I was recently asked by one of my readers what my “go to” option strategy was so I thought I would write about that in this post. Even though I have been mainly writing about iron condors and butterflies in my blog in the last two years, my favourite options strategy has got to be selling cash covered puts. More details on this strategy can be found in my free e-book “A Low Risk Income Strategy for all Economic Conditions” which I wrote in April 2012 after trading the strategy for three years. I am still actively trading this strategy in 2016 and I expect I will still be trading it for many more years to come. Your trading strategy must suit your interests, personality and desired lifestyle, and I find this strategy ticks all the boxes for me.
I like buying stocks when they are cheap so when a stock on my watch list is trading at a good price, I will look to sell some puts with a view to owning the stock or just making some additional income on my cash. A recent trade I did was on CBA. On September 12, CBA was trading at $70 which is at a strong support level as shown in the chart below. The MACD was showing a bullish divergence providing further indication that the bearish trend might be reversing soon. Morningstar had a fair value of $85 for CBA so at $70, CBA was trading at a 17% discount to fair value.
As the stock had just gone ex-dividend and there was a lot of negative sentiment on the banking sector, I was not in a hurry to buy the stock so I decided to sell $70 put options which expire in November 2016. I collected a premium of $2.35 per contract which would further reduce my cost basis to $67.65 should my puts get assigned. It turned out my analysis was correct and CBA rallied shortly after I sold my puts. Two weeks later, my put options were trading at $0.85 and the rally was starting to stall at around $73 so I decided to close my position. My net profit after commissions was 1.8% or an annualised return of 36%.
What if my analysis was wrong and the stock continues to go down? My losses will be smaller from selling puts compared to holding the stock. This is because the delta of at-the-money puts is around 0.5 which means that if CBA fell by $1, the put price will only fall by 50 cents. The time value of the put option will also decay over time which will further help reduce my loss. In the case of my CBA trade, I wasn’t too worried about the stock falling further as I was quite happy to buy the stock at a net cost of $67.65. However, this may not be the case for all my trades.
On August 22, I saw that WOR had recently made a new 52 week high and broken above a strong resistance level at $8 as shown in the chart below. As the stock was in a strong uptrend, this breakout looked like a continuation of this uptrend. The stock was trading around $9.30 on that day so I decided to sell some $8.75 puts for a premium of $0.54 per contract. As this was not a stock I wanted to hold long term, my plan was to take a loss if the price below the new support level of $8 and below the 50 day MA. As it turned out, my analysis was wrong and WOR fell after I put on my trade. On September 15, I decided to close my trade as both my stop loss conditions had been met. WOR was trading around $7.30 at the time and I managed to buy my puts back at $1.60 per contract. My net loss was $1.06 ($1.60 – $0.54) per contract. Had I bought the shares at $9.30 and sold them at $7.30, my loss would have been $2 instead of $1.06.
Although my potential profits are limited by selling puts instead of buying stocks outright, my risks are also reduced as I can sell puts at below the current market price and use the premium collected to further reduce my risk. I also do not need to monitor my positions closely especially when I am prepared to own the stock. This strategy fits my risk profile and desired lifestyle which makes this strategy one I can trade very comfortably.
This strategy does require you to find the right stocks to trade and stock research does take time. Finding trades will take more time compared to trading mechanical strategies such as the iron condors and butterflies using index options, so this strategy will only suit someone who is interested in stocks and has the time to do stock research. I am interested in what goes on in the financial world so I probably would spend an hour a day reading articles from the BusinessAge and Bloomberg Finance and other financial newsletters that I subscribe to. Even if I wasn’t trading options, I would probably still spend the same amount of time reading the financial news just as most people would spend the time reading the newspaper every day.
I might get a few ideas for trades from my daily reading and I would have to do further research on these stocks before putting on any trades. Further stock research would involve checking the stock fundamentals on Morningstar, Intelligent Investor or other independent stock research providers. If the stock has just fallen in price, I need to understand why it fell to help me decide if the stock is at a good value or if it is a stock to avoid. I would then look at the stock charts to help me determine the right time to put on a trade. I use technical indicators such as moving averages and MACD to determine the trend of the stock, if the stock is at a good support level, etc. Doing all this will take more time but again this is something I enjoy doing so it does not feel like work to me.
Some exciting news! I have received notification from my broker that weekly options will be available on select ASX stocks from 17 October 2016. This will provide us with more choices of duration for our option trades and I will write more about how this can help with our trading in another post. We can also find out more about weekly options in the upcoming ASX seminar called The Power of Options which will be held in all major cities.