Option Investor

Option Writer Update

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Over the last few weeks I have been thinking of the best way to review the strategy of Option Writing. First of all, we need to establish some terminology. The newsletter is Option Writer but we are selling options or shorting calls and puts. I sure hope everyone understands by now that selling a put is an obligation to buy the stocks at the strike price should the put buyer either exercise thier option early or it be automatically assigned if the option closes only a penny in the money on expiration. Selling a call is the opposite in that it is an obligation to sell the stock at the strike price should the call buyer either exercise thier option early or it be automatically assigned if the option closes only a penny in the money on expiration. When we close out a short call or put we are buying the option thus neutralizing the position. Initial Margin only represents the amount of money necessary to create the position. Max gain is the estimated maximum gain should we hold the position to expiration while the option stays out of the money. The assignment value represents how much capital the option posiition will require should it become assigned at expiration (Short Put = Buy the stock; Short Call = Sell/Short the Stock).

Now that we have that behind us, we can discuss the fun part of selling options. We sell options because the potential return on capital can be very high relative to buying or shorting stocks. In general, we can sell options for about 10 - 20% of the capital normall required to buy or short the shares of the underlying asset. We write calls and puts to generate the initial premium with the goal to profit from directional movement as well as time decay. Option writers can be conservative or very aggressive. The more aggressive the more likely the trader will get a margin call. For instance, let's assume that you have $20,000 in your account and you sell 18 puts against a $55 stock. The initial margin is $19,600. Should the stock decline to $54, the margin increases above $20,100. All of a sudden you get a margin call to either send in more money or close out part of the position. While the stock hasn't broken any of your risk management parameters you are forced to close out a part of the position for a loss.

My goal is to provide you with 8 to 10 stocks/ETFs per month to put into your portfolio. I try my best to diversify accross a few industries the first few trades. The reason is that some of you can do 5 positions while others can do 50. My other goal is to make it so that 80% of the trades are profitable. Sometimes that is hard to do but we have to try. The other aspect is to select the proper strike prices that provide the highest profit probability while achieving a minimum return goal. My return goal is set to be a minimum of 10% max return (10% on the initial cash requirement). I have been doing this strategy for a while and have found that setting up the average to be greater than 15% with a couple of outliers at 11% and 25% gives me the best return and the best probability of return for the risk taken.

So far I have been discussing this strategy as if you were prepared to be assigned all of the stocks. That isn'y exactly what this newsletter is about. However, that is the necessary realization of selling options; there are consequences to your actions. So the worst case scenario is that you have to pony up the cash to buy the stocks assigned by the puts and short the stocks assigned by the calls. But the reality is that most brokerages provide same day substitution. For instance, buy the stock and sell it in the same day without having to deposit or allocate the capital. Another way to execute the strategy is to set aside risk capital to margin to the max. For instance, using the previous example of a $20,000 account we could concievably sell options against 10 positions. With an average margin requirement of $1,800 and an initial premium of $200, the total margin requirement would be about $18,000 and the cash requirement would be $16,000. This allows for about $4,000 of downside fluctuation before the margin desk begins calling. I don't know about you, but I would rather talk to a phone solicitor. Early in my carreer I used to make those calls to other brokers and thier clients. I built the conservative strategy because I wanted to avoid the possibility of a margin call all together. With all of that being written we are going to continue to present the conservative method (for now). The aggessive method can be implemented easily on your own. Just take your account value and multiply it by 90% to determine the total intial margin. Then divide that by the average margin per contract which will be provided on the position summary I send out each week. That will let you know how many positions you can trade. For example, you have $10,000 and $9,000 available intial margin. If the average margin per contract is $1,200 then you can trade 7 of the 10 positions. If you have $80,000 you can trade all of the positions with $72,000 of it. The average number of contracts per position is 6 ($7,200 / $1,200 = 6).

Let's have some fun next time and go through the process of a hypothetical analysis of a new position.

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