Options for Rookies

The Care and Handling of Covered Call and Naked Put Positions

Hi Mark,

Thanks for presenting this article on a topic related to covered calls.

Steve's question, as well as the oft repeated discussions on the JustCoveredCalls Yahoo Group regarding whether to (1) close or (2) roll; short puts (in the case of cash-secured puts [CSP]) or short calls (in the case of covered calls [CC]) leads me to conjecture that there is an insignificant difference concerning the "What to do?" question when one compares the comparable decision facing either the CC or the CSP writers.

2) In a related (albeit different) line of inquiry, it seems to me that individual investors who are put writers might be slightly more conservatively oriented in that they tend to sell out-of-the-money strikes whereas covered calls investors are more likely to be somewhat more aggressive in that they seem to have a greater tendency to sell out-of-the-money calls.

Do you have any thoughts on this question?

Are you aware of any academic research in this regard?

Best Regards,
Jeff

***

1)  Although I've never seen a discussion on this question, it's makes for an excellent blog post:

Let's assume that the reader of this post already understands that covered calls and CSP positions are equivalent (if you are not certain this is true, here's evidence).  That means they offer essentially identical profit and loss profiles.

Do the covered call writer and cash secured put (CSP) seller face essentially identical decisions?

Let's assume the trader is short RGTO Jun 40's.  The covered all writer owns the shares and wrote Jun 40 calls.  The CSP trader sold RGTO Jun 40 puts.

a) When the stock is near 40 as expiration nears, each is faced with a similar decision:

Do you exit the trade, eliminate all risk (associated with significant negative gamma)?  Is this decision affected by whether the position is profitable? 

Do you hold because theta is relatively large with a decent daily reward?

These decisions are identical. The put and call options have the same gamma, vega, and theta.  The positions have identical risk and the traders face identical decisions, even though they don't necessarily recognize that fact.

i) If the traders decide to exit, they make the same decision.  There's not more to say about that choice.

ii) When the CC writer rolls the position to the same strike in July, he/she is selling the call time spread.  The new position is the RGTO Jul 40 covered call.  That position is equivalent to being short the RGTO Jul 40 P.

When the CSP seller decides to roll the position to the next month, that trader also gets short the Jul 40P. 

Thus, each makes the identical play: changing the Jun position to Jul and each has a position equivalent to the other. 

iii) This is a constant.  Regardless of the strike price chosen - as long as each trader sells a RGTO option with the same strike and expiration, each makes an equivalent trade when rolling and each owns an equivalent position.

b) If the stock is not near 40, then either the call or put is relatively DITM and the other is FOTM.

i) If the stock is > 40, then the CC writer is assigned an exercise notice, has no residual position and earns the maximum possible profit for that trade.  The CSP writer sees the short put expire worthless.  This trader also has no residual position and earns the maximum.

ii) If the stock is well below 40, each has a losing situation - but it's the equivalent.  Each has lost an equal amount of  money.  One reasonable action is for the call writer to sell the Jul 35 call - either after the Jun option expires worthless, or prior to expiration.  Why prior?  To collect extra cash NOW, and not gambling on the stock price change between NOW and expiration.

It's also common for the CSP seller to 'roll down' by covering the Jun 40P and selling the Jul35P.   If that's the decision, then once again each has made the equivalent trade.

Bottom line:  Jeff, I agree with your premise: "there is an insignificant difference concerning the 'What to do?' question."

***

2) I also believe it's true that most option sellers feel safer when writing OTM options.  That would leave the CC writer selling options with a higher strike price (calls) and the CSP writer selling lower strike price puts.

Why does this happen?  In my opinion, it's a result of covered call writers not quite 'getting' the idea behind their strategy.  The need to have a chance to earn a profit on a rally (call it greed) overwhelms their need to minimize loss potential.

Using a $40 stock as an example, if the CC writer understood that writing the Jun 45 call resulted in a position equivalent to selling the Jun 45 put (when it's five points ITM), he/she would be horrified.  Yet, unaware of this equivalence, they write OTM calls month after month.

3) I am not aware of any academic studies, but Odean and Barber have written many papers about the investing habits of individual investors.  If you write to one of them, you may get a reply (I did).

625

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Use Options to Protect Assets and Feel Secure

Mark,

Just read your article on selling calls, thanks. My step-father is a bit uneasy in the market now and has 1.5 million in assets. 60% in equities via mutual funds/ETF's/some individual stock.

Here are my thought and if you could expand or correct me I would appreciate it:

Would he buy puts on an S&P index/Dow Index? Would you try to find that beta of the portfolio to see if this is the way to go, or do you need to find out what stocks are making up most of the portfolio. I think he would sleep much better at night knowing he had some protection, but I need to find out how much the insurance (puts) is going to cost. He is 70 yrs old.

Would you suggest selling calls on an index/certain stocks?

From what I gather this is solid theory too, unless the market loses a lot of value and the premium doesn't outweigh the loss in stock value.

Thanks,

TC

***

These are important questions.  And your general idea of how to handle the situation is good.

About your step-father. If he is UNEASY, then something must be done. Obviously you are looking for a good solution, but be certain that he is comfortable with any decision being made. Don't do something just to do something. Emotional comfort is very important.

1) If he were to buy puts, it's very unlikely that the DOW index would be the best puts. Obviously it depends on his holdings, but the S&P 500 Index (SPX) puts are more likely to be a better match; i.e., SPX is more likely to have a higher correlation with the market value of his holdings.

2) That said, I HATE (dislike, loathe etc) the idea of buying puts. That's my personal feeling and buying puts may be ok for some investors. The bottom line is that puts are expensive. And if you wait until the market is declining to buy those puts, they become even more expensive. There are better alternatives.

3) Portfolio beta doesn't tell you much that would be helpful with this decision. In his situation (not that 70 is old these days), his beta should not be 1.5 - that would be a very volatile portfolio. Beta near 1.0 is better suited for him, but beta values are difficult to find.   A 1.0 beta means his portfolio can be expected to perform in line with the major market averages. Neither much better nor much worse. 

4) I prefer selling covered calls to buying puts.  I prefer to collect that time premium rather than pay for it by buying puts. However, the biggest problem with this strategy is that downside protection is limited. It's minor protection. Covered call writing has been shown to slightly outperform a simple buy and hold plan.  I don't believe this is your major concern.  His discomfort is obviously fear or loss, not fear of making less on a large rally.

Thus, if downside risk is your major concern, the protection is limited to the cash collected when writing (selling) the options. 

5) To me, the right solution for you (please understand that I cannot possibly know enough of the details to make a specific recommendation for your situation, but this certainly feels right and I know I would do this if I were in a similar place) is to adopt BOTH of your ideas.

6) That means collars. Buy puts and sell calls. There are difficulties in making the trades - choosing which specific options to trade and how many to trade - and I cannot go into all the details in this post.  But if you get ready to act, post a comment/question and we can get into more details at that time.

If you trade SPX options, the broker is going to consider the call sales to be naked - even though you have bullish assets to back them up. That means a significant margin requirement. He may have enough funds to meet that requirement, but margin may present a problem.

If you buy and sell options on the specific items you own - such as he individual ETFs and stocks, then you will be making a bunch of trades and commissions become a factor. Your step-father may have been using the same broker for many years, but when trading options, you want to switch to a broker that charges minimal fees for option trades.

I've written about collars many times in this blog. Take a look at the categories in the right hand column and you can find those posts.

7) Don't rush into this. Be certain you understand what can be gained and lost with collars. This strategy protects the downside. The cost is sacrificing the big upside, if there is a strong rally. My guess is that both of you prefer that protection and that substantial gains is not your prime consideration.

What happened to my objection to paying for those puts?  When you sell the calls, most of the time the call premium is enough to offset the price paid for the puts.  Many times there is even a net cash credit.  That gives you protection at essentially zero cash cost.  The true cost is the limited upside.  A very good deal for both of you.

618

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Webinar: Covered Calls From a Different Perspective

I'm, presenting a one hour webinar next week.  I'll be taking a look at an old favorite, covered call writing.  But this time the discussion takes a non-traditional course.

Tuesday, February 16;  5pm ET

Covered Call Writing: From a Different Perspective

Register for this webinar.

From the announcement by Trade King:

Which option to write?  Should you write ITM or OTM calls?

Do you have trouble when the stock rallies and want additional profits?

Do you hate it when the call moves into the money and you regret selling it?

Join Mark as he provides critical explanations to these and many more questions about covered call writing.

For Rookies.

613

One Trader's Thoughts on a Dividend Capture Trade

Jason sent an example in reply to this Q & A.

An example. Pfizer is going ex-dividend next month. Paying $0.18 div and currently trading at $18.50. March 18 call selling for 1.10. Break-even of stock minus div and premium of 17.22.

If called 4.13% earned, if uncalled 6.84%.

Sell stop limit on shares at 17.22 and buy back the call (not sure what this would cost, so don't know how to include for further loss.

***

Thanks for the example Jason,

I'm asking questions below.  I'm NOT looking for answers.  I just want to be certain you think about this and have a plan.

I believe your prices are not accurate.  Right now (Jan 28, 2PM), the stock is 18.75 and the call is only $1.11  That makes a big difference.  Be that as it may, I'll go ahead and use your numbers as well as the ones that I see right now.

1) If you are adopting this strategy for the purpose 'capturing the dividend,' then it's fairly risky.  The dividend (plus option premium) is small and the potential loss is larger.

2) If you are doing this because you like PFE and want to own its shares, then this plan is viable. You already considered risk when deciding that you want to own the shares.

3) You obviously have an exit point in mind:  A stop-loss on the downside and an assignment (sale at the strike price) on the upside.

What happens when the stock is between those prices?  Do you hold and write another covered call, or do you sell?  There's no dividend for another three months, and you appear to be interested in collecting dividends.  Do you hold despite the fact that the dividend is 'far' away?

4) How do you determine the P/L if uncalled?  What stock price are you using?  I believe you made a mistake.

I find it difficult that you believe you can earn almost 7% if uncalled and only 4% if called.  The stock is higher when you are assigned that exercise notice.

When writing covered calls, being assigned yields the maximum possible profit [Yes, I know if the stock price is a penny or two less than the strike, you save on the assignment fee].

5) To estimate the cost of call repurchase, guess a buy-back date, raise implied volatility (due to price decline) by a small amount, and calculate the option's fair value.

6) With your numbers, if called, you sell @$18, and earn $60 (pay $18.50 sell at $19.10) + dividend.  Less cost of carry (interest you did not earn because cash is tied up in stock).

Using the current  numbers that I see, that's $36 earned + dividend, less cost to carry.  Earnings are almost $54.

The put is $53.  If you sell the Mar18 put instead of buying stock and selling calls, you earn $53. 

That's $1 less.  But you save cost to carry, you save on commissions.  You save on an exercise fee. [If you are going to unload the stock @ 17.22, you can buy the put (to close the trade) and will not incur an assignment fee]  At that point, the put should cost the same as selling stock plus buying the call.

I see no advantage to your buying stock for the dividend. 

I am comparing covered call vs. cash-secured naked put.  I am not telling you to avoid either.  Your investment decision apparently suits your needs, and you cannot bet that.

The two strategies are equivalent and have the same P/L profile.  The dividend is taken into consideration by the option prices.  The evidence for that example comes with using my numbers.  You can double check to see that yours are accurate.  But I caution you to use live bid/ask prices, and never use 'last.'

Don't get your data from Yahoo.

600

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:

***

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 

596

The Covered Strangle. No-Brainer or Risky Trade?

Having just blogged about the fact that equivalent positions are truly equivalent, I received this question that's based on the same topic.

***

Mark,

I have done covered calls for a while. Looking to increase returns without taking on much more risk.

Wondering about a covered spread approach where I own the stock, short OTM calls, short OTM puts, and enter a stop sell order to automatically liquidate shares if stock hits my put strike price to cover situation where stock could be put to me.

This seems like a no brainer to enhance returns without anymore risk but wondering if I've overlooked anything.

Thoughts?

Jason

***

You are referring to a covered strangle. This is another example where it's important to understand equivalent positions.

It is NOT a no-brainer.  This has real risk and obviously a very decent reward potential.

Stop-loss

I agree that the stop-loss order does limit risk, but are you aware of how much risk that is, or are you just assuming it's acceptable?

If you are stopped out of the trade, you can lose a substantial sum on the 'no-brainer' put you sold to enhance profits.   That put is now ATM, making it worth substantially more than the premium you received when selling it.  In addition,  IV has probably increased - and that's also going to hurt.  The passage of time is not going to help enough to offset very much of the loss.

Add to that your covered call position.  I acknowledge that if you were going to exit this trade at the same stop loss point, then you are already aware of how much this trade can lose. 

What concerns me is that you entered the stop loss so that 'the stock could not be put' to you.  That's not a good reason for entering a stop-loss order. [As an aside, I believe that stop-loss orders are very inefficient where options are concerned.  You would be forced to enter a market order when the stock is falling, and that's going to get you a very bad fill because you would be paying the asking price when the bid-ask spread is likely to be extra wide.]

Being assigned an exercise notice

First, no one would exercise a put option that is ATM, so there is no immediate danger of being assigned an exercise notice.  The reason for exiting a trade via stop-loss should NOT be to avoid assignment.  It should be because you decided that the loss at that point is enough.   You recognize the trade has not worked and you want to exit.

Second, when you are writing covered calls, having stock put to you is not so bad.  After all, the covered call and naked put represent a similar trade (in your case with different strike prices).  Having the stock put to you doubles your stock ownership and is merely another covered call position that has gone bad. 

Downside risk

When writing an OTM call, I assume you understand that you have downside risk, and that the call offers very little in downside protection.  If you want to get so aggressive as to sell additional naked puts, I suggest you consider that markets do not always rise, and perhaps writing an ATM, or even an ITM covered call instead of your OTM can provide much-needed protection.  Either provides additional (but limited) downside protection, but the downside is where your risk lies.  That protection is needed when you are about to double your position size (by writing extra puts).

