My Stock Trading Strategy: Using Options to Enhance Returns

by Silicon Valley Blogger on 2010-03-057

Can this interesting stock trading strategy help you beat the market? Let’s see what Stephen Jeske, an independent option trader, has to say. He’s come up with “themeatballeffect”, a complete swing trading option strategy. If you’ve gotten your diversified, core investments off the ground, have picked up some free investing tips and ideas from brokers like TradeKing and Scottrade, but would like to be a bit more adventurous, then you may be interested in learning how to manage trades for maximum profit potential.

Disclaimer: the following information is not for the weak-hearted. What’s ahead is a description of some pure stock market plays (and trades) that I’d consider only relevant to those who are highly interested in active investing and trading (e.g. this may not be for the average long term equity investor).

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Think of your favorite stock. Surely, there must be a price at which you would be willing to buy more. Conversely, there must be a price at which you would gladly sell your existing shares. Today, we’ll show you how to buy that stock at a discount and sell it at a premium each and every month. The goal is to do this consistently enough so that you increase your portfolio returns while reducing its volatility. This technique can also be a wonderful complement to a mutual fund investment portfolio or a basic stock portfolio.

Regular readers of The Digerati Life may already have read about using options to buy stocks at the prices you want. But it’s the combination of both techniques, buying at a discount and selling at a premium, that really makes the difference.

Getting Started With My Stock Trading Strategy

The best way to learn this technique is by discussing an example (but I’ll change the names). The only thing I will leave out is the commission and taxes. We won’t use any margin here either. So let’s check our favorite stock The Digerati Life (symbol TDL).

As I’m writing this, my discount broker account shows that TDL is currently trading at $127.47. Let’s buy 100 shares for a total cost of $12,747. I’m willing to sell my 100 shares of TDL for $135 if it hits that price over the next several weeks (e.g. 58 days).

So I sell 1 MAY 135 Call for $62. (100 shares equals 1 option contract).

I’m also happy to buy 100 more shares of TDL for $120 if it hits that price over the next several weeks. I have an extra $12,000 cash sitting in my online broker account, ready to buy those shares.

So I sell 1 MAY 120 Put for $107. (100 shares = 1 option contract).

Now whatever happens, I get to keep the $169 ($62 + $107) option premium that I sold. Let’s look at the possible outcomes:

  1. Scenario 1: TDL reaches $135 or more at the end of 58 days. My stocks get called away. By selling that call option, I agreed to sell my stocks at $135. So I’m selling at a premium because I also collected $0.62 + $1.07 per share from the call and put I sold. I’ve made a profit on the stock, I’ve made a profit on the call option I sold, and I’ve made a profit on the put option I sold. Altogether it works out to a 26% annualized return.
  2. Scenario 2: TDL reaches $120 or less at the end of 58 days. I have to buy 100 more shares of TDL at $120. That’s the agreement I made when I sold the put. (I’m buying at a discount but I’m also collecting $0.62 + $1.07 per share from the call and put that I sold). I’ll have a paper loss on my shares, but I will also have an extra $169 cash in my account. That’s from the put and call that I sold.
  3. Scenario 3: TDL remains in between $120 and $135. Both the put and the call expire worthless. I will still have 100 shares of TDL and $169 in cash from the call and put that I sold. I’ve reduced the cost basis of my shares by $1.69 per share.

But what do we do in the next cycle?

  1. In the first scenario, I could buy 100 shares again, then sell 1 call and 1 put.
  2. In the second scenario, I could sell 1 or 2 calls, since I now own 200 shares. I could also sell a put, if I were comfortable with yet again owning more shares.
  3. In the third scenario, I can sell 1 call and 1 put, since I own 100 shares.

Using Options to Enhance Returns: The Key To Making This Work

This strategy works best on the more stable stocks — definitely avoid dealing with the cheap stocks. Also, any companies in wacky industries will just cause you too much grief: sure, you can collect a lot from selling the options of volatile stocks, but that’s because these stocks move around a lot… in fact, too much in most cases.

You also need to acknowledge the fact that you can’t predict prices. You can’t be greedy nor resentful; you need to focus on your own success. Use this technique consistently and you won’t have to worry about stock market timing.

If the stock shoots way up and it’s called away, you can’t be too upset. You made a good profit, be happy. If the stock drops to the strike price of the put ($120 in our example) you have to be comfortable buying it. You can’t be second guessing yourself and constantly changing course mid-stream.

In order for this to work well, you need to be consistent, systematic, disciplined and capable of following a plan. But aren’t those the hallmarks of a successful investor anyway?

Copyright © 2010 The Digerati Life. All Rights Reserved.

{ 6 comments… read them below or add one }

basicmoneytips March 6, 2010 at 6:37 am

This is a very good article. I must admit, I have never traded options, but have considered it. However, I have a close friend who trades options regularly, and he basically has the same advice as you.

First, find a stock you would not mind owning. Second stick with stocks from a good company with a proven track record. Companies such as Apple or IBM were always candidates he mentioned, but there are 100s of others.

Simon Paul March 7, 2010 at 11:50 am

I’m learning the ropes on options right now. So far, I’ve been testing things out with a play account. I’m having more fun than making money at the moment, but we’ll see how it goes. How much of my money should I risk on this? I’m starting out small, and see how well I do.

Silicon Valley Blogger March 7, 2010 at 12:06 pm

I believe that you should try this strategy out only if you’ve done everything else — building a core investment portfolio that’s well diversified. I’d go through traditional investing approaches first before going with anything more adventurous. But in the investing world, there’s always a market for those who want to have a bit more fun (along with the requisite risk) with stock and options trading. Make sure you watch your step!

Question I have here is this: would you use options to try to enhance returns and make more money, or would you try it out to manage your risks better (or both)? I’m with the camp that cares more about investment risk management.

Stephen March 14, 2010 at 12:38 am

This seems like a terrible strategy to advocate for the average investor and it’s not clear to me that it reduces volatility. If the stock drops below 120 then the put option increases your losses as you effectively double down (you lose on both the 100 original shares and the 100 from the put). If the stock rises well above 135 then you’ve totally neutered any upside. In the past year, we’ve seen huge swings on stock prices to the tune of +/- 50% or more.

Basically this strategy exposes you to potential losses of 200% of the initial investment for a maximum upside of only +7%.

In order to make excess returns on this type of scheme long term you need to be able to accurately price the call and put options and identify when they are mispriced. Which is going to be very difficult when you consider that buyer on the other side of the transaction is likely very sophisticated.

jayagopal March 15, 2010 at 6:22 am

I think this trade can be used with some technical analysis indicator, when the 200 simple moving average is in a flat position. This strategy works.

Anthony September 11, 2011 at 4:28 pm

Several strategies for different market conditions. One of the best strategies I have found successful is the Elliott Wave combined with Fibonacci with the current market conditions, the results have been awesome. Mind you this is in the Australian Market. The US market seems daunting to me, however I’m keen to learn more.

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