Tweaking Option Strategies

Jun.27.12 | About: SPDR S&P (SPY)

"Nothing is so certain as uncertainty" - Heisenberg

It seems the most commonly recommended option strategies are bull or bear spreads. Next in line seems to be methodologies to increase yields through covered calls or cash secured puts.

The primary skill to make these effective strategies certainly lies in selecting the appropriate stock. Once the right underlying stock has been picked, these strategies are fairly easy to implement and monitor. After all, for any of these strategies to work, the underlying stock must behave in accordance with the prediction. They are "one-off" proposals.

These simplistic strategies need to be distinguished from the more complex strategies, those that are maximized through a "process" that evolves over time and requires repetitive action. For these more complex strategies the investor needs to bring various levels of skill and knowledge to implement them effectively.

Most of my prior articles involve complex strategies such as hedging through calendar spreads, buying far-dated options (usually six months or a year ahead) and selling, repetitively, near-term (usually weekly) options against the long position. The hardest part of these strategies is setting the strike prices, repetitively, on the near-term (weekly) options. They are not "no-brain/one-offs" and the result achieved by the investor will depend, to a large extent, on the efficiency of this component.

In this regard, let me share one "tweak" that I employ from time to time. I'll use near term (next week's) puts on the SPDR S&P ETF (NYSEARCA:SPY) as an example, but it can be easily applied to any stock.

SPY is currently trading at $133, and let's assume any strategy that involves selling the next weekly put (or near term monthly puts if weekly isn't available). Normally, the best "bang for the buck" is in selling ATM puts, as it maximizes the extrinsic value of the put. This, after all, is what selling puts is all about.

However, sometimes the investor is looking for more potential gains than the ATM put will deliver and it is necessary to go ITM (for instance, to protect a far-dated long position or an expected bounce). By example, next week's ATM $133 strike put has a credit of $1.17,which is all extrinsic. Next week's ITM put, on the other hand, with a strike of $134 receives a larger credit of $1.53, but it is only $.53 extrinsic and $1.00 intrinsic.

There is a "tweak" that could be employed instead of selling next week's $134 ITM puts to generate extra premium credit. Consider selling a "combo". This would entail selling next week's ATM $133 strike put for a credit of $1.17. Though this represents a shortfall of $.36 vis-a-vis the $134 put, the "combo" makes up the difference by selling, additionally, one-half as many of next week's OTM puts with a strike at $132 for a credit of $.81. Since there are only 1/2 as many, this adds, on a relative basis, $.40, bringing the total received to $1.57 ($1.17 for the $133s and $.40 (.81 times 1/2) for the $132s).

So, in summary, instead of selling next week's $134 ITM put, sell slightly more puts, but ATM and OTM to realize the same premium credit.

Well, what is the result?

1) If SPY goes above $134, both strategies are functionally equivalent.

2) IF SPY lands next week between $134 and $133, there is some "give-back" on the $134s, but the $133/$132 combo earns their full amount. At precisely $133, the $134 earns only its $.53 extrinsic whereas the $133/$132 earns the full $1.57.

3) IF SPY lands at precisely $132.47 the $134s break even, whereas the $133/$132 earn $1.04.

4) The reader can do the rest of the math, but the $133/$132s show a gain over the $134s as long as SPY finishes above the "break-even" of $129.92. This equates to SPY falling over $3.00 in just one week ... about 2.25%. Below that level the "extra" puts will cause losses to mount at a 50% greater rate than the $134s, alone, would.

The investor needs to consider the chances of a big drop vs. a small drop in such a short time frame. Of course, it has and will happen at times. So this would make a good choice when markets appear somewhat stable, the VIX is relatively low or no big "issues" look likely. And, of course, the investor need consider all the places SPY could land next week between $134 and $129.92 that favor the "combo".

The same strategy could be employed for monthly options, but the chances of a big move in the wrong direction increases.

Conclusion: Option strategies can be "no-brain/one offs" or involve a process, for which the investor is an integral part. For those willing to put their own investing skills to work they may want to consider "tweaks" such as the "combo" as one possibility.

Disclosure: I buy and sell options on SPY.