It's important that you recognize that writing an OTM covered call is the same position as selling a naked, ITM put. The loss on that portion of your covered strangle is going to hurt when the stock drops several strike prices and you are stopped out of the trade.  When that happens, don't be surprised when you get a bad fill on buying your OTM call with a market order (higher IV and wider bid/ask spread).

Summary

This is far riskier than you imagine.  You have doubled your position size, going from one naked put to (the equivalent of) two naked puts.  Yes the 2nd is more OTM and not likely to result in your being forced to exit - but 'not likely' events occur all the time.

Rethink this.  If you don't 'see' it then please use some graphing software to plot your positions.  Then you can decide whether the extra risk is worth taking.  It may be a good trade for you.  I want you to be aware of the risks before making the trade.  You should also understand the probability of getting stopped out (that's the delta of the naked put you are selling) of the entire trade.

Be careful.  'No-brainer' options strategies don't exist.

594

Writing Covered Calls in 2010

As mentioned by Tadas at Abnormal Returns, Saturday's online Wall Street Journal had a significant article about covered call writing.  The reporter (Jeff D. Opdyke) interviewed several people to present a diversified set of opinions on the strategy.

Covered call writing is one of my six favorite option strategies, but it does have one significant fault:  Downside losses can be significant.  That's why I encourage more experienced traders to consider less risky strategies, such as collars and the sale of put spreads. 

Note: Writing covered calls is equivalent to selling naked puts, and collars are equivalent to selling put spreads.

I have some comments on that article:

1a) Opdyke correctly states that "Covered calls generate income and can juice returns in any market, though they often make most sense in a market that is flat to mildly bullish."

The covered call is delta long and is a position with a bullish bias.  It makes money when the market rises. Jeff goes on to state: "Selling calls generally makes sense only for investors who don't mind losing the shares they own."  I never mind losing the shares.  When that happens, I know I earned the maximum possible profit available to the covered call writer.

1b) He also points out the obvious negative factors: "But investors still could get hammered if stock prices collapse. And the big drop in stock-market volatility means investors are receiving less income for selling calls than they did in the aftermath of the financial crisis, when high volatility pushed options prices way up."  I agree.  There is no doubt that this strategy has its risks.

2) Jim Bittman, author and Senior Instructor at the Options Institute, and someone I have known for a long time, takes a different view: "If you are bullish about 2010, then don't sell calls because you'll miss out on a rally."

Recognizing that different traders have differing points of view, I disagree with this statement because:

a) A 'rally' does not mean the stock will move as high as the option's strike price.  [Most writers prefer to write calls that are out of the money]

b) You don't  miss out on a rally when you earn a profit on a stock that moves higher.  What you may miss is the opportunity to earn additional profits - over and above the limited profits available to covered call writers.

 But to me, that's unimportant. 

Not every trader has to earn the maximum possible profit from each trade

Seeking the maximum, and taking the risk that goes with that approach, is not a long-term winning strategy IMO

Writing the covered call provides a small hedge and some extra income - just in case your expectation of a rising market does not come true.  We all know how difficult it is to predict market direction, and if I were bullish, I'd prefer to hedge that bias by using a mildly bullish strategy.

3) The director of trading and derivatives at Charles Schwab was not afraid to state that he wrote covered calls during the big rally during the last 9 months of 2009: "I used that strategy throughout 2009, when the market was rallying," said Randy Frederick.

He did well with that strategy, even if he might have done better without it.  Making money is the name of the game.  Covered call writing provided nice profits in 2009 - after a very shaky start.  The BXM, CBOE BuyWrite Index gained, 25.9% in 2009,  compared with a 26.5 % return for SPTR (Standard & Poor's 500 Total Return Index).  Thus, covered call writing produced no extra income last year, but it did provide a less volatile ride.

567

Deep in the Money Calls as a Stock Substitute

Hello Mark:

I am awaiting your book, but I have read other authors, and I want to use a "Deep ITM" option to buy and control a stock, XYZ, a blue-chip company. This to control the stock at less cost than buying outright, while taking advantage of a near 100% delta relation between shares and option.

My intention is to sell a Covered Call against the shares, just above ATM, with the intent of assigning my shares (those for which I do not yet own, but hold an option) if the holder of my sold option exercises his option. I want to collect the difference in my option strike price and present price of the shares for my account, rather than just exercise my option to close the Call I wrote. Another goal is to own the right to buy my shares at a future time, at today's price, when I will have more cash on hand.

If my Covered Call is assigned, I am delighted. I will wait for another dip in the share price to buy another "DITM" option as above, as I want to own XYZ stock when the price is right.

For the short time I "pass-on" my assignment I would prefer not to have cash on hand.

I am sure this can be done, can you help me with the mechanics. Thanks-Joel

***

Hello Joel,

Options for rookies is primarily an educational blog, so first let me correct some terminology for the benefit of other readers.

When you say: 'assigning my shares,'  it should be: 'exercise my options.'

***

Next a discussion, then the mechanics.

1) Good use of a DITM call.

2) If you are assigned an exercise notice, it's a simple matter for you to exercise your DITM call. Even when it's prior to expiration.

3) But, if you want to collect any remaining time premium remaining in your call option, then you simply buy shares and sell your calls.  Pay attention to just how much time premium remains and don't ignore the fact that you will have to pay two commissions when you buy shares and sell the call, rather than one exercise fee (not all brokers charge this fee).

Keep in mind that if you are assigned an exercise notice, it's most likely going to be at expiration (or very near), and it's virtually 100% guaranteed that there will be zero time premium in your deep in the money call to collect. 

If that's the case, or if the premium is too little to justify any extra commissions, then simply exercise your call to offset the stock you sold when assigned.

4)  You have the correct attitude.  Being delighted when assigned is the winner's attitude.

***

The Mechanics

1) Enter an order to buy a call spread.  The option you buy is (obviously) your DITM option and the one you sell is your slightly out of the money (what you refer to as 'above ATM') call.

Specify the debit for the spread.  That means how much cash you are willing to pay.  It's important to specify a debit because that makes the order a 'limit' order.  DO NOT enter a market order.  You can always (ok, at least 99% of the time) pay less for the spread than the price you see on your trader screen.

2) I assume the options both expire at the same time.  If that's true, there is no problem.

If the option you buy expires later, that's also not a problem - but from your strategy description, I don't believe that would be advisable.

3) If you are NOT assigned an exercise notice, and the option you sold expires worthless, you must either sell your DITM option, or exercise it and become a stockholder.

There is another choice (buy the calendar spread, moving your long option out one month.  If you do this, buy back the call you sold (at a very low price; $0.05) AND sell another covered call that expires in the same month as the new DITM call.

You cannot expect this strategy to work every time, and you will see the options expire worthless more often than you prefer to see that happen.

I want to mention, but assume you are aware, that this is a bullish strategy with a limited reward.  The potential loss is much larger.

515

Overwriting a Collar

Hi Mark,

I have been reading this blog for a while and decided to ask a question.

I have been out of option trading for a while and have decide to come back to it. You have been mentioning that today it's really important to hedge risk and I totally agree; that's one reason I've been out; I hadn't really figured out a comfortable way for me to do that.

One strategy I have been considering, and now testing in my paper desk, is to sell covered calls for premium, and delta balance the buy/write - and then hedge that buy/write with with a long ATM put 6 or 7 months out. My thoughts are that the put will protect me against big opening gaps while costing me less theta than the premium earned by the short call.

Any thoughts?

Terry

***

Welcome.  Glad you've taken the time to post a question.

The overall concept is sound.

You are really talking about a collar and not a covered call - if you buy the put.

There are modifications to consider.

1) I agree that hedging is a solid idea, and it's important.

2) Overwriting, or selling more than one call per 100 shares of stock does balance the deltas, but introduces upside risk that is not normally part of a covered call strategy.  I'm NOT suggesting that you avoid this play.  I'm only emphasizing it to be certain you are aware.

Unless you sell very low delta calls (I don't recommend that strategy), you won't be selling many extra calls.  And if you add the negative delta from buying puts, there will not be room to remain delta neutral and sell extra puts.

3) All by itself, buying puts adds a double safety feature: protected downside and (because fewer calls are sold) an upside that's not as bad.

4) The longer-term put is a big issue.

Yes, less rapid time decay is important, but it's not the whole story.

Yes, the longer term option has been shown to do better than one month puts, but data supporting that idea is limited.

Be aware that these puts are loaded with vega (that means their price is very sensitive to a change implied volatility).  In my opinion, you cannot buy longer term options, ignoring how much they cost.  When IV is high, you may be better off with one-month puts.  When it's elevated, perhaps 3-month puts would be a good compromise.  I'd own the 6-month put when IV feels 'reasonable' and the option price is not prohibitive. 

There is some judgment if you adopt this idea.  Obviously, if you always buy the longer-term puts, there's less judgment, and there is nothing wrong with that.  It depends on your preference.

5) I want to make one more point about the puts.  If you are truly buying them ONLY to protect you against large opening gaps, then near-term, OTM, not too expensive puts should be good enough.  Lots of bang for the buck.

But if you want to own puts for true downside protection - gap or no gap, that's a different story and your idea is sound.

I like collars.  The profit potential may not be too large, but being protected from big losses is far more important.  At least to me.

508

Covered Call Alternatives. IV

In the final part of this series, we'll consider two additional modifications to using a call spread, instead of a call - when modifying the covered call writing strategy.  This position already looks nothing like a covered call, so I'm not going to be using that term any longer.

Part I, Part II, Part III.

As pointed out in the original article that spurred this discussion, it's not necessary to use either stock or long-term options.  There's no reason not to use options that are far less costly to buy.  Let's look at an example in which we buy SPY Jan 90 calls instead of the very long-term SPY Dec '11  90 calls (which we used in Part III).  We'll still sell 3 Jan 106/Jan 109 call spreads.

The downside is better, but imagine how much better it would be if we bought less expensive calls.  Let's look at this position, substituting Jan 102 calls for the Jan 90 calls.

Jan 102 calls cost $5.70.  The cost of this position is $570, less 3 x $115 (premium from selling each call spread), or $225.

By cutting the net cash required to purchase this investment, the downside risk has been eliminated, or at least severely cut.  But look at the big picture.  If you need some protection for a portfolio that has upside risk this is a very inexpensive way to get that protection.

Note the progression:

• Begin with a covered call
• Substitute a LEAPS call for the stock
• Sell a call spread, instead of a single call
• Sell multiple call spreads
• Buy nearer-term options as the long, replacing the LEAPS call
• Buy a less costly near-term option

This final spread bears no resemblance to a covered call position, yet we moved from a covered call - with significant downside risk - to a much less risky position. 

• The downside is much better 
  

• The position still shows a good profit when the market undergoes a big move to the upside

• This position can never* lose more than the initial debit when the market moves higher

*As long as you don't sell too many spreads.  At expiration, the 102 call is worth $700 with SPY at 109.  The three call spreads are worth $900.  This trade can result in a small loss ($225 cost plus the $200 resulting from a 109 expiration price). But it's worth it if the portfolio needs good upside protection.  If you choose a 2:1 ratio, then there is never an upside loss, other than the original debit.

NOTE: This is not the right position for a covered call trader.  This is completely different.  This is an inexpensive bullish play that provides excellent protection for an iron condor trader.

It's the possibility of big profits (or buying protection against big losses) resulting from a big upside market move that makes this strategy so attractive.  And it's the reason I've been recommending this specific strategy as one good method for insuring iron condor positions.  I've been using it successfully for the past few months.

The beauty of this position type is that it works for the downside also, using puts.  Here's one graph for a typical put position:

Is this an idea you can use for your portfolio?

Donald - I think we've moved a long way from your original question.  Thanks for suggesting this topic.

506

Covered Call Alternatives. III

This series is the result of a question from Donald.

Part I and Part II set the stage.  Today we'll look at the suggested strategy and the benefits of adding it to your trading arsenal.

The modified strategy calls for buying one LEAPS call and selling a call spread, instead of just writing a covered call.  This has two major effects on the position, one of which is readily visible in the graph.

Reminder: 

Buy SPY Dec '11  90 C;  Sell SPY Jan '10  106/109 call spread

• The premium collected is reduced.  In our example, the $109 call costs $2.10 and the premium collected for the spread becomes $1.15 instead of $3.35.  That's the bad news, and reduces the amount of downside protection from 3.35 points to only 1.15.

• Profit potential is no longer limited.  This position contains a long call, and that provides unlimited upside potential. 

You can see that the maximum loss (displayed on the graph) increases by a small amount (compare with graph in Part II).  It's the $210 paid to buy the Jan 109 call. 

The maximum profit is no longer capped, but instead has no upper limit.

This position, using the long-term call option or the underlying stock, works for the extremely bullish investor who likes the idea of writing covered calls, but still wants the chance to win big on a huge rally.

***

The exciting part of this trade idea is that it allows for the sale of extra call spreads.  In other words, instead of selling just one call spread per long term option, the investor can sell multiples.  That puts a temporary damper on the upside, but because the position still contains an extra call, the upside potential remains unlimited.

Here's the same trade with the sale of three Jan 106/109 call spreads, instead of only one.

The downside is improved simply because extra cash was collected by selling two call spreads.  The upside was cut - but only by the possibility that the 106/109 call spread reaches maximum value.  And any move beyond the upper strike price (of the Jan call spread) once again increases profits.

Still bullish, with a downside that's not as bad.  That's seems like a good combination to me.  Keep in mind that as expiration nears, the huge upside becomes more and more remote, but it's always present - just in case there is ever an upside black swan event.

Let's take this play one additional step and look at the graph if 10 call spreads are sold, instead of only three.  The point of this trade is to illustrate that you can go too far.  Sure, the ultimate upside is always going to be a winner, but if this trade is made to produce a profit when the market rises, there is a limit to how many spreads you can sell. [Please don't ask about the limit; it's going to depend on which option you own and which spreads you sell.  More on this in Part IV]

Selling all those extra call spreads makes the downside better.  This is not an efficient method for downside protection.  In fact it's a very poor choice.  

We can do better

This strategy works equally well when using puts, producing a pretty downside.  That discussion is reserved for Part IV.

to be continued...

