I recently had client who is bringing more money into his account. This money was already earmarked for equities(stocks) in his portfolio because his fixed income portion, in other words his “bonds,” is already providing income and working fine. He is aware that the equity market is pricey, and I tend to not want to buy stocks when they are expensive. But that doesn’t mean we can’t go fishing for stocks that he would want in his portfolio at a better price and even if we don’t get to buy them at that better price, we will make money for his account.
When I explained to him that we could sell “out of the money” cash covered puts, I knew I would get a blank stare and a proclamation from him that he has no idea what I’m talking about. My explanation went something like this; first we want to identify some companies whose stock he would want to own. For exemplary purposes of this strategy, we will use Apple.
What I’m about to explain is a technique using options to build a portfolio or just to gain revenue into your account. Apple is a technology company that has a beta of 128, which means it is more volatile than the benchmark S&P 500. This higher beta or volatility means that the option premium, when collecting will be high in relation to a less volatile stock. Presently Apple is trading at $315. If we look out one month in the future, we could sell a “put” with a strike price of $315 for $850, so this is an “at the money” put. For this “put” which represents 100 shares Apple, we will receive $850 in premium that goes directly into the clients account. By the time this option contract expires in about one month, one of three things will happen. The first thing is that Apple does not move under $315 and the $850 remains in the clients account. The second thing is that before expiration the time element or intrinsic value of an option contract could make it worth next to nothing, which the client could buy back just to ensure the fact that the stock will not get put to them. The third thing that could happen is that Apple moves below $315 and the stock gets “put” to the client at our strike price of $315 less the $850 of premium which we collected to give the client a purchase price equivalent to $306.50.
The client needs to keep $31,500.00 of cash in the account in case the stock is put to them. $850 is collected for the one-month period, that is 2.7% return on the money for the 30 days, even if the client never has the stock “put” to them!
This option strategy allows my client not to “chase the market” and bid on stocks at lower prices while keeping the premium dollars if the stocks are not “put” to them.
