at least some level of desire to own anyhow?

Company (Ticker) Monday Close Short Put (Entry) (Exit) Gross Profit Effective Price if Assigned
Tiffany (TIF) $62.72 $57.50 ($3.50) ($2.06) $144 $54.00
Johnson Controls (JCI) $30.08 $28.00 ($1.35) ($0.85) $50 $26.65
Apple (AAPL) $373.60 $360 ($15.75) ($7.62) $813 $344.25
Lululemon (LULU) $50.62 $43.75 ($3.40) ($1.70) $170 $40.35 (AMZN) $193.55 $175 ($8.45) ($3.75) $470 $166.55
Chipotle (CMG) $294.56 $280 ($13.30) ($7.25) $605 $266.70
Click to enlarge

I fully realize the market could have tanked as opposed to rally on Tuesday, creating a much different chart. I write these articles, however, to help demystify options as they continue to go more and more mainstream. These are all hypotheticals, put out there to help us work through various outcomes and decisions.

In any case, that effective price is where you would be, for all intents and purposes, buying shares if you get assigned on the puts. In most cases, particularly on AAPL, LULU, AMZN and CMG, it's unlikely you would get assigned prior to options expiration day. That gives me confidence that I probably would not get put the shares. To be clear and to reiterate, however, it is plausible to think that any or all of these stocks could tank between now and options expiration, so you have to make sure you're comfortable buying at the listed effective prices (again, the strike price minus the premium received).

With that mind, you could play it close to the vest and take the profits listed in the table. Or you could let it roll and either pocket a larger profit further on up the road or keep the entire premium close to or on expiration.

It's amazing, though, what a one-day market rally can do. Had you gotten into those trades on Monday at the listed entries and closed them at Tuesday's listed exits, you would have walked away with a cool $2,252 in the span of 24 hours.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.