As an investor who prefers to use options to make long-term, instead of speculative, trades, I often cringe when I read articles touting strangles, straddles, other more complicated spreads and, worse yet, directional bets on volatile stocks.
I say "worse yet" because at least when you put on a non-directional spread, you give yourself a fighting chance if you're wrong. Going long a call or a put into an earnings report often mixes a recipe for disaster.
Unless I am writing a call or a put, I rarely execute options trades right in front of an earnings report, particularly on potentially volatile stocks. If I am long an option prior to a quarterly call, I make sure I go in-the-money and/or use long-dated contracts so that I have a mix of intrinsic value and time to hang my hat on if things go south.
In this article, I discuss a pair of options strategies that make the most sense for long-term investors looking to collect income and possibly establish a long-term position in a stock around earnings. It's important to consider the intent of the articles I write, specifically ones that deal with options. The trades I outline will not work for all investors; instead, I hope to demystify the mechanics of relatively basic options strategies so that you can use them on stocks suitable for your portfolio at a time that's right for you.
Covered Calls and Cash-Secured Puts
Although roughly 75% of my portfolio tends toward a buy-and-hold philosophy, often in dividend-paying stocks, I think most portfolios can and should make room for speculation and active trading strategies. An excellent way to work active trading into a long-term investment plan involves moving between covered calls and cash-secured puts, though not necessarily in that order. Earnings season can represent an excellent time to sell options because implied volatility often sends premiums higher ahead of a major event.
Let's consider an example. When using the following strategy, you must come to terms with yourself on several important qualifiers before executing the trade:
- If you write a covered call, you must be content with the point at which you cap your potential profits.
- If you write a covered call, you must be all right with the possibility that the stock drops below your break-even point on the trade, which would result in on-paper losses.
- If you write a cash-secured put, you must be OK with the chance that the market price of the underlying stock drops below -- maybe even well below -- the strike price of the put you sold.
Simply put, from my perspective, you must be long-term bullish on the stocks you write covered calls and cash-secured puts on, particularly around earnings, because you could be left holding a stock at a loss.
If you are long-term bullish Apple and have cash on the sidelines to buy the stock, consider selling the Apple May $605 put. As of Monday's close, you would collect $18.40 ($1,840) in premium that you keep no matter what. If Apple breaches $605 between now and options expiration day, you run the "risk" of getting put shares and having to buy 100 shares of Apple for $605 apiece for every put you sold, regardless of Apple's market price. Because of the premium you received for writing the call, you would not start to lose money on this trade until Apple traded below $586.66 ($605 strike minus the $18.40 premium).
Of course, this trade anticipates a pullback in the stock. If you do not see that happening, you can always increase the strike price to something closer to or around-the-money. Again, just make sure you're comfortable buying the stock at that particular strike.
In the event that you get put shares, you could simply hang on to them and proceed as you would with any other stock transaction. But to keep the income train rolling, you could look out to June come mid-May and write out-of-the-money Apple covered calls against your position. When you select a covered call strike, you have to consider your cost basis on the stock and make certain that if you get your shares called away, you'll be happy with the price you're getting.
For instance, in this example, if you get put Apple at $605 (with a breakeven of $586.66), you'll want to use those numbers in conjunction with covered call strike prices to calculate your return in the event your shares get called away. Writing the Apple June $630 call would cap your profit at 4.1% using $605 as a cost basis and at 7.4% when you factor in the premium and use $586.66 as your cost basis.
Of course, you could turn this series of options trades around, particularly if you anticipate strength post-earnings. You could write the covered call first. From this perspective, I would consider selling the Apple May $660 call and collecting $22.15 ($2,215), as of Monday's close. If Apple soars post-earnings and you end up getting your shares called away, you've realized a roughly 7.2% gain.
To come to that number I used Monday's closing price of $636.23 on Apple. One hundred shares would run you $63,623. If you put in an order to sell your shares at $660, you would turn a 3.7% profit if it gets triggered. When you factor in the covered call income of $22.15, however, you generate gross proceeds of $68,215 and a 7.2% gain. That's powerful stuff, particularly if you enter the virtuous cycle by turning around and selling an Apple cash-secured put after you get your shares called away in a covered call trade.
Disclosure: At the time of publication, Rocco Pendola held no positions in AAPL.
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