Are you interested in investing in options? There's a lot of information out there you can read and some of it is crazy complex. Back in 1998, the head of the derivatives desk at Goldman made me read a 1,000 page book called, Options As A Strategic Investment by Lawrence McMillan after our first round of interviews.
When I came back for my next round of interviews two months later, all they asked was,”What is a butterfly spread?” from the second chapter! I got the answer right, but was annoyed that I had spent so much time on a book I'd never use again. Ever since then, I haven't spent any time trading options myself. Instead, I just buy the occassional structured note for a fee to keep things simple for downside protection.
But for those of you who are super gung-ho about investing, here is a guest post from Dom at GenYFinanceGuy.com about the benefits of investing in options.
Two Strategies For Investing In Options
I have always believed that risk is a function of education. The media may have you convinced that options are very risky. But what if I told you that you could actually take on less risk than buying stock outright? If you take careful steps and don’t speculate, you can increase your probability and reduce your cost basis. Oh, and you won’t be afraid of volatility again, you will actually hope and pray for it.
There are two option strategies that will allow you to buy Stocks and ETF’s below current market prices. The Covered Call and the Short Put are option strategies that allow you to go long at discounted prices every trading day of the year. The discount prices get deeper during corrections when fear drives volatility through the roof, which inflates option premiums.
Before we get into how options can be safer and more advantageous than buying stock outright, let’s get a few definitions out of the way.
Option Trading Definitions
Option – An option is a derivative, which means its value is based on something other than itself (in this case the underlying asset/stock). Make a note that every option for stocks represents 100 shares.
Call Option – As a buyer, a call option gives you the right, but not the obligation to buy a stock at a certain price by a certain date in the future. You pay a premium for this right. As a seller, a call option gives you the obligation to sell a stock at a certain price by a certain date in the future, should the buyer execute his/her right. You collect a premium for this obligation.
Put Option – As a buyer, a put option gives you the right, but not the obligation to sell a stock at a certain price by a certain date in the future. You pay a premium for this right. As a seller, a put option gives you the obligation to buy a stock at a certain price by a certain date in the future, should the buyer execute his/her right. You collect a premium for this obligation.
Strike Price – The price at which a put or call option can be exercised.
Expiry – The date the option expires.
More Definitions To Know When Investing In Options
In The Money (ITM) – A call is said to be ITM when the underlying’s current market price exceeds the strike price. A put is said to be ITM when the underlying’s current market price is below the strike price.
Out of The Money (OTM) – A call is said to be OTM when the underlying’s current market price is below the strike price. A put is said to be OTM when the underlying’s current market prices is above the strike price.
At the Money (ATM) – A call (and put) is said to be ATM when the current market price is equal to the strike price.
Intrinsic Value – The intrinsic value is the difference between the underlying's price and the strike price.
Only options that are In The Money (ITM) have intrinsic value.
Call Intrinsic Value = Underlying Current Price – Strike Price
Put Intrinsic Value = Strike Price – Underlying Current Price
Time Value (or Extrinsic Value) – The value in excess of the intrinsic value.
Time Value = Option Premium – Intrinsic Value
Margin of Safety – The amount a stock can fall from its current market price before you start losing money.
Investing In Options Versus Stocks
For this post on investing in options, let’s assume that we are die-hard index investors, and in particular we love the SPY ETF (which represents the S&P 500 index).
When it comes to getting long an underlying, I want to compare 3 choices, all of which have their own tradeoffs. In these examples, we are going to assume you are investing with cash and not on margin. All examples are based on a 1 year holding period. We will also ignore commissions, for simplicity. Lastly, we will assume where applicable, that a full years’ worth of dividends is received.
Below is a screenshot of the SPY and the option prices used in this post for your reference:
Example #1 – Buy 100 shares of SPY @ $189.70 in October, 2015 (current dividend yield is 2.18%)
This is the example that I believe most people can understand intuitively. To buy 100 shares requires $18,970. With the SPY ETF, you have minimal downside protection, but unlimited upside.