505

Covered Call Alternatives. II

Part I

Looking at the strategy mentioned by Steve Smith in a Minyanville article:

As an improvement on writing covered calls, the suggestion is to:

• Replace long stock with a LEAPS option

• Instead of writing a call, sell a call spread

I'm using an example that is similar to (but with different strike prices) the covered call position Smith used. 

My bias is towards writing covered calls that are not OTM (I like the better downside protection that comes with writing calls with a lower strike price, even though this reduces the maximum possible profit) and chose to write a call that is closer to being ATM than Steve chose.  It does not alter the discussion.

I included risk reward graphs* generated by using the online software tool available from Interactive Brokers.  I am using last Friday's (10/30/2009) closing prices to generate these examples.

* You can call these risk graphs, P/L graphs, risk/reward graphs.  It doesn't matter what you call them - just use them.

First let's compare the covered call with the LEAPS version.  In Part III time we'll look at the idea of selling a call spread in place of a call.

Covered call:

• Buy 100 shares of SPY @ $103.56
  

• Sell (write) 1 SPY Jan 106 call @ $3.35

• Net debit (excluding trading costs): $100.21  Corrected
  

LEAPS version.  I'm using the Dec 2011  90 calls. (I know Steve Smith used Jan 2011 calls, but I cannot verify that those options are listed for trading on any exchange).

• Buy 1 SPY Dec '11  90 call @ $21.50

• Sell (write) 1 SPY Jan 106 call @ $3.35

• Net debit (excluding trading costs): $18.15

As I've previously mentioned, the substitution of a long-term option for stock makes a big difference in the results.  The downside risk is cut substantially, as can be seen in the graphs.

But, the profits are also limited.  In fact, if SPY rises above 135 in this example, the position loses money.

Thus, using a LEAPS option as a stock substitute when writing covered calls is not as simple as it may seem.  It does make the downside better, but the proponents of this idea never talk about the potential upside problems.  I don't recommend using LEAPS as a stock replacement when writing covered calls.

***

There is special beauty in the strategy we are going to discuss.  I know it's taking me a long time to get to it, but my purpose is not just to discuss the strategy recommendation, but to write about the steps leading to it, allowing readers to have a better understanding of why the suggested strategy is good (or not so good, depending on your trading style and comfort zone).  Options for Rookies is a blog devoted to helping readers understand options.  It is not designed to show you a trading idea and tell you - "okay, now go ahead and trade." 

to be continued...

504

Covered Call Alternatives. I

Mark,

I was wondering what you thought of Steve Smith article at Minyanville basically blasting covered calls and recommending instead, combining the following two techniques:

"Replace the underlying long stock with the purchase of an in-the-money LEAP, or long-term call option.

Rather then selling a single strike call, sell a vertical spread for a credit."

After reading your book on Creating Your own Hedge Fund. I certainly will be sticking with your recommendation. Nothing like getting an instant discount when buying stock, especially when I have no ambitions to sell the ETF once purchased. Looking forward to studying it more in depth and just ordered your other book on Options for Rookies, hope to enjoy it equally as well.

Donald

***

Hello Donald,

1) You will like the new book much more than you did Create...

2) I'm pleased you like the covered call strategy, especially after living through the 2008 market debacle.  In the Rookie's Guide (and throughout this blog) you will find other strategies that are similar.  The advantage to any of those alternatives is reduced risk.  Yes, that comes with reduced reward potential, but that's where you get to decide which is 'better' for you. 

If you like the idea of being invested in the markets, writing covered calls will suit you nicely.  If you prefer more protection - call it insurance - you may prefer collars, or it's equivalent, selling OTM put spreads.

The strategy you asked about is worth considering.  I'm NOT telling you that it's better because that is such a relative term and better for me is not necessarily better for you.  There are advantages - especially when you are very bullish, but there are disadvantages, such as less protection in a down market.

3) I agree with Smith that writing covered calls leaves much to be desired in the risk department.

But for investors (as opposed to traders looking for short-term profits) who plan to remain 'long the market' all the time, I believe writing covered calls is a viable method.

Because I believe so strongly in the importance of risk management to long-term success as a trader, Steve's idea is very much worth discussing.

4) The term is LEAPS, not LEAP or 'leaps.'   And Steve should know better.

5) Some people who discuss option strategies recommend replacing stock with LEAPS and selling calls against those LEAPS.  They look at the position as being a modified covered call, but technically it's a diagonal call spread. 

That modification to writing covered calls has merit, but I don't recommend it.  For the sake of being thorough, let's look at that idea before moving on to Steve's suggested strategy.

Both the good news and the bad news with owning LEAPS, instead of stock, is that they are options with less than 100 delta. 

If the stock tumbles, it's far better to own one LEAPS option than 100 shares of stock.  First, LEAPS cost less than stock and the maximum loss that results from a severe decline in the stock price is significantly reduced.  In addition, such a price decline is often accompanied by an increase in implied volatility.  The owner of a LEAPS call benefits from that IV increase because LEAPS are vega-rich.  Thus, the LEAPS option will be trading at a higher price than you might expect when the stock tumbles - and that results in a further reduction of losses. That's all good.

But, if the stock rises sufficiently and your short option moves significantly ITM, the LEAPS option now increases in value at a SLOWER rate than your short option - because it still has less than 100 delta.  Whereas a covered call never runs into trouble on the upside, that's not true for the owner of a 'LEAPS covered call' position.

Bottom line - using the LEAPS has a lot to recommend it, but it's not foolproof.

6) The strategy discussed in the Minyanville post is different.  Significantly different.  It has it's good points and bad points, but it is a trade I not only like, but frequently use in my own trading and discussed previously on this blog (although it's in disguise and may not be readily recognizable as the same method).

It's worth looking at this idea in detail.  To make it easier to follow, I'll include charts - per the suggestion from Simon.

to be continued...

502

Taking Losses. Why is it so difficult?

Mark:

I write covered calls on SPY.  When the ETF drops in price, I would never write a covered call at strike price and expiration date, where if assigned, I would lose money.

Recently I woke up in the middle of the night (that was a mistake) and thought what would happen if I did.  What would happen if I accepted the unrealized loss and just wrote at the new price like it was the first, which would give me the best premium.  What if I thought of the ETF holding as shares that generate premium, rather than dollars?

Ultimately the ETF goes back up or I die, and then my estate has the unrealized loss, but at that point I’m not worrying about it.

I must be wrong some where here, what am I missing?

Thanks,

Martin

***

Good question.  This is a common situation that must be faced by writers of covered calls.  But, it's similar to investors who buy something and watch it decline in price.

For many, taking a loss is just impossible.  Over the years, they wind up with a portfolio of garbage - all those losers they are still holding.

'Traders' as opposed to investors are less likely to be in that situation because they understand that when the investment doesn't move as anticipated, the investment decision was wrong and it's time to exit and move on.

471

ADDENDUM:  The difficult for most to recognize is that you have already lost the money.  Refusing to write covered calls until you can sell calls at the original strike price is a strategy based on hope.  To me you must decide:

Do I write calls now - and generate premium as income - or do I become a investor and hold the stock, doing nothing unless it rallies?  For my comfort zone, this is an easy choice.  I write the calls, hoping to reduce my loss.  My goal is to make money from today forward - I do not worry about realizing a loss - because the money has already been lost.

Can You Beat the Market? Part V. Collars Outperform Buy and Hold

Parts: one, two, three, four

University of Massachusetts Professor Schneeweis and doctoral student Szado conducted a study, sponsored in part by the Options Industry Council (OIC).  The results are first being announced today, 9/23/2009, in a paper entitled: "Loosening Your Collar: Alternative Implementations of QQQ Collars."

Using 10 years of data, the study compared the performance of QQQQ, the PowerShares exchange traded fund when collared and when unhedged (owning QQQQ only, with no options).  As with the CBOE S&P 500 CLL 95-100 Collar Index, this study involved the purchase of 6-month puts and the consecutive sale of one-month call options. This time both the puts and calls were 2% OTM when traded.

[NOTE:  If the same nomenclature were used for this collar as for the CBOE collar, it would be called the OIC PowerShares 100, 98-102 Collar Index].

The study included two different collars: passive (with a set of fixed rules) and active (the rules vary according to changing economic conditions).

The study shows that the collared QQQQ portfolio significantly outperformed a portfolio that simply owned QQQQ from April 1999 through May 2009.  And if that's not enough of an eye-opener, risk was reduced by 65% over the 122 month study.

These results are spectacular, especially when compared with the performance of the CLL 95-110 Collar Index.  I'll comment on that later, but for now, let's concentrate on the findings.

***

Author's Conclusions: 

The 6-month put purchase is better than buying either one- or 3-month puts.

Active collar more effective than passive.  But, this is not the place to be concerned with the active collar.  The original paper can be accessed for that information.  UPDATED:  link to that paper.

The authors state that the collar was less effective during the steady up years of 2002 to 2007.  That's as expected.

My comments:

The graph says it all.  The QQQQ got hammered during the bursting of the technology bubble, and that's understandable because QQQQ consists of the 100 largest capitalized, non-financial stocks that trade in the NASDAQ market.  That means this ETF was loaded with technology stocks.

But, something bothers me - and I'm publishing this post before discovering the answer.  Collars are slightly bullish strategies. If you recall from previous discussions, a collar is equivalent to selling a put spread.  These positions are protected against large losses, but how did the collared QQQQ increase in value as the underlying asset was plunging in 2001? 

Is it possible that the premium collected by selling the call was so much higher than the premium paid for the put that it offset losses in the decline of the ETF?  That's just doesn't sound reasonable.  When markets are falling, IV is high, but is skewed so that lower strike prices (the puts bought) is higher than that of higher strike prices (the calls sold).

The only way I can see the collars increasing in value occurs if the strategy is not a true collar but includes more than one put per 100 shares of QQQQ.  Yet, the collar in this paper is defined as one put and one call per each 100 share.  I'll go through the details when available, and report back.  But right now, I find these results very unusual.

Addendum @ 6 minutes later.  Apparently when puts were significantly ITM, there was no longer any downside risk.  Thus, the sale of 2% OTM call options resulted in a profit month after month, as the calls expired worthless in a declining market.  These feels 'wrong' to me.  It's essentially selling (almost) naked calls.  Who would do that in the real world?

***

These results are very unexpected.  The normal expectation for collars is that they will do an excellent job and protect your portfolio when the market declines.  But, to gain the benefits of that downside protection, the collar owner must accept a limit on upside profits.

And that's the problem.  During the  years of this study, the market was down.  The annualized return for QQQQ over the 122 months of this study is -3.57%, and that's a significant decline.  In other words, there was no upside to sacrifice.  But there was plenty of downside - specifically the bursting of the technology bubble in 2000 - 2001 and the 2008- early 2009 bear market.  Under these conditions, collars always perform well.

Don't misunderstand.  As someone who believes strongly that millions of individual investors should seriously consider using collars on all, or part, of their holdings, I like the results of this study.  But I have no plans to use it out of context.  I want to see how this strategy worked from 1995 through 1998 and May 2009 through the present time.  I want to see the data for this strategy at its worst, not only at its best.  Then we would all be able to see just how well collars perform when compared with buy and hold.  I know this study was performed in academia, and that the numbers can be trusted, but I wonder whether the time period chosen was cherry-picked to produce these outstanding results.  More data please.

From the performance of the CLL 95-110 Collar index (see part IV), we can see severe underperformance for the collar strategy in the most bullish years.  Yet, collars were very valuable during bear markets.  Overall, the performance of this specific collar was disappointing. 

But, in defense of collars, the CBOE produced a collar index that is not as valuable as they might have chosen.  Writing call options that are 10% OTM may be suitable to the bullish investor, but to someone who wants to use collars for both capital gains and protection, I believe the more useful Index is the 95-100 CLL Index, which includes the sale of ATM calls.  I urge the CBOE to publish the CBOE S&P 500 95-100 collar index, which would allow a direct comparison with its BXM (Buy-Write Index).  

There is a lot of data, but it's costly and time consuming to put it all together.  And there are so many possible collars that it's difficult to know which to produce.  But I would love to see the CBOE continue to produce indexes that pull all the data together.  And I'm encouraged that the OIC took part in this study, and I encourage them to support additional studies.

Bottom Line: This paper is very welcome and shows that collars are not always too expensive to pay for themselves and are capable of producing market out-performing returns.  I just wish we had more data.

458

Can You Beat the Market? Searching for Answers. Part IV Collars

Parts I, II, III

The results are in for the buy-write indexes, but they are far from definitive.   Writing covered call options on a basket of stocks that mimic broad-based indexes is a reasonable play.  But I cannot conclude that it's a strategy that always makes extra money.

What is true, is that covered call writing:

Reduces portfolio volatility (good)

Enhances profits for a portfolio of large cap stocks (good)

Provides mixed results for more volatile stocks, such as those in the NDX and RUT (not as good)

Under-performs during strong bull markets and out-performs otherwise (as expected)

***

Personal note and a chance to vent: I have a bias towards the adoption of collars by a large segment of the world's investors.  I want to see studies that demonstrate that collars are a viable investment strategy, and not too costly.

Most investors use the buy and hold strategy because they don't know any better, take the advice of professional advisors who are more concerned with their own commissions and fees than with the best interests of the client, or just follow advice they read in the newspapers or find on many financial blogs. 

I'm not saying that buy and hold is a always a poor idea.  I have no problem with it when it's the investor's own decision.  Not when it's based on listening to someone who has a vested interest (annual fees) in telling you to hold stocks forever and continue to buy more.  None of these investors is Warren Buffett and it's not a good idea to attempt to do what he does.

Proof that investors make poor investment decisions is the trillions of dollars invested in traditional mutual funds.  These are funds which cannot perform as well as the market averages, but which are not bashful about collecting management fees for that under-performance. 

Many such funds even charge a sales load (I shudder at the thought of people wasting money on extra commissions) to be allowed to buy funds that, on average, under-perform index funds.  It's a shame that so many investors never learned how to invest. 

Avoiding mutual funds should be the number one lesson.  OK, end of rant.

