In 2020, options trading contributed 9.2% of my 2020 portfolio gains. The options tactic that I utilized the most was selling a weekly at-the-money (ATM) straddle combined with a weekly or semi-weekly short deep in-the-money (ITM) put. This post describes the what, when, and how of this technique. As always, I’m just sharing the method I used and continue to use for my own trading. This post should not be considered as advice or as encouragement to try this method. I can’t emphasize enough that I consider a thorough understanding of the company’s fundamentals a prerequisite for my options trading activities. Here is a specific example showing the implementation of the method.
THE TECHNIQUE
A three-legged options trade:
- Sell to open 1 short ATM call (one week or less until expiration)
- Sell to open 1 short ATM put (one week or less until expiration)
- Sell to open 1 short deep ITM put (usually 10-20% in-the-money; 2 weeks or less until expiration)
By selling these three options, we collect premiums on each of the legs. I consider the size of the combined premium of the short straddle (i.e. ATM call and ATM put) to be a very important factor in the decision to enter into the trade. Specifically, for selling the ATM straddle with about one week until expiration, I have seen premiums range from about 3% to 16% as a percentage of the strike price. For example, if the shares and strike prices of the straddle legs are $100 and the premium for the call is $4 and the premium for the put is also $4, then we collect $8 or 8% of the stock price.
The deep ITM put is similar to buying shares but with less capital. In the same example (see the previous paragraph above) of a $100 stock, selling a $120 put with 1-2 weeks until expiration would usually yield slightly more than $20 ITM value premium. The purpose of selling this put is to protect against losses from the short call leg of the straddle. Remember that we are trading options on a stock that we believe will have a tendency to rise.
MULTI-WEEK ONGOING TRADE
I often use this trade on the same underlying stock over the course of several weeks. The use of options that expire in a week or less enables time value decay harvesting sequentially for several weeks by closing the trade at or near expiration and simultaneously selling the options for the following week. Below I will describe the details of how this works.
THE RISKS ASSOCIATED WITH THE TRADE
There are two main risks associated with using this technique. I will continue to use the hypothetical example of a stock price of $100.
Stock price drop
When selling a put, we’ve sold a contract that obligates us to purchase the underlying shares for the strike price. In our example, we have sold two puts, one with a strike price of $100 and a second one with a strike price of $120. Since each option controls 100 shares of stock, the maximum loss from the puts is $100 x 100 shares plus $120 x 100 shares which equals $22,000. However, the collected premiums of $8/share for selling the straddle and $20/share for selling the deep ITM put offset any loss. Therefore, the true maximum loss for the trade is $22,000 less the $2800 already collected, which equals $19,200. This maximum loss would occur if the underlying stock dropped to zero.
A small drop in the stock price, however, can still result in a profitable trade. In our example, the premiums collected would offset losses all the way down to a share price of $96 or a 4% drop in the underlying shares.
Stock price rises significantly
The stock price would need to rise significantly to realize a loss from the trade. A loss from a stock price rise would be the result of the short call leg of the straddle. The deep ITM put completely offsets this loss up to a share price of $120 (a 20% increase). In addition, the $8 in collected premiums from selling the straddle offsets an additional $8 per share rise thereby giving protection up to $128 or a 28% share price increase. However, since there is no upper limit to how high a share price can rise, losses on the trade due to the short calls on the straddle can be unlimited. The short deep ITM put and the premiums from the short straddle offer protection up to a point, but I almost always own the underlying shares so the short calls are also covered by shares that I own.
WHEN I USE THE TECHNIQUE
As a reminder, understanding the underlying stock on which options are traded is the primary basis for my decision to enter into options trades. I like to use the tactic discussed in this post when all or most of the following conditions are met. Options trades using this technique comprised the vast majority of my options trades in 2020. Note that each condition is not an absolute truth, but it is my personal opinion.
- The stock is undervalued.
- The chance of the stock dropping significantly is limited.
- There exists a catalyst in the near future (e.g. upcoming earnings announcement).
- I am not interested in making a directional bet on the stock’s response to the catalyst event.
- The stock is likely to rise in the coming weeks.
- Premiums received for selling the ATM straddle are high as a percentage of stock price.
Let’s go through each condition and examine why I think it is important.
