The Three Horsemen of Income

There are three popular options strategies for generating income, each of which allows investors to collect a premium while adding protection to their portfolios. The three strategies-best used in stagnant to bullish market conditions-are:

1. Covered Calls
2. Cash Secured Puts
3. Calendar Spreads

Conservative investors use them to generate monthly income. Speculative investors, seeking stock price appreciation, tend to Buy options, Pay a premium, and leave themselves with No downside protection. But each of the Three Horsemen strategies has advantages and disadvantages.

For example, in a raging bull market it’s best to simply go long on stocks without using an option hedge. Conversely, in a major bear market it’s best to stay in cash or use bearish options strategies (i.e., bear call credit spreads) to take advantage of falling prices. These strategies may not be the answer for every portfolio or investing situation, but a successful investor should understand them and keep them in reserve for the appropriate time. Here’s a more in-depth look at the Three Horsemen of Income strategies:

Covered Calls:
The most popular Horseman is the Covered Call. This strategy is often called a buy/write because an investor buys a stock long and then writes a call short against the stock position. The long stock shares ‘cover’ the delivery obligation of the short (sold) call option contract. A simple example:

* Buy 100 Hewlett Packard @ $30.98 (HPQ)
* Sell 1 contract 06 Feb 30 Call @ $2.00 (HPQBF)
* ITM (In-the-Money) by 3.2%
* Return if Assigned: 3.5% (This is the return if the stock is trading above $30 per share at expiration)
* Theoretical Annual return: 34.7%
* Downside Protection: 6.5% (This means the stock can drop 6.5% before the position becomes an unrealized loss).
* % Probability Above: 63.5% (This is the theoretical probability the stock will be above $30 strike price at expiration)

The most important decision for a covered call writer is selecting which strike price to write. Writing month by month is generally preferable to writing a 9 or 12 month option because the overall, annualized returns are greater with more frequent writing.

Choosing the correct strike price depends on your risk/reward preferences. Writing Out of the Money (OTM) strikes has the highest potential gain, but in order to realize this gain the underlying stock must rise in price. Therefore, the potential gain may be very high, but it is only potential and not realized unless the stock actually rises above the strike price. One of the calculations to help evaluate the probability of reaching the strike price is the % Probability Above (probability of being assigned). These high gain opportunities usually have a low probability of success.

Conservative covered call writers usually write strike prices that are In the Money (ITM). In this case, the % Probability Above will be much higher because your stock will likely be assigned (sold) at the strike price. Remember: the ITM strike is lower than the actual price of the stock. It may look as if you’re losing money, but the premium you receive for the option sale more than makes up for the lower sale price of your stock. The option will always sell for its intrinsic value plus some time premium.

Another measure of the safety of the ITM write is the % Downside Protection. Using an Option Chain for guidance, you’ll see that deeper ITM options have a higher premium due to the increased intrinsic value and offer higher % Downside Protection. Therefore, the underlying stock can have a deeper price correction and your investment will still be protected.

There is a continuum of risk/reward that depends on which strike price you choose. Deep ITM writes have large downside protection, but they also have relatively low returns compared to deep OTM writes that have large potential returns, low downside protection, and low probability of assignment. By trading deep OTM, you are relying on stock price appreciation for the return rather than the option premium for cash income.

An extremely valuable tool to help you assess your risk/reward profile is an Option Chain that delivers calculations-such as Downside Protection, % If Assigned, % ITM, and % Probability- for more than 170,000 Covered Call combinations. To be truly effective with your Covered Calls decisions, you should make it a regular practice to review the PowerOptions Chain.

