My Favorite Equity Option Strategy: Profit from Stock Volatility

There are many trading strategies that employ stock (equity) options, and I describe here a somewhat low-to-medium risk play that can boost your returns on a stock investment. This article assumes you already know the basics of stock options; if not a good place to start learning about them is the Chicago Board Options Exchange (CBOE). The strategy I describe here is one of a class of option strategies known as a covered combination. It is a variation of the more basic strategy known as a buy-write or covered call, in which you buy a stock and also sell a (usually out of the money) call against it.

In the covered combination you also buy a stock and write a (usually out of the money) call, but you in addition write a (usually out of the money) put on the same stock. Thus you collect two premiums, and at most only one of them will likely be exercised (only one can close in the money if they are both written at out of the money strikes). This strategy is one to be used when you are bullish on a particular stock, but you can't be sure it might not go lower before it goes up (who can ever be sure of that!) and you want to generate some extra gains with little extra risk. The strategy will lower your basis (net cost) in the stock, thus boosting your return when you eventually sell.

Here's how I implement it (there are some variations on this theme). I buy a number of shares in a stock equal to half the amount I am willing to own, and at the same time I write a slightly out-of-the-money put option (thus having a strike just below the current price) for the same number shares. I also at the same time write a slightly out (strike just above current price) call option for the same number of shares. Now, by the time the options expire there are three possible scenarios:

(1) The stock price has moved higher than the call strike. In this case my stock will be called away, for a price slightly higher than I paid, and I also earned the premiums for both options. The result is like a buy-write strategy but gives a higher return because you also get to keep the put premium.

(2) The stock has moved down below the put strike. In this case I will be "put" additional shares of the stock, essentially "doubling down" by buying more shares at a slightly lower price. I will have reduced my net cost by getting a lower average price and further by the value of the option premiums.

(3) The stock ends up priced in between the two strikes. In this case I get to keep both premiums as extra income and the stock I purchased. The premiums can be considered as income or as lowering my cost basis which will increase my return when I ultimately sell. When the options expire, I could then do it again by selling the next calendar series of the options.

If you are bullish on the stock, none of these scenarios is bad for you-even when the stock goes down it just causes you to buy more (you already decided you are willing to own more) and you lower you cost basis. The only potential problem is if the stock drops by such a significant amount that you want to "cut your losses" and sell it. You would also have to buy back the options you sold in order to fully close out your position and not be liable for them. In this case, the call will have dropped in value so you could buy it back for less than you received selling it, but the put will have gone up in value in relation to how much the stock dropped in price and you will need to pay this differential. It really isn't any worse than if you had just bought the full amount of the stock in the first place, and the loss is reduced by the call premium.

Another downside to this strategy compared with simply buying the stock is that you limit your potential gain. If the stock soared but you had to sell it at only a slight gain because of the call option you wrote, you might be disappointed. But you would still have a nice net gain.

Now consider what conditions contribute to making this strategy work best. Option premiums tend to be higher when stocks are more volatile. So if a stock you are interested in has a relatively high volatility, then consider using this strategy to boost your returns.

I particularly like to use it with stocks that are normally low-volatility but temporarily experience circumstances that make them more volatile for a short time. A good current example of this is the stock of British Petroleum (BP) in the wake of its Deepwater Horizon explosion and resulting Gulf oil leak. Because of the high level of uncertainty about BP's ultimate liability and costs with this incident, there is a good deal of speculation about large swings either up or down in the stock price, which leads to unusually high premiums in both the calls and the puts-- even the very short-duration ones.

Let's see how this strategy works with a specific real example using BP stock:

On July 2, 2010, the following prices were available:

BP stock: $29.35

BP options expiring August 20:

32 Call: $2.03

28 Put: $2.52

If you opened a position on that day using this strategy-buying the stock and selling both the 28 put and the 32 call, then at expiration just 7 weeks later the situation would be one of the following:

(1) The stock moved above 32 and was called away from you. You get to keep all the premiums and the 4 points of gain in the stock, for a net profit of 29%. Not bad for 7 weeks.

(2) The stock closes below 28 and you have to purchase more shares at $28 each (regardless of where it closed). You get to keep all the premiums, effectively lowering your net average cost per share. On your total BP position this is now $26.40, which is a 10% discount to what you would have had to pay for those shares if you had not used the options. Another way to look at it is that you would make money on the position even if the stock goes down, as long as it goes down less than 10% (of course all these calculations exclude commission costs).

(3) The stock closes anywhere in between 28 and 32. By keeping all the premiums and the stock, but not purchasing more, you will have lowered your net cost on the BP shares to $24.80 and will then be showing a net gain of between 13% (at 28) and 29% (at 32).

For less volatile stocks the numbers will not be this good, but they will always goose your returns somewhat or lower your costs.