Options for Rookies

Covered Straddles

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

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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.

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 hypothitcal 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.

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.

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

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 that stock - 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, theOptions Industry Council, or by ordering The Rookie's Guide to Options (e-book sampler available for free.)

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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 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 he 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.

Choosing An Appropriate Strategy

Introduction to option trading

Your goal is to make money when using options and to do that, you must make some trades.  The trades cannot be made randomly, and obviously, some thought must be given to which specific options to buy and/or sell.

That's where choosing a specific option strategy comes into play.  It's important to choose one or two option strategies that suit your style.  Some traders are aggressive and want to make a pile of money in a hurry. The only way to accomplish that goal is to take lots of risk.  I strongly discourage that approach, but if you insist, then risk will be your constant companion.

I prefer to adopt methods that have a higher probability of success and which entail much less risk.  When you adopt a strategy with those attributes, then potential profits are limited.  Less risk and less reward go together like:

As mentioned, you want to learn various strategies so you can find some that you not only understand, but which you can adopt and remain within your personal comfort zone.  There is nothing to be gained by trading strategies that make you too afraid of taking a loss.

When you adopt a strategy and make some trades, then you have an investment portfolio and are playing the game.  Note:  the purpose of the strategy is to allow you to play.  It's your point of entry.  And strategy selection is important.  But too many traders and investors never grasp this fact: the most important factor that will ultimately determine your success as a trader is your ability to manage risk.  It's not your choice of strategy.

Below I list my favorite methods - the only methods I use when trading my own money.  There are other strategies, and if they appeal to you, by all means, use them,  But learning how these specific strategies work is just the first step.  Managing risk should always be on your mind.  Please remember my #1 rule for traders/investors:  DON'T GO BROKE. That means refusing to take more risk than your experience and pocketbook dictate.

Favorite strategies - with brief descriptions and links to previous posts on these topics.

1) Covered call writing is a good method for rookies to learn how options work.  It's a bullish strategy and is not designed for bearish markets.

2) Collar.  Considered by many to be the most conservative strategy available.  Both gains and losses are limited.

3) Writing naked put, secured with cash.  Good strategy for learning about options, but it's equivalent to writing covered calls and should be sued only by investors who prefer to accumulate stocks over time.

4) Credit spread.  Buy one option and sell another with the same expiration.  Both are puts or both are calls.  If you sell the more expensive option, it's a credit spread.  If you buy the more expensive option, it's a debit spread.

5) Iron condor.  A market neutral strategy in which you sell one call credit spread and one put credit spread.

6) Diagonal (or double diagonal) spread.  Similar to a credit spread (or iron condor), but the option(s) you buy expires later than the option you sell.

I'll be posting some discussion on each of these methods.  Or you can take a look at previous posts or The Rookie's Guide to Options.

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.

The Importance of Being Flexible

"One of the least recognized trading strengths is mental flexibility: the ability to keep an open mind to the evidence of the evolving marketplace and revise views and strategies accordingly."

The quote above is by Dr. Brett from his excellent TraderFeed blog.


We all have our favorite methods for using options.  If you have been earning good profits year after year, it's difficult to accept the fact that times may have changed.  For example, most individual investors only understand bullish strategies, such as owning stocks and mutual funds, or writing covered calls (or writing naked puts, an equivalent strategy). 

When neutral to bullish markets are absent - such as when the technology bubble burst early in this century, or during 2008 - those who insisted on continuing to trade using bullish strategies performed poorly.  Those who adopted an investment strategy that provided a partial hedge, e.g., the slightly risk-reducing strategy of writing covered calls, fared better than those who owned a diversified stock portfolio (compare BXM and SPTR for 2008*).  But those who recognized that times had changed soon enough to do something about it fared far better.

    *The buy-write index (BXM) declined by almost 29% in 2008

     SPTR (S & P total return index declined by >36%

During the market declines, the bears were successful.  But even bullish traders who owned insurance (by adopting the collar strategy, for example) performed far better than their bullish peers.

The point is that it's not so easy to abandon successful methods.  But it's also important not to fight the trend and to recognize that your favorite methods will not always be appropriate. 

If you consider yourself to be a better than average market prognosticator, then there must be times when you don't want to be either bullish or bearish.  That's the time to adopt a  market neutral strategy (iron condors, for example).  Such flexibility allows you to survive in any market - but only when you are diligent in managing risk.

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 meant calls that are at-the-money, or slightly in-the-money. 

I don't believe it's sound to base investment decisons on the possiblility 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 bullish I'd adopt a strategy with limited losses - and thats the purchase of calls preads or it's equivalent, the sale of put spreads.  Managing risk is the key to success when trading options.

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.

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-buywrite 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.

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

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

Q & A. Rolling a Covered Call

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 my $5.70...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

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 reduced 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 own 300 shares of XXZ and want to write three Nov 35 calls, you know you can simplify the process (only one commission to pay your broker, instead of two) by selling three Nov 35 puts instead. 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 a lower strike price instead, 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.

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

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.