Option Strategies: Don't Buy And Sell Shares, Write Options Instead

Summary

• Buying and selling stocks can be replaced with option writing.
• This strategy applies only to certain companies with specific criteria.
• Whether the options are written in the money or out of the money depends primarily on the stock trend and whether the stock is overvalued or undervalued.
• A portfolio of written options creates an efficient frontier that is much better than a portfolio of diversified stocks (lower risks and higher returns).

This article was amended on 11/27/2020 to fix a typo in the section discussing actionable suggestions.

What was the impetus for writing this article?

Over the last five years, I significantly increased my trading activity as I sold my company and started heading towards retirement. The marketable securities asset allocation that I set up for myself was 70% to corporate bonds, while keeping about 20% invested in large-cap mature companies and about 10% in high-risk equities; I did not say "small cap," as some of the stocks that I invested in had a large cap, but high risk/volatility, for example, Zoom (ZM).

Within the first year, my equity portion (the 30%) dropped significantly as I shifted from buying and shorting stocks to writing options instead. In other words, I closed a big part of my stock positions, coincidentally, by writing covered options on them and letting the options be assigned. I used the assignment proceeds in buying more fixed-income securities, and restricted my trading activity to writing call and put options.

Despite the fluctuations in the stock market, the return on investment of my portfolio beat the major indices by a healthy margin; I was comparing the portfolio primarily against the S&P 500 (SPX). At the same time, the overall volatility of my portfolio was much lower than the volatility of all the major indices by a healthy margin a well.

As part of my series about option strategies articles, I decided to share this strategy here. The article is written to focus on the practical aspect of writing options versus buying and selling/shorting shares, rather than addressing the academic theory and mathematical formulae behind the strategy.

Source: Quantra, Option Payoff

Thesis and Outline of the Article

The options strategy presented here is based on replacing buying new stocks and covering short positions with writing put options. The strategy also calls for replacing selling stocks and shorting new stocks with writing call options. Options writing replaces the following specific transactions:

• If you want to buy a new stock => Sell naked put option instead
• If you want to cover a short position => Write covered put option instead
• If you want to short a new stock => Write call option instead
• If you want to sell an existing stock position => Write covered call option instead

Writing options (the transactions on the right) are less risky than the transactions on the left, while the return on investment for these transactions is potentially higher. The previous statement is empirically substantiated by the performance of my portfolio. There is also a theoretical corroboration for it, which I will try to explain later in the article.

I proceeded with performing some complex mathematical calculations (which I am not presenting in this article) to try to explain the low risk/high return dilemma; this flies against common logic and the principles that we have learned about investments and financial management over the years. I have not yet completed formulating these mathematical formulae, and once completed, I will publish them.

Until then, I have tried to simplify the logic behind these formulae near the end of this article. To summarize it here, the portfolio that relies on both written options and fixed-income securities provides a much better efficient frontier than portfolios that rely solely on stocks and fixed-income securities.

Source: GuidedChoice: "Harry Markowitz's Modern Portfolio Theory: The Efficient Frontier"

The article first identifies the criteria of the companies for which this strategy would be suitable. It then proceeds with providing a few decision tables that can be used for determining whether the options need to be written in the money or out of the money; the decision tables are driven by the current stock trend and the analysis of whether the stock is overvalued or undervalued. The advantages and the drawbacks of using the strategy of options writing are then provided. After that, the article presents a clear action plan of what investors should be doing in this era of high volatility. The article concludes with my personal thoughts about this strategy and its impact on my portfolio.

Please note that while this strategy can be used in lieu of buying and selling stocks, it is not a substitute for conducting the traditional thorough and comprehensive analysis on the stocks. Also, be aware that like any investment strategy, there is a certain level of risk in writing options in lieu of buying and selling stocks.

Which companies does this strategy apply to?

This process cannot be used for every company, and the companies on which you can apply this strategy need to fulfill certain conditions. Here are the criteria that you need to consider:

• The company has a high volatility (higher than 60%, and the higher the better).
• There is a big demand on the stock and the options, resulting in a relatively small spread between the bid and the ask prices of the options.
• New options are available every week rather only than on a monthly basis.
• When writing put options, the company should not be distributing dividends, or should be distributing minimal dividends (yield less than 1%).
• When writing call options, companies that distribute dividends provide a lower risk and should be considered.