Undervalued stock
A stock being undervalued or not is always an opinion based on some assumptions. Therefore, it is up to each investor to reach their own conclusion of the value of a stock based on his own assumptions. For me, an undervalued stock has a higher margin of safety and therefore more limited downside. The degree to which I think a stock is undervalued may influence the amount of risk that I am willing to take on options trades using this method.
Chance of stock dropping significantly
The chance of a stock dropping can never be known for sure. This is also an opinion that can range anywhere between a wild guess and an educated one. Since I don’t like to lose money, I prefer to make trades based on educated guesses. When I believe that a stock is undervalued, it increases my confidence that the stock is less likely to drop. I look at a lot of other information and for me the final assessment is very nuanced. Again, each investor will need to weigh the facts and his opinions to reach a final conclusion, which can drive action or inaction.
Upcoming catalyst
An upcoming catalyst, often an earnings release, is an important consideration for entering this type of trade because the volatility on the stock typically remains high due to the uncertain outcome of the catalyst event. High volatility means that the premiums for selling the ATM straddles will remain high until the date of the catalyst passes. I often like to begin the first trade several weeks prior to a catalyst event so that I can continue to trade the weekly options for several weeks before the volatility drops back down.
Stock likely to rise
Anyone who could consistently predict stock price rises over a short timeframe would be insanely wealthy. I certainly don’t have such an ability. However, it is common for stocks to rise going into a catalyst event such as an earnings announcement.
High premium
A higher premium for selling the straddle makes the trade more attractive. When a stock is volatile the options for that stock are more expensive. For trades on underlying hypergrowth stocks that I own, I prefer to enter into trades for which I receive weekly premiums of at least 5% for selling the ATM straddles.
The conditions described above provide me with a framework for making decisions about which options trades to enter. Since this technique includes short put contracts, it requires either cash reserves or available margin capacity, both of which are finite. Therefore, especially when I see multiple stocks to target with this technique, I must choose carefully not only which trades I enter but also the size of each trade.
THE TRADE WITH OR WITHOUT A CATALYST
No Catalyst
The method can be used without a catalyst. If I believe that the stock is undervalued, that the downside is likely limited, and that the stock will have a tendency to rise, then the trade has a good chance for profits. In this case, there is no catalyst, so the timing of a rise is not known. However, if the stock merely stays at its current price then the method will deliver weekly profits from the time value decay of the short straddle. Therefore, when I have identified a stock or stocks that meet some of the conditions outlined above and there is no upcoming catalyst, I may still execute these trades. I may then continue these trades until the conditions change or until I’ve identified a better trade to execute.
Catalyst
A better trade may be, and often is, that one of my other stocks has an upcoming catalyst, which can increase volatility (and therefore the options premiums) and also help provide support for the stock price. Many of the trades that I enter using this technique involve an upcoming earnings announcement. Initiating the trade multiple weeks prior to the earnings provides several opportunities to profit from collected premiums and decaying time value, assuming that the underlying stock either holds within a relatively tight trading range or rises. Exiting the trade prior to the catalyst event eliminates the risk that the catalyst could cause the stock price to fall. If we want to bet on the outcome of the catalyst, a likely better trade than carrying the downside risk of holding two short put positions and one short call position might be merely holding a long call position.
THE ADVANTAGE OF TIME
Unlike buying call options, which requires paying a premium in exchange for a limited period during which the stock must rise, an advantage of this method is that being right on the timing of a stock price rise isn’t required. In fact, the opposite is true because with this method we are selling options, collecting a premium, and with the passing of time watching the time value decay. For example, consider a stock with a price of $100 and a combined premium of $6 for selling an ATM straddle with one week until expiration. Selling the straddle and collecting the $6, will provide $6 in profit if the stock stays at $100 after one week. Rinse, repeat, and the next week another $6 and 6% is earned. Since I invest in hyper growth stocks that I expect will significantly rise in value, I prefer to sell the deep ITM put to protect against losses on the short call leg of the straddle.
SELLING STRADDLE: MAXIMUM PREMIUM ATM & SHORTEST EXPIRATION
When selling the straddle, I’ve found that the maximum combined premium of the call and put options occurs when the strike price of those options is at the current stock price (i.e. at-the-money). Therefore, I usually select the strike prices of the short straddle to be as close to the money as possible. I select the nearest possible expiration date because this enables me to maximize time value decay. This is still the case when the nearest expiration is less than one week away; for example, if I were first entering into a trade on a Wednesday, my preference would be to sell the straddle that expires in two days rather than the straddle that expires in nine days.
