Anatomy of an Options Trade

Owning individual stocks rather than an index ETF affords many more opportunities to sell option premia as a way to generate some side income. I generally avoid covered calls since most of my holdings are intended for long-term. The implied volatilities are usually higher for puts anyway. My preferred modus operandi is to sell cash-secured (margin-secured really) puts on stocks that I don’t mind owning. That said, the timing and strike are such that the vast majority expire worthless. The position size is so small that I only aim to generate a couple percent per year of the eligible securities in my main trading account. 20-30% returns are not unheard of for those who are serious at it.

This post, however, describes an on-going high-conviction, directional bet the likes of which I increasingly look to as the conviction in my forecast grows. BTW, to put S&P 3400 in Q4’18 into perspective, a 27 handle is implied for the end of 2017.

McDonald’s (MCD) was the underlying stock and the two trade dates were indicated by the blue vertical lines. On 8/23/16, MCD was around 113 after falling from a high of 128 in May. RSI was showing a small negative divergence (lower low but RSI higher), the following option spread was opened:

Two Jan’18 125 strike calls were bought, financed by selling a 110 put of the same expiration. It was a net credit transaction for which I received $80 minus the $2.66 commission. Since MCD had a lot of downside momentum I got a good price on the just out-of-money put. I got the idea for this spread from synthetic equities (buying a call and selling a put at the same price) and synthetic equities with split strike (to ensure a net credit transaction normally). I had to use very wide split strikes (110/125) to get the 2:1 ratio. It was indicative of an extremely bullish bias.

Jan’18 was the furthest expiration available at the time. Since it was a net credit transaction, I was never worried about time decay and I wanted the furthest out options to make the trade work. As MCD continued to drop this trade was underwater until the start of the “Trump rally”. On 2/13/2017, MCD touched 125, the strike price of the calls and I conducted the following trade:

I swapped 3 130 strike calls for the 2 125 strike calls for $30 and moved up the put strike from 110 to 120 for $283 credit. In total, the transactions carried a net credit of $253 minus the $6.20 commission. I’m still long these 3 calls and short 1 put that together have a current market value of $1200+. Not too shabby considering it’s been all credit transactions from the get go. Of course it was not riskless — downside risk being defined by the short put.

I haven’t engaged in many similar trades. There is one with Disney that’s almost a carbon copy. A more recent split strike synthetic equity (non-ratio) position in Gilead is up but losing steam. There was also an earlier trade with Novo Nordisk that was closed with a loss. My conclusion is it’s all about timing. The hope is the favorable market environment will skew the chances to the upside.

Update: The option spreads in both MCD/DIS were closed on 3/23/2017. All were Jan 2018 LEAPs. They were put on as credit transactions so time decay was not a problem initially. However, as the trade started to work and call ratios were increased there were a lot of time premia to lose if there was a correction of several months duration. I kept the synthetic equity position in GILD using Jan 2019 LEAPs.