A Conservative Trading Strategy with Options

It has been a while since my last blog entry. Longer than I would have really liked but I kind of have an excuse as I've been focusing on setting up a new trading strategy using options.

Over the summer I read a book by Michael Thomsett titled Options Trading for the Conservative Investor: Increasing Profits without Increasing Your Risk.

I liked the concept so the past couple of weeks I read it again more thoroughly and started to implememnt some of the trading strategies discussed in the book.

I will go through the core principles discussed although I will not describe what options are per se and how they work.

1. Only trade options on stocks you would happily own.

2. The stocks must fullfill certain fundmentals so can be considered as good quality and solid investments.

3. Sell puts on these quality stocks for income but only at a price you would be happy to own the shares.

4. If assigned stock switch to covered calls for income and reduce further the entry buy price.
5. Sell more puts as part of a rescue strategy if stock price continues  to fall.

5. Allow assignment of covered calls or sell for a profit.

There are more detailed tactics described when selling puts and covered calls but I won't go into those for now. An absolute critical factor, which he states many times, is to first select which quality stocks you wish to own first then trade the options on those companies.

'High risk' stocks are more volatile increasing premiums and attract many option traders as they provide greater profits but the risks are greater and such a strategy would not be considered 'conservative'. 

Imagnine selling puts for example on Netflix and being assigend shares at $120 earlier this year, only to have seen the drop plummet 50% to the current price of $60.....painful. There must be confidence in the underlyting stick and the ability of its stock price to recover.

  

Classic large cap blue-chips stocks such as IBM, Catapillar and Intel are given as examples in the book as quality companies with good fundamentals to trade options against. At the moment I am just trading options in the Swedish market, there aren't so many available, espcecially comapred to the US, but it's a good place to start and learn put selling strategies.

My quality criteria are quite simple, I have chosen large cap stocks that currently pay a good dividened but also managed to keep paying the dividened through the turmoil of the 2008/2009 financial crisis. I believe a quality dividened puts a floor in the price of a stock and would add some protection to my portfolio if we go through another bear market. This has narrowed my watch list of stocks to large cap companies such as Boliden, SKF, Telia Sonera, H&M, Investor, AstraZeneca.

I will now go through a trade I recently did with TeleiaSonera, a Swedish telecommunications company. Like most companies of this type it's a pretty boring stock with no growth but pays an attractive 2.85kr, 6% dividened and has a P/E 11.5, P/FCF 9.

On the 23rd July Telia was trading at around 44kr which is near the lows for the past two years (see below). I sold the Oct 44 puts for 1.6kr which if assigned would give me an entry price of 44-1.6= 42.4. Not bad when looking the past price action, although I could always buy back the puts if necessary and re-sell them  further out, for example, Dec at 42kr.

As long as the price stayed above 44 I would keep the income I received from the put selling. For every share that I am obligated to buy at 44kr I have earnt 1.6kr, so effectively my cash would be earning 3.6% over 3 months, roughly 14% APR. Not bad.

Since then the share price has significantly gone up so on the 6th Sept with the stock selling around 47kr and with over a month left until expiry of the puts I bought them back at 0.25kr. Total income was 1.35kr or 3% (24% APR). It didn't seem worth locking my capital for the remaining 1.5 months just to earn 0.25 kr.

Overall a nice trade. The key though is knowing that if it goes against you then the worst that can happen is that you have bought shares in a comapany you like and at a share price you are happy with.

In this case it I would own shares in Telia, a global telecommunications company that pays a 6% dividened at a price that was at the lows of the past two years. I could then sell covered calls to earn more income.

However, another interesting way of looking at this is to say I could have bought the shares at 44kr back in July and sold them at 47 in Sept, a 3kr profit which is greater than what I received from the put selling. 

Of course it is always possible with hindsight to say what one should have or could have done to have made a profitbale trade. However, in July I did not know which way the price would go, I was happy to recieve my 1.35kr as it fullfilled my investment goals of a minimum 1% income per month on my capital.

The benefit of put selling is it is still profitable if the share price goes up or stays the same. There is of course no free lunch. The 'cost' of having a winning trade if the price doesn't move is paid for by the limited upside potential if the price goes up.

I will write more as I enter further trades in the coming weeks.