Using Options to increase gain and reduce risk

There are probably as many trading strategies for options as there are traders. Some buy calls to leverage gains; others buy puts to protect positions. This article is about using option strangles to increase gain and reduce risk.

A strangle, as I use the term, consists of selling a put and a covered call on the same stock for the same expiration with different strike prices. For example, if you own 1000 shares of Alcoa at $16.27, a possible strangle would be to sell ten of the April 16 puts (last at 88 cents) and also sell ten of the April 17 calls (last at 72 cents). Normally, I couple these strangles with the purchase of the stock when I open new positions, but I also use them on occasion with stock I already own. If you look at the Alcoa example just listed, you see that if you bought the stock, you paid a net of $14.67 per share for the stock/option position. If Alcoa rises above $17 by the April expiration, you have a profit of $2.33 per share for an annualized return of 63%. If Alcoa closes unchanged in April, you still have the stock and keep the option premiums of $1.60 (an annualized return of just under 40%). If Alcoa goes down below $16 at expiration, you will buy another 1000 shares of stock at $16 when the puts are assigned. Your composite purchase price for the 2000 shares will be $15.33 ($16.27 for the first 1000, plus $16.00 for the second thousand, less the option proceeds of $1.60.) In other words, so long as Alcoa is above $15.33 on the April expiration, your trade will be profitable. That means that Alcoa must decline by over six percent before you will start to lose money on the trade.

The whole point of using a strangle is to take advantage of the time value that others are willing to pay when buying the options you are selling. Obviously, the time value for options is not the same for each stock, so the point is to look for stocks where the options have high premiums. To do this, I focus on stocks that have strong fundamentals, good buzz and rapid recent movement. Right now, a good example of this is Entropic Communications Inc. (symbol ENTR). Entropic makes chips that allow for the dissemination of entertainment like video throughout a house. Entropic’s products are used in the multi-room DVR’s that many of the cable and satellite TV companies now install. The current consensus estimate of earnings for 2011 is 76 cents, up from 53 cents in 2010. In the last twelve months, the stock has traded between $2.95 and $13.96. it is currently at $13.51. In short, Entropic is a perfect candidate for the type of trade of which I speak.

Let’s look at an example:
If one were to buy 1000 shares of Entropic at $13.58 and write 10 of the May 10 puts at $0.55 and the May 12.5 calls at $2.50, the total investment for the position would be $10.53. This means that if Entropic stock is above $12.50 at the May expiration, you will earn $1.97 on each share for an annualized rate of return of 56%. The breakeven point on this trade is $10.53. So, Entropic can decline by $1.03 or 7.5% to $12.50 and you will still earn the maximum profit for an annualized return on this four month investment of 56%. Entropic can actually decline by up to $3.05 and you will still make a profit on the investment. At the worst, if Entropic falls below $10.00 you will own 2000 shares of the stock for which you paid a composite price of $10.27, not a bad price for a stock now selling at $13.58. (I am using the prices at the open on January 19th, but the principle remains the same as the numbers shift.)

So what is the downside here? First, if Entropic suddenly runs up to $25.00 per share, you will not make the resulting profit since you are capped at a maximum profit rate of 56%. Second, the point of the trade is to make money as the time value erodes, not as the stock price moves. This means that the day to day ups and downs of the stock are not traded and for those of you used to very short term trading, this strategy may leave you feeling antsy. Third, you can obviously lose if the stock you pick tanks in a major way. Of course, that is true of any investment, and here, you will have the cushion provided by the option premiums to soften the blow. Indeed, at worst, you will be buying the stock at a price 24% below the current market price.

The strategy can be adjusted when there are major moves in the stock. Were Entropic to move up by three points in a month, it might make sense to adjust the strike prices of the options going from the 10 to the 12.5 put and the 12.5 to the 15 call. Alternatively, one can roll the options out to later expiration dates, going from the April 10 puts to the July 10 puts and from the April 12.5 calls to their July counterparts. Frequently, I roll the puts out at the same strike and roll the calls out and up in order to increase the profit potential. One can also begin with strike prices that bracket the stock price (like the May 12.5 puts and the 15 calls for Entropic.) This is a more aggressive strategy that gives higher potential returns but with greater risk.
One last note: for those who are not familiar with selling uncovered puts, you should know that these trades use up margin balances. I recommend that for a while, you buy only half the amount of stock that you would otherwise purchase and then consider the puts to be the other half of the position. In other words, in the Entropic example above, but 500 shares of stock and think of the 5 short puts as representing the other 500 shares that you would want to own.
Disclosure: I am long both Alcoa and Entropic Communications stock, and I have periodically used this strategy with both holdings. Currently, I have option strangles in place only on Entropic.