Sep

30

Shocking News Swaps (SNS)

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“Hey you. Yeh, I’m talking to you. I know you put on those twenty vertical spreads a while ago. You must be a little nervous with the VIX moving up and all?
Who am I, you ask? The real question is: if you could buy insurance to protect you from getting assigned, would you be interested in that? I’m talking about a tiny cost; just 2% of the net of the premiums. You keep asking me who I am. Listen, I figure it would cost you a measly grand to protect yourself from any potential losses. A person would be a fool not to buy the insurance I’m offering you.
Listen to me before you just turn and walk away. Did you know that the Sultan of Brunei is about to purchase Starbuckles? Do you know what that would do to the stock? Of course you do. I see you’re interested now. Is that because you’re vertical spreads are in Starbuckles? Yeh, I thought so. The world is changing my friend. That’s why I’m offering to sell you these SNSs…to help you in these time s of uncertainty. The “random walk” ain’t so random anymore…ya know what I mean?
Of course you do. And that’s why I am offering you a cheap way to cover yourself.
Contract? Nah. We don’t need that.
Am I licensed to sell insurance? Well, you see my loss guarantee is not really insurance per se. It’s just an agreement between us.
How much money would I put up in escrow in case I have to make good on our deal?
You don’t trust me? I give you my word; I’ll cover your losses.
Hey, come back!
This scenario sounds cheesy and sleazy. Who in their right mind would enter into such a deal? Well, dear reader, some of the largest and most respected companies, Investment and commercial banks and even governments entered into deals like that to the tune of about $400 trillion. TRILLIONs! Where was the due diligence? The legal departments? The fiduciary responsibility? The SEC? Stupidity is not the answer. Avarice is. Screw you and hooray for me on an industrial scale! Just sign on the line and that tells the court that you understand that there are no guarantees when investing and sometimes bad things can happen. Caveat Emptor, baby. “The random walk” turned into the random walk-away with your money. Not the isolated event, mind you, but on a world wide scale. A giant wink from the new class of robber barons to the stupefied little guys. It’s just too complicated for you to understand. Trust us.
What underwhelming outrage from the public. The sad fact seems to be that if government officials are smart enough to take your money without a whimper, just imagine what real smart people can do? As serious investors, perhaps the picture is clear: the rules have changed and they are probably about to change again. So what does that mean?
To succeed in most things, it is necessary to understand the rules of the game and how things really work. In my mind, the day of technical analysis has taken a big hit. Nowadays, the news-both spoken, unspoken and between the lines-is really moving the markets. Uncertainty and half truth seem to be the defining variables. But have no fear, this can work in your favor if you open your mind and start thinking out-of-the-box. And that is why I am convinced that options are the only way to go. Why do I think that?
Options can allow the knowledgeable trader to hedge, morph and play “both ends against the middle”. Of course, the devil is always in the details. And that is exactly why it is an excellent idea to enroll in the Advanced Options Courses offered by Option University. Don’t be fearful of change. Embrace it as an opportunity. Indeed, flexibility and the varied strategies that options offer can help you ride the new wave heading our way.
(Len Goodman is one of the editors for The OU Strategist and author of The Meltdown Chronicles available from amazon.com).

Sep

29

A Trader knows how to lose.

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This is what it’s like to be an option trader. You’ve done all the due diligence. You’ve checked the stock and option charts and studied the fundamental issues of the underlying stock. The March out of the money- option looks like a good time interval and strike price to move into-the- money and hit your target price. You decide that it looks like a good option trade and you have three of your four technical indicators supporting your decision. You’re just waiting for the stock price to move through the 20 day simple moving average (SMA). As, you watch the stock price move up to touch the SMA line, you call your stock broker and place a market order for five March 50 strike price call option contracts along with a 7% trailing stop loss. You get a confirmation and you sit back to watch the action. Your heart is beating faster and you move closer to the screen. “Come on, babies, show me the money”, you murmur to yourself.

You’ve told yourself that keeping glued to the scream is something you want to avoid but for some reason you get hypnotized by the promise of seeing the stock and its option price move in your favor. Finally, the option price starts moving up slowly. You feel excitement and a sense of anticipation. You did exactly what your options trading system procedures called for and a surge of confidence brings a smile to your face. You decide to tear yourself away from the screen and go for a walk to enjoy the feeling and relieve the tension.

When you return to the computer, you gasp in horror as you see that the option price has retraced and is nearing your stop-loss. You quickly check the news and the charts for some indication of what’s happening. Nothing. As a matter of fact, you notice that the RSI (relative strength indicator) has moved down. Maybe this is the testing before it really takes off. “But what if I get stopped out before it makes the move back up?” you ask yourself. You quickly call your broker and ask him to move your stop-loss lower to give your position some room to breathe. You know you shouldn’t have done it but you did it anyway.

