The Complete Guide to the Covered Call: From Start to Finish

[Kunal of HSM]

An Introduction: Clearing the foggy idea around the covered call.

The ‘pitter-patter’ of the raindrops hitting the window sill as I type this sentence can’t even stop me from clearing the dark clouds surrounding the misconception of the covered call stock option strategy.

In my experience as a stock market option investor, and as a true enthusiast and student of stock market investing, the covered call is probably the most underestimated option strategy. Granted, it is probably the most well known stock option strategy – partly because it is often taught in introductory stock option courses to beginner investors.

Unfortunately, it’s true potential is also overlooked, as many beginner investors are quick to dump the simple covered call to get in bed with the sexier stock option strategies that many websites often pump-up. But then, what is really that sexy about a strategy that can be repeatable, scalable, and often profitable (if done right)? Who wants that anyways?

I will keep this thread as an on-going conversation as I provide details of my own covered call experiences, conversations I have with other well-known covered call enthusiasts, and to dispel misconceptions that many beginner investors have with the covered call strategy.

Part 1.0: The most common way to use covered calls (and why it sucks)

You know what? The covered call does suck. There, I said it. The reason being is that the way it is taught sucks, and the target audience who is learning this strategy is left with the sucky-results. Then, they get discouraged, trash-talk the whole covered call strategy, eagerly wanting to forget the experience in hopes of learning more advanced option topics, go through the school of hard knocks of losing more money, and then look to re-learn the basics of option trading, which should have been taught to them, correctly, from the beginning.

The way most beginners are taught to think about the covered call strategy is to think of it in terms of getting monthly rental payments as a real estate landlord – a nice fat cheque paid on every month, on time. While there is a lot of truth in this analogy, as that really is the best way to describe the covered call method in a plain-vanilla, relatable, down-to-earth manner, this explanation leaves a LOT of information out. I can name two exclusions just off the top of my head:

1. A covered call CAPS your gains. Do you remember the reason why you bought your shares in the first place? I’m guessing it’s because you actually LIKE the company. So why would you shoot yourself in the foot by capping the gains, just to make monthly income which could be just a fraction of potential gains that you miss out (and really, should be entitled to) if your stock goes through a high momentum bull run?

2. The covered call SHOULD NOT be your number one choice of protecting your portfolio: I laugh. No, I literally laugh when I read how people use covered calls to “protect” their portfolios. Yes, there are ways to use the covered calls as hedges, but the way most people are taught to sell covered calls (out of the money strikes, at best, at the money strikes) is a pathetic excuse of a hedging tactic.

Let’s just get technical for a second. Whenever you sell a covered call option, you must own at least 100 shares, right? 100 shares = ability to sell 1 call option. For this example, we’ll assume you have 100 shares of a stock that we’ll call, “HelloStockMarket”, just for kicks.

Rule of thumb: the at-the-money front month call option has a delta of 0.50.

You own 100 shares, each share has a delta of 0.01, so owning 100 shares gives you 1.00

Doing the quick math, you’ll notice you leave your stock portfolio exposed 0.50. This is NOT an efficient hedge!

And this, usually, is the best case scenario, as most covered call books teach you to sell out-of-the-money call strikes (so that you can get that time value depreciation).

So, you’re thinking, “Kunal, then, what is the solution?”

Coming in Part 2.0! Stay tuned. By the way, I will try to update this thread twice a week, but because I work a fulltime job, it may be once a week. So maybe bookmark it if you would like.

Also, leave a comment if something is unclear. I’m trying to make this the most awesome covered call thread available online. I love this stuff! Stock option investing is my passion!

Thanks everyone,
Kunal

 

[daveyc]

Kunal of HSM,

I don't think there is a very large audience on this board but I will be here to challenge your enthusiasm on this topic of covered calls as gently and respectfully as possible. You may have read my posts on this strategy recently.

Do you agree that the risk profile of this covered call strategy is the same as selling a put on a particular stock? So if you owned a stock like merrill lynch or worldcom or ge or bank of america or aig or enron and were selling calls on these stocks, where would those covered call sellers be now and what could they be thinking about covered calls? and would they be willing to share this strategy with their family members?

there are some out there, that say hey, what if you didn't sell your shares, thats not a loss right? hmmmmm think about that one..... there are many out there that don't think they lost money because they are holding shares at depressed levels but still haven't sold their shares. maybe those stocks mentioned are not considered 'good stocks' right? well, what about goldman sachs at 250 or pfizer at 25 or lilly at 60 or cisco at 34 joyg at 90, seriously, the list goes on and on and on.

