In last week’s article I discussed an idea for creating cash flow from the stock market without owning stocks. In a nutshell, this involves selling put options on stock index ETFs, like SPY (based on the S&P 500), QQQ (Nasdaq 100), or IWM (Russell 2000). The example I gave there was selling the October 182 put options at $.72 per share, at a time when SPY was at $192, on October 1.
As of today (October 7) those 182-strike puts, which were at $.72 per share a week ago, are now at $.05. We could terminate this trade by buying to close these puts for $.05, locking in a $.67 profit in just six days.
Here are the numbers on this trade. In order to sell each put we had to obligate ourselves to buy 100 shares of SPY at $182, if asked to do so. We did not believe that it was likely for SPY to drop below $182 (it was at $192) before the options’ expiration on October 16. Unless it did drop below $182 and remain there all the way until October 16, we would not be required to buy the SPY shares.
Because it was not impossible for SPY to end up below $182, our broker would require that we reserve the money in our brokerage account to buy the shares if needed. This was $182 per share times 100 shares or $18,200.
If we remained in this position until the October 16 expiration (15 days after we sold the puts) our return would be $72 on $18,200, which works out to four-tenths of one percent (actually .396%). Since this would be over a fifteen-day period, the annual rate of return would be 365/15 times this amount or a 9.6% annual rate.
As it happened, we did not have to hold the position for the whole fifteen days. When any short option drops down to a very low price, like the $.05 current price, it is worthwhile to close out the trade early. This releases the cash being used as security for the puts so that it can be put to work in a new trade. In this case our return was not the entire $72 originally received since we had to pay back $5 of that to terminate the trade. However, it did leave us with a $67 profit – and in only six days. That works out to an annualized rate of return of over 14%.
So, all was blue skies and green lights this time around. We were helped by a good-sized rally in the stock market since last week which carried the SPY to over $199.
This might have turned out quite differently though. If SPY had dropped below $182 we would have been stuck with it at that price. Our potential loss was theoretically unlimited if SPY kept dropping. I say “theoretically” unlimited because it is not actually possible for the ultimate worst case to happen, where SPY becomes completely worthless. This is because SPY is composed of 500 stocks. Any of them that did implode would just be replaced by other companies. So although SPY can certainly go down, it can’t go out. This is not true of the stock of any individual company (VW anybody?). This relative safety in numbers makes ETFs better candidates for put-selling strategies rather than individual stocks.
If we still don’t like the idea of really big potential losses from selling puts we can take one more step – buying puts of our own as protection. This uses up a little of our profits but caps our losses and actually improves our percentage return on capital considerably.
Last week when we sold the 182 puts for $72, we could have simultaneously bought the October 172 puts for $17. This would cut down our maximum profit by the $17 insurance cost, to $55. But the risk involved, and also the capital required, were now much less. Since we now could never be liable for more than $10 per share (the difference between the $182 and $172 strike prices), our capital requirement was only that $10 per share, or $1,000 for 100 shares. This is compared to the $18,200 that was required to sell the $182 puts without protection. So for the protected short puts (also called a Bull Put Spread), the return of $55 was on an investment of just $1,000. This was a 5.5% return in 15 days (if held until expiration). As it turned out, we would have closed this out today when the short $182 puts dropped to $.05. We could have sold the $172 puts that we owned for $.02. Our total profit would be $67 on the 182 puts (the original $72 premium received minus the $5 cost to buy to close them); less a loss of $15 on the protective puts (their $17 cost less the $2 recovered). Total profit: $52 in six days on $1,000.
Besides providing an annual rate of return too high to bother to calculate if it worked out, adding the insurance puts also capped our maximum loss. We now could never lose more than $1,000 (minus the $55 originally received, or $945 of our own money, plus commissions). While $945 is a lot of money for a return of “only” $55, doing the spread trade would allow us to keep most of our $18,200 in our pocket and not at risk at all.
This is just one of the ways in which options can be used to generate cash flow in the stock market without owning stocks. Talk to your local center about our Professional Options Trader course. It’s easy to know enough about options to be dangerous – learn enough to be safe.