In the Money or Out of the Money? That is the Question

The next decision that the investor needs to make is determining whether to write the options in the money or out of the money.

Definition: According to Investopedia: In options trading, the difference between "in the money" (ITM) and "out of the money" (OTM) is a matter of the strike price's position relative to the market value of the underlying stock, called its "moneyness".

An ITM option is one with a strike price that has already been surpassed by the current stock price. An OTM option is one that has a strike price that the underlying security has yet to reach, meaning the option has no intrinsic value.

For put options to be ITM, the market price needs to be lower than the strike price. For call options to be ITM, the market price needs to be higher than the strike price.

Source: Money-Zine; for put options, "In the Money" and "Out of the Money" are switched.

The decision of whether to write call or put options, and whether it is in the money or out of the money, depends on many criteria, and the main criteria are:

• Your current position on the stock, whether you are holding an existing position or you are starting a new position.
• The type of existing position you are holding, whether it is a long position or a short position.
• The outcome of your fundamental and technical analysis, whether the stock is undervalued or overvalued.
• The trend that the stock is currently taking, whether it is trending upwards or downwards.

The next two sections will analyze these criteria. We will look at writing options to start a new position, and then proceed with looking at writing options to close an existing position.

Starting a New Position

Starting a new position is normally done by writing naked options. Writing naked put options is equivalent to starting a long position in lieu of buying a stock, while writing naked call options is equivalent to starting a short position in lieu of shorting a stock. The following list shows when to write in-the-money naked options versus out-of-the-money naked options:

Writing in-the-money naked put options

• The company stock price is taking an upward trend.
• Your fundamental and technical analysis is indicating that the stock is undervalued.

Writing out-of-the-money naked put options

• The company stock price is taking a downward trend.
• Your fundamental and technical analysis is indicating that the stock is undervalued.

Writing in-the-money naked call options

• The company stock price is taking a downward trend.
• Your fundamental and technical analysis is indicating that the stock is overvalued.

Writing out-of-the-money naked call options

• The company stock price is taking an upward trend.
• Your fundamental and technical analysis is indicating that the stock is overvalued.

The following magic quadrant chart summarizes the above criteria for writing naked options, and whether they should be in the money or out of the money together with the rationale for this decision:

Source: Created by Author

Actions on an Existing Position

Against popular belief, while they may be construed as less risky, writing covered options requires far more analysis before making a decision about how to write the options. With existing positions, there are four choices:

• Write the covered options in the money,
• Write covered option out of the money,
• Write more naked options to increase your position, or
• Just close your position (immediately buy the shares you shorted or sell the shares you own).

As expected, the action taken will depend on whether you have a long position or a short position, and these positions mirror each other, as we will show below.

Written covered put options, when assigned, is equivalent to closing a short position in lieu of buying the shorted stock. Written covered call options, when assigned, is equivalent to closing a long position in lieu of selling a stock.

Another time, the key drivers for making a decision are the trend direction for the stock and whether your analysis is indicating that the stock is overvalued or undervalued.

The next two magic quadrant charts explain the actions to be taken when holding a short position on a stock and when holding a long position on a stock, and provide the rationale behind the action to be taken:

Source: Created by Author

Source: Created by Author

As shown in the above charts, your fundamental and technical analysis can drive you to immediately close your position or to increase your existing position if the stock price trend confirms your analysis of the stock you are holding or shorting.

What are the advantages of writing options versus buying and selling/shorting stocks?

Writing options provides the investors with some significant benefits, which include:

The additional premium - Whenever you write an option, you receive a premium equivalent to the time value of money of an option. You can consider this amount as the value that is attributed to your decision to buy/sell a stock at a certain price within a certain period of time. You can also consider this additional premium as an additional dividend you are receiving on the stock, as described in my earlier article: "Option Strategies: Earning Dividends From Non-Dividend-Paying Companies."

Not running after the stock - One of the biggest problems that plagues traders and investors is the lack of discipline of sticking to a price target for transacting on a stock. The investors end up "running after the stock" while buying and selling, and they never succeed in timing the market. When we write options in lieu of buying and selling stocks, we are setting a fixed price for transacting on the stock and forfeiting the opportunity to change this price during the life of the option. This forces a discipline that is quite hard to realize for stock traders and investors.

