Fri Apr 20, 2007: 11% Monthly Income from ENER Strangles

The stock of Energy Conversion Devices (NASDAQ-ENER) closed today at 36.35 per share.

A May 35-40 option strangle currently offers a monthly income of 11% from selling ("writing") an option combination of both the May 40 call and the May 35 put.

This return is calculated based on an income of $220 per strangle and a margin requirement of 50% of the call strike, or $2,000 per strangle. Actual margin requirements may be lower depending on your brokerage firm.

Today's Quiz: What are the break-even points for this trade? (answer below)

The 11% return assumes the stock closes between 35 and 40 on expiration day Friday May 18th so the put and call both expire worthless.

Let's consider what will happen if it finishes outside this range and you are assigned on one of the options.

You still get to keep the 11% income but you'll have to deal with an underlying stock position that could start you out with a loss bigger than that.

If it's below 35, the put buyer will exercise their option to sell ("put") to you 100 shares of ENER at $35 per share, which your broker will automatically buy for you in your account.

If it's above 40, the call buyer will exercise their option to buy ("call") from you 100 shares of ENER at $40 per share, which your broker will automatically sell short for you in your account. Note that if no shares are available for shorting within a few days (unlikely but it does happen sometimes) you'll be required to buy back the stock ("cover your short") even if that means you take a big loss if the stock has gone up a lot above 40. As discussed in a previous commentary, if you really wanted to stay short in this situation you could of course put on a synthetic short at this point.

Assuming you maintain a short position of some type, you might then want to hedge it by writing some out-of-the-money puts to generate extra income even if the stock does not go down.

Please discuss with your financial advisor the risks of the type of strategy described here.

Until next time, best of luck with your option investments!

Quiz answer: 32.80 and 42.20