Generating Income With a Limited Risk

Jason Ayres
March 24, 2016
6 minutes read
Generating Income With a Limited Risk

Selling or writing options can be a great way to generate cash flow as a compliment to a diversified investment approach. In general, the strategy involves selling a call or a put and getting paid to take on the obligation to either deliver or purchase the underlying shares at the strike price agreed upon. The objective of the option writer is to keep the premium as the written contracts expire out of the money. If an investor believes a stock is going to stay relatively the same or drop in value, a call my be written. If the investor believes the stock is going to stay relatively the same or go up in value, a put may be written. Implementing this approach in the absence of holding a position in the underlying stock is refereed to as being “naked”.

For more detailed information refer to the following equity option strategy guides:

The challenge for many investors when considering this strategy is that there is an undefined risk exposure if the shares trade beyond the written strikes. Because of this, the broker will require the option writer to put up sufficient margin to maintain the position. This can also be a challenge for investors with smaller accounts.
One consideration is to implement a Credit Spread to limit the risk and reduce the margin requirement.
The primary objective of the Credit Spread is to collect a premium from selling a contract expected to expire worthless, not unlike the naked option writer. The key difference is the simultaneous purchase of a less expensive contract using a portion of the premium collected. While this second “leg” reduces the overall credit collected, the investor has limited the risk exposure of the the position to the difference between the two strike prices less the net premium collected.
For a general overview of the bullish and bearish Credit Spreads check out the links below:
Let’s take a look at an example using Cameco Corportion (TSX:CCO). When considering any option writing strategy, I like to look at the price chart to identify support and resistance levels. If the share price is approaching a resistance level, the consideration is to write calls with the expectation that the move higher is likely to stall and pullback for a period of time. If the share price is approaching a support level, the consideration is to write puts with the expectation that the move lower is likely to stall and bounce.
Based on the chart of Cameco below, it appears as though the share price is at a resistance level and that a short term pull back is likely.
CAMECO (TSE:CCO) Daily, March 23, 2016
If we expect that shares of Cameco are likely to be trading below $17.00 between now and April 15th, 2016 (options expiration) A Bear Call Credit Spread could be constructed as follows:
Sell April expiration 17 strike call = $0.50 per share credit
Buy April expiration 18 strike call = $0.20 per share debit
Net credit = $0.30 per share
Max Risk = $0.70 per share ($1.00 spread between strikes less $0.30 credit)
Our maximum loss would be realized if the shares are trading above $17.30 on expiration.
To look at it more practically, an investor could sell 10 credit spreads and collect $300.00 for a maximum risk of $700.00. This represents a 42% return on risk for holding the position for 22 days (present date to April 15 expiration)
Lets’ consider a $100,000.00 portfolio
Granted the credit received will differ from spread to spread, Let’s assume this strategy is implemented successfully on a monthly basis. Based on that assumption, approximately $3600.00 in cash flow could be added to the portfolio representing about 3.6%. That said, each time the strategy is implemented the risk is limited to the spread less the credit. In this example, $0.70 times the 100 multiplier is $700.00 or less than 1% of the over portfolio value. The overall risk is that the investor is consistently wrong about their expectation and losses add up.
To conclude, this strategy can be a relatively passive way to increase cash flow in a non-registered portfolio beyond the traditional means. The investor can switch between the Bear Call Credit Spread and Bull Put Credit Spread depending on their outlook on the individual stock and overall market. The probability of the spread expiring profitably can be adjusted higher by selling further out of the money spreads. That considered, the trade off is the collection of less premium and the resulting increased risk.

Jason Ayres
Jason Ayres

CEO and Director of Business Development

R.N. Croft Financial Group

Jason is CEO and Director of Business Development at R N Croft Financial Group, a member of the Croft Investment Review Committee and a Derivative Market Specialist by designation. In addition, he is an educational consultant for and an instructor for the TMX Montreal Exchange.

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