any options traded on it? Or what if your core
portfolio contains a bunch of odd lots—150
shares here, 75 shares there? It takes 100
shares to cover the risk of most stock options.
This is when thinking like a trader can help.
In thinkMoney 33, we discussed how to
potentially generate income on a long stock
position with covered calls. This is often
handy for a single stock position. Let’s extend
that discussion to (1) a stock position that
doesn’t have options, and ( 2) a position in a
stock basket that would require too many
transactions or not qualify for a covered call.
A long stock position in a small company
with no calls to sell.
Maybe you have shares from an employ-ee-stock program or inheritance. Or maybe
it’s a company you really like, but the stock
doesn’t have options, and you don’t want to
sell the stock and buy another. Let’s call your
stock XYZ. How can you sell calls against it?
To solve the problem, turn to the tools
on the thinkorswim® platform from
TD Ameritrade. Consider selling call
vertical spreads in a stock that has options and a
high correlation to XYZ. (Correlation is the
numerical value that describes how closely
XYZ moves with another stock or index.)
First, look at stocks in the same industry
sector. Is XYZ a biotech company? An energy
company? High tech? On the Scan tab, click
on “Scan In” in the upper left-hand corner,
and from the dropdown menu, click on “By
Industry” at the bottom (Figure 1A). Here
you can narrow the stocks into a specific
industry. Next, click on “Intersect With”
and select “Category,” then “All Optionable”
(Figure 1B). Then click on Scan.
This loads up a list of optionable stocks in
the same industry as XYZ. Next, find one that
has a high correlation to your stock. Go to the
Charts page, click on Studies in the upper
right-hand corner, select “Add Study,” click
on “All Studies,” then “C-D” to find “
Correlation” (Figure 2). This will display the correlation between XYZ and the SPX (by default)
on the chart.
You can then edit the Correlation study,
replace SPX with XYZ, and enter the symbol
of an industry stock to see how it correlates
with your stock. The closer the correlation
is to 1.00 (max correlation value), the closer
to perfect positive correlation. Keep in mind
that correlations can change over time, and
there’s no guarantee the industry stock will
move up and down at the same time as XYZ.
Now, look at the options on that industry
stock, and consider
money (O TM) call
vertical to short.
Why a call vertical?
Selling a naked call
in a stock you don’t
own has unlimited risk if that
stock rallies and
XYZ—the stock you
own—doesn’t. Because a call vertical
has defined risk,
even if the correlation breaks down,
and the industry
stock rallies while
XYZ drops, the loss
on the short call vertical won’t exceed the
Finally, you need to figure out how many
call verticals to sell in the industry stock.
First determine the value of your XYZ
shares. Then divide that value by the price of
the industry stock to see roughly how many
shares your position in XYZ represents.
For example, if you have 1,000 shares of
XYZ trading at $25, the value of your XYZ
position is $25,000. If the industry stock is
trading at $75, then $25,000/$75 = 333. If the
two are perfectly correlated, theoretically,
your XYZ position has the same value as
333 shares of the industry stock. So, you may
want to consider selling three call verticals in
the industry stock.
Selling call verticals in a different stock
from your core is a way to add theta to your
portfolio. It adds a certain amount of defined upside risk, as well as commissions,
but that positive theta is one way to potentially add a little extra return to an otherwise “lazy” core stock.
Smaller odd-lot positions in stocks where
selling calls is not possible.
Over time, perhaps by making smaller investments in individual stocks to diversify a portfolio, you may have acquired odd lots in 20,
30, or more stocks. An odd lot is a number of
shares that isn’t evenly divisible by 100. For
example, 225 and 560 are odd lots. A single
option represents 100 shares of stock. So, if
you have 225 shares, you can’t sell 2. 25 calls.
You could sell two calls against 225 shares,
but that would mean 25 shares, or 11%, of
that position isn’t working as hard for you as
you may want. Besides, you may not want to
look for calls to sell in 20 or 30 stocks.
You can apply the same process just dis-
cussed to selling a call vertical in an index that
could be a benchmark for your portfolio. Let’s
say your core portfolio consists of 30 small-
cap stocks. The NASDAQ 100 index could
be a benchmark for your portfolio. The Mini
NASDAQ-100 Index (MNX) is an index on
the NASDAQ that also has options. The MNX
has a contract multiplier of 100. So, if MNX
is trading at $550, it has a notional value of
$55,000. If your core small-cap portfolio is
worth $100,000, its value is nearly twice that
of the MNX. So, you might consider selling
two OTM call verticals in MNX options.
Again, the MNX call vertical offers your
core small-cap portfolio defined risk and
positive theta. It also offers the potential to
increase returns over time in exchange for
upside risk if MNX moves up more than your
core portfolio and commissions.
WORK THAT CORE
Selling call verticals against a core portfolio
is just one strategy to consider, and it may
or may not fit your objectives. But the larger
goal is to review long-term positions you may
be sitting on as assets that could be working
even harder for you. You’ve worked diligently to construct a sensible portfolio. Make sure
it’s doing all it can.
FIGURE 2: How well do they sync? By charting the correlation between the stock
you like and a related index or stock, you can visually see how the two move. Source:
thinkorswim from TD Ameritrade. For illustrative purposes only.
Thomas Preston is not a representative of
TD Ameritrade, Inc. The material, views, and opinions expressed in this article are solely those of the
author and may not be reflective of those held by
TD Ameritrade, Inc.