Is anyone a long term investor anymore? I don’t mean people who hold trades for more than fifteen minutes. This is a strategy for investors who identify a stock or ETF that they want to own for several years, then use call and put option selling to generate sufficient cash flow over time to completely pay for the holding, once the position has been paid for it can then be held indefinitely.
Here’s how it works: The first step is to decide on the stock or ETF that you want to accumulate a long term position in. I’ll leave that up to the reader and focus on explaining how we are going to pay for that position. For the sake of explanation, I am going to use the silver ETF (NYSEARCA:SLV); this is not a recommendation to purchase SLV, it is merely being chosen for explanatory purposes.
The strategy consists of three distinct phases. The first phase is the accumulation phase, where we sell puts and calls until the desired size position is accumulated. The second phase starts once we’ve accumulated enough shares, now we just sell calls until we have paid for the cost of the position. The third phase is the holding phase where we have paid for our shares and we are holding for long term capital appreciation. In this writing we’ll focus on building the position, not on defending it once it’s built or taking profits down the road.
Our hypothetical investor has decided to build a 1000 share position in SLV. She starts the process by selling two out of the money front month SLV puts. Two things can happen here, either the puts will expire worthless or the SLV will get put to her. If the puts expire worthless, we keep track of the profit earned to pay for the position and repeat the process next month. If the stock gets put to us, we take delivery of the stock and we now have 200 shares. Once we get assigned, we now own 200 shares and we will sell 2 puts and 2 calls both out of the money.
Now, three possible scenarios can unfold. One is that both options expire worthless and we keep track of our profit and repeat until we either get assigned or one goes in the money. The next scenario is that we get assigned another 200 shares and the call expires worthless. Now we will own 400 shares, and we’ll repeat the process again next month. If the call goes into the money prior to expiration, since we want to accumulate shares, not liquidate them, we’ll roll those calls for a credit into the next expiration.
Once we’ve met our goal for accumulation, 1000 shares, by repeating the process of selling puts and calls, we’ll stop selling the puts and just sell calls until we have collected sufficient premium to pay for the total cost of the position. Then our purchase price for the position has been returned to us and we can hold that investment as long as we wish.
Looking at actual prices of SLV as of this writing, by selling the first strike out of the money on the calls and puts would generate $1.70. SLV is trading at $26.10. $1.70 is 6.5% of the price of SLV. If you could collect that much premium each month it would only take 16 months to pay off the position if the price remained static, which it won’t, if the price were static you wouldn’t get any option premium, volatility is a factor which helps determine the option price.
Volatile stocks will have higher premiums than less volatile stocks. Because prices are obviously not static, it’s impossible to determine in advance how long it will take to build and pay off your position, but a good rule of thumb for an issue with good option premiums should be 2 to 3 years. Hypothetically, say you already owned 1000 shares of SLV and that your cost was $26.00 per share. The next month’s first strike out of the money calls are at $0.72 cents, if you could collect that much each month just from the calls it would take 36 months or 3 years to pay off your position.
The reality of building positions this way is that some months you’ll have stock getting put to you, some months you’ll be rolling calls up and out for a credit and some months both sides will expire worthless and you’ll keep the credit. You’ll need to keep track of every trade, including the costs and keep with the strategy until your stock is paid for.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.