After over a year of a remarkable market rally, volatility has again reared its ugly head. The VIX index is back up and the stock market is rising and falling by more than 100 points daily.
Rather than panicking or trying to time the market, financial advisor David Keator, of the Keator Group in Lenox, Mass., said now is a good time to use options selectively to potentially make extra tax-free money on your long positions and use a covered put strategy to buy equities cheap with side-lined cash designated for equity allocations.
“Option premiums get rich in the face of volatility and you may be able to take advantage of that on a tax efficient basis,” he said.
The more volatility there is in the market, the richer the premiums are on options, Keator said. So times of high volatility can be opportunities to write covered options both on the upside with calls and the downside with puts. “You want to have a consistent allocation and use options to potentially enhance the return based on volatility,” says Keator.
Let’s look at a covered call example. Say you bought 100 shares of XYZ Corp. at $20 a share and XYZ is down 25%, trading at $15. You could buy another 100 shares at $15 and write one call with a strike price of $18, representing an if-called 20% increase in stock price. So you sell a call expiring in July and pocket a 30 cent premium per share. On the 3rd Friday of the strike month when the call expires, you can sell the XYZ, but instead of selling the newly purchased shares that you bought at $15, you sell the $20 shares. You would take a loss on your first purchase ($20) and use that loss to offset the call premium that you have already earned. Since calls are considered capital gains, this is an opportunity to harvest capital losses against which you can offset any current capital gains—and you can carry forward any remaining loss to offset future gains.
You can also do this on the down side on the same day.
Assume you have $1,500 in cash sitting on the sidelines waiting to go back into the stock market because your portfolio is underweighted in equities. Volatility gives you a potential opportunity to buy into the equity market at lower than current prices.
Say you think ABC Corp. is a good long-term holding, and it’s trading at $16 a share, but you would be willing to buy it at $15 a share. You would sell a put option to buy it at $15 and collect a premium of say 43 cents a share. By selling the put alone, you would have made 2.86% on your cash (0.43/1500) in anticipation of potentially purchasing the stock.
“If that option has 51 days before it expires, you can theoretically do this seven times in a year, giving you an annualized return of 20.5%,” says Keator. “That’s compared with a money market return. So I’m working my cash harder.”
Keator further cautions that this strategy should only be employed with cash that is allocated to buy equities, not an emergency fund or with cash that is designated for fixed income. “It’s not a strategy for money that should be in bonds or cash,” he warns. “Essentially it’s a way to potentially dollar cost average into a position that you would otherwise purchase at a lower price.”
You can write a put and a call on the same stock, says Keator. If you have 200 shares of LMNO Corp. at $20, you could potentially write one call with a $22 strike and one put with an $18 strike. If the stock goes up, you only have to sell 100 shares, but those shares have still appreciated up to the strike price. The other 100 shares have unlimited upside potential, yet you have pocketed the call premium. Additionally, if the stock has risen to the point of being called then you keep the put premium as well since the stock can’t be in different places at the same time.
The same holds true on the down side. If the price of LMNO falls below the put strike price you are obligated to purchase at the put strike price, but your actual cost is reduced by the put and call premiums because again, the stock can’t be in different places at the same time. Of course, your risk is always the loss of principal
“So, there are multiple ways to make money on the same security,” says Keator. A position can go up, down or stay the same. If it goes up, then you make money on the appreciation of the security and the expired put premium combined with some call premium. If the stock stands still you gain on both the expired call premium and the expired put premium. If the stock price drops, you lose on the long position minus the call premium that was received with the opportunity to purchase more and dollar cost average into the same position less the put premium that you have received.