The Best Income Strategy for Small Caps (SLV, IWM)

SmallCapInvestor.com


As an options trader I am often asked about my favorite options strategy for producing income. And recently, after working with Ian on an issue for SmallCap Investor Daily, "What You Need to Know Before Using Options on Small Cap Stocks," I have been bombarded with questions from small cap investors about how to trade small cap stocks for income using options.

This is a broad topic, so I'll address part of it today. Since I do not have the space to thoroughly delve into my favorite options-based income strategy in one sitting, we'll discuss options strategies in future newsletters too. So keep reading over the next few weeks.

In my opinion, the best way to bring in income from options on a regular basis is by selling vertical spreads, otherwise known as credit spreads.

Let me give you a simple example using my most recent trade.

Recently, I suggested a trade for our TradeMaster publication. I placed an options trade using the highly liquid iShares Silver trust (NYSE:SLV - News) as my underlying. Similar strategies can work with small cap stocks too, you just need to make sure that there are liquid, i.e. frequently traded, options on the stock in question.

With silver trading at new lows and consolidating I decided to place the following trade:

  • Sell to open Aug11 SLV 28 puts
  • Buy to open Aug11 SLV 26 puts
This spread created a total credit of $0.24 (or higher) for a return of 12 percent.

At the time silver was trading for roughly $33. While I was bullish on silver, I still wanted some downside protection, which is why I sold the Aug11 SLV 28/26 vertical put spread.

The SLV credit spread allowed for a 15 percent decline in the underlying (in this case SLV) before the trade was in jeopardy of becoming a loser.

As long as SLV closed above $28 at August expiration, I would make 12 percent on the trade.

Amazing, right? Nice upside, with limited downside. This is why options are a necessity in any portfolio. If used correctly, they can be a powerful tool to enhance returns in your overall portfolio - even if the market slips significantly lower.

With July options expiration behind us and August expiration 32 days away, the credit spread that we placed is only worth $0.03. Given the limited upside remaining, I have decided to take all risk off the table and buy back the spread. Here is the trade to do this:
  • Buy to close Aug11 SLV 28 puts
  • Sell to close Aug11 SLV 26 puts for $0.03
Some of you might be asking why would we not just let the spread expire worthless, which would allow us to reap the entire $0.24?

The answer is that upside from here is very limited. While I don't think SLV will move 28 percent lower over the next 32 days, I am not willing to take a chance of silver breaking to new lows just to make an additional $0.03.

Trading, particularly options trading, is about taking profits when it makes sense; and being prudent, staying disciplined and most importantly, looking at the long-term picture.

As I always say, opportunities are made up easier than losses. Trying to squeeze $0.03 out of a trade just isn't worth the risk. The trade was successful, making 11 percent in just over three weeks. Now it is time to move on to the next opportunity.

On Monday I'll discuss a small cap specific trade using the iShares Russell 2000 ETF (NYSE:IWM - News). We'll go over the income strategy in more detail as well.

If you have any questions about the strategy, or any options related questions for that matter, please do not hesitate to email me at andy.crowder@wyattresearch.com.

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