Meet our Readers: Wayne

Like many beginners, when I started trading options, I sold covered calls, then cash secured puts. Then buying calls and puts. I remember in those days, I often said to myself, “covered call writing is such a wonderful strategy because at the end of every month the calls expire worthless and I’d sell another call and collect the premium. I can do this month after month!”

But after using this strategy for a while, I have to say that this is not as “safe” of a strategy as some people believe. Yes, you sell your call; keep your premium no matter what happens to the stock. But the fact is you can lose a lot from your declining stock–much more than the premium can ever give you. Yes, in a declining stock you can keep selling lower and lower strike calls, but the loss from the stock would still be greater than the premium collected, or break-even at best. For example,

–bought SPY at 120 and sold the 119 call
–at expiration SPY closed at 114. Premium kept, long stock.
–sold the 112 call trying to collect higher premium in a declining stock
–at expiration SPY closed at 108. Premium kept, long stock.
–sold the 106 call trying to collect higher premium in a declining stock
–suddenly SPY went up and at expiration closed at 115
–assigned at 106

Overall, SPY was bought at 120 and assigned at 106, a loss of $14. Yes, I collected premium along the way, all ITM calls:
— sold 119 call when stock at 120 then,
–sold 112 call when stock at 114 then,
–sold 106 call when stock at 108.

Sorry, I couldn’t find the exact amount of the premium collected. But, I do not think it’s more than the $14 loss from the declining stock. Perhaps at best, it was a break-even. That is, I collected $14 in premium but then lost all of it from assignment at the end. (This message is not: assignment is bad.)

Well, even if it was a break-even, it still wasn’t a good experience: I put in all the time, effort and anticipation that I am using a very “safe” & “good” strategy, but at the end, it was just a break-even or a loss.

So, I just wanted to share with you about the experience that CCW is not without risk, especially when the stock plummets and suddenly shoots up. And the fact is, it is not uncommon nowadays to see a volatile market, so stock prices behaving in an unpredictable & erratic manner is not at all unusual.

Wayne

,

11 Responses to Meet our Readers: Wayne

  1. Mark D Wolfinger 02/26/2011 at 7:50 AM #

    Wayne,

    Your transition from one strategy to another is a common occurrence. Plus it’s a good idea. However, I am surprised to find that you went from being a naked option seller (the covered call is a naked short put) to a call/put buyer. That’s not very common.

    There is no chance that you collected $14 in premium – or a number that’s even in the neighborhood. You were long, the underlying asset declined by a significant amount, and you lost money. Selling ITM options turned out better than writing OTM options, but rest assured that this was a losing series of trades.

    Agree: Writing covered calls is not a safe trade. It is ‘less risky’ than own stock, but it still entails risk.

  2. Wayne 02/26/2011 at 2:23 PM #

    Yes, it’s not common to see people transitioning from covered call writing to buying calls/puts. That happened to me because (I don’t know if this thinking is a bit off from many) but to me safety is the no. 1 priority. There is just so much talk & publicity out there about the low risk in CCW. Safety is what fascinates me.
    About buying calls & puts: to me it is very obvious that the strategy is risky. Without much education about it but just the simple fact that buying calls & puts means you’re owning decaying assets. Why own decaying assets? They are losing money daily! You have to be right about so many things (e.g. price, time, volatility) I don’t know, but to me, this thought is simple enough to convince me that I probably should look at other strategies.

    • Mark D Wolfinger 02/26/2011 at 2:37 PM #

      Wayne,

      I always refer to CCW as ‘safer’ not safe. I understand that others don’t do that.

      There are very good reasons for owning decaying assets. One example is to use them as portfolio insurance. However, it depends why one is buying them. If it is to speculate on market movement, then I agree 100%: The trader must be correct on several things simultaneously, that it’s just a poor bet.

      If safety is #1, it’s a shame you were trapped into become an option buyer. Losses may be limited, but to me that strategy is gambling.

      Regards

  3. Wayne 02/26/2011 at 2:53 PM #

    OK, let’s think about buying these decaying assets as adjustment, such as buying call/put spreads when one side of my iron condors is in trouble. Do you recommend buying them in the same month as the current IC or something farther out? It’s just the consideration that time decay is most rapid in the front-month, so it’d be less effective if I buy the front-month spreads. Or no? What do you think?

