CLIMB TO PROFITSWITH AN OPTIONS LADDER

WE BELIEVE THE NUMBER ONE JOB OF YOUR PORTFOLIO IS TO PRODUCE INCOME.

Covered calls are widely considered one of the most conservative options strategies available. You can use this strategy when you own underlying shares of stock and write calls against them. If the shares are called away (the elimination of a contract due to the obligation of delivery), you are back to cash and profit from the option premium. If the options expire worthless, you still own the stock.

Of course, trading covered calls is never that simple, is it? The best stocks for a covered-call strategy are those with high volatility and open interest, which typically translate to higher option premiums. But highly volatile stocks have a nasty habit of swinging both ways: Just as they have the potential to jump in price by expiration, so too they could just as easily fall—and sometimes significantly.

Then you would be stuck with a position that is worth considerably less than what you paid for it, and there is no easy way to get out without taking a loss.

A common way around this issue is to place a stop-loss order fairly close to the purchase price (say, within $5 or $10). Some investors take it a step further and employ a collar strategy. Both techniques can limit your downside potential, but they also limit any long-term profit potential. This is because stop losses and collars are inherently short-term strategies.

Perhaps a perspective change is in order. For an investor focused on income, covered calls can be a profitable option (pardon the pun). And investors can borrow a tool from the fixed-income world: laddering. This tool can help manage the downside risk and capitalize on long-term income potential.

Laddering is powerful technique borrowed from the fixed-income world

Laddering covered calls can help manage downside risk and capitalizeon long-term income potential.

With laddering, price declines that cause many covered-call traders toabandon their positions often prove beneficial for income-focused investors.

INCOME FOCUSWe should point out that if your objective is solely capital appreciation, particularly over the short term, this strategy is not for you. If you would not feel comfortable holding a position that has declined significantly for a long period—no matter what the income potential—you will want to look elsewhere. This method may be a bit counterintuitive as you look to sell the positions that climb higher, while holding those that decline. The bottom line is that it can be an effective tool for generating long-term income.

WHY LADDERINGLaddering is a simple concept most often used by investors in certificates of deposit and bonds. The idea is to distribute the maturity dates to smooth fluctuations in interest rates. A five-year bond ladder, for instance, would consist of five purchases: One at a one-year maturity, another at a two-year maturity, then three, four and five. After a year, when the first bond matures, you invest the proceeds into a new five-year bond. Every year, one of your bonds matures, spreading out the distribution of income.

Laddering covered calls is a similar concept. Only, instead of smoothing fluctuations in interest rates, the idea is to even out variations in stock price. Each purchase made as the stock price declines will lower your cost basis, which lowers the bar to be able to close the position at a profit. And as you accumulate additional shares each month, you may be able to sell more calls - generating even more income.

If you are called away above your cost basis, you close the position at a profit, and you can start the process again. If there are no calls available above your total cost basis, you may be able to sell calls against some of your lower-priced shares to still generate income.

THE PROCESSYou’ll start the process like you would most covered-call strategies, but with one small twist. In the first month, you buy a stock, sell a covered call one strike above the price and sell a cash-secured put at the strike immediately below the price.

Why sell the put? By selling the put, you get to collect a little extra income for the month. If the price increases above the call strike on expiration, your shares are called away and you keep the premium.

If the price falls below the put strike, you automatically buy additional shares.

The whole idea is to buy additional shares next month anyway (if your initial purchase isn’t called away), so this merely automates the process and generates extra income. In subsequent months, if your position isn’t called away, you will continue to buy shares and attempt to sell calls one strike above your average cost, but you usually won’t sell a put (exceptions will be discussed later).

STOCK SELECTIONThe objective in selection is income. You want to find stocks that can generate decent option premiums. That means you look for stocks that have high volatility and high open interest, along with a high enough initial price. However, don’t play with fire: Reduce the chances of buying a stock whose company goes belly-up.

AN EXAMPLEIt’s often better to show than it is to tell, so let’s take a hypothetical example. In Figure 1, you open a position at $38 only to see the price drop significantly over the next few months. After six months, the price dropped 38 percent. But because you spread out purchases and continued to buy on the way down, the position’s total cost basis declines less than 20 percent.

Now it’s time to sell calls to generate income. To decide how many to sell (and at which strike price), consider all your share lots and the front-month option chain. Assume that because the stock’s price has dropped so far, there will not be any premium available at the strike price above your total cost basis. So instead of selling options to cover all six purchases, you leave some shares uncovered.

ALLOCATION MATTERSBecause this is an income strategy, it’s necessary to have sufficient capital allocated to each position to make the income worthwhile. We typically recommend that clients allocate at least $25,000 for each position, because:

You want to purchase a stock with an initial price that is high enough to trigger acceptable option premiums. You are more likely to get a higher option premium per share on a $25 stock than for a $5 stock.

Because you spread purchases over time, you want to make sure to have available cash to make future purchases. Whatever is not used to buy stock one month can instead earn some interest in a money market sweep account. Every little bit helps!

1

2

Look for financial stability, using tools like bankruptcy predictors such as the Springate Model. Keep in mind that these predictors do not measure the risk of capital depreciation.

