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Premium Shorting Time?

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Premium Shorting Time?

Courtesy of Adam Warner at Daily Options Report

 

Time to shake up the investment cart? Stephen Sears had some options shorting ideas in Barron’s the other day.

 

Consider the financial sector. Options on many financial stocks remain at historically-high volatility levels even though many of the stocks have doubled in value off their 2009 lows. The heightened volatility indicates that options traders, generally the most sophisticated stock investors, are cautious about stocks such as Bank of America (ticker: BAC), Citigroup (C), Goldman Sachs Group (GS), J.P. Morgan Chase (JPM) and Morgan Stanley (MS) that have rallied so far, and still remain far from historical highs.

Individual investors can monetize the fear of many professional investors by selling options to buy stocks.

To Scott Fullman, WJB Capital’s derivatives strategist, the financial sector’s high volatility is an opportunity to build positions using a "covered combination" strategy.

Rather than just buying stock all at once, or building a position in a stock, the "covered combination" strategy lets investors benefit from high put and call prices.

Consider Goldman Sachs. Most investors who want to own the stock would just pay the recent market price of $146. But by only buying half as much stock as desired, and selling an out-of-the-money put and call, investors set themselves up to potentially buy stock at a discount.

The October 165 call, for example was recently trading at $7.75, and the October 115 put was at $5. This means that an investor who used options to build a stock position would initially be paid by the options market to buy the stock. If Goldman’s stock was trading at $165 at October expiration, Fullman says investors would realize a profit of $30.34, and a return of 38%.

If the investor has to buy stock because the put is "assigned," Fullman says the cost of buying the stock would be $124.83, or about 15% below the stock price.

Look, I could argue this two ways. One is that it’s misleading to look at options sales as "yeah, I would sell GS at 180 and buy it at 125, so why not?" Stocks always look like sales 25% up and down, so ergo options are always a sale. Until the stock gets to one of those prices.

But the flip side is, I do like the idea as an alternative to owning stock. In fact almost all my longs are of the "short puts" variety. The issue is you have to look at that as more trade off vs. simply owning the stock. Remember, you’re bullish anyway, so you’re making the decision to be less aggressively bullish. The green shoots may be Really Green Shoots and GS may be $250 by October, in which case you’ll kick yourself that you left so much on the table.

So if you want to stay long, but are not afraid of missing a huge pop, this is an excellent strategy imho.


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