Within several hours, the price of the underlying stock is starting to move up and you watch with hopeful anticipation for the options to follow suit. But as you watch in horror, the option prices not only blow past your original stop- loss but also scoot right past your adjusted stop. Before the first day is over, you’re out of the game and score some red on the trade. You’re angry and confused. All the study and preparation for what? You should have listened to others and stayed away from options trading. No more options trading for you!

This scenario is too typical and is what separates successful traders from the majority of stock option trader “wannabees”. Listen, losing is part of trading. As a matter of fact, a trader who has an option win-loss ratio over 60% is probably making good profits over the long term. The idea is that if you cut your losing option trades quickly and without second guessing yourself, and let your winners run, you will do well.

The key to becoming a successful options trader is being able to “stay in the game”. Simply put, staying in the game is a matter of setting up a strict policy regarding the amount of trading capital allowed for each trade and religiously “punching out” when a stop loss is hit. Most successful option traders limit their trading capital to about 5-8% of the option trading account on any one trade. If they draw down the option trading account below 30%, most option traders will stop trading and go back to redesigning their trading system or adjusting their heads. Simple rules to trade by, but most new traders don’t go into options trading with these sorts of con-straints in place. And even if they do, many let the emotions take over and will violate their own option trading system to save their egos or try to salvage money they shouldn’t be trading.

In options trading, losing is part of winning. Nobody wins ‘em all, and any trader with a win-loss ratio over chance (50%) is usually doing well because the average losing option trades lose much less than the average winner. For example, if average losers have an 8% loss and the average winner gains 18%, multiply that average margin difference (in this case, 10%) by the number of contracts traded over time and that is what it’s all about. It’s not about hitting home runs, but hitting for average.

To learn more about options, take advantage of Options University to give you the education on everything you need to know about options-from basic to master.

Sep

28

Using Options to Short the market-Introduction

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Short selling works because traders are obligated to return a fixed number of shares and not a fixed dollar amount. In our example, you shorted 100 shares with a value of $7,000. Your obligation is to return 100 shares of IBM and not $7,000 worth of IBM. If you can purchase the shares for less money than you received, you will make a profit.

This is not meant to be a course in shorting stocks but rather a way to understand what the term “short” really means when applied to the stock or options market. Shorting means you receive cash from selling an asset you don’t own and then incur some type of obligation. In the case of shorting stocks, your obligation is that you must buy back the shares at some time.

If you short an option, you have sold something you don’t own. You get cash up front and then incur some type of obligation depending on whether you sold a call or put. If you short a call, you get cash up front and have the obligation to sell shares of stock. If you short a put, you get cash up front and have the obligation to buy shares of stock. The cash is credited to your account immediately and is yours to keep regardless of what happens to the option. That is your compensation for accepting an obligation, much like the premiums you pay to an insurance company.

When you sell (short) an option you will receive cash, which is yours to keep regardless of what happens in the future.

The following table may help you to visualize the rights-versus-obligations relationships:

LONG SHORT
Call Right to buy stock Obligation to sell stock
Put Right to sell stock Obligation to buy stock

Notice that the long and short positions are taking opposite sides of the transaction. For instance, the long call (call buyer) must be matched with a short call (call seller). The long call has a right while the short call has an obligation. Rights and obligations are opposites. In addition, the long call gets to buy while the short call is required to sell. Buying and selling are also opposites.

For put options, the long put (put buyer) must be matched with a short put (put seller). As with call options, it is the long position that has the right while the short position has the obligation (opposites). The long put, however, has the right to sell while the short put is required to buy (opposites).

This arrangement is required to make the options market work. Both parties (the buyer and seller) cannot have rights. They can neither both buy nor both sell. One side has the right to buy (or the right to sell), while the opposite side has the obligation to complete the transaction.

This arrangement is often a source of confusion for new traders. They wonder how the option market can work if everybody has a right to buy or sell. The answer is that it is only the long position that has the rights. The short position has an obligation. It is important to understand this relationship when going through this book, especially when you get to strategies.

Long options have rights. Short options have obligations.

Getting Out of a Contract
We just learned that you can get into an option contract by either buying or selling a call or put. But once you’re in the contract, is there a way to get out of it at a later time? The answer is yes. All you have to do is enter a closing transaction (also called a reversing trade). In other words, you can always “escape” from your rights or obligations by simply doing the reverse set of actions that got you into the contract in the first place.

For example, if you are short an option and decide at a later time you don’t want the corresponding obligation, you can get out of it by simply buying the options back. This is much like you do with shares of stock if you are short. However, just because you can get out of the contract doesn’t mean that you can avoid any losses that may have accrued. The price you pay to get out of the contract may be higher and, in some cases, much higher than the price you originally received from selling it – just as when shorting shares of stock. But the point is that you can get out of a short option contract by simply buying it back.

