Safely Juicing Your Returns With Options
In a recent column, I discussed one way to profit from market volatility. An example I used was Apple (NASDAQ: AAPL), which I had recently picked up on a dip and sold on a spike using limit orders.
In a nutshell, I always have some cash in reserve, devoted to limit orders on quality companies at deep discounts.
But today I want to talk about a slightly different strategy — one that actually pays you as you await the execution of those discounted limit orders. (Note that my colleague Scott Chan went into more detail on the basics behind this strategy in an article in March).
A Better Way
Let’s once again use the example of Apple, which closed last Friday at $162.32. Apple shares are well off their March highs above $180 a share following concerns about slowing demand for the iPhone.
Apple may be a bargain at this price, but let’s say the most I want to pay is $155. It’s far from certain that it will drop that low, but I could put in a limit order and wait. While you wait, you must have cash set aside to execute the order. It may be in a money market account, drawing less than 1% interest.
But there’s an alternative if you have enough money available to buy 100-lot shares. In the case of Apple, that means you need to have $15,500 set aside for the $155 limit order.
In this case, instead of putting in a limit order for $155, you could sell a cash-covered put at a strike price of $155. This gives the buyer of that put the right to sell shares of Apple for $155. For someone that owns Apple but is afraid of the share price falling, this can be insurance for them against a steeper drop.
At last Friday’s close, the premium for that put with an expiration date in two weeks (May 11th) was $2.04 per share, or $204 per contract (which represents 100 shares). When you sell that put, you pocket the money — regardless of what happens with the trade. The $15,500 remains set aside in the money market account unless the buyer of the put exercises the option. But $204 represents an additional return of 1.3% of that $15,500 in just two week’s time.
What might happen? If the price of Apple on May 11th is above $155, then the option expires worthless. You keep the $204, and the good news is that you can turn right around and sell another put.
If Apple shares close below $155 on May 11th, then you will be the new owner of 100 shares of Apple. In fact, if Apple shares trade below $155 before May 11th, the owner of the contract could opt to exercise the option prior to expiration.
Your cost basis will be $152.96 because you already received a premium of $2.04 for the contract. This strategy is superior to simply executing a limit order — provided you have enough shares set aside for a 100-share purchase.
If the $15,500 purchase price of Apple, in this case, is too much or would represent a disproportionate percentage of your portfolio, then you could always opt to execute this strategy on a company trading at a lower value. The same strategy for a stock trading at $50 a share, for example, would require $5,000 to be set aside for the trade.
Flip the Script
One final thing to point out is that once you eventually purchase shares, you can start selling covered calls against those shares. In this case, you would sell the buyer the right to purchase your shares at an agreed-upon strike price at some future time.
Using the case of Apple once more and last Friday’s closing price, an owner of Apple shares could have sold a call option with a $170 strike price (representing a 4.7% gain above Friday’s closing price) and a May 11th expiration for $1.56 a share.
If shares rise above $170 a share by expiration, the buyer of the option can purchase them from you at $170 (regardless of how high shares rise). If they don’t rise above that level, you still get to keep the premium, which amounted to an additional 1% return in just two week’s time.
In either case, whether you are in the process of buying shares, or you already own them, you may want to consider selling options to juice your returns.