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.
17 Comments
Mark · June 3, 2011 at 12:06 pm
Very interesting strategy from an income generating point of view. I’ve never tried this, but I like the short duration and extra leverage. Your explanation is really well done. Thanks =)
libertatemamo · June 5, 2011 at 9:51 am
Thanks Mark. I like the short duration as well. I never go more than 30 days out.
Paul
Raj · June 4, 2011 at 3:49 am
Nice article. What stocks or category of stocks fit the bill as least volatile currently? BTW your mREIT analysis is very good. Thanks.
libertatemamo · June 5, 2011 at 9:54 am
Thanks Raj. Well, the toughest part of this strategy is finding something to trade. Even when volatility is low the strike prices of the traded options need to line up in your favor. But the returns are worth the hunt. Bond ETFs tend to be good candidates for this strategy because of their low volatility. Big tech lines up pretty well for this right now.
Paul
Raj · June 6, 2011 at 7:31 am
Thanks Paul.
Now, may I ask you a question that involves both options and mREITs? 🙂
Due to the predictable nature of the mREIT share price movement around EX-Did date and SPO, how does one play the options around this scenario? Your thoughts are much appreciated.
Raj
libertatemamo · June 6, 2011 at 8:36 am
Raj, option prices fully take dividends into account. Watch the option prices before and after ex-div on any of the mREITs, they don’t change. The only options I trade on mREITs are selling puts because the premiums are elevated because you are being compensated for not receiving the dividend via stock ownership.
Paul
paul · June 5, 2011 at 3:02 pm
Another great post. How do you pick your strike price on the in the money call? Are you looking for a specific Delta ? or some other screen?
Paul
libertatemamo · June 7, 2011 at 8:17 am
Hey Paul, sorry about the delay in responding. There is no science, at least not for me, to picking the strike of the in the money call. It’s a trade off between the higher delta of deeper ITM calls and a higher break even, lower leverage for that deeper ITM call. I want my breakeven price not to be too high above market and still get a decent premium on the short call, say 5% for 30 days out. Hope that helps.
Paul
Don · June 6, 2011 at 6:42 am
This is an interesting strategy. And although I have a number of longer term in the money Calls, it’s one I have not tried in the past.
TLT could be a risky choice. The end of QE2, our account deficit, and economic recovery will eventually result in higher interest rates putting TLT under pressure. With this trade, you are betting that will not occur until after Dec 2011. That may be a reasonable bet with the recent economic data and issues in Europe. Let’s face it, even though it’s lower risk, we don’t want to loose 7%.
It’s the startegy that important. So I will look for a candidate that might be lower risk than TLT.
libertatemamo · June 6, 2011 at 8:33 am
Don, you definitely need a long thesis on any position that you enter with this trade. Nice thing is that the long thesis doesn’t have to be for the stock to go up, just to remain flat. As far as TLT goes, I personally think that it will remain flat if not go up due to a slower than expected economy. There are plenty of other trades in the market, to each his own.
Paul
Benjamin Guilford · February 2, 2012 at 12:54 pm
Very interesting strategy. I’m not well versed on options but am very interested in learning more about this strategy. Question for you on this: What happens at expiration? Would the long call have any liquidity to sell? Do you exercise the call and then sell the stock?
Also, at expiration, what happens if the stock is at the strike price? Wouldn’t you then lose a much larger % of money? Using your example above, If I was able to sell covered calls three times by expiration, assuming all were at the price above, I would receive $189 ($0.63 per contract * 3), but I would be out the $673 I paid for the long call, which based on the current price of the stock ($95.96), is only 6.2% above the strike of $90, leaving minimal downside protection. What are your thoughts around this?
libertatemamo · February 2, 2012 at 5:58 pm
Hey Benjamin. At expiration lots of things can happen depending on the price of the underlying stock, volatility, etc.. Liquidity is normally not a problem especially in ETF like TLT. You can take care of any potential liquidity problems by choosing the stock/ETF and strike prices to trade with some forethought. I normally won’t trade anything with less than 1,000 contracts in open interest for example.