If the idea of buying back a contract sounds confusing, think of the following analogy. You probably have a cell phone are locked into some type of agreement such as a one-year contract. Cell companies do this to prevent people from continually shopping around and jumping to the hot promotion of the month. However, your cell provider will also have some type of “buy back” clause in the contract. That is, if you wish to get out of the agreement, you must pay a fixed amount of money, perhaps $200, and you can escape your remaining obligations. If you pay this fee, the company cannot take you to court later and say that you didn’t fulfill your obligations. The reason is that you bought the contract back – it no longer exists between you and the company. That’s the fee they specified to end all obligations.

This is mathematically the same thing that happens when you buy back a contract in the options market. Although it is not a fee to end the contract, what you’re really doing is going long and short the same contract, thereby eliminating all profits or losses beyond that point. If you’re long the contract and you’re short the same contract, then you’ve effectively ended all obligations.

Likewise, you can get out of long call option by simply doing the reverse; that is, selling the same contract that you own. Because of this possibility, most option traders simply trade the contracts back and forth in the open market rather than using them to buy or sell shares of stock. As we will later see, trading option contracts is a big advantage because they cost a fraction of the stock price.

You can always get out of an option contract at any time by simply entering a reversing trade.

Let’s make sure you understand the concepts of long and short calls and puts by using our pizza coupon and car insurance analogies. If you are in possession of a pizza coupon, you are “long” the coupon and have the right, not the obligation, to buy one pizza for a fixed price over a given time period. In the real world, you do not buy pizza coupons; they are handed out for free. But that doesn’t put an end to our analogy because the basic idea is still there. Since you are holding the coupon, that means you posess the right to use it, and that’s the role of the long position. The pizza storeowner would be “short” the coupon and has an obligation to sell you the pizza if you choose to use your coupon. You have the right; he has the obligation.

If you buy an auto insurance policy you are “long” the policy and have the right to “put” your car back to the insurance company. The insurance company is “short” the policy; it receives money in exchange for the potential obligation of having to buy your car from you. Whether you make a claim or not, the insurance company keeps your premium just as you will when selling options. That’s its compensation for accepting the risk.

In the real world of car insurance, you cannot just force the insurance company to buy the car back for any reason. There are certain conditions that must be met; for example, the car must be damaged or stolen. You can’t just obligate the insurance company because you don’t like it anymore or because it has depreciated. However, in the real world of put options, you can sell your stock at a fixed price for any reason while your put option is still in effect. There are no restrictions. Of course, you wouldn’t want to do that if the fixed price you’d receive is less than the current market price. The main point is that if you are long a put option, you call the shots. You have the rights. You have the “option” to decide. You have the right to sell your stock for that fixed price at any time during the time your “policy” is in effect.

To be continued…….

Sep

25

One Reason to use Stock Options-Investment Protection

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One way that investors can greatly reduce the downside risk of stock ownership is to simply buy calls rather than stocks. But downside protection is not the only benefit that investors get by purchasing call options. They also gain tremendous leverage and the ability to better diversify their investments. So there are three main reasons why investors and traders buy calls rather than stock:

• Protection
• Leverage
• Diversification

Which reason is most important depends on what type of investor you are and what you’re trying to accomplish. While any one of these benefits may appear to be the best to you now, it’s equally important to understand the other two, so let’s take a look at each in turn.

Protection
Let’s assume you are bullish on IBM, you believe it will rise sharply over the next six months and wish to buy 200 shares. Table 8-1 lists the current stock price along with some April IBM option quotes with 230 days until expiration:

If you buy 200 shares of stock it will cost about $16,000, which also represents the maximum amount you could lose on the investment. Although it would be hard to imagine that IBM becomes worthless, you’d certainly have to agree that a loss of, say, 30% or $4,800 is not out of the question. Let’s see if we can construct a more favorable risk-reward profile for less money by purchasing call options.

In this example, we’re assuming that you’re bullish on IBM, which is a directional outlook. In other words, you are buying the call option as a near substitute for a stock, and you are not attempting to trade the volatility component of this option. The only decision you’ve made is that you think the stock’s price will rise. With this one-dimensional outlook in mind, make sure you buy an option that has a high directional or stock component to it. Chapter Six showed us that if you wish to buy a call as a stock substitute that you should look for one with a delta in the 0.80 to 0.85 range.

We learned that the difference between any two call (or put) prices cannot exceed the difference in their strikes. We can use this principle to give us a reasonable estimate of the delta. For example, look at the asking prices for the $50 and $55 calls, which are $30.50 and $25.70, respectively. The difference in these prices is $30.50 – $25.70 = $4.80. The maximum that difference could ever be is the difference in strikes, or $5. So the average delta between these two strikes is $4.80/$5.00 = 0.96. This tells us that the delta of the $50 call (lower strike) is somewhat higher than 0.96 while the delta for the higher $55 strike is somewhat less. Regardless, the delta of the $50 call is too high.

