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Using Puts and SelectSector SPDRs to Create an Ultra-Conservative Option-Selling Strategy

Selling out-of-the-money puts and using top-performing SelectSector SPDRs can be combined to design an extremely defensive option-selling strategy in a volatile market environment like we are currently experiencing. Using Inverse Exchange-traded Funds is another approach. In this article, we will discuss the former strategy,.  When we sell an out-of-the-money cash-secured put we are agreeing to purchase that security at a price lower than its current market value. In a bear or volatile market environment this can be a sensible approach to generating monthly income while still emphasizing capital preservation. Our breakeven becomes the strike price minus the put premium. If a stock was selling for $52.00 and we sold the $50.00 out-of-the-money put for $2.00, our breakeven would be $48.00.

The SelectSector SPDRs are exchange-traded funds that divide the S&P 500 into nine sector index funds. We can choose the current top-performing sectors and then sell out-of-the-money puts on those ETFs that are currently in favor. Since ETFs in general, and especially those associated with the S&P 500, have lower option premiums, we must lower our goal expectations in exchange for the protective nature of this strategy. 10% – 12% annually would be a reasonable objective. The screenshot below depicts the top-performers as of 7/28/2015, a screenshot I took prior to the current market decline:

Put-selling on ETFs

Top-Performing SelectSector SPDRs

Note the following 3-month performances

  • S&P 500 SPY)- (-)0.59%
  • XLY- + 3.26%
  • XLV- + 3.75%
  • XLP- + 3.05%
  • XLF- + 3.53%

 

31-day returns

We first access an options chain and then feed the information into the BCI Put Calculator:

put-selling calculations

Put Calculations for SelectSector SPDRs

Note the following % discount if exercised (black arrow) and annualized returns (red arrow)

  • XLY- 2.61% (10.89%)
  • XLV- 2.76% (11.65%)
  • XLP- 1.38% (13.34%)
  • XLF- 3.07% (10.67%)

 

 

Steps after exercise or non-exercise

If the option expires worthless (share price remains above the strike price), we continue to write out-of-the-money puts looking to generate 1% per month. If the option is exercised and we buy the underlying ETF(s) at the “discounted” price, we can then either write an in-the-money covered call or sell the security and replace it with a better-performer.

 

Discussion

Option-selling strategies can be crafted to accommodate market conditions and personal risk-tolerance. In bear or volatile market conditions combing out-of-the-money cash-secured puts and SelectSector SPDRs is one way to develop a defensive option-selling blueprint.

 

Department of Labor proposed Laws Relating to Options in IRA Accounts

Some of our members have become aware of and are concerned regarding laws recently proposed by the Department of Labor regarding the use of options in IRA accounts. Many of our members currently use options in these accounts and have expressed concern to me.

I have contacted the CBOE, contacts I have at FINRA and a few Financial Advisors familiar with the situation and here is what I can report at this time:

  • DOL’s proposal wouldn’t preclude covered call writing in self-directed IRAs
  • The proposal essentially would require those advising holders of 401(k) plan accounts, individual retirement accounts (IRAs) and other self-directed retirement plan accounts to act as fiduciaries
  • The fiduciary standard is the applicable standard for Investment Advisory-based accounts. For brokerage accounts, the standard is not as stringent
  • The impact of the proposal would be on the brokerage side
  • The rule would not prohibit covered call writing in self-directed IRAs, but may prohibit Advisors from charging for covered call writing-based recommendations
  • The rule would permit brokerage account Advisors to charge for recommendations in connection with the purchase or sale of an “Asset” for an IRA. Regarding the definition of an “Asset,” the proposal, in its current state, specifically excludes options-based recommendations, meaning an Advisor would not be able to charge for recommending writing calls
  • It appears more about precluding charges for options based advice vis a vis IRAs, and not about precluding the strategy itself
  • The OCC formally commented on the DOL proposal. I think you will find the OCC’s submission useful. You can find it here: http://www.dol.gov/ebsa/pdf/1210-ZA25-00063.pdf

If you want contact your political reps on this issue, here is a link created by TD Ameritrade:

The information I have received thus far indicates that we will still be able to write calls in our IRAs. The proposed laws seem geared to assuring the advisers adhere to the fiduciary responsibilities they are legally bound to. Any additional insurances or costs to advisers and brokers may, however, eventually be passed onto us. I will update our members as I learn more on this topic.