***

It's appropriate to look at collars in our search for methods that beat the market.  The collar is a covered call, but it also includes the purchase of a put option.  Those puts are costly, and comparing portfolio performance for a collared portfolio against the same portfolio (unhedged, or buy and hold) should give investors an idea of just how much it costs to protect a portfolio against losses.

As we have seen with covered calls, the unhedged index is going to out-perform substantially during bullish markets.  In fact, collars should do less well than covered calls because cash is spent on the puts.  But, during bear markets, those puts are extremely valuable and the results are going to depend upon how much money the puts save when they are needed compared with how much they lose when they expire worthless.

Data on collars has been scarce.  But the CBOE recently (one year ago) published the CBOE S&P 500 95-110 Collar Index.  I've described that index previously, and more details are available at the CBOE site.

As the 'name' of the collar indicates, the puts are 5% OTM (95% of the index price) and the calls are 10% OTM (110% of the index price).

As previously discussed, this collar does not scream 'use me, use me.'  It provides excellent protection when needed, but is costly most of the time.  This can be seen in the data:

The results here are spectacular.  At the market peaks in 2000 and 2007, the collar index (CLL) lagged dramatically.  It's doubtful that anyone who adopted the collar strategy would be very tolerant of his/her portfolio performance.  Yes, at the market bottoms in 2002 and 2009, the unhedged portfolios declined by enough to 'catch up to' their collared counterparts.

The single collar index for which we have data tells us that collars work extraordinarily well when needed.  But something less spectacular is probably needed to attract a large number of individual investors. 

I'm waiting and hoping the CBOE will make the data available in the form of the 95-100 CLL Index. 

[ADDENDUM: Why? It allows direct comparison with BXM, the covered call index that writes ATM calls, and not 10% OTM calls.]

***

At 11:30 today (CT), data from a new study will be available.  This data shows that a collar strategy can provide returns that make collars a viable investment alternative.  I'll publish another post with further details at 11:32.

457

Can You Beat the Market? Searching for Answers. Part III; the Graphs

Parts one and two

The data is available for download at the CBOE.  But I've saved you the trouble and show the data in graphical format.  The performance of each of the three buy-write indexes is compared with a simple buy and hold for the same index.

When you look at the graphs, it's important to know that the time periods differ widely.  BXM was constructed earlier than the others, and although it may be possible to collect and use data from earlier times, it has not be done (BXM is available back to 6/30/1986).

BXM:  The CBOE S&P 500 BuyWrite Index

These two indexes have been averaging similar results most of the time.  During the very strong, bubble-building years of the late 1990s, buy and hold, as represented by the Standard & Poors Total Return Index (SPTR) performed much better than a portfolio that held the same stocks, but against which covered calls were written.

And that makes sense.  Writing covered calls limits potential profits.  That's the price that must be paid during raging bull markets.  But such markets are not common and writing covered calls outperforms sufficiently to make up for those very bullish years - for this portfolio - an investment in the 500 largest companies listed for trading.

When the bubble-bursting market decline began, BXM, the Buy-Write Index outperformed and made up for those under-performing years.  During the recent rally (since March 2009), the unhedged portfolio has once again done better, and SPTR  has almost caught up with BXM.

The bottom line for investors is that during the 21 years of available data, those who wrote ATM covered calls fared at least as well as those who owned a diversified portfolio of large cap stocks.

Question: Is this result good enough to claim that covered call writing provides  'enhanced returns'?  Probably not in dollar terms.  But what is true is that BXM provided a less volatile, smoother ride for those who adopted this strategy.  Reduced volatility is very desirable, and although most unsophisticated investors prefer to see extra profits, the idea of owning a portfolio that provides less volatile returns ranks near the top of the list of 'good attributes' for an investment portfolio. 

Please note: It's not a good idea to replicate the BXM strategy by owning all stocks in an index and writing index calls.  It's simpler to buy ETFs that mimic the performance of the specific index that interests you, and write covered calls on that.  The proper ETF for mimicking the BXM strategy is SPY.  You can use QQQQ as a substitute for NDX and IWM to represent RUT. For large cap stocks,

BXM performs well.  How about buy-writes for other indexes?

***

BXN:  The CBOE NASDAQ-100 BuyWrite Index

This graph illustrates what can happen when the market rises so rapidly that covered call writers are left far behind.  In 1999 the performance of NDX (NASDAQ 100 Index) is so much better than that of BXN (CBOE NASDAQ 100 BuyWrite Index), that I truly find it difficult to believe.  During 1999, NDX more than doubled from 454 to 917.  During the same year, BXN was up by 43%, but that outstanding return was dwarfed by the bullish performance of NDX.  Those who rode the rally unhedged collected big time.  On this graph, that 43% return for BXN looks unimpressive. 

As we now understand, that huge rally was based on nothing more than hope, and those Internet companies were not worth the prices at which they were trading.

By year end 2002, the excessive gains of NDX were wiped out by the market decline and the two indexes were trading near the same levels (NDX was still higher).  If the bulls never exited or hedged their positions, as most didn't, the out-performance soon disappeared.  

This demonstrates that a volatile index, such as NDX can perform much better during rallies, but also much worse during declines.  In simper terms - it's a very volatile index and writing covered calls reduces that volatility, but at the expense of smaller profits.  At least that's the story over the limited lifetime of the available data. 

Bullish investors may not be well served by any strategy that limits profits.  But, not every bullish investor is aggressive, and deciding whether to hedge (reduce the risk of owning) a portfolio is one of your major decisions.

***

BXR: The CBOE Russell 2000 BuyWrite Index

Over the 9 short years for which data is available, there is little to recommend either strategy - although buy-writing has the edge.  The interesting data is missing - and that's the bubble years from 1998 through 2000.  It's very likely RUT outperformed it's buy-write index during those years.

***

I'm attempting to draw valid conclusions from the data, but we must remember that data covering 10 to 21 years is not likely to tell the whole story.  We have seen some strong markets and some weak markets, and that tends to make the data more reliable.

Your task is to gather information that allows you make a decision on how to invest/trade.  Investors want to build a portfolio that suits their needs.  Reducing risk should be (ok, that's my opinion, not a fact) near the top of those needs.

Writing covered calls is a worthwhile strategy.  It provides the comfort of a less volatile portfolio, and depending on the type of stocks owned (large cap vs smaller, highly volatile companies) can even provide better returns.  Reduced volatility with good returns is a big plus.

But, covered call writing is a bullish strategy and does not fare well in bear markets.  It's much better than buy and hold.  But what about the conservative investor who prefers much more protection against large losses?  After a short break, we'll continue with a discussion of collars.

455

Can You Beat the Market? Searching for Answers. Part II

See Part I.

I know that being able to find individual stocks that out-perform the market averages is a skill I lack.  I have not made the attempt in years.  If you have that skill, more power to you.

The question is:  can using risk-reducing option strategies enhance returns?  I'm looking for an investment strategy that increases my earnings at the same time that is reduces risk.  Isn't that what every investor wants to find?  Apparently not. 

Despite the evidence that using options gives investors (and traders) a better chance to beat the market - and with less risk - many shy away from options.  In fact, my quest (part I) to pique the interest of personal financial bloggers has not borne fruit. 

I'm not interested in only teaching investors who have an interest in options how to take advantage of this excellent risk-reducing tool, but what I'd love to accomplish is finding a way to get the average investor - who has never heard anything positive about stock options - to adopt option strategies as a method of guaranteeing that his/her retirement portfolio can survive any market crisis.  The strategy discussed today is not that effective and can offer no such guarantees.  Later in this series, such a strategy will be covered. 

The idea of buying options doesn't work for me, and I discourage that strategy whenever possible.  But for anyone who buys stock, or takes a passive investing approach and owns shares of broad-based ETFs (exchange traded funds), there is more than one option strategy that should be considered.

Covered Call Writing

Today the discussion is on covered call writing, which involves owning 100 shares of stock and selling someone else the right to buy your stock at a specified price for a limited period of time.  When you do that, you are selling (writing) a call option, for which you are paid a cash premium that is yours to keep - regardless of whether the option owner eventually buys your stock.

I consider this strategy to be one of the three basic conservative option strategies because it is among the easiest methods for an option rookie to use and understand.  

The purpose of this series is to compare the relative performance of various strategies, and data must be available.  Fortunately the Chicago Board Options Exchange (CBOE) has published indexes that measure exactly the performance of the investing methods we want to compare.  These are the Buy-Write (a term synonymous with covered call writing) Indexes. 

The first of these to be published was BXM, based on the S&P 500 Index.  Today, there is also BXN, an index based on buy-writing the NASDAQ 100 (NDX), and BXR, based on writing covered calls on the Russell 2000 (RUT) index.

The methodology for each of these indexes is the same, and can be found at the CBOE site.  The methodology involves:

Own a basket of stocks equivalent to owning the index.

On expiration Friday, approximately one hour after the market opens for trading, sell one call option that is out of the money, but as near the current index price as possible.  The call sold expires in one month and is held through expiration, when the process is repeated.  There are no adjustments.

Now that we know about these indexes, how did each of them perform, compared with their individual benchmark indexes?  This is a direct comparison between a covered call writing strategy vs. buy and hold for three different portfolios.

to be continued...

453

Can You Beat the Market? Searching for Answers. Part I

Investors want to 'beat the market,' and continue the the search for alpha (a coefficient which measures risk-adjusted performance, based on the specific security and not the entire market). 

Professional mutual fund and hedge fund managers are paid big bucks to find alpha, and deliver enhanced performance to their investors.  Most are unable to beat the market on a consistent basis, and the search for alpha remains elusive.

There are those who believe actively trading in an effort to find that alpha is misguided and it's better to invest passively (thereby saving a bunch of money in trading costs and management salaries and bonuses) by owning share of index funds or ETFs.  Those funds charge very low management fees.

It's not my purpose to continue the debate over passive vs. active money management, but along the way I will mention some studies that have been made. 

Are there other ways to enhance market performance?  Can we use option based methods to produce the equivalent of alpha? That's the basis for this series of posts.

***

In late August 2009, one blogger (potato) wrote that "MW has been popping up in the comments sections of a lot of blogs recently touting an options collar strategy."  I wouldn't mention this if I weren't that 'MW.'

It's true.  I've been entering into discussions, where I feel it's appropriate, suggesting that personal finance bloggers give more support to the idea of using collars as a conservative investment strategy.

Here's the background:  Most PF bloggers take the position that active investing is inferior to passive investing.  The data supports their stance.  In other words, most mutual funds cannot match the performance of the appropriate benchmark (S&P 500 Index is the most commonly used benchmark). 

Why can't those funds, operated and managed by professional money managers beat the market?  The bottom line is that they can, on average, match the market.  But, it's been shown that the costs associated with active trading plus the management fees are high enough to convert the average fund from a market matcher to an under-performer.

Sadly most of the investing public is unaware of such studies.  In addition, there are many salesmen (earning hefty commissions) for those actively managed mutual funds.  Thus, most individual investors have no reasonable method for learning about the benefits of buying shares of index funds instead of actively managed funds.  The information is widely available, but most people trust their brokers and advisors, ignoring that free information.

Studies have also shown that individual investors have a higher opinion of their performance than that performance deserves.  Along the same lines, those who believe they are doing well tend to trade more frequently.  Additional data shows that those who trade the most, underperformed the most.

Thus, not only is passive investing more likely to produce a better result for professionals, but the same is true for individuals.  Less frequent trading of stocks yields better results.

The bottom line is that personal finance bloggers, who tend to be conservative and frugal, favor passive investing.

With that in mind, I entered the conversation on several blogs, suggesting that owning option collars (buy stock, buy puts, sell calls) represents a conservative strategy that is guaranteed to minimize losses.  The trade-off is that profits are also limited and that's a big turn-off for investors who believe it's easy to out-perform the markets.

Thus, one of my responsibilities when promoting the use of collars is being able to demonstrate that they produce reasonable returns and are not cost prohibitive. That is now possible.

Our path will include covered call writing as a method for enhancing stock market returns.  It may not strictly count as 'alpha,' but the cash earned is just as spendable.

to be continued...

451

Q & A. Covered Calls or Collars When Already Retired

Mark,

Would you consider a Put Credit Spread to also be an approach for Retirement Investment money during actual retirement? I get that impression from "Rookie's Guide to Options". If I understand correctly from your book, a put credit spread is equivalent to a collar but wondering if it is a good place for retirement investing or are actual covered calls a better method?

Thanks
Greg

***

Hello Greg,

1) Yes, the put credit spread is equivalent to the collar when you use the same strike prices and expiration dates.

2) Yes, to me it's an appropriate strategy for any conservative investor.  The real danger from these spreads is the feeling of overconfidence that may encourage you to trade too much size.  When you own 500 shares, then obviously doing 5 collars is appropriate.  But when the put credit spread involves a small amount of cash per spread, it gets tempting to trade 10, 20, or more credit spreads.  If you have the discipline to trade only the same number of credit spreads as you would collars - then this strategy is appropriate.

Being retired, preservation of capital is important. A collar is far less bullish than owning stock outright or writing covered calls.  But, even collars can lose money during bear markets.  That's why it's important to pay attention to which put strike prices you use for the spread.

Buy the same put when using the credit spread strategy as you would have bought for the collar.

Similarly, the put sold should correspond (same strike, expiration) to the call you would have written, if you were trading a true (rather than synthetic) collar. 

Risk management is the name of the game for someone in your situation.  Of course, I believe skilled risk management is essential for every trader.

3) My usual caveat applies.  I don't believe any specific strategy is 'better' than any other.  There are always trade-offs.  What I want to do is to be certain you see the advantages and disadvantages of each.  Then you can choose which method is 'better' for you, your financial goals, and current bankroll.  For example, a very wealthy person is more concerned with preservation of capital than additional income (Income is important, but secondary). 

4) The covered call strategy allows you to earn greater profits when compared with the collar.  That's a plus for covered calls.

But the collar is a covered call with the purchase of an extra put.  That put makes a big dent in your profit potential.  But, it does guarantee the safety of your investment because losses are very limited.  And you can establish the maximum possible loss by adjusting the strike price of the put that you buy.  Is that a plus for collars?  It depends on how you value profit potential vs. insurance protection.

