Playing Leapfrog With Molycorp

Summary

• The serial sale of puts may be a good means of attenuating risk.
• Large bid and ask spreads shouldn't be allowed to stand in the way of completing trades.
• Cumulative return may be significant and outstrip risk in time.

The case study woven in this article is still one that is evolving and has not yet come to its final outcome, although interim outcomes have been realized. It is a story of another variation of a covered option strategy that seeks to transform risk into reward, but does so in a less traditional manner.

While I'm not by nature a risk-taker, and tend to use a covered option strategy to help limit my risk and exposure, I do recognize that there is a corner of most every portfolio that should be reserved for more risky propositions.

The size of that corner depends very much on individual tolerance, but the use of cash covered sales of put contracts can be a nice way to tame risk, even among very risky stocks.

For illustrative purposes, I will use Molycorp (MCP), a fallen angel of momentum investors, and whose direct ownership is not for the faint of heart, having at one time been among the kind of Momentum stocks, a new generation of which are currently under siege.

However, while using Molycorp as an example, the same approach may be used for other stocks that have a volatile trading range, expanded weekly options available for trading and sufficient volume of options trading. All of those criteria are critical before considering to undertake the strategy. Additionally, the stock should have a history of regularly occurring alternating direction price moves during short time frames.

The basic building block of the strategy is the sale of put contracts on a stock that meets the above criteria. The other building blocks are simply more put contract sales at various times dictated by the price moves of the underlying shares.

The sale of a put contract may obligate you to assume ownership of shares, perhaps at a price far above the market value of shares. That is an outcome that should be avoided, if possible. You should be aware of the potential liability associated with the sale of put contracts, especially the worst-case scenario, such as may be encountered if a company declares bankruptcy. The net liability is the difference between your obligated price of purchase and the accumulated premiums received. You should, therefore, not consider the use of this strategy for any stock that appears to be in a death spiral with little to no chance for some price stability nor recovery to your initial entry point.

As with most everything, you have to start somewhere, and in this case, the strategy is initiated with the sale of put contracts. Ideally, I like to sell those initial contracts using slightly in-the-money put contracts. Doing so enhances the option premium received due to the intrinsic value component of the premium.

The goals for that initial block may be to see the contracts expire or get rolled over to a new contract expiration date. Rolling over is a two-part trade that is best undertaken as a spread, rather than as individually executed trades. In such a spread, you concurrently buy back the contracts (Buy to Close, or "BTC") you sold, and then sell new contracts (Sell to Open, or "STO") for some future date. The absolute prices of the individual legs of the transaction are not important, but the difference between the purchase and sales price should be a "net credit" to your account.

As a pragmatic issue, when there are large gaps between the bid and ask prices on either or both legs of the transaction, it may be helpful to begin the process of entering a proposed "net credit" by employing the following calculation for your starting point.

((STO bid - BTC ask)/2) minus ((STO ask - BTC bid)/2)

The figure can then be adjusted by a small increment to test the market, keeping in mind that you don't want a disagreement over a penny or two prevent you from making the trade.

In the case study illustrated below, using color coding to track the origins of each new contract branch, the initial entry on March 4 was for a contract expiring on March 7 and subsequently rolled over to a new contract expiring on March 14, when with contract expiration approaching, it appeared that action was necessary to prevent assignment of shares.

Subsequently, the new contracts expired as shares closed above the $5 strike. The net premiums obtained through the sale of contracts represented realized profits.

However, on that same day, a new branch was added through the sale of put contracts expiring on March 22, 2014. Those contracts simply expired, but not before adding two new branches on March 18 and March 19 utilizing expiration dates one and two weeks after the expiration of the initial branch of this sequence.

At that point, there were three concurrent option contracts outstanding, with their expiration dates representing three successive weeks. These form the basis for the "leap frog" rollovers that may be undertaken if the share price moves in an adverse direction that may otherwise result in assignment. At the point that the expiration of the March 22, 2014 contract was an essentially foregone conclusion, a fourth branch was added on the expiration date to take its place in order to maintain a trio of contracts.

In the above sequence of put sales, the net premiums currently total $1.42. Assuming the continued maintenance of three lots of contracts that represents an ROI of 9.7% over a period of 10 weeks, based on the most distant contract now open.