As we check the other combinations, we find that the $70 and $75 calls are $12.20 and $8.30, respectively. The difference in their prices is $12.20 – $8.30 = $3.90. If we divide that by the $5 difference in strikes, we find that the average delta is $3.90/$5 = 0.78. This means that the $70 strike has a somewhat higher delta and the $75 strike has a somewhat lower delta so the $75 strike looks like the one we’d want to trade. In fact, at the time these quotes were taken, the delta on the $75 strike was 0.73.

It’s very important to understand why we choose a strike with a delta of roughly 0.80. The reason is that a call option with a delta of 1.0 is no longer considered an option; it is now a perfect stock substitute. There is no time premium in a call option with a delta of 1.0 and it will rise and fall dollar-for-dollar with the underlying stock. Keep in mind that this is only true as long as the delta remains at 1.0. It could decrease if the underlying stock price falls sufficiently. However, a call with a delta of 1.0 contains a lot of intrinsic value that we would rather not pay for. So you do not need to find a delta of 1.0 but should get close; and the 0.80 to 0.85 range will suit your needs as a means for stock replacement.

Sep

24

Looking for a Lower Risk Strategy?

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In the Long Run, Covered Calls Are Less Risky
There are some studies that have shown where covered calls have produced superior returns to the market while reducing downside risk, which seems to go against the premise of the risk-reward tradeoff. But these studies are considering shorter time periods when the markets are relatively flat and, in these times, covered calls will outperform the market. But it’s a myth that they will always outperform the market while reducing your risk, which is what these studies lead many to believe. They are not taking into account the “homeruns” that stocks sometimes hit during good markets, and covered call writers will not participate in these to the same degree as long stock holders. In the long run, covered call writing is more conservative than owning stocks. As stated before, this doesn’t mean that there won’t be situations where the covered call writer outperforms the long stock holder. We just mean that you cannot consistently reduce your risk and increase your returns over time.

Despite this fact, covered call writing can be a very lucrative and rewarding strategy. In fact, in 2002, the CBOE created a buy-write index (BXM), which shows how a portfolio of covered calls would have performed over a given time period by writing slightly out-of-the-money calls against the S&P 500 Index. At certain times, the BXM can boast some pretty impressive results. Covered calls are also a good strategy that can be combined with other strategies; they do not need to be used as an independent strategy.

For example, rather than buying shares of stock, you could start by selling naked puts as a way to acquire the stock. Remember, if you sell a put, you create the potential obligation to buy stock. Selling naked puts is not a strategy that we will cover, but we’re just trying to make the point of how option strategies can be used in conjunction with one another. Continuing, once the stock is acquired, you could then write calls as a way to sell the stock. By adding the additional step of selling puts, the investor acquires at least two option premiums – one to buy the stock and one to sell the stock. He may acquire more if he’s able to write additional puts to acquire the stock and additional calls to sell the stock.

So while covered calls may be presented as a basic strategy, don’t think that experienced investors do not use them. They can be very powerful when combined in the right ways for specific situations. As with any strategy, there are many ways to fine-tune them to suit your needs. The important thing is that you understand the basics. Once you do, you’ll find that covered calls may not be so basic after all.

Key Concepts
1) Covered calls are created by selling calls in a 1:1 ratio against your long stock.
2) The covered call strategy is a neutral to slightly bullish outlook.
3) The risk of a covered call is that the stock price falls.
4) Covered calls are synthetically equivalent to naked puts. If you would not write a naked put on a particular stock then you should not use a covered call either.
5) Do not expect to get assigned (called out) of a covered call early. If you do, it only helps the position since you receive the maximum reward early.
6) You can buy stock and sell calls simultaneously with a buy-write.
7) In the long run, covered calls must be more conservative than long stock.

Sep

23

Are You Ready to Roll?

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Roll-Outs
We learned earlier that it doesn’t really matter if the stock price rises above the strike of the short call at expiration since this is the maximum gain portion of the profit and loss curve. While it may not be the ideal situation, it is not a losing situation by any means. When this happens, most investors feel they only have two choices. First, they can let their shares get called away. Second, they can buy back the call and end up with an unrealized gain in the stock. However, there is a third and often overlooked strategy available, which is called a roll-out.

Assume that AGIX is $21 at expiration and the October $20 call that you sold is trading for $1 intrinsic value and November $20 call is trading for $3. You could buy back the October $20 call and simultaneously sell the November $20 call for a net credit of $2. In other words, you have rolled out to the following month. Effectively you sold another $20 call for $2, which again lowers the cost basis of your stock by the same amount.