Below is the graphical representation of the risk/reward for investing 100 shares. Notice the 1 year breakeven is $185.56, represented by the orange line. This is calculated by subtracting the dividend ($4.14/share) from the purchase price ($189.70/share). This also represents your theoretical risk per share because it is highly unlikely that an index fund is going to go bust and be worth ZERO. If this were to happen, it would imply that all 500 companies in the SPY went bankrupt.
The purple line represents the risk/reward continuum. Your reward is unlimited to the upside, as it can theoretically go up infinitely.
The only downside protection you have is the dividend you receive while you own the stock, which in this example is 2.18%. We will call this your margin of safety, as this is how much value the stock can lose over a 1-year period before you start losing any money.
Capital Required = $18,970 (the amount needed to initiate the position)
Potential Reward = theoretically unlimited upside (average return of 8% would be $1,517)
Downside Protection = the Dividend @ 2.18% or approximately $4.14 ($414)
1 YR Breakeven = $185.56 (Purchase Price 189.70 – Dividend 4.14)
Theoretical Risk = $18,556 (assuming you collected the full dividend)
Margin of Safety = 2.18% (185.56 divided by 189.70 minus 1)
Example #2 – Buy 1 September 2016 $190 Strike Covered Call for $175.77 (buy 100 shares @ $189.70, sell 1 call option @$13.93), with 364 days to expiry
Now let's look at an example of investing in options. A covered call still involves the purchase of stock, while also selling a call. It is a “covered” call because you already own the stock. When selling a call against a long stock position, I typically like to sell the ATM call or 1-2 strikes OTM (i.e. strikes above or at the current market price). These calls are going to have the most extrinsic or time value. As a seller of the call you promise to sell the stock at the strike price anytime between the time of the sale and the options expiration date.
In this example, you are selling the $190 call for a premium of $13.93, which obligates you to sell the shares at $190 to the person who bought the call if they execute (giving you an effective sales price of $203.93). Either way you get to keep the $13.93 (or $1,393).
Keep in mind it wouldn’t make any economic sense for the call buyer to execute his option unless the SPY was trading at $203.93 (his breakeven) or higher (he doesn’t start making money until the SPY exceeds $203.93).
The premium you collect from selling the call now gives you a new cost basis of $175.77 in the event you don’t end up getting exercised to sell your shares ($189.70 minus $13.93). Of course the trade-off for the reduced cost basis is capping your upside.
Let’s look at 4 ways this could play out:
1. The buyer of the call exercises his option to buy the stock from you the same day he buys the option (unlikely, but hang in there). In this case you don’t collect any dividends and you make an instant 8.1% return ($190 sales price divided by cost basis of $175.77 minus 1).
2. The buyer waits until the option expires to exercise his right to buy the stock from you. In this case you collect $4.14/share in dividends, which reduces your cost basis from $175.77 to $171.63. You have now earned a 10.7% return (190 sales price divided by cost basis of $171.63 minus 1)
3. The third scenario is that the option expires worthless, you keep the premium and your stock. Your new cost basis is $171.63 and you can do it all over again.
4. You also have the option to buy the call back at any time and keep the spread.
Capital Required = $17,577 (the amount needed to initiate the position)
Max Potential Reward = 10.7% or $1,837 [($1,393 premium + $414 dividend + $30 appreciation) divided by risk $17,163]
Downside Protection = the $18.07/share [$1,393 premium collected from selling the call, plus the $414 dividend (or $1,807)].
1 YR Breakeven = $171.63 (Purchase Price 189.70 – premium 13.93 – dividend 4.14)
Theoretical Risk = $17,163 (assumes you collected the full dividend)
Margin of Safety = 9.5% (171.63 divided by 189.70 minus 1)
Let’s look at an analogy of how selling a Call against stock would work with selling a house.
You live in the Bay Area and the market is on fire. An identical house to yours sold for $1,000,000 three months ago in your neighborhood. It was listed at $900,000 and through a bidding war went for 11% over asking. You met with your real estate agent who wants to list your house at $1,000,000 because it will likely sell for a premium. You set a goal to sell for $1,080,000.
Just as you finish placing a “For Sale” sign outside, a stranger passing by asks if you’re the owner and if the house is indeed for sale.
