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Richard Berger
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Mr. Berger is the creator and developer of the YDP screening tool, a chart system and its analysis for screening and monitoring dividend income equity investments. The recipient of Seeking Alpha's Outstanding Performance Award (... More
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Income From Covered Option Writing
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Income From Covered Option Writing
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  • A Primer On Option Terminology & Strategic Uses For Them

    Option Primer:

    This is a very basic option primer. I have prepared it in response to some of my readers' questions about terminology and their desire to be more familiar with options generally, the different types, and strategies for using them. While I do discuss the broad strategies of option use here, I do not get into tactics, such as spreads, straddles, iron condors, and other such detailed combination contract uses. These are almost all used generally for leverage and or speculation and therefore outside the scope of the covered option writing for income boosting which I focus on.

    First, lets be clear what an option is. Options are of 2 types.

    Calls give the owner of the Call option the right (but not obligation) to buy your shares from you (the one that created the option by WRITING it) at the Strike price anytime until the contract expires. The amount you are paid for writing (selling) the contract on your shares is the premium price.

    Puts give the owner of the PUT right (but not obligation) to SELL you (the writer) their shares at the Strike price at anytime during the contract.

    All options are time decaying instruments. They expire on a specified date. Therefore, each day their premium becomes worth a little less money because the time value runs down like sand through an hourglass.

    The other aspect of an option is its intrinsic value. This is a term for how far the option Strike Price differs from the market price of the ticker shares. A Strike price is said to be "in the money" if there is intrinsic value in the difference between the Strike and the Market price. For example, a ticker trading at $35.50 with a Strike price of $35.00 is $0.50 "in the money" for a call option. If the holder of the call option contract were to call-away the shares today, they would have to pay the $35.00 Strike price and the shares would have a market value of $35.50, thus the $0.50 intrinsic value net from the Strike price. For a Put option using the same price example, the option would be 50 cents OUT of the money since the net intrinsic difference is negative. The holder of the PUT would be entitled to RECEIVE the $35.00 Strike price for presenting (selling under the put contract) their shares but the market price is 50 cents above that and so is better than the Strike price for them. "Out of the money" is the amount the shares must move for the option to become worthwhile to exercise by the holder. A call option with $20.00 strike for shares trading at $19.00 currently is $1.00 out of the money. "At the money" is when the Strike price and current market price are the same.

    The price of an option premium is largely driven by its time value (how long is left to run on the contract) and by its intrinsic value. The prevailing interest rate (since you are tying up your asset -stock you own on if you write a covered call, cash if you write a covered put), the volatility of the ticker and of the market overall, and many other factors also come into play. The Black Scholes equation was developed by 2 gentlemen of those names and is a mathematical equation that exactly determines the theoretical perfect value of an option premium. In my work, I focus on real world live time option trading bid/ask/last-traded prices. The are often close to the Black Scholes price model but may depart considerably from it, especially in thinly traded units.

    We call it "selling to open" when we begin by writing (selling) an option contract. We specify the Strike price of the contract and which contract (expiring month) we are offering, and the premium we are asking. Option contracts are for 100 shares per contract (except the new mini-options, which are usually for 10 shares only ... only a few big and expensive companies trade mini-options. GLD, AAPL are some that come to mind). So, you get 100X the premium price per contract. If you write a Covered Call ("covered" because you own the shares already which must be delivered if they buyer of the option decides he wishes to purchase the shares by exercising the option and paying you the Strike price). Example: For a Covered Call for 7/10/2015 $30.00 @ $0.50 premium you would need to own 100 shares for each contract you write. You immediately are paid $50.00 per contract ($0.50 X 100) and the buyer of the option has anytime until 7/10/2015 do choose to buy your shares (in 100 per contract lots) for $30.00 per share. (note: American options can be exercised at any time during the contract, European style options only are executable on the closing day of the contract. Most option contracts are American style).

    A Put is the opposite of a Call, but the contract structure is identical, Strike price, Date until expiration, premium, 100 shares per contract, etc. The difference is that the buyer of the contract may decide to SELL you his shares. We call it a Cash Covered Put because you must have sufficient cash in your account to buy the shares at the Strike price if they are "presented" to you by the Put contract owner. For an example similar to above: Cash Covered Put for the 7/10/2015 $25.00 @ $1.10 premium. Here, write (sell to open) this put contract which will expire on 7/10/15, has a Strike price of $25.00 and we are immediately paid $110/contract by the option buyer. We must have the cash in our account to meet our obligation to buy the shares if the option owner presents them to us. So, we need $25.00 X100 = $2500.00 of our own cash per contract in our account at the time we write the PUT. This cash will be tied up for the duration of the contract as a guarantee of the ability to buy the shares if they are presented ("put") to us. Because we receive the $110 premium per contract immediately, our net covering cash per contract is only $2390.00.

    When we want to begin by buying shares and concurrently selling a covered call on them at the same time, that is called a Buy-Write. We buy the shares and write (sell) the call on them at the same time, all in one order usually which specifies the net price. Thus, a Buy-Write for shares to buy at $50.00 and write a covered call at $1.00 is a net $49.00/share order ($4900.00 / contract). In addition to avoiding having to come up with the entire $5000.00 to place the order, we also insure that we only buy the shares IF we also sell the options. This is important on some stocks that have very low volumes of options traded (such as the EXPL I wrote up). Also, the net basis share price after allowing for the premium we are paid is the trigger to the trade. If shares are $49.50 and option premium is $0.50 then the trade still executes, since it is a net $49/share basis to us. This is useful since we have targeted a fair value and desired entry point price along with the value of the option premium relative to the share price (premium/netSharePrice). One additional feature of the Buy-Write is that it is a single commission instead of one for buying the shares and another for selling the option, thus minimizing the transaction costs of the trade.

