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Basic Strategy

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We are fast approaching September expiration so I want to go through the foundation of the Option Writer strategy. I play blackjack and poker mostly when I go to Las Vegas. If you have played either you know that there is a basic strategy that everyone is supposed to play. For instance, basic strategy says to always split aces and eights. It also says to always double on an eleven. Basic strategy gives the player a foundation to base bets. While I don’t believe selling options is gambling it does share some general concepts including: probabilities, timing, position sizing, money management, etc. Unless you count cards and bet accordingly, the house has a slight advantage (roughly 2%) over the player. However, with option writing we can increase our advantage with tools like probability and technical analysis. As I see it we have an opportunity to sell put and/or call options on up to 10 stocks or ETFs a month. If we are only selling one contract per position then we can probably get away with using less than $10,000 for the cumulative margin requirement. However, I like to even out each position's exposure as much as possible so it means that at a minimum you need $15,000 for the initial margin. That doesn't mean that the actual margin will stay the same. If you have been selling options you know that the margin requirement adjusts according to the underlying stock and option's prices.

I used to write about the basic strategy as if we were willing, on a worst case scenario, to be assigned the shares. However, it required me to track two methods of position size and return calculations. I still set the target allocation to an assigned level, which is currently $10,000 per position. For instance, sell 3 contracts of the October 35 Put for $0.70 would require $10,500 if the put is assigned. The assigned cost is also referred as the notional value. Therefore, if we sell 10 positions with an average of a $10,000 notional value then the total portfolio would cost about $100,000 to buy all of the positions on assignment with cash or $50,000 with margin. While there isn't anything wrong with selling options to get assigned, I don't run the option writer strategy to get assigned stock. If I wrote the Covered Call section, I would use selling puts as an entry into the next month’s position.

Our goal is to write put and/or call options on up to 10 stocks per month. Sometimes we end up selling more because risk maintenance allows us to cover the short option position for a profit or risk management forces us to take a loss at one of our predetermined price levels. For instance, some positions are stopped out at the strike price, the cost basis, a technical level or at a loss equivalent to the max gain multiplied by -1. Our profit goal is $200 per position at the minimum allocation. I present the number of contracts as a guideline for a hypothetical $20,000 account ($15,000 - $17,000 for margin plus $2,000 for portfolio fluctuation). If your account is less, then adjust the quantity on the lower priced stocks to fewer stocks. Otherwise, take your Option Writer allocation and multiply it by about 5 to get the total notional value. Then divide that by 10 to get the assigned value per position. For instance, you allocated $75,000 for the strategy. That means that the total notional value is $375,000 ($75,000 x 5) and the position size equals $37,500 if assigned. Finally, if we are selling the October 65 Puts then we will be selling 6 contracts ($37,500 divided by $6,500 = 5.7…round up). Therefore our basic strategy is to sell call options on weak or overbought sectors and puts on strong or oversold sectors. We may sell both calls and puts to create a more neutral position (strangle). Our goal is to sell options on up to 10 positions a month and profit on roughly 70% of the trades while keeping the losses to a minimum.

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