The most important characteristic of long term successful investors is to relentlessly pursue high probability return for minimal risk strategies.
One of the most successful of these strategies is to buy a solid equity exposure and then sell (write) a call option on the same equity in the same amount. By doing this trade the pay off is converted from the straight blue line above, into the purple line.
Yes, the upside is now capped. However, the likelihood of a positive return has increased substantially. Unless, the S & P 500 closes below 1275, the investor receives a positive return. Also the risk of the combined Buy – Write Strategy is much less than just owning the S & P 500.
In effect, the S & P 500 is fully hedged above a certain level and the hedge generates an income as the time value of the option expires. If there is in addition very efficient loss mitigation in the event of the S & P 500 falls much below 1275 then this becomes a high probability return with very low risk.
An example demonstrates how this works:
Consider a trade I recently did:
Buy 100 T at 36.65, T has an annual dividend yield of around 5%.
Then sell the April 15th 35 Call for 2.15. At the time the April 15th option was 2 months from expiry.
At expiry on April 15th the investor still owns T + time value of the option:
Time value is 2.15 – (36.65 – 35) = 0.5
So the profit from selling option was 0.5 / (36.65 -2.15) = 1.4%
As this was a 2 month option the option can be bought back just before expiry and another 2 month option can be sold for a similar return.
So after a year the return is 5% plus 6 x 1.4% = 5% + 8.4% = 13.4 %, all with very low risk.
What is the risk?
On this occasion the smart stop was placed at 32.84. The actual loss would depend on when the stop is executed and the prices when the stop is executed. Assuming this takes place at expiry of the option. The loss would be
( – 36.65 + 32.8 +2.15)/ (36.65 – 2.15) = -1.7 / 34.5 = – 5%
Not only is this loss very unlikely, but the position is earning 13.4% per annum while it stands. So the loss will have already have been earned from income after just 4 1/2 months. So it is only a loss if it closes below the stop before 4 1/2 months have passed. Any loss is an increasingly diminishing loss.
All this is before several additional loss mitigation techniques are employed, to either further boost the yield or lower the risk or cost of loss.