You're correct in saying that this is a beginner strategy the big brokers offer as a level one (i believe) which further fools the novice trader into thinking that this is really, i mean really a safe strategy. i mean its got to be right, if my broker says its safe then its got to be? wrong!! fidelity investments offers this as level one as i recall. but is it really conservative? risk is in the stock right? higher premiums for more risky stocks. where am i going wrong?

same is true for 'in the money covered calls', although with a little more safety. bottom line is that selling puts on stocks is the exact same thing as selling covered calls. say you have $100,00 to buy stocks and sell calls, how many stocks are you going to own and just take a look at the risk you are taking and how could you sleep at night knowing that most of your money is seriously at risk? one big spike in volatility is going to hurt you big time.

 

[Kunal of HSM]

Dear Daveyc,
Thank you for your comment, I honestly read your comment about five times, just to sense the multi-part complexities written in it.

To answer this question, I’m going to completely go from my own experience, and my thought process. I’ve done both: sold naked puts, and written covered calls. And in my experience, I hate selling puts. I completely agree that the risk graph between selling puts and writing covered calls are identical, but in my mind, there is a lot of difference between the two strategies.

Selling naked puts in bull trends is an inefficient use of capital:

Without getting into too much about option Greeks, option premium is based on intrinsic value, volatility and time decay. In bull markets, volatility is contracting, so your premiums are contracting, especially for premiums entirely based on extrinsic value – which is usually the case for ATM and OTM options.

Second, there is no demand for puts in a bull trend. The easiest way to refer to this is by referring to the VIX (Volatility Index) which illustrates puts being bought on the SP500. In bull trends, VIX goes down.

What this means is that if you are selling puts in an uptrend, you are not getting a good premium for selling them.

Even more:

Your max profit on a short put is the premium collected. But what if the stock continues to ride the bull trend? You would have gained much more from owning the stock, than by selling the put which had no intrinsic value (i.e. I’m assuming you are not selling an aggressive in-the-money put).

Selling naked puts is a risky idea in bear trends:


While selling puts in bear trends is probably a better idea if you are a contrarian (volatility shoots through the roof so your put premium also skyrockets), it is a risky endeavour because you stand a risk of being assigned stock. I don’t usually like purchasing stocks when a stock is down trending or in a bear market. If you sell a put, you may not have a choice, someone can assign you stock – unless you close your put position. If you did decide to close your put position, you are actually getting messed over because you are paying an inflated price to close the put position due to inflation of premium due to volatility increase. And depending on when you close the put position, you may also have to pay intrinsic value that the put has gained. I mean, after all, you are only going to be closing your put position if the naked put you sold becomes in-the-money.

On the other hand, selling a call in an uptrend makes sense … hear me out for a second ... :
As stock continues to rise, more people want to buy calls, so you can usually squeeze out a better premium due to demand for calls.

But … it really depends on WHEN you sell the call:

I have Part 3.0 that clarifies this a bit better, but essentially, the way most people are taught covered call writing is to sell calls at the start of the new front month cycle. I disagree with this technique, I am more of an advocate of selling calls near resistance, or when there is too much optimism in the marketplace. For example, today is September 20, 2010, I just sold calls, despite the market moving up +150 points. But I was able to sell calls that were 3-4 strikes out of the money, on a stock that has an average true range of 0.75 – meaning, because there was so much optimism and demand for calls today, I could really get a juicy premium on calls that have a good probability of expiring worthless. And this comes in the face of the VIX collapsing. In this case, calls were expensive due to demand, not due to volatility spiking.

However, covered Calls are NOT a solution for choosing lousy stocks.

I notice the examples of MER, BAC, GE, Worldcom, AIG, Enron. Maybe it’s just my investing style, but I don’t usually choose stocks based on what premium I get for the covered call, I hand-select based on their fundamental business – i.e. the reason I bought the stocks in the first place.

