Powerful Plays for Cautious Times – Combination Buy/Writes

Powerful Plays for Cautious Times – Combination Buy/Writes 

We’ve just experienced a very solid run-up in the broad market. That makes it harder to find bargain stocks. It also adds to the risk of a pullback. A see this as a prime time for buying shares while simultaneously selling calls and puts at near-the-money strikes. 

Why is that? When you sell both calls and puts you reduce your initial cash outlay while defining a wide band of profitability that stretched from below the trade inception price to well above your entry point. This occurs because at least one of the option buyers has to be wrong. If the shares close above $15 on expiration date they cannot close below $15. 

Here is an example of this type of trade from almost exactly one year ago. Slot machine manufacturer International Game Technology (IGT) was selling for $15.47 on Feb. 7, 2012. I liked the shares but saw an even better opportunity to use the combination technique as described below. The prices shown were real, not theoretical. This is what I published on Feb. 7, 2012…

IGT trade from Feb. 7, 2012 (2)

The best-case scenario was locked in as long as IGT closed at $15 or higher on the Jan. 18, 2013 expiration date. History showed that did occur. The $15 call was exercised and the $15 put expired worthless (a good thing for the seller). 

Those who played the combination as described laid out $1,127 while receiving $1,500 upon expiration. Because they owned IGT shares as part of the combination they also collected four quarterly dividends totaling $25 per hundred shares. 

Net profit equaled $1,525 -$1,127 = $398 / $1,127 = 35.3% cash-on-cash in about 11.5 months. A straight purchaser of IGT at the trade inception price of $15.47 would have needed to see $20.88 to reach the same 35% profit point.

IGT had a good year in fiscal 2012 (ended Sep. 30, 2012) and is looking for even better in FY 2013. The stock closed at $16.85 on Feb. 8, 2013. Here’s what could be done with a similar set up as of yesterday’s close.

 New IGT combo trade (1)

If IGT merely closes at $17 or higher on Jan. 17, 2014:

  • The call will be exercised and the put will expire worthless
  • Your shares will be sold for $1,700
  • You will likely have received $28 in dividends
  • Your final position will be no shares and $1,728 in cash

Net profit would equal $1,728 – $1,250 = $478 / $1,250 = 38.2% cash-on-cash in eleven months. That’s not too bad as you can achieve this on even a 1% upward move from the original trade entry price.

If IGT remains below $17 on the Jan. 17, 2014 option expiration date:

  • The call will expire worthless and the put will be exercised
  • You will be forced to buy another 100 IGT 
  • You’d need to lay out an additional $1,700 in cash
  • You will likely have received $28 in dividends
  • Your final position will be 200 IGT shares and $28 in cash

The net cost would be $1,250 + $1,700 – $28 = $2,922 / 200 = $14.61 per share. IGT could decline by up to $2.24 /share (-13.2%) without causing a loss on this trade.

Outright purchasers of IGT would need to see arise to $23.25 to make the same percentage gains as out best-case scenario. Simply owning shares without the option sales would not provide the downside protection that our combination play allowed for. 

Disclosure: Long IGT shares, short IGT options

IGT option prices (1) 

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