Frequent readers will know that I favour option selling over stock ownership because of strategic versatility, greater downside protection, lack of capital requirements, and potentially better returns. One may argue that options carry more risk, however, when used in replacement of equity ownership, the advantages do outweigh the disadvantages.
The main disadvantage is the limited capital gains. Selling put options simulates stock ownership because the seller is speculating that the stock will remain above a certain pre-determined price, known as the strike price. However, the option seller does not participate in any strong rallies and gains only on the decreasing put option price. Statistics do show that within a diverse put option account, one can still beat the market's historical returns.
Below is a chart of the top 25 widely held companies by institution that have November 2014 options. Note, only Pepsi was removed from the original list of the top 25 as November options have not been issued by the exchanges.
The data suggests that dividends paid to the investor over the next 84 days will be less than the premiums received by selling the out-of-the-money put options. As well, there is a larger hedge for the put seller, which can be used to offset the automatic price reduction on cum-dividend day. Using Apple as an example, a trader, whose options expire worthless, will theoretically earn over 12 per cent, assuming option deltas remain stable. Because future prices are often uncertain, it may be worth sacrificing any larger gains by accepting the 12 per cent yields on the option.
This strategy is best used for those that are willing to own the stock even at a later date and at a lower price in exchange for immediate upfront cash. This is because almost at-the-money options have a greater chance of being assigned, and as such, the investor must understand they will own the shares if the other party exercises their rights. One must also take into account elevated commission and tax consequences. Dividends and capital gains may be taxed differently in your country. It would be prudent to look into the strategy further.
Other worthy facts: the downside protection for all 25 companies exceeds 3 per cent. That is, the premiums received plus the out-of-the-money (OTM) amounts are all greater than 3 per cent. In the event of assignment, the new stock owner has actually purchased the stock at a discount in November. For investors borrowing money, this will reduce the interest payments to the brokerage. Other people may also purchase short-term debt instruments to expire in November because the loan values of GICs and treasury bills may be 90 per cent or greater. This means a person with $100,000 can sell options and buy short-term debt instruments at the same time!
