Options cash flow strategy

Hedging With Options.

2.1 Financial Statements 2.2 Taxes 2.3 Capital Cost Allowance And Depreciation 2.4 Cash Flow And Relationships Between Financial Statement.

4.1 Net Present Value And Internal Rate Of Return 4.2 Capital Investment Decisions 4.3 Project Analysis And Valuation 4.4 Capital Market History 4.5 Return, Risk And The Security Market Line.

You can think of speculation as betting on the movement of a security. The advantage of options is that you aren't limited to making a profit only when the market goes up. Because of the versatility of options, you can also make money when the market goes down or even sideways.

The other function of options is hedging. Think of this as an insurance policy; just as you insure your house or car, options can be used to insure your investments against a downturn. Critics of options say that if you are so unsure of your stock pick that you need a hedge, you shouldn't make the investment. On the other hand, there is no doubt that hedging strategies can be useful, especially for large institutions. Even the individual investor can benefit. Imagine that you wanted to take advantage of technology stocks and their upside, but you also wanted to limit any losses. By using options, you would be able to restrict your downside while enjoying the full upside in a cost-effective way.

The Myth of Monthly Cash Flow.

It's what I call the Myth of Monthly Cash Flow.

Don't get me wrong. I love high yield income.

And one of the reasons I love stock options so much is because there are many different option trading strategies one can employ to generate high yield income. The potential cash return from option trading dwarfs the typical income streams available through more traditional income investments such as bonds and dividend paying stocks.

Option income strategies are not without risk, of course. But, conversely, there's no rule that actually says these trades have to be reckless in order to be lucrative. In fact, just about any option trading strategy that generates a credit can be used to create your own personal cash flow business. And those can be as risky or as conservative as you choose.

As such, the option writer has many choices to consider - covered calls, cash-secured or naked puts, bull put spreads, bear call spreads, and iron condors are all common option trading strategies that can result in great short term cash returns relative to the amount of money placed at risk.

There are numerous online resources that focus on income producing option strategies, some free and some subscription based. Many of these online resources are quite valid and valuable. But in the vast majority of cases, option income strategies are described explicitly as, or touted as great potential candidates for, high yield monthly cash flow vehicles.

So why is that a problem?

If you think about it, isn't it perfectly natural to view covered call writing and various credit spread trading strategies as a means to generate sizable MONTHLY income?

After all, there are two primary factors reinforcing this perspective: every month, a different set of options expire, and, just as importantly, most of our bills and other financial liabilities come due on a monthly basis.

But there's a major problem with the idea of an options based monthly cash flow business.

Only in theory can you consistently produce a steady, predictable stream of income month in and month out. In practice, no market index or individual stock is so predictably well behaved.

If it is, then that index's or stock's implied volatility (and therefore the amount you get when you write its options for income) will be quickly readjusted downward to reflect its newly tamed behavior.

No matter how conservative you are, how lucky you are, how much the odds are in your favor, or which specific income strategy you employ, there's a chance than any credit spread you set up is going to move against you.

To require of yourself or a dynamic stock market returns that are consistent AND high yield AND monthly is unrealistic and serves only to increase the chance that your trades WILL move against you.

Quota Danger.

And why is that?

Quite simply, when you approach option income strategies with a quota mindset, or an inflexible requirement that all your trades need to produce a certain percentage return over the course of the next month's option cycle, the quality of your trades will deteriorate.

When good four week opportunities are unavailable on the Monday morning following the previous option cycle's expiration, you will instead be tempted to chase premium and choose an inferior trade. The required four week return can easily take precedence over the quality of the trade and the likelihood of its success.

There's absolutely nothing wrong with attempting to use options to construct a cash flow operation. It isn't the option cash flow that I object to - it's when you tack on the extra stipulation that the cash flow must occur on a regular, set schedule that you begin to sabotage yourself.

Security vs. Freedom.

High yield returns and consistent monthly cash flow are opposing mindsets with little chance for reconciliation.

Like much of life, it seems, we must choose between security and freedom. The stock market is a mystical creature of the forest that, if approached properly, can lead you to treasure. But it doesn't always take the same path or travel at the same speed. It is not a dumb brute that you can bridle and beat into domestication.

Domestication is the key here. That's the fantasy of the Monthly Cash Flow mindset. But profits in the form of option income can't be domesticated unless you castrate them first.

If you want lucrative returns from your option income strategies you must lose the Monthly Cash Flow mindset. You can't have both high yield cash returns AND the consistency of a regularly scheduled annuity payment. If you want the security of a specific payout on a specific date, you'll have to ratchet back your expectations of how much those payments will be.

Great income returns are very much possible, but successful income traders are flexible and patient. If you want to earn 60% a year in returns, don't attempt to do so by anticipating a 5% realized payout on the third Friday of each month all year long.

In general, the more frequently you need to be paid in life, the poorer you're going to be. This is as much a cause as an effect. The annual income of a day laborer, for example, may be paltry, but the primary cause of his poverty is that his daily pay structure requires and reinforces a short term mindset.

The more of your income you can produce irregularly and covering longer periods of time, the more consistent and healthy your overall returns become.

Moving from a monthly mindset to a quarterly mindset (or even an annual mindset) is as radically beneficial as the day laborer moving from a daily mindset to a monthly mindset.

So when you send your ships to sea, be flexible and patient, and let them return on their schedule, not yours.

