I was recently reviewing articles related to option trading and came across a strategy I had never actually considered. Even though I’m an experienced stock and option trader I still research and read about trading and trading strategies constantly. I learn something new every day and sometimes I come across a strategy or idea that makes perfect sense, yet I had just never considered it.
LONG-TERM DITM PUT WRITER
Wow, there’s a title. What does it mean? Well, let’s start with the long-term, most option traders think short-term. It’s who we are and we like short-term for various reasons. One reason in particular for me is less exposure to the market overall. If I can make 3-5% in less than 30 days, I’m not exposed to the market unless I want to be. Thinking long-term with an option seems strange to me at first because of how I’ve been programmed.
DITM means “deep-in-the-money” so the put option(s) we’re selling will have a strike way below the current underlying stock price. The farther below the current stock price the better.
The put is simple enough – we are selling cash-secured put’s which provide the buyer (we are the seller) the right, but not the obligation to “put” their shares of stock onto us (the seller) if the underlying stock price falls below the agreed upon strike. We (the seller) are legally obligated to buy said shares from the buyer at the agreed upon strike price.
The writer just means we are the writer of the contract or seller, not the buyer. This also means that as the seller, time decay or time is on our side. Always a good thing.
For this particular strategy long-term would be a year or more. WTF? A year? Are you crazy? Well, not exactly. It sounds strange at first, but the more I thought about it the more I liked the idea and maybe you will too.
So let’s look at an example: say we have $200,000.00 to invest and this is not our “trading” portfolio this is more a long-term hold account that we manage because we’re better than money managers (joke, but true). We have 200k and we want to almost guarantee a certain percentage return for twelve (12) to twenty-four (24) months.
Wow, still sounds like a long time…because it is. Regardless, the trade is so simple it’s weird. We like Nordic American Tanker [stock_quote symbol=nat] so we feel like we understand the industry, the fundamentals and stock technical analysis and don’t mind potentially owning stock. What we want to do is look at the January 2018 option chain. That provides seventeen (17) months of return (and yes exposure). What strike? Any of them really as long as they’re DITM and the premium return is worth tying up cash (as collateral) for that long.
The first strike we will review is the $3.00. The option chain will be the JAN 18 expiration $13 PUT. It is currently trading at .28 cents per contract or a very respectable 9.3% return for seventeen (17) months. On an annualized basis that is slightly more than 6.2%. No one can really argue with 6.2% return in today’s market. The risk level is extremely low, but more on that later.
The second strike we will review is the $10.00. The option chain will be the JAN 18 expiration $10 PUT. It is currently trading at $3.00 per contract or an extremely respectable thirty (30) percent return for seventeen (17) months. On an annualized basis that is slightly more than 20%. Wow. 20%? Who is getting that in their annuity? NO ONE! This strike is not as safe as the $3.00, but pretty damn safe given the break-even would be $7.00 per share.
WHAT’S THE RISK – REALLY…
The risk is always there. Nothing is without risk, but what is it…in reality? Well, the market could always crash completely. Oil could go to .50 cents a barrel and there might be no need to transport it. An asteroid might hit the planet and destroy mankind too. Anything is possible.
Seriously, the real risk is the underlying stock price falls below the break-even price of the transaction. The break-even is the strike minus the premium we were paid for the transaction. For the $3 strike your break-even would be $2.72 per share because we paid .28 cents. The underlying would have to drop below $2.72 to lose money. This would be a roughly 80% drop in the stock price. Likely? Yes. Probable? No.
With the $10 strike your break-even would be $7.00 per share. Again, the underlying stock price would have to drop below $7.00 to lose money. That would be a roughly 45% drop in the stock price. Again, likely? Yes. Probable? No.
If you use the $200,000.00 and this strategy with the $10.00 strike for JAN 2018 (which is what I would do) the premium would be $60,000.00. Yes, 60k would be paid to you, the seller, of this transaction. Let’s say that in six (6) months, the market starts crashing and you want out…just buy the contracts back. Maybe you’ve burned 10k or so of the premium and you walk out profitable. No one ever said you had to hold the contracts for the entire 17 months. In fact, if NAT goes up immediately or next week you could make a great deal of the premium quickly. Happened to me a few weeks ago with Freeport-McMoRan [stock_quote symbol=fcx}.
THE OBJECTIVE AND PURPOSE
If you’re a long-term investor, a big picture thinker and you would like to almost guarantee a certain annual percent return you may want to consider a far out expiration DITM cash-secured put option strategy. Take less risk and sell a strike far, far away from the current stock price and you’re almost guaranteed to profit.