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
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.