While many traders want to consistently see triple-digit gains, there are opportunities to make relatively low-risk trades that could add up to income of more than 10% a year. The strategy I'll detail below uses the idea of low-risk to capture a potential gain of more than 1% in less than two weeks.
Market prices can drift away from the fundamentals at times. In the stock market, this happened in early 2000 when the Internet bubble pushed stocks beyond any sense of reasonable value. At the other extreme, stock prices were irrationally depressed in March 2009. This same pattern is seen in individual stocks and also in individual options contracts.
Options can be more difficult to track. You can trade options on more than 2,700 stocks. There are at least 187,000 different contracts trading now, and you could buy or sell any of those contracts. With about 374,000 different trades to consider, access to a database and screening software is needed to find the best trade opportunities.
At times, the best opportunities will come from selling calls. A call option gives the buyer the right, but not the obligation, to buy 100 shares of stock at a predetermined price, called the strike price, before a certain date, known as the expiration date. When selling a call, you receive an immediate payment and agree to accept the obligation to sell 100 shares of the stock at the strike price until the expiration date.
In the last weeks before options expire, there are often a significant number of opportunities to sell calls. There are some risks with these trades and this strategy definitely isn't right for everyone. But let's look at an example rather than using theory to explain the potential rewards and risks.
I found an opportunity in Tempur-Pedic International (TPX), a company that makes and sells mattresses and pillows. This is simply a short-term options trade and I'm not worried about the fundamentals of the company or the industry, so I'm not going to detail the numbers like I would if this was a stock trade.
TPX has an overvalued call option -- the TPX March 45 Call is trading at $0.85 at the time of this writing, and will be worth $0 on March 15, unless the stock moves up by almost 10% from current levels. To clarify:
-- The March $45 call options on TPX give the buyer the right to buy 100 shares of TPX at $45 a share on or before March 15.
-- That option is currently trading at about $0.85, so the buyer will pay $85 per contract (100 shares times $0.85 per share) to the option seller (that's us).
-- Unless TPX reaches $45 by March 15, the option will expire worthless.
-- Currently trading at $41, TPX needs to gain about 9.8% in less than two weeks to reach $45.
The trader selling the calls will receive $85 per contract, so we want to be sure this option makes sense to sell, i.e., we want to check for potential news on the stock that could cause it to move higher. In the case of TPX, no significant news is expected before the option expires. The next earnings announcement is scheduled for April 15. TPX is completing a merger with Sealy Corp. (ZZ), but that was announced months ago and the stock has already factored that news into the price.
With no news expected, we want to look at what the market says about the odds of TPX reaching the strike price. We can do that by using an options pricing formula to find the delta of the stock. Delta shows how much the price of the option should change when the price of the stock moves by $1. Some options traders multiply delta by 100 to provide the odds that the option will be profitable at expiration.
Using an options calculator, we determine that the delta for the TPX March 45 Call is 0.27. Multiplying this by 100 tells us there is a 27% chance that the option will be profitable for the buyer, which means there's a 73% chance it will be profitable for us as the options sellers.
After checking for news and finding a trade that offers odds of winning that are at least 70%, I look at how to manage risk. When you sell a call option, you will be obligated to sell the stock at the strike price no matter what the market price is at expiration. For example, if TPX jumped to $100 a share, an unlikely event, but I'm just using a number to illustrate the risk, you would be required to sell it at $45 and accept a loss of almost $55 a share.
To manage the risk, you could buy a call to guarantee that you have shares available to sell. With the $50 March call selling at about $0.10, I can limit the risk to $5 a share, the difference between the two strike prices.
By selling a $45 call for $0.85 and using $0.10 a share to manage the risk, this trade generates immediate income of $0.75 per share, or $75 per contract. There is some risk until March 15, but it is relatively small. Doing trades like this once a month can generate significant income over the course of a year.
To calculate a potential return, let's assume that you maintain a balance of $5,000 to buy 100 shares of TPX at $50, the worst case scenario. The total return of $75 on a $5,000 investment is 1.5% in 12 days. If you made a similar trade once a month, you could generate an annual return of 18%.
Selling options can be an important part of your income strategy and could deliver great returns with limited risk.
Recommended Trade Setup:
-- Sell TPX March 45 Calls at $0.60 or more
-- Buy an equal number of TPX March 50 Calls at the market price to limit the risk (this is the equivalent of a stop-loss on the trade)
-- Your net credit (premium you receive for selling the calls minus the price you pay to buy the calls) should be $0.50 or more, for a 1% return in two weeks