Using Diagonal Spreads For Long Term Investing Plus Monthly Cash Flow.

October 10, 2016.

Diagonal spreads are an excellent long-term way to both invest with options and produce some monthly cash flow at the same time. Many traders actually don’t know much about how powerful and flexible these spreads can be for successful trading.

Diagonal option spreads are established by entering both a long and short position in two options of the same type (either two call options or two put options) but with different strike prices and expiration dates.

Take a second to digest that and read it again if you need to. In effect, the strategy is similar to a covered call, except that a long call is substituted for the stock.

Spreading Time And Strikes.

This strategy gets the name “diagonal” because it combines a horizontal spread, which represents differences in expiration dates, with a vertical spread, which represents differences in strike prices. You could even think of it as the offspring of a calendar spread and a vertical spread.

Simply put once again to drive home the point, you buy an option that will not expire for many months and then sell options that will expire in the front month against the current long option. Thus you get exposure both in different contract months and strike prices. In a nutshell, you will be choosing a back-month leg that is different from the front-month leg. Starting to make a little more sense now?

To understand and be able to implement this strategy more successfully, you also need to know the differential time value decay. Worth mentioning here is that any diagonal spread has only two possible strike combination which has to always be the same.

“Love Your Diagonal” – thinkMoney.

Thinkorswim recently just ran an excellent article in their recent quarterly publication thinkMoney that I urge you all to check out if you haven’t already.

AAPL Diagonal Call Spread Example.

Using a current example with AAPL stock, let’s say that you have determined using your awesome technical analysis skills that AAPL will rise gradually for the next four months. You enter a diagonal call spread by buying a NOV 425 call for $300 and at the same time sell an OCT 450 call for $100. The net investment required to put on the spread is a debit of $200.

Just like a vertical spread, you have both limited upside profit potential and limited risk. The ideal situation is for the position would be that AAPL either remains flat and or closes in between the two strike prices (say $435). In this scenario, as soon as the near-month 450 call expires worthless, the options trader can sell another call and repeat the entire process every month until expiration of the longer term call. Now you can see why it's similar to a covered call strategy right?

As you can see, the benefits of diagonal spread can be found in the potential profits that the long back-month option stands to gain. This way, you realize your profits by leveraging time decay of the options involved.

As you possibly know, short term options contracts generally have a faster time decay compared to their long-term counterparts. As such, if you write short term contracts and at the time buy long term contracts of the same underlying instrument, there is a huge possibility that you will make a return from these differing rates of time decay. This is exactly the same concept which is involved when you are dealing with diagonal spreads.

The maximum risk of any diagonal spread is limited to the initial debit it cost you to enter the position. If AAPL all of a sudden starts falling hard, then your losses are capped at $200 and no more.

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When and How To Close a Diagonal Spread.

One of the primary reasons you may want to close a diagonal spread is if you think you can earn enough premium from the resulting trade. Conversely, you may be prompted to close the trade if the near month options are about to go into-the-money and you want to avoid the potential of getting assigned on the sold options.

Below are a few steps to follow when looking to close a diagonal spread;

Enter a buy-to-close order for the near-expiration contract that you had previously sold.

As a rule of thumb, it is important for you to always close the short side of a diagonal trade first for margin requirement reasons.

Evaluate the profit potential of the long option that’s remaining in the trade.

At this point, what you need to determine is whether the underlying security is likely to move in the right direction. If you have a calls contract, then you will be hoping that it moves up. On the other hand, you will be anticipating that it moves down if you have a puts options.

Enter a sell-to-close order for any remaining options.

Finally, you will need to sell the remaining options contracts at the current option prices. You can complete this process any time before or on the expiration day of that particular options.

Although diagonal spreads is a great strategy to add to your toolbox, it still is possible to lose money with it especially if you are not somewhat correct on the underlying direction of the market. Besides, due to the multiple trades involved, trading diagonal spreads can be an expensive affair since you’re likely to spend more on commissions compared to other less sophisticated trades. Hopefully you didn’t think it was a one-way ticket to riches!

As always, being proactive and using stop losses, risk management, and hedging can significantly increase your odds of success.

A Quick Word On Volatility…

Lots of books and other websites talk about various trading strategies that are designed to benefit from changes in volatility. All of that is good and well. However, sometimes as an investor in options, my interest is in gaining leverage and managing risk on a somewhat directional basis.

There is no arguing that volatility needs to be watched closely, but when the premiums make the diagonal spread unattractive, it’s a good idea to do your homework first before entering a position for the next couple months.

About The Author.

Kirk Du Plessis.

Kirk founded Option Alpha in early 2007 and currently serves as the Head Trader. Formerly an Investment Banker in the Mergers and Acquisitions Group for Deutsche Bank in New York and REIT Analyst for BB&T Capital Markets in Washington D. C., he’s a Full-time Options Trader and Real Estate Investor.

He’s been interviewed on dozens of investing websites/podcasts and he’s been seen in Barron’s Magazine, SmartMoney, and various other financial publications. Kirk currently lives in Pennsylvania (USA) with his beautiful wife and two daughters.

Well done article. Clear and informative.

As long as there is time left until expiration having the options ITM shouldn’t be an issue.

Huge fan of the diagonal bull call… I trade this primarily in my Roth IRA. I trade it fairly conservatively, buying LEAPS and selling weeklies.

This and the short Iron Condor should be in every option traders repertoire.

Maximizing Cash Flow with Options.

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