Passively Achieving Your Goals With Options Part3
Nikhil is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
In this little series, I am trying to explain how the use of simple option selling strategies can help an investor to achieve their investment goals, whether through a passive investment strategy or an active yet conservative investment portfolio as I have created. I will make my passive portfolio demonstrations based on the SPDR S&P 500 ETF and the iShares Dow Jones Select Dividend ETF , and make recommendations of a more active equally weighted portfolio based on these tickers: Aflac, Inc. (NYSE: AFL), KKR Financial Holdings (NYSE: KFN), PepsiCo, Inc. (NYSE: PEP), The Proctor & Gamble Company (NYSE: PG), and Petroleo Basileiro (NYSE: PBR).
In this final part, I will use an investment strategy known as a short strangle to achieve investment goals of 10% annually. Know that an investment return of 10% annually requires an investor to take on a lot more risk than a 5% or lower goal strategy.
So what is a short strangle? To understand the full effects of a strangle, make yourself an expert on covered calls and naked puts with these links: https://www.borntosell.com/covered-call-tutorial/covered-call-writing, http://www.theoptionsguide.com/uncovered-put-writing.aspx.
A Short Strangle is an options strategy where we own 100x shares of stock, sell x ATM or OTM call options, and sell x ATM or OTM put options, all the while holding enough cash to buy 100x shares at the strike price of the Put option sold. Let me explain each leg of the strategy in a bit more detail.
First we own 100x shares of the stock. We do this because we don't want the call options to suprise us if exercised, and force us into the dreaded 'margin call.' This way, we aren't borrowing money anywhere, and we eliminate the downside risk of selling the call option itself. This owning of shares beforehand is what differentiates a 'covered call' from a normal call option selling strategy.
Next, we sell x call options at a desired strike price. We sell x call options for every 100 shares owned because options control 100 shares each. This option selling gives us upfront income with the downside risk being the ownership of the stock (100%-whatever % return you got on the call option). If stock goes above the call option strike price, you may be forced to sell your shares, which should be fine because it removes an element of risk from this strategy. This is the first of two income legs.
The second income leg of the strategy is where we sell put options at a desirable strike price. Selling the put option gives us upfront income with the downside risk of a naked put writing strategy: if the price falls below the strike, option may be exercised and you will be stuck with the downside risk of the stock itself. In this case, you would end up owning 2x shares of the stock, and I would recommend maximizing this by selling another call option at the same or lower strike with the same expiration to increase income.
Finally, you must have cash on hand equal to the strike price X 100, so that if the put option is exercised, you will have the cash necessary to buy the shares you are obligated to buy. This is simply a self-insurance policy, but investment returns should take this uninvested cash into account.
So in this little series, we have shown you how to effectively use covered calls to achieve a 5% investment goal (a goal which would beat the S&P 3 of the last 5 years, making this effective in market turmoil). To achieve a higher investment goal, you have to take a higher risk level along with it, so while I will use the strangle to virtually guarantee a small percent return, a lot of this strategy is about leaving room for the upside to allow higher market based returns:
Using the Strategy with the SPDR S&P 500 ETF (NYSEMKT: SPY)
To get a 10% return with the S&P 500, begin by buying 100x shares at market prices (127.5). A 10% return requires an annual increase of 12.74. The dividend yield of SPY makes it so that we only need a gain of 10.22 from our option sales and market increases to achieve our goals. Selling the Jan 2013 $130 call option for 9.98 allows us to have a maximum upside of about 11 or 12% if the S&P goes to 1300 or above by Jan 2013. However, to make this even more likely, we will also sell a Jan 2013 $125 put option for $12.13, and hold $12,500 in cash. This way, if the put option is exercised, and market prices are at 125, we will have an investment of 25200, and profit losses that look like this: Market price of 125 (down 2% from market prices)
Loss on initial stock investment: -200 Gain on Put exercise: 0
Gain on written call option: $998 Gain on written put option: $1213
Total Investment Return of 7.9% assuming market prices go down 2%. If market prices go up to 130, and options are unexercised, you have a 9.7% return (including the 0% return from the cash as part of this return calculation), essentially fulfilling our 10% requirement (keep in mind that if options are exercised that would lead to a higher return if market prices went back up to 130). Remember that as soon as the put option is exercised, if there is any time before the end of the year, sell a January 2013 call option to increase income.
(NYSEMKT: DVY)- I won't be able to give you exact option sales for the iShares Dow Jones Select ETF because its options only go up until June; however, the strategy is essentially the same (just sell 6 months options twice instead of 12 month options once - actually a more profitable strategy if market prices haven't moved against you). Also notice that because DVY has a 1% higher dividend yield than SPY, you should have a higher likelihood of achieving your investment goals with this method.
Active Equally Weighted Portfolio: Goal-10% return.
My portfolio is made up of Aflac, KKR Financial Holdings, PepsiCo, Proctor & Gamble Company, and Petroleo Brasileiro. Since the portfolio is equally weighted, the average dividend yield of the portfolio is 4.556%. This means we simply need a 5.444% gain from each part of our portfolio to reach our 10% investment goals. Using the short strangle strategy, we should be able to effectively achieve the 5.444% gain and achieve our investment goals. However, we will only sell Put options on our lower yielding options plays because we don't want to have to hold too much cash in our portfolio either. On the others I will simply sell a covered call option.
Aflac: Sell the Jan. 2013 $45 call option and the Jan 2013 $42 put option for a total return of about 10.7% (including cash or option exercise) assuming market prices of $42.
KKR Financial Holdings: Sell the July 2012 $9 call and the July 2012 $8 put for a total return of 6.5% assuming today's market prices (market prices falling to $8 is a bit large to use in market stays still return calculations). Remember to repair this strategy with options expiring in Jan 2013 once these options expire to maximize return.
PepsiCo: Sell the Jan 2013 $67.5 covered call option for a total return of 5.49%.
Proctor & Gamble Company: Sell the Jan 2013 $67.5 for a 4.8% gain. While this is below our 5.4% return goals, above average returns from Aflac and Petroleo Brasileiro should help our average gains stay at our goals.
Petroleo Brasileiro: Sell the Jan 2013 $25 covered call option for a 12.1% gain. If you want to boost returns even more but take on a bit more risk, you could also do a short strangle here, as the $25 put option also offers a 13.8% gain.
This options strategy should push investors closer to a 10% return faster than their peers in a stand still market; however, in a market that performs over a 10% return, it will leave investors with much to ask for. This and the covered call option strategy are great ways for passive investors or investors looking to lower their risk/reward to enter the market with specific investment goals. I hope you all benefited from this mini series, and good luck going into the new year.
Fool Blogger Nikhil Shamapant owns shares of Aflac Inc and KKR Financial Holdings and will not buy shares in the next two trading days.