What you don’t try to predict is whether the stock will increase or decrease in the short term. If you get called away at more than your cost basis, just start over next month. If the stock price continues to fall, keep buying to lower your cost basis. Be willing to experience some unrealized losses in the short term with the goal of closing the position at a profit in the long term—all the while attempting to generate income by selling options.

Let’s say the stock closes above $30 on expiration and the two covered lots are called away. The uncovered shares remain in the account with an unrealized loss.

On the first trade day after expiration, you can buy an additional lot of shares at $31, which brings the total cost basis to $33.80. Also you can sell calls over all five of the remaining purchases at $35 (See Figure 2).

In this example, you do not have to wait for the stock to return to its initial price in order to sell at a profit. If your shares are assigned at $35, you achieve an average of $1.20 per share in capital appreciation (plus all the income from option premiums over the preceding months.

In this example, you could sell two calls at $25, covering the previous two months’ purchases. By selling these calls, you will generate income as well as limit the profit potential on the covered lots and leave unlimited upside on the uncovered shares. When the expiration arrives, you may have the shares called away, or if the options expire worthless, you can try to sell covered calls against your shares for the next month.

600 SHARES/AVERAGE COST $33.83

Month Shares Purchased

$40

Sell to Open2 Calls at $25

Figure 1

Figure 2

$30

$20

$0

JAN FEB MAR APR MAY JUN

Shar

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Pri

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$37 $38

$34

$29

$24$23

500 SHARES/AVERAGE COST $33.80

Month Shares Purchased

$0

$20

$30

$40

JAN FEB MAR APR MAY JUN JUL

Shar

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$37 $38$34

$29

$24$23

$31200 SharesCalled Away

Sometimes that isn’t possible, though, and there are times when the position cannot generate any income—occasionally for several months.

We can only say to be patient in these circumstances as stocks are generally cyclical, and what goes down often comes back up. Although not always - there is a chance that your stock’s price may never rise above your cost basis, and your unrealized losses may not be offset by the Income you have been able to generate.

Another risk of laddering covered calls is one that is common to all investments: the potential for the stock to stop trading for reasons such as bankruptcy or acquisition. Although you should screen for financial strength, you cannot completely eliminate the risk of a company bankruptcy, which can result in a permanent loss of all your monies invested in that position. And if a company is acquired, we often advise to sell at a loss and buy another position while keeping the cost basis of the previous position. This process can get complicated and is best left for a separate paper.

Finally, you should prepare yourself to be in a position for the long haul. If you need to liquidate a position before it can close above its cost basis, you will experience a permanent loss of capital, and sometimes the loss will be greater than the total income you were able to generate from the options. Most of the positions we have tracked closed within a year, but some last as much as five or longer. So be prepared to hold positions even when the price seems to be heading south for the winter. And that’s really the point of this strategy.

PRECAUTIONSFor this strategy to be effective, the “rungs” of the ladder need to be spaced far enough apart. If you buy too many shares at too close a price, you are not really smoothing potential price fluctuations. We typically advise clients to make no more than three purchases within a $5 range for most stocks, but you can shrink those ranges if the price falls below a certain point.

If you have the maximum number of purchases in a certain range, you may want to sell a put at the closest strike price below the current price instead of buying additional shares. We figure that you would buy the shares anyway if the price were lower, so you can collect a little extra option income while waiting for the price to drop. If it does drop sufficiently, you buy the stock. If the option expires worthless, you still earn the income.

DRAWBACKSThe goal with laddering covered calls is to manage downside risk, but by no means does it eliminate risk. The stock’s price could very well drop dramatically after a few purchases—extending the time the position remains open (you only want to close the position completely when it’s above your total cost basis). When this happens, we advise that you try to sell calls on your lowest-priced shares whenever possible to generate some income.

ABOUT SNIDER ADVISORSSnider Advisors is a boutique Registered Investment Advisor. Helping our clients become better investors has been priority number one since we opened our doors in September of 2002. The cornerstone of our business is the Snider Investment Method, a long-term investment strategy designed to produce monthly portfolio income.

Snider Advisors considers personal financial management a life skill everyone should be taught. Our company was built on belief that a good financial education is the best way to avoid being taken advantage of. That’s why, unlike other financial advisors, we combine financial education and ongoing support with the products and services we offer.

THE BOTTOM LINESince you are seeking income over the long term, you have to put on blinders when it comes to short-term account value. Price declines that cause many covered-call traders to abandon their positions often prove fruitful from an income-generating perspective. It’s not foolproof, of course, but stepping down the ladder is a creative way to manage risk when trading covered calls.

The intent of this document is to help expand your financial education. Although the information included may be relevant to your particular situation, it is not meant to be personalized advice. When it comes to investing, insurance, and financial planning, it is important to speak to a professional and get advice that is tailored to your unique, individual situation. All investments involve risk including possible loss of principal. Investment objectives, risks, and other information are contained in the Snider Investment Method Owner's Manual; read and consider them carefully before investing. More information can be found on our website or by calling 1-888-6-SNIDER. Past performance is not indicative of future results.

Options involve risks and are not suitable for all investors. Before opening an option position, a person must receive a copy of Characteristics and Risks of Standardized Options. Copies of this document are available by calling 888-6- SNIDER. Please read it carefully before investing.