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


10 Responses to Covered calls, naked puts, covered strangles and position size

  1. Michael S. 01/27/2010 at 1:57 PM #

    Mark: I absolutely love your blog read it daily. Thank you for the great and valuable info. I am not a beginner, but I am not an expert by any means either. I trade covered calls primarily. Short term 3months out on highly volatile stocks. And I also trade covered calls using leaps on stocks i don’t mind holding for a long time or big names that I’ve had in my portfolio for a long time and collect dividends and look to lower my cost basis in.
    Having said all that, you posted a comment yesterday that I would love if you could expand upon…
    “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.”
    For some reason i can’t seem to be able to get my head around this concept. A covered call is a way to collect additional income and lower cost basis on positions whiles still having all the rights and benefits of stock ownership, voting, dividends, etc. I don’t see those benefits with selling a put. could you please expand on your comments?
    Thank you, and keep up the awesome work with this blog!

  2. Mark Wolfinger 01/27/2010 at 2:18 PM #

    Thanks.
    I get it. Although this will be ‘obvious’ to you one day, until that day arrives, the two strategies seem so different that it’s next to impossible to convince some people that they are equivalent.
    Please note this: They are not identical. They are equivalent.
    That means the profit and loss profile for the covered call and the corresponding naked put (same strike price,same expiration date) are identical. It means that your account has the same value at expiration, regardless of which of the two equivalent positions you held.
    There may be minor difference, when options are not priced efficiently. There may be minor differences when interest rates change. There are differences in expenses when commissions are considered. But if you write a covered call or sell the naked put – you are going to come out with the same account balance when the position goes away.
    1) I see no benefit to be derived from holding shares. Your vote is meaningless anyway. Don’t misunderstand, when I owned socks, I always voted.
    2) The dividend doesn’t count either. The puts and calls are appropriately priced so that the the covered call seller and naked put seller are appropriately compensated for (or penalized) by the fact that the stock pays a dividend.
    In other words, the dividend is priced into the options.
    3) If you have a tax advantage to collecting dividends, that makes covered calls better.
    4) You are correct: the put seller gets no dividends and cannot vote. I cannot place a value on that for you. If you like those attributes of stock ownership, then, by all means, own stocks. If you see no benefit, writing naked puts provides the same stock market gains and losses, with reduced commissions and ease of exiting positions (simply buy back the put).
    Note: Neither is a ‘safe’ investment. There is plenty of downside risk. But I assume you are aware of that and appear to be very comfortable with your chosen strategy.
    5) I can show you a (non-rigorous – i.e., these are not equivalent strategies down to a bunch of decimal places, but in real-world profit and loss, the differences are tiny) mathematical proof that the two strategies are indeed equivalent.
    But when you cannot wrap your head around it, it may not make any difference to you. buy you can consider the facts and re-think your stance.

  3. Andy 01/27/2010 at 9:41 PM #

    Hi Mark,
    Just finished watching a webinar on options and TA. One argument the presenter made for buying OTM calls is that when the stock price goes up, the value of the option rises at a greater magnitude than the reverse (when stock price goes further OTM, value of the call declines at a slower magnitude). He also mentioned this applies only to short term swing trades (over a few days only).
    I was wondering what you thought of this concept. Also… will you be releasing any hints about the big announcement on the 1st? Is it related to your ebook?

  4. Mark Wolfinger 01/27/2010 at 9:52 PM #

    Hi Andy,
    No. Not related to my e-book. It’s not related to this blog either.
    Immediate comment: This speaker is merely describing the definition of gamma. The delta of an OTM call increases faster than it declines for a given $ stock price change. Big deal.
    1) I need more details, but I’ll say this. He is correct about option values. But so what? These options are very difficult to trade profitably.
    2) A 20 cent option can move up 20% to 24 cents. Nice return. Buy you cannot collect it. The b/a spread will kill most of that 4 cent gain and commissions will take care of the remainder.
    3) Are we talking about a big gain? Maybe a 30 cent option will move to a buck? OK. Nice gain. But for a swing trader, if the advance doesn’t occur, the loss is huge. First the option price is lower. Second, the b/a spreads represent a big percentage of the option price. And then there are trading costs.
    A CTM or ATM option would provide a better trade strategy.
    4) If I were a swing trader, I’d never trade cheap options. I would guess that an option in the 35-40 delta range would proved a huge bang for the buck – because of exploding gamma.
    But, I’m not a swing trader. And I’m never a call or put buyer (except for insurance).

