Would you like to collect income regardless of the see-saws in the market? Here’s how to use two complementary strategies for collecting short-term income.
The first thing that’s needed is a low-dollar stock with options that have high implied volatility. The higher implied volatility means there’s more premium to collect. For this example, take a look at the Yahoo (YHOO) price chart below. At the bottom of this chart you can see that the implied volatility is trading in the middle of its one-year historical range. My rule on this is that if the volatility clearly isn’t low, then it’s high. That’s the case here.
The first strategy is selling a short-term ATM (at-the-money) put spread. With the stock trading at $27.25, and 10 days remaining until expiration, selling the 27 strike put for $0.33 provides the credit. But we’ll also buy to open the 24 strike put for three cents as protection in case the stock drops. The net credit for the spread is now $0.30 and has a maximum risk of $2.70. In this instance the net credit represents a potential 11% ROI in 10 days.
If the stock remains steady, or moves higher, the put spread will drop in value. By expiration, if the stock is higher than $27, then both puts should expire worthless and you would keep the full credit as the income.
I said ‘should expire worthless’ because even though the 27 strike put option is out-of-the-money, the option holder still has the right to exercise it and might do so in certain circumstances. So ‘best practices’ would dictate buying to close the option when it drops to one to two cents. Some brokers offer no, or lower, commission costs to close short options below five cents.
After buying the short option to close, it’s time to sell the ATM put spread again for the next expiration. Depending on the stock or ETF you’ve chosen, the next expiration could be anywhere from one week to one month away. Sell the ATM put option to open, and buy a lower strike put, as a short vertical put spread. Which strike should you buy? Look for something cheap, five cents or less, just to hedge the downside risk.
Repeat this trade every expiration until the day comes when you get assigned the stock. It’s going to happen, so you need to be prepared to buy the stock. What do you do now? This is where the second strategy comes in: A collar.
In a previous issue the use of a cashless collar was discussed, but the implementation of this collar differs. Instead of selling an OTM (out-of-the-money) call as a way of paying for the protective put, this strategy sells a call with the same strike as the put on which you were just assigned. Let’s assume the 27 strike again for this example.
For those who understand synthetics, you’ll see that owning the stock from the assignment and selling the 27 strike call acts just like a short 27 strike put. By buying the OTM put for protection, this position resembles the same short put spread.
At expiration, if the stock remains below $27, you keep the credit income from the call, and your long put protects the stock if the price continues to drop. If the stock moves above $27 at expiration, then you sell the stock back at the same price you bought it, and you still keep the credit.
As long as the implied volatility remains high, keep this trade going. When the implied volatility reverts back to the low end of the range, then it’s time to find another suitable candidate and start the process again. Over time, taking in these short-term credits will start to add up regardless of which way the market moves.
Greg Loehr is a former CBOE market maker trained by Susquehanna Intl. Group, and founder of education firm OptionsBuzz.com. He has written and presented extensively on options globally.