Cash Secured Puts:
Also called Naked Put Writing. Cash Secured Puts obligate a seller to buy a stock if assigned…and it’s assigned if the stock is trading below the put strike price at expiration (ITM). This strategy is an uncovered position; an investor does not own the stock when the put is sold. Conservative investors who trade this strategy will select a put strike that is OTM (below the stock price, opposite of the call discussed above). A simple example:

* Hewlett Packard @ $31.01 (HPQ)
* Sell 06 Feb $30.00 Put @ $0.90 (HPQNF)
* OTM by 3.3%
* % Naked Yield: 3.0% (The premium collected vs. the strike price).
* Theoretical Annual return: 29.6%
* % Probability Above: 63.9%

Cash must be available in the account to buy the stock if the put is assigned. The stock will generally be assigned if the put strike price is in the money (ITM). This happens if the stock price is lower than the strike price of the put option at expiration. The risk/reward curve for naked puts and covered calls is the same, but some Brokerage firms treat them differently. Some will allow the use of covered calls in an IRA account but not allow the use of cash secured puts. This has been changing over time as the Brokerage community has offered better support through the increased use of naked put options.

Since the put is written OTM, the investor expects the option to expire worthless. In this case, the stock is not assigned to you and the premium is yours to keep with no further option obligations. An investor can sell another put against the same underlying stock, or look for a new position that matches his or her risk/reward preferences. Writing puts every month is generally more profitable than writing them over a several month period. There is more work involved with more frequent writes, but it’s not unusual to double your potential returns with monthly writes compared to 9 or 12 month writes.

A naked put writer can use the calculations of % Naked Yield, % If Unchanged, or % Time Value to position the reward and use % OTM and % Probability Above to assess the risk of the investment. When using naked puts, the most conservative positions are OTM and the most risky are ITM (which offers the highest returns). There is a continuum of risk/reward with your choice of strike price for the put option. The deeper OTM positions have more downside protection, but deliver lower returns.

To gain an advantage by consulting these measures for every strike price, make it a regular practice to review the PowerOptions chain.

Calendar LEAPS Spreads:
Using this strategy, the most aggressive of the Three Horsemen, an investor will buy an ITM, long-term LEAPS option in lieu of stock ownership and then sell shorter-term call options against the LEAPS option. A simple example:

* Hewlett Packard @ $30.96 (HPQ)
* Buy 07 Jan 22.5 Call @ $9.90 (VHPAX) (used as a surrogate for stock purchase)
* Sell 06 Feb 32.5 Call @ $0.75 (HPQBZ)
* Net debit $9.15 (net cost of trading the two options)
* % If Assigned: 20.5%
* Break Even: $30.42 (break-even at expiration time of the sold option)

Buying a LEAP instead of a stock creates leverage, since a LEAP can be purchased for only 30% of the cost of buying shares of stock. Therefore, this strategy has about 3:1 leverage over the owned equity or cash-secured techniques used for covered calls and naked puts. Because of this extra leverage, Calendar LEAPS are more speculative and provide higher returns or potentially higher losses if the stock moves in the wrong direction. There can be a tendency for investors to overtrade when leverage is available, but this can be avoided by understanding the risk/reward makeup of the strategy.

An investor pays for a LEAPS option and receives income from the call option he sells against the leap (similar to a covered call). An initial debit is created because the cost to buy the LEAP is larger than the income created from the call sold in setting up the position. This net debit is the maximum risk for the spread and the amount you have invested in the position.

The value of this position is very fluid because the value of both options changes every day due to stock price changes, volatility fluctuations, and time decay erosion from both option premiums. But a break-even point can be calculated for the spread given two conditions: First, the short-term option expires, and second, we have to estimate the remaining value of our asset, the LEAPS option.

Once the short-term option expires worthless, you have realized its entire premium. That means the total amount you invested is still the net debit of the position. So break-even would occur when the remaining asset value (the LEAPS option value) equals the amount you invested to own it. Break-even happens at some unknown stock price that would make the LEAPS option value equal to your initial net debit.

To calculate this stock price you must employ an option-pricing model, which can be extremely complicated unless you put technology such as PowerOptions to work for you. Every 20 minutes it will calculate break-even and other important trade characteristics for over 200,000 Calendar LEAPS Spreads.

In the example described at the beginning of this analysis, if the stock was trading at $30.42 on February expiration, the short option would expire worthless and the long LEAP option would have a theoretical value of $9.15. Break-even would be $30.42 for a stock currently trading at $30.96. The % If Assigned is the maximum potential return that could be made on this spread if the stock is trading at the strike price for the short-term option on its expiration date.

