How do we compare the results of a fully invested stock portfolio to an options writing portfolio? The comparison is between owning a stock portfolio with writing options on underlying stocks and having the cash to purchase them at the strike price. We are not going to consider margin.
For a fully invested portfolio, one way to measure performance is to start with a given size portfolio, say $100 for illustration. As the year progresses we could determine the current value of the portfolio and add in any dividends received. For example, if the portfolio is currently worth $120, and we received $5 in dividends then we are up $25 or 25% on our original investment. The $25 total return is tentative since the $20 capital gain is still an open gain, while the $5 is cash in your hand. Quite often, open capital gains are an illusion, and the market takes them all back.
There is a very important distinction between open and closed gains. Namely, any gains or losses that are open can continue to change, while closing a position cements your gain or your loss. In a fully invested stock portfolio your capital gains or losses are open until you sell, while in an options writing portfolio, most of the gains are from premiums that you receive and are closed and in your account in minutes.
My favorite option writing strategy is to write puts on high quality dividend growing companies, when they are selling at a good entry price. These are great businesses that you want to accumulate for the long term, because they give you a chance to keep up with inflation. Being selective on companies you write put options on is one of the most important consideration in writing puts.
There are several outcomes of writing a put. First, the stock price can rise above your strike price. For this outcome, you do not get the stock, but you get to keep the premium. This case closes by itself at the expiration date or sooner if you decide to buy back the put to close the position. If it closes by itself, you avoid any further commissions and your downside exposure ends at expiration. If you decide to buy back the put before expiration, you eliminate any further downside exposure that may occur before expiration and you free the money to pursue other opportunities.
The second case is somewhat more tricky. Suppose you do get assigned the stock at expiration because its market price is below the strike price? At this point, the premium you collected is yours, but now you own the stock and it is open and below the current market price. There are several possibilities here. First, you can sell the stock and close your long position. Second, you can just hold the stock and collect dividends and hope that the price recovers. Third, you can now write a covered call on the position you own. It is quite easy to calculate a gain or loss if you close the position, but what if you leave it open. The premium you collect by writing the call is closed, but your stock position remains open. As long as the stock remains open, you do not count the extent that your capital is lower or higher than your initial outlay. Again this points out the importance of only writing options on quality dividend growth companies.
Thinking about open and closed positions illuminates the main difference between a fully invested stock portfolio and an options writing portfolio. First, it is relatively easy to calculate your return in the fully invested portfolio at any time, but the catch is that your capital gains are only realized when you close the position by selling. The options portfolio is much harder to calculate a return because the amount of money at risk keeps changing as your positions close and you constantly take on new positions that may be sized differently.
By writing options, it is possible to increase your chance to profit in exchange for limiting the amount of profit you make. In a raging bull market, such as what we have had in 2013, it is generally more profitable to just buy the underlying stock than to write a put on it. However, in flat or falling markets, the put write strategy is superior. In a flat market, your put writing strategy is generating gains that are more than dividends, but you are not giving up a potential capital gain. In falling markets, the put write strategy should mitigate the loss better than dividends but is not the best strategy to employ.