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Enhancing Equity Positions with Options

Option Matters

Contributor:
Option Matters
Visit: Option Matters

By:

Head of Product Strategy for OptionsPlay

Introduction

Options are typically utilized and viewed as an instrument for trading the direction of stocks and ETFs with leverage. However, they are also useful to equity investors as a way to increase the yield of a portfolio by generating income and purchase stock at a discount. Investors looking to enhance their equity positions can write covered calls to generate income. Additional yield can be added by purchasing stocks at a discount with cash-secured puts. In this post we will explore which options strategies to use, how to implement them and best practices for maximizing their effectiveness. To learn more on how to enhance your equity investments with options, view our latest webinar.

Cash-Secured Puts

We will start by exploring cash-secured puts, since every equity investment begins with a stock purchase. A cash-secured put simply involves writing a put option while setting aside enough cash to buy the stock in case of assignment. By writing a cash-secured put, the option writer is obliged to buy the stock at the strike upon expiration if the stock is trading below the strike. This is primarily considered a stock acquisition strategy. Put writers receive a premium, so the strategy allows the investor to generate income while attempting to purchase the stock. Furthermore, the premium received from writing the option reduces the total cost of the stock in the event of assignment. To learn more about best practices for cash-secured puts, visit our blog post and webinar on this topic.

Consider the following theoretical example:

XYZ is currently trading @ $100/share

Goal: To purchase XYZ at $95/share, with a target price for the stock of $120

In the above example, XYZ stock bought through a put option is acquired at a $2/share discount compared to entering a buy limit order.

Strategy

The ideal outlook for this strategy is when the investor has a short-term neutral or bearish view and expects a longer-term rally. If the stock stays above the strike at expiration and there is no assignment, the investor keeps the premium as income. A put writer can continue to write puts and generate an income stream on the cash that has been set aside to acquire the stock.

Covered Calls

Once a stock is acquired at a discount using cash-secured puts, a covered call can further enhance this equity position by generating an income stream while holding the asset. There are two steps required for an investor to execute this strategy – owning a minimum of 100 shares of a stock and writing a call option against it. By writing a covered call, the option writer will be obliged to sell the stock if it is trading at the strike upon expiration. To learn more about covered calls, visit our blog post and webinar on this topic.

Covered calls and cash-secured puts can be combined to acquire a stock at a lower price and create an income stream while waiting to sell the stock at a higher price. Consider the following example:

The investor acquires 100 shares of stock XYZ @ $93 by writing a $95 put for $2.

The investor has a target price for the stock of $120.

Limitations

Combining both strategies is one way for investors to buy low (through cash-secured puts) and sell high (with covered calls). It also generates an income stream for downside protection while the investor waits for both the stock acquisition and sale trades to be executed. However, there are limitations to this strategy:

  • Patience is required, as options trades generally only execute at expiration
  • Opportunities may be missed when short-term price action can be captured by limit orders but not by the cash-secured puts or covered calls prior to expiration
  • Requires trading at 100-share increments

Best Practices and Tips

  • Acquire shares at a discount using cash-secured puts
  • Start writing covered calls immediately after acquiring shares
  • Use shorter-dated options to maximize time decay
  • Use a more aggressive strike (higher delta) on cash-secured puts
  • Use a more conservative strike (lower delta) on covered calls
  • Avoid writing options into earnings announcements

Summary

Options can be used for many different purposes and portfolios. Any equity investor with stock or ETF holdings should consider utilizing options as a way to generate an income stream to enhance the underlying positions. To maximize the yield of an equity portfolio, both covered calls and cash secured puts should be used together, as this allows the investor to generate an income stream while acquiring and holding the asset. Regardless of the portfolio, following the best practices mentioned above for each strategy and having a consistent, methodological approach will allow you to maximize the effectiveness of each strategy and enhance the yield of your portfolio!

Join the Montréal Exchange and Tony Zhang at the next Options Education Day in Toronto on Sept 14 to learn more about options and ask questions!

Originally Posted on September 12, 2019 – Enhancing Equity Positions with Options

Disclaimer:

The strategies presented in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.

Disclosure: Option Matters

This material is from Bourse de Montréal Inc. and is being posted with its permission. Opinions expressed in this document do not necessarily represent the views of Bourse de Montréal Inc.

This document is made available for general information purposes only. The information provided in this document, including financial and economic data, quotes and any analysis or interpretation thereof, is provided solely for information purposes and shall not be construed in any jurisdiction as providing any advice or recommendation with respect to the purchase or sale of any derivative instrument, underlying security or any other financial instrument or as providing legal, accounting, tax, financial or investment advice. Bourse de Montréal Inc. recommends that you consult your own advisors in accordance with your needs before making decision to take into account your particular investment objectives, financial situation and individual needs.

Although care has been taken in the preparation of this document, Bourse de Montréal Inc. and/or its affiliates do not guarantee the accuracy or completeness of the information contained in this document and reserve the right to amend or review, at any time and without prior notice, the content of this document.

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Information posted on IBKR Traders’ Insight that is provided by third-parties and not by Interactive Brokers does NOT constitute a recommendation by Interactive Brokers that you should contract for the services of that third party. Third-party participants who contribute to IBKR Traders’ Insight are independent of Interactive Brokers and Interactive Brokers does not make any representations or warranties concerning the services offered, their past or future performance, or the accuracy of the information provided by the third party. Past performance is no guarantee of future results.

This material is from Option Matters and is being posted with permission from Option Matters. The views expressed in this material are solely those of the author and/or Option Matters and IBKR is not endorsing or recommending any investment or trading discussed in the material. This material is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry or sector trends or other broad based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation to buy, sell or hold such security. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.

Disclosure: Options Trading

Options involve risk and are not suitable for all investors.

Options involve risk and are not suitable for all investors. For more information read the “Characteristics and Risks of Standardized Options”. For a copy, call 312 542-6901.

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