After you confirm, the stranger (we will call him James) explains he is in the market. He offers to pay you $20,000 up front if you are willing to hold the house for 30 days and sell it to him for $1,080,000 when he returns from his travels around the world. If you accept, you are locking in a sales price of $1,100,000 (the $1,080,000 + $20,000 fee for holding). If someone else offers you more, you can’t take it.
You agree to the offer James makes. He pays you $20,000 on the spot and now 1 of 3 scenarios are to play out:
1. James returns from his trip and exercises his option to buy the house from you at $1,080,000, you had to pass on an offer of $1,120,000 to fulfill the agreement you made with James (leaving $20,000 on the table).
2. James returns from his trip and decides not to execute his option, you keep the $20,000, and sell it to the next best offer. Your next best offer is $1,060,000 (for an effective sales price equal to $1,080,000 after you add in the $20,000 you get to keep).
3. After James decides not to execute, you find out the next best offer is at asking of $1,000,000. You decide to hold out for better prices. You just made an easy $20,000.
Example #3 – Sell 1 September 2016 $190 Strike Put for $17 (or $1,700), with 364 days to expiration
Now let's look at an example of investing in options of selling a put. Take notice that the risk profile charts for a covered call and a short put are exactly the same shape. This is because they are synthetically the same strategy.
Like the covered call, I typically like to sell the ATM or 1-2 strikes OTM. In this case we are selling the ATM $190 put for a $17 premium or $1,700. By selling this put we are obligating ourselves to buy the stock at $190 if exercised. But after you take into consideration the premium collected, our effective long price is actually $173. Again, it doesn’t make economic sense for the put buyer to exercise his option if the stock is not trading at or below $173/share.
Let’s look at 3 ways this could play out:
1. The buyer of the put exercises his option to sell the stock to you. You keep the premium and now own the stock with an effective cost basis of $173/share. You are now free to turn this into a covered call (see above).
2. The stock finishes somewhere between $173 and $190, you buy the put back for less than you sold it for and keep the difference. You make something between 0% and 9.8%.
3. The option expires worthless, you keep the premium and you have no position left. You make a 9.8% return ($17 premium divided by effective cost basis of $173 minus 1).
Capital Required = $17,300 (the amount needed to initiate the position)
Potential Reward = 9.8% or $1,700 ($1,700 premium divided by risk $17,300)
Downside Protection = the $17/share premium collected from selling the put (or $1,700).
1 YR Breakeven = $173 (Strike Price 190 – premium 17)
Theoretical Risk = $17,300
Margin of Safety = 8.8% (173 divided by 189.70 minus 1)
Let’s look at an analogy of how selling put options would work with buying a home.
This example was taken from a newsletter called “The Palm Beach Letter.”
It’s your dream home. But it’s listed for $500,000… $100K more than you’re willing to pay. The seller isn’t interested in your offer.
So, you come up with a creative solution to keep yourself in the game… You offer to buy the house for $400,000. But to sweeten the deal for the seller, you add this carrot: The seller can accept your $400K bid at any time over the next year.
The seller likes this because it gives him time to try to find a buyer who’ll pay more for his house. It also gives him reassurance he’ll still get money from you if he can’t find another buyer.
But in exchange for this new contingency offer, the seller must give you $5,000. And you get to keep this $5,000, whether or not you end up buying his house.
Now, if the seller agrees, one of two things can happen:
1. Sometime over the next year, he’ll agree to sell you the property at your initial asking price of $400K. Maybe housing prices will fall dramatically… or he’ll need to move quickly… or he just won’t find a buyer willing to pay more. In either case, you’ll get the house for $400,000. Plus, you’ll get to keep the $5,000 (an effective cost basis of $395,000).
2. He’ll never sell you the house. Maybe he’ll find someone who’ll pay his $500,000 asking price, or he’ll decide not to sell at all. Still, you’ll get to keep the $5,000. So, while you didn’t get the property you wanted, you’ll generate an easy $5,000 in income.
Volatility Can Be Your Friend When Investing In Options
Here is a quick note on volatility.