Investing the margin without paying interest on it - When we are writing a naked option, we are using the margin in the account to earn the premium, but you are not actually borrowing money from your margin for that. This is equivalent to borrowing the margin and investing it without having to pay an interest on the margin borrowed.

Lower margin requirements - Writing options on stocks requires a much lower margin requirement than buying or shorting the stock, especially shorting. If managed wisely, the likelihood of receiving margin calls from writing options is much lower than receiving margin calls from holding equivalent stock positions and using the margin to achieve this position.

Investing the premium - When writing options, the written or "shorted" options are deposited in the long account of the investor rather than the short account. This means that the cash received as a premium remains in the long account and can be further invested in fixed-income securities to earn interest. I believe that this is a loophole with brokerage firms that is relatively hard to plug, and investors need to capitalize on it; this amount can be substantial when an investor writes in-the-money options.

Avoiding the cash fluctuation for shorting - Because the written (shorted) options are kept in the long account, no mark-to-market cash adjustment would take place. This means that the cash would not fluctuate in the long account and will remain constant. I have always had a problem with shorting where I had to keep a cash amount without investing it so that the daily cash fluctuations do not push me into a margin position. Since I decided to write in-the-money naked call options instead of shorting stocks, I did not need to keep a pure cash reserve in the account, as there were no longer any cash fluctuations.

Continuously taking profits off the table - We all know that no one ever got poor in investments out of making a profit. When we write options and they expire, get rolled into future dates or get assigned, we are practically taking the premiums, our profits (and sometimes, losses) whenever they occur. In general, taking the profits is a more conservative approach compared to buying and holding.

Source: Touch Screen Museum

What are the drawbacks of writing options versus buying and selling/shorting stocks?

While the advantages are significant for writing options versus buying and selling/shorting stocks, the strategy also has its drawbacks. These drawbacks include:

Earlier recognition of taxes - Because the investor always recognizes the profits as options expire, get assigned or rolled over to a future date, taxes are recognized earlier and cannot get deferred.

Limiting the profits for high-flying or crashing stocks - Compared to buying and selling stocks, writing options has an inherent function of capping the potential profits whenever the stock price crosses the strike price. While this may be considered by some as a negative characteristic, I don't see it as different from the capping done by placing limit orders on stocks.

Relatively higher commissions - The commissions on options are generally higher than the commissions on stocks. I generally target paying a minimum of 50% extra commissions for writing options versus direct buying and selling/shorting stocks.

Extra effort and weekly monitoring - Managing a portfolio of written options requires weekly monitoring and active management to write more options as they expire worthless or to roll over to future options (possibly at a more favourable price for a higher premium) before the options are assigned. These actions need to be taken on a timely basis just around the expiry date of the option.

What about the term of the options?

The decision about the term of the options is tricky, and is primarily a function of the risk profile of the investor. If the investor is a risk taker, he/she would go for a longer term; if the investor is risk-averse, he/she would choose a shorter term.

Please note that while the shorter term is less risky than the longer term, it requires more management, as the investor will need to make investment decisions associated around the expiry dates of the options, and shorter terms come with more frequent expiry dates.

How can an investor benefit from this in the current high-volatility environment?

The main thesis presented above indicates that writing options provides a better return and lower risk than selling and buying stocks. The reason is because the "risk" for the option writing is inversely proportional to the standard deviation (the volatility) of the underlying security. That is, the higher the volatility of the stock, the lower the risk of writing the options, as the investor would have a higher buffer through a higher time value of money of the option.

The stock market volatility, measured by the CBOE Volatility Index (VIX), has been at a historically high number since the start of the COVID-19 pandemic. Historically, as shown in the next chart, the VIX has been trading between 10 and 20, and since the pandemic, it has been trading over 25, peaking up to 80 during the first pandemic rout.

