Let’s see what we can find at the $25 level. At the $25 level, you can sell a put on Bank of America right now, for $1.07. Let’s say you were very bullish on the stock, and you wanted to sell that. If you were put that stock, you would love to own 1000 shares of the stock.
However, if it didn’t get to that level, you would like to be able to collect that money. At $1.07, we would collect a total of $1070, minus commissions, in order to have the privilege of owning the stock at $25, which you feel is an extremely attractive level to own that stock.
Look at the volatility again. The volatility is 81%. In other words, if the volatility of this stock was much lower, there is no way that this $25 put is going to be priced at $1.70. In fact, it would be dramatically less, if this volatility level was way lower than this.
Just like we did with CitiBank, let’s take a look at a few months in which the volatility is dramatically lower than it is right now. If we go out to August, it’s 74%. It’s a slight positive skew. If we go out to November, it’s only 58%. That’s not too bad.
Let’s take a look at the 58% levels on the put side, at the $22.50 level. We can purchase a diagonal. We’re selling the $25 July put, which we collect $1.07 for. Let’s go out to the November, because that’s the lower volatility month. We can purchase the Novembers, at the $22.50 level – which is only $2.50 below the current level of the put that we’re selling – for only 78 cents.
Let’s take a look at different scenarios, just like we did with the CitiGroup. Well, we can sell the Julys. If Bank of America stock never drops below $25, we collect that entire $1.07 times 10 contracts, which is $1,070. We still own the November $22.50 puts. We can continue to write those, against those July options.
We sell those for $1.07 at the $25 level in July. When those expire, we go out to August. In August, those $25 puts are probably still going to be around a dollar. The volatility level is still pretty high, and if it continues to be high, we should get another dollar for that.
We’re now collecting $2 in premium, against a purchase of a put that is $1.84. Even as we go out, we can sell August. We can sell September. We can sell October. We can sell two additional months against our November puts. This particular strategy is very attractive to bottom fish stocks, stocks that have really gotten hit hard.
What it allows you to do is purchase stocks not only at an attractive level, but get paid for waiting for the stock to drop to the level that you want to purchase it at. Now, what happens – let’s say in July, the stock actually trades down below $25.
If the stock does trade below $25 during the time that you’re short these options, you will purchase 1000 shares of Bank of America, at $25. Remember, we have collected $1.07, which we do not give up. We are still able to keep that $1070 for waiting. We also now have the obligation to purchase this stock at $25. Even if this stock were to fall lower, we would have to purchase at $25.
Remember, we have the $22.50 puts in November, to help protect our position. Even if the stock were to fall lower, these would continue to increase in price, because we are long these options. That’s a very attractive scenario. If the stock does continue to drop lower, we’ll be able to cash in our insurance policy. This, hopefully, has already been paid for, or significantly paid for, by the sale of the July options, and maybe even the sale of the August options.
Now, this becomes free. There’s no cost to this put, after we’ve collected over $2 in premium. We have a free put. It’s a long-dated put. We have this put as our protection. If the stock does drop down, we can cash in our insurance policy, to purchase additional shares of the stock. As you know, eventually – the probability is that Bank of America is such a large corporation that there’s no way they are going out of business.
Even if they did, you still have your $22.50 put that you can cash in, even if the stock dropped to 0. You would still collect $22.50 on that position. This is a very attractive strategy, especially using the sale of a diagonal position on a long-dated option. The thing that really makes this work very well is the high volatility of the near-month options.
If you have extremely high volatility in the near month, and you can purchase a lower volatility on the far months, that gives you a tremendous positive skew on the volatilities. You have a number of months in between that you can continue to sell premium.
Let’s say the stock does move up. You own the $22.50 puts in November, and the stock continues to move up. You have a couple of different choices. You collect a premium on the $25. That expires worthless, so you collect $1000. You go out to August. If the stock continues to move up, maybe you want to sell the $27.50, instead of the $25 puts. That means that you would own the stock at $27.50, if you were to own assign that stock.
It may be an attractive premium, and you feel that at that time, it’s still attractive to own that stock at $27.50. In other words, because you own the put option, you can write any of these options that you want. You can write the $22.50. You can write the $25. You can write the $27.50. After this July option expires, wherever you feel that you would like to own that stock, you can write a different put option, in the subsequent months.
In August, after the July expires, you have the August expiration. After that, you have the September expiration. After that, you have the October expiration. Then you’ll go into the November expiration, in which you can either create a debit spread, or another credit spread, in the final month of the option expiration.
There are lots of attractive strategies here. Does it work for all stocks? It might. This is how it works very well on a stock that declines. It can also work very well on a stock that goes up. This is a stock called Enbridge. This stock has been on a long-term uptrend. It’s an energy stock, and as you know, most energy stocks have been going up dramatically over the past couple of years.
This stock, in particular, has a very attractive pattern. It’s been going up consistently. Let’s take a look at the volatility of ENB’s options. As you can see, they’re not as volatile as the Bank of America or the CitiGroup. In fact, the July options have an implied volatility of only 31.72%.
However, it does have a positive skew over the next dated option, which is October. In most cases, on individual stocks, you’re only going to have the opportunity to purchase or sell the near-dated option, which is the current month expiration of July. Occasionally, on larger stocks, you’re going to get a number of different months in which you can buy or sell options.
In this case, you have the front month, at least, and you have an October of 08, which is 118 days away. You can see that the volatility drops approximately 5% for the October, and approximately 8% for the January of 08 options.