When it comes to selling options, the higher the volatility the higher the premium you can extract from the market. More premium translates into an increased margin of safety.
Here is a quick example why volatility is your friend when selling options.
– On 8/18/2015 when the SPY was trading for $209.98, the October-2015 $200 strike PUT was $2.00 (a put that was $10 OTM) = Effective long price of $198
– On 8/24/15 when the SPY was trading for $189.55 the October-2015 $179 strike PUT was $6.38 (again $10 OTM) = Effective long price of $172.62
During large moves to the downside, fear increases, which in turns increases volatility as investors look to buy protection to decrease their losses (volatility and price have an inverse relationship).
In this real example, the SPY was almost $20 lower, but because of the explosion in volatility (fear), you were able to get 3X the premium for a put that was still only $10 OTM from the current market price. I should point out that during this move the VIX went from 13.8 to a high of 53.3 and closed at 40.7.
Investing In Options Takeaways
If this is your first exposure to options, I hope you keep an open mind about the role they can play in your portfolio. For those who have been brain washed to believe that options are dangerous, I hope this gives a view of the other side of the coin. There is a difference between using options for speculation and using them to reduce risk (and thus cost basis).
Like anything in life, there are tradeoffs when selling options. In return for the premium you collect, you are agreeing to a defined upside reward, but you also are giving yourself more than one way to win. Think about the examples we went through above. In either case you make money if the SPY goes up in value, stays the same, or if it goes down until it reaches your breakeven point. That is a pretty good trade off if you ask me.
These are the two best strategies to get long stock at below market prices. With options, every day is a sale in the market.
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37 thoughts on “Investing In Options For Profit And Risk Reduction”
I sell covered calls and naked puts every week. Every premium reduces cost basis and boosts annualized returns. Getting assigned on calls and puts can be avoided by rolling. The main consideration is avoiding a margin call on the naked puts by not leveraging too much; limit the number of put contracts.
Cash secured puts are not an efficient use of capital. They will not keep up with a rising stock. Better to buy stock, sell covered calls on it, and use margin judiciously for the puts. I favor doing this on the same underlying, a covered short strangle.
The main risk is picking a bad underlying. It’s an amplified version of buy and hold. It’s safer selling puts on margin than buying stock on margin (and puts charge no interest).
After accumulating enough premiums, losses become moot; this is how casinos and insurance operate. Build up a big war chest and occasionally pay out.
I have 2 personal favorite times when I use options:
1 – Whenever I roll over money – for example, from after tax Thrift 401k to Roth IRA. The process can take 1 – 2 weeks depending on whether the 401k plan administrator agrees for a trustee to trustee transfer or I have to take the proceeds and deposit into the Roth IRA.
I would not want to be ‘out of the market’ for those 1-2 weeks. I simply buy call options on the day the stock is sold in my 401k.
2 – Tax loss harvesting: In some good years, there is no stock position that has a loss. Then I would buy two sets of options (usually in November) – these 2 sets will have opposing bets. Say one will profit if SPY gains value, the other will benefit if SPY loses value. After a couple of weeks, one set would invariably be making profit and the other making loss. I try to exercise the set that is making profit and sell the one that is making a loss.
Dom/Gen Y Finance Guy – In example #2 (covered call), why does the purple line cross the x axis at about $182 rather than $189.70? Come to think of it, are you able to point me to anything (good) with further detail around those graphs and their makeup?
Also if anyone else is interested, I found this document provided a nice simple introduction to some other option strategies (#23 is the covered call, and #2 the short put):
That is a great question that I didn’t even think to cover.
The purple line is the CURRENT risk profile based on current market prices, volatility, and days to expiration.
The blue line is the risk profile of the position at expiration.
You can see that the purple line has a date of 10/6/15, which was the day I ran those. Basically what it is saying is that if the breakeven of your position if the stock were to tank that day would be around $182 assuming all other variables remaining constant.
However, in reality this would be a moving target. As a decline that fast with create an explosion in volatility.
These screenshots are from my Think or Swim platform that I use through TD Ameritrade. You can sign up for a free account to get access to them. They are great in visualizing P&L at different prices…they also have a built in options pricing calculator, to run what if analysis.