    Now, lets turn our attention to the various uses of options that different types of investors use:

    1. Leverage: Because the cost (premium) to buy an option is a small fraction of the cost of the shares itself, an option buyer can buy options instead of shares to make his money go a lot further, leveraging its buying or selling power. This leverage also multiples his risk much like buying on margin or selling short. However, the theoretical risk in margin buying is the full value of the shares since they could drop to zero and you would still owe the full margin price buy amount (as well as suffering margin calls each time they drop in value enough to decrease your net equity below your broker specified minimum). Likewise, theoretical exposure on short selling is infinite since shares could go up in value forever and you would be obligated to buy them at whatever price they rise to in order to cover your short obligation. With options however, you are always limited to risking only the amount of the premium you pay. You, as the option buyer, have the right but no obligation to buy (call-away) or sell (present shares under a put contract). I do not ever use options for leverage in this program. It is a high risk and speculative way to bet on shares you think are going to make a move in a particular direction. Options are also time limited, so even if you "guess" right on the direction and size of a move, if it happens after the expiration of the contract, your option is already gone and of no use.

    2. Options used to hedge a position. A person may own shares and want to insure that he limits how low they might fall over a given period of time to limit his downside risk. He can do that by BUYING a put option that gives him the right to sell his shares at a specified price. This is useful to "lock-in" or insure a paper profit on shares you own that have risen in value but you want to continue to hold for more upside, for dividends, to avoid taxable gains on sale, etc. Buying the option is like buying insurance protection. You can to this on specific tickers you own or buy a broad market index option such as SPY (which covers the entire SP500) to insure against a market crash or major correction. Again, I do NOT use options for any of this in this program.

    3. Similar to ticker hedging or whole market hedging, options can also be used to hedge commodities someone may cost sensitive to. Examples can be; fuel, a specific chemical (ammonia or gold for example), or other commodity. By purchasing options on an index or ticker that is correlated inversely to the objective you are trying to hedge, an investor can decrease or eliminate the risk of those underlying price changes. Let's say I bid on a contract to supply chocolate Easter bunnies to CostCo next year. I will need to make those bunnies in about 8 months. So I can buy calls on some index or ticker linked to the price of chocolate to help insure that my bid estimate of what my sugar costs will be are in line with any price rise for the sugar. These are not strategies used in the income boost program.

    4. Covered options to boost income while lowering market risk. This is our program. Covered options do not rely on leverage nor on speculation to generate returns. Properly used, they add premium income to shares you already hold in your portfolio (writing covered calls) or pay you premium cash to continue to wait on the sidelines until shares you are interested in drop to the price you are willing to buy them at (writing a cash covered put). This form of option trading is so low risk (in fact reducing market risk - but not eliminating it) that covered options are the only type allowed to be traded inside tax-preference accounts such as IRAs, SEP, SIMPLE, and other pension oriented accounts. My program only uses options of this strategy. First we identify companies with attractive and safe dividends that we want to own. Then we determine the fair value share price for those. Only once we know both of those, do we search out an option contract for that ticker which will generate an income boost for us while creating a better basis price for us to enter/exit the shares. The basis improvement versus the retail market price is the percentage by which we lower market risk. While market risk of owning shares always exists that they will rise and fall, by improving our basis price, we have automatically lowered the amount of that risk by an equivalent to the improvement in basis. At the same time, we generate cash from the premium which is immediately available for us to invest, to buy groceries, to pay the rent, for anything you want do spend it on. So long as we keep focused on tickers we want to own at prices we want to own them at anyway, the covered option writing simply provides a cash boost we would not have on these shares if we did not write the option. Some people will argue that is not true because we risk shares moving up in price and therefore miss out on capital appreciation if we write a cash covered put and the shares rise away from our strike price so we do not end up owning them. This is a fallacy however since we select the cash covered put option only when shares are already over-priced compared to fair value. Being over-priced, we would not by buying them anyway without the put strategy. We are simply being paid to wait until the fall to our price instead of waiting without being paid. Likewise, for a covered call, some argue that we have sold away the upside potential for shares to rise in price above our strike price. While it is true we have sold this upside away, it is only upside above the fair value price which we have sold away (or if below fair value, still above our basis and with the premium paying us adequate yield rate to justify selling off that blue sky upside). So, we are only selling away the blue sky upside above which we would sell the shares as being over-priced anyway.

    I use a few calculations to describe the boosts that are achieved from the option premiums. There is the absolute gain. This is the dollar amount and yield percent of net price obtained on the contract. This could be a gain achieved in as little as a 1 day or as long as the full duration of the option contract. I assume it is the duration of the contract. Because these periods may very from a few days up to many months, I also present a calculation of the "annualized" yield rate and gain. This takes the absolute gain, divides it by the number of days of the contract, then multiples by 365 to show what it would be pro-rata over an entire 1 year period. This is purely a theoretical number but is useful for comparing to other numbers we look at on annualized basis, such as dividend amounts and yields. It is also useful for comparing one boost against another since one absolute may be in 5 days and another equal absolute require 5 months. Only a standardized metric can be used to understand which of two is better or at least comparable. The annualized pro-ration does this for us.

    This concludes my brief remarks at this time. Please feel free to use the comment section here to ask further questions about options. This way, this blog spot can evolve into an FAQ for reference.

    Richard

    Apr 21 7:07 AM | Link | 4 Comments
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