The way I like to think of Covered Calls is two-fold. First, is to boost ROI for when the stocks you own go through a pullback or sideways trend. Second, to provide a cushion for when the markets do pullback … If I get the technical signals (i.e. oscillator divergences, price pattern failures), then for sure, I would be using more aggressive hedging techniques – BUT this isn’t what a covered call is used for. A covered call is simply a method of scalping a few extra bucks when the stock is going no-where, or at best, just helping when your stock has a pullback.

Hedging or protecting your stocks to the downside require a bit more work, because then you have to start employing put positions to hedge your portfolio, or even possibly selling out of the stock completely.

I’m not going to get into details here, (I will save that for a future post to this thread), but if I was to hedge my portfolio appropriately, I would be selling a high-delta call option, or even better, doing buying a synthetic put option.

But in either case, I would not be relying on my covered call to provide coverage.

In conclusion …

Wow, this was a long response …

Selling naked puts and covered calls have the same risk profile. But selling naked puts are not the best return on investment in bull markets, and quite often buying shares during bull markets is a better profitable strategy. Secondly, naked puts while having more juicy premiums in bear markets, are often a very risky idea – unless you like buying shares in bear markets, or like to go “bottom-fishing”.

Owning shares in a bull trend is a good idea, because your profit potential is not capped. It is when you sell a covered call is when your profits are capped, but choosing where to sell a covered call is where the art really comes into play: I mentioned that I like to sell covered calls when the stock is near resistance (because price has a chance of decreasing) or when there is a lot of optimism in the markets (I can get a juicy premium due to extrinsic inflation).


Does this help? Let me know if you have any questions. Thanks again! And actually, please don’t give such a hard question … I just spent the last hour just writing it and editing it.

Thanks again,
Kunal

 

[daveyc]

ha Kunal, not necessary to put so much time into a post. just look how sloppy my posts are. you hate selling puts but you like selling covered calls? but you know they have the same risk?

let me first disagree with your statement in bold print, 'selling naked puts in a bull trend is an inefficient use of capital' and 'there is no demand for puts in a bull trend'. an uptrend is where you would want to be selling puts because you would be bullish and/or may want to own shares at lower levels.

with my broker (tos) my margin on my one position this month where i sold puts is only requiring 1/4 of the price of the stock at current level and will increase if the stock drops. this is an efficient use of capital. and for myself i don't care to own any shares so i would either adjust or close the position but i wouldn't get assigned, not that it would be the end of the world. you correctly point out that selling puts in a downtrend is a risky idea and yes it sure is.

technical indicators cannot predict the future price of a stock or tell you where it is going next. the market or individual stocks can remain overbought or oversold for months, how can you trade on this? you don't even need to see a stochastic study to know if a stock is overbought or oversold. divergences either bullish or bearish happen all the time but i don't think that is something to trade off of either.

In my examples of MER, BAC, GS, GE, PFE, JOYG, AIG, WCOM, where not considered risky stocks before they fell out of favor, in fact they were solid (some still are) companies and fundamentally sound and widely held and were therefore low volatility stocks and option premiums reflected this. The point is that even solid companies will tank and covered call sellers will be left with the loss. This is why people get into this business and lose, it really only takes one bad stock and there go all those gains.

thats all for now.
take care,
dave c

 

[Kunal of HSM]

Hi Dave,
Awesome rebuttal – I have a feeling this could be one heck of a discussion!

Actually TOS is pretty awesome, I had a chance to visit their Chicago Headquarters and meet some of the trading desk. Beautiful office, it’s like going into a contemporary art museum. Tom Sosnoff definitely added some flair to that office space!

I started this thread to discuss more creative ways to use the covered call, as I agree, the way most people use the covered call leaves them either making more trades (because covered calls involve more trades than selling naked puts), or they cap their gains prematurely – since most sources teach to sell calls every month, as if it’s a calendar-based decision. While investors are more focused on long-term portfolio maintenance, traders are more focused on price movements. I have been a trader (I no longer trade today, but rather, primarily invest – since I work a fulltime job), and I know that if I were to sell a call “just ‘cause it’s the beginning of new front month expiration” I would never forgive myself. No covered call is ever going to make you recoup the lost gains of missing out on a huge momentum move, or even a support bounce. It’s like if you’re thirsty, and there is a flowing river beside you – you decide to use a 6 oz cup to capture some water to satisfy your thirst, rather than take a dip in the water. That is what a poorly executed cover call is: sure you can collect some premium, but that will be just a fraction of what your investments could earn if you had NOT sold the covered call, i.e. in the face of a new bull run, bullish candlestick trigger, a support bounce etc.