Of course, you could choose to sell other strikes as well. If, instead, you sold the November $25 call you would be rolling out and up (rolling out in time and up in strikes). This strategy is used when the stock makes a significant upward move. For example, assume AGIX is trading for $25 at October expiration and the $20 call you sold is trading for the $5 intrinsic value. Further assume that the November $25 call is trading for $3. You could buy back the October $20 call and sell the November $25 call for a net debit of $2. Effectively, you have paid $2 for the chance to make an additional $3 (the difference in strikes less the $2 paid) if AGIX is above $25 at expiration.

In our example, you had a cost basis of $14.41 on the stock. If you buy back the $20 call and sell the $25 call then your cost basis increases by $2 to $16.41. You could make a maximum of $25 for a net gain of $8.59, which is $3 more than your previous gain. Rolling out or rolling up trades are collectively known as rolling trades and they allow investors to make another investment based on the same shares that are already in the account. If you don’t want to let go of your shares, you can always execute a rolling trade. The important point is that you make your decision based on sound objectives rather than rolling up just because you don’t want to see your stock taken away.

Roll-Downs
A roll-down is the reverse of a roll-up. With roll-downs, the investor buys back the existing strike but sells a lower strike call against the shares. Investors are often forced to do this when the stock price falls since the higher strike price may be trading for too low of a price to make it worthwhile. For example, assume AGIX is trading for $15 at expiration. The October $20 call you sold is close to worthless, but you may find that the November $20 isn’t commanding much of a premium either. You could execute a simultaneous order to buy back the October $20 call and sell the November $15 call.

The problem with writing the $15 call is that it reduces the potential sales price of the stock. By selling the $15 calls, you have the potential obligation to sell your shares for $15, which means the potential sales price is reduced by five dollars. You will always reduce your potential selling price when you roll down. For example, assume you can buy back the October $20 call and sell the November $15 call for a net credit of $2. Your cost basis on the stock is reduced from $14.41 to $12.41 but now you have the potential obligation to sell your shares for $15. In this case, the roll-down worked out okay but, depending on the cost basis of the stock you could lock yourself into a potential loss if assigned. For instance, if your cost basis on the stock was $18 and you rolled down for a net credit of $2 then your cost basis is $16 but you may have to sell the shares for $15.

Remember that the covered call strategy is a neutral to slightly bullish strategy. If the stock price is falling then you may be in the wrong trade and it’s usually not the best idea to try to “write” your way out of the loss by selling lower strike calls. In most cases, you just end up digging a deeper hole. But depending on your cost basis it can be a viable trade, so it’s worth understanding.

Sep

22

Buy-Writes- Part 1

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There is a special order that allows traders to enter into a covered call as a “package deal” to the market maker, which is called a buy-write. With a buy-write, you can send an order to “buy” the stock and simultaneously “write” (sell) the call, which can be executed “at market” or as a “limit order.” Regardless of how the order is placed, any executed order results in a net debit (because the stock must always be more valuable than the call). Since you’re giving the market maker two trades rather than one, you will generally get a little better price for the package deal and every little bit helps.

Are Net Debits Confusing?
Sometimes new traders have trouble with the concept of net debits but it’s very similar in concept as when you negotiate with a car dealer to trade in a used car for a new one. If the dealer is asking $30,000 for a new car and you would like to receive $10,000 for your used car then there is a $20,000 difference between the two prices. You may, for example, try to make a deal by telling the dealer that you want to buy the new car by trading in your used car plus $18,000 cash. In other words, you’re telling the dealer you want to buy one asset and sell another for a net payment or “net debit” of $18,000. It’s should be of no concern to you if the dealer says he cannot sell the new car below $30,000 but is willing to give you $12,000 for your trade-in since that is still a net payment of $18,000 to you. Car dealers often work with the differences between the two cars.

This is exactly the idea behind the net debit with buy-writes. When you enter a buy-write, you’re telling the market maker that you don’t care what price they charge you for the stock or what price you receive for your calls as long as it is executed for a price less than or equal to your net debit limit.

The simultaneous execution of both positions eliminates execution risk, which is the result of adverse price movements. For example, assume the stock is $50 and you wish to buy the stock and then sell a $50 call, which is trading for $3. Notice that this means you are expecting to end up with a net debit of $47 for the two trades. However, if you place an order to buy the stock at market, you may get filled at a little higher price than $50, say $50.25. Then you immediately place the order to sell the $50 call and the stock’s price suddenly drops, which makes the call price $2.90. Because of the adverse price fluctuations, you paid more for the stock and received less for the call and end up with a net debit of -$50.25 + $2.90 = 47.35 instead of the expected $47. If you enter the two trades as a buy-write, you will not face this adverse movement. If the stock’s price suddenly jumps higher while the order is being executed, you’ll pay more for the stock but will also get more for the call. If the stock price drops lower during execution, you’ll get less for the call but also pay less for the stock. The result is that the net debit should stay pretty close to the same and not leave you with any unwanted surprise fills.