  5. Andy 01/27/2010 at 10:24 PM #

    His example was google when it was trading at 380. Basically, a 410 call was $7.3, a 420 call was $4.8 and a 430 call was $3.1 (36 days to exp.)
    He explained that if you owned the 420 call and google went to 390, the new price would be $7.3 and you would be up $2.5
    But if google went down to 370, your 420 call would be worth $3.1 and you would be down $1.7
    I believe his point was that reward can be greater than loss with OTM calls.

  6. Mark Wolfinger 01/27/2010 at 11:24 PM #

    He agreed with my thesis. He did not buy cheap FOTM calls. He bought a ‘decent’ call with a decent delta.
    I would never have guessed that the term ‘OTM’ referred to an option that is only 8% OTM.
    I cannot argue that it is OTM. Just not what I thought you had described.
    Those options are fine to buy if speculating. They do have explosive gamma.

  7. Jason 01/28/2010 at 9:57 AM #

    First, ordered your book.
    Second, wanting feedback on a variation of my original post. Continuing with the idea of expanding ideas on the covered call strat through adding of put selling.
    Lets say I have $100,000 I want to dedicate to this approach.
    $50,000 is used capture approach on dividend stocks and calls are sold against them with a one month expiration. I buy a week or so ahead of ex div and sell ITM calls to cover the gap down when the price drops for taking dividend into account. Also, place a limit order to sell shares after ex div date if B/E is met. If stock ends up on the increase I keep div and any net premium, if stock ends down I breakeven.
    That would be for current month. In addition, I have identified the div candidate I will want to purchase the following month so in preparation of this I use the other $50,000 I keep in cash to sell puts against this desired stock. If it drops below I get my stock as desired at a lower cost. If price stays flat or increases, I’ve still brought in some extra premium.
    I think this approach is better suited than the last but curious to hear your thoughts. Thanks

  8. Mark Wolfinger 01/28/2010 at 11:10 AM #

    Jason,
    1) Suggestion. Just look at the naked put selling as separate. It is NOT part of your covered call, dividend-capturing play.
    It’s separate. It’s an investment plan suited to accumulating shares at prices that are attractive to you – and you get a consolation price (put premium) if the put expires worthless.
    If you do buy any stock this way, you may decide to keep them and write covered calls.
    2) You are missing something. The price of the call option takes into account that the dividend is coming and that the stock will be trading lower.
    I don’t know what you mean. How can you place an order to s sell shares (if B/E is met). What about the call you sold? you cannot ignore that.
    What B/E? Do you mean if the stock declines to some specified price? If you do that and then buy back the call you sold, you will be far below break-even. That call is not going to be priced near zero – unless expiration is nigh and the call is reasonably OTM.
    Send an example. There are too many alternatives for a discussion. How deep ITM is the call you sell. That makes a huge difference.
    Tell me stock, div amount, strike and expiration date of call you sell and option price. Two examples should be enough. Examples don’t have to be current, but I’d want to know how many days prior to expiration the trade was made.

  9. Jason 01/28/2010 at 1:43 PM #

    An example. Pfizer is going ex div next month. Paying .18 div and currently trading at $18.50. March 18 call selling for 1.10. Breakeven 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 of call (not sure what this would be so dont know how to include for further loss)

  10. Mark Wolfinger 01/28/2010 at 2:27 PM #

    Jason,
    This requires a lengthy reply.
    I’ll post that Saturday morning, Jan 30, 2010.