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If you think that this is a particularly attractive stock to own, you might want to take a look at the fact that it is trading at the $44 level. Take a look at the place at which you would potentially like to own that stock.
Unfortunately, because the volatility is so low, the actual price of the options that you can sell, is almost 0 at the $40 level. You would have to sell the stock at $45, which is approximately $1 in the money, in order to generate any premium income at all.
Well, if you were to sell the $45 options – let’s do a diagonal – and you were interested in purchasing 500 shares, and you wanted to buy it at $45. That doesn’t make a lot of sense, does it? You can go out and purchase the stock in the market right now, for approximately $44.06.
Why would you want to sell the option at $45? Well, if you went ahead and took a look at this particular option, you could buy the stock at $45, but in October, you would have a long-dated protective put at $40. Remember, though, that you’re selling and you’re receiving 68 cents of extrinsic value.
You get to keep that, whether or not the stock goes up or down. You get to keep the entire premium. Since the stock is at $44, there’s approximately a dollar of intrinsic value in this option. There’s only 68 cents of time value in this option.
In reality, you are buying the stock for $44.06, because you have 68 cents of extrinsic value if you sell this option. Now, if the stock continued to move up, you would continue to collect that entire $1.50 of premium. If the stock were to move down, this particular option would increase in value. You would buy the stock at $45, but you would still have your long-dated October 40 put as protection against the stock that was put to you.
This can be an attractive strategy if you like to collect premium on stocks that are rising, and they have a positive skew between the months that you’re selling, and the months that you’re buying. That’s another way to take a look at it.
My preference – and I’ll show you one that I did – was on Starbucks, which I find to be a particularly attractive scenario. It has reached some low-term support right around the $16 level, and has started trading up. I would have loved to have owned the stock at around $15, which was just below this previous bar.
I don’t know if it will show you now, because this was a few months ago, but the volatility level of the July options was closer to 55%. Because this stock has moved up, the volatility has dropped to about 39%.
This is not a particularly attractive strategy, if you wanted to own Starbucks stocks now, at $16, while it’s trading at $17.23. Because the volatility has dropped, these options are not as expensive as they used to be.
In fact, there is a negative skew on the options, now that the stock has moved up. The option volatility of these options has fallen by 20%. The longer-dated October options are 42%. You have a negative skew of close to 3%.
This is not an attractive strategy to use on a stock that has already started moving up. I would much rather use it on something like CitiGroup, Bank of America, or other stock that has fallen dramatically, in which the implied volatility has risen dramatically.
What’s a good strategy for Starbucks, if you wanted to purchase Starbucks now, and wanted to get paid for waiting? The only strategy that I would use is by just simply purchasing the stock and using a covered call strategy. Because the volatility is low, you’re not paying as much for your puts, now.
Do you see the difference? Now that the volatility is low on the front-dated month of these options, your insurance cost is going to be less expensive. That’s a very important detail that you need to keep in mind. When volatility is low, that means the market is not pricing. The probabilities of a sharp drop in the stock are low, and you can purchase your insurance at a much lower cost.
Now, if we were to purchase covered stock – and that’s the only strategy I would use for Starbucks here – let’s analyze that as a duplicate trade. The stock is currently trading at around $17, so we would want to go a little bit further in the money here, just to be a little bit more protective. We can purchase 1000 shares, by using the 17.50 put, which has an implied volatility of only 34%.
Our total risk at this point, of 1000 shares of stock, is only $540. If you wanted to purchase 500 shares, the total risk is $270. Where is our breakeven? Our breakeven is just about $18. If you wanted to go even further in the money at $19, now our breakeven is all the way out to $19.10. Our total risk on the trade is only $65, with unlimited upside potential.