Selling Puts And Calls: A Better Recipe

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 |  Includes: SPY
by: Reel Ken

"I'm not the greatest; I'm the double greatest. Not only do I knock 'em out, I pick the round." Muhammad Ali

Gourmet Chefs and successful investors have a lot in common. Both must gather extensive knowledge and available product (produce). They must come up with a concept, pick the best ingredients, mix, match and refine the proportions until they get it just right. Then put it in the oven, set the timer, wait and taste. If it works, serve it, if not, start over.

I have been working with options as ingredients for many years and have slowly tried to get it right. Here's the best recipe I have been able to find.

Let me start by saying that over the last several weeks I've authored several articles that have been purposed as a base for this more complete recipe.

The first article discussed covered calls and concluded that selling covered calls against the Total Return S&P 500 (SPTR), precisely 2% OTM, could add to long-term returns while lowering volatility. Putting it in its most basic terms, the selling of 2% OTM calls is a net plus. For simplicity, I often use the SPDR S&P 500 ETF (NYSEARCA:SPY) instead of SPTR.

My subsequent article discussed selling ATM puts on SPY as a replacement for the typical portfolio. It was not offered as a "risk-on" leveraged strategy, as is popular with those usually recommending selling puts. Rather, it took a bold step in suggesting selling PUTS as a Replacement Strategy to a portfolio of stocks and ETFs. It concluded that such a strategy would, as with selling 2% OTM covered calls, offer the potential for increased returns and lower volatility.

Now, I'd like to put these two "courses" together and offer them up as a meal (appetizer and entree, if you will).

Here's the strategy... Sell calls, monthly, on SPY, 2% OTM, but instead of "covering them" with SPY, sell them technically naked and "cover" them by selling monthly ATM PUTS on SPY. For those most familiar with options, it really boils down to a 2% short strangle.

The reasoning for this "double strategy" is simple... If, over time, selling monthly ATM PUTS on SPY will outperform SPY and 2% OTM naked calls are a net plus, then putting them together is a double plus.

Here's a chart that show a comparison of 1) SPTR, 2) Selling ATM PUTS and 3) Selling ATM PUTS plus adding 2% OTM Naked calls. It covers 12 years, from January 1, 2000 through July 2012.

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During this time frame, the S&P 500, including dividends, would have grown just under 25%. The PUT sales would have added 75% to that, having grown 98% and the 2% OTM Naked calls add another 42% to a total growth of 140%. WOW is the only word I have to describe the difference.

But let's look a little deeper. The SPTR was negative to flat from mid-2000 through mid 2006. That's a pretty long dead period. At one point it was down about 35%. During this time frame, "double strategy" would have been mostly positive and suffered only a few modest points of negative activity.

Digging deeper, when the "crash" of 2007-2009 hit, the SPTR, once again would have suffered set-backs bringing its losses to nearly 50%. Though the "double strategy" would also have given back much, it remained in positive cumulative territory.

I could go back as far as 1988, and the results would be even more spectacular, but, instead, need to go to a more recent period, to properly explain this phenomenon

Both the 2% OTM naked calls and the PUT strategy gain value versus outright ownership of SPY, in flat, down and slowly moving markets. In a fast rising market both components will under-perform SPY. It is the gains during the slow times that provides the cushion during the fast times. Strangely, close to the opposite of typical investing, where quick gains cushion against losses.

Let's look at some more data so we can get our hands around this.

First, let's look at the period from Oct 2007 through March 2009, the most recent bear market and one still in most of our memories.....

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Here we see the SPTR dropping by almost 50% whereas the "double strategy" would have dropped by only 20%. If the PUT was sold without the naked 2% OTM call, the drop would have been about 30%.

Now, let's turn to the "recovery" period from March 2009 through July 2012. keep in mind that this was one of the largest three-year run-ups ever...

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Now, in this graph I added a little more data, so we could get a better understanding of what's going on.

First, the SPTR shot up just over 100%.

Next, selling 2% OTM covered calls on the SPTR would have risen only about 93%. That means the short call component of the covered call strategy lost 8% (SPTR +101%, minus call component loss of 8%=net rise of 93%).

Third, PUT would have given up about 27%, rising only 74%.

Fourth, combining a Naked Call with the PUT would have given up 35% (27% +8%) relative to SPY, rising only 65%.

Let's now combine the 2007-2009 drop with the 2009-2012 jump....

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What results is that the gains made during the drop, more than make up for the loss during the rise, putting the "double strategy" well ahead of the SPTR.

Summary: There is no "magic wand" in investing. However, if one brings forth knowledge of ingredients it is possible to construct a recipe that will work, over time.

The "double strategy" proposed here, namely, selling ATM PUTS on SPY, coupled with 2% OTM Naked calls on SPY can provide long-term, outsized returns when compared with investing in SPY or most balanced, diversified portfolios.

What I find particularly appealing here, is that it works best in a range bound market or one that is unlikely to rise quickly and dramatically. This seems to meet current market conditions pretty well.

Conclusion: Presented here is a "two-course meal," appetizer and entree. It is designed to offer an alternative strategy to constructing a balanced portfolio of stocks and ETFs. It can be especially appealing to those that want to lower their portfolio risk or volatility, and willing to give up a little return, in exchange, but only if there's a massive run-up.

But, with any two-course meal, there's something missing-- desert and coffee. Relax, digest, they're in the kitchen and up next in my series of articles.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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: I trade options on SPY