You walk into your local stationery store and pull out a $20 bill. “Give me 20 state lottery tickets, please.” You can’t help but dream of all the riches that $20 investment will provide to you. After all, the grand prize is up to $25 million dollars. You even go so far as to compute the money left over after taxes! Some of you (and you know who you are) are formulating the manifesto you will present to your dreaded boss after the drawing (stop smiling and admit it!).
You are now the buyer of a decaying asset. When that drawing takes place, you will either be incredibly wealthy or more likely your ticket will expire worthless. Your brain tells you that the latter situation will occur, despite the fact that your heart told you to do the deal. Come Sunday morning, you are back in the stationery store, reaching for another $20 bill hoping to make up for last weeks losses.
So what does this scenario have to do with selling covered call options? I always allude to this strategy as a safe form of investing (although there is some risk in the stock). The government concurs with this opinion as we are allowed to use it in our self-directed IRA accounts. We are selling an asset that is at the mercy of time decay. Better yet, the greatest amount of time decay occurs as we near expiration Friday and we sell predominently 1-month options. Every expiration Friday, 80-90% of all options expire worthless! Would you rather be the buyer or seller of a decaying asset? When we sell covered call options we are the state collecting money for lottery tickets. We are the casino running the business of allowing gamblers to throw their hard-earned money into the slot machines (sorry Mom!). Sure the state and casinos have to “pay up” from time to time, but that is expected and inherent in a system that generates small but consistent returns over and over again. Based on this concept, I am asked at all my seminars, “why then are there option buyers?” The answer lies in the lure of the big return. The casinos and lotteries are still in business, aren’t they. We are happy with our 2-4% monthly returns, others aren’t.
Let’s create an example and look at it from our perspective and from that of the option buyer (aka the gunslinger):
The Option Seller (You and me):
1- We buy 1000 shares of company XYZ @ $48 per share for an investment of $48,000.
2- We sell 10 contracts (100 shares per contract) @ $2 for an option return of $2000.
3-We have generated a 1-month return of 4.2% (2000/48,000) or 50 % annualized.
4- If our shares are assigned (pass the $50 strike with no exit strategy invoked) we double our profits as we garner another $2000 on the sale of the stock (1000 shares going from $48 and sold @ $50). This computes to an 8.3% 1-month return. Now that’s pretty impressive but let’s examine the motivation of the option buyer (holder).
The Option Buyer (aka, the gunslinger):
1- Purchase 10 $50 Call option contracts for company XYZ @ $2 for an investment of $2000.
2- If the shares appreciate to (let’s say) $54 by expiration Friday, the option value has $4 of intrinsic value ($54 – $50) and will have at least doubled in value. Stated differently, the buyer can exercise his (her) right to buy those shares from us @$50 and turn around and sell them at market for $54, thereby generating a $4 per share profit or $4,000 for the 1000 shares. Let’s deduct the option premium of $2000, so the real profit is $2000. This represents a 100% 1-month return or 1200% annualized. Of course, there is no limit to the amount of money the buyer can make since the stock appreciation has no limitations. Now you can see why we have option buyers. They also buy the lottery tickets and play the slots.
Pros and Cons:
Okay, calling the option buyer a gunslinger may be a bit unfair. I’m a conservative investor always emphasizing risk management over profit optimization. Buying or selling naked options (not covered, without owning the underlying equity) is too risky for my comfort level. There are some advantages to buying call options and it’s only fair I mention them. First there are the obvious possibilities of generating through the roof fabulous returns that are not achievable as the seller of covered calls. Secondly, option buyers are controlling large numbers of shares at a relatively low cost. In the above example, the option seller is controlling 1000 shares at a cost of $48,000. The option buyer is controlling these shares at a cost of only $2000. Furthermore, the buyer can only lose the $2000 investment, whereas we, the sellers are risking $48,000 (that’s where our exit strategies come into play).
The advantages to the option seller far outweigh those of the buyer. We are selling a decaying asset. If the option expires worthless, we win because we still have our shares plus the option premium. If the share prices exceeds the strike price and we allow assignment, we still win because we have made a profit on the option sale and possibly additional income on the sale of the stock. No problem if the buyer of the option also generates a profit. Remember, we are the state selling lottery tickets. Money is consistently coming in month in and month out. Every so often we will have to pay out (lose out on equity appreciation) some cash to the lottery winner. This occurs when our equity appreciation goes through the roof during the contract month. Let’s say that $48 stock that we sold the $50 call option on goes to $70 by expiration Friday. We get paid $50 per share and the option buyer makes out like a bandit. Do we shed any tears? We shouldn’t because we still made a great 1-month profit and will do it over and over again, not just once in a blue moon.
