For some reason, everyone wants to know about selling premium these days. People see the market has been range-bound and think there is money to be made selling out-of-the-money options.
While it seems like an easy way to nickel-and-dime your way to riches, the recent tech-stock swoon has left plenty of put-sellers in a position to buy
10 bucks above the current market price. Ouch.
Let's get one thing straight for the second week in a row: Writing options is not a good defensive position. It is a position best used when a stock's trading range is well defined and volatility is lacking.
So, this week, we have addressed some options-writing questions to try to cover some of the ground necessary to keep you playing profitably.
Send questions to
email@example.com, and be sure to include your full name.
We've bundled the first two questions because they are closely related.
Where to Strike
I am new to options trading and I have one question. If Cisco (CSCO) - Get Free Report is trading at or around 100 and I am somewhat bullish about the stock, I might consider selling a covered call for March or April. My problem is that I do not know what is the best exercise price to sell. Obviously, selling March 115s probably doesn't get me much; therefore I may wish to sell March 110s. Could you please explain how most options traders determine the correct expiration price when deciding which Option Series to sell? -- Scott Geiger I'm the guy who wrote an at-the-money call that is now $6 in the money, down a little since I last wrote to you. The company is Boeing (BA) - Get Free Report. Are there some rules I should consider when writing a call? Such as how far out to go and how much out of the money is a reasonable strategy for a particular time until expiration? I didn't think Boeing was that volatile. I was obviously wrong. -- Ron Dunn
Scott and Ron,
Selling options successfully is a function of a delicate balance of how much upside you want to give up and how much premium you want to take in.
The problem, in Scott's case, is that selling Cisco calls is tough. As of Feb. 17, the stock was at 95. The March 100 calls were selling for 4 1/2 ($450). But if you sell that call, you're going to be assigned if the stock is at 100 by the third Friday in March. If the stock pops quickly to 100, you can buy the thing back and let the stock ride.
Savvy options investors sometimes will go further out on the strikes to make sure their options don't get assigned. The March 105, for instance, would be one of those strikes. The problem there is that you're only taking in 2 7/8 ($287.50) for every contract you sell.
When you sell calls, however, your big risk is opportunity risk, meaning that you can miss the opportunity to participate in a bigger move. Selling puts is more dangerous because you can get forced to buy a stock for more than its current market value.
For instance, if last week you sold Dell 90 puts and felt relatively confident the stock wouldn't fall below 90 because its earnings would be in line, you would've been wrong. Worse than the pain of being wrong would be the feeling of cash being wrenched out of your wallet to pay 90 (or maybe 86) for a stock that was trading at 81.
Sure, you would've made some of that up by taking in the premium (as you would have in any of these scenarios), but your downside here is almost unlimited because you could be buying a dog.
A Year of Writing Dangerously
I've noticed some big spreads between theoretical values and bids on some popular stock options, and I'm thinking about getting in on the writing action. Let's say I decide to play with $10,000 to start with. I find a good equity candidate trading for 100 a share. I write the near-month 105 puts for $8. Hopefully, since I'm in the money, I get assigned. So now I have some stock, and write the near-month 95 calls for $8. Again: in the money, assigned, back to square one. Except I'm $600 better off (+800-10,500+800+9500=600, minus commissions, about 4x$15=$60 for two writes and two stock transactions). If I don't get assigned, I have to wait around for expiration, but I'd rather churn and burn so I can rotate through this process several times a month (making about 5% each time). The biggest downside I see is the stock tanking while I've got naked puts written, but I could hedge by buying the teenie puts way out of the money (writing a wide put spread instead of running around naked). This concept is hard to paper-trade, since I'm not sure how to simulate assignments. What am I missing here? -- John Capell
The strategy itself is fine, kind of.
It's a little high velocity for our taste. In doing so much trading, you're likely to be wrong more, simply because you are trading more. If that sounds too simple, think instead of how much you'll be spending on commissions and whether you have the time and energy to do this enough to be profitable.
With all those transactions, you are a broker's dream. Be warned, however, that writing options is like hitting a baseball: It looks a lot easier than it actually is.
Your scenario seems OK, but I think you're low-balling the commissions. If you were using
, a $2,500 transaction would cost $40, and anything less would cost $35 plus $1.75 a contract.
If you're doing such small numbers, I'm wondering if this strategy is worth it -- although I do appreciate the visions of an endless stream of 5% hits.
If you truly want to sell options, there may be a chance to take advantage of writing calls on some of the Internet stocks where volatility has subsided, or picking a few good put positions on stocks that can weather the turbulence of the past two weeks.