Its been a while since I’ve talked about option selling as an income strategy. Actually, my first and only post on the topic was back in mid November of 2010. With the US stock market on a nice uptrend since that time and with volatility being low it hasn’t been a great time in general to sell options. The options yields, premiums as a % of stock price, just haven’t been that great. But all that seems to have changed this week. Lets see what opportunities selling options during these times gives the income investor.
While there are opportunities to generate good income in any environment, some market conditions are better than others. The best time to generate income by option selling is when option premiums are high. Option premiums are high when fear in the market is high, i.e. when the implied volatility in the options is high. The best market wide measure of implied volatility is the VIX index. A 1 year chart of the VIX is below.
A good rule of thumb is that its a great time to sell options when the VIX is above 30, and a pretty good time when its above 20. As I said earlier you can always find good option opportunities in individual stocks but you’ll find many more when the VIX is elevated. As you can see from the chart the VIX pretty much has doubled since early in the year so there are a lot more opportunities in the options market right now. Lets take a look at two potential opportunities as examples.
The first opportunity is in Intel (INTC). I’ve posted on Intel before and have said that it represents a great value at $19 a share. What if I wanted to sell a cash secured put on Intel at $19 and get paid to wait. Below are the prices for the May 2011 puts on Intel.
If you look at the May 2011 $19 put, the option premium is currently $0.57 (when selling options always use the bid prices to calculate yields). That is an option yield of 3% ($0.57/$19) for 63 days, given the option expires on May 20th. 3% for 63 days is an annualized yield of 17.15%. You could also just look at the annualized premium column which does the calculation for you. This is one of the reasons I like using the Morningstar website to look at options. The link for Intel is here. All in all not a bad opportunity to make 3% in 2 months, 17% annualized. Worst case you get to buy the stock at $19 which we determined was a great value and keep the $0.57 in cash. Another way to look at it is that worst case you get to buy the stock at $19 minus the $0.57 option premium or $18.43.
Another example of a good opportunity to generate income from options is Miscrosoft (MSFT). I’ve also posted on MSFT before and said that it was undervalued. Since my post, I think its even more undervalued now given the success of Kinect and the Nokia Windows Phone deal. I think it’s worth at least $30. Below are the prices for the May 2011 puts. The link is here.
With the stock trading at around $25, an investor could sell the May 2011 $25 put for $1.15. That is an option yield of 4.6% for 63 days or 25.87% annualized. Even better than the Intel opportunity in my opinion – the stock is more undervalued by the market and the option yield is higher. If the stock is trading below $25 by May 20th then you must buy MSFT at $25. Again, given that I think MSFT is worth at least $30 a share this would not be a bad thing to happen.
One important point an investor who implements option selling needs to decide on is what to do when the trade goes against you. There are two choices. One, buy back the option at a pre-determined loss point, say 25%. Or let the option expire and have the stock put to you at the strike price of the option. I always choose the latter which is why I make it a fundamental rule to only sell options on stocks I would be happy to own at the strike prices of the options. However, since this is a trading strategy for me whose purpose is to generate income I do not plan to own the stocks for a long time if they are put to me. If the stocks are put to me I then turn around and sell covered calls as near the money as possible to continue generating income for this portion of my portfolio. So, while I am OK to own INTC and MSFT at $19 and $25 respectively I don’t want to own them for long. This is a personal choice. Its perfectly reasonable to set maximum loss thresholds and to close your positions once they are hit.
In summary, with the VIX rising significantly since the beginning of the year options premiums are getting attractive again. Both INTC and MSFT are offering attractive option yields and are both undervalued by the market. This represents a good income opportunity for what I call an aggressive conservative income investor.
6 Comments
paul · March 18, 2011 at 3:50 pm
I enjoy reading your opinions and ideals on investing. Did you not consider a covered call option with the benefit of a dividend payment in May, because you don”t really want to own the stocks best case scenario?
libertatemamo · March 18, 2011 at 4:12 pm
Hi Paul, thanks for the comment. I’m not a huge fan of covered calls. While technically they are the same as a cash secured put, I think there are some differences. The purpose of the part of my portfolio I use for this trading strategy is to generate cash. Ideally I don’t want to own the stocks. But since I won’t be 100% right I know that I will end up owning some – so I pick stocks that I know a good thing or two about and would be ok holding for a while if forced into it. The other thing I prefer about shorting puts is that I can get out with a loss without ever owning the stock. With the covered call, I’m into the stock no matter what and suffer the losses. I think its more style vs substance.
Also, on the dividend front dividends are priced into options so one benefit is the put premiums are higher than call premiums on the same stock.
Paul
J Carroll · March 20, 2011 at 10:38 am
Paul, great Morningstar link. Still new to trading options, only covered calls so far, I will definitely use the Morningstar information in the future. I appreciate your preference for cash-secured puts on stocks you would not mind holding; however, what do you think of the strategy of using covered calls (perhaps starting ownership via a cash-secured put) to generate income from non-dividend paying and fairly volatile stocks. Thank you.
libertatemamo · March 21, 2011 at 9:07 am
J, I think its fine to use options to generate income on non div stocks. I do it sometimes. For example. I have done it on Sprint (S) quite often and made good money. Its a volatile stock so the option premium are quite high. My preference for selling options on div stocks has more to do with my style and that those are the stocks I know the best. I think that’s the key. A question I ask myself when I enter an options trade is ‘what will I do if the stocks takes a 25%+ drop during the time I hold the position?’ Will I hold and let the stock be put to me? If doing a covered call will I continue to hold the stock? Will I be able to sleep at night? The thing about selling options is that you make a little bit on most trades but often investors blow up big on one trade that costs them all their previous gains. Risk management is key. And to make risk management possible I find that an investor needs to trade options on stocks they know, whether they be div stocks or not. For me, its div stocks most of the time mainly for that reason. Everyone needs to find a style that works for their temperament.
Troy Knight · March 22, 2011 at 9:30 pm
Hi Paul – Good idea on using the VIX as a screen tool for option premium levels. Thanks!
libertatemamo · March 22, 2011 at 11:03 pm
Sure thing Troy.
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