I have a question for someone who is competent in options.
Since this is not a capital gain (huge upside) stock, say my cost basis is 17, and it moves beyond that slightly, and I want to have downside protection buying a protective put and limit the upside potential by selling a covered call, premium for the short call somehow paying towards the long put insurance. Is it feasible? thoughts? In the case of this stock, what timeframe I should look at, Strike prices are kinda no brainer I guess.. I am kind of new to the options and will apppreciate any feedback. If you provide an example that will be the icing on the cake. Thanks.
The devil is in those contracts? Sorry couldn't help myself but the contracts might get exercised. I don't think they will be "exorcized".
I think your plan is sound but be careful in your thinking about rolling the calls out. You can lose a lot in the difference between the bid and the ask that far out and that far in the money. Sometimes it's like being held hostage.
Also consider, if you have a margin account you can buy extra stock and then sell the calls to avoid paying interest.
You most likely will get called the day before ex-date. The majority of the open interest will be market makers who have hedged the long option position by shorting the stock. If the stock goes up, they break even. If the stock goes down, at some point it will go down more than the option, and so they will make money. All that changes on ex-date, because the short stock would have to pay the dividend. Hence, the long option holder will exercise to cover the short. (In actual fact, the market maker will not hedge 1:1, but rather with some ratio based on a computation of the volatility of the stock. But the trade will still end before ex-date.) Even if a long option were not a hedge, the holder would be better off to exercise and then buy the option back after ex-date. There is experimentation going on with options that adjust the strike price for dividends.
You sound like more of an academic than an investor. What you postulate, or rather what you read postulates, is true of near the money option plays. However, this is not an option play but rather a dividend play. Hence, the finance theory is not applicable. The deepness of the option written merely magnifies the yield and does so while being much much safer than just owning the stock naked. . NLY is not a stock to own for upside appreciation as it has only a .26 or so beta and moves pretty much independent of the market, so there is little upside potential forgone. Thus the play brings the best of both worlds, increased return with decreased risk.
Process is essentially selling off the upside while retaining the downside. Transaction should work the vast majority of the time, but the hit when it fails can be big.
In general, call writing makes money most of the time. But call buying has a positive expected return while call writing has a negative expected return(general finance theory). A very small number of occurrences with very large payoffs can outweigh a large number of occurrences with small payoffs. Just because most of the time you make money, does not make an investment worthwhile.
A lot of junk bond investors learn this the hard way whenever we have a recession after a long stretch of economic growth.
I will advise. If I make it through this dividend without a call, I will probably roll the options out to 2014 to minimize the chance of an early call. I figured I'd roll the dice since it only will cost $50 to find out. There are around 2600 open contracts and I don't think a large percentage are going to be exorcized a year in advance, so I figure my chances are good unless some specialist decides to get cute. Because the stock has fallen from a long plateau around 18 I have to believe most longs on this option are losing on their positions and have no reason to exorcize. Time is not pressing them to exit and buy the stock to hope for a rebound, so we'll see.
Here is an idea for you. Lets say you have $16,000. You buy 1000 NLY and collect $2400 in dividends a year at current rate.
Now what I've done is this. I did a buy write using the same $16000. I bought 1600 NLY and sold 16 Jan 2013 10 calls at break even with no time premium.
I now collect $3840 in Dividends a year and am protected down to $10 a share. The only risk is in getting called in which case I lose the dividend, break even on the stock and also lose about $50 in transaction costs. Worth the risk in my opinion. But going out to Jan of 2013 reduces the risk and you could go out to 2014 if you want. I am in at Jan of 2013 and will collect until eventually I am called.
<<I now collect $3840 in Dividends a year and am protected down to $10 a share. >>
The buyer of the call will exercise so that he can collect the dividend. Only on very small positions when someone makes a mistake will this slip buy.
Let me state your assumption a little more clearly: the option market makers, who make millions each year, have computers constantly looking for opportunities are going to pass on a free dividend. Not the way LaSalle Street works.
Joe to me that seems like a bad strategy.
Your getting called at $10 unless NLY falls below 10 or you just buy to close on your calls at some point in time.
Since the FED at least right now looks like they aren't raising short term rates until mid-2013, it seems unlikely NLY will fall below 10 (i.e. your gonna get called).
I buy puts the day before it goes ex, thats when the price will usually top out. In the next day or two I will sell them for a considerable profit as the stock price dives on the ex date. I still own the stock, and my account has not lost any value and its picked up some cash.
Covered calls work as well. If the stock is around 17, sell those 16 dollar calls and pick them up after it goes ex for pennies.
neither of these strategies work, the puts have the dividend premium in them which disappear at ex dividend, then replaced by actual underlying stock decline, so that the option price stays exactly the same from the day before, to the ex-dividend day (in general) and then you would make money if the stock goes down more than the dividend, which is, like any other day, a 50/50 chance... there are many times that the underlying stock will go up on ex-dividend day (more than the dividend decline)...
also on the covered calls, you will in most cases have your stock taken by the person holding the call, so that they can get the dividend... so basically you are fairly certain to lose the dividend and lose your stock.... (worse the covered call will have no premium at all past it's strike price) so really a bunch of transactions ending in you losing your stock and having to re-buy it...
here is the known in options.... the option market NEVER makes a "sure thing" .. nor does the market in general.
in otherwords, you could never structure an option trade where you are guaranteed a profit...
you will find that the call premium from a short call + the expected future divis between strike months, will always about equal the amount of the put option you would want to buy for protection... (if you want reasonable protection)
in otherwords, the option market is exactly like the general market, you have to make a guess as to the underlying stock's move, in order to make a profit in the option market... exactly the same as the general market... even when selling short the options...
the only difference is the option market will increase your reward for being right, and increase the penalty for being wrong...
that being said, the option market was set up in the first place as "insurance" for stocks, commodities.. etc... "insurance" ALWAYS costs you money... if it were not so, there would not be any insurance companies in business...