In part 2 of the Option Writer review I am going to cover why we trade this strategy. We sell premium for three reasons: 1. income 2. hedge 3. lower cost basis. For those of you looking to create income, then the Option Writer newsletter is for you. We aren’t discussing selling options against existing positions or creating covered calls or calendar spreads. Lowering one’s cost basis is helpful for those selling put or call options with the intention of being assigned the shares at the strike price.
Selling options naked or uncovered requires margin. Margin is simply the cash that is required as collateral in case the position goes against you. The required margin isn’t enough capital to purchase or short the underlying stock but provides a good faith amount based upon 20% of the assigned price less the out of the money plus the premium. When I started writing (selling) options, I used to calculate margin on each position by creating a spreadsheet. Today most option trading platforms calculate the buying power effect or margin requirement as a nice service aimed at better trade cost disclosures and to speed up trading. I recently fielded a question regarding the differences between writing options versus selling vertical spreads. The simple answer is that as the price of the underlying stock increases the average margin requirement also increases faster than the average initial premium/return. Therefore, the margin requirement is higher on pricier stocks because the calculation is based upon 20% of the underlying stock’s price. Furthermore, the higher the stock price requires us to compare vertical spreads to selling the put premium to determine the risk/reward of each strike.
One other note on initial return is that it is really based upon the initial premium (also referred to as the max gain) divided by the initial margin. Because margin is elastic the max return as a percentage is constantly changing. Calculating return is all arbitrary until the option either expires or is closed out.
Finally, I am going to cover strike price selection by discussing the probabilities of the stock closing in the money. A quick and easy explanation to determining the probability is by looking at the strike price’s delta. For instance an option with a delta of 0.26 has a 26% chance of closing in the money on expiration. Let’s be frank here, the market makers are bookies placing odds on the stocks. Whether in sports betting or in option trading, becoming a good handicapper is very important to establishing a good track record and being profitable. Determining the proper strike price requires us to determine the probability of assignment and measure that against the max return. For instance if the probability that the stock will be in the money on expiration is 29% and the max return is 21% then the trade isn’t providing enough return for the risk. I hope this helps.