Hope that helps.
I am having a though time in wrapping my head around the below statement. May be I am missing something very obvious.
“Keep in mind it wouldn’t make any economic sense for the call buyer to execute his option unless the SPY was trading at $203.93 (his breakeven) or higher (he doesn’t start making money until the SPY exceeds $203.93)”
Since he has already paid the premium of 13.93 for buying the call option wouldn’t it make sense to exercise the option as long as the market price is more than the strike price of 190?
Your right in thinking that the option still has value (if it is ITM by expiration), so it wouldn’t make sense for the buyer to just let it expire worthless.
But due to transaction costs, it is usually best to just close the position by selling it back for its current value (keeping the spread, or in this case salvaging at least some of the value paid for the put option).
Does that help?
Selling options can make you a lot of money if you are very careful. Most investors have little understanding in how to make consistent monthly income with options. The key to successful trading with options is using strategies that work well in any market and have minimal drawdowns. As long as you know and understand the risk of what you are trading, do not put all your eggs in one basket, practice good risk management, take small losses before they become big losses, then you can make money over the long-run.
My personal problem with options is that it makes one take a short term view of the market. The view is always around some arbitrary expiration date. I like to look more long term, set it and forget it. I have friend(s) that mess with options and every trade revolves around that expiration date. Talking stocks with them is always a little different.
AAB – They have long dated options that make it easy to set and forget. Even Warren Buffet sells puts and calls.
I regularly sell options that are a year out, but only on things I would not mind owning (index ETF’s or Blue Chip Dividend stocks). A perfect example is when markets are at all time highs. I never want to get be the guy that buys the high in the market…so instead of sitting out of the market I will sell an OTM put option that allows me to participate from “lower” prices.
When I traded for the oil company, I was much more aligned from one option cycle to the next. But I tend to like the set and forget as well. I typically sell anywhere from 90-days to 1-year out.
Yeah, makes sense. I couldn’t predict to know anything 90 days to a year out. It’s a little easier for me to think 5, 10, 15 years out. Do I want to own something 5, 10, 15 years from now, if yes then buy now. I do get that there are options strategies that can allow you to accumulate underlying stock to hold long term but it’s just simpler for me to buy outright.
Thank you, thank you, thank you for writing this article! I’ve been curious about options for quite a while now, but they are still like a foreign language to me. I mostly understand the concepts if they’re written down and I have a lot of time to mentally process them, but I haven’t gotten good enough at it to be able to understand what “native speakers” are saying at their normal speed of talking. I know I will have to re-read this article at least another dozen times before I totally get it, but you did a great job of simplifying it as much as possible, so thank you so much for that.
Yetisaurus – I am so happy to hear that. Sometimes I wonder if I simplify enough. Really want to do a good job like Sam does in taking the mystery out of finance. It doesn’t have to be complicated.
If you ever have any questions, let me know.
“Again, it doesn’t make economic sense for the put buyer to exercise his option if the stock is not trading at or below $173/share.”
I’m not sure that I agree with what you’re saying here. Once the buyer has purchased the put their premium is gone. Now all that should they care about is the strike price. If the index is selling for anything less than the strike ($190 in this case) it makes sense for them for exercise the option. Sure they’ve lost money on the whole operation, but they lose more money if they don’t exercise. It always makes sense to exercise an in the money option at expiration, regardless of the premium paid.
If anyone can show me that I’m thinking about this the wrong way I would appreciate it!
Hey Joshua – Once you purchase a put, the premium is not gone for ever. It still has value up until expiration. The buyer can sell that put back into the market at anytime from when he buys it and expiration.
It is cheaper from a transaction/commission perspective to just sell the option back out in the open market vs. exercise. You still get to extract the spread between what you paid for the option and what you sold it for.
The same is true when selling options. Let’s say you sell a put option for $5 today and a week from now it is going for $4…you can close your position by buying back the options and pocketing the spread of $1. The same is true at expiration. For me it cost $15 for exercising options…or $0.75 to just buy it back, so in this example I am just better off to buy it back (and save $14.25 in commission)
Back to the buyer of the put. You also have to think about whether that buyer is a speculator with not stock or if they were protecting a position. If they are a speculator they likely have now stock to put to you by exercising their option.