Source: Yahoo Charting, as of 2020/11/02

So, with this historically high volatility, what should investors do? Here is a practical suggestion for the investor who has a long portfolio of stocks:

1. Identify the stocks that would be suitable for the application of this strategy; this is described in the section: "Which companies does this strategy apply to?" Assume that you identified Zoom as one of these securities.
2. For these stocks, write in-the-money short-term covered call options on the existing stocks. The term I am suggesting is three to six weeks. Assume that the current price of Zoom is $500; you would write call options with a strike price of $450 for a term of four weeks, and receive a premium of approximately $75.
3. If the stock price drops and the options expire worthless and do not get assigned, be happy with the premium that you received, and repeat from point 1. Assume that after four weeks, Zoom stock price dropped to $420, you would then keep the $75 and proceed with writing another in-the-money call, say for $380 for a term of four weeks, and receive another premium of $60.
4. When the options get assigned, write naked put options on the stock; the process for dealing with the naked put options is described in detail in my earlier article: "Option Strategies: Earning Dividends From Non-Dividend-Paying Companies." Assume that Zoom stock price remained at $500, it would then be assigned at $450, and that would have been equivalent to selling the stock at $525 ($450 plus $75). If you are bullish on the stock, you would then write in the money naked put options at $530 for a week or two, and receive a premium of $45. If you are not very bullish on the stock, you would then write out-of-the-money naked put options at $480 for a week or two and receive a premium of $10.

The following flow chart shows the process in a visual form. If you are shorting stocks, you can apply the same strategy; just replace "call options" with "put options," and vice versa.

Source: Created by Author

To summarize, once you determine that the company you are analyzing is suitable for writing options, you would write the options as follows:

• Instead of buying the stock, you would write put options. If you do not have a position on the stock, you would be writing a naked put option. If you are buying the stock to cover a short position, you would be writing a covered put option.
• Instead of selling the stock, you would write call options. If you do not have a position on the stock and want to short it, you would write naked call options instead. If you hold the stock and want to sell it, you would write a covered call option.

The decision on whether to write the option in the money or out of the money depends on two factors:

1. Your fundamental and technical analysis of whether the stock is overvalued or undervalued.
2. The recent historical movement of the stock of whether it is trending upwards or downwards.

These two factors are well-represented together with their rationale in the three magic quadrant decision tables presented earlier in the article. These decision tables would give the investors the blueprints of how to conduct their investments using options writing.

There are many other factors that need to be taken into consideration, including the term of the options (which primarily depends on the risk profile of the investor), the number of contracts to be written, if spreads can be used in lieu of naked option writing and whether multiple strikes/terms for the same security should be used or not. These would be topics of future options strategies articles.

Personal Experience and Conclusion

Over the years, I switched my investment/trading strategy towards almost strictly writing options while investing my cash in fixed-income securities. I occasionally let an option get assigned and end up owning or shorting a stock. When to let a written option get assigned versus rolling it over to a future date is a complex decision and may be the topic of another article.

Zoom was one company on which I have used this strategy very effectively; I had 2 naked put option contracts expiring on almost a weekly basis over the last year. This resulted in a very good return on investment, much higher than what I would have received from buying and holding the stock. In general, my portfolio contained naked call and put options of approximately 15-20 different companies at any one time.

This strategy allowed me to invest in a very large number of securities that I could not have invested in otherwise without taking a significant security risk, in addition to selling my fixed-income securities; most of the stocks that I invest in are described in the AI portfolio that I had published in an earlier article.

Since adopting this strategy, I found my portfolio providing a more steady return at a much lower volatility. I performed some mathematical calculations associated with this, and I now have an idea of how to prove mathematically that creating a diversified portfolio of written options provides a higher return and a much lower volatility compared to a diversified portfolio of stocks.

In a very simplified manner, the primary reason for this hypothesis is because the valuation of the individual options is based on the individual volatility of the stock, while the volatility of the overall portfolio is based on the "indexed" volatility, which is much lower than the individual volatility. In other words, you would sell a security that has a very high volatility, while the overall risk (measured by the portfolio volatility) would relatively be very low. This results in creating a better efficient frontier for my portfolio, as described earlier in the article.

When you write options, you are more of an insurer than an investor, and you are earning a premium on the insurance you are selling. The strategy presented here is far less risky than buying or selling/shorting individual stocks and placing limit orders on them, but it requires a remarkable discipline in the management of your portfolio. This discipline would result in achieving abnormally higher returns, while experiencing a very low volatility on your portfolio.