ROLLING FORWARD
The Straddle
Rolling forward means closing out an option position and simultaneously opening another option position with an expiration further in the future. For example, if on 8Jan2021 we had sold an ATM straddle on a $100 stock with an expiration of 15Jan2021, and it is now 15Jan2021, we could buy to close the15Jan2021 $100 call and the 15Jan2021 $100 put and sell to open the 21Jan2021 $100 call and the 21Jan2021 $100 put. We would receive a net credit for this trade. Since we are the seller of these 21Jan2021 options, we are granting an additional week of time to the buyer on the other side of our trade in exchange for cash consideration. By 15Jan2021 the time value of the 15Jan2021 options has mostly decayed. The rate of time value decay accelerates the closer the option gets to expiration; therefore, to maximize premium collection, it is most profitable to sell options with the nearest expiration and then, when the options are very close to expiring, rolling the options forward to the next available expiration.
The Deep ITM Put
On the other hand, for deep ITM puts, most of the value is intrinsic (i.e. there is very little time value) so rolling the option forward very close to the expiration provides little, if any, additional benefit/credit. In fact, the deeper ITM the put is the smaller the credit for rolling forward; in some cases, rolling a deep ITM put forward only one week may require a debit trade. A debit trade for the deep ITM put roll may be avoided by rolling the option forward by two or more weeks. In fact, I often roll forward the deep ITM put several days before expiration since there is little benefit in waiting.
Early exercise of deep ITM puts happens occasionally and will cause a share assignment in my account. In this case, I usually just sell the shares that were assigned and then sell the deep ITM put again.
If the shares rose from the previous week, I may or may not choose to roll up the deep ITM put to a higher strike price.
ROLLING FORWARD WHEN THE SHARE PRICE HAS MOVED
Above I’ve described how rolling options forward works. I’ve also previously stated that I like to sell the straddle as close to the money as possible. What if it’s time to roll options forward and the underlying stock price has moved up or down? The first decision is whether the stock price movement has changed my view on whether I want to continue with the trade or close out the trade; I will discuss this in the next section below. Assuming that I want to keep the trade going in spite of the stock price move, I will almost always prefer to sell the following week’s straddle with strike prices nearest to the new current price. Let’s continue with the previous example. Let’s assume the date is now 15Jan2021 before the market has closed, and we have the following open positions:
Short 1 contract 15Jan2021 $100 Call
Short 1 contract 15Jan2021 $100 Put
Short 1 contract 15Jan2021 $120 Put
The share price has now moved up 5% from $100 to $105. Therefore, if we do nothing, the $100 call will cause the sale of 100 shares at $100/share, the $100 put will expire worthless, and the $120 put will cause an assignment (i.e. forced purchase) of 100 shares for a price of $120/share. In this case, we’ll replace the short straddle with a new $105 straddle; we’ll also replace the $120 short put with another deep ITM short put with a farther out expiration date; in some cases, we may decide to increase the strike price of the deep ITM put to maintain the buffer in the event the underlying shares rise sharply. Thus, the actions on 15Jan2021 would be the following:
- Buy to Close 1 15Jan2021 $100 Call (cost to close will be approximately $5/share)
- Sell to Open 1 22Jan2021 $105 Call (premium received would be about $3.15)
- Buy to Close 1 15Jan2021 $100 Put (cost to close will be less than $0.05/sh or could let it expire worthless)
- Sell to Open 1 22Jan2021 $105 Put (premium received would be about $3.15)
- Buy to Close 1 15Jan2021 $120 Put (cost to close would be about $15/sh)
- Sell to Open 1 22Jan2021 $120 Put (premium received would be about $15/sh)
The costs to close and premiums received to open the above trades are not based on actual quotes but are within an expected range for options on a hyper growth stock. For this example, we’ll assume that the volatility on the stock remained the same as it was one week prior. Thus, the $100 stock which on 8Jan2021 yielded a $6 or 6% for the combined ATM call and put legs of the straddle still yields 6% for the 15Jan2021 straddle but now the premium is $6.30 ($3.15 per leg) or 5% more since the new price of the stock rose 5% to $105. To execute the above trades, I would typically combine #1 and #2 in a combination/roll trade for a net debit, combine #3 and #4 into a combination/roll trade for a net credit, and combine #5 and #6 into a combination/roll trade for a small net credit. If I prefer to let #3 expire worthless then I would just execute leg #4 independently. I would like to emphasize a few generalized points using the above hypothetical example.