Incidentally, there is a mirror-image trade that allows the investor to simultaneously get out of a covered call, which is called an unwind. If you unwind a covered call, you will sell your stock and simultaneously buy back the call option. As before, the reason for doing both transactions simultaneously is to prevent execution risk. Most brokerage firms that offer buy-write screens also have unwind screens available online. If you are an avid covered call writer, you should strongly consider using the buy-write and unwind transaction screens if you are buying the shares at the same time you are writing the calls.

Sep

21

How will I Know If I’m Assigned?

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If you are ever assigned on a call, you will be notified by your broker the following business day.

But be careful at expiration and do not assume that you will not be assigned just because the stock closed below the strike price on Friday. The reason is that many brokers allow you to exercise the call after the closing bell. It is possible that after-hours news could propel the stock to new higher prices and you could get the assignment notice on Monday.

Assume you have purchased 100 shares and sold one $20 call. It is now expiration day and the stock is trading below the $20 strike, say $19. Because its price is below the strike, you decide to not pay the commission to close the call and just let it expire worthless. However, after the close, a news story hits stating that the company will be bought out at $30 per share. Upon hearing this news, the long call holders-who thought their $20 calls expired worthless- could potentially make $10 just by exercising the call. All they have to do is call their broker and exercise the call option.

They will pay $20 but receive stock worth $30, which they can immediately sell for a $10 gain rather than the 100% loss they took by letting the option expire. Even if the call owners are afraid the stock might fall on Monday, they could short shares in the after-hours market for $30 per share and then cover it for $20 by exercising the option. That’s the risk-free route. The point is that there will be big demands to exercise the call and you can bet that assignment notices are likely to follow on Monday. If you do not have an assignment notice on Monday morning following expiration (assuming that’s not a holiday), you can be sure that you were not assigned on the call.

Sep

18

Covered Call Trap

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Covered calls can contain an unforeseen risk, and we’re ready to show how investors unknowingly can take step right into a trap if they believe that all covered call positions are conservative.

Because most investors do not realize the downside risk inherent with covered calls, they unknowingly choose their covered call trades based on the volatility of the underlying stock. An investor new to the covered call strategy may hear that covered calls are conservative and, when searching for investment ideas, will end up choosing the call options that have the highest premiums. After all, if all covered calls are conservative, he feels he might as well choose the call option that brings in the highest premium. However, if you choose the call options with the highest premiums, you have automatically chosen the riskiest stocks since it is the higher-volatility (risky) stocks that command higher option premiums. The investor ends up holding onto a highly volatile stock that he otherwise would not be comfortable holding. These call writers are often called “premium seekers” since they seek out the options with the highest premiums and then they buy the stock for the sole reason of writing the calls. This is a high-risk way to use covered calls that can lead to disastrous results.

For example, assume that you are comfortable holding stocks in your IRA (Individual Retirement Account) such as Conservative Consolidated Company but not comfortable with highly-volatile stocks such as Gargantuan Growth Company. If you are new to options and decide to write calls, you would find that the premiums for Conservative Consolidated are not nearly as large as they are for Gargantuan Growth. The reason is simply that Gargantuan Growth is far more volatile. And when stocks are more volatile, option traders are willing to pay more for the options so that they don’t have to hold the stock. When you decide on which stock to buy in order to write calls, you may see a one-month, at-the-money call on Conservative Consolidated trading for 50 cents while an at-the-money call on Gargantuan Growth may be $5.

When faced with these prices, you may think that it doesn’t make sense to buy 100 shares of Conservative Consolidated and only receive $50 from the sale of the call when you can buy 100 shares of Gargantuan Growth and receive $500. So you decide to buy 100 of Gargantuan Growth and write the call to gain the $500. But look what just happened. You ended up with the stock that you weren’t comfortable holding. It was the high option premiums that lured you into buying the stock. That’s what happens when you let option premiums dictate which stocks to buy. Investors who base their covered call decisions on option prices end up taking far more risk than they intend and end up holding a risky asset that could fall substantially.

Example:
Around 1998, I remember one investor who bought 7,000 shares of Egghead Software (EGGS) at $53 during the “dot-com” craze. (To make matters worse, he bought the shares on margin or borrowed funds.) He thought he was laughing all the way to the bank when he discovered that a three-week option was bidding $8 for a $55 stock. “Wow, that is over 15-fold on your money” he exclaimed. “At that rate, it would take less than two and a half years to turn $1,000 into $1,000,000.”

The trader bought the shares and wrote the calls waiting patiently for his windfall to arrive. At option expiration, the stock was trading at $4. Yes, he did get to keep the entire $8 premium for the calls. I will let you decide if it was worth it.