There is no limitation on the number of concurrent weeks represented by the put contracts, but the potential liability of the positions should be consistent with your overall tolerance for risk and the pre-determined size of that specific corner of your portfolio, remembering that in a worst-case scenario, such as the company's bankruptcy, your net liability is the strike level less any premiums received.

The utility of leapfrogging, that is rolling over the first in the series of option contracts to a date after that of the last in the series, is that it delays or possibly averts assignment by increasing the length of time until expiration. For stocks not in a "death spiral" but simply undergoing periodic price adjustments, time can be your best friend. While doing so, it also generates a net credit in option premiums, and results in the discovery that getting paid to wait can be appealing.

Visually, the leapfrogging that is illustrated in this case study can be seen in the "STO" column when focusing on the color coding used to identify the origin of existing put contracts.

Ideally, the rollover would be performed as close to expiration as possible, so as to minimize the added expense of buying back the time value remaining on contracts. However, it is far more important to seize on the opportunity to complete the transaction as price movements may make them available. The most favorable time to roll over a contract that is in-the-money is at the time of a price surge. It's, therefore, important to stay on top of prices and not get caught by extreme moves in either direction. A sudden price spike that takes shares well above the strike price, even with time remaining on a contract, may still warrant closing out the position and taking profits, and then simply awaiting the next price drop and opportunity to initiate a new position.

Similarly, a sudden price drop well below the strike may offer the indication to roll over the position to a more distant date to buy time.

The contract most imminently due to expire is rolled over to a date that follows that of the last in the series, and so on and on until the chain is broken by expiration.

When expiration does occur as share price exceeds that of the strike price, the process can begin anew at the point that shares once again fall to approach or go below the selected strike price, which should be consistent among the various branches.

As an added bonus, while I don't generally like to use margin accounts for anything other than to avoid "free riding violations," the use of cash secured puts in a margin account only incurs margin fees if the position is assigned and you are forced to take possession of shares. Since the goal of this strategy is to avoid assignment, the use of a margin account allows you to leverage your assets, but with somewhat less risk than when using a margin account in the more traditional and intended manner.

While this variant of a covered option strategy may require some high maintenance and frequent oversight, it can offer a very attractive return, with each week of maintaining the contracts significantly reducing the net liability in the event of extreme adverse price movement.

Disclosure: I am short MCP. 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 may buy back MCP put contracts and/or sell new MCP put contracts at various expiration dates.

Comments

[Rockstone]

who is next?

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[George Acs]

Thank you for those very kind words.

I was relatively slow to come to an appreciation of the power of put contract sales, but increasingly see their utility. The hardest thing is to remember what side you're rooting for and to develop a mindset that sometimes seems counter-intuitive to what most of us have believed to be the traditional approach to equities.

[User 8083141]

George, Great article (and comments), as usual.

For quite some time, I too have been a big fan of writing puts for premiums rather than just as a tool to take a slightly discounted ownership of stocks.

Predictable regular cash flow is a wonderful thing.

And, ever since I discovered the world of options according to Goerge Acs, a while back, I now look forward to your weekly musing as one of my favorite sources for some of those potential put candidates.

Thanks again.

[12345gel]

Thanks, George for your trading discipline…… I like the profits derived from put premium. My favorite strategy for put selling is to identify a strong trend that will last for many months. Preferably, I often target an ETF that does not have to consider earnings risk, which is indigenous to individual stocks. I then get DITM, and go out at least 12 months in order to capture higher premium. As long as the trend is kept intact, then the trade should be profitable…. not much maintenance.

An example of this strategy is to sell puts on TBT at least 12 months out, at the time the bond market is experiencing higher rates. These trends last for very long periods when inflation is building and the Fed is raising rates. The longer dated puts are priced higher because of extrinsic value that will evaporate as time passes and the TBT price curve rises.

[George Acs]

As I mentioned in an earlier comment, it's really true that only the imagination limits what may be available through the use of options. There's so much more that can be done than simply looking to take advantage of leverage and than can lead to a much more sane way of navigating through markets.