Like all other option strategies, you need to have a solid mathematical background to be able to "feel" the options and their prices. The mathematics behind the strategy is not easy, and explaining it goes beyond the scope of most articles published on Seeking Alpha. There are many resources available that I would strongly recommend that you go through, including YouTube and the book I have written, which I am making available for you to download ("Naked Puts - Risky or Not? A Simplified Guide to Options Investing"), together with countless other resources on the Internet. In other words, before investing using options, you need to first invest in yourself by studying the intricacies of the behaviour of market-traded options.

If you have any questions or comments about this strategy, or you would like me to address other specific option strategies in subsequent articles, please post on the comments below, or send me a message.

If you liked this article, you might want to follow me so that you can get an e-mail notification of the articles that I write.

Analyst’s Disclosure: I am/we are long ZM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Comments

[larryklein]

what online tool do you recommend:
I want to quickly see the various calls and puts for an indicated security and have the software tell me the specific put or call that has the best return and lowest chance of exercise

[Ramy Taraboulsi, CFA]

@larryklein Seeking Alpha Premium has some good features. However, I am using TD, and look at the specific options with the highest volatility for a specific stock that I deemed underpriced to write put options on. I never let the volatility select the stock, and always start with fundamental analysis on the stock.

[larryklein]

@Ramy Taraboulsi, CFA since 90% of a stock's performance is correlated with the market in the short run, if you have 5 positions on which you have written puts, then they all "go south" during a market decline and you have either been put the shares in all positions or buy back the puts at a loss. Is this correct?

[Make good choices]

@larryklein You asked,
"if you have 5 positions on which you have written puts, then they all "go south" during a market decline and you have either been put the shares in all positions or buy back the puts at a loss. Is this correct?"

You listed two, out of three possible choices.
1) Take assignment, where the current stock price is lower than what you paid for the shares.
2) Buy back the puts at a loss.

But there is a third choice.
My favorite choice is,
3) Roll the same put strike, or down one strike, and out to a farther expiration, to earn a net credit, and avoid assignment.

(Buy to close the expiring put for a loss, and simultaneously sell to open a new put, either at the same strike price, (if the stock price is slightly in the money), or one strike price down, (if the stock price is deep in the money), and out far enough in expiration to earn a credit that is LARGER than the cost of buying to close the expiring put. This results in a net credit.

I consider rolling down one strike, as a repair strategy, and do not look for a large net credit. I am looking to avoid assignment. I am looking to earn a small net credit, and extend the expiration duration as little as possible.)

If the put is still in the money by expiration day, roll the put again, down one strike, and out to a farther expiration, to earn a net credit, and avoid assignment, and extend the duration of the expiration date. Eventually, the put strike will be brought down to the stocks current market price, and will eventually expire out of the money. You keep all the accumulated net credits as profit.

Rolling down one strike price at a time, accomplishes three objectives.
1) Avoid assignment of a deep in the money put. This benefit should be obvious.
2) Earn a small profit that is credited into your account immediately, but does not count as taxable income, until the put is closed by expiring worthless, or you buy to close the put for less money than you sold it for.
3) Each time you roll the strike price down, you are reducing your capital at risk, AND, you are bringing the strike price closer to at the money premiums, which become more profitable.

There is a bonus benefit.
4) You have the opportunity to have your put strikes follow the stocks falling prices down to their bottom low, where you can then choose to let the put expire at, or near the stocks new low.
Get PAID to buy the stock near it's low.

A rolling put gathers no loss.
Knowledge IS power, ONLY if you apply that knowledge.

[Tennislover]

Thank you for the great article.
Have a question ( it may sound silly).
I have sold a covered call on XOM ( Exxon mobil ) - and I own the shares of the company hence the covered call.
I know the 2 boxes that explain - "Action on existing position" is applicable here.
Do I use the box for Short position or long position. ( I know it sounds basic)- but I am trying to figure out if I am short or long on my Exxon mobil stock and the covered call option I have sold on it.
I think I am short as I have sold a call . Am I correct.
Thanks

[Ramy Taraboulsi, CFA]

@Tennislover , if you hold the shares and sold calls, which are now in the money, you are neither short or long. If the options are "out of the money" then you are long with the existing shares. If you don't have the shares and just wrote the options then you are short.