The decision as to whether to be an option buyer or seller is yours to make. Are you happy with consistent monthly returns of 2-4% (in normal market conditions) or are you looking to hit that grand slam homerun? Do you want to feed the slot machines or collect the money from them at the end of the day? You worked hard for that $20 bill. Maybe you should put it back in your wallet.
Market Tone:
The industries that will get this economy back on track, in my view, are housing, automobile, and banking/financial. The 1-year charts of these industries are by no means strong or even positive. But the fact that they are improving to a consolidating and in some areas uptrending patterns is a sign of encouragement. A strong economy will definitely drive the stock market back up but so will the perception that things are improving. It wouldn’t shock me if it took most of this year to finally feel that the economy is on the right track. It also wouldn’t surprise me if the stock market showed improvement much earlier. The charts that I have been looking at to evaluate market tone appear to be consolidating. If we are at a bottom, that bottom can remain with us for a while. We can even test previous lows. Given the improved chart patterns of these industries along with those of the S&P 500 and the VIX has motivated me back into the options game with a conservative portion of my stock portfolio. I will be extremely diligent with my monitoring for potential exit strategies because of the unpredictable market environment. Here are the industry charts I alluded to above:
Automobile Industry
Banking Industry 1-16-09
Housing/Construction 1-16-09
Economic News of the Week:
I suggest you close your eyes as you read this section. Several negative economic reports re-enforced the continued global economic slump. The U.S. suffered through lower industrial production , decreased retail sales and reduced international demand for U.S. exports. The economic crunch along with lower energy prices continued to push consumer and wholesale prices lower for the fifth straight month. For the week, the S&P 500 fell 4.5% to 850.1 for a year-to-date return of -5.78%. You can open your eyes now.
___________________________________________________________________________________________________
To those of you who are selling covered calls in this market environment:
If you find a stock that has been working well for you, we’d love for you to share it with our group. You can post it by clicking on the “comments” link of this article (with or without your name) or by emailing me directly @ [email protected]
To those of you who have asked about my upcoming book:
Thanks for all those emails. The book is in the hands of the publisher. Because of all the charts and graphs, they tell me about 3-4 months before it will be available to the public. All those on my mailing list will get first notice of its availability. To join my mailing list use this link:
Wishing you a warmer week than we’re having here in New York,
Alan
Very nicely described. You put my thoughts into words that are understandable to everyone!
I am still a little reticient to start selling covered calls in this environment. Think I will wait a couple of months.
NORMAN STORM // Jan 18, 2009 at 8:14 am
REALLY ENJOYED YOUR BOOK
LOOKING FOREWARD TO YOUR NEW ONE
Thanks to one and all for your supportive comments.
Alan
It always amuses me when someone throws out that old statistic about 80-90% of all options expire worthless.
It is such a misleading statement because it is an incomplete statement being used with an agenda.
First of all, yes, the statement all by itsef is true.
But it implies that the option decays over time and winds up worthless.
Here is the info that it leaves out.
Lets take the option that is $4 on day 30 and worthless at expiration.
During those 30 days, where did that option travel?
What prices did that option see?
The implication is that it went from $4 to zero in a decreasing number each day.
What about the $4 option that during that 30 day period traded along the way at $11, $21, $5, $15, $2….and expired worthless.
When citing a statistic such as the one about 80-90% of all options expiring worthless, it might be good to include other related statistics.
For example, well you get my point.
You would like to know what % of options that expire worthless trade higher than their price on day 30, and by how much, how often…etc
I am not here to try to scare people away from being a net seller of options.
I have been a market maker of options since 1980 on the floors of Nymex, Comex and Amex and have seen ALOT.
There is alot of good to be said for both buying and selling options.
I would think that on balance, over the long run, being a net seller wins out.
But you also make a reference to the ability to create consistent monthly returns during “normal” market conditions.
