While I do have some speculative bets like long Twitter (NYSE:TWTR), or short BlackBerry (NASDAQ:BBRY) via puts, the bulk of my investing strategy is a system I've developed over the years, We'll call it KIA's Options Strategy.
KIA's Options Strategy
KIA's Options Strategy is designed to deliver good returns in flat to up markets, and to return dividends in flat to down markets. The worst case scenario when making use of KIA's Options Strategy is to end up holding great companies that pay a dividend.
Now don't let the notion of options trading scare you. There indeed exotic strategies involving options spreads, with crazy names like condors, calendar spreads, and strangles/straddles. But we won't be covering those here.
Today I will outline a fairly simple use of options that I use daily and have been perfecting over the years.
Step #1: Buy only great companies that pay a dividend
The first rule in KIA's Options Strategy is to only buy only great companies that pay a dividend. Optionally and also important is to buy companies in an industry you understand and are willing to follow.
For instance, I'm a technology guy. I understand technology, I study technology, and I'm interested in for instance all the latest smartphones and computers and willing to continue following these developments. I'll use Microsoft (NASDAQ:MSFT), Cisco (NASDAQ:CSCO), and Hewlett Packard (NYSE:HPQ) for my examples.
If you don't know banking and what may affect banking stocks, stay away. If however if you know all about the all the different cloud offerings, then investing there is a reasonable choice.
If you are however uninterested in following any investment sector (like for instance: energy, industrials, information technology, materials, etc.) then this strategy probably isn't for you.
Step #2: Use puts to enter those positions
After you've picked the companies, you'll use puts to enter those positions.
The basic idea is simple.
You will sell a some number of put contracts (one contract controls 100 shares of the underlying stock.) You will get paid a premium for doing so! If the underlying dips down to your strike price, the shares are put-to-you, and you keep the premium.
So in essence, you were paid (premium) for waiting for the price of the underlying to dip down to your entry point (strike price.)
Lets just stop here and bask in the beauty of such an arrangement.
Say MSFT is currently trading at $60.40. You sell (sell to open) 10 puts with a strike price of $60 and an expiration of 11/25/2016. You make a guaranteed $340 in 8 days for promising to buy Microsoft at $60 if the actual price of MSFT drops to $60 or less within the next 8 days.
If MSFT stays above $60, you keep the premium and wash, rinse and repeat. If on the other hand MSFT drops below $60, you probably just bought yourself some MSFT at $60. I say probably since there is no guarantee the shares will be put to you, in which case ... you guessed it! Keep the premium, wash, rinse and repeat.
Now you will keep doing steps 1&2 until you finally get the shares put-to-you. Now we move to step #3.
Step #3: Use covered calls to enhance yield and exit the position
Now that we own 1,000 shares of Microsoft (remember 1 contract represents 100 shares of stock,) we immediately sell 10 calls on those 1,000 shares. And since we own the underlying, these are referred to as "covered calls", that is, you have the shares to cover the calls should your shares get called away.
In essence, a covered call is an options strategy whereby an investor holds a long position in an asset and writes (sells) call options on that same asset in an attempt to generate increased income from the asset. If the underlying rises to the strike price, the shares of the underlying will likely get called away, and as you may have guessed, you keep the premium.
So for example; we now own 1,000 shares of MSFT at $60. What I will often do is to sell at-the-money calls. That is, the strike price matches (or is close) to the current stock price. Again, we will only commit ourselves for 1 week. We will sell (sell-to-open) 10 contracts of MSFT with a $60 strike which expire on 12/2/2016. Our premium is a nifty $440 clams!
What happens now?
If on or about 12/2/2016 our MSFT shares get called away because the shares were above $60, we keep our premium and start the process over at Step #1 above.
If the share price is at or below $60, then we can rollout the contracts for another 8 days and another premium, or establish a new position by selling another 10 covered call contracts. The only real advantage of a rollout is most brokers only charge you one commission instead of two (to close the old position and to open a new position.)
I have maybe 20 great companies in tech that I follow closely.
My process boils down to this:
- I sell puts to enter the positions I want and get paid a premium to do so.
- If I do not get the shares put-to-me, goto #1.
- I immediately write the covered calls and get paid a premium for doing so.
- If my shares don't get called away, goto #3.
- If they do get called away, I loop back to writing the puts and start the whole process over again. goto #1
If the stock market tanks, you will often be left holding the shares. You probably won't want to write covered calls since if you get called away you may lose money since the price is now below what you paid for them.
In this case, we go back to the reasoning for Step #1, "Buy only great companies that pay a dividend". If the stock market tanks, you will be holding securities like many others, except you will be holding great companies that pay a dividend. Although, you can always set up some sort of stop loss and simply close out your positions, but the strategies for this is a whole other article.
If your stock tanks, remember you are holding a great company that pays a dividend. However, if you get stranded like this, then you are out of the KIA's Options Strategy and are now a long term investor. To avoid this forced change of strategy, stay away from overly frothy valuations or 52 week highs.
This happens!! I've been a "long term" investor in Hewlett Packard for this reason and I'm just now able to exit. The upside is that all the while, I was making a sweet dividend.
Finally, when you've written the put to say enter MSFT at $60, but MSFT gaps down to $50, you've just bought a bunch of MSFT at $60 and locked in a $10 per share loss. This is another reason why I make "great companies that pay a dividend" a priority.
I've tried to simplify the strategy by leaving out broker commissions and the nitty gritty details of put and call options. I did however link to investopedia to help the reader with core options concepts.
So in addition to the options premiums described here, you will also be collecting the dividends for the underlying for those times when you are holding the stock come the ex-dividend date, which may be on the order of 50% or more of the time.
Disclosure: I am/we are long MSFT, TWTR, HPQ.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: While the options strategy presented here is relatively straightforward, you should read and understand the linked material. Before investing any money, always do your own due diligence.