Enhance Your Gains on Stocks You Already Own With Options
Options are a leveraged trading instrument that can be used in many instances and as part of many strategies. Traders and investors can use options to replace stock positions, protect them, repair them and even enhance them. That’s right. With the stock enhancement strategy, we can take an ordinary stock position — perhaps on a name you already own — and boost the gains.
The best part is that we can do this without paying any money out of pocket. How does such a strategy exist and how does it work?
The strategy is simple. First, traders will have to be approved for the right level of options trading. Specifically, they’ll have to be able to enter debit spreads. That is, we’ll pay for the position rather than get paid for the spread, which would make it a credit spread.
To get started with options trading, see our recent post here.
In any regard, what is the stock enhancement strategy? Clearly a bull call spread cannot be put on for free. It’s also not a stock enhancement strategy, it’s simply a bullish strategy. However, say we own 100 shares of stock, buy a long call and sell two upside options.
The premium collected from the two short calls can pay for the premium of the one long call. In essence, the stock enhancement strategy is a combination of a covered call and bull call spread. The goal is to put the strategy on for as little net debit as possible, and possibly even a net credit. If shares fall or stay flat, the options position expires worthless, but we don’t lose any money on the trade. If it rallies, we have the chance to juice our gains on the position.
Breaking Down the Stock Enhancement Strategy
Let’s take a closer look at the stock enhancement strategy. Say we’re long 100 shares of ABC at $30. Shares are currently trading at $32, so we’re up $200 on the position. Like trading covered calls on stocks we already own, it’s a position we’re okay with holding for a while, but would also part ways with at the right price.
With that in mind, say we consider buying a slightly out-the-money call option at $33 and sell two $36 call options as a result. We pay $1.00 for the $33 call and collect $0.50 on each of the two $36 call options. Our net debit is $0.00, although we’ll have to account for commissions.
Let’s go through a few scenarios, the first of which is a stock that falls back to $30 on expiration.
All of the option positions expire worthless. Our 100 shares of ABC fall $2 per share, leaving us with a $200 loss and brings our gains back to flat overall on the trade.
In the next scenario, say ABC rallies $2 a share and climbs to $34 per share by expiration. First and foremost, our two short $36 calls expire worthless, since the stock is below the exercise price. Our 100 shares of stock rack up an additional $2 per share in profit, bringing our total gains on the common stock to $400. However, our long $33 call ends up being worth $1.00.
Even though we paid $1.00 for that call, we collected $1.00 in premium from the short calls, making our effect cost zero. Thus, that $1.00 in premium is a profit to our trade, or $100. So rather than collecting “just” $200 in gains on the trade since we initiated the options trade, our profit actually increased by 50% to $300 thanks to our long call.
Finally, our last scenario involves a big rally in ABC, say to $37 per share.
With the stock over the strike price for both of our short calls, we will be exercised on our position. We sell the 100 shares of ABC at $36, netting a $6 per share gain overall ($600) and a $4 per share gain ($400) since initiating the options trade.
Our option position is worth $3.00 total and we do not have a net debit to subtract out. Again, this additional $300 gain becomes significant, increasing our gain on the trade by 75% and our overall gain by 50%.
How did we figure this out?
The gain on our trade after we initiated the options trade ended up being $400 on the stock position and $300 on the option position. Increasing the stock gain by $300 totals a 75% improvement to $700 altogether. On the overall trade, our $300 gain on the options position increased the $600 we made on the stock position, representing a 50% improvement and brings our total to $900 overall.
Drawbacks and Other Considerations for the Stock Enhancement Strategy
So how does the stock enhancement strategy improve the total gains? Well, let’s look at the last scenario from above with a bit more scrutiny. Not only will it answer this question, but it will point out some obvious drawbacks too.
Owning just the stock from $30, we would have seen a rally to $37, good for $700. Notice though that we sold at $36 using the stock enhancement strategy. That’s one of the drawbacks, in that, just like the covered call, we are capping our gains. Thanks to having the long call though, we still came out ahead and ended with gains of $900.
In this scenario, we generated a return of 30% using the stock enhancement strategy, vs. a return of 23.3% under the stock-only strategy. Some will say, “is a 670 basis point increase worth it?”
Considering that the cost to put the trade on was zero, it seems so. But remember, that was on a stock that we were already long and already profiting on. Had we initiated the stock position at the same time or been underwater on the trade, our strategy would have generated an even larger return vs. the stock-only strategy. Had the stock closed closer to our short strike price on expiration, the stock enhancement strategy would outperform the stock-only strategy by even more.
For instance, had ABC closed right at $36, our stock enhancement strategy would have still generated a total return of $900 vs. a gain of just $600 for the stock-only strategy.
Clearly though, there are downsides to consider. As is always true with the market, we can’t have our cake and eat it too. Other drawbacks include not collecting a net credit. One of the main benefits to the covered call strategy is generating income. But by using that income to offset the cost of a long call, we all but eliminate that income.
That also leaves us exposed to more downside. Not that a covered call provides adequate protection, but it at least provides some insurance. Further, the stock enhancement strategy doesn’t work well in all trading environments — not that any strategy does. This one in particular works better in low volatility, trending markets rather than erratic and volatile ones.
One last tidbit? Investors can also use this strategy for bearish positions as well. Specifically, if they are short 100 shares of stock, they can sell two lower strike puts and buy one higher strike put to create the same strategy.