Tuesday, March 24, 2009

Show & Tell: USO

In January USO was exhibiting slowing momentum in addition to a steady increase in volume, potentially implying institutions and big money stepping into the market and beginning to accumulate shares. Implied Volatility was also rather high, juicing up option premiums. Because I expected the stock to begin to bottom out, and didn’t mind getting long the stock if it continued to decline, I sold naked February 26 puts. For simplicity purposes, let’s assume I sold 2 contracts.

When selling naked puts, I generally sell 3-6 weeks out to exploit the time decay of short-term options. At the time we were about 5 weeks out from February expiration. In choosing which strike, I generally go as far out-of-the-money as possible while still receiving an acceptable credit. For me, that’s usually around $1.

Trade Inception:
Jan 13 – sell (2) February 26 puts for $1.00
Max Reward - $100 x 2 = $200
Theoretical Max Risk = $25 x 2 = $5000
At February expiration, USO was trading at $24.35 causing the naked puts to expire in the money. Remember, all in-the-money options are automatically exercised at expiration. Consequently, I was assigned on my short puts, requiring me to buy 200 shares of USO at $26. Although I bought the shares at $26, I was able to keep the $1.00 of premium, dropping my cost basis to $25.

Once I’m assigned the stock on a naked put trade I usually consider the following 3 actions:

1. Sell the stock to close the trade (if bearish)
If I was going to just sell the stock when assigned, I probably would have simply bought back the short puts prior to expiration to avoid assignment.

2. Stay long the stock (if bullish)
If I’m bullish on the stock, I’ll simply stay long the shares to participate in any upside movement in the stock.

3. Sell covered calls to further reduce your cost basis (if neutral to mildly bullish)
By selling covered calls, I can continue to lower my cost basis and risk in the position.

In the USO trade, I decided to sell March covered calls against my stock position. Rather than selling both covered calls at once, I scaled into different strike prices. Within a few days of being assigned the stock, I sold a March 26 call option for about $1.50. This further lowered my cost basis from $25 to $23.50. After the USO rallied a few days, I then sold a March 28 call option for $1.50, bringing my cost basis on all 200 shares to $23.50. Take a look at the numbers below:

Long 200 shares at $23.50
Short (1) March 26 call
Short (1) March 28 call
If USO were to rally above $28 by March expiration, I stand to profit $250 on 100 shares and $450 on the other 100 shares.

At March expiration USO closed at $30.76, causing the short call options to be automatically assigned and my long 200 shares to be sold at $26 and $28, resulting a total accumulated profit between the naked puts and covered calls of $700.

A few observations:
1. At trade inception (Jan 13th), the USO was trading around $31. About 2 months later at March expiration the USO was right back around $31. Had I simply bought the stock at $31 and held for 2 months, not only would I have had $31 at risk, I’d also have nothing to show for it after 2 months.

2. By using options (naked puts, covered calls), I was immediately able to lower my cost basis/risk to $25, and then later to $23.50 (a whopping 24% less than $31), as well as rake in a tidy profit over 2 months.
USO has had a nice little run up as oil has popped above $50 a barrel. A pullback in USO may provide an opportunity for some type of bullish play for April…



DeLara said...

Great Post!

Sharon P said...

Thanks for the Post!

Jeff said...

I too am in USO. I entered a covered call on 3/6 - Stock 27.65 and MAR 29 Call for 1.00. I rolled out/up to APR 30 for a net credit of .55. My cost basis is now 26.10. I have a bit to go to catch you, but I also have not owned the stock as long as you. I trade in an IRA and my broker will not allow me to go naked on options even if I have the cash. Pity! Check out my covered call blog at http://buywrite.wordpress.com

Jeff said...

By the way, nice blog!

Tyler Craig said...

Thanks Jeff. Good luck on the USO trade. I'll check out the blog.

Teddi K said...

Okay I have to tell you, that I am having an ongoing discussion with a blogger who runs the yahoo group justcoveredcalls regarding puts and calls being used together. I sent him the link to your blog to show the advantages that using puts also have as I use puts extensively. He replied that he was unimpressed and the same return would have been got by just purchasing the stock and selling the covered call. Can you look over his notes below my post and reply to me as to what I can say to him to prove that the put was worthwhile. Thanks. Teddi K

I read the article and it did little to change my opinion. With USO at $31 he sold a Feb 26 Put. He could have also bought the stock and sold a Feb 26 Call and had similar results.
Today USO is also around $31. Here's a comparison of selling a Apr 26 CC vs an Apr 26 Put:
Description Covered Call Cash Secured Put Variance Put vs Call
Stock Symbol USO
Starting Capital $3,122.00 $3,122.00
Stock Price $31.21 $0.00
Buy 100 Shares of Stock $3,121.00 $0.00
Commissions $1.00 $0.00
Net Stock Investment $3,122.00 $2,600.00 ($522.00)

Strike Price $26.00 $26.00
Premium $5.50 $0.30
Sell 1 Option $550.00 $30.00
Commissions $1.00 $1.00
Net Premium Received $549.00 $29.00 ($520.00)

Net Investment $2,573.00 $2,571.00 ($2.00)
Cash Remaining in Account $549.00 $3,151.00 $2,602.00
Margin Requirement $0.00 $2,600.00 $2,600.00
Cash Available for Reinvestment $549.00 $551.00 $2.00

Days Until Expiration 24 24
% Premium Generated 17.58% 1.12% -16.47%
% Downside Protection 17.58% 17.62% 0.03%
Dividend Received $0.00 $0.00
Back to Cash Profit $27.00 $29.00 $2.00
% Annualized Back to Cash Return 13.15% 16.96% 3.81%

Annual Interest Rate 1.00% 1.00%
Interest Received $0.36 $2.07 $1.71
Total Back to Cash Profit $27.36 $31.07 $3.71
Total % Annualized Back to Cash Return 13.33% 15.14% 1.81%
As you can see the net investment and returns are about the same. This is not theory. You may disagree but the numbers speak for themselves.
Mike A

Jeff said...

Hey Teddi (sorry Tyler for using your blog like this)...
I think you should kill the dialogue on the Yahoo group and agree to disagree. I understand yours and Mike's trading strategy is different - and mine is different than either of yours as Tyler's is. Point is, it ours and it works for us. I didn't want to say this in the group for fear of being attacked for not allowing freedom of speech. What do you think?
Jeff W

Tyler Craig said...

I’ve got a few errands I got to run this morning, so let me throw out my short answer, then I can go more in depth if you need me to when I have more time. If you assess the risk graph of a covered call vs. a cash secured short put (using the same strikes- as was used in your example), their risk-reward characteristics should be nearly identical. This is why sometimes the naked put is considered a synthetic covered call. Now if your broker only charges you say 20 or 25% of the stock price as margin when selling a naked put, then your ROI will be higher than the covered call, b/c you don’t have to put up as much cash. Keep in mind there is room here for personal preference - It’s tough to make a blanket statement that one strategy is better than another. In my post I was merely trying to show the benefit of using naked puts and covered calls vs. buying stock outright.