In the show, Extreme Couponing, people clip out mass amounts of coupons to accumulate mass amount of goods for absolute pennies. In the very first episode, a woman uses coupons to only pay $100 on her $2,000 grocery bill.
Sounds pretty nice, to save $1,900 right?
What if I told you that you could do essentially the exact same thing with stocks? Pay less for more?
Most of the time I trade iron condors or vertical spreads because I am a small account. But there are many options for traders to reduce their cost basis, and apply some “couponing” techniques to stocks. I often look for high IV in my trades, but there are a couple of choices for utilizing lower volatility stocks, such as the Diagonal Spread, or the Poor Man’s Covered Call (PMCC) (this term is coined by Tasty Trade).
The more expensive alternative to the PMCC is simply implementing a covered call. This type of trade requires high volatility and high capital, but it’s important to know the foundations of a trade before you execute an alternative such as the PMCC. After all, fundamentals are the building blocks of fun (Uptown Girls).
A covered call (the fundamentals of a Poor Man’s Covered Call) involves selling a call against buying stock – which is honestly, the most basic thing that you can do to get into options. Anyone can sell a call. It reduces your overall cost basis, acting as your coupon, and we make money if the stock price goes up.
This can be an income generation technique as well. Simply close out the call into each trading cycle to gather the remaining extrinsic value, and repeat the process again and again.
The only issue with this, is that you have to go long on 100 shares of stock. But selling the call allows you to reduce your overall cost basis through the premium collected. It is a coupon for stock, essentially. A discount.
Let’s take a loser stock, such as General Electric (GE) for our covered call example. This stock has plummeted, from a high of $58.69 in 2000 to today’s price of $14.09 (5/29/18). This is one of the dinosaurs. People were given shares of GE when they were born. Probably over 50% of people with 401ks have this stock in their account.
And it’s failing HARD right now.
But, as option traders, we don’t have to lament when it drops low. We don’t have to settle for that 50/50 shot (or be completely underwater if we had bought the stock at $58.69 in 2000).
Instead, we can look at this as a buying opportunity. Getting something from the bargain aisle in the grocery store.
GE is a pretty big company. The likelihood that they completely fail is pretty low. Sure, they are selling off pieces of the business, but if GE fails, that would essentially mean that no one, except for maybe the tech stocks (Facebook, Apple, Netflix, Google) are safe.
GE also has pretty high volatility, sitting at the 81st percentile for the 30 day time frame which is good, because like most options we trade, we want volatility to contract. (However, as we will see later in the PMCC, this is not always the case)
So we are going to buy GE – and implement a Covered Call against it. Think of it as getting a pair of shoes at a discount, and then having a coupon to save even more.
Image via Google Finance
(Refresher: we look for high volatility stocks, with an IV rank of more than 50% in hopes to collect the premium of the volatility contraction that should occur over the timeline that we hold the option)
I am first going to walk through the steps of a regular covered call (which I highly encourage those with a large amount of assets to do, and those with a small amount of assets to learn) and then walk through the steps of a Poor Man Covered Call and other couponing alternatives.
I am going to trade into the 51 day expiration cycle (July 20 2018). This is a good time frame, since we look for that sweet spot of 45 days. However, I will more than likely roll the trade before then.
I am looking to trade at a higher strike price than the stock price, about 30 deltas out.
The 30 deltas represents 1/2 standard deviation. 16 deltas would equate to 1 standard deviation. We collect more premium at the 30 delta than we would at the 16 delta ($0.17 more in the GE example at 30 vs 16).
It all goes back to the normal distribution curve. 16 delta represents a 68.2% probability of profit, whereas 30 delta represents a 38.2% probability of profit.
Image via Math is Fun
So how does that work in trading terms?
As you can see in the above picture, I am selling the OTM call at 31 deltas (close to the stock price), with a strike price of $15. The bid-ask spread is tight, which isn’t terribly key for this trade, but important because it shows liquidity in the stock.
But this type of trade does cap our max profit.
For example, lets say that the stock price of XYZ is at $100. We sell a call for $200 credit against it at the strike price of $115. If the stock price goes above $115, we hit our max profit of $1,700 (15 + 2).
If the stock price completely blows through 115, we are protected by the 100 shares. The call trades for intrinsic value, and any losses faced are protected by the value of those shares.
So let’s say that we breakeven. Let’s say the stock ends right back at $100 – and we are just done with it. Don’t want to mess with it anymore (this does happen).
We can sell it at $100 we originally bought it at, taking back the $10,000 (100 shares).
In a normal situation, we would have made $0 (probably would have even lost money with commissions).
But really it only cost us $98 ($9,800) to get into the trade, because of the $200 credit we received for selling the 115 call. The stock can go up, stay the same, or go down just a little bit (to $98) and we still profit.
That’s much better than the only option being for the stock to go up.
The downside to this type of trade is you do give up some max profit. It also ties up a lot of capital in the 100 shares (which is why we have the PMCC as another choice)
Essentially, your profits are limitless when you buy a stock. Theoretically, you could make infinity dollars if the stock price went to infinity. But this will never happen. We have to be realistic in our trading.
For our GE trade, we sell the call for $0.305 (as it goes, a lower priced stock = lower credit).
Our profit is the distance between the stock price and the short call (in this case, the difference between $14.05 and $15) and the premium received ($0.305) which amounts to a profit of $125 ($95 + $0.305)
- Profit = (Stock Price – Short Call Strike) + Premium Received
Our breakeven is the stock price – credit from the short call. In this case, $14.05 – $0.305 = $13.745. So instead of paying $14.05 for each share, we are only paying $13.75. That means that for our 100 shares, we are paying $1,375 vs. $1,406.
- Breakeven = (Stock Price – Credit from Short Call)
We will close this call when the stock price moves past the strike of the short call (this is a bullish strategy). For example, if GE moved all the way up to 16, we would roll the call up and out for a credit (income generation technique) when the extrinsic value is low.
Right now, the extrinsic value is at 30. We would probably chose to roll this when the extrinsic value dropped to around 10. We would simply buy back the call we sold, and then sell another one into a further expiration.
This an excellent trade strategy for hardcore buy-and-holders (which is almost everyone). This reduces your cost basis, and provides an income other than dividends. Also, you get 100 shares of stock at a cheaper price.
The next blog will discuss the alternatives to the covered call – most notably, the Poor Man’s Covered Call.
Welcome to the profitable and time-effective version of extreme couponing.
Image via Mommy Savers
(Also, it drives me crazy when I say “there are many options here” regarding to trading techniques because it’s one bad pun after another essentially, and I apologize. But I digress).