This trader was correct in realizing that the $8 premium was tremendously high. But there was a reason the markets were bidding up the call options so high. They wanted someone else to hold the risky stock. The risk of a covered call is that the stock falls.

Notice how it’s possible for two investors to be using covered calls and yet be on nearly opposite ends of the risk spectrum. Options are risky only if used improperly. Don’t be misled into thinking that all covered call positions are conservative no matter how convincing the argument may sound. If any broker tells you that the risk of a covered call is that you miss out on upside gains then ask him why the strategy is called “covered.” He will immediately tell that it’s because you’re not at risk if the stock rises since you already own the stock. That’s the correct answer but it presents a dilemma since he also believes that you’re at risk if it does rise. The reason that people make this mistake is because they are confusing “risk” with “missed opportunity.” Once again, risk is never defined as missing out on some reward (missed opportunity). People who forget the simple risk-and-reward relationship are easily led to believe that the risk of a covered call is that they miss out on the upside gains and are inevitably led to writing calls on the riskiest stocks they can find. If the “risk” is that you may miss out on some upside gains, you might as well collect the biggest premium you can! These investors usually learn the hard way that there is a big difference between risk and missed opportunity.

The very best tip we can give you for writing calls in a conservative way is to be sure you’re buying stock that you wouldn’t mind holding anyway even if options were not available. That way, it shows you’re willing to assume the downside risk and the sale of the call does not change the risk. It simply provides a downside hedge. Don’t let the tail wag the dog by purchasing stocks based on the prices of the options. Of course, it doesn’t mean that it’s wrong to write covered calls because of the high premiums; it just means that it changes the nature of the strategy from conservative to speculative. The point to remember is that all covered calls are not equal. Just because you’ve written a covered call does not make it a conservative strategy. It is your reason for doing it that dictates the risk in the strategy.

Sep

17

Which Strike Should I Write?

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One of the first questions new traders have is which strike they should write. There really is no correct answer although, upon reflection, some strikes will certainly sound better to you than others. If you remember the covered call is a premium collection strategy it makes sense to sell an option that is rich in time premium; hopefully you remember that is the at-the-money strike. It would also make sense to sell a relatively short-term option, say 30 days to expiration or so since these options are hit hardest by time decay. By selling a short-term, at-the-money option, you have a mathematical advantage by bringing in a relatively large premium that will quickly lose its value, which is good for you as the covered call writer.

However, different investors have different objectives and every strategy comes with a unique set of risks and rewards so we can’t really say that selling the at-the-money option is “the best.” It’s just that it has a lot of nice characteristics but there are always tradeoffs.

Which strike to write boils down to different philosophies of why you’re writing the calls in the first place. Because options are classified as out-of-the-money, at-the-money, and in-the-money then those are the different scenarios we can create with covered calls. Each comes with its own philosophy and sets of risks and rewards so let’s look at each in detail.

Writing Out-of-the-Money Calls
One of the most common approaches is to write calls against your long stock position but with the intent of never losing the shares. These investors usually write short-term, out-of-the-money (higher strike) calls. Investors who write out-of-the-money calls are really hoping the stock will rise to the strike price (or very close) but still leave the call out-of-the-money at expiration. In the AGIX example presented earlier, we assumed the investor wrote the $20 call for $4.40. This investor would ideally want the stock to rise to $20. If the stock’s price does not exceed $20 at expiration, there is no reason for the long call holder to exercise the call since they could just pay $20 in the open market. The $20 call expires worthless but the covered call writer enjoys the price appreciation of the shares plus the premium received from the sale of the call yet is never forced to sell the shares. Avid covered call writers with this philosophy hope this situation happens time after time so they can write new calls when the current call expires while continuing to hang on to the shares. The sale of many call options can greatly enhance the returns that you may otherwise receive from holding onto the shares alone. In fact, if you successfully write calls month after month, you may even write your shares into a negative cost basis.

For example, assume an investor buys the stock at $18.81 and writes the $20 call for $4.40. Let’s assume the stock rises during this time very close to $20 at expiration. Because the stock price doesn’t exceed $20, the call will expire worthless and the investor keeps his shares and can write another call the following month. With the stock near $20, perhaps the investor will write a one-month, $22.50 call. The price received obviously depends on the price the market is placing on that call at the time. But let’s say it is trading for $4. If the investor writes this call, the cost basis for the stock falls by another $4 to $14.41 – $4 = $10.41. The investor then hopes the stock will rise but close near $22.50 at expiration. At that time, the investor may write a $25 strike for $4 thus making his cost basis $6.41 and so on. Of course, hoping a stock will behave this well for sustained periods is an unrealistic expectation but the covered call strategy will still work even under less favorable assumptions. We’re just saying this is the ideal situation for those investors who choose to write out-of-the-money calls.