As for what to do before expiration here are a few scenarios. First I always exit the positions before expiration. I’m trading options with this strategy, I’m not interested in owning the underlying at all. If the trade went in my favor and the stock rises in price then I’m a winner no matter what. If the stock goes above the short strike then my gains are capped. Oh well. If it goes up but stays below the short strike then I could let the short option expire worthless or buy it back. For the long option that I’m now profitable on I could sell it and exit the whole trade or keep it and sell another call for the next month and pocket that premium. The tough part comes when the stock price goes down. The downside is protected by the premium on the short strike but the long call position will be down. In this case is where you need to heed your stop losses and exit the position when it exceeds your loss limits.ou
As for the example you bring up you would not be out the $673 in the long call. The long call had $596 of intrinsic value when you bought it and it still does since you’re assuming the stock price stays flat. Only time premium decays to zero.
This is not a beginner options strategy. It takes some time and practice to see all the little nuances of the trade. I would recommend paper trading this strategy until you get comfortable with it. Hope that helps.
Paul
Benjamin Guilford · February 3, 2012 at 8:14 am
Paul, thanks for the timely response. I’ve studied options but don’t have any experience beyond simple strategies such as long calls, traditional covered calls etc. and really appreciate your insight. I’ve recently been researching DITM covered calls and synthetic strategies such as yours, and am trying to learn as much as possible before actually trying to trade one.
Your volume limit was very helpful, thanks. I’ve been focused on the middle market for stock picking so a lot of the option volume is low. I’ll keep this in mind when looking for option strategy candidates.
In the options class I took in school we always looked at hypotetical strategies through the time of expiration, without much real world application, so its very helpful to learn about when you actually look at exiting, versus holding until expiration and then exiting. Based on your response, it sounds like if the trade goes agains’t you, e.g. the stock starts declining towards your long call strike, you would just exit the trade. Is that correct? In your example, I’m assuming the long call would lose value if the stock went from 95.96 to say 94. Without looking at the greeks I’m not sure how fast the long call would decline and some of the decline would be offset by the short call premium you received, but do you typically aim to sell the long call if it is near your break even? And if you do, would you then also buy back the short call (which would be cheaper at that point)? Do you somehome actively monitor where your break even is based on the current long and short call market prices?
Also, when analyzing a potential trade, do you look for a certain % of downside cushion?
Last, have you ever experimented with a synthetic deep in the money covered call? I’ve been looking at this strategy with owning the underlying but can’t find much online about creating the same trade exclusively through options.
Hopefully this isn’t too long, I really appreciate the insight.
Thanks,
Benji
libertatemamo · February 3, 2012 at 9:52 am
Benji, trading options in the real world is nothing like what they taught you in school. Even paper trading is nothing like real trading. When your own hard earned real money is at risk everything is different. The most important part of trading is risk management. The technical aspects of trades are a far second. I never enter a trade without a pre determined max loss point. An I always make sure my position size is appropriate for my strategy.
What I would recommend is that you learn the technical aspects of different option strategies from some great blogs that just focus on options, like Tyler’s Trading or SMB Trading’s option section. Or even what Options action on CNBC. Understand every trade they talk about. Then paper trade some of these strategies in a practice account. Also, develop a risk management plan. What is your target position size? What is your max loss per trade, per month, etc….
As far as my options trading goes, the majority of my trades are very simple, I sell premium, call or puts. I have strict rules for position size, max loss per trade per month per year, max number of trades per trading period, target returns, etc….Only a small percentage of the time to I go into fancier strategies like diagonal calls which we have been discussing.
Paul
Benjamin Guilford · February 3, 2012 at 11:48 am
Thanks, Paul. I appreciate the insight. I’ll definitely be doing more research before using more advanced options strategies regularly. I’ve learned the hard way that some of the more exotic trades can go very wrong w/o enough practice.
Have you ever experimented with a synthetic deep in the money covered call, or seen any blog posts on such a strategy? Using DITM covered calls on a traditional basis is a nice mkt neutral income startegy if the premium is high enough but I’m curious if you can replicate it without the underlying long stock position to get greater leverage. The math looks compelling but I haven’t been able to find much on the internet discussing it.
Thanks again for all the responses,
Benji
libertatemamo · February 4, 2012 at 8:17 am
Benji, a synthetic DITM covered call if I get your meaning is exactly what I call a leveraged covered call. I don’t see a difference. More commonly this is known as a type of diagonal call spread.
Paul
August income investor dashboard « Investing For A Living · August 1, 2011 at 10:15 am
[…] to be a great income generating vehicle via the leveraged covered call strategy I’ve posted on before. One last thing about bonds. Despite what you read in most of the financial media bonds […]
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