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A Covered Call with Ultrashorts

January 26, 2009

It is generally assumed, and rightfully so, that Ultrashorts SRF, SKF are not for everyone, those are highly volatile and average investors should stay away from those. However, I think, if managed properly, these can also be valuable tool to generate passive income.

Firstly, let’s look at the 2 popular ultrashorts SKF, SRS. Attached charts are pictorial view of how volatile these stocks are. SKF (Ultrashort Financials) has a trading range of $100 to $300 and SRS (Ultrashort Real-Estate) from $50 to $250 and intraday movements are good enough to stir stomach muscles. As such general markets are speculative these days and on top of it ultrashort nature makes these even doubly volatile; and if you are doing options on it, that simply magnifies volatility exponentially.

That’s where as an option trader, this volatility comes to my advantage. Here are a few things I need to assess EVERYTIME I am placing a trade-

  • Is this capital something I don’t need in foreseeable future (6-12months)?
  • What is the general market environment, Technical Analysis?
  • How much ATM option premium current environment is generating?
  • How long will it take for my stocks to become free?

Let me take you through with a real covered call example that I placed on Jan 16th. The trade was opened purchasing SRS on average @ $61.15 and then I sold $60 Feb Calls for $10.85 average. This essentially resulted my effective price of $50.30. Since I am using portfolio margin facility, my cash outflow is almost half of $61.15 but let’s forget that for a moment.

Attached Risk/Reward chart (approximate) show that this trade will be yielding nearly 17% for almost 4wks holding period assuming SRS remains over $60 (and based on last Friday’s prices). This trade will break-even at $50.30 below which I shall be making losses. Albeit, when It’s Feb’09 expiration, I can sell March’09 call ATM options as well (or earlier). However, the yield and subsequent losses will be determined at that point. What needs to be noticed is that in few month’s time, these stocks will be free to own. It is essentially like rental yield on a property that is bought for free.

While this seems all good, there are watch-outs that one needs to be careful about.

  1. Risk premium is dependent on the prevailing Implied Volatility and the underlying price. It may take longer to recover investment in underlying.
  2. The risk/profile is only on expiration. Before expiration however, the sold call will still have time value and hence the losses might be more than what it might be on expiration day.
  3. Due to inherent characteristics of ultrashorts, the extreme movements can easily stir emotion. Hence it is beneficial to keep a risk management plan in place, in advance, all time.
  4. We are in the bearish markets and hence underlying are commanding high absolute price, but as the markets starts to calm, the absolute value will fall and it may happen that it never recovers to those high value.

The same covered call can be done via naked put selling as well. I however like to combine the technical analysis to the option selling i.e. when SRS is about to turn up, I buy the stocks and sell the covered calls when stock might be turning downwards (the above case may or may not represent that). I can sell stocks and let the call value decrease and buy back stocks later. There are multiple ways this can be played.

However, net-net, there are risks with ultrashorts and hence it is important to do proper due diligence and stress testing of your trade before you place one, in case you decide to follow. Above mentioned trade is for real and I may get out of the trade anytime depending upon risk/reward profile vis-a-vis other opportunity.

You may want to explore it further to review if this is something you would like to add to your Option Trading Strategy toolbox. What do you think of this strategy? did you try this before? what kind of issues did you face?

Profitable Trading, OP

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