Hope that helps.
Thanks, but I’m not sure that I understand. The original post said that “it wouldn’t make economic sense for the buyer to exercise his option if the stock is not trading at or below $173/share.” Why not? This put is in-the-money below $190. Regardless of the initial premium paid I don’t see how it would it make economic sense for the buyer to let an in the money option expire worthless.
I’m by no means an expert, but I have used a buy-write strategy and sold cash covered puts. It has been my experience that in-the-money options are always exercised.
I should say young side boomer / old side X (Both a boomer and an X as they overlap slightly as such I choose to identify X, but Sam would just call me a geezer)
Great article. Options always seemed scary (risky) to me. You have made covered calls seem rather pedestrian. Thanks for the knowledge sharing with simple examples especially using the mother of all Indexes. I may have to meander over to your Gen Y site now… are you Gen X friendly? or do you make fun of us old farts too. ;-)
Would love to have you. Gen X, Gen Y, Baby Boomers, we take them all :)
Glad this example helped simplify things for you.
Thanks for reading & commenting.
Dom, thanks for your post.
I guess my main question is: why wouldn’t someone sell calls at a premium all day long? It’s a guaranteed profit. Sure, you will miss out if the stock zooms higher, but if you have a system of always selling calls, how do you lose?
Well, if it’s not covered (i.e. you don’t actually own the stock), then you could lose pretty badly if the stock soars higher and you need to buy it to cover or close out your position at a loss. If it covered, then there’s not much downside risk, but you’re essentially selling your upside potential, which might make sense for some people.
I appreciate that the article’s summary points out how a lot of people have been brainwashed into thinking options/derivatives = bad. They’re actually designed to reduce risk and will effectively do so if used properly. People who solely criticize their usage simply don’t know enough about them.
This is an excellent point (re options getting a bad name). I sell calls, both covered and naked, when it makes sense and will also sell puts when it makes sense.
Still, this is not a domain into which most people should tread. It can be very dangerous. When used correctly, options can mitigate risk, when used incorrectly, or if something moves against you, you can feasibly create unlimited risk. A protective put is a decent idea when you’re up big. I only sell naked calls when a trend is down, like in oil, and I only sell puts when I think something has bottomed or I am willing to be assigned at a given price.
Anecdotally, check out the guy that shorted a penny stock on margin and opened a go find me account when he lost his shirt yesterday. I believe he shorted KBIO. Horror stories do happen.
I think a big point that should be pointed out is that you are trading options to speculate.
But I think it is important to point out the difference between investing with options and speculating with them.
What I was trying to suggest in the article was that selling a cash secured put or writing a covered call was a alternative way to get long a particular underlying.
In these examples there is no extra risk, in fact, your risk is less than if you were to just buy the stock without selling any options. The trade off is the capped upside. In return for giving up upside after a certain price, you get downside protection…which effectively gives you a lower cost basis.
I agree that you can use options in a way that could blow up your account. But the cash secured put and covered call are not ways you will be blowing up you account.
That’s not to say you can’t still suffer losses. However, I would much rather have a breakeven point that is less than the current stock price at order entry. When you buy a stock/etf your breakeven is the price you paid. When you sell a cash secured put, your breakeven is the strike minus the premium (below the current market price).
Could not agree with you more K-Man.
Because the premium pricing balances the trade, and is based on the likelihood of stock price movement and the time frame.
This is like asking why you can’t make money all day long with a “system” of betting on the Patriots to win. The point spread balances risk vs. payout.
I use options every now and then, but they’re a tool to bet on a specific stock price movement… not an arbitrage opportunity.
Great point. I bought Dell puts in the Silverlake-shareholder fiasco. Lost my entire bet. But, the bull case was valid and I had a marginal outlay against potential gains. Event driven bet, not just gambling.
But the Warriors just can’t lose! Life savings on an 82-0 season for 1,000:1 odds!