So, the question to ask is:  do you want that protection?  Do you need that protection?  Would you rather try to earn extra profits, knowing it comes with more risk?

I have no idea if the markets will crash, continue to rally, or do neither.  You can take a chance that all will be well and adopt more bullish strategies.  I'm more cautious and prefer to avoid large losses.

And you can compromise.  You can sell covered calls on your holdings and buy fewer puts.  You don't have to be all collars or all covered calls. 

If you do not already own the shares, then I do prefer selling a put spread to trading the collar.  But if you already own shares, you can combine strategies.  The final test for you is going to be your comfort zone.  Don't gamble.  These trading methods make money over the long-term if managed well, but a market debacle can be very costly. 

443

Option Trading: How Important is Asset Allocation? Part II

Subtitle:  How does an individual investor reduce the volatility of an investment portfolio and avoid devastating financial losses?

Part I

Tom Lauricella, writing in The Wall Street Journal, caught my attention with two recent articles.  The first discussed whether asset allocation should still play a vital role for all investors:

"Asset allocation, a bedrock of investing for decades, appeared to fail miserably in 2008. The conviction shared by most investors -- that they should spread their money across myriad asset classes to minimize losses -- was shaken as nearly all markets tumbled in unison...

"Many investors came away from the carnage believing that last year was an anomaly...But a number of influential investors and analysts... argue that asset-allocation strategies are fundamentally flawed. This wasn't a one-off failure, they say, but one that's been long in the making."

As Tom notes, not everyone agrees.  But asset allocation is a fundamental concept.  It's part of modern portfolio theory.  Diversification and asset allocation were gospel.  Now there's some doubt.

The second article was published just four days earlier. 

Trying to develop new funds for retirees, Deutsche Bank's DWS Investments executives chose an ok strategy but they ran into problems.

"The experience at Deutsche Bank's DWS Investments ... reflects the challenge facing mutual-fund companies and life insurers as they try to transform volatile stocks into stable investments that offer retiring baby boomers predictable income or protection from losses. As if that isn’t hard enough to accomplish, they are trying to do it at a low cost to investors and in a way that doesn’t lock up money for years, as has been the case with many traditional guaranteed investments such as annuities."

Let's see...

    Stable investments. 

    Protection from losses. 

    Something that's not difficult to accomplish.

    Doesn't lock up money for years.

 

If we stir the pot and put our minds to it, perhaps we can discover a way to accomplish those four goals.  I know it must be a very difficult problem because the top brains at banks, mutual funds, and financial firms everywhere cannot find an answer...

Eureka! It's not difficult at all.  Why can't these highly paid investment professionals see the attractiveness of creating a series of funds based on the conservative collar strategy?  Wow.  Can it really be as simple as that? 

Collars:

    Protect the value of an investors holdings by establishing an adjustable minimum value for a stock market portfolio.

    Cost very little (if any) cash out of pocket.

    Allow for limited growth when the markets move higher. 

Can it really be that easy?  Isn't owning insurance a far better method for protecting your assets than spending a lot of time on asset allocation and diversification? (These are not to be ignored, but they are far less important than you have been led to believe.)

Is there some obscure law that prevents the widespread use of collars?  Perhaps the problem is with me.   Perhaps I see a very simple solution to a very complex problem and there are obstacles that are beyond my understanding.  But I believe too many people have decided that options are not worth discussing and that's the 'end of story' (to quote Tony Soprano). 

To me, options are the perfect risk-reducing investment tool for solving this very important problem - how does the individual investor reduce the volatility of a portfolio and avoid those occasional financial disasters?  Not everyone is willing to place any limit of the amount they hope to earn by investing.  Such investors have to find their own solution for managing risk.  But surely investors who already have a nest egg that they cannot afford to lose will be interested.  Surely those who demand insurance against loss, but who are still accumulating the wealth would be interested. As would any conservative investor, regardless of age or net worth.

I wrote The Rookie's Guide to Options for individual investors who enjoy hands-on portfolio management.  No need to trust a broker or advisor to manage an account as a fiduciary should - with the best interests of the client being the only consideration.  Wall Street doesn't work that way - the broker comes first and the client comes next.  There's much to be said for doing it yourself.  For those who cannot manage their own finances, I'm out to get the financial planners and advisors of the world to join the 'options team.'  That will take some time.

Maybe it's the highly paid professionals who need this book the most:  The DWS team that tried to develop such a family of funds but failed to use options; financial planners who failed to protect the value of their client's assets; traditional stockbrokers who shun options.  These 'professionals' are amateurs to me.  I know that's harsh, but how can they be allowed to get away with ignoring the needs of the investing public?

Collars are not difficult to understand.  They are not difficult to employ.  They protect the value of an investment portfolio.  They allow room for profits to be earned.  Sure, they are not perfect because potential profit is limited.  But when the goal is protecting assets, especially among investors who want to keep what they already have, collars solve the problem.

With a family of funds, the investor can choose among actively managed funds and passive funds (mimic the performance of a broad based index).  There is no need to invest with 100% of your positions collared.  I recommend funds with 25%, 50%, 75%, and 100% protection.  Something for everyone.

Perhaps collars represent a solution that is just too simple.  Perhaps they are not sexy enough for mutual fund, life insurance, and bank executives.  After all, if it's as simple as I am suggesting, who would pay these people the enormous salaries and bonuses they earn?  I'd start my own managed mutual fund composed of collar strategies, but I'm a bit short on seed money.  Say a few billion dollars short.

Why are collars so effective?  As I described as a recent guest columnist for Steven Sear's column, The Striking Price, in Barron's, collars can be used by both active and passive investors.  Collars contain a built in insurance policy (buy put options) - and you choose your deductible.  Collars include an income stream (sell call options) that pays for the cost of the puts. 

The problem, or the sacrifice one makes when adopting a collar, is that profits cannot exceed a specified maximum.  That's true because you sell call options and those calls give someone else the right to take your stock by paying a previously agreed upon price (strike price).  Thus, if the underlying investment moves higher than that price, all profits above that price go to the call owner.

To me, this is an ideal situation.  You can use collars for any portion of your holdings, or for the entire portfolio.  That allows you to have as much protection as you feel you need, and enough upside potential to grow your net worth.

P.S. Collars are just to get investors started with options.  There are simpler strategies that provide exactly the same protection and returns as collars.  Options are truly flexible investment tools.

to be continued...

388

Covered Call Confusion

Money Hacks Carnival # 70 went live today and one of my posts was used.  The carnival includes articles on a wide variety of money/banking/finance issues.

***

A series of questions from a rookie options trader outlines some problems with understanding how the writing of covered calls works.

1) When I sell a covered call and, at a later date, purchase the same number of covered calls (same strike and expiration as I sold), is it the brokerage that keeps track of the fact that the stocks are no longer obligated (assuming no assignment has taken place)? 

The definition of a covered call is a call option that is written (sold) when the writer owns enough shares to make delivery (sell), if assigned an exercise notice.  Thus, by definition, you cannot 'buy covered calls.'  You can sell covered calls, and you can buy back those calls (to close), but they are not called covered calls when you buy them.

No.  It's the OCC - that's the Options Clearing Corporation - that keeps records of the options - who owns them and who is short.  The broker must keep a record of whether you are long stock when you sell calls - but only to enable them to be certain you are allowed to sell the calls and to calculate the margin requirement for the position.  Some brokers do not allow the sale of uncovered calls. The broker's computer instantly recognizes whether the stock is 'obligated.'  You can sell that stock only when a) your broker allows you to carry a naked short call position and b) when you can meet the margin requirement that selling stock will inflict upon your account.  Otherwise you must maintain ownership of those 'obligated' shares.

2) If I purchase the calls as in question 1 and my stocks, are therefore covered...

That's the wrong word.  Call options are 'covered'  when you sell that option and own enough shares to deliver - if assigned an exercise notice.  Stocks are neither covered nor uncovered.  You just own them.

One day you are short those calls and you buy them in the open market.  The next day your account shows no position in that specific option.  No position means you can no longer be assigned an exercise notice and thus, are under no further obligation.  NOTE:  If you buy the options on a given day - there is no chance you will be assigned an exercise notice that night.  In other words, those assignment notices are not delivered during the trading day.  They are delivered overnight to some - randomly selected - account that still has a short position (after the day's trading has ended) in the option that was exercised by its owner.

how long to I have to keep ownership of the calls I purchased?  It seems that I would have to hold them through expiration?

You do NOT own them.  If you buy stock and then sell it, you have no remaining position.  Options work the same way.  If you sell options and then buy them back, you have no position.  Be certain that you understand this.  It's important.  No position. 

Thus, you cannot 'keep' them.  The important thing for you to know is that by closing your short option position (that simply means buying the options you sold earlier) you are no longer under any obligation to sell your shares.  You cannot be assigned an exercise notice.  Nor can you pass 'Go' and collect $200.

These probably seem like such basic a trivial questions to an expert such as yourself.  I really appreciate your help.

The problem is that too many beginners think stuff is just too trivial, refuse to ask questions, and then get into trouble.  It's a very good idea to get your questions answered before you invest with real money.  You want to understand what you are doing when using options (or anything else).  When it comes to procedural question like yours, after you have been through the process one or two times, it's much easier to see how it works.

370

Covered Straddles

This post was included in the Economy and your Finances Carnival- June 21, 2009.

***

A recent comment prompts me to write about a very attractive-looking strategy, the covered straddle.  This method is often chosen by option rookies, believing they have discovered one of the 'best' option trading ideas.

A straddle is a position in which an investor buys or sells both a put and call on the same underlying, with the same strike price and expiration date.

Example:  APPL Straddle
 
Long straddle:  Buy 5 AAPL Jul 140P and 5 Jul 140C

Short straddle: Sell 3 AAPL Oct 135P and 3 Oct 135C

When you sell the straddle and own enough shares to cover the call options (i.e., you own enough stock to deliver, if you are assigned an exercise notice on the calls), then the position is known as a covered straddle.

Thus, an example of a covered straddle:

Buy 500 shares of IBM
Sell 5 Oct 100 calls
Sell 5 Oct 100 puts

What's the appeal of this strategy?  Is this a good strategy for you?

The Appeal

The numbers look great, especially when trading highly volatile, risky stocks.  In fact, many option newbies think of this strategy as a gift (free money).  Isn't not, but let's work through this more slowly.

As of yesterday's close, you could buy SVNT (the stock used by the commenter) at 7.07 and sell the Jun 7.50 straddle @ $3.30. 

If SVNT is above 7.50 when expiration arrives, you are assigned an exercise notice on the calls and sell stock @7.50.  Adding the $3.30 premium, gives you a net selling price of 10.80 - and a net profit of $3.73 per spread, before commissions.  The appeal of that > 50% return is so attractive that too many rookies jump right in, place the trade, and fail to recognize that news must be pending, due to the high option prices.

If the stock remains below 7.50 at expiration, then the investor is assigned an exercise notice on the puts, and buys stock at $7.50 - minus the $3.30 premium.  Net cost: $4.20.

Looks great.  The options are priced this high for a reason.  Most covered straddles do not present such attractive looking numbers.

Is this a good strategy for you?

Probably not.  Here's why: I must remind you that lessons learned earlier still hold true.  One of the important aspects of learning to trade options is understanding that some positions are equivalent to others.

When you own a covered straddle, the position can be broken down into two parts: a covered call plus a naked put.  In case you don't remember, a covered call is a naked put.  Thus, the attractive-looking covered straddle trade is equivalent to the sale of two naked put options.

I've written about naked puts previously, and my recommendation is that this strategy is appropriate for investors who want to accumulate stock positions over time - but that it's too risky for short-term traders who are looking for trading opportunities.  For those investors and traders, I recommend the less-rewarding, but far less risky sale of put spreads, rather than the sale of naked puts.

Thus, this covered straddle is the same as selling two naked puts - and that's fine, if writing naked puts suits your comfort zone and trading style.  Don't make this trade just because the naked puts are disguised as a covered straddle.

346

The Versatility of Writing Covered Calls

Covered call writing is one of the most popular option strategies used by individual investors.  It's a topic that has already been discussed on this blog.  But it's a versatile strategy and today I thought I'd share an intelligent use for covered call writing - an idea that is seldom discussed. 

Let's assume you own shares of stock and it has reached a point in time when you no longer want to own these shares, but you don't want to let them go at today's price.  You can write call options to give you a much better change to sell stock at an elevated level.

For example, assume that you bought GOOG when it dropped sharply some months ago, and today have a gain of more than 100 points.  Being a bit greedy, you decide that 440 is your target price.

Yesterday the stock closed @ 408.  You decide to sell one Sep 400 call for each 100 shares of stock and collect $40.  If the stock remains above 400 when September expiration rolls around, you will collect $400 per share, plus the $40 you receive now.  That's $440 per share.

Perhaps you don't want to hold stock for such a long period of time - especially when you don't own any puts for protection.  In that case, you could consider writing the Jun 430 call at price near $10.  The call was offered at less than $9 yesterday, so it would take a rally to collect $10. 

Note:  There is no discussion of whether you are being greedy (my vote is yes) or whether you should be satisfied with the current profit.  This is a hypothetical example illustrating how to collect an above market price for shares you want to sell.

If you truly want to hold the stock to eke out some more profits, but holding the stock feels dangerous, you can take this rally as an opportunity to buy some inexpensive insurance.  If you buy the Jun 360 or 370 put, it doesn't cost too much ($350 to $500 per put) and gives you more staying power to attempt to reach your $440 goal.

326

Dividend Risk When Trading Options

Can someone explain dividend risk please

Greg

In options terminology, 'dividend risk' refers to the chances of not collecting the dividend when you have written a covered call.

If you own stock and want to collect the dividend, and if you also want to write covered calls that are slightly in the money, then you may encounter dividend risk.

When the stock rallies before the stock goes ex-dividend, sometimes that dividend is large enough to encourage the call owner to exercise the option, one day before the stock goes ex-dividend.  When that happens, you are obligated to sell your stock and thus, fail to collect the dividend.