 

September live appearances

1- St. Louis, Missouri

September 15, 2015

6:30 PM – 9 PM

Link to register

 

2- All Stars of Option Trading

September 16, 2015

Discussion panel

New York Stock Exchange

4:10 PM – 5:00PM

Pre-event webinar (FREE): Wednesday September 9th @ 5:00 – 5:20 PM ET

Click to register

 

DISCOUNT PROMO CODE for early-ordering the Complete Encyclopedia for Covered Call Writing- Volume 2

I am pleased to announce that we are still accepting early-ordering and offering a $5.00 discount for Volume 2 of the “Complete Encyclopedia for Covered Call Writing” between now 12th of September.  Only soft-cover versions are available at this time. Hard-cover and kindle versions will be available in the fall. Shipping will begin the third week of September for all orders taken after 9/3/2015.  We are expecting two shipments this week and both are completely sold out (THANK YOU!!!). For those members who placed orders prior to September 4th, shipping will begin this coming Wednesday. Here is the link to the information page:

http://www.thebluecollarinvestor.com/alan-ellmans-complete-encyclopedia-for-covered-call-writing-volume-2/

Promo code:

volumetwo5: $5 discount valid from September 5th through September 12th

 

Market tone

Market volatility continued as investors remained concerned about China’s slowing economy and a possible interest rate increase by the Fed in September. Stocks moved considerably from day-to-day and mostly on the downside although volume was light due to the upcoming holiday weekend. A positive jobs report increased concerns about a rate hike. This week’s reports:

  • The US economy added 173,000 jobs in August, fewer than expected, but initial estimates for that month tend to be revised up significantly
  • The unemployment rate fell to 5.1%, the lowest in more than seven years
  • Average hourly earnings increased 8 cents and average weekly hours worked rose to 34.6
  • The broader U6 measure of joblessness, including discouraged workers and those working part-time for economic reasons, fell to 10.3%, the lowest since June 2008
  • The US trade deficit fell to a five-month low in July, declining 7.4% to $41.9 billion from $45.2 billion in June
  • US non-farm productivity rose 3.3% in the second quarter, its strongest pace since the fourth quarter of 2013, after shrinking 1.1% in the first quarter
  • The longer-term trend in productivity remains weak, increasing just 0.7% from a year ago
  • The US services sector growth improved from 55.7 in July to 56.1 in August
  • The manufacturing PMI fell from 53.8 in July to 53.0 in August
  • The Institute for Supply Management’s index fell from 52.7 in July to 51.1 in August.
  • Initial jobless claims increased 12,000 to 282,000 for the week ended 29 August
  • Continuing claims fell 9,000 to 2.26 million for the week ending August 22nd

For the week, the S&P 500 rose 0.91% for a year to date return of (-) 3.40%.

Summary

IBD: Market in correction

GMI: 0/6- Sell signal since market close of August 24, 2015

BCI: This site remains bullish on the US economy but concerned about market reaction to events in China as well as the Fed watch. I am also watching the VIX, usually inversely related to the market direction, currently at 30, a bit high for my taste. At this time, I am retaining all shares currently in my portfolios but not purchasing new ones or writing calls until a bottom is identified.

Wishing you the best in investing,

Alan (alan@thebluecollarinvestor.com)

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About Alan Ellman

Alan Ellman loves options trading so much he has written four top selling books on the topic of selling covered calls, one about put-selling and a sixth book about long-term investing. Alan is a national speaker for The Money Show, The Stock Traders Expo and the American Association of Individual Investors. He also writes financial columns for both US and International publications along with his own award-winning blog.. He is a retired dentist, a personal fitness trainer, successful real estate investor, but he is known mostly for his practical and successful stock option strategies.

26 Responses to “Using Puts and SelectSector SPDRs to Create an Ultra-Conservative Option-Selling Strategy”

  1. Barry B September 5, 2015 5:05 pm #

    Premium Members,

    The Weekly Report for 09/04/15 has been uploaded to the Premium Member website and is available for download.

    Also, be sure to check out the latest BCI Training Videos and “Ask Alan” segments. You can view them at The Blue Collar YouTube Channel. For your convenience, the BCI YouTube Channel link is:

    http://www.youtube.com/user/BlueCollarInvestor

    Best,

    Barry and The Blue Collar Investor Team

  2. Jay September 6, 2015 12:48 pm #

    I have been an admirer and student of Alan’s for years. He has taught me more about investing than any other individual I can think of. OK, maybe my Dad taught me more :)

    His strategy of selling a cash covered put to enter a position then follow it up with a covered call works.

    I am retired and sell options to pay my bills. Heaven forbid I ever draw down my nest egg! I sell spreads and condors in my self directed IRA weekly. But I also do the basics as described in this blog. Anyone can profit from them. It only takes initial options clearance.

