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Profiting in Small-Caps Whether They Go Up, Down, or Remain Flat

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It’s not often that we can make money even when our underlying investment goes down in price.

But one simple option strategy has the power to do just that. In fact, this strategy has consistently produced above-average returns with relatively low risk.

Before we delve into the strategy itself, let’s review some option basics.

Option Basics – A Refresher

There is no need to worry about complex mathematical formulas or equations. Over the years I’ve found that the more complicated a strategy is, the less likely it will work over the long-term. We want to employ a strategy that has a history of profitability and is easy to follow.

Options are standardized contracts that give the buyer the right – but not the obligation – to buy or sell the underlying stock at a fixed price which is known as the strike price. A call option gives the buyer the right to buy a stock, fund, or index, while a put option gives the buyer the right to sell the same. The investor who purchases an option (whether a put or call) is the option buyer, while the investor who sells a put or call is the seller or writer.

Options consist of time value and intrinsic value. In-the-money options consist of both components. At-the-money and out-of-the-money options consist only of time value. At options expiration, options lose all time value. When we are short an option, the time value of that option becomes profit at expiration regardless of the price movement of the underlying stock or ETF.

Become Your Own Bank

Most investors are not familiar with the concept of selling option premium to generate cash income. Selling option premium is a very simple but lucrative income strategy. When you sell an option, cash equal to the premium is immediately credited to your brokerage account.

Unlike a traditional stock dividend, you don’t have to own the stock on the dividend date to receive a quarterly dividend and you don’t have to wait a year to receive a 2% or 3% annual dividend yield.

The key to selling option premium to generate cash income is to make sure the option you sell is ‘covered’. In this example, we’ll be using what is known as a buy-write or covered call strategy. In this strategy, we buy in increments of 100 shares of a stock or ETF and sell a related call option. As options cover 100 shares of the underlying security, we want to make sure that we sell 1 call option for every 100 shares purchased.

Weekly covered calls are initiated by buying 100 shares of a stock and selling 1 weekly call option. As noted previously, when you sell an option, cash equal to the option premium sold is immediately credited to your brokerage account. This cash credit reduces the cost basis of the stock and reduces the overall risk of the trade. The great advantage to selling weekly calls is that you get to sell 52 options a year.

This strategy incurs less risk than owning the stock outright, but has the potential to deliver returns far in excess of simply owning the stock. Because the short option is ‘covered’ by the purchase of the stock or ETF, this strategy incurs limited risk. The covered call strategy can profit if the market goes up, down, or remains flat and gives us an edge in producing consistent returns during any type of market condition.

Weekly options are the ideal investment for turning small amounts of money into large amounts. This strategy is the ultimate game changer and can help us realize a more consistent profit flow.

Ideal Strategy for Today’s Volatile Markets

Selling option premium is a great strategy for profiting during hostile market conditions. Weekly options amplify this strategy as we get 52 opportunities each year to generate income as opposed to just 12 with monthly options.

Let’s take a look at an actual trade example. Small-caps have roared back from the dead this year and are staging an aggressive entry on today’s pullback. The Direxion Daily Small Cap Bull 3X ETF (TNA - Free Report) gives us levered exposure to this group and is a good candidate for our strategy. 

With TNA trading at 40.29, the May 24th 40.5-strike call is trading at 1.04 points and is an out-of-the-money option consisting of only time value. When you are short an option, the time value portion of an option becomes profit as the time decays to zero at expiration. At option expiration next week, the time value of this option becomes profit regardless of the price movement in the TNA ETF.

Added Dimension of Profitability

Purchasing just 100 shares of the TNA ETF and selling the 40.5-strike call equates to a cost of only ($4,029-$104) $3,925. We can see a risk/return analysis of this trade below:

Zacks Investment Research
Image Source: Zacks Investment Research

The table above displays the risk/reward profile for this trade. The TNA ETF is currently trading at 40.29 (orange box). We are selling 1 May 24th 40.5-strike call at 1.04 points (brown box), which is the option premium and is credited directly to our brokerage account. Since options account for 100 shares of the underlying stock, the total cost for this covered call trade is $3,925; our breakeven price is $39.25 as we can see in the yellow highlighted box.

The top (blue) row shows the performance of the TNA ETF based on different percentage scenarios at expiration. The bottom (purple) row shows the corresponding percentage return for our covered call trade.

If the TNA ETF remains flat at $40.29 upon the weekly option expiration, the 1.04 points of time value in the 40.5-strike call becomes profit as the value of the option goes to zero. We would realize a 2.6% return in this scenario.

If the TNA ETF increases in price at option expiration, we still collect the 1.04 points in time premium profit. The short option may show a loss if TNA increases above the 40.5-strike price, but this loss is more than offset by a gain in the ETF. At option expiration, an upward move in the TNA ETF would equate to a 3.2% gain in our covered call trade.

If the TNA ETF decreases in price at expiration, we collect the 1.04 points in time value as the short option goes to zero. The $104 profit could be offset by a loss in the ETF price depending on how far the ETF declines.

- TNA remains flat at option expiration = +2.6% return

- TNA increases at option expiration = +3.2% return

- TNA declines -2% at option expiration = +0.6% return

When you buy a stock or ETF at a discount via the sold option premium, you can profit if the underlying security increases in price, remains flat, or even declines from your entry point. This results in a much higher probability that the trade will be profitable. It’s a big reason why this option income strategy has a huge advantage over a stock purchase strategy.

Cash-on-Cash Return

As stated above, each call option covers 100 shares of the underlying stock or ETF. Purchasing 100 shares of TNA at the current price of $40.29 and selling 1 of the 40.5-strike calls at 1.04 would cost $3,925 to initiate this covered call trade. If we were to rollover the short options weekly and receive a similar premium, we’d have the potential to collect $5,408 over the next year ($104 x 52). Receiving $5,408 in cash over the next year would result in a 138% cash-on-cash return ($5,408 cash income / original $3,925 covered call cost = 138%).

If you receive a 138% cash-on-cash return, a lot can go wrong and you could still profit.

- The underlying ETF can decline substantially and you could still profit

- If you have bad timing on the trade or encounter volatility, you could still profit

- This gives the buy-write strategy a huge advantage over owning stocks outright

Bottom Line

There aren’t many times when we can profit even if our investment goes down in price. The buy-write strategy offers very attractive returns and very low risk making it one of the best overall strategies for investors.

This strategy can be profitable in positive, sideways, or even slightly downward-trending markets. This allows us to maintain our positions through volatile market environments, when normally we would be stopped out of our position. The strategy incurs less risk than owning stocks while also having the potential to produce enhanced gains.

I think the above analysis demonstrates why the covered call strategy should be a part of every investor’s portfolio!

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