I've never really understood interest rate instruments nor currencies and think my mind would really get scrambled if I had to invert my thought process both to deal with the mindset required for puts as well as the mindset required for interest rates. Too much inversion for me.

[George Acs]

Thank you.

You clearly have more faith than I, especially if using naked calls. I'm at that stage in life that stress is something that doesn't get me to function at a higher level anymore.

A "spread" is simply a trading technique that eliminates the need to make two individual trades and waiting for one to execute before being able to submit and execute the second. It also eliminates that maddening feeling of finally getting the first leg of the trade to close and then seeing prices move against you before the second leg can be executed.

Instead of specifying specific bid or ask prices you specify the "net" premium you wish to receive after all legs are made. No trade will be made unless both legs can be executed at that net premium or better.

[Purple_K]

Great article - I do a ton of covered calls and naked puts, with a sprinkling of naked calls when we're close to expiration and I'm ratcheting up the stress a bit :)

That said, I never looked into "spreads" per se, if I am understanding you correctly. That is something different than manually closing out a call and selling another a bit further out? I do this pretty much weekly in X, usually with another 1 - 1.5 on the strike, but lately the SOB has been vaulting to the strike a day later... though I guess there are worse things than having to be bought out 5% higher a week later, but since my cost is <16 I don't really want to lose it.

[lesgasuuse]

Yes, that is a good strategy raykrv6a. Write puts only on stocks you don't mind owning if you are assigned the stock. I'm a strong proponent of this method. If for some reason you change your mind and decide not to own the stock you can always roll out your maturing put option farther away in expiration and you may even lower your strike price to a new level. In this way you are reducing your chances of being assigned at the new level when expiration time comes. This is assuming you still don't want to own the stock if assigned.

[raykrv6a]

lesgasuuse, I like to roll and roll. I'm up 11 bucks on CREE since December just rolling it. Of my 37 open option trades, 17 have been rolled at least once.

[George Acs]

CREE has been a good one. It can really be amazing just how significant returns can be even when a stock makes no net movement in share price.

For years while people were moaning about how Microsoft was dead money it was anything but for those rolling and rolling. I would so much rather see these trading ranges with occasional spikes or plunges than any other kind of movement. The alternating price moves are far more predictable than trying to guess when shares will go up or down.

[raykrv6a]

George, I think the best use for me anyways is to write PUT's only on stocks that I would normally buy and hold. Write puts on what you are comfortable owning and not just writing for the premium.

The option industry seems to be predicated first to the volatility and premium where as I look first to my book of stocks and find the setup I want to use.

Nothing worse then owning something you don't like........ lol

[George Acs]

While none of the suppositions you make are part of the strategy presented in this paper, the math is correct, because you do not lose the premium.

If you sold puts and were completely passive and exercised no management at all of the position if the price finished below the strike level you would be obligated to pay that amount per share to the holder of the options contract.

Of course, even if you did actively manage the position your absolute risk potential would be that shares became completely worthless, yet you are still obligated to pay $5 for them.

WHether worthless or otherwise, if the options are exercised you would then take ownership of shares, with your cost basis being adjusted to reflect the premium you received. When looking at your account you would see a cost basis of $4.40, in this example.

Once you own the shares you can elect to sell calls against them and collect a premium. In this case, if you used a $5 strike level to sell call contracts, you would be obligated to turn your shares over to the contract holder if shares closed above $5 at expiration, or even sooner if the price was significantly above the strike level.

In the strategy presented here there is the need for active management of the position because one of the goals is to avoid taking ownership of shares. That is usually done by closing the existing position and replacing it with a new one, that will provide its own premium to the seller and expire at some time into the future.

[lesgasuuse]

I'm been an option trader for many years and my specialty is writing puts and calls, mostly puts. The strategy that George Acs describes here is one that I employ extensively. Once mastered this system provides more than decent returns consistently year over year. Not only does option selling offer greater rewards, it is also, in my experience, a safe method of building capital steadily and consistently over time.

[George Acs]

Thank you.

Like so many things, it's sometimes unfortunate how late in life you are able to actually appreciate what has always been there right in front of you.

