Dispelling a Popular Myth About Options

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Last month in Cabot Wealth Advisory, I explained some of the basics of options and showed you how buying puts and calls can benefit investors. You can read that issue here.

In the beginning of the article, I mentioned that approximately 75% of options expire worthless. And while that statistic may be true, it's misleading because there are a huge number of options written that are designed to expire worthless.

Let me explain this last point a little bit. Let's say that XYZ Trading Group thinks that the S&P 500 SPDR ( SPY ) , trading just above 129, has topped out and won't go any higher. While XYZ is confident in their opinion on SPY, they want to give themselves a little cushion. They decide to write the February 132 strike Call. The bid on the option is 0.85. Because each option represents 100 shares, the firm receives $85 for each call they write.  While it might not seem like all that much, large institutions may write 10,000 of these options (10,000 X $85= $850,000).

For this trade to be successful for XYZ, the price of SPY needs to stay below 132.85 (the strike of 132 plus the 0.85 premium collected). Ideally, SPY will never go above the 132 level, allowing the company to keep all of the premiums it collected. If this trade is successful, 10,000 options will have expired worthless.

Trades like this add to the statistics of options that expire worthless, but that is exactly what these types of options are supposed to do. And there are many other types of trades that can add to the misleading statement about 75% of options expiring worthless.

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Let me give you another example: Let's say you think the Materials Select Sector SPDR ( XLB ) is in a long-term uptrend and want to own it, but think it is too overbought to buy it now. XLB is currently trading at 38.88, but you are more comfortable owning it down around 36.50. You have two choices: Sit and wait to see if the stock pulls back out of overbought territory or write Puts.

If you want to buy 500 shares of XLB, you can write five of the February 37 puts (remember each option represents 100 shares). The current bid price on this option is 0.40 or $40 for each option. So you write five February 37 Puts on the XLB and collect $200. If the stock drops below 37 between now and the expiration date of February 18, the owner of the option can exercise the option and you must buy the stock from them at 37. If the exchange-traded fund ( ETF ) doesn't drop below 37, the options expire worthless and you keep the $200.

If XLB drops to 36, you are obligated to buy the stock at 37.  But, because you collected the premium of 0.40, your cost basis for the stock isn't 37, it is 36.60. This is 5.9% lower than the current selling price. If the options expire worthless, you can repeat the process next month and maybe collect another couple of hundred dollars. You can do this as long as you want and you can adjust the price you are willing to pay for the XLB each month. If the stock goes up to 40 and becomes even more overbought, perhaps for the March expiration series, you write the 38 strike put. This is the Priceline.com version of investing … "you can name your own price."

In each of these trade examples, the investor would have made a profit by writing the options and having them expire worthless. In the SPY example, the investor wants the options to expire worthless.  In the second example, if you wrote the February 37 Put on the XLB, you are somewhat indifferent on the trade. If the ETF drops below 37, you just bought the stock at a discount from its current level. If the ETF remains above 37, you still collected $200 and produced a little income for your portfolio.

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In the early 1990s I worked as a broker's assistant in Dayton, Ohio. At that time, Dayton was a big General Motors town as the Moraine Truck plant employed thousands of workers. We had a lot of GM employees as clients and they owned shares of GM. Back in those days, GM wasn't what you would call a high-flying stock-it was fairly predictable and not very volatile.

What we did for a number of our GM clients was write calls against the stock they held in GM, this is called covered call writing. Rather than rehash the glory days of GM and how we were able to enhance returns back then, let's look at an ETF where investors can enhance their returns today.

The Utilities Select Sector SPDR ( XLU ) is a somewhat stodgy investment. It doesn't seem to change greatly in either direction from month to month. Over the last two years, XLU has traded between 22.50 and 32.50. XLU currently yields just over 4% through dividends it pays throughout the year.

The strategy here is to buy shares of XLU as an income-producing holding for your portfolio and then write covered calls against these shares. If you buy 400 shares of XLU at the current price of 31.80, you can write one, two, three or four calls and still remain covered. I like to write options for half of my holdings, so in this case, I would write two calls. This allows us to keep a portion of the original investment even if the ETF rises sharply and goes above the strike price of the calls we have written.

Because the XLU is so slow and steady with its movement, the option premiums are very low. The current price on the June 33 Call is 0.40 ($40 each). So if we write two calls, we are collecting $80 in premiums and 200 of our 400 shares are at risk of getting called away should the XLU move above the 33 level between now and June.

Let's look at how this trade scenario could work out. To purchase 400 shares of XLU would cost us $12,720 at the current price of 31.80. If XLU rises to 33 between now and June, our return would be 3.7% (roughly $470) plus you would collect approximately 2% (roughly $250) in dividends. This would result in a return of approximately 5.6%. If we add the $80 we get from writing the calls, we've made approximately $800 for a return of 6.3%. So we boosted our return by 0.7% over a five-month period! And if none of the shares get called away from us, we can do this again and again. You can add several percentage points to your annual returns by writing covered calls.

Sincerely,

Rick Pendergraft
For Cabot Wealth Advisory

P.S. Leverage your investments to make money in all markets! Cabot Options Trader Editor Rick Pendergraft uses the market's volatility to bring his subscribers huge profit-making opportunities. Just check out these gains from the last three months: A 109% gain on a Call on Pride International ( PDE ) in only 15 days! An 88% gain on a Put on Arcelor Mittal (MIT) in 13 days! A 70% gain on a Call on Linear Technology (LLTC) in 14 days! Join today!



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks

Referenced Stocks: ETF , PDE , SPY , XLB , XLU

Cabot Heritage Corporation

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