Seems that your options are now in the money. Usually, I do one of two things: If I believe that the stock will further go up, I roll over the options. If I believe that the stock has taken its run then I let the option be assigned and we have another fork: If I want to maintain a position, I write a put option. If I no longer want a position, I do nothing.

Please let me know if this answers your question.

Thanks.

[Tennislover]

@Ramy Taraboulsi, CFA
It does answer my question, I did not know that there was a position where you are neither long or short. But it does make sense. So is it fair to assume short position always means you are in a position that you owe someone something that you do not have whether it is cash or stocks ? Or does short position have other definitions as well. I like the detailed explanation of the position you are in , rather than saying long or short. Thanks again for your insight, explanation.

[Ramy Taraboulsi, CFA]

@Tennislover A short position means that the value of your holdings will drop when the stock price goes up. When you have deep in the money covered calls, the increase in the stock price will have a very small effect on the position of your portfolio, implying that you are neither long nor short.

This is a simplified definition of a "short position".

[User 48581110]

We make a comfortable living doing just what you are doing. In our case, are totally out of bonds, and only 28% in stocks on 27 positions, at this point. Our equity portfolio was mostly achieved through writing puts on stocks we wanted to own anyway. So, we can either live off of the income from writing the option or use it to effectively reduce our average cost on the stock if assigned...win-win! We, too, write calls when positions get lofty in price and create a profit and use that capital for further options profits.
We are sometimes baffled why some of these high-yield authors are "giddy" when they recommend and buy a stock with an 9% yield. Selling a put option, or a strangle or straddle on the stock can easily create a conservative (very low risk option) of 15-30% annualized return or a huge discount on the underlying. One does not have to trade options in a risky way.
Trading options is not for those who have a tendency toward addiction, either to drugs or adrenaline. It requires great discipline, patience and a system to do well repeatedly. If one is not able to put a a good deal of time into options training, then it is best to not pursue it casually.
Another thing, we never buy options. We are sellers of options...we are the casino, not the gambler. It is a business for us and over 1,000 trades later, has provided a nice living
No day trading, and no margin...safe, conservative, dependable.

[Ramy Taraboulsi, CFA]

@WCM Investments
"no margin"? I am not entirely sure about that. Maybe no interest, but your margin is certainly consumed out of writing put options.

Thanks for your comment. It 100% reflects my conviction...

[31October]

I have learned that no matter what I do, I will be WRONG, but I use options to make money by being wrong. I sell an inverted strangle, with the put side ITM for this Friday and a *lower* strike price deep ITM call for the following week. High-priced shares to be put to me this Friday, then shares will be assigned and called away at a lower price the following Friday. Repeat bi-weekly. I lose money on every share but make more on every contract, leading to less risky returns.
Example: Sell PLUG $17.50 May 20 put + $12.50 May 27 call for $542 in total premiums. ($542 premiums -$1750 put assigned + 1250 call assigned = $31 profit) That is about 44% annualized yield.
There are of course risks to any strategy, but I like this one for the consistent returns and low impact on margin.

[Make good choices]

@WCM Investments We have a lot in common, on our view of selling CSP's.
BUYING options, is gambling.
SELLING CSP's, is like being the CASINO.
Over the long term, the HOUSE, ALWAYS wins.
Be the CASINO.

Especially if you know how to roll ITM puts, out to a farther expiration,
OR, down one strike price, and out to a farther expiration, out far enough, to earn a net credit.
(NET CREDIT=Buy to close the expiring ITM PUT at a loss, and simultaneously, sell to open a new PUT with a farther out expiration, for a credit that is LARGER than the loss of buying back the old put.)
You (almost) never have to take assignment on a deep ITM put.
On the rare occasions that I have had shares "put" to me, because of early assignment, I used the "share/put swap" strategy, to return my position back to a ITM put position, AND earned a few dollars in the process.

This has worked out soo well for me, that I sold off all my dividend, and growth stocks, and now stay in cash, to use as collateral to sell CSP's.

I no longer use margin either. Good thing too. The recent market has brought ALL my puts deep ITM.
So what if my account value is only equal to 60% of the cash in the account.
As I roll the strike prices down one strike price at each expiration, OR, as the market recovers, the drawdown from the ITM puts will shrink.