The nice thing about options is that only the imagination limits the applications and for the seller they can be such a powerful tool for income generation or portfolio protection, just as for the buyer they can be a powerful tool for sucking your assets away in the hopes of leveraging them.

[pollyserial]

I'm a little dense and trying to understand the absolute risk potential of selling puts.

In the case of MCP, if I sell 10 JUN MCP 5$ puts today, @ .60, I get a 600 dollar credit, right? And if MCP closes at 4$ at expiry, I then have to buy 1000 shares of MCP worth 4$, for 5$, right? If I immediately sold those for approx 4k, then how much have I lost? would it be 1000 bucks (the difference between 5 and 4) minus the 600 dollar premium? Or would I also lose the premium in this scenario?

[George Acs]

While none of the suppos

[George Acs]

Or you could just get Option to Profit, although my own use of puts has significantly changed over the years since that was written.

I am a relatively simplistic devotee of options and stay away from the more complex strategies, but occasionally like doing something that is a little off the beaten path.

I should have mentioned, as you did in your comment, that "covered" puts is the way to go if you want to be consistent with a conservatively cautious strategy.

[th3decider]

Oh the great rare earth hype of 2009. Still failing to deliver I see. Best of luck to the traders,, you'll need it.

[George Acs]

You may have noticed that I never said anything about the merits of the company. This is simply about trading a stock based on the criteria mentioned in the article. The ticker symbol is irrelevant. What is relevant is that its price moves and does so on a very regular basis, while offering reward. The longer the leapfrogging game can continue the easier it is to eliminate risk as premiums accrue.

[McGonicle]

It seems unwise to attempt to collar a stock that shows that kind of volatility. MCP has been stable over months, but that is because it had its "three bounces" last year, and now it is locked in a capex/weak pricing death spiral.

Its my observation that gold stocks occasionally do this (IVN, TSE, KGC, AGI), they just totally collapse to a new, lower level, and stay there, pricing (sometimes for years) within a new range. That is collarable, but its not a reason to want to have the stock put to you.

If MCP could literally rise $1-$2 in a single session (though now very unlikely as all catalysts and enthousiasm for the stock are gone/known), or it could declare functional bankrupcy and a liquidity crisis and drop to $2 overnight.

Attempting to collar that "weak" $4-$5 price range in MCP is picking up nickels in front of a steamroller.

Further, I pay $50 plus fees for each leg of my options trades. You may pay much less, some say as little as $20, but unless you are allocating say $50K-$100K to one stock position (including options and common/prefered shares), these small fees will eat your nickels alive. The trade you show appears two-legged (requiring 4 trades in/out per strike), some more complicated straddles are four legged (8 trades in/out). If you are rolling a weekly option your chart shows 17 separate positions, which would require 58 trades in 2 months, nearly 1000-2500 dollars (for trades, not including fees) is spent in costs just position keeping.

Considering these factors, I maintain that those with less than the mid-hundreds of thousands of dollars to trade with should never use these types of strategies because they are

1) enormously dangerous
2) extremely expensive to maintain and roll
3) not very rewarding even when your stock is rangebound
4) less effective than calling a direction and buying common stock.

Thank you.

[raykrv6a]

My fee's are 7.95 for the initial contract and 1 buck for each additional. My fee's run 4.45% of my profit. So for every $100 bucks profit, $4.45 is taken out. I can live with that.

MCP isn't my bag of tea as I like to only take a chance on companies I would like to own.

[McGonicle]

You are providing a sterotypical example; your profits (when they exist) can be taxed by the fee, but your losses are also increased by the cost.

As I stated, your cost is much higher than mine; for 100 contracts, you pay $108. For 1, you pay $9.

Unless I take you to mean that you only call winning positions, always make money, and have a >SNP return at all times and in all positions.

[raykrv6a]

I usually only write 3,5, or 10 contract positions. I like Fidelity's platform, so I pay more. I used IB in the past and never like it even if it was cheap.....

[raykrv6a]

Morning George.

Sold puts on GILD and UAL. Different way of thinking about it, but I kinda like it. Another option.

[George Acs]

I tried to sell puts on GILD yesterday for personal account, but couldn't get my price, as I was a little too late and shares started their recovery right after placing my weekly bid at $0.59 for the weekly $67.50.