Covered calls, naked puts, covered strangles and position size

One important factor in becoming a successful options trader is understanding when you don't know enough to begin trading.  I've said it many times:  Too many rookies buy or sell options with no understanding of how the process works.  That understanding is necessary.  Jason gets that point as this follow-up to a recent post illustrates:

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Thanks for info. Like your site.  Thanks

I didn't truly think it was a no brainer as I know nothing in the option world is, and that's why I posted.  'Knowing nothing' is a good place to begin. :-)

You mentioned the otm call offers no downside, so if feeling bearish an itm call may work in this situation a well?  Because you asked a question that suggested you had more experience, my reply assumed that.  Had I known this was new to you, I would not have been using ideas that would be brand new to you.

"Work as well?"  It gives you more protection if the stock falls, but it gives you less reward if the stock rises.  So 'works as well' depends on what you are trying to accomplish when writing covered calls.  Some people are very bullish (and sell OTM covered calls) and want to make a lot of money.  For that to happen the stock must rise.  Others are more conservative and are willing to earn ONLY the time premium in the option price.  They write calls that are ITM - for example when the stock is 31 to 32, they buy stock and write a call with a 30 strike price.  NOTE:  Not a 25-strike price.  There is too little profit potential in that.

***Important:  A covered call is a bullish position.  It does well when the market rises and poorly when the market falls.  If 'bearish' this is not an appropriate strategy.  Save it for when you are neutral or slightly bullish.

On the put side. I'm probably over thinking this (NO.  Just not realizing all the ramifications of trading options) but the risk to me is the difference between the put strike minus premium for put sold minus closing stock price correct? If the put triples in value am I responsible for that as well at expiration or only having to purchase stock at the put strike?  Example: Stock is 42 and you sell a put with a strike price of 35 and collect $0.70.  In the stock falls to 35 - the point at which you said you would enter a stop loss order to exit the trade - the put may be trading near $3.00.  If you want to exit the trade, you must buy  back this put.  Yes, you are responsible for the market price of the put.  This is prior to expiration.

At expiration, all the time premium in the option disappears.  But, if the stock drops to 35, it may drop to 30 and the put price would go from $3 to $6 or $7.  Would you hold the put position forever?  That's not how a stop loss works.  If you want to get out of the trade, you must pay the price at which the option is trading NOW.  Just like the person who bought the put from you paid the going price THEN.

If you hold all the way to expiration, then you are correct.  The strike less the premium collected would be the point below which losses accumulate.  But the whole point is that you should not be willing to wait until expiration.  that where knowing when to cut risk comes into play.  That's why you are using a stop loss in the first place (even though it works much better for stock trading than option trading).

Trying to keep a covered position and just squeak out a bit more potential return with least amount of associated risk. Is there another "option" I should consider?  Selling naked puts is an acceptable strategy - as long as you understand what is involved.  In fact, if you plan (for example) to buy 200 shares of stock and write 2 covered calls, trading ONE (not two) of your covered strangle is a reasonable method.  But trading two of them just doubles ultimate risk for very little additional reward.

Look into selling put spreads instead of writing covered calls.  This means a bit of patience on your part.  Do what you are doing; don't take extra risk right now - unless you understand that risk - and try to learn more about options.  You'll love my book, The Rookie's Guide to Options.  But you can find plenty of material on the blog.  Look at credit spreads in categories and read some posts.  Or visit the  CBOE and see what they can tell you about selling put spreads.

Be sure to read the post tomorrow as I added to it before receiving this.  We can continue the conversation later.  I'd love to chat via e-mail, but I simply lack the time to do this because of e-mail volume and other projects.  But do post comments and I will reply to your questions.

Thanks,

Jason 

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