Prosper by Understanding Trade Consequences

Fear of the unknown often keeps traders from maximizing returns. True understanding of risk and reward allows investors to feel comfortable with previously misunderstood techniques. Back in March 2017, I loved the look of high-end mall operator Simon Property Group . The REIT's yield, at 4.16%, was the best since 2008. Its price to funds from operations ratio (P/FFO), then 14.6x, was the lowest since 2011. Both those time frames proved to be spectacular entry points. I was both a buyer of SPG shares near $168 and a seller of its Jan. 17, 2020, expiration date naked puts at strikes of $170 and $175. I also sold some out-of-the-money covered calls with a $190 strike price, bringing in $9.42 per share. All four of those real-money trades are detailed below. The lower table shown lists the cash out/cash in generated from all the trades. Money collected from option sales was used to help pay for the stock purchased. That reduced a buy of greater than $67,000 to a net outlay of just below $40.000. There is no margin requirement when selling covered calls. The margin requirements needed to secure the naked puts was met by utilizing free buying power generated from existing paid-up equity already held in my margin-type account. It now has been about a year and a half since those trades were initiated. SPG went lower at times, but closed last week at $181.69, about 8% above my trade inception price. Things are looking good so far. The graphic below shows what would play out if the Sept. 7, 2018, price simply holds steady through expiration day. The dividends collected represent only what has been earned so far, though. With SPG at its current price, all three options would expire worthless. That's the best-case result on the put options. It's not a bad one for the out-of-the-money calls, either. A less-than-stellar 8% gain, translated into a 93.83% cash-on-cash total (paper, so far) return! The true best-case scenario only can occur if the positions are held right through Jan. 17, 2020. It also would need to see SPG climb to, and hold, $190 or better, or about 13% north of the trade inception price. The longer time frame would make for substantially more dividend income, too. Imagine how good it would feel turning about a 13% rise into a total return of better than 114%. Of course, things don't always work out as planned. What bad things could happen if SPG declines to below our put strike prices? That worst-case scenario is spelled out below. If Simon Property declines to below $170 we'd be exercised on both sets of put options. Another $121,000 of cold hard cash would be needed to pay for the extra 700 SPG shares. That sounds pretty scary. It really isn't if you are well-capitalized. The actual return on the whole trade would be determined by SPG's expiration day price. It cannot be known in advance. However, we can know the break-even points for each of the components of the full trade. The three pieces each have average net cost ownership levels ranging from about $135 to $141 per SPG share. Future stock market action never can be guaranteed. Still, SPG hasn't changed hands below $145 since the early days of 2014, almost four and a half years ago. If SPG closes above that $145 level on expiration day, which is quite likely, the entire position could be liquidated immediately for a decent profit. The five-year chart below shows that owning SPG at $141 would have been a winning position 100% of the time dating back to February 2014. The technique described, buying shares while selling both calls and puts on the same stock, and the identical expiration date is like booking opposing bets from both bullish and bearish option players. Both of those gamblers can lose, but it's impossible for both to win on expiration day. Collecting the substantial vigorish (vig in gambling parlance) sets you up as the bookie rather than the bettor. Over the long run, bookies tend to win a high percentage of the time. Option sellers get all the advantages of being the house with none of the overhead with which sports books or casinos have to contend. Understand the game and you'll never want to play the other side again.

Prosper by Understanding Trade Consequences

My experience with Simon Property Group shares and options illustrates how it can be done.

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