Options Trading Explained-Writing Options

This is the second article of our options trading explained series, in which I will attempt to help you learn options trading strategies as opposed to restricting myself to a generic explanation of stock options. In the earlier post I explained stock options trading in terms of simply going long, or buying, puts and calls as the simplest but most risky of stock options strategies. In this article I’d like to talk about selling or writing options as it opens up a range of possibilities for an investor to improve the overall performance of his portfolio.

When you move beyond thinking of options only as leveraged, risky investment vehicles you begin to understand them as savvy investors and professional traders do, ripe with opportunities for conservative option strategies. There are many ways to use them besides either making multiples of the premium you pay or losing most or all of that premium. I’ll cover options trading examples like writing puts and calls, which affords you hedging options (as it were) that can help you protect existing gains in open stock positions; you could sell options to create an ongoing income from your portfolio without having to sell stock at all; you can even offset losses in stock positions you are not yet prepared to close out, by writing contracts against those long or short positions. All these trading strategies involve simple options selling, and these are just a small fraction of the ways that you can use these incredibly versatile investment tools, once you get stock options explained to you.

Writing Options As A Simple Hedge

Let’s say that you have a nice profit in a stock that you would prefer not to sell yet. Maybe it’s had a run-up recently, and while you are still bullish on the company, your practical side tells you that the stock might very well be due for a pullback.

In addition to the optimism reflected in the stock price, it seems like the options associated with the stock have relatively pricey premiums, with even the out-of-the-money options costing more to buy than they normally might.

For an investor contemplating buying options, this is a risky situation. If you bought, or went long calls here, not only would the upward stock move have to continue, the volatility in the stock has to stay relatively high, or you will see time value decay eat away at the value of your long calls. Let me be clear: buying, or going long, calls after a vigorous upward move (or going long puts after a spike down), is a great way to lose money with options, as you are buying time value in the premium that is bloated by the general excitement surrounding the stock. Even if the stock continues upward, if it does so at a slower rate, you might even see the premium fall! Most options neophytes have a story like this, and unfortunately many of them are unaware of the dynamic that hurt them, i.e. the decreasing volatility, and how the trade had odds stacked against it from the beginning, just when they (and everyone else) thought they had a sure thing.

Could you still make money as a buyer in this situation? Can’t the stock continue higher? Who can say for sure that the stock rose so fast that the options premiums are too inflated for a user to make money? The answers are ‘Yes’, ‘absolutely’ and ‘No one’. It’s nearly impossible to quantify the odds of success for the buyer here; suffice it to say that it is a trade with a low probability for profit, from the buy side.

Why have I gone into such detail sketching a tough buy-side trade? Well, what if you could take the other side of the trade from excitable ‘retail money’ who saw a headline and threw some money at some calls or puts (depending on whether the stock has just moved up or down, respectively) just like they might in Vegas? Selling covered options, a conservative options strategy, is precisely how you can accomplish this, and as a person who owns shares that have already seen a run-up you are in a perfect position to do so.

You can sell, or write, covered calls. (For the sake of simplicity let’s talk about a stock you own that is rising. The dynamic for puts is the same for a stock you are short that is falling.) They are ‘covered’ because you own the stock that you would be obligated to deliver as the seller of the calls.

Here’s a real-world example. On October 12, 2010, NFLX stock closed at 155, having moved up from 95 in 10 weeks or so. Let’s say you bought 100 shares at 100 so you are ecstatic. While many people might simply sell or hope for the best, you could write a November 175 call, presently priced at 5.40, collecting $540 against the 100 shares that you own. If NFLX is at 175 or higher at the close of trading on November 19th, 28 trading days from now, you’ll be obliged to deliver your shares to the owner of the call you wrote for $175 per share.

It is certainly possible that this could happen. You would be left with a huge percentage gain that occurred very quickly, plus the $540 premium you collected from the call buyer.

On the other hand, selling the right to gains in the stock beyond 175 before November 19 for $540 might be something you’d be willing to do. After all, exiting the position after a further $20 run-up still leaves you with a big profit. And if the stock drops, this trade lowers your cost basis by about 5.5 points. Selling options involves diametrically opposed financial goals from buying them, as well as a distinctly different psychological relationship to the passage of time, for the investor. Every that the call buyer doesn’t get a move in the right direction is a day where time decay occurs, whereas for the option writer, even a flat day sees decay in the time value of the option, which for an out-of-the-money option with no intrinsic value means the contract’s value gets closer to zero.

You can see that with call writing as an options trading strategy you participate in a move higher, and you also buy protection against a move lower. This is a strategy where you limit your potential gains in return for buying protection. Writing covered calls in this way with a tight trailing stop loss would ensure that before November 19 you will do no worse than the value of your position right now, and you could do considerably better. Naturally you can close out the position any time you’d like to; if the stock simply lingers at 155 for instance you will see a drop in the premium as a result of decaying time value as well as declining volatility. Your likelihood of profiting one way or another from this trade is the inverse of what the call buyer needs to see as soon as possible to make money. In plain English this means that of all the things that could happen between now and November 19th, the call writer has a much better chance of waking up November 20 with a profit from his position than the buyer. The call seller doesn’t stand to make multiple of his investment as the buyer hopes to, but if you approach this transaction with a conservative mindset you’d very probably be on the ‘sell’ side of it.

Writing Options For Income

Now for the sake of argument let’s say that when November 19 rolls around FLX is trading at less than $175 per share. The calls you have written have expired worthless, out of the money. You get to keep that $540 premium that you received from the call buyer. Depending on what the stock has done you have a paper loss or gain relative to where it was trading on 12 October. Let’s say that the stock has been fluctuating and you still believe that it has further upside, so you do not want to sell yet. Why not employ the same trading strategy again? You could write another call contract, December for instance, and receive another premium amount. This further lowers your cost basis, which when added to the premium you’ve already received constitutes further protection. If the stock ends up being called away from you at whatever strike price upon which you write the new option, the situation will be the same as it was in the previous example, except that you have collected an additional premium.

Many savvy investors and professionals use this sort of ongoing protection/premium collection as a way to get an income from an existing stock portfolio in addition to any dividends one might accrue through stock ownership. This is definitely not a “set and forget” option trading strategy, and to do this indiscriminately with a large part of one’s portfolio is folly. One of the oldest trading adages is to cut your losses and let your profits run, and writing covered out-of-the-money calls means that you are less likely to see very large gains in individual stocks that you own. After all, in the long run you do stand to see some trades that work better than you hoped, that result in multiples on your original investment.

Still at certain times, such as when the market or an individual stock has had a very fast run up, it can be prudent to write some covered calls on some of your stocks, in the name of securing a return as insurance against potential pullbacks, which obviously tend to occur.

My goal with this site is changing toward getting the basics of options trading explained to laymen, in the hope that a fuller understanding of the wide range of stock option trading strategies will make investors less inclined to recklessly speculate with options. Even investors who are very conservative can make use of options strategies by which they can reduce total portfolio risk by writing options, once they have the details of options trading explained properly to them.