    Thanks again, Alan, for another timely blog article. – Jay

    • Nate September 7, 2015 12:15 am #

      I’m glad I found Alan’s work early in life. I’m in the early thirties. Right now I’m in the compounding stage building that nest egg. Actually I to think of my savings as a goose and the covered call writings as the golden eggs laid each month. Jay it’s good to hear it’s been working for others over the long term. I’ve been using the system since February with good results. Now as Alan says, I have years and decades to benefit from his teachings. Awesome!

  3. Nate September 7, 2015 12:03 am #

    Hello Alan, What do you usually look for to determine that a bottom is in place? You mentioned a lower VIX. To me a VIX below 20 seems like a good start. Any other tell tale signs?

    • Alan Ellman September 7, 2015 7:12 am #

      Nate,

      I use a mosaic of the chart of the S&P 500 (50-d sma above the 200-d sma), the VIX (I agree, 20 or lower is a positive), and a positive trend with the weekly reports. Currently only the latter is a positive in my view. To get other points of view, we publish the IBD outlook and Dr. Eric Wish’s GMI Index in our weekly blog articles and in our premium member reports.

      Alan

      • Nate September 7, 2015 8:00 pm #

        The 50 sma above the 200 sma makes sense. I’ve heard of the death cross so it only seems right to wait for the opposite, the golden cross. (I had to look up the name.) Thanks.

  4. Ken September 7, 2015 12:03 am #

    Alan, learning lots here. A few questions.
    How long is the option contract?
    When is expiration fri?
    If I don’t want to give up my stock shares, how do I avoid this? By buying the option back, at the market?

    Thanks, Ken
    Ps. Wife wants to know if you’re still a full time dentist?
    Very impressed with your lessons and service! Thanks!

    • Alan Ellman September 7, 2015 7:18 am #

      Ken,

      My responses:

      1- Option contracts are available in many different lengths…some up to 2 1/2 years into the future (called LEAPS) and some as short as one week (Weeklys). In use mainly 1-month options which expire on the 3rd Friday of the month.

      2- The 3rd Friday of the month at 4 PM ET.

      3- Buy back the option, yes. Try setting a limit order (a specific price or better) if the bid-ask spread is wide.

      4- I sold my dental practice two years ago. I had to make a career choice as both were taking up a lot of time. I love what I do and don’t miss root canals!

      5- Thank you for your kind words.

      Alan

  5. Jim September 7, 2015 2:43 am #

    Alan. I was hoping to see you in St. Louis, but we have a conflict that evening.

    I’m still working my way through the concepts. Although I did buy 100 shares of NHTC at 25.99, which sadly isn’t on your screening list (bought before I subscribed). I sold the 22.5 ITM call for Sept 18 for 3.91 a share. The stock has been sinking towards that strike price. I realize am losing value because the stock price is going down, but I am having trouble understanding why someone would exercise the option at 22.5 when the stock price is actually at 22.50 without the option. I am sure there is a “eureka!” piece I am missing.

    You probably get a million emails like this, but if you have any pointers, I’d be grateful.

    Thanks,
    Jim H

    • Alan Ellman September 7, 2015 6:21 pm #

      Jim,

      You’re still okay at this time. Let’s break this down:

      Buy NHTC @ $25.99

      STO the Sept. $22.50 @ $3.91

      Now your shares are worth $22.50, the price you’ve agreed to sell them for

      Share loss = $3.49

      Option credit = $3.91

      Net credit = $0.42 per share = $42.00 per contract

      Initial 1-month return = $42.00/$2250 = 1.9%

      This profit is guaranteed as long as share value does not decline below $22.50 (currently at $24.11)

      The option buyer can ell the option today for a minimum of $2.15 (I checked an options chain)

      If the option buyer exercises the option and buys your shares for $22.50, the credit will be $24.11 – $22.50 = $1.61

      Which would he rather have: $2.15 or $1.61? That’s why your shares will probably not be sold at this time.

      Use the multiple tab of the Ellman Calculator to do the math…

      Alan

  6. Adrian September 7, 2015 5:50 am #

    Alan, I need to ask some questions about initially buying any stock that I am to use to sell options on, and these are:-
    1. Why is it alright to buy a stock that has risen up alot to a resistance level(maybe with indicators overbought too), but you say that I should not re-buy any stock I have just done a MCU on some 2 weeks prior?(like if I want to re-buy same stock again at expiration, if price doesn’t dip down at all but instead holds steady?)