Sam – In very low volatility environments the premium could hardly be worth selling. But as long as you are covered every call you sell against stock is a cost basis reduction, just as a dividend in effect reduces cost basis.
I never hold stock positions that don’t have calls sold against them. Sometimes I just have to go further out in time to get a decent premium.
The boggie is that the market declines faster than you can offset the declines with short premium. Which would effectively force you to lock in a loss by selling a call against your shares.
Example: Lets say you write a $25 Covered call on MSFT. For simplicity sake we will say that MSFT was $25 at the time and you were able to sell the $25 call for $2.
At expiration MSFT is down to $15 (loss of $10/share or $8 for you when you consider the premium collected). The $25 call expires worthless and you keep the $2, but when you go to sell another call you need to be able to make $8 just to get back to even.
The $15 call may only be trading for $1 (and that’s generous unless volatility is elevated). That doesn’t work because you would be locking in a $7 loss. You go out to the $23 strike and realize that it is so far OTM that it is only trading for a nickle…hardly worth selling just to break even.
So, that is the downside to selling covered calls.
This has definitely happened to me, and in some cases I will roll down and out…meaning I will buy the call back at a cheaper price that I paid, sell a call that has a lower strike, with more time to expiration. It’s not fool proof, but it is still a great strategy.
For me, it’s the jargon that scares me away from options. I want to be sure that both parties are saying and understanding the same thing when money is on the table. So this really helped. Thanks.
Glad you found this helpful Adam.
Financial industry has a way of making things much more complicated than it needs to be.
Thanks for the detailed look into options. Personally, I’ve never traded any type of option before. I suppose it’s because I didn’t want to take the time to try to figure them out. It’s good to know there are options out there on SPY and not just on single name stocks. Dom, how much time do you usually spend researching an option versus a stock or ETF before deciding to trade it? Curious if it takes you significantly longer or not as I have no experience. Thanks!
I don’t spend much time at all looking at options vs. stock. I personally always either have calls sold against any long positions and/or I sell puts in names that I am interested/willing to get long if exercised…but am also just happy to keep the premium and move on.
Personally, there are only a handful of stocks that I watch and sell options on. They are either index ETF’s like SPY and/or Blue Chip Stocks that pay dividends.
I spend about 30 minutes a week watching my account and looking for opportunities. Looking for relatively high Implied Volatility rankings and big down moves to find opportunities.
People have made a lot of money short strangling SPY. I don’t have the guts for a 2009 event to wipe me out after six years of up and to the right SPY.
Austin – short strangles are much different that cash secured puts and covered calls.
Your risk is theoretically unlimited with strangles, well at least to the upside (or call side of the position).
You could always hedge both ends by buying a long put and a long call for the wings and then you have yourself a defined risk Iron Condor. No risk of getting wiped out.
And again if I didn’t make it clear in the article, I am not suggesting people go and sell options on margin. If you have no intention/interest of owning the stock, then you probably don’t want to follow these strategies.
But it is an alternative way to get long exposure in the market and ensure a reduced cost basis relative to the market price at the time of sale.
Selling puts and naked calls requires level 4 broker approval. The risk is very high. I would advise against anyone tiptoeing into this market without thinking “I may lose everything and bankrupt my family, should I proceed?”.
Spreads are likely a better alternative for most. There are short volatility and long volatility strategies available which can afford a limitation of risk. In general, stick to covered calls unless you’re willing to be either assigned or file for bankruptcy.
I am not suggesting that people go out and sell puts using margin. Instead sell cash secured puts. This is something very easily done in a IRA account (you don’t need level 4 broker approval).
There is no more risk in selling a cash secured put vs. buying the stock outright. In fact by selling an OTM put you will actually be taking on less risk, by reducing your effective cost basis of the stock by the amount of premium you collect.
I think you are generalizing and assuming that everyone that sells options is speculating and using margin to do so.
Also from a risk standpoint a short put is a synthetic covered call.
Not trying to be rude but your comment is not true.
You’re right. I think a naked put is level 3. I was wrong about that.
I am not hating, I just think people should be cautious. Even a cash secured put can result in 100% loss. I am short the 56.50 put on APC right now. Wish me luck for the next half hour!