Covered call writing and selling cash-secured puts are more conservative strategies than trading naked options (selling calls and puts without having the resources to execute the potential trade obligations, if exercised). A naked call occurs when a speculator writes (sells) a call option on a security without ownership of that security. It is one of the riskiest strategies because it carries unlimited risk as opposed to a naked put, where the maximum loss occurs if the stock falls to zero.
Naked call example
An at-the-money $30.00 call option is sold without first owning the underlying security. Our obligation is to provide shares at $30.00-per-share if the contract is exercised. If share price rises to $50.00-per-share by expiration we are obligated to buy the shares at market ($50.00) and sell at the strike price ($30.00). Since the upside is unlimited, so is our risk.
Naked put example
An at-the-money $30.00 put is sold without first shorting the underlying security (borrowing shares from our broker and selling them at current market price). We are obligated to buy shares at the strike price. Share price can theoretically move to zero defining our risk at the strike price minus the put premium. If the stock was initially shorted, the option risk is lower and defined but there is unlimited risk in the shorted position should the stock price accelerate. Shorting is not a strategy for most retail investors and that’s why we stress cash-secured put-selling and keeping our arsenal of exit strategies on alert.
Conservative approach: Covering our positions
Covered call writing obligates the call writer to sell shares at the strike price, if the call buyer decides to exercise the contract (s). Since the underlying shares are owned before the option sale, the cost basis is known and potential loss due to exercise is measured and known. For example, if we bought shares for $28.00 and sold $30.00 calls and later share price moved up to $40.00, we would be able to relinquish those shares at a profit. If we didn’t first own the stock, we would be required to purchase at the market price of $40.00 and then sell for a significant loss at $30.00.
Selling cash-secured puts obligates us to buy shares at the strike price if the option holder decides to exercise. If share price is $32.00 and we sell the $30.00 put for $1.00 and then stock price declines to $15.00, we would be required to buy shares at 30.00 per share for an unrealized loss of $14.00 per share [($30.00 – $1.00) – $15.00]. Of course, our position management trade executions (like the 3% guideline) will mitigate losses in situations like this.
Risk-Reward profiles of long calls and puts
I never liked these graphs because they are deceiving to newbies. It appears that upside is unlimited and downside limited. However, the downside is limited to 100% of our investments. A better way to state the conclusion, is that there is less capital risk with options but we must also understand that our entire investment can be lost.
Risk-reward profiles for short calls and puts
Once again, the graphs are deceiving to the beginner. It appears to show limited upside with unlimited downside. The charts do not take into consideration position management opportunities that should be executed when trades turn against us. Also, with covered call writing, we own shares at a known cost basis to mitigate to the upside and in the case of cash-secured puts, we have the resources to execute our trade obligations should share price move below the strike in addition to exit strategies where option positions are closed when trades turn against us.
Why covered call writing increases our chances of winning trades
Nobody, I mean nobody, can reliably predict the price movement of a stock in the short run. There are way too many factors that influence price movement and no matter how sophisticated an algorithm is, it cannot be relied upon 100% of the time. This includes the guys who scream the loudest on TV and radio. Many offer very valuable information but nobody knows for sure. That said, we can certainly throw the odds in our favor by mastering the 3 required skills for option trading…stock selection, option selection and position management.
Looking at worst case scenario and assuming that the odds of a share price moving up in the short-term is 50/50, we can make a case that covered call writing, by definition, increases our opportunities for a winning trade. The reason has to do with the option sale. In essence, this aspect of the trade lowers our cost basis and so we can realize a capital gain even if share price declines by less than the option premium. The tradeoff is that upside is limited by the strike price. So let me go back to my baseball analogy which I have used frequently over the years: covered call writing is a strategy where we will never hit grand slam homeruns. But we will hit singles and doubles all day long.
Naked option trading involves selling call and put options without owning the underlying resources to execute our trade obligations. Risk-reward profiles can be deceiving when deciding on appropriate strategies as covered positions are safer and more in alignment with those who have a conservative, low risk tolerance.
Next live events
Global stocks showed moderate increases this week along with lower volatility and stable interest rates. Volatility, as measured by the Chicago Board Options Exchange Volatility Index (VIX), dropped to 11.28 from 14.75 a week ago. The price of a barrel of light sweet crude oil was little changed, at $47.55 versus $47.20 a week ago, despite potential supply disruptions from Hurricane Harvey. This week’s economic and international news of importance:
- According to media reports, senior Trump administration officials and congressional leadership have agreed on an outline for significant reform of the US tax code. The framework includes lowering individual and corporate income tax rates while phasing out popular deductions
- The US Department of the Treasury levied new economic sanctions on several Chinese firms and a Russian firm, as well as Chinese and Russian individuals, for helping supply materials to North Korea’s nuclear and ballistic missile programs
- The synchronized global economic recovery that began about a year ago continues with global purchasing manager’s indices showing that growth is holding firm in most major economies
- Europe showed a strong rise in manufacturing-sector output while in the US the service sector showed strength
- US Federal Reserve chair Janet Yellen spoke on financial stability matters, but did not touch on monetary policy, appearing to favor a more dovish policy on future interest rate hikes
- Gulf Coast refineries are preparing for the potential devastating impact of Hurricane Harvey. Oil and gasoline markets are little changed ahead of the storm’s landfall.
- According to the Wall Street Journal, the US government is considering a ban on the trading of some Venezuelan debt by US-regulated financial institutions
- With 475 of the 500 members of the S&P 500 Index having reported, second quarter earnings are expected to increase 12% compared with the year-ago quarter. Stripping out the energy sector, earnings growth is seen at 9.4%
- Revenues overall are expected to increase 5.1%, 4.2% excluding energy
THE WEEK AHEAD
Mon, August 28th
Tue, August 29th
- US Case-Shiller home price index
Wed, August 30th
- Eurozone sentiment index
- US Gross Domestic Product
Thu, August 31st
- Japan industrial production
- China purchasing manager’s indices
- Eurozone unemployment, consumer price index
Fri, Sept 1st
- US: Employment report
- Global manufacturing, purchasing manager’s index
For the week, the S&P 500 moved up by 0.72% for a year-to-date return of 9.12%
IBD: Market in confirmed uptrend
GMI: 2/6- Sell signal since market close of August 11, 2017
BCI: I am currently favoring in-the-money strikes 2-to-1. Next challenge for the stock market is Hurricane Harvey
WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US
The 6-month charts point to a neutral outlook. In the past six months, the S&P 500 was up 3% while the VIX (14.28) moved down by 7%.
Much success to all,
Alan and the BCI team