Dave, I have a sneaking suspicion that the past reply was still comparing selling naked puts vs. the traditional ways covered calls are taught (i.e. sell a call at the beginning of each new front month cycle). If that were the case, for sure, I would definitely say do the naked put strategy. It’s less commissions, and less headaches (because with naked puts, all you have to worry about is if your short put is in the money or not. If not, turn off the computer and sleep. Whereas with stocks, you have to check on it every little bit, just to make sure Armageddon hasn’t hit).

I don’t like the way the covered call is taught, that’s why I started this thread to hopefully educated on some creative ways to use the covered call. And hopefully as the weeks progress, I will add to this thread discussing some ways that I like to use the covered call (and variations of it) to really add some boost to my portfolio. So perhaps we can revisit this discussion in a few weeks when I’ve added some more info here.

Just as an aside:

In a bull market: selling a put vs. buying stock:
(This is going to get really technical; sorry in advance to the new guys reading this):

As mentioned earlier, volatility decreases as price increases. An out-of-the-money put, or OTM is only based on extrinsic value: time and volatility (no intrinsic value in OTM options). If volatility is getting smaller, which happens in any bullish move, premiums on stock options are also getting smaller. That being said, people who do not know this fact, will usually sell naked puts that are closer to at-the-money – because premiums for ATM options are better than OTM premiums. To me, selling an OTM put in a bull market is like trying to find meat on starving animal – you’ll take whatever you can get.

It just gets better:

The ATM options are usually delta of 0.50 (rule of thumb). So if you sold a put that is ATM, for every $1 the stock moves up, you only gain $0.50 per contract (assuming we totally disregard vega, gamma, and theta – theta actually works in your favor as an option seller, so I guess that’s good). This is a 1 to 0.5 relationship.

However, compare this to owning 100 shares (I’m using 100 because I’m comparing it to selling puts which if something goes wrong, you will be assigned 100 shares). If the stock goes up $1, you gain $1/share. This is a 1 to 1 relationship.

From an ROI standpoint of potential gains, it makes a much better choice to own shares because of this correlation.

But it was pointed out about margin being the deciding factor in determining an efficient use of capital:


You are right, the margin requirements aren’t exactly 1-to-1: if I sold a put strike of 50, they won’t keep $5,000 in margin, just a fraction of it, for example say, $3000. As price keeps moving higher, the margin requirements actually get smaller (i.e., now you only have to keep only $2000 in margin). However, should the stock fall, you STILL have to have $5,000 to pay for the assignment! Just because you need less margin, doesn’t protect you from stock market volatility in the case that the market pulls back. And correct me if I’m wrong, but I don’t remember a market crashing upwards. Bear pullbacks are much more fierce and price deteriorates much quicker than it does going up. As the household saying goes “the market takes the stairs up, but takes the elevator down”.

I am aware of this margin requirement, but I am a conservative investor even if my margin is only 80%, I still keep the full 100% in the account should anything happens. I would imagine there must be other conservative investors who do this as well, to avoid any margin calls, or untimely assignments (I have also been assigned stock in my time as well, and it sucks if you don’t have the necessary funds in the account – I did have cash reserves, but I do know people who had to sell assets to pay margin calls). Also recall that covered calls are usually used by non-active traders, many who could have full service brokers, where the margin requirement is 100% (I know, ridiculous, I live in Canada, and I’m just checking Royal Bank of Canada’s website, where they require 150% margin for shorts … very ridiculous).

And I don’t like getting assigned stock when the market starts falling apart, so you are right, if I absolutely had no other choice of making money in the markets, I would choose to sell puts in bullish moves. But the option model pricing is not catered to selling puts in bullish trends. You sell calls during bullish moves. But you have to know how to sell calls which gives you the best chance at reward. And that is the art of selling covered calls: determining if right now is a good time to sell a call. You can’t predict the future, but you can see what is happening now, and that is all you have to base your decision on.

Dave, awesome comment. Thanks for putting my brain to work!

