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.


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.



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