Today I wanted to present an alternative way to generate income using options. In a previous post I discussed selling options as a great way, and my preferred way, to generate income. In my Investing for A Living retirement model this is the predominant strategy I use for the ‘trading’ portion of my portfolio, usually the 20-30% cash part of the total portfolio. While selling options is a great way to generate income there are times when it is too risky or the option premiums are too low to justify the risk. When volatility is very low, as it is today, there are other choices to generate income. It takes a while to really understand this strategy but I think it is worth learning.
One alternative during times of low volatility is the use of what I call the leveraged covered call. I’ve never heard it called this but this just seems like the obvious name to me. The more common name of this option trade is the diagonal call. It is a version of a call spread which combines a vertical call spread (same month different strikes) and a horizontal call spread (same strikes different months). I guess thus the name diagonal. That seems overly complicated to me. The easier explanation is that the diagonal call spread is similar to a covered call except that you own a call option on the underlying stock instead of the actual stock itself. Let me break the trade down into its two components.
The primary strategy here is to own a deep in the money call versus owning the stock outright. Why would you want to do this? Deep in the money calls are a great stock replacement strategy. It’s is like owning the stock with the exception that your downside risk is limited. Sounds good so far, right? Lets look at an example. Lets say I wanted to establish a $50K position in long term treasuries. I could buy shares in the long term treasury fund TLT which when I wrote this was trading at $95.96. Alternatively, I could buy long term deep in the money call options on TLT. I could buy the Dec 2011 $90 calls for $6.73. So, for $3.5K I could control the same number of shares as $50K of TLT ($6.73 is 7% of $95.96). That is option leverage. A big difference in these positions is that my downside risk in TLT shares is 100% while my downside risk in the options is limited to the price of the options, in this case only 7% of the $50K. In essence, by using the calls I have all the upside potential in TLT but with only a 7% downside for the equivalent position. The reason to buy deep in the money calls, as opposed to out of the money calls, is that you are paying very little for the time value of the option. Almost all the value of the option is intrinsic value ($5.96 of the $6.73 option premium). Your time decay risk in this option is only $0.77 for the right to control the shares until the end of the year. That is a good deal and reduces your risk significantly. For you option geeks this basically means that delta for deep in the money call options approaches 100%. Now lets move on to the second part of the trade.
While the deep in the money calls are a great stock replacement strategy this is not what I’m trying to do with this part of my portfolio. I’m trying to generate income. So, now that I own the deep in the money calls instead of the stock I can do the same as in a covered call strategy and sell a call against my longer term call position. In the TLT example, I can sell the June 18 2011 $97 call and collect a premium of $0.63. Why the $97 call? $97 is the nearest strike price to my break even point of $90 plus the $6.73 I paid for the long call. On my $6.73 investment in the Dec TLT options I collected $0.63. That is a 9.3% yield on this option trade, initiated in June 2nd 2011 and expiring on June 18th 2011. Not bad. Better than the covered call trade on TLT to put it mildly. If TLT goes lower by expiration I keep the $0.63 and then sell the next month’s $97 call. If TLT goes above $97 I have a few choices. I can wait until the shares are assigned to me and then exercise my long call position to close out the trade. Alternatively, I can buy back the short call before expiration and sell the long deep in the money call and pocket the gains. What I really want is for TLT to stay flat. This way I can keep selling calls throughout the year and pocket the income. This strategy is best implemented on stocks with low volatility and that you expect to remain that way.
Below are the option prices I referenced for TLT on June 2, 2011 when I was looking at this trade.
As with all option trades the key to not getting hurt too bad is to have a risk management strategy. In the case of the leveraged covered call you can only be hurt one way, by the stock and thus the option prices going down. Before I enter any option trade I always have a pre-determined exit point and I stick to it no matter what. For example, on the TLT trade above my exit point is the $6.73 I paid for the call minus the $0.63 I received for the option, or $6.10. This would get me out of trade at close to break even once I account for option fees. Its more important to live to trade another day than to hope and pray the trade turns around in your favor. Another way I limit my risk is by never selling options more than one month out. This way I can re evaluate the fundamentals every month and adjust accordingly. Also, you will collect more premium by using the front month options.
In summary, during time of low volatility when the premiums on options selling are just not compelling there are some good alternatives available to the income investor. The leveraged covered call is good way to generate income on low volatility stocks. It takes a bit of time to understand all the permutations of this trade but your time invested in learning this trade could be well worth it.
Full Disclaimer - Nothing on this site should ever be considered advice, research or the invitation to buy or sell securities. These are my personal opinions only.