Kunal

 

[Kunal of HSM]

My mistake, I forgot to mention, whether you sell naked puts or covered calls, if you choose a stock where the company goes bankrupt or commits fraud, there is no protection. That is the risk you take as an investor. I don't have an answer to your question about how to teach someone about covered calls when the company's internals are falling from the sky. I would imagine you won't be selling puts in this situation either.

K

 

[daveyc]

Hi Kunal,

While I think trading covered calls is not a good trading idea, I'm going to give you and 'A' for writing skills and effort.

Your last post on a company bankruptcy or scandal is precisely a major cause of concern and unforeseeable to any investor/trader. But, its not just this that you have to consider, its also maybe smaller moves down of say 5-10%, so that if you sold a call against your stock 'at the money', in the money, out of the money, the investor will probable lose on that trade overall as well.

Its true, an increase in volatility means that all options increase and when the market goes up volatility is decreasing and therefore option premiums are decreasing. While premiums may be more juicy for the next month out or the month after that, the risks remain.

The covered call is just a tool of many strategies and should only be used in conjunction with others to be effective. For example, you own 100 shares of YUM and you sell the OCT $50 call but maybe you own a JAN 11 $60 put and would consider buying more shares at a reduced level so you would either sell a OCT $45 put or to reduce risk just sell a OCT $45/43 put spread. But, maybe you are worried this stock could just keep going higher and higher as it has, so instead of capping your gains, instead of just selling the $50 call, maybe you could buy the $55 call. So, I'm not trying to dazzle you or add to the confusion, the point I'm trying to make is that a covered call is just one tool of many that novice traders/investors fall in love with and for no real reason and without enough thought or experience.

Also, one more point that I think is pretty important to make clear to anybody out there. If you think you are going to use one strategy, could be any, and be consistent, you are probably going to get hurt. The fact is that if one makes the leap and decides that option trading is worth their effort, and I believe this is the #1 business in the world, but this business requires hands on hard work and effort. This is not an easy profession and is certainly not for most. Don't believe any hype and know the risks you're taking before entering any trade.

Ok Kunal, or Kunal of HSM? Do you own a small country or something? haha.

take care,
dave c

 

[Kunal of HSM]

Dave, thanks for the kind remarks. I must be one of those rare types: an engineer who likes to write. Back in my University days, the highest level of English proficiency that was required for our degree was (and I’m not joking), grammar. Can you imagine? To become an engineer, you just had to know where to stick a comma. Hilarious.

You are totally letting the cat out of the bag, as I completely agree, you almost need two strategies working on any given portfolio: an income generator (which I like to think of as more of a portfolio-crash-cushion, a short-term insurance, per se), and a portfolio head-on-deer-in-headlight-crash-protector. You hinted on two aspects which I completely agree with: the short call vertical, which is a variation of the covered call, where you sell a covered call, but buy a call at a higher strike price.

The second is where you protect your investment via buying a put. But unlike the traditional sense of buying a put, you are selling a covered call, and using the proceeds to finance the put. This is called a synthetic short position.

I will be talking about both of these in upcoming weeks.

You can’t rely on a covered call to either protect your investment, as similar to my points about selling a naked put, a covered call also has a delta of less than 1.00. And because you own 100 shares of stock which together have a delta of 1.00, the math shows the clear imbalance: if you own shares (delta of 1.00), selling a covered call (which has a delta of less than 1.00), is not a good enough insurance. Furthermore, as the stock price continues to fall, while your stocks still maintain a delta of 1.00, the covered call actually loses delta (since gamma is working against the call as price falls), so now the imbalance actually increases, and leave more of your portfolio exposed.

Thanks for ruining the surprise.
Kunal

 

[daveyc]

Ok Kunal, I must say I am relieved to read your most recent post. I see that we are on the same page.

Covering your stock with a put is the safest way to go if you like to own stocks. Maybe the cheapest way to get into owning a stock that you like is to either sell an out of the money put or put spread, that way if you are assigned you will own stock at a lower price than you anticipated. So buying a far out put for protection is important and financing it with selling calls against your stock is a great way to pay (among other strategies) for this put protection which could give you a zero risk trade. This is a smart way to trade or invest.

Sorry for letting the cat out of the bag, haha. I thought you were going to tell us (all two readers, including us) how great covered calls are and how I could retire early.