That means the short option would expire worthless and the long LEAP option would have a theoretical value 20.5% above the initial cost (net debit). An investor could sell to close the long option and realize this profit, or sell another short-term option against the LEAP option, lowering the cost basis further. After some months of writing, the investor could own the LEAP option contract with no cost basis.

If the stock is trading above the short-term strike-price (ITM) near expiration, the short option may be assigned. In this scenario the investor could:

1. Buy to close the short option and sell to close the LEAP for profit. Since the delta of the ITM LEAP is greater than the delta of the short option, the rise in stock price will cause the LEAP to gain in value over the short-term obligation (Delta Ratio).

2. Buy shares of stock at market price to deliver the short obligation then sell to close the LEAP. This covers the obligation and allows the investor to take advantage of the time premium remaining on the LEAP. A profit will still be made since the intrinsic difference between the stock purchase and the short strike will be covered by the intrinsic value of the LEAP.

3. Exercise the long LEAP to purchase shares of stock to deliver the short obligation. In the above example this means shares would be purchased at $22.50 and sold at $32.50. This would provide a $10 credit from the difference in strike prices, thus yielding a $0.85 profit over the initial $9.15 debit. A conservative investor will always look for spreads where the net debit is less than the difference in strike prices (Debit / Difference in Strike Price Ratios).

4. Buy to close the short call, closing the obligation then selling another call against the LEAP. This adjusts the initial net debit and potentially leads to higher profits if the stock continues to rise.

A Calendar LEAP Spread investor will use the calculations for % Return If Assigned, % Return If Unchanged, and Delta Ratio to determine the potential rewards…and also use Net Debit and Break Even to assess the risks of the spread. A Calendar LEAPS Spread with a lower net debit will naturally have a lower risk. A conservative investor will look for spreads where the Break Even is lower than the current trading price of the stock so the spread is protected against a stock price correction. These parameters and calculations are shown on the patented search and analysis tools on PowerOptions for every possible Calendar LEAP Spread combination.

Since all Three Horsemen strategies are best used in neutral to bullish market conditions, the greatest risk in using them is when there’s a fall in the price of the underlying stock or index. It is up to you how quickly you want to accumulate your nest egg…and how much risk you want to take on that path. You can ride a racehorse and bet it all on the outcome of one race. Or you can ride in a buggy and get there a little later, but a lot safer.The PowerOptions tools will help you pick the right race and keep you on track.

Click for a glossary of investing terms that will help you put the Three Horsemen to work!
* Expiration Date – The date on which an option and the right to exercise it or have it assigned cease to exist.
* Assigned – The obligation of the option contract was exercised.
* Strike Price – The price at which an option owner has the right but not obligation to buy or sell the underlying stock. For call sellers, this is the price at which you will have to deliver stock shares if your short option gets assigned. For put option sellers, this is the price you will have to purchase the stock shares if your short option gets assigned.
* ITM – An option is In the Money, when the stock price is lower than the strike price of a put or higher than the strike price of a call.
* Buy/Write – Buying a stock and selling or writing a call against the long stock position.

* LEAPS Option – An option with an expiration date more than one year out in time.

* Naked Put – Selling or writing a put option without owning the stock. The sale is generally cash secured.

* Call Option Sale – Selling a call when you initiate a naked or covered call.
* Call Option Buy – Buying a call when expecting a rise in the stock or buying back a call previously written.
* Put Option Sale – Selling a put when you initiate a naked put
* Put Option Buy – Buying a put when expecting a decline in the stock or buying back a naked put previously written.
* Hedge – The use of selling an option to offset the purchase of an asset to minimize the change in prices.
* Delta – A measure of the sensitivity the option value has to changes in the underlying equity price.
* Delta Ratio – With regard to spreads & calendar LEAPS, the delta of the long option divided by the delta of the short option. Many calendar leap investors look for a delta ratio of greater than 2.

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