The first installment (here) in this series illustrated how systematic selling of near term ATM puts on the SPDR S+P 500 ETF (SPY) has a trading advantage over buying SPY (.PUT Index). This led to a theoretical strategy of selling the puts and "shorting" SPY. This would garner the trading advantage with little risk to capital. In the second installment (here), this was "converted" to a much simpler method of just selling near month ATM naked calls on SPY.
This works particularly well when SPY is either flat, in a trading range or falling. There is an apparent disadvantage when SPY rises rapidly. However, no rise is straight-up or without some down segments and eventually a rising stock levels off. During these segments the naked calls "catch up" to any losses that were incurred during the climb upward. So, a strategy of simply selling ATM naked calls, each and every month, can be safely added to any portfolio. In our current market climate it may be particularly appealing as a further rapid rise is not as likely as it was back in March 2009.
For those who are comfortable with their portfolio make-up and its performance, a routine of systematically selling near term ATM calls on SPY can be a welcome addition. At the least, it will smooth out returns while providing some downside protection.
An integral part of my portfolio strategy consists of option strategies. "Black Swans" almost seem to be baked into the system. Such events are buying opportunities for 30-somethings, but for someone in or near retirement they can be devastating. I like to purchase far dated puts and sell weekly puts (put calendar spread). This provides me an opportunity for profits while protecting against a decline. With so many unresolved macro issues this works for me.
One risk to a put calendar spread is a rapidly rising market. If a market rise overshoots the strike of the weekly put, the far dated put can lose more then the weekly put gains. I don't mind trailing a little during an up move, but losing money, that's another story.
Now, if we sell ATM naked calls and then added a put calendar spread it would be counter-productive. Market direction influences both in the same way. If the market goes down I have "double protection" and if it goes up rapidly, "double losses."
In order for these two strategies to better complement each other, it is appropriate to trade some of the "double downside protection" for more upside potential. There are many ways to do this (including selling "extra" puts) and I've covered quite a few in previous articles. Here, I want to explore just two.
First: Sell the weekly puts ITM. Moving the strike just $1.00 ITM will provide $1.00 intrinsic but lose 50 cents extrinsic. This could earn 50 cents more if the market rises, but at a cost of 50 cents if the market falls. Going too much more ITM and extrinsic starts to fade fast. Selling puts is "all about the extrinsic," so going too much ITM defeats the strategy.
Second: Buying a far dated OTM call. With SPY currently at $135, the March 2013 $142 OTM call costs $4.83. This gives me enough protection (about 5%) against a rising market. Keep in mind that the weekly puts will provide most of my hoped for gains. This is just to guard against an upward spike.
If I look at a weekly cost of this call, the $4.83 divided by 46 weeks (March 2013) is about 11 cents per week. This cost can be more than offset by allowing me to more confidently sell the weekly puts ATM, OTM or slightly ITM. This can gain nearly 50 cents in extrinsic, netting 39 cents more extrinsic each week.
Obviously, one can bring their "market prognosis" into play in setting strikes. Absent any market directional bias, here's the method I employ.
1. If SPY lands very near a strike, set both the call and strike ATM.
2. If SPY is near the middle of two strikes, set both options slightly OTM. For instance if SPY was at $135.45, the call is set at $136 and the put at $135.
3. In one week the put needs to be re-set. If SPY lands near a strike, set the put ATM. Otherwise, if SPY is between two strikes and the call (not yet at expiry) is OTM, set the put slightly OTM. If the call is ITM, set the put slightly ITM.
There is a reason for doing this. If the call starts to go OTM, your "down-cushion" decreases and you have some room going up. If the call starts to go ITM, then you have room going down, and lose some "up-cushion." Following the call's strike with the put re-set moves them, ever' so slightly, toward neutral.
If SPY drops precipitously then this needs to be modified. Those who consistently read my article are aware of my concerns regarding the see-saw market (here) and option strategies. If SPY drops, I would hold the weekly put ITM at the pre-drop strike, as long as possible. The naked calls, on the other hand, should continue to be sold ATM. This is probably the most effective counter to the see-saw.
So, let's look at these four component parts:
1. Sell monthly ATM naked calls
2. Sell weekly ATM puts
3. Buy far dated (March 2013) protective put.
4. Buy far dated (March 2013) $145 strike protective call
Those familiar with options might recognize these four legs as slight modifications of a near term short and a far dated long strangle.
Selling a weekly ATM put and a monthly ATM call is a slightly modified short strangle. Selling strangles, as a strategy, works best when the market is in a narrow trading range.
The far dated call and far dated put represent a long strangle. A long strangle works best when the market fluctuations are wide.
So, by combining these two strategies, gains are made if, in the near term, the market trades within a range, while protecting against a pronounced long term bi-directional swing. Looking at the pieces this way, confirms that the two separate strategies, when combined, are complementary.
It was my intent in authoring this series to challenge the reader into looking at various option strategies in different ways. Increasing understanding of options will increase chances of success. It is my belief that the best result can be achieved when option strategies are consistently applied as part of an overall portfolio strategy and not just "one-off" trades.
Additional disclosure: I buy and sell options on SPY.