Your clients probably recognize that holding cash on the sidelines guarantees a loss of purchasing power. The challenge they face is trying to time when to enter the market. However, there is a compromise strategy: the “covered combination,” which takes advantage of mathematical certainties and plays off market volatility.
I like to think of the covered combination as enhanced dollar-cost averaging in which clients invest regular amounts at periodic intervals rather than investing all of the capital at one particular time.
The covered combination recognizes that DCA and volatility are inexorably linked. Thus, you should be able to create a more efficient DCA approach using this options-based strategy. The trick is to understand both the DCA and volatility concepts, and then apply the option combination with a specific goal in mind.
The covered combination is a three-step process:
1. Purchase the underlying stock.
2. Sell a covered call.
3. Sell an uncovered put (or, if your client is more conservative, a “cash-secured” put).
By way of explanation, consider Bank of America Corp. (symbol: BAC; price at time of writing: US$7.23) as a case study. Like the stocks of most financial services companies, BAC shares have fallen sharply throughout 2011. But, as Warren Buffett had suggested when he made his deal with BAC, 2011 is not 2009 — which means that some of the biggest financial services companies will survive and prosper in time. BAC will be a survivor.
With BAC, two factors draw us to the covered combination: the Warren Buffett seal of approval; and, given BAC’s recent volatility, rich options premiums. Of course, rich options premiums imply higher risk, which is why your clients may not want to commit all of their money today.
To implement the covered combination, your client would purchase 100 shares of BAC at US$7.23 a share and sell one BAC January (2013) 7.50 call at US$1.95 and one BAC January (2013) 7.50 put at US$2.20. The sale of the two options will net your client US$4.15 a share in premium income. The out-of-pocket cash for the initial 100 shares of BAC is US$3.08 a share (i.e., the initial purchase of 100 shares at US$7.23 minus US$4.15 in premium income = US$3.08).
The January 2013 call obligates your client to sell the 100 shares of BAC at US$7.50 a share until the third Friday in January 2013 — the last trading day for the January 2013 series of options. (Note: options actually expire on the Saturday following the last trading day.)
If BAC is above US$7.50 a share in January 2013, the call will be exercised and your client will deliver the shares against the exercise notice. As the out-of-pocket cost on this trade is US$3.08 a share, your client earns US$4.15 a share in profit. If your client is a more aggressive trader and was employing the uncovered put (rather than the cash-secured put), the leveraged return would be 144% over 16 months.
However, that’s a best-case scenario, representing only one possible outcome. BAC could also decline between now and January 2013. The BAC January 2013 put obligates your client to buy another 100 shares of BAC at US$7.50 between now and the put’s expiration.
If you are looking to reduce the risk associated with this strategy, your client would set aside sufficient capital to honour the obligation, should the put be assigned. That’s what is defined as the “cash-secured put.”
Assuming the stock declines and your client buys additional shares — which, by the way, is the intention of a DCA strategy — it’s important to understand the true cost of the resulting position.
Recall that your out-of-pocket cost for the initial 100 shares was US$3.08. The purchase of a second block of shares will be US$7.50. The average cost for the 200 shares is US$5.29.
This strategy should appeal to clients who are moderately bullish on the underlying stock. Whenever clients buy stock and agree to buy more at a lower price, they ought to be bullish. In this example, your client ought to be comfortable holding BAC at an average price of US$5.29.
Covered combinations should also appeal to clients who have a basic understanding of covered call writing, because 50% of the combination strategy is a covered call write. Familiarity breeds comfort.
The covered combination, like DCA, is a disciplined approach to investing. The underlying stock is held when the put and call are sold. The sale of two options generates up-front income based on the volatility of the underlying stock.
Finally, the covered combination defines purchase and sale parameters at the time the strategy is initiated. Buying half now and perhaps, half later, should appeal to clients who adhere to DCA theory or, more important, recognize the risks of watching from the sidelines but are afraid to dip their toes into the water. IE