You need to clearly define, in the context of your trading plan, exactly what is the criteria for “normal” conditions and what is the “trigger” that indicates that we have just left “normal” conditions.
And lets take that $4 option.
On day 30 the stock is 46 and the 50 call is $4.
First of all. If you compute those numbers it indicates that it is a very volatile stock.
Look around. You will not see many, if any, stocks with options that have numbers similar to those.
But lets say you buy that stock at 46 and sell the 50 call for $4 on day 30. When would you exit that trade? Would you still be in it with the stock at 30, 25, 20?
A covered call IS a naked put. The is no difference.
But since most investors who do that trade are selling out of the money calls, what they are really doing is selling a naked in the money put.
Another premium selling scheme is to just actually sell naked out of the money puts.
For example. There is a stock that you would like to own if it came down in price.
It is at 40 now. just sell naked 30 puts.
As you say, 80-90% of the time those options will expire worthless, so now you have another way of achieving consistent returns.
But you do it on a stock that , if it were 40, you would be very happy to own at 30.
Based on implied volatilities, out of the money options on the downside are always far more expensive that on the upside.
Just take a look at any stock. If the stock is 40 then the 50 call should be the same price as the 30 put right?…The 30 put will always be more expensive….
Sorry for this long ramble
David,
As a market maker of options for three decades, we welcome and value your comments and opinions. Despite the fact that this site is geared to average investors, the insight of a Wall Street insider such as yourself is a perspective we can benefit from. In the past I have bought and sold naked options and found this approach too risky and in some instances too complicated for the average investor. Selling covered call options is relatively easy to understand and gives the average investor a great chance to succeed. I always say that there are many ways to make money in the stock market and I respect them all, including your remarks regarding naked puts, but my experience selling covered call options has led me to the conclusion that this approach offers the best chance of success for a majority of the average folks. I remain steadfast in that opinion despite the fact that I welcome and respect your comments regarding other option strategies.
That being said, David, allow me to respond to a few of your points:
1- The statement that 80-90% of options expire worthless is an important concept for average investors to be aware of. To reference the statement as misleading is not fair since I spent countless pages in my book, my entire upcoming book and many journal articles highlighting the importance of exit strategies which are based on the movement of an option value both up and down. For example, when I speak of hitting a double, I’m sure you would agree that implicit in this strategy is that the option premium is required to fall in value and then increase in value. All expiration Friday exit strategies are based on option premiums which have intrinsic value.
2- In my book, I reference market conditions appropriate for selling cc options as moderately bearish, neutral and moderately bullish. I have made it clear that I use the charts of the S&P 500 and the VIX as two of the indicators for determining market sentiment. There is no magic trigger in my view. If you questioned the specialists on the floor of the exchange, how many different responses would you expect? Just listen to the experts on CNBC bash each others opinions. Who are my people to listen to? For me, self-education is the answer, just as it was for you. I’m sure you wouldn’t have achieved your level of expertise without it.
3- I agree that a $4 option premium on a $46 equity is unusual and defines a volatile stock. That is why I used a more realistic premium of $2 in my example.
4- The folks I write for and for whom I am the most concerned about, are those who knew very little about the stock market and options in particular. My book, DVDs and website has turned so many on to self-investing in the stock market and that is a positive for market makers such as you. Think back to when you first started learning about equity investing and perhaps you, too, will come to the conclusion that cc writing is one of the best approaches for non-Wall Street Insiders. Once again, let me reiterate that there are other ways to make money in the market, cc writing is one of them and the strategy that has worked best for me.
5- I’m glad that we found some common ground on perhaps the most important issue and that is your statement that in the long run, sellers of options will win out.
Thank you again for your comments and I hope you continue to post on this site as my readers will definitely benefit from the perspective of an experienced Wall Street market maker.
With respect,
Alan
Email from Barry regarding our exit strategies:
Barry Bergman // Jan 19, 2009 at 7:10 am
Alan,
I wanted to let you know how well the exit strategies have worked for me. Specifically, I want to discuss Pfizer. I originally sold the Pfizer (PFE) $17.50 Put. the stock was Put to me with a net cost to me of $16.10 (after receiving the Put premium). I then sold the Jan $17.50 call. As expiration approached, I wanted to keep the stock…so i was watching it closely on Friday.
