OPTIONS
Spice Up Your Option Strategy
Beating The Benchmark
by Roberto Chahín
Use out-of-the money covered calls to improve your buy & hold portfolio's risk efficiency.
UNlike investors, most traders look at buy & hold strategies as a necessary evil at best. Traders may have a large portion of their portfolio in a basket of stocks or exchange traded funds (ETFs) that they allow to roll with the market, hoping to at least get the same returns as the benchmark of their preference, be it the Standard & Poor's 500 or the NASDAQ 100. The remainder of their portfolio would be in their trading capital. Some simple methods can improve the risk-adjusted return of this side of a portfolio by using out-of-the-money covered calls. This can also be complemented with your favorite technical analysis tools to further improve risk-adjusted returns and reengage yourself in the active management of a buy & hold portfolio.OUT-OF-THE-MONEY COVERED CALLS
An out-of-the-money covered call is simply established by selling a call option on the stock or ETF in the investment portfolio with a strike price higher than the current price of the underlying. For example, if you hold SPY, the ETF that tracks the S&P 500, and it is trading around 150.00, you could initiate an out-of-the-money covered call position by selling the 30-day 155.00 call. This position allows the SPY 30 days to go up 5 points, or 3.3%.
If the SPY does not close above 155.00 on option expiration day, you get to keep the premium collected at the sale of the call option. This would act as a buffer if the stock drops in price or would provide extra profit if it were to hold steady or rise less than the 5 points. If, however, the SPY closed above 155.00 on expiration, you would have to surrender the shares at 155.00 and repurchase the equity position at market price. The difference between the market price and the 155.00 strike price would be your loss.
So it is critical to determine an adequate spread between the underlying and the strike price of the call option to be sold. If this spread is too wide, the buffer effect of the collected premium would be very small. If it is too narrow, the option would be exercised too often and losses would accrue. A simple way to figure this spread out would be to sell the option with a strike price one standard deviation above the underlying. This would allow options to be exercised, in theory, around 16% of the time.
...Continued in the July issue of Technical Analysis of STOCKS & COMMODITIES
Excerpted from an article originally published in the July 2008 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2008, Technical Analysis, Inc.
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