Your english is great even for an engineer, hahaha. joking.

take care,
dave c

 

[Goldmansucks]

Interesting discussion guys.
You have certainly evaporated my ideas about using covered calls for income. I am completely uncertain now about my approach.

Can i just clarify a few things from your posts please ?

So it is possible to buy stocks cheaper by using some of these option methods ?
It is also possible to derive an income from premiums on stock purchases or some other method of option selling?

One of my concerns using options was if a company went tits up how can i prevent large losses? Is there a way of limiting your risk?

I was just looking at a simple way of investing some of my capital and getting a good income as opposed to putting the money in the bank.

It all seems like pretty hard work.

Thanks for sharing guys.

 

[anley]

One of my concerns using options was if a company went tits up how can i prevent large losses? Is there a way of limiting your risk?

Why have this concern?

How many times does it happen every year?

But more importantly how many times does it happen when an investor doesn't get plenty of warning, ie companies aren't in good health today and then dead tomorrow.

Take Enron, Worldcom of any of those other skanks. Price was moving lower and lower long before they went broke.

But can it still happen? Sure, but then the only way to protect yourself is not to get involved in the markets and keep your cash in the bank but then you won't be compensated for the risk you're taking because there is none.

 

[daveyc]

Interesting discussion guys.
You have certainly evaporated my ideas about using covered calls for income. I am completely uncertain now about my approach.

Can i just clarify a few things from your posts please ?

So it is possible to buy stocks cheaper by using some of these option methods ?
It is also possible to derive an income from premiums on stock purchases or some other method of option selling?

One of my concerns using options was if a company went tits up how can i prevent large losses? Is there a way of limiting your risk?

I was just looking at a simple way of investing some of my capital and getting a good income as opposed to putting the money in the bank.

It all seems like pretty hard work.

Thanks for sharing guys.

Hi Goldmansucks,

Buying puts on your stocks is the safest way to own stocks if you feel you must own stocks. Its true, buying puts is like insurance on your stock investment and will be good for as long as you hold the put protection. Some people like to buy 'deep in the money ' far out puts to protect their stock and therefore limit the risk to a few percentage points but that comes at a cost like everything in trading. Some like to buy the front month puts for protection 'at the money' and use the put insurance to purchase additional shares if the put becomes profitable (stocks goes down). I like the far out 'in the money' puts and then using the front months to help to finance the cost of the puts to reduce or eliminate the risk in stock ownership, meaning you could have a free trade or a no lose situation and have several months for the stock to take off. Hope that makes sense.

A good way to buy a stock if you feel you like to own a particular stock and are really confident the stock may go up but you might not want to pay the current price its trading at, you could just sell a put 'out of the money' and if assigned you will have purchased the stock for less than you would have otherwise. You might be able to do this for several months and own a stock that you really like for substantially less. Having said all that, this is easier said than done but doable. Hope that makes sense too. Just wait for the OP to write his posts on this topic, I think it'll be worthwhile.

And with all that I wrote, just please note that I am not an expert in this business, YET and I don't own any stocks at this point and I'm just a very small timer. I would encourage you to know your risk (use risk graphs, they tell you the whole story) before you enter any trade.

 

[Kunal of HSM]

These comments are great. Here is my take.

Goldmansucks:

Fantastic name by the way. Well, you aren’t really buying stocks for “cheaper” per se. I agree with Dave - by selling puts, you are able to generate monthly income. But this doesn’t come without risks, obviously! As Dave and I have already discussed in this thread, the only way you will be assigned stock when you sell out of the money puts is if the stock actually falls to that strike price. On one hand, this completely sucks, because that means you must buy these stocks (since you are obligated by selling the put) when the stock is falling/or has fallen – as the stock must be in a downtrend for it to have fallen to an out of the money put option strike – wow, trying saying THAT 10x fast!

However, if you read any introductory book on stock options in regards to put selling, they’ll say something like, “well, if you were planning to buy the stock anyways … then who cares if you get assigned?” I disagree with this concept, because what if that was the beginning of the company’s downfall? Getting assigned stock at the beginning of a company’s demise will surely be a good kick in your investing account’s butt, plus will be a good story to tell your buddies about “that time when you gave your investment account a hair cut”.

