Selling out-of-the-money
calls and puts on a stock can reduce risk without having to concede all the
upside.
Editor's Note: Steven Sears, the regular writer of Striking
Price Daily, is on vacation. Today's guest columnist is
FINANCIAL STOCKS LED the market higher during the bull
market that began in March 2003, with the Financial Select Sector SPDR
exchange-traded fund (ticker: XLF) achieving a near perfect double from trough
to peak in May 2007.
Since that time, the shares of this fund have fallen 46%,
virtually erasing 93% of those gains in approximately a quarter of the time it
took to achieve that performance. Investors are now pondering the future of the
financial sector and what to do.
Rumors of acquisitions and more problems within the group are
raising concerns and interest. The second quarter ended with an increase in
volume and volatility, stretching from the brokers to the banks. Options on
insurance companies also experienced increased activity.
For the financial SPDR fund, implied volatility levels, the
measurement of option premiums based on time and expectations,
have recently risen from the May lows, to 45.83%. That's a relatively high
reading for an exchange-traded fund.
This reading is below the March 17 peak of 61.46%, according
to IVolatility.com and well above the 52-week low of 17.27% set nearly a year
ago. Concerns about the credit crisis and potential write-offs could keep
premiums high for the foreseeable future.In about two
weeks, banks will begin to report their earnings for the second quarter and
several may preannounce results and additional write-downs. Investors may be
looking for hedging opportunities, especially if they are planning to go on
vacation.
Relatively high option premiums and a bear market in the
sector have made the task difficult. One suggestion is to write calls against
existing positions in those shares, buffering any potential negative impact
with the premium received. However, this can severely limit any potential
upside should a positive surprise materialize, and may not provide enough
coverage against a negative impact.
One unconventional suggestion is to sell half of the existing
position in the underlying shares and write three-to-five-month
out-of-the-money calls and out-of-the-money puts against the remaining shares.
This would allow the investor to take advantage of high
premiums, in most cases, and help to buffer the remaining position. If the
stock does decline below the striking price of the put contract, the option
will likely be assigned, resulting in the repurchase of the half position that
was sold, at a price equivalent to the strike price of the put less the
combined premiums from both options.
If the shares rise above the call's strike price, the
remaining shares may be called away at an effective price of that strike price
plus the total premiums collected.
A good example is found in the shares of Bank of America
( BAC). The company is expected to report earnings on
July 21. The stock has lost 53.3% from its October high and is down 40.2% on a
year-to-date basis. The implied volatility level is just below the 52-week high
set on June 26 of 65.98%, and well above the year-ago low of 16.78%. One
potential strategy is to sell half of the stock position and then writing the
November 30 calls and November 20 puts, for a combined premium of $2.88 per
share, or 10% of the value of the underlying stock.
Should the shares drop below the $20 strike price, the shares
that were sold would be repurchased at an effective price of $17.12, nearly 30%
below the current value of the stock. If the share price rises above the $30
strike price, an effective sale price for the remaining shares would be $32.88
per share, which is 35.8% above the current market value. This would create an
effective average sale price of $28.55 per share or 17.9% above the current
price of Bank of America.
Investors need to be creative during periods of increased
volatility and sharp corrections. While these strategies may not result in
profits or even recovery of lost capital, they provide some downside cushion
and allow holders to use the higher premiums to help manage their positions
without putting additional capital at risk.
For those that have purchased the shares while they were
declining, this technique may help them reach or near the break-even point.
SCOTT H. FULLMAN is the director of derivatives investment
strategy for WJB Capital Group, a privately held institutional broker-dealer.