    2. When the price channels s/ways then there is less importance on what the trend indicators for instance MAV’s look like, so why then would the price need to always be above these 20d & 100dEMA’s when in a s/ways channel if I am wanting to buy or rollout any particular stock?

    3. When checking over the stocks news before thinking of buying one, then how far back should I need to see this news?

    4. As you stated on a PDF that we could sell if price goes 7-8% below our buy price, then couldn’t this target price be above the 20%/10% option values we are to wait for, before thinking of closing any open position?

    5. And am I to pass up any listed stock that has an N/A for the R/R rating?, – but if not, then should I be more cautious and sell ITM options irrespective of what the technicals,etc are like?

    Hope your portfolio didn’t get to burnt too much the other week with the large market declines. I have read that this correction could be ending soon anyway which should be a relief for most.
    Maybe now is the time to open some positions while volatility is high and a possible market low is in.
    Thank you for all your advise.

  7. Alan Ellman September 9, 2015 12:57 am #

    Adrian,

    Here’s 1 – 3:

    1- When we’ve taken advantage of the MCU opportunity, it is with a stock that has increased in value in a very short time frame and profit potential is maxed out for that contract month. Rolling up in the same month is risky because the time to expiration may not allow ample opportunity for exit strategy repair if there is profit-taking. However, this may very well be an eligible candidate for option-selling at the start of the next contract month. My main concern is due to the sharp price rise in a short time frame.

    2- A stock trending sideways renders the moving averages less significant. I still want to see the shorter-term EMA above the longer-term EMA. I will also take more conservative approaches to option-selling compared to securities that have established definitive uptrends.

    3- Stock news is already factored into the current market value of a stock. I tend to look at news when there is a sudden change in price (either direction) or if the implied volatility is unusually high (option values much higher than normal).

    I’ll get back to 4 and 5 as soon as time permits.

    Alan

    • Barry B September 10, 2015 9:58 am #

      Adrian,

      A comment to item # from Alan’s response to you:

      In the situation where the price of the underlying is moving sideways,the moving averages do not give you actionable information. In these cases, you can use both Stochastics and MACD to help you with your trading decisions. See pages 55 through 78 in the …”Encyclopedia” for more in depth details.

      For other views on the topic, check out:
      – Finviz
      https://finviz.com/help/technical-analysis/oscillators.ashx

      – Stock charts.com
      Check out their “Chart School”. You can find the link in the
      “Chart School” tab on the Stockcharts.com page

      Best,

      Barry

    • Alan Ellman September 11, 2015 6:17 am #

      Adrian,

      4- It is critical to close the short option position first. Through trial and error of different percentiles over several years (many years ago), I have found that the 20/10% guidelines will keep us out of trouble. We can even set a limit order to close the short option position right after entering it. Now IF the option is bought back, when do we sell the stock? I use chart technicals and a comparison to the overall market. Some members use a percentage drop from purchase price, usually in the 7-10% range.

      5- Very good question. In the BCI methodology, we use a series of rigorous screens and the Scouter is one of them. American Depository Receipts (ADRs) have never been assigned Scouter Ratings but yet still have a presence on our watch lists. If they pass all our other screens, they are still eligible and outstanding candidates for option-selling. The Scouter will weed out highly volatile stocks, a key criteria in that algorithm. We should look at the returns of a near-the-money option which reflects the implied volatility of that stock. If high, take a more cautious approach and use an ITM strike. If not (say in the 2-4% range for a 1-month return), treat as any stock that has a Scouter > “4”.

      Alan

  8. Jabar September 9, 2015 1:59 am #

    HI Alan,

    My goal as The Blue Collar Investor is to retire in the next four years by doing ITM covered call trading. Moreover, I just want to let you know that you are a great mentor and I don’t know what I would do without your help.

    I understand you’re busy but if at all possible I have A Few questions

    How protected is downside protection? Is it something to hang on to or something that I would need to prepare an exit strategy for?

    What would you say will be the most common exit strategies for ITM covered calls?

    Since I will be starting my investing with $15,000 what would be more sensible ETF trading or ITM cover call trading?

    Again thank you Alan!

    • Alan Ellman September 9, 2015 12:08 pm #

      Jabar,

      The amount of downside protection is directly related to how deep in the money (below market value of the stock) is the strike we sold. The deeper ITM, the greater the downside protection of the option profit. We always have to be prepared with potential exit strategy opportunities no matter what our strike choice is.

      All exit strategies are on the table with ITM strikes as they are with all strikes. Master them all to become the best option-seller possible.