Not all options are exercised for the dividend.  Obviously the option must be a call and not a put, and must be in the money - or there's no chance it will be exercised (barring a very unusual mistake by the option owner).  But being ITM is not sufficient reason to exercise.  Why?

The exerciser now owns stock instead of calls.  Thus, the proud owner of the stock, and its dividend, now has downside risk,  That's  the risk of losing money if the stock declines below the strike price of the call (which no longer exists).  When that happens the exerciser loses more money (when owning stock) than he/she would have lost owning the call.  That possibility makes the decision to collect the dividend a difficult choice.

The careful call owner only exercises when two things are true:  the stock has zero time value and the delta is 100. 

For readers who are less experienced in the finer points of options, here's an easier way to understand the explanation:  The perceived risk that the stock will dip below the strike price must be low enough for the call owner to take that chance - in return for the dividend.  In practical terms, this often means the corresponding (same strike and expiration date as the call) put can be bought for less than the dividend; and b) the cost to own the stock from exercise date through expiration (interest not earned on the cash used to pay for the shares) is less than the dividend.

To clarify:  The sum of a) an b) must be less than the dividend

If you have a copy of the Rookie's Guide to Options, there's a thorough discussion on pp 92-93.

313

Trade Options: Now Is The Time

Are you an investor who has not yet learned about the risk-reducing properties of options and how adopting conservative strategies can preserve the value of your portfolio?  If not, that's a shame because if you had been using a very conservative option strategy - collars - to protect the value of your portfolio, you would have been able to escape relatively unharmed from the gut-wrenching (for most) stock market debacle of 2008.


Are you someone who believes in buy and hold investing, despite all the bad press that strategy has received?  You can write covered calls to increase your chances of earning a profit when owning stocks  - and at the same time benefit from a minor insurance policy that protects you from losing money - but only if the stock declines by a small amount.  You collect a cash premium that's your to keep when selling those calls.

This is an ideal strategy for learning how options work.

Are you an investor searching for stocks to buy at good prices?  There's an options strategy tailor made for you.  Select your stock, decide the price you want to pay, and you can sell a put option.  You collect a cash premium that's your forever.  The good news is that there are only two possibilities for this trade: You may buy your stock at your price (and you keep that cash premium), but if you don't buy the stock, you keep the cash as a consolation prize.

When you sell a put option, you give someone else the right to force you to buy 100 shares of stock at a pre-determined price.  The idea is that you will not sell the put unless that price is to your liking and you'd be willing to buy shares.

These three trading ideas are easy to learn for most investors.  If any of them sound appealing, you can learn much more about them at this blog, or by visiting the CBOE learning center, the Options Industry Council, or by ordering The Rookie's Guide to Options (e-book sampler available at no cost.)

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309

Choosing An Appropriate Strategy, Continued

An introduction to the idea of selecting an investment method when using options was recently posted, and I suggested a few of the options strategies that I trade.  The first one mentioned is covered call writing.

When you write (sell) a call option, you accept the obligation to sell 100 shares at the option's strike price.  You may never be required to sell those shares, but as long as that option is outstanding (you haven't repurchased it and it has not expired) that obligation remains intact.

When you are 'covered' it simply means that you already own the shares that you are under obligation to sell. [If you do not own the shares, your option position is 'naked' and if you must sell the shares, it would be a short sale.]

Only the option owner has the right to decide if he/she wants to exercise the option to buy your shares.  You, as the option writer, have no rights.


Warning

When investors first hear about the idea of covered calls, they are often surprised at how much 'free' money there is to be made and thus, are eager to adopt this investing method.  And the sooner the better. 

It's not that easy to make money, and it certainly is not 'free.'  But, this method can be considerably less risky than owning stock outright - as in 'buy and hold.'  There is still risk of loss when the share price declines - and profits are limited (you cannot sell stock above the strike price), and if the market surges at any time, you may be dissatisfied with the profits.


Benefits of writing covered calls

This is not the safest of option strategies available to the option trader.  But it has two very special benefits that, in my opinion, make this the ideal strategy for the rookie option trader to study.

1) It's the option strategy that's easiest to understand for the investor with experience trading stocks.  That's true because it involves the stock ownership.   You buy shares, or use stock you already own.  Then the final step is to sell a call option.  That option gives someone else the right (it's their choice, not yours) to buy your stock by paying an agreed upon price (the strike price).  You are paid cash (premium) for selling the call option, and that cash is yours to keep, no matter what else happens.  The option has a limited lifetime and expires on a known date.

That's pretty straightforward.

Of course, there's lots more to the strategy, such as deciding which stock to buy and which call to write, from among the many choices. 

As with owning stock, the primary factor that determines your long-term profitability when you adopt this strategy, is stock selection.  It's also important to understand how to manage risk when owning stock and/or covered call positions.

2)  Profits.  When using this method, you have a higher percentage of winning trades when compared with the buy and hold investor.  When you do incur a loss, that loss is smaller than that of the buy and hold investor.  Thus, you make money when the stock rises, holds steady, or even when it declines by a small amount (less than the premium you collected when selling the call).

Most authors suggest that rookies begin their trading careers by buying, rather than selling, options.  That idea 'feels' right to the rookies who are not in any position to know if the suggestion has merit.  The good news is that losses are limited to the cost of the options.  The (unmentioned) bad news is that it's very difficult to know which option to buy, when to buy it, and how much to pay.  As a result, the beginning investor often loses the maximum.  To me that's the wrong way to go. 

Why learn about a new investment tool by adopting a method that's unlikely to return a profit?  Why not modify your existing investing method (buying stocks) by reducing risk, and increasing your chances of earning a profit?  That's what covered call writing offers to the options rookie

This topic was discussed earlier.

270

Q and A. Writing Deep In The Money Covered Calls

Mark,

I just stumbled across MDWOptions.com and must compliment you for a very easy-to-read site that is both "usable" and "readable" in terms of content and style. Thanks...Your articles and comments, as with your blog, are a hidden gem in the retail investing education world, and I'm glad to have found your stuff over the weekend.

[I could not resist including the above comments; I certainly appreciate receiving them]

I've not found anyone who can give me a decent answer about DITM covered call writing.

Let's say investor X has a long-term stock position and has made some nice profits over the years by writing covered calls on it, and collecting its quarterly dividend.  However, his investment thesis has changed, and the stock is trading at $6.50, down from his initial cost basis of $9.  Looking at the call chains, the investor looks for a covered call to sell, perhaps allowing him to recover his unrealized capital loss on the position.

My belief is that history is irrelevant.  Whether the position has been a winner or a loser should have no bearing on your decision concerning what to do now.

According to his broker, a front-month very DITM call (all intrinsic value, delta = 100) would give a $4 credit and the b/e on the position of ~ $6.50.  As investor X sees it, the premium received would more than offset the unrealized capital loss on the position, and come expiration, the underlying would be called away at $6.50.  Thus, the investor has used options to "dump" his shares and recoup his paper loss. Sure, the option sold is already in the money, but the plan would be to allow the stock to be called away anyway.

Is there something I am missing from this hypothetical strategy I describe?

Rick

Yes.  The underlying would be sold at $2.50 - the strike price, not $6.50.  Your net selling price is $650 because you get $400 now and $250 when assigned an exercise notice.

When you sell a covered call (CC) the profit potential in the trade is represented by the time premium in the option.  Writing options with zero time premium is a very bad idea.  You have nothing to gain, pay commissions to the broker, and incur risk.  If your plan is to accept $6.50 for the shares, better to just sell them now, rather than wait for expiration to arrive.

If you want to try to earn some money and are willing to take the chance of holding this stock, consider writing a call with a strike of 5 - providing it has enough time premium to make it worth your while.  If this call can be sold @ $1.55, that's only $5 of time premium - before commissions - in your pocket, and is not worth your time. 

That time premium is your reward for taking the risk of holding the position through expiration.  If the stock drops below $5 per share by then, you will lose more money.  Thus, this is not a free play.  There is some risk.  That's why you must have an acceptable (to you) reward for taking that risk.

When you sell the DITM at parity (zero time premium), you gain nothing for the risk you take.

If you make the trade recommended by your broker, You would pay an extra commission (one to sell option plus one for assignment; vs one commissions to sell stock now).  Thus, holding gains nothing, incurs extra costs, and involves a minimal risk of a stock price collapse.

Here's my main comment: The broker had been no help and does not appear to understand how options work.  If he/she is paying a full service broker's high commissions, investor X deserves much better advice than this person is providing.

253

Q and A. Covered Call Writing in Today's Volatile Market

Mark,

Most of my friends who write covered calls are choosing out of the money calls so they will not have to deal with losing their underlying stock.  Maybe they all need to read your book.

Also, please comment on how you feel in general about the covered call strategy in today’s extra-volatile market.

Scott


Hi Scott,

Writing covered calls makes me uncomfortable because there is simply too much volatility - and that translates into too much downside risk.  And if I were confident enough to believe that downside risk is minimal (I'm not) and chose to adopt that strategy in today's climate, I'd never write OTM calls.  I'd want the additional downside protection that comes from writing calls that have more premium - and that means calls that are at-the-money, or slightly in-the-money. 

I don't believe it's sound to base investment decisions on the possibility of a tax problem.  If an investor does not want to sell shares, then writing covered calls is the wrong strategy.

I understand the desire to write OTM calls.  It's the path taken by most investors because it allows for much larger potential profits - in case the stock rises significantly.  Seeking the maximum profit while ignoring potential losses totally ignores risk management.

As an aside, the writing of cash-secured naked puts is a strategy equivalent to writing covered calls.  My idea of selling ITM calls is equivalent to writing OTM puts.  Your friends are choosing to write naked ITM puts.  That's very aggressive and very bullish.  Nothing wrong with that, but I must remind you that risk and reward profiles differ for each trader, and my personal comfort zone (and yours) does not have to match that of your friends.

In today's volatile world, if I were bullish, I'd adopt a strategy with limited losses - and that's the purchase of call spreads or it's equivalent, the sale of put spreads.  Managing risk is the key to success when trading options.

221

Trying To Sell a House? Write a Covered Call Option

I've tried to get the mainstream media interested in writing about options and how individual investors can benefit by using them to hedge (reduce the risk of owning) a stock market portfolio. 

No deal.  The usual, and reasonable, response is that options are too difficult to understand and that their readers may get the wrong impression about options, and use them as gambling tools. 

But perhaps the tide is turning.  Harriet Johnson Brackey is the personal finance writer for the South Florida Sun-Sentinel, and in a recent blog passed on the recommendation of a real estate broker who proposed that homeowners increase they chances of making a sale during these difficult times.  The idea is to sell a covered call option on a house.

Here's the blog post in full (underlining is mine):

I just got a job in another city. I need to sell my house — quickly. What can I do?

In this depressed housing market, with so many homes for sale, you have to be creative. Real estate agent David Dweck with Re/Max Professionals in Coconut Creek [FL] suggests listing it rent-to-own.

The concept is an old one, in which buyers work their way into home ownership. The way he structures the deal: You set a price to sell your house at some point in the future. The renter pays you a non-refundable, upfront sum for the right to buy it at that price.

The renter moves in, and handles all the maintenance of the home just like an owner would. At the end of the contract, the renter either goes through with the purchase or walks away.

"People who rent-to-own maybe had a foreclosure, and they're rebuilding their credit," he said. "They can kick the tires before they buy it."

***

There it is.  The renter buys a call option.  The cost (option premium) and strike price (the set purchase price) are established upfront.  At the end of the trial period, the renter must exercise the option (buy the house) or walk away (allow it to expire worthless). 

The real estate agent understands the benefits of writing covered calls, and a well-respected financial journalist encourages the idea. 

The covered call provides a cash premium to the owner, as a partial hedge in case the price of his home declines.  The potential buyer gains time to make a final decision - one that is going to be based on whether real estate prices move higher or lower.  If the current trend continues, there's little chance the renter will exercise the option, but if home prices bottom out and move higher, the renter will have a bargain.

That bring up the following question from my perspective:  How can I encourage other financial journalists to write about using covered call writing on an individual stock, and not only on a house? 

It's not that covered call writing is the ideal strategy.  It isn't.  But, it's a great entry point for investors who want to gain the benefits of learning to use options as a tool for reducing stock market risk.  The markets have been volatile and one way to reduce exposure to that volatility is to use options as a hedge.

215

Option Strategies For the Small Investor

During the market decline of 2008, I blogged about why the average individual investor should learn to use options to protect the value of his/her stock market portfolio.

However, options are contracts that cover 100 shares per contract, and many investors own less that than minimum.  The question is, can those investors also benefit from using the versatile investment tool - options.

The answer is yes.

When you own 100 shares of a specific stock or ETF, you can buy or calls or puts.  If you trade one-lots (a single call, put, or combination), then you can adopt a specific strategy that offers partial, or complete insurance against losing a large chunk of your investment in that stock. 

For example, you can write one call option and adopt the covered call strategy.

Or you can write one call and buy one put to establish a collar.

But, there's no specific strategy geared to investors who own odd lots (less than 100 shares) of various stocks.  Sometimes you can get around that limitation, depending of the nature of your portfolio.

Suppose you are an investor in tech stocks.  If you own a few shares of GOOG and perhaps 10 shares of AAPL and 20 shares of RIMM, then you have a portfolio worth about $3,000 devoted to tech stocks that have significant representation in the NASDAQ 100 index - the underlying asset for QQQQ.

Thus, if you sell one Jan 30 (or any other) call, you would have a position that approximates a covered call.  It's not exactly a covered call, but if you want a small amount of downside protection and are willing to sacrifice a large upside profit in return, this trade provides something similar to a covered call.  NOTE:  Your broker will consider this to be a naked call option, and may not allow the trade.

Important NOTE:  I chose the call with the 30 strike price for a reason - and it's not because it is the call option that's at the money.  Your portfolio is worth about $3,000 and the Jan 30 call covers $3,000 worth of QQQQ.  If your portfolio is worth $6,000, you can write two of those calls.

Similarly, you could write one Jan call (perhaps the 31) and buy one January put (the 28??).  That would give you a position that is approximately a collar.  Choose strike prices that suit you and your comfort zone.

