Fri Jun 2, 2006: Double Your Option Income: Sell Strangles! (NYSE-TIE)

It’s exciting to find covered call opportunities that pay you an income of over 10% per month. But how’d you like to make that much in only two weeks?

Check out the options on Titanium Metals Corp. (NYSE-TIE, 39.96). Right now if you write an option strangle you could potentially make 11.3% in only two weeks.

Strangle writes involve selling an out-of-the-money put and an out-of-the-money call. This is a neutral strategy. The hope is the stock will remain approximately unchanged. If the price stays below the call strike and above the put strike both options will expire worthless and you will pocket both premiums as income.

As outlined in red, the total income at current bid prices for selling each combination of the TIE June 37.50 put and June 42.50 call is $240 which works out to 11.3% on margin. These options expire in only 10 trading days, two weeks from now, on Friday June 16th.

The yield is calculated by dividing the income by the margin. For this table the margin is assumed to be 50% of the call strike price. Consult your broker for actual margins, which may be 30% or less and typically vary depending on the out-of-the-money distance.

The upside risk is if TIE closes above 42.50 on expiration day you’ll be assigned short 100 shares per option contract, no matter how high the stock goes. The owner of the call option contract will exercise the option and call away from you 100 shares that you don’t have, so your broker will borrow them for you and sell them short at 42.50 per share.

The downside risk is if TIE closes below 37.50 on expiration day you’ll be assigned long 100 shares per option contract, no matter how low the stock goes. The owner of the put option contract will exercise the option and “put” 100 shares to you, meaning your broker will buy those shares for you in your account at 37.50 per share.

To avoid being assigned on these options, you must buy them back prior to the close of trading on expiration day if they are in-the-money. If they are not in-the-money (the stock closes between 37.50 and 42.50) then they’ll expire worthless.

In any event either the calls or the puts must expire worthless because the stock can’t finish both above 42.50 and below 37.50 at the same time! So when you write a strangle you’re guaranteed to “win” on at least one side of the trade.

How about making 11% not just for one month but four months in a row? This is possible by selling the same strike price options for September instead of June. See the table above where the Sep 37.50-42.50 strangle is outlined in blue. 44.2% for four months! Actually it’s only 3 ½ months. Not bad.

Remember though when selling naked strangles the potential risk of loss is unlimited – you could lose much more than your entire margin deposit if the stock makes a big move prior to expiration. So be sure to study not just the potential income but also the risks, and consult your broker or financial advisor for more details. He or she can help you plan a strategy to limit losses.

Generally when I sell strangles I’m willing to accept assignment on either option, then sell offsetting options to work out of that position. For example, if I were assigned short 100 shares of TIE at 42.50 I then might sell, say, 4 naked puts at 40 to hedge the short position. Or if the stock started up quickly prior to expiration I might just buy it at the market. Then my naked call would become a covered call and if assigned, that stock would just be called away and I wouldn’t end up short at all. Note that to be able to do either of these I would need to set aside in advance some extra money above and beyond the margin requirement. One common mistake inexperienced traders make is to always be fully margined. I’ve learned to never put myself in that position. As the old saying goes, success is the result of good judgment; good judgment is the result of experience; experience is the result of bad judgment.

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