A Little-Known Twist to Options Trading

Karim Rahemtulla By Karim Rahemtulla, Options Strategist, The Oxford Club

Alternative Income

I remember sitting with a broker from Smith Barney (now a part of Morgan Stanley) some 10 years ago.

I was trying to explain that, when factoring in risk, the covered call strategy I personally used at the time would beat the pants off a conventional covered call strategy.

He couldn’t get past the fact that I was willing to sell the shares at a price below the current price.

He wasn’t disputing that I would make money. But in his world, the only covered call strategy was one where you sold above the current price.

That’s one of the problems with those on Wall Street. They have one mantra: Stocks only move higher.

The strategy I used gave me downside protection. My interest was not in beating the pants off the market… but beating the pants off my returns from cash with a system that provided winners more than 80% of the time.

The wins weren’t huge, and the strategy was much like watching paint dry in terms of excitement. But when you consider that cash was paying less than 3% at the time, making two or three times that amount regularly – with 20%-plus downside protection – was just fine by me.

I also maintained another portfolio, one that invested in stocks and options for the purpose of capital gains. This strategy was strictly for the cash/fixed-income component of my account.

The downside came only if the market crashed. But even then, I wouldn’t lose as much as someone who did a normal covered call strategy or someone who held a stock with absolutely no protection would.

There is only one way to never be exposed to a market crash: Don’t invest in the market.

I’ve been using covered call strategies for almost 20 years now. However, the way I do it has a twist that few people are familiar with…

But it works well only during periods of volatility, when options premiums are much higher than they are currently.

So the current environment is not ideal. When volatility returns, however, you’ll be happy that you know this strategy. That’s why I’m suggesting you print this and put it with your other important papers.

What I do, and what you should do, is invest using deep-in-the-money (DITM) covered calls. By using a DITM strategy, you can accomplish several things. You can…

  • Lower your cost of entry into a stock that you like
  • Beat the returns from cash
  • Increase your margin of safety on any trade
  • Capture the dividends that might be available for shareholders, something not available to put sellers
  • Execute trades in any account, including your retirement account, without the need to try to qualify for selling puts – which many people cannot qualify for.

DITM covered call investing requires that you buy shares of a company and sell options against those shares. With a DITM strategy, it means finding a strike price that’s well below the current share price. This is where the strategy differs from conventional covered call investing.

Remember, with DITM, you’re seeking good returns on your cash while reducing your risk. Holding cash is considered a risk-free investment, so the object here is not to significantly increase risk – that can be accomplished in the regular portion of your portfolio.

How the DITM Covered Call Strategy Works

Let’s take a look at how the strategy works by using stock XYZ as an example…

You would buy XYZ at current levels of $15. Against this position, you would sell the XYZ $13 calls expiring in January. These calls are currently paying you $2.70, plus another $0.40 in dividends over the course of your holding period. Of the $2.70, only $0.70 is premium, and the $2 is intrinsic value, since the shares are trading above the strike price.

To calculate your return on this trade, you need to figure out your ultimate cost first.

  • In this case, it would be around $11.90 ($15 minus $2.70 minus $0.40).
  • The profit potential is your ultimate cost subtracted from the strike price ($13), or $1.10.
  • Your return is that $1.10 divided by your ultimate cost ($11.90), or about 9.2% in this case – dwarfing the returns from cash.

Your downside cushion is 20%. That means XYZ would have to fall 20% further from the current price before you were faced with a loss.

  • If XYZ stays at current levels, you make 9.2%.
  • If it falls, but not under $13, you make 9.2%.
  • If it goes up, you make 9.2%.

You can lose money only if it falls below $11.90 (your ultimate cost). Then you would sell more options to take in more income and reduce your cost further. The ultimate goal is to own the shares for zero or even a negative cost.

As the saying goes, “cash is king.” But that’s true only most of the time. If left sitting for long periods of time, cash can quickly lose the battle against inflation.

It’s important to have a strategy if you’re holding cash. This is one to consider in the future, especially when market volatility returns.

Good investing,

Karim

P.S. I recently discovered an options strategy that pays you to own stocks at HUGE discounts. Netflix trades for $165. But imagine getting $1,200 for the chance to get shares for $75. To learn how I do it, click here now.