If you own a more diversified portfolio of large capitalization stocks, you can trade options on SPY in a similar manner.  The underlying asset for SPY options is the S&P 500 index.  Keep in mind that it takes a portfolio that's worth about $9,000 before you should consider writing one call.  SPY is currently 88 and one call option represents roughly $8800 worth of stock.

Warning

The correlation is not 100%, and these trades can easily result in losses (or gains) that are a bit higher than anticipated. But you would gain some of the benefits of the option strategy.

This point is vital:  You cannot just do this with any stock portfolio.  There must be some expectation of a high correlation with the performance of your specific portfolio and the index whose options you trade.  Don't fall into the trap of believing that any old index will do.  And please be certain you understand the specific strategy - before making trades with real money.

188

The Covered Call Returns. Is It Possible?

Here's a 1949 quotation from the popular early television series, 'The Lone Ranger': "With his faithful Indian companion, Tonto, the daring and resourceful masked rider of the plains led the fight for law and order in the early West. Return with us now to those thrilling days of yesteryear. The Lone Ranger rides again!"

Is it possible for a popular, bullish strategy to be gaining in popularity during a bear market?  Can the covered call strategy return to yesteryear's glory?

Abnormal Returns provides links to good stuff in the financial blogosphere - articles you may otherwise miss.  They recently pointed Adam and his Daily Options Report to the Wall Street Journal.  Adam commented: "Seeing lots of pro-buy-write articles lately. Such as this one in the Journal." Then the idea of writing covered calls on RIMM was discussed.

Adam is not a big fan of writing covered calls and feels that:

"you don't necessarily get compensated enough for the volatility of the stocks themselves." 

"You have to always compare a buy write to how you would do just simply owning the stock."

These comments express the opinion: when option premium is high, it's still not high enough to give up the large potential upside move for the limited downside protection.  If the markets makes a big move - and that's more likely now than ever before - then it may be better to buy the stock, if bullish.

I see things differently.  When I am willing to write covered calls (and I prefer less risky strategies (credit spread, iron condor) right now, I'd rather collect a fat option premium in a stock I want to own, even though that limits my potential gains.  If the stock rallies and I am assigned an exercise notice, that's good enough for me.  If the stock doesn't rally, I would accept the limited protection of that option premium.  Deciding if the premium is 'fat' enough is the difficult decision.

This is what makes options such versatile investment tools.  They allow users to adopt different methods, and when considering a specific strategy, there are different points of view - allowing you to find options strategies that allow you to remain within your comfort zone.

Buy-writing (the simultaneous purchase of 100 shares of stock and the sale of one call option) is the same strategy as covered call writing.  Although this is my recommended strategy when it comes to teaching option rookies how to successfully learn to trade options, it's too risky for today's very volatile markets.  It's important to understand how this strategy works because it provides an opportunity to understand how to reduce losses in a down market, while providing excellent income possibilities in neutral or rising markets.  It also has a good chance to provide (unfortunately) ample opportunity to test your risk management skills.  Thus, I do not recommend this strategy for trading - but it's still a good idea to understand how it works.

Today, I recommend option strategies that are similar to writing covered calls, but which provide much more protection against loss in a bear market.  Those include: collars, credit spreads, iron condors, and double diagonals.

180

Q & A. Stretched Collar (LEAPS Puts and Short-Term Calls)

Mark,
I'm buying your book based on that excellent answer! [For readers who want to know which answer, it's this post.] While I wait (impatiently) for it to arrive may I ask; if selling OTM covered calls and collecting dividends is my (income) strategy then would I be wise (after IV calms down a bit) to buy insurance puts w-a-y out, say a year or so? They seem relatively inexpensive and the (then fixed) cost could "amortized" over the next 12 months as I roll through various call contracts... (Commissions would be less too). Yes, I wish I'd done just that a year ago, but is this a strategy to consider going forward?

Thanks, Dave

Dave, Thank you.

For readers who want know to which answer Dave is referring, it's the first comment to this post.

Yes, it's a strategy to consider.  But it's not quite as advantageous as it appears to be.  You will have to play with the numbers, using an option calculator, and decide if it works for the specific stocks you own.

I know some of the statements below are obvious to you,  but am including these details for the benefit of other readers.

In today's low-commission world, commissions should not be a factor in your trading decisions.  If it is, you may be using the wrong broker for your trading style.

1) You obviously prefer to take a bullish stance on the market, and want to make good profits on a substantial rally. At the same time you are looking for a reasonably priced insurance policy.

2) By waiting until things 'calm down' you are taking the chance that there will not be another substantial meltdown before you buy those puts, but in return, you avoid paying today's high option prices.

3) Yes, long-term puts (LEAPS) are 'cheaper' when you look at the time decay per day.  But,these are vega rich options - meaning that if IV drops, the price of these puts will decrease dramatically.  If you buy these puts - just for the insurance aspect - then you should not care if the price declines, because they still afford the same protection.  But...

4)There is one serious problem that investors forget to consider when buying longer-term options for protection.  And that's price of the underlying. If your stock is in the $50 to $60 range and you decide to buy a LEAPS put with a strike of 45 or 50 - you get good protection, even though the put is costly.  But what happens when the stock rallies?  If it moves to 70, then you have little protection.  And besides that, you may be forced to buy back your call at a loss (or lose the stock via assignment).  If you no longer own the stock, you will have a nice profit on the covered call part of the position, but there's going to be a substantial loss when selling the put.  You don't want to adopt this method unless there's a decent profit on the overall position.

If you don't lose the stock, you can buy a new put with a more appropriate strike price and sell the put you own.  That allows you to maintain sufficient protection.  But, it costs additional premium.  The difficult part is trying to decide just how much you can afford to pay for insurance - especially when profits are limited by your sale of call options.  And you must sell calls, because that's a vital part of your strategy.

There's no free lunch here.  You must give up something to gain something.

I'm NOT saying this is a bad idea.  But I am warning you that you may spend so much on insurance that you cannot earn a profit.  If you are dealing with a dividend paying stock, then the OTM calls you write will probably provide minimal income, so consider the cost of doing business this way.  The long-term puts may be inexpensive enough to make this viable.  Just check the numbers carefully before deciding.   You probably don't want pay $6 for puts and sell front-month calls for $0.40.

Sometimes it's better to own puts with shorter lifetimes, even though the daily time decay is greater.

Mark

159

Q&A Writing Covered Calls During 2008 October Massacre

Greetings Adam and Mark:

Thanks you both very much for your excellent blogs. [NOTE: Adam writes The Daily Options Report]  I try to read every entry and have learned a great deal from both of them, as well as having many a good laugh.

Thanks.

I have got a question, or maybe a series of questions, that have come up from reading a several posts and the comments that have appeared on both of your blogs and on that of Don Fishback [NOTE: Don Fishback's Market Update].

My basic question is what sort of options strategies are suited to this environment. 

NO NAKED SHORTS.  I haven't sold naked shorts for several years, because I prefer less risky spreads.  Why? Because that suits MY comfort zone.  I'm NOT telling you what should fit yours. 

Look for spreads that provide a good profit potential, but which allow you to sleep at night because of limited risk.  For this environment, I recommend selling call or put spreads.  Or both (buying iron condors).  But, unless you trade very few spreads, it's a good idea to own extra protection.  In this environment that protection is costly.  But, if you understand how to gain that protection (download free eBook, Ch 20), you will be ready if and when you decide to use the methodology.

Don's blog advocated covered call writing or its synthetic equivalent, put selling.  In the comments section of a post Adam argues that the covered write/put sale strategy is best used, counter-intuitively, in a up market.  (Adam's blog suggests not to do covered write but ratio spread - in comments section.)

I disagree with your premise that CCW (covered call writing) is counter-intuitive in a bull market.  I agree with Adam: CCW and naked put selling are BULLISH strategies.  Sure profits are limited, CCW provides excellent returns when the markets rise, and unless it's a raging bull (think 1990s bubble), often does as well as simply owning stock.   And you should not (IMHO) be seeking the maximum possible profit on every trade.  You want lots of winners, and CCW provides a series of winning trades, especially when markets rise.  I know most investors hate to be assigned an exercise notice, but to me - that assignment means I won the bet and made my profit.

Ratio spreads (CCW where you sell extra calls) is fine if you are willing to sell naked call options.  I am not, and many brokers do not allow any customer to sell naked call options.  Besides my comfort zone, there's likely to be a big rally some day - either a dead cat bounce, or the end of the bear.  Buy, why be exposed to that possibility by selling naked calls?

For awhile, in this volatility spike and much earlier, Adam has been advocating buying elevated volatility.  So far this has been right.  Then in a recent post Adam discussed how near term put sales in this environment were more a gamble on stock price (volatility) whereas longer term put sales (3-6 months) were more of a gamble on actual IV.

Near-term options have more negative gamma, so you have more risk if there's a sharp decline.  Thus, it's a gamble on stock price.

You also lose when owning a longer term option, but gamma is less and the time premium gives you a bit of added downside protection.  When you sell the longer-term option (yes, even at a lower IV than the near-term), that option has more vega.  Thus, if IV drops, it makes more money - that's dollars per option, not IV units per option.

So what I don't quite get here is why is this environment not a good one for put sales?  Don Fishback is not the only person I have heard advocating put sales or covered writes here.  There was also some discussion of it in a recent Think or Swim chat.  But there is no arguing with right - and Adam has been right that buying premium would have worked a lot better over the last few weeks. 

I gather from reading his site that that has something to do with the inversion of the normal relationship between HV and IV, but I am a little unclear on what this point means for IV going forward.  If either or both of you could address that question maybe it would also clear up why covered writes/put sales are not ideal in this environment.

I'll let Adam reply to the first part. 
Not ideal? That's because there is high risk.  That's all.  Such high potential rewards cannot be expected without the significant possibility that this bear is far from finished. 

One way to control risk is to control size.  Perhaps you can open a position at less than your normal size.  That's a reasonable compromise.  That way you do some of the strategy that appeals to you with reduced risk.

Mark

130

Option Selling Gains attention

In the past couple of days, this violent, volatile market has gained some adherents to the idea of selling options as a profitable investment idea.

 

Although I am in agreement, I want to be certain that readers of this blog who enter the action do not sell NAKED options.  I strongly recommend owning protecting by selling options spreads - if you decide to play.

NOTE:  If you play.  I am not suggesting this as a great idea if you are an options rookie.  At these times, the rookie can get his/her feet wet with a paper trading account.  But if you do decide option premium is so high that you want to sell some - please be aware of how much you can lose and do not get greedy.

Here are some relevant comments on the idea of selling options:

Adam, at Daily Options Report, mentions the idea of selling puts, or perhaps puts and calls.

Don, at Don Fishback's Market Update,refers to a Bloomberg.com article and goes on to say that he believes this is an excellent time to write deep in the money covered calls.  As readers of this blog may recall, that's equivalent to writing deep out of the money puts.

That Bloomberg article by Kearns and Gore talk about this being the best year ever for option traders.  But beware, those quoted may not be telling the whole story.

Options volume is soaring once again and last year's record volume will be left far behind.  As Jimmy Durante used to say "Everybody want's to get inta da act."

As I write this, SPX just dipped below 1000.  It's a dangerous world.  Be careful our there.

126

Don't Ignore Risk in a Volatile Environment

As a trader who adopts strategies with negative gamma*, this should be a very difficult period for me.  But, I've been fortunate.  My iron condor portfolio has a few extra long puts and calls, and those extras have served their purpose.

*Negative gamma positions tend to lose money when the market makes a big move in either direction

I don't claim to have taken no losses, but my complex portfolio (20+ iron condors) has performed well.

The point I want to make is that not everyone who buys iron condors is going to be as fortunate.  If you've been having a difficult time because the market swings are too wild and your positions have been threatened with relatively large losses, I want to offer words of encouragement.  Assuming you don't decide to get out of the market completely, there are steps you can take to achieve good results.  No one knows when this volatility will end, but it will end.  For now, it pays to be more conservative.

1)  Reduce size.  That means placing less money at risk, and accepting reduced rewards, during periods of such uncertainty.

2) If you buy iron condors (or sell credit spreads), consider spreads that have strike prices more distant from (corrected) each other.  Again, this reduces potential reward, but cuts risk.  Right now, reduced risk of losing is a very desirable investment objective.

3) It's important to manage your positions with an eye on overall risk.  If you adopt one of the suggestions above, don't feel that you no longer have to bother managing your positions just because the total dollars at risk have been reduced.

4) If you use a strategy (covered call writing or the sale of naked puts) because of your desire to own and/or add stocks to your investment portfolio, give yourself a bit more protection.  Implied volatility is relatively high these days, so you can afford to write options with a lower strike price.  This does reduce potential profits, but it increases the probability of owning a profitable position.

Better yet, you can make covered call or naked put positions much safer by buying OTM puts to convert that covered call into a collar or the naked put into a put credit spread.

5) If you have had poor results and are looking to make a change, keep your wits about you.  If you decide to try a different strategy, please start slowly.  Remember you will be  learning how to use a new strategy, so please reduce the size of your trades until you are satisfied that you understand the new strategy well.

6) If you have been taking losses, please don't take desperate action in an attempt to get even.

Risk management is more important than strategy selection, so keep your risk under control and find a strategy that allows you to remain within your comfort zone when you initiate and hold your option positions.

One final point:  Don't ignore risk management in any environment, but this is no time to get careless.

105

Options from a Different Perspective

Today’s blog is intended for visitors who know nothing about options – and especially for people who believe that options are only used by speculators.

 

Every year you pay a premium to renew your insurance policies.  Do you know the probability of losing your home to a fire or other disaster?  Does it really matter?  You buy insurance for the peace of mind it provides because the thought of losing your home is so emotionally devastating that you cannot also afford the financial loss.

When you buy insurance, you are making a bet with an insurance company.  The company bets you are going to live (life insurance) or your car is going to avoid accidents, and you take the other side of the wager.  You don’t want to win these bets and you hope to lose money on the premiums you pay.  But you pay good money for those policies to gain the protection they provide.

All financial advisors agree that owning insurance is necessary.  The cost of that insurance is seldom discussed.  How would you like to insure your valuables and get paid to do so?

