My Rookie Season Writing Options: Fourth Inning, Late July To Mid August

by: J.D. Welch

What a train wreck of an inning the last five weeks have been! Everything from unforced errors to the "other guys" just getting hit after hit and scoring runs, to my dismay.

If you're just joining us, this series is my way of documenting my learning journey through the tricky minefield that can be option writing, both cash secured puts and covered calls, as I explained in the first "inning" of this, my rookie season. That's the extent of my options explorations for the moment, and the way things are going, I may not venture into any other uncharted options territories any time soon.

This past Friday saw the close of my fourth month (inning) of trading options, but nothing got called away or assigned, and I'll explain why in a little bit. The first inning was profitable, and the in the second inning things seemed to be going well, with me gaining experience as well as a little extra cash. The third inning got a bit interesting as I discovered that, if I paid attention to the general ebb and flow of the market, I could buy back calls that I'd previously written at very low cost, wait for an upturn in the market and sell the calls again. Wash, rinse, repeat. Simple, right?

It should be simple, and if I'd kept it simple, things might have turned out differently this past month. But I got a little too tricky for my own good, and things turned sour. What was the root cause of these problems? Two things, I think: Inexperience (leading to a bit of panic), and a touch of greed.

I didn't write any cash secured puts this past month, just covered calls. Things started out OK when I wrote calls against my Arch Coal, Inc. (ACI) stock on July 5th for the August $9.00 strike price when ACI was going for $7.27, all for a $0.25 premium. The coal market took a big hit in the intervening days, and I ended up buying the calls back at the $0.06 premium for a tidy, albeit small profit which came out to a 16.24% annualized return.

Not too bad, and it seemed like my plan was working so far. The very next day, the market, including coal, took off, and I ended up selling the exact same calls again, but this time in order to get a decent premium I ended up selling at the October $8.00 strike when the price of ACI was $6.18, in order to get a decent $0.33 premium.

Wash, rinse, repeat, right? First error: Picking a strike that was too far out in the future, contrary to my original plan of picking a strike price 3 prices away from the current price and for the very next month. More on what happened with ACI in a bit.

Next up, I wrote calls for Nokia Corporation (NYSE:NOK), but I didn't follow the basic rules and I wrote them for a strike price [$2.00] that was way too close to the current price at the time [$1.84], even for an August strike, for a paltry $0.16 premium. Nokia had been taking a beating, so whoda thunk that they'd rally and, in a relative sense, in a big way.

Here's where the second error came into play, and it was something I'd experienced before but hadn't managed to learn from: Panic. With a $2.00 August strike that was a week away from expiring, NOK hit $2.93 and I didn't want to have the shares called away when things seemed to be turning the corner for Nokia. So, I bought the calls back for a $0.85 premium and ended up losing, well, a bunch. Not too much that I can't afford it, and certainly nowhere close to 4 figures, but more than I'd like to lose on any one trade of this size. In the end, with NOK closing this past Monday at $2.75, I'm actually ahead a few bucks if I were to sell my NOK shares now. Sure, I could've, probably should've let the shares get called away, then sell a put for a price that I'd like, but I didn't, and the reasons again were: Panic, and a touch of greed.

At the same time I sold the $2.00 NOK August calls, I sold calls for Microsoft Corporation (NASDAQ:MSFT) at the $31.00 strike, but again, in order to get what I considered a decent premium, I had to go to a September strike, all for a $0.40 premium, which I felt was OK. I was expecting August of this year to be a repeat of last year, but so far, that hasn't been the case, and MSFT has been edging its way upward. This time, I'm leaving it alone, and if the shares get called away, they get called away, and I will write a put and attempt to get them back. August isn't over yet, and the September expiry is a ways off, so anything can happen between now and then, right? Right…

Meanwhile, after putting Medtronic, Inc. (NYSE:MDT) through the wash for a small (very small) profit, I sold the same calls again late in July, but again in order to get what I considered a decent premium of $0.45, I had to select the September $40.00 strike, all when the going price for MDT was just $38.91. See that pattern? Too far out, strike too close to the current price, too greedy for a few bucks.

Medtronic had been trading sideways for months, but it just closed at $41.45 this past Monday, so unless early September turns into what I thought August would be, those shares are likely to get called away, too. C'est la vie. I've learned, and I'm not going to panic this time; if I want them back, I will either just buy them on a dip via a limit order, or sell a put just out of, or in the money, and only a month out, and then bide my time. I've got to learn patience!

So what happened to ACI, you ask? Different story, similar result to NOK. You see, I've been thoroughly converted to Dividend Growth Investing [DGI], and I was in a Zen-like trance contemplating my portfolio over the weekend looking for any remaining stocks that weren't fitting into my DGI mold when I remembered that ACI had slashed its dividend just before the June expiry that got the shares assigned to me in the first place. Which meant that now ACI is just yielding 1.69%, which is far too low for a self-respecting DGI portfolio to keep around. On a capital gains basis I was slightly ahead, so I decided to sell my ACI shares in order to pick up a bit more Vanguard Natural Resources, LLC (NYSE:VNR) and a bunch more BreitBurn Energy Partners, L.P. (BBEP), which are yielding 8.4% and 9.8%, respectively. (And yes, at this stage in my investing life, I'm chasing a bit of yield, but it's because I'm so woefully behind in building up my nest egg and a solid portfolio of DGI stocks like Aflac (NYSE:AFL) and Johnson & Johnson (NYSE:JNJ), and I've got to play catch up.)

Alas, when I tried to sell my ACI shares, my broker's system notified me that I wasn't allowed to short shares on margin. Huh? Oh, yeah, I still had the outstanding covered calls, so I couldn't sell what I'd used to cover the calls. Wonderful. So, after a bit of quick math on the spreadsheet, I reckoned with the profit of the eventual sales of the ACI shares I could afford to lose a little bit more by buying back the ACI calls at a $0.41 premium for a small net loss, which I did. I then used the proceeds to buy the aforementioned VNR (which pays distributions monthly now) and BBEP, much to my DGI heart's content.

So now I'm left with open calls for MDT and MSFT, one or both of which will likely get called away come the September expiry, which I will allow to happen this time and not interfere with the natural progression of the market, come what may. I've added up all my premiums, positive and negative, and find that at this point in time this little four month experiment with writing options has put me in the red by a mere -$18.43, less than the cost of a night out at the movies with the Missus. When you consider the cost of education these days, that's not too bad of an outcome. Plus, I still have my NOK shares, which I have high hopes for once Windows 8 comes out in late October. And, hopefully, I'm all the wiser for the experience.

That's it at this point in time, just the open MDT and MSFT calls, which I'm going to let ride. I've been busy fine-tuning my portfolio to yield as much as I can and still sleep well at night, which I actually do. No use crying over spilled milk, as they say. However, I don't think I'm going to be placing any covered calls for a while. I need to observe the market and go back to making paper trades, and see how that goes. In the meantime, I will await the outcome of the September expiry, and report back to you, dear readers, in a month's time.

Disclosure: I am long AFL, BBEP, JNJ, MDT, MSFT, NOK, VNR.

Additional disclosure: In addition, I have open covered calls on (MDT) and (MSFT).

Disclaimer: I am not a professional investment advisor or financial analyst; I’m just a guy who likes to crunch numbers and can make an Excel spreadsheet do pretty much whatever I want it to do, and I’m doing my best to manage my own portfolio. This article is in no way an endorsement of any of the stocks discussed in it, and as always, you need to do your own research and due diligence before you decide to trade any securities or other products.