Of course, I am not a financial advisor, but if I was going to be selling puts, I would be selling them below a very well defined/established/important support level. That way, you have time on your side as the stock putz’s around that level. Time is your friend as an option seller, remember.

The only thing is that the market doesn’t just hand out free money. So when I say “sell below a support level”, many other well-trained option sellers will be doing the same and the market knows this as well – so usually the premiums below this support level are (insert your favorite expletive here)-poor for the risk you take. This is why you may have to wait for the price to drop – and then be selling puts. This seems a little counterintuitive: Kunal, why the heck would I sell a put when the price is dropping?
Two reasons:
First, because your support level gets closer to the current price level – so, your premiums on the options go up (think of at-the-money option premium vs. out-of-the-money option premium).

Second, volatility increases as price drops – so option premiums get inflated as well, which is good as an option seller.

Obviously, I don’t give recommendations in general, but don’t read what I just wrote and be running out selling options when price is falling. You still have to make sure the company is fundamentally-sound and that the overall trends (the primary, but just for kicks, watch secondary trends as well – remember we are investors; traders will be watching tertiary/short term trends for their positions ) haven’t broken: otherwise you could be selling puts in the face of a bear correction, or worse… bear market. This also is not good.

How about that? I feel like a politician with my answers, “do this, but watch for this”, but that’s what the market does to you, there will always be two sides to every trade: a reason to make it, but the risk associated for NOT making it. Yes, option trading takes effort, but as an investor, you want to be using option trading to better your portfolio, not to be the primary focus of your portfolio. I used to trade options entirely, but now that I’ve become a real-world working citizen, I have adopted more conservative, wealth-building tools, like buying stocks for the long term, but using my option repertoire as means of watching my assets, but also scooping up some extra money while sitting on my butt.

Kunal

PS: I also agree with Dave about protecting to the downside, I like deep in the money puts with a far in the horizon expiration time frame – just to provide that insurance, but also because I don’t like freaking out over option time decay – last thing I need is to navigate a market bear landmine AND have to juggle time expirations on my put insurance policy. If you cut your teeth on option trading in the past, one strategy I’m toying around and testing with is the effectiveness of synthetic shorts. Basically it’s selling a call and buying a put, but the benefits of doing this vs. the deep in the money put option, is that you don’t have to worry about time decay (because the option decay of buying the put is offset by the option decay you gain by selling the call), plus some other benefits (which I won’t bore you with right now). Essentially, it’s pretty advanced stuff. Would DEFINATLEY NOT recommend to anyone starting out.

Also, I don’t usually finance my out of long term puts via selling shorter term puts (i.e. I believe Dave is referring to a bear put spread, or bear calendar spread, for those readers who feel like starting up the Google machine and doing some research on their coffee break). It’s a pretty smart move, and I completely understand why you would do this, as I have done this before. The reason I personally don’t do this anymore is that during bear pullbacks, the market is violent and non-sensical: it could drop for the most ridiculous of reasons: maybe Obama’s shirt tie doesn’t match his shoes on a Wednesday...

So, I don’t like limiting my downside protection.

I also like Anley’s point, big time companies don’t just go bankrupt on a dime, and they usually start its decent months/years prior. That is why risk-management is very important. There have been times when I HAD to exit a trade because my exit trigger was hit (stop-losses are a gift AND a curse), only to watch the stock reverse and go back up. You have to appreciate that even if you are taken out of the stock, to watch it go in the direction you wanted, always remember there will be another opportunity on another day to get back in.

But if you don’t watch your risks, there may NOT be another opportunity to get back in … if you don’t have the cheddar!

Kunal (but you already know who it is!)

 

[GTS]

Interesting discussion guys.
You have certainly evaporated my ideas about using covered calls for income. I am completely uncertain now about my approach.

Can i just clarify a few things from your posts please ?

So it is possible to buy stocks cheaper by using some of these option methods ?
It is also possible to derive an income from premiums on stock purchases or some other method of option selling?

One of my concerns using options was if a company went tits up how can i prevent large losses? Is there a way of limiting your risk?

I was just looking at a simple way of investing some of my capital and getting a good income as opposed to putting the money in the bank.

It all seems like pretty hard work.

Thanks for sharing guys.

It sounds like spreads are your answer.