Did you know you can insure your IRA or other investments?  It’s readily available and depending on the size of the deductible, it can cost much less than traditional insurance.  In fact, you can obtain this insurance at no cost.  Why haven’t you heard about this type of insurance before?  Is it a secret?  I believe it’s because there are no high-commission salespeople pushing it. 

Your stockbroker, or financial advisor should be able to tell you all about portfolio insurance, but many lack the knowledge.  Many investing professionals don’t understand how the versatile investment tool, the stock option, can be used to insure the value of your portfolio.  That’s a shame because too many investors get hurt for no reason when the stock market tumbles – as it periodically does.

Let’s assume you are a conservative investor who owns a diversified stock portfolio.  There’s more than one strategy you can adopt to provide that insurance protection you deserve.

 

METHOD ONE: Pay a premium to buy put options

If your insured car is destroyed in an accident, you can sell that car to the insurance company for its replacement cost.  When you buy a put option, you can do the same – i.e., if your investment becomes damaged (if its value drops below a predetermined level) you have the right to sell that investment at its insured value.

• You own 100 shares of YZY, currently priced @ $115 per share.

• Buy one YZY put option with a strike price of 115.  Puts trade on an exchange, just like stock.

The put gives you the right (for a limited time) to sell 100 shares of YZY @ $115 per share.  (You may choose different deductibles and time frames.)

You are not obligated to sell your shares at that price, but you have the right to do so.  Thus, during the lifetime of the put option, you may always collect $115 per share, no matter how low the price drops.

The good news.  When you own this insurance you have complete protection – i.e., you can always sell your shares at $115.

The not-so-good news.  This insurance is not cheap, and the price of the put option depends on several factors.  In the example, you may have to pay $150 for a 6-month policy.  If you buy this protection again and again as the years pass, the costs become overwhelming.  But, that’s true of any insurance policy.

Is it worth the peace of mind?  For some investors, the cost is reasonable.  For others, it’s far too costly.  But, there are alternatives.  One such alternative involves a different strategy.  Instead of paying a premium to gain complete protection, you can receive cash and gain limited protection.

METHOD TWO:  Receive cash and gain limited protection.  Sell a Call Option. 

If you don’t like the idea of paying for insurance, you can be paid for accepting less insurance.  When you sell a call option, you receive a cash payment, and that cash is yours to keep.  In return for the cash, you grant the call buyer the right to decide if and when he/she buys your shares at the call strike price.  You have no say in that decision.

This agreement has two possible outcomes:

• If the call owner chooses to buy, you must sell. 

• If the call owner decides not to buy, the option expires and you keep your shares and the cash.

Example

• You own 100 shares of YZY, currently $115 per share.  Sell one call option with a strike price of $115.

  That call grants the buyer the right to buy your shares @ $115 for a limited time. (You may choose different sale prices and time frames.)

  You collect a $200 cash premium of ($2.00 per share). 

  The cash ($200) represents your limited insurance against loss. 

  If YZY rises, or declines by less $2 per share, you earn a profit

  If YZY declines by more than $2 per share, you lose money.  Thus, protection is limited.When option expiration day arrives, there are two possible outcomes:

Scenario 1. Your YZY shares increases in value and are above $115 per share.

The call owner buys your 100 shares and you receive $11,500.

You also keep the $200 cash premium.  Net to you: $11,700.

Scenario 2. SPY is below $115

The call owner refuses to buy your shares and the option expires.

You keep the cash premium.

Both results are good. In the first scenario, you sell YZY and keep the cash you received for selling the call, raising your sale price (to $117 in this example).  When you entered into this arrangement by selling the call option, you were willing to sell at this price, so you should be satisfied.In the second scenario, you continue to own your YZY shares.  By selling the call option, you are better off by the $2 per share cash.  If you apply that cash towards your original purchase price, your shares now cost $2 less. You don’t have as much protection when selling the call option.  Thus, if YZY had dipped to $110, you incur a loss, but that loss is reduced by the premium collected

• You can insure your stock market portfolio.  You may elect to pay cash and buy complete protection.  Or, you may collect cash to gain partial protection.

  There is much more to learn about options and how they can be used conservatively to protect your family’s financial assets.  For example, you may decide to both buy the put and sell the call.  That’s known as the collar strategy and a more detailed discussion can be found here.  
  

76

Q & A. Rolling a Covered Call

I received this Comment:

Scottrade will not allow selling puts so I did a covered call on FSYS back about a month ago with an Oct expiration on the 50 strike which is now well over the $5.70 I received...about 11.20 bid 11.90 ask.

 My calculations are that if FSYS is above the 50 at expiration I will get 1739 for the shares and 570 for the premium. If I buy back the calls and sell now, the profit is 1300 per 100 shares. Or should I buy back the calls and roll to the 70 strike with a current premium of about $370...what is your opinion Thanks, I read the book

 Dave

 ***

 Hello Dave,

 

1)    Scottrade doesn’t seem to understand that writing a covered call entails the same risk as writing a cash-secured naked put.  They are not alone and short of changing brokers, there’s not much you can do about that.

 

2)    If the stock is above the strike at expiration, you receive $5,000 for each 100 shares.  You also keep the premium.  That makes your sale price $55.70 per share (and that’s the price to report to the IRS).  I don’t understand where your ‘1739’ comes from.

 

3)    It’s often a good idea to buy back the calls early and to sell the stock (I do NOT mean simply buy back the calls and hold the stock) before expiration.  You sacrifice a small amount of potential profit, but your money is free for reinvesting and all risk is eliminated.  The question is:  just how much potential profit are you willing to sacrifice?  That’s up to you.  I note that there is still a considerable amount of time premium remaining in the calls ($4) and that buying back now would sacrifice a substantial portion of your maximum profit on this position.  This is obviously a volatile stock with high option premium, and that always increases risk.  But because you are considering rolling to the 70 strike, you are obviously not too concerned with the possibility that the stock will drop below 50 anytime soon.  I don’t know why you chose this specific covered call, but if it was to generate a small profit, you have already earned that profit.  If it was to collect all, or nearly all, of the time premium in the call option, you are far from meeting that goal.  That’s why I cannot offer advice on whether you should close the position now.  That has to be your decision based on your profit objectives and tolerance for risk.

 

4)    As far as rolling to the Oct 70 calls, that requires the investment of a substantial chunk of cash (to buy the Oct 50s and sell the Oct 70s).  Are you that bullish on the stock? Do you want to move from a reasonably conservative play of owning a position that is equivalent to being short a put that is 9 points out of the money to being short a put that is 11 points in the money?  I cannot decide that for you, but sellers of naked puts traditionally sell options that are out of the money. 

 

5)    I want to take this opportunity to point out something that’s easy to miss.  Your initial idea was to sell the Oct 50 put.  At some point your plan was to buy back that put, earning a profit.  Did something change?  If you had sold that put, would you be thinking of rolling it to the Oct 70 put instead?  I seriously doubt that you would.  My point is:  If you wanted to write the naked put, then stay with that plan.  The fact that your broker forced you to adopt a position (covered call) that is equivalent to the position you wanted (naked put) does NOT mean you should revamp your methodology to accommodate your broker.  I believe you are considering this roll - not because you like that new position better - but because you own stock and want to sell out of the money call options.  I suggest you think of your position as being short the naked put and trade the position as if you were short that naked put.  If you would buy back that Oct 50 put and roll to the Oct 70 put – a very bullish trade, then it may be okay (but risky) to roll to the Oct 70 put.  Instead, if you would be happy to see the stock rally and the value of your naked ‘put’ decline, then do nothing and your only decision is when (if ever) to repurchase that put.  I’d hate to see you change strategies because your broker does not allow you to own the exact position you want to own.  The two positions are equivalent and you should think of them that way.  Let me know if that makes sense to you.

 

Mark

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Q & A. Expiring Worthless

Mark,

I have written a covered call. At this point it is in the money. When the expiration date arrives if the stock has not been called away is there anything I need to do to close the position? Or will it expires worthless if it is not exercised?

Thanks

John

 

Hi John,

Good question.

If it’s not exercised, it expires worthless. There is nothing more for you to do.

If you have access to your brokerage account over expiration weekend, you will notice that the option is still in your account on Saturday. DO NOT assume that it has not been exercised.

It will not officially disappear from your account before Sunday, or sometimes Monday morning. The reason is because Saturday is the true expiration date and expiring positions are not removed from your account until after Saturday.

If it is exercised, then both your stock position and the option will disappear from your account on Sunday or Monday.  In it's place will be the cash you receive for selling your shares at the strike price.

Mark

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Recommended Option Strategies: Advice for Covered Call Writers

I encourage option rookies to begin their option-trading careers by writing covered calls. To me, this is the simplest strategy to understand when you have never previously used options.

The first drawback to this strategy is that it’s bullish. There’s nothing wrong with being bullish, but not everyone wants to own bullish positions all the time.

The second problem with covered call writing (CCW) is that you can lose a substantial sum if unexpected news causes the stock price to plummet. It’s true that the call option you wrote reduces your loss, but it still may be an unhappy experience.

Are there alternatives?

You can adopt a strategy that is much safer than CCW. In return for that safety, you must sacrifice a portion of your potential profits. It’s the same as buying insurance. Most of the time that protection doesn’t save you any money, but it does allow you to feel more comfortable with your position, and that has to be worth something!  If that insurance turns out to be necessary, you are going to be very pleased that you had the foresight to buy it.

If you read the recent post about equivalent positions, then you know that writing a covered call is equivalent to (same risk and reward profile) selling a naked (uncovered) put option when the strike price and expiration date are the same for the put and call options. In other words, these two positions are equivalent:

Position One:                       Position Two:

Buy 100 shares of XXZ           Sell 1 XXZ Nov 35 put

Sell 1 XXZ Nov 35 call

If this is news to you, take a few minutes to read the post on equivalent positions.

How does knowing that these are equivalent help?

Because these are equivalent positions, if you want to buy 300 shares of XXZ and write three Nov 35 calls, you you can simplify the process (only one commission to pay your broker, instead of two) by selling three Nov 35 puts. Most brokers require that you maintain enough cash in your account to buy 300 shares of XXZ -- just in case you are assigned an exercise notice.

Now you are short three puts. What next? Next you buy put options – specifically a put that is further out of the money than the put you already sold and which expires on the same day. Example, buy three XXZ Nov 30 puts. You may buy a put with an even lower strike price, but that provides less insurance.

What’s the bottom line? By selling puts instead of writing covered calls, and by buying a put for protection, your position is now a bullish put credit spread. But it’s not quite as bullish as selling the put naked or writing the covered call. Your hope is to see the both options expire worthless. That provides the maximum possible profit for the position.

See the previous post for a discussion of credit spreads.

 

If you have any questions regarding this (or any) post, please feel free to ask that question by clicking the ‘comments’ link below.

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Recommended Option Strategies #1: Covered Call Writing. Part II

Choosing which option to write

Reminder: When writing covered calls, you own 100 shares of stock and sell one call option.

Important: There is never a ‘best’ option to sell. Different investors, each with his or her investment objective, risk tolerance, and minimum profit objective can choose a different option that is entirely appropriate for them – but which is inappropriate for you.

 

Month: You will have at least four different months from which to choose

· Options which expire first (the ‘front’ month’) have the most rapid time decay. Time decay is good for option sellers.

· Options which expire in the latest month are the most costly and thus, by selling them, you collect the most cash (now) and have greater protection against a market decline.

· As you gain experience, you will learn whether front month, 2^nd month or other is more appropriate for you.

 

Strike Price: You have at least three choices. Volatile stocks have many strike prices

· In the money options: The stock price is higher than the strike price

o The lower the strike price, the higher the option premium, but there's less profit potential

o The higher the strike price (remember we are talking about in the money options) the greater the time premium

o Your maximum profit potential is the dollar amount of the time premium in the option

 

· At the money options: The strike price is equal to (or very near) the stock price

o These options have more time premium than any of the other options and thus, are attractive to sell

· Out of the money options: Strike price is higher than stock price

o If the strike price is too high (compared with the stock price) the premium is very small. Don’t sell these options

o OTM options can be sold by very bullish investors who want the chance to earn large profits.  But remember that profit only arrives when the stock rallies.  If the stock holds steady or declines, you may discover that cash premium you collected was too small to make the process worthwhile.

The space here is too short for a more detailed discussion of how to choose a strike price that affords a good combination of protection (if stock declines) and time premium. That information is available elsewhere. But paper trading for a few months can give you a great deal of insight.

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Recommended Option Strategies #1: Covered Call Writing

There are six strategies I recommend for option traders. There are other good strategies available, but these are the ones I use for my own trading and each is easy to understand. At the top of the list is covered call writing.

This is a wonderful way for rookies to learn all about options and gain experience buying and selling call options.

Most option rookies already understand the stock market and have investing experience. Thus, beginning with an options strategy that includes stock ownership is a logical way to introduce investors to the world of stock options.

Definition: Covered call writing – The sale of a call option that is backed (covered) by 100 shares of stock for each option.

To implement this strategy, buy 100 shares (or more, in multiples of 100), or use shares you already own, and sell one call option for each 100 shares.

When you sell a call option, you collect a cash premium that is yours to keep, no matter what happens in the future.

When you sell a call option

• You become obligated to sell 100 shares of stock at a specific price, known as the strike price - but only when the option owner elects to 'exercise' the option.  You, as the option seller, have nothing to say about that decision.

• Both you and the call buyer agreed upon the strike price when you sold the call option.

• The obligation to sell your shares lasts for a limited time - until the expiration date. If the option owner fails to exercise when that date arrives, your obligation ends and the call option expires worthless.

 

When you are assigned an exercise notice, it’s nothing to alarm you. It’s simply a report from your broker stating that the option has been exercised and that you must sell your shares at the strike price.

 

There is much more to this strategy. You must choose an appropriate stock to own.  When selling an option, you must choose a strike price and expiration month. There are always at least three strike prices and four expiration months from which to choose. It may seem complicated at first, but if you practice in a paper trading account, you’ll learn how to select appropriate options to sell.

Part II.

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