I hate to quote this guy, cause I generally think he is full of it, but the old market adage often attached to Warren Buffett, “Be Fearful When Others Are Greedy and Greedy When Others Are Fearful” can be applied to your portfolio in many different ways. If you are a deep pocketed billionaire like Buffett and have a 20 year time horizon, you can be greedy when you first see fear with little care of when the fear subsides. If you are like the rest of us and have to adhere to stringent risk management for your kid’s futures sake, then there are other ways to take advantage of fear, without adding incremental risk to your existing holdings. There was an options trade in GM yesterday that caught my eye that I thought was worth detailing as an attractive yield enhancement strategy in a period where implied volatility (options prices) of most single stocks are well above their one year average.
When GM was $30.12 a trader bought to close 20,000 Sept 36 calls for 0ne cent and sold to open 20,000 Dec 32 calls at $1.01. This is likely an investor rolling an overwrite against 2 million shares of stock. So now the position looks like this, the investor is long the 2 million shares, and short 20,000 Dec 32 calls. On December expiration the investor has capped their gains in the stock to up to $32, so as of last night’s close of $30 that would be $2. But the investor has sold 20,000 Dec 32 calls at $1.01. So if the stock is at $32 or above on Dec expiration then the investor would have their stock called away at $32 for a $2 gain, but would have effectively sold their stock at $33.01 (the call strike plus the call premium received), making a call-away level up 10% from current levels.
If the stock is below $32 on Dec expiration then the Dec 32 call would expire worthless and the investor would receive the $1.01 in premium or $2.02 million, or about a a 3.3% add yield in 3 months, or about 13% annualized.
So the fear in the market is making overwrites in a stock like GM attractive, giving investors the potential to add yield to their holdings while also providing a potential buffer to the downside. This strategy works best after a period of volatility, followed by a period of cooling. The worst case scenario is thinking that this is a defensive strategy and then watching the stock fall out of bed, as the premium received in the call sale only serves as a minor buffer to the downside. And the strategy can be brutal in the event of a sharp V reversal after a precipitous drop if the call sold is too tight.
In the case of GM, the $32 strike looks like a fairly obvious spot on the chart for the stock to find some resistance as it was an important breakdown level back in early July and served as staunch near term resistance for much of August until the stock broke-down to the mid $20s:
If your time horizon is more like Buffett’s a 32 call sale is probably not necessary when you buy a stock like GM after a sell-off. But for most of us we need to buy time until markets reverse. Implied volatility spikes allow for us to take in some premium on longs, provide (a tiny bit) of protection by lowering our breakeven and allows us to get through a couple of expirations while we wait. The downside of not having deep pockets like Buffett is that there are sacrifices. Like getting called away on the long if the stock rips. But getting called away in a long for a profit beats not being able to play at all.