I want to discuss today an investment strategy combining stock and options that takes great advantage of time decay. It is absolutely a bullish options strategy with limited downside protection and some upside risk. I am illustrating this strategy, which is quite popular with Dutch asset managers, among others, as a way of lowering the investment cost of a stock by selling both puts and calls.
Basically, the strategy calls for selling the at the money (ATM) straddle and buying half the amount of stock under it. I’ll say again, it is a 100% bullish options strategy, make no mistake about that. As such, I am neither advising for nor advising against this strategy but simply functioning in my role here as an options educator and illustrating an investment alternative.
Let’s use Facebook (FB) as an example. Using real time (July 30, 10:30 CDT) prices and using October options we can do the following:
Buy 500 shares of FB at 36.90. At the same time sell the October 37 straddle 10 times at 4.65 (2.15 in the call, 2.50 in the put). Our cash outlay is then $13,800 instead of the $18,450 it would be if we just bought the stock.
The straddle will decay with time no matter which way the stock goes. If the stock is higher we can buy back the calls, sell the stock and let the puts expire worthless. Alternatively, if the stock is lower we can, if we choose, not buy back the put but take assignment, giving us 1000 more shares of FB at the net price of 32.35 (strike price minus straddle premium received) thereby leaving us with 1500 shares of FB at an average price of 33.9, or 8.37% lower than its current price.
This strategy is even more interesting when a dividend is involved. Take AT&T (T) as an example. At this writing T is trading at 35.60 and will pay a $.44 quarterly dividend on September 5.
We can buy 500 shares of T at 35.60 and sell the October 36 straddle 10 times at 2.10 (.75 in the call, 1.35 in the put). After we collect the dividend if the stock is higher we can sell the stock and buy back the straddle closer to expiration after time decay has done its work or if the stock is lower we can take delivery of an additional 1000 shares at 33.90 leaving us with 1500 shares at 34.46 average price giving us a nice annual dividend yield of 5.22% (dividend note: T has increased its dividend every year since 1985)
So we see that if one is bullish on a stock this strategy is a cost effective way of investing. One final note of caution: Because the strategy leaves one net short 5 calls it is very unadvisable to do this in any stock that may be a takeover candidate.
As always, if you have any questions or comments, I can be reached either through this website or my own, www.thelissreport.com.
No positions in any of the mentioned securities at the time of publication.
Any opinions expressed herein are solely those of the author, and do not in any way represent the views or opinions of any other person or entity.