Disclaimer: please understand that options trading is complex and you should only pursue the activity after learning about the process yourself. This article is here to provide a different perspective on investing. It is not a recommendation for you to start options trading.
You say “bull put spread” and I say WTF? You too? Well, I’ve got a good one for you guys today. @blerghhh has been kind enough to bestow us with some excellent and controversial investment advice. Ever since we crossed paths on the internetz, I’ve been fascinated with @blerghhh’s investment style. His is very, very different from the standard stuff all of us personal finance bloggers spout day in, day out. To the uninitiated, this style seems controversial, complex, and dangerous. I laugh in the face of danger. Come check it out.
Mainly due to my own ignorance, I don’t yet 100% understand @blerghhh‘s method of making money in the stock market. Again, mainly due to my own ignorance, I probably would not employ this style myself. But @blerghhh shows how employing a profitable options trading strategy can be a very financially savvy play. Take it away @blerghhh!
A CRASH COURSE IN OPTIONS TRADING
There was a time in my life when I was full of youthful enthusiasm, zeal, passion for my craft and world-domination. If that’s you, don’t bother reading this. However, if you’re sick of the rat-race, want to spend more time with your family, have a few thousand saved up, can keep your life-costs down then I have an investing strategy for you.
If you think the stock market is gambling, than read no further. I have no interest in attempting to convert the closed minded. But if you are interested in a way to make incremental gains with highly controlled risk, without much volatility then you might want to pull up a chair.
I’m going to assume you’ve heard of the stock market, but you may not have heard of the options market. It’s where people trade contracts that represent the potential purchase or sale of the underlying stock market.
I won’t delve into the explanation much further than that because I can already hear the heads rolling. It’s really not that complicated, but it is a mind-job at first. Just do yourself a favour and don’t ever ask who or why is on the other end of your trade. (With thousands of traders, banks, insurance companies, etc. they all have different strategies and will be trying to do something else. So it doesn’t concern you. Save time and don’t ask)
My primary trading “thing” is called a “bull put spread”. It can go by other names like Vertical Spread or some such. But it can be dumbed down by saying it works like insurance. I’m insuring somebody’s stock price and hedging that by insuring my move by buying some of the same with a slightly lower face value. Hence the “spread”, which is the difference between the face value of my 2 positions. (face value = strike price). The biggest plus is that because your absolutely worst case is defined, the capital requirements to cover this move are very low, so you can collect the gains from hundreds or thousands of shares even if you could never afford to buy hundreds or thousands of shares.
As insurance has premiums, I collect premiums from the person I’m insuring and give premiums to the person insuring me. I’m on the hook for the difference between the two, but at the same time that’s my absolute drop-dead loss if I decide the play isn’t working out (because the underlying company has gone wrong). Otherwise, you can postpone your move by trading it to a similar move with a longer expiry. (Think “term” based on my insurance analogy)
So if things all go to plan then I keep the difference, which happens more often than not, provided you choose your entry wisely. Picking an entry depends on what company you want to do this on. I generally stick to big, boring, blue-chip stocks that are by all means bellwether friends and aren’t exactly the type a young, money-hungry, get-rich-quick-scheme desiring 20-something wants.
For an example, Apple Computers was one of the first spreads I publicly tweeted as a live-tweet trade (yes yes, I know it’s not a typical blue chip, but it’s huge and sells a LOT of phones), was on August 1st. Apple was Trading around $95-96 per share. I opened a bull-put-spread for 5 contracts (5 lots of 100 shares) $85/80 with a January 1st 2015 expiry. (Selling $85 puts and buying $80 puts.) I collected $1.08 (per share) for a total of $540 – commissions.
Now, the fun bit: Come January
1. if Apple goes up, I win
2. if Apple stays at $96, I win
3. if Apple falls but doesn’t go below $85 I win
4. If Apple falls to $84, I break even
5. If apple goes bust, I lose $500 (the spread) MINUS the collected premium $108 per contract of 100 shares.
However, there is a way to extend this thing by “rolling” the position into a new one, which would provide more time for apple to recover. (If that were the case). I picked Apple because I didn’t see it falling 12% or more in 6 months. Now that it’s gone up, it would have to fall 15% for my position to lose money.
Now the juicy bit:
5 contracts $500 spread = $2500
$1.08/s * 500 shares = $540 premium collected.
So a $540 potential max gain on $1960 max loss (2500-560) is a 27.5% gain in 5 months, which represents an annualized yield of over 50%.
How is this trade doing now, now that it’s October? Apple has gone up in value $10. Thus the premiums on my position have decreased. (Which is exactly what you want to happen). So I could close now (after 7 weeks) to capture 50% of it’s max gain. So this represents an even crazier annualized yield. Why not close it? Commissions. It’s only 1/2 way done. I’ll let it go to collect the full amount. I don’t need to trade trade trade all the time.
Now this example is one of the juiciest trades I’ve done lately. My typical targets are about 1/2 or 2/3s this much. I just like Apple, and the premiums were very compelling.
Summary: Why do I like this?
Low volatility. Your positions can survive considerable market/stock price drops.
Low capital requirements. You don’t need a lot of money to do this
Low risk. By doing this on a broad basket of stocks you eliminate sector and company risk, AND if necessary you can “roll” your troubles away.
predictable and steady gains
You won’t get rich quick
It does take some capital… My apple trade example requires $2500 of cash in the account for 5 months to make $540.
You can only do this in a taxable brokerage account, and nearly every broker in Canada charges crazy high fees for this sort of thing. Interactive Brokers is the best choice for this type of trade as their costs are less than 1/4 of what everybody else will charge.
Conservatively a 20% return is not difficult doing this, even on big blue-chip companies. You can even make 10-15% annually on positions that have enough wiggle room to survive market corrections of 30%
Update since writing: I also had a position I opened 1 month later for a similar spread on Apple. It was with a December expiry. I just closed it yesterday (position open for 28 days) after it had captured 80% of the maximum premium. Since I closed early, this represents an 80% annualized return.