First, in the above example, since the stock price moved up, the 15Jan2021 short call option is the “losing” leg of the trade. However, rolling forward the option enables us to minimize the loss. Assuming that we originally received a $3.00/share premium for selling the 15Jan2021 $100 call option on 8Jan2021, our loss on that leg of the trade was only $2.00/share since there is virtually no time value remaining when we closed the trade on 15Jan2021. Furthermore, when we sold the 22Jan2021 $105 call option, we are receiving the time value portion of the premium for a second time. Thus, rolling forward is a powerful technique for minimizing losses when selling options. In addition, rolling the call forward and up from $100 to $105 rather than just rolling the call forward, allows us to capture more value.
Second, for the third leg (i.e. the closing of the 15Jan2021 $100 put), our profit is the entire (assuming we let the option expire worthless) or almost all (assuming we buy to close the $100 put for $0.05/share or less) of the premium that we received on 8Jan2021. The combined profit from the prior week’s selling of the 15Jan2021 straddle was $2.95-3.00/share.
Third, the short $120 put for which we had received a $20 premium on 8Jan2021 was repurchased for about $15 for a $5 profit bringing our profit to about $7.95-8.00/share. If we simply roll the deep ITM put forward and not up then this put is now less in the money (i.e. $15 above the stock price compared to $20 above the stock price the week prior). In this example, we chose not to roll up the deep ITM put; however, we could have rolled up the deep ITM put to say $125.
Fourth, in this example, the stock price increased $5 in one week, and there were two sources of profit. First, the 5% move in the stock price was less than the 6% premium received for selling the straddle resulting in a small profit. Second, the increase in stock price lowered the value of the short deep ITM put thereby creating a profit. Conversely, had the stock price fallen 5%, the short deep ITM put would have shown a $5/share a loss, but the short straddle would still show a small gain as the 6% in premiums collected was greater than the 5% drop in the stock price.
Fifth, two key benefits for selling options are the collection of premiums and the advantage of time for the ongoing trade to become profitable. In fact, even if the underlying shares drop and losses are incurred, the eventual rise of the shares will allow us to recoup all these losses plus additional profit if the trade is rolled forward repeatedly.
WHEN TO EXIT THE TRADE
There are various reasons for exiting the trade. Below are a few.
Shares are less undervalued or no longer undervalued
An important condition for entering the trade is that the underlying stock is undervalued. The higher the share price rises the less undervalued it becomes. Alternatively, new information that changes the opinion of the stock’s valuation, even if the stock price remains unchanged, can also affect the decision to exit the trade.
Better target stock for this type of trade
A short put position either ties up cash or adds to margin. Either way it is utilizing a finite resource so there is an opportunity cost to holding onto a trade when there is a better one available. The trade can be closed for the simple reason that there is a better stock target for this method.
Close the trade prior to the catalyst
Holding short put positions through a catalyst event involves the risk of the catalyst triggering the stock to decline. This method can be used to earn profits in the weeks leading to the catalyst event. Exiting the position prior to the catalyst outcome sidesteps this risk. If the investor wishes to bet on the catalyst event itself, buying a call option could provide upside with less downside risk.
Reduce leverage or risk exposure
Not every investor uses leverage, and investors vary in their risk tolerance. Personally, I remain fully invested most of the time, but I also dial up and dial down margin and leverage for a number of reasons. If I’m inclined to reduce my margin/leverage then I may choose to close an options trade simply for that reason alone.
I try to remember that trading is different from investing. While this method has been very profitable for me, my utilization of this method is a trade even though I usually also hold shares in the same stock as an investment. I don’t expect all my trades to be profitable and sometimes it’s prudent to accept a loss and exit the trade or move on to another trade.
The opinions, thoughts, analyses, stock selections, portfolio allocations, and other content is freely shared by GauchoRico. This information should not be taken as recommendations or advice. GauchoRico does not make recommendations and does not offer financial advice. Each person/investor is responsible for making and owning their own decisions, financial and otherwise.