      An account of $15k is best suited for ETFs which will allow for broader diversification. We can use all strikes with ETFs as we can with individual stocks, including ITM strikes.

      You’re doing a great job studying and asking excellent questions before risking your hard-earned money.

      Take your time and keep up the good work.

      Alan

  9. Steven September 9, 2015 1:05 pm #

    hi alan, why does my options market value (on Scottrade summary brokerage page) show a negative when all i did was sell covered calls?? btw yesterday i sold 4 covered calls totaling $551

    Market Value$14,953.86
    Options Market Value-$781.00

    tnx for your valued education, steven

    • Alan Ellman September 9, 2015 1:09 pm #

      Steven,

      Don’t worry all is fine. This is an accounting procedure used by all brokerages when a security is sold short. This is done because the option may be bought back (but certainly doesn’t have to unless we are invoking an exit strategy). Once the option expires, is bought back or is exercised, the brackets and negative implication will remain but the cash generated from the option sales is real and is in your cash account.

      Alan

    • Jay September 9, 2015 7:24 pm #

      Steven,

      To possibly build on the answer Alan will provide: all options you sell will show as a credit in your cash balance and a debit on your holding page for a net zero in your account balance.

      Cash secured puts, covered calls, credit spreads, credit condors, regardless. I once thought my account balance would go up instantly when I sold an option :). Silly me….

      Your account only goes up or down depending on how the option settles and what exit strategies you use when the football takes a funny bounce! – Jay

  10. Frank September 9, 2015 8:19 pm #

    I don’t know if I missed it, but BRLI was on the 7/17 newsletter as a “buy”, but I haven’t seen anywhere that you commented on what happened (is happening) with their stock.

    It was selling at the time for about $44-$45 and fluctuated in that range until about 8/5, and then the stock was … suspended?

    Has this ever happened to you? Any comments?

    If you already addressed this, could you give me the reference?

    thanks

  11. Bilal September 9, 2015 9:06 pm #

    in volatile times like write now do you suggest to hold off on taking any positions hedged or non until the dust settles?

    • Alan Ellman September 10, 2015 6:02 am #

      Bilal,

      Yes, this is a perfectly reasonable position to take when market is behaving in an unusually volatile manner. I am currently taking no option positions but still retaining shares already in my portfolio. Some investors will take advantage of a severe decline to purchase shares at the lower price.

      Alan

      • Bilal September 10, 2015 9:34 am #

        First off thanks for reply to poorly worded sentence.
        Followup to you: If I understand correctly you are not taking option positions in stocks you own at this juncture.
        What do you say to strategy of selling cash secure put on a stock you love but can’t afford the current price. And if it falls to that price fine otherwise you pocket the premium. That is for today’s market off course. Where anything is possible.

        Thanks,

        • Alan Ellman September 11, 2015 6:50 am #

          Bilal,

          Absolutely. You have identified one of the fantastic ways we can implement put-selling…an alternative to setting limit orders in order to purchase a stock at a discount from current market value.

          Alan

  12. Alan Ellman September 11, 2015 6:47 am #

    Thanks to Ron for sharing his Senator’s response to the Department of Labor’s proposals regarding the use of options in IRA accounts:

    Dear Mr. M :

    Thank you for contacting me about the Department of Labor. I appreciate hearing from you on this important topic.

    As you may know, on April 20, 2015 the Labor Department acted on President Obama’s direction to issue regulations requiring retirement advisers to abide by a “fiduciary” standard and put their clients’ best interest before their own. While well-intended, this rule could actually harm those it aims to help by limiting access to financial advice and raising the cost of saving for retirement.

    Given the complexity and wide-ranging nature of this proposed rule change, I joined 35 of my colleagues on May 12, 2015 in sending a letter to Labor Secretary Thomas Perez asking the department to extend the proposed rule’s comment period from 75 to 120 days to allow for sufficient review time. In his response to our letter, Secretary Perez informed us that, after the 75-day comment period, a public hearing will be held. After the hearing, the comment period will temporarily reopen – providing “between 111 and 127 days” of discussion time. I will certainly keep your comments in mind as I continue to monitor the Department of Labor’s decision.

    Thank you again for contacting me. Please do not hesitate to do so again in the future. I also encourage you to visit my website, which may be found at flake.senate.gov.

    Sincerely,

    JEFF FLAKE
    United States Senator

    From Alan: Based on the information I have thus far, I do not believe that we, as retail investors, will be impacted by these proposals. The BCI team will continue to follow this matter and I’ll see if I can glean additional information when I attend the All Stars of Option Trading event at the NY Stock Exchange next week.

    Alan

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