I bought back the PFE Call for $0.07, giving me a nice return as well as not having any Call outstanding. The stock closed at $17.52 on Friday. If I didn’t execute an “expiration Friday” strategy, the stock would have been call away from me. I will be selling a new Feb call on PFE tomorrow, allowing me to continue a nice revenue stream from this stock.
Barry
Hi Alan,
I just wanted to touch on what David had said.
David you are correct . A covered call IS a naked put. The is no difference.
If you would have told me that 3 months ago I would have gave you that look that a dog gives when he hears a high pitched whistle.
What Alan has done for me is open my eyes to the wonderful world of options. I have owned stocks for years and never new you could sell calls on stocks you own!
He has started me on a road that I hope will last a lifetime. His simple and direct treatment of covered calls has demystified options for me.
I am now enrolled in an advanced options course and visit the CBOE website daily. I am currently trading put spreads using Alan’s system. Heck I might even do a iron condor next month!
All I want to say is for people like me (An average Joe) Alan is a Godsend.
Thank you Alan!
Uptick Rule:
Eric Newman recently posted some interesting comments opposing reinstatement of the uptick rule. At The Blue collar Investor Website, we appreciate all points of view. Here is a link to those remarks (comment #5 at the end of my article:
https://www.thebluecollarinvestor.com/blog/call-to-the-sec-wake-up-and-reinstate-the-uptick-rule-now/
We thank Eric for sharing his thoughts on this controversial topic.
Alan
A few weeks ago, I highlighted the Schools Industry and ESI in particular as an industry and stock to keep an eye on. Both have been on fire since. I also wanted to bring your attention to the Gold/Siver Industry which is also attracting institutional interest the last few months. ABX and NEM are two of the better performers in this group.
Alan
I’m putting the finishing touches on tomorrows article to be published on this blog:
“President Obama and our stock investments plus Our readers pick their favorite stocks”.
Thanks to all those who sent in recommendations. Last minute suggestions will be considered.
Alan
This is a good article as I’ve always wondered what would be the advantages as an options buyer.
The example you gave here is if the seller sells an OTM option.
What is the advantage to the buyer if the seller sells an ITM option?
Arnold,
Selling an ITM strike has the advantage of additional downside protection of the time value (our profit) of the option premium. If we buy a stock for $32 and sell the $30 option for $3, $2 is intrinsic value and $1 is time value. That $1 is protected as long as share value does not decline below $30. So our profit is $1/$30 = 3.3% and protection of that profit is $2/$32= 6%. In other words, we are guaranteed a 1-month 3.3% return as long as share value doews not decline by more than 6%.
Alan
Hi Alan,
Thanks for the quick reply. I was keen on knowing the buyer’s perspective though? What is the advantage to the buyer?
Thanks,
Arnold
Arnold,
Options give the holder the advantage of leveraging more shares of stock for less money. For example, to own 100 shares of stock @ $30 will cost us $3000. If the $30 call costs $1 an option buyer can control 3000 shares instead of 100. Remember, the option is a decaying asset so many conservative investors would prefer to be the seller rather than the buyer of call options.
Alan
Thanks a lot Alan, I understand now 🙂
Thanks a lot Alan, I understand now 🙂
Hi,
I have some experience trading options and am trying to move more to the selling side, selling call and put options.
Was interesting to read this article
Could somebody explain me the following a bit better :
“A covered call IS a naked put. There is no difference.”
Could somebody explain me this a bit better ?
The way I see it :
– You receive money for both, in that way they are the same
– You loose money if the stock decreases (heavily), in that way they are the same
– if the stock increases a lot, you might regret having sold these options, since you would have money more money with a different approach, buying options or others
I kinda think think that in the event of a big decrease in the price of the underlying stock, one risk to loose more with a short put that with a covered call.
So I kinda think, there are some, although slight difference
Any further info, insight that would clarify would be highly appreciated.
Best Regards,
Gregory
Gregory,
The two strategies have similar risk-reward profiles but there are nuances that distinguish each from the other. The max profit for put-selling is the premium only. When writing covered calls, additional profit can be generated from share appreciation. Also, covered call writing is more universally accepted to be used in self-directed IRA accounts because it is considered more intuitive for retail investors. For a more detailed comparison, see Chapter 15 in my book, Selling Cash-Secured Puts.
Alan