by Ken Trester | December 10, 2010 9:40 am
Many investors think writing options (i.e., covered calls) is an easy way to generate cash. But there’s more to it than meets the eye.
There are many decisions for investors to make before they get into covered call writing. For example, what kind of stocks should they purchase to maximize their call writing potential? What are their profit targets for the options they write? How can they maximize profits without losing their shares? And so on, and so on.
Looks like it’s not as easy as it seems, and it requires some study in order to improve your chances of success.
Follow my plan and learn how to make the most of the options you write.
I believe that when you begin writing option contracts that there are two objectives that are paramount to every covered option writer: maximizing income and minimizing risk.
First, in order to maximize the flow of income from writing covered options, the writer should attempt to extract at least a 20% annual return on the value of the shares held in their portfolio.
The second objective is to continually gather enough premium to reduce the downside risk of holding common stock, and to sell off positions that become unattractive because of changes in their inherent price trend.
Of course, many investors already own a portfolio of common stock that they definitely plan to keep for tax reasons or other considerations. But others will have the freedom to select stocks that are more conducive to option writing.
Many option players believe that stocks with low volatility are far easier to handle, are assigned less often, and require less watching. But stocks that maintain a low volatility normally have poor premiums, and it would be difficult to use these types of stocks in your portfolio and attain the goals we have set for ourselves.
On the other hand, you will find that stocks with high volatility have much-higher premiums in their listed options. These stocks normally have better liquidity, as do their listed options. Normally, stocks with high volatility also act in a much healthier and more predictable manger. Further, volatile stocks will create a good income flow — one that can generate up to a 30% to 40% return per year.
In covered option writing, we buy stock and sell call options against each 100 shares of stock. Therefore, it’s important to insure that the stocks that you do purchase are in a new uptrend.
Volatile stocks provide good premiums, and normally you can write options fast enough to protect some of that downside risk, although it is very difficult to protect all of it when stocks are falling rapidly in a bear market.
Investors locked into a situation where they cannot afford to divest themselves of stock positions must, of course, take their losses during the periods when their stock is moving down significantly. But it is far better to be writing options during this period than to sit around praying for the next bull market.
The wise covered option writer will always have a good range of common stocks in his portfolio. This diversity greatly diminishes risk.
If you have only one position and the stock dives downward in price, your performance will suffer, as you would not be able to write options fast enough to protect the total downside risk.
To smooth out the peaks and troughs of the stocks that are being held in your portfolio, attempt to hold at least four positions in different industries — this number has been academically proven to provide good diversity.
Low-priced stocks, such as $10, $15 or $20 a share, tend to have higher premiums per the value of that stock as compared to stocks that are selling for around $100 or more per share.
Commissions are another area in which the writer of low-price stocks has an advantage. If you use your funds to purchase 1,000 shares of ABC at $10, rather than 100 shares of XYZ at $100, you can reduce the commission costs of writing options because you now can work with 10 options, rather than one.
When you begin writing options, set aside a sum that you will use to purchase the common stock that you will be writing options against. If you are aggressive, you should attempt to get the maximum leverage from your investment. If you have $20,000 to invest in covered option writing, you should be purchasing as much stock as you possibly can with that money, even if you have to buy stock on margin (borrow money from the brokerage firm to buy stock).
The going interest rate for borrowing money to buy stock currently runs 3% to 8%. But by following the guidelines I have provided, you will generate better than 10% returns from writing options, making marginal stock profitable. Thus, the option writer will buy as much stock, or merchandise, as he can on margin.
Another great advantage of covered option writing is that when you write options, you receive the premium from that option back immediately in the form of cash, which goes directly into your account, and can help to finance the purchase of more stocks.
As you continue to generate more and more premium from writing covered calls, this premium should be used to reinvest and obtain more and more stock, and at the same time, make more margin available to purchase additional stock. By holding a philosophy of expansion, you will obtain an attractive return on your investments and see your portfolio grow rapidly.
A final consideration in the selection of which playable stocks should fill your portfolio is the yield of that stock. Again, remember, our objective — to maximize the flow of income per month. Dividends, of course, would be part of that income flow.
Therefore, the option writer should not only look at what kind of a premium he is going to obtain from writing options against their stock, but also at the dividend of that stock. They should add those dividends to the returns they will receive from other option writing premiums.
This is critical. In measuring the income generated by an option, the only thing that we can consider is the time value (or premium value) of that option. (More on this in a minute.)
The intrinsic value of the option should not be considered in this analysis. You should only consider the intrinsic value of an option when you are attempting to provide some downside protection, but are not looking for actual income generation from that portion of the option.
The secret advantage of option writing is that you can enter trades where you have a very high probability of winning no matter what the market, a stock or a futures contract does. In fact, you can sometimes enter a trade that has a 99% chance of winning. In a sense, at times, they are giving money away on the exchanges.
The option writer usually wins if the underlying instrument moves in the direction you expect, stays still or moves against you very slowly. The only time the option writer gets hurt is when the underlying instrument makes a large, fast move against you. The disadvantage to the option writer is the chance of a big loss, for you face unlimited risk.
You have probably discovered the second secret advantage for option writers: time.
You should never hold options in the last month before expiration. But that’s good news for option writers. Only write options that have a small amount of time before they expire. For us, that means we should write options that have less than one month before expiration and avoid writing options that have more than two months before expiration.
Option premiums collapse during the last month to the advantage of the writer. Your goal as a writer is to stay in an option position for as short a period of time as possible. The more time you give the position, the more chance you have to get bitten.
Sometimes you’ll find an overpriced call whose premium is a much higher percentage of the share price in stocks under $15.
However, don’t buy a low-priced stock just to write a high-priced call against it. Make sure it is a stock that you want to own or you may end up with stocks whose option premiums will not offset any losses in share price.
I’ve created some really attractive risk-reward plays using this strategy. For example, in 2001, I bought 100 shares of Rambus (NASDAQ: RMBS) at $16 and sold a Jan 2003 25 Call at $8.
The premium paid for 50% of the stock ($16 – $8 = $8), so my total cost and risk on the position was only $8. So, my maximum profit was $17 (%25 minus the cost of the stock at $8), which meant a return of more than 200%.
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