Using Options To Pay Off Debt

By Adam Brownlee | August 10, 2012 AAA

As investment tools, options can provide great leverage and tremendous, potential upside but options can also be used as a part of a well-rounded debt reduction plan. Here's a run-down of some preeminent option strategies that can serve as debt reducers through net credits and potential gains.

Covered Call Option
Put simply, a covered call option allows the investor to generate cash flow through option premiums and transform the underlying asset into a virtual rental property.

An Example
An investor owns 100 shares of Coke at $70 and sells an $80 Coke option contract generating $90 in total premium for a 1.3% return on top of the $7,000 investment. The buyer of the option is granted the right (but not the obligation) to buy the stock at $80 a share. If the stock ends above the strike price, $80 in this case, then the option will likely be exercised.

The 1.3% return in premium in this example seems paltry, but keep in mind that if the option is near-month, this return is monthly. Once annualized, this return comes to 15.43%. Not too shabby. Of course this depends on achieving the same level of performance throughout the year.

Using It to Pay off Debt
The premium earned in the covered call strategy serves as a debt eliminator.

Iron Condor
An Iron Condor strategy is composed of two strangle positions: a long and short position in each case, four different options each with its own strike. The strangles at the two middle strike prices create a wide area for profit and the maximum profit is equal to the net premium received, minus the commissions paid. The investor utilizing this strategy is collecting a premium and hoping that the options expire worthless at the end of the cycle.

An Example
An investor buys one October SPX 1,450 call for $4.50 and sells an October SPX 1,440 call for $8.80. At the same time, an October SPX 1,350 is purchased for $93 and an October SPX 1,340 is sold for $102.90. The total credit comes to $14.20 with a maintenance requirement of $209.20 for a potential gain of more than 7%.

Using It to Pay off Debt
In this strategy, the investor is collecting an up-front premium and hoping for a worthless expiration. If this happens, the $1,420 in premium can be applied to debt.

Iron Butterfly
Similar to the Iron Condor, the Iron Butterfly is created with four options at three consecutively higher strike prices. Because of the offsetting long and short positions, this architecture limits the amount of risk and reward.

An Example
In-A-Gadda-Da-Vida

The Iron Butterfly investor buys one OTM call, sells an ATM call, sells an ATM put and buys one OTM put thus creating a long or short straddle with the options in the middle. This strategy limits the amount of risk and reward because of the offsetting long and short positions. "If the price falls dramatically and the investor holds a short straddle at the center strike price, the position is protected because of the lower long put."

The investor buys one November $45 call at $1.05, sells one November $44 call at $1.50, buys one November $43 put at 50 cents and sells one November $44 put at 75 cents to open. The net credit is equal to ($1.50 - $1.05) + (75 cents - 50 cents) or 70 cents.

Using It to Pay off Debt
The profit potential in this strategy lies in the arch of the butterfly's back: a limited range created by the straddle. Additionally, the structure set-up results in a net credit spread resulting in potential debt reduction premium.

Bear Call Spread
In expectation of a price decline in the asset, the option strategist sells call options at a specific strike price while also buying the same number of calls at a higher strike price.

  • A call with lower strike price is sold and a call with a higher strike price is purchased.

  • Both have the same underlying stock and the same expiration date.

The Bear Call Spread strategy pays off when the price of the stock drops below the strike of the short positions.

An Example
The investor sells 1 ABC June 40 Call at $3.40 per share and buys 1 ABC June 45 Call at $2 per share. This spread is created at a net debit of $1.40 not including commissions.

Using It to Pay off Debt
If the example position falls below 40 by the expiration, then both positions will expire worthless and the total position profit is the $1.40 spread. If the underlying stock ends between 40 and 45, then the 45 expires worthless but the 40 call will have value. The break-even point is equal to the lower strike price plus the total cost of the spread or $41.40 in this case.

The Bottom Line
Net credits and gains received from the previously detailed option strategies can be used as part of a well-rounded financial plan designed to reduce debt. The Covered Call, Iron Condor, Butterfly and Bear Spread can each be used in tangent with neutral to bearish outlooks that allow investors to generate income which can be used for debt reduction.

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