    • Mark D Wolfinger 02/26/2011 at 3:42 PM #

      Wayne,

      You have it all wrong. The problem is that you believe time decay is all that matters when trading options. You chose to seek positive time decay, and I approve of that. But when there is a risk problem, you MUST deal with risk first and not be concerned with theta.

      I have no idea how long you have been using options, so I’ll ask: Are you familiar with the greeks? Do you ever use them?

      I am not going to tell you what I recommend. I want you to LEARN something for yourself.

      I assume your broker supplies appropriate software for analyzing risk.

      Sell a vertical spread (not with real money – just for the purposes of looking at the risk graphs). Choose the strikes so that it is ‘in trouble.’ Next adjust by buying an appropriate debit spread that expires in the same month as your vertical. Look at the graph. Examine it carefully. See what happens as time passes.

      Next adjust the same spread with a longer term debit spread (instead of the same-month spread). Analyze the same way.

      Which is more effective?

  4. Wayne 02/28/2011 at 6:40 PM #

    Hi Mark,
    Actually I do look at the Greeks and know what they mean, but I also have to honestly say that I do not know what’s the most important one(s) to look at & to use.
    In addition to time decay, I am considering all the more now the risk of negative gamma in the front month, and have seen this risk when (through virtual trading) I traded front-month vs. longer terms IC.

    In the past, I have also bought some debit spreads (front month only) after purposely setting up short strikes that are in trouble. I’m continually experimenting to see which is more effective adjustment–debit spreads expiring in the same month as the vertical or DB that’s farther out.

    But the question is still, what’s the most important Greek you’d look at? Maybe you could give some insight on how you use the net delta exposure as provided by my broker.
    Wayne

    • Mark D Wolfinger 02/28/2011 at 8:17 PM #

      Hi Wayne,

      Here’s what you must know about the greeks (other stuff is less important):
      Greeks are used to MEASURE risk. That’s all they do.

      Once the risk is measured, you decide if that risk level is within your comfort zone. If not, make some adjustment to reduce risk. The greeks allow option traders to have a very good handle on risk.

      It is very tempting to own negative gamma (by selling front month options) and own positive vega by buying longer-term options. Why? Because traders love the positive time decay.
      Please believe me when I tell you that this is guaranteed to result in a disaster. This cannot work. Markets get volatile and negative gamma will kill the theta-loving trader.

      To learn about near-term vs. long-term as protection, you really should study risk graphs.

      The most important greek? The one that is outside my comfort zone. That can be any greek. However, I know what you are really asking and ‘delta’ comes first because the risk is immediate. But negative gamma makes delta worsen quickly – and that’s the hidden (and most important) greek for people who collect time decay.

  5. Michael DeAngelis 03/06/2011 at 7:16 AM #

    Wayne,

    I read thru your covered call example and as I see it you never calculated what the cost basis was for your stock after you sold the call. This would have helped you determine what strike price you should choose for your next covered call if the first had wxpired. Always keep in mind where your profit and loss zones are each time you place a trade.
    Once you stock dropped in price you continued to sell ITM calls ( I assume to try and collect the most premium). A better strategy would have been to sell OTM calls knowing waht your cost basis is for the underlying and allowig for the stock to recover. The premiiums may be smaller but the risk of losing money would be less. You never know when or for waht reason the market will change direction in either a positive or negative way. Bookkeeping to me is an important part of a winning strategy. I hope this helps.
    I have learned a ton from Mark’s books , blogs and questions he has answered for me. I just hope that I can pay it foward.

    Mike

    • Mark D Wolfinger 03/06/2011 at 8:17 AM #

      Hi Mike,

      I appreciate your response with advice for Wayne. Paying it forward is a great thing to do.

      In this example, I must disagree with your advice and I’m going to write an entire post based on your suggestions.

      Regards

    • Way Isne 03/06/2011 at 4:17 PM #

      Mike,
      Thanks for sharing. From time to time, I have considered your “better strategy”, i.e. selling OTM calls . But what I observed is, the premium would be very small in a declining stock and also the question: what if the stock doesn’t recover? The small premium and the stock never recovering to your cost basis are very valid considerations. Even if it does recover to the cost basis, how long would it take? What’s the opportunity cost in waiting (and not knowing whether the stock will recover)?

      Wayne

      • Mark D Wolfinger 03/06/2011 at 5:27 PM #

        Way,

        Amen