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.

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2 Responses to Choosing An Appropriate Strategy, Continued

  1. Erin 03/12/2009 at 3:56 PM #

    Hi Mark,
    I’ve been trading ICs for a while now and typically adjust when my short put (or call) reaches 20 delta. If the short put is hit then the likely spike in IV means there is often a suitable spread I can roll down to. However, if the market has a huge rally (as it has done this week) and my short calls need adjusting, the likely IV implosion makes it very difficult to find a spread to roll up to that is within my comfort zone. I ended up closing the entire IC for a small profit but was wondering what sort of adjustments you would make in this situation (i.e. call spread is in danger and IV has imploded)?
    Many thanks.
    Erin

  2. Mark Wolfinger 03/12/2009 at 4:50 PM #

    Reply is a separate blog post