By Timour Chayipov
How many times have you bought a fundamentally good stock after it had dropped 10 percent or more and found later that the down trend continued and stock lost another 10% or more?
Like anybody else I hate to lose money (remember rule #1 - don't lose money)
I'm not a chartist; technical analysis has never worked for me so I started looking for a better way to protect my positions against losses.
One of the most popular methods to protect your stock is to sell calls against it (a covered call, or Buy/write strategy); it is definitely better than just holding a stock, but it will only protect your position by the premium of your short call and below that is a free fall.
Another strategy is to buy put options to protect your downside, but this is even more expensive and eats into any profits you would otherwise have made. It is a good strategy in a crisis if timed correctly, but otherwise it often ends up just lowering a portfolio's potential appreciation.
I would like to introduce you to a strategy which has better profit potential and will protect your portfolio much better than the regular buy/write strategy.
The name of this strategy is an ''artificial buy/write.'' Why it is artificial? It is because we replicate a long stock position with a combination of options. It is really easier than it sounds. I'll give you the details so it won't be confusing.
Instead of buying stock we buy a long duration bull call spread and make it free by selling a long duration deep out of the money put. Because a short put is an obligation to buy the stock at specific price (the strike price); if at the expiration date the price of the stock is below the strike price, you must be very comfortable with the idea of owning the stock at that level. This is usually far below the current price.
Let's take a look at an example: At what price would you be comfortable owning Apple (NASDAQ:AAPL); $500, or maybe $400? The $400 price sounds very good to me. Now let's see what kind of premium we can get if we sell a January 2014 put with a $400 strike price. Well, today June 30, 2012, the premium is about $38. The margin requirement for a short put will depend on your broker and the type of account you use, but shouldn't be more than 50% of your total obligation (if in a margin account) to own 100 shares of AAPL at $400, so it shouldn't be more than $20,000. Now, when we sell this put option contract, we can use the $38 premium ($3,800) that we collect to construct a bull call spread. I can see that today a January 2014 bull call spread of $600/$650 would cost about $19, so we can buy two of them. A bull call spread of $600/$650 means that we would buy a call option with a strike price of $600 and simultaneously sell a call option with a strike price of $650, both in the same expiration month.
So, what do we get? If, at the expiration date, the AAPL stock price is above $650 we make a profit of $10,000 (using a margin of less than $20,000), our two call spreads will be in the money at expiration date and we will collect $5000 each minus what we paid for them ($1900 each); our put will be expired worthless and we'll get to keep that premium, so the total profit will be 2 x ($5000 - $1900) + $3800 = $10000.
If AAPL stock is below $600 but is above the put strike price ($400) we don't loose anything because both our two call spreads and our put option will expired worthless and the premium received from selling the put will compensate us for the price we paid for two Call spreads; $3800 - (2 x $1900) = 0.
The only way to lose money here is if AAPL stock falls below $400. But at this level we should be very happy because we will be able to buy 100 shares of AAPL with a cost basis of $400.
This next step is optional, but it can help to increase our return just like using a traditional buy/write strategy. Now that we have constructed our long position, let's think about how we could make additional profit by selling some monthly or quarterly calls against it.
It is tricky, very often (this may sounds strange) we get burned from the upside movement rather than from the downside.
When you sell calls against your stock in a conventional buy/write strategy, there is no way for you to lose money when the price goes up because the delta of you stock is always 100% but the delta of you short call is always less than 100%; meaning that your total delta is always positive which results in a profit when the price increases.
When, instead of stock you buy a call spread, the delta of your spread is less than 100% and falls when the price is going up because your profit is limited.
But your short call delta is going up with the price; plus it also has a much higher Gamma than the Gamma of your spread because your dividend call has much less duration, so at some level your total delta will become negative and you start loosing money from your dividend calls faster than you make money from your long position. I realize that this may be confusing but there is a solution.
To avoid this problem we should sell what I term dividend calls as far out of the money as possible while still receiving the "dividend" we are targeting. A "dividend call" is a call option that allows an investor to receive the equivalent of the dividend in premiums from selling calls.
Here are a few rules of thumb:
Try to replicate dividends from the stock. For example if you open a position for IBM (NYSE:IBM) and they pay $0.85 per quarter, try to sell a 3-month call options with a premium around $0.85 -$1.00.
If the price of a stock approaches your dividend call, your long position probably is doing very well and you need to roll this call to a higher strike price and a later expiration date to keep the same premium.
By the way, we do not need to hold this position until January 2014. Profit from this strategy is limited as we calculated earlier that the maximum is $10,000 for 18 months (plus whatever we can get from our short dividend Call) If, in 3 to 6 months, we already have 50%-60% of the total potential profit why should we risk losing it? At this point I would just close out all positions and wait for another opportunity.
You can use this strategy for any stock, but I highly recommend that you choose very solid candidates with a solid price floor. As always, it is best to use strategies like this only on stocks that you would like to own.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.