The covered call strategy would also work with the stock price remaining the same. In the previous example, we had written the cost basis down to $6.41 with the stock price near $22.50 at expiration. Obviously, there’s nothing wrong with this cost basis if the stock’s price had remained at $18.81.

Investors who never want to lose their shares tend to write out-of-the-money call options. They are willing to take a small chance for the stock’s price to exceed the strike in exchange for collecting monthly premiums.

The problem with the philosophy of writing covered calls with the intent of never losing the stock is that you are really acting like a “naked” call writer even though you also happen to own the underlying stock. A naked call writer, as we said earlier, is one who writes calls but does not own the underlying shares. This is a high-risk strategy since there is no limit as to how high the shares may be trading if you are forced to deliver them. Naked call writers definitely do not want the stock to rise. If you are writing call options against your stock but do not want to lose the shares, then you are acting like a naked call writer. Because of this, you will tend to write short-term, out-of-the-money calls to reduce the chance you’ll lose your shares. But when you write short-term, out-of-the-money calls, you will usually not bring in much premium either (since higher strike calls are cheaper), but you still have the potential obligation to sell your stock.

Because there’s not much time premium involved, you will not have a lot of downside protection either. Writing out-of-the-money calls can yield very high returns but most of those returns are due to stock price movement and not from the sale of the option. So for many investors, writing out-of-the-money calls doesn’t make a lot of sense no matter how small the chance of getting assigned (“called out”) may seem.

Writing At-the-Money Calls
If there were such a thing as a textbook definition of a covered call, it would probably be defined as one where the investor writes the front month, at-the-money call. Remember, the idea behind the covered call is to collect a relatively large premium from an option that will quickly decay in value. The strike that carries the most time value and sharpest decay is the at-the-money strike. Investors who write at-the-money calls collect the highest amount of time premium and also create a lower cost basis on the stock, which provides a little bigger downside hedge.

Investors who write at-the-money calls will not have the room for capital appreciation like out-of-the-money call writers. However, at-the-money calls provide a little more downside protection so they are less risky.

Risk of Covered Calls
As Figure 6-2 showed, the covered call writer is exposed to all of the downside risk of the stock (less the premium received from the option). The one thing you don’t want to have happen as a covered call writer is for the stock’s price to fall below the cost basis. This also corresponds to why we said that covered call writers should have a neutral to slightly bullish outlook. You do not want to write a call if you think the stock is going to crash. However, many new investors believe that you should write calls against stocks that you think are about to fall. You must remember when combining assets in a portfolio (such as shares of stock plus short calls) that it is the overall behavior of all assets that counts. When new investors learn about options, they learn that selling a call is bearish so they immediately infer that the covered call strategy is bearish since they are selling a call. But this ignores the fact that the covered call writer is also long the stock. In Chapter Two, Pricing Principle #5 showed us that the maximum price for a call option is the price of the stock. This shows that the call option will always be worth less than the stock. So if you own the shares and write the calls, you are holding an asset (stock) that is far more valuable than the calls. The last thing you want is for the price of that asset to drop significantly even if that action may be beneficial for the lesser-valued option.

Obvious as this may seem, there are many “professional” brokers of financial planners who will emphatically tell you that the risk of the covered call is that you give up potential price appreciation. In fact, here are three samples found on three different financial sites on the Internet:

• Since the short call is covered by the portfolio, this strategy has no downside risk. The only upside risk is that you give up the price appreciation above the strike price of the call; however, the call premium paid at the outset may compensate for this risk.

• While the covered call writer has no risk of losing huge amounts of money, there is an attendant risk of missing out on large gains. This is pretty simple: if a stock has a large run-up in price, and calls are nearing expiration with a strike price that is even slightly in the money, those calls will be exercised before they expire, i.e., the covered call writer will be forced to deliver shares (known as having the shares “called away”).

• Writing covered calls (i.e., call options over stock that you own) is perhaps the safest of all options strategies and possesses minimal risk. The aim is to generate income through premiums with the potential to collect capital gains as well, should the share price remain below the exercise price.

You can see that the suggestion or tone of many “professionals” is that covered calls are essentially risk-free. In fact, the first and second examples state that the risk is that you miss out on large gains. As we said before, the risk of any financial asset is never defined as missing out on some reward, and you must question the judgment of anyone who tells you that it is. If that were true, then the risk of buying Microsoft at $30 is that you might sell it later for $35 only to see it trading higher. Missing out on potential gains is always a regrettable possibility with any asset – but it is not the risk. To combat the downside risk of the covered call, many investors write in-the-money calls and there are many benefits to considering this often-overlooked variation.

The risk of the covered call is that the stock price falls. The risk is not getting assigned on the short call and selling below market price. That is a missed opportunity and risk is never defined as missing out on some reward.

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