During these bad times, I still roll my deep in the money puts, as they are about to expire, to avoid assignment, and to earn net credits, (more cash flow), and earn more ROI than the average dividend stock.

Then, when my puts strikes are ATM again, the premiums will be HUGE, again.

If I had kept my dividend stocks, and NOT sold puts instead, my account value would STILL be deep in the red, but with no cash in the account, and who knows if the div's will be cut or halted during these tough times we live in.

"No day trading, and no margin...safe, conservative, dependable."

Most stock investors just can't wrap their heads around just how true your statement is, regarding selling CASH secured puts.

A rolling put, gathers no loss.
Make good choices

[RedRock Asset Management GmbH]

@Ramy Taraboulsi, CFA I wan going through your criteria for stock selection and I have some doubts.
you mention, among others:
1) The company has a high volatility (higher than 60%, and the higher the better).
2) When writing put options, the company should not be distributing dividends, or should be distributing minimal dividends (yield less than 1%).
3) When writing call options, companies that distribute dividends provide a lower risk and should be considered.

so I was wondering, especially in regards to the strategies applicable when you do not own the stock.
Say that I identify a stock that is undervalued and is on a current downtrend (like Pepsi). I like it but it has a IV of 22% and pays a dividend of more than 3%. Based on your chart, I should sell a PUT OTM, but this goes against your criteria number 1 and 2 above, for stock selection. Could you please explain better? Thanks a lot

[Ramy Taraboulsi, CFA]

@Saviolino , great question and thanks for commenting.

Let me first start by saying that option strategies are not suitable for every situation.

To illustrate, let me take the case case of Pepsi: seems that buying the stock directly seems to be a better choice than writing options.

I would not advocate writing options for Pepsi for two reasons: The volatility is low and it distributes relatively high dividends. These two factors make the premiums very low, and as a result, the return on investment would not be as high as buying the stock directly.

Please let me know if this answers your question and thanks again.

[Ashland Heights Investments]

@Ramy Taraboulsi, CFA You highlight kind of the conundrum of Options. The underlying needs to be high volatility, which implies low volume/Mkt Cap of shares, but also liquid enough to have high volume of Options, in addition to low dividends, etc. It's a rare case that all requirements are satisfied--but they do exist.

[RedRock Asset Management GmbH]

@Ramy Taraboulsi, CFA yes, it makes sense. Thanks for your answer. I just finished your book, and I wonder why my parents in love never gave me those piece of advice :)

[Ashland Heights Investments]

I just came across this post on Twitter which has tables of Real Volatility vs. Impl Vol of various ETF's. Interesting concept. He programmed it from IB's API:
pbs.twimg.com/...

[Ramy Taraboulsi, CFA]

@Ashland Heights Investments Very interesting. TD Waterhouse gives me historical for any stock for 20 days; it would be nice to see the implied volatility against the historical volatility as part of the option chain for each option, where the historical volatility is for a period equal to the term of the option.

Do you know the twimg link is for which option term?

Thanks for posting the link.

[Ashland Heights Investments]

@Ramy Taraboulsi, CFA I believe he mentioned it is 30-day term.

[RedRock Asset Management GmbH]

Dear Ramy, I will try to take advantage of your knowledge and understand better the concept of rolling. I will use an easy example of a strategy that I do understand.

Say that there is a stock I would like to have, which is undervalued and currently in uptrend. You want to earn an income with the Premium and, if mistaken (meaning the option expires ITM), end up with the stock (you wanted in the first place, so no big deal). I will use a real example of a stock I want (VOW)

So the stock today is at a PRICE = 189, I sell a PUT ITM with a STRIKE = 220 (deep ITM), and collect a PREMIUM = 30,40. My breakeven would be STR – PREM = 189,60.

First, easy scenario, is when the final price at expiry date is above the Strike, hence the option expires and I get the premium and not the stock.

Second case is when, close to expiry date, the stock price is in the range between 0 & 220, meaning the buyer will exercise the right to sell at 220 and I will have the stock. Now I could have 2 scenarios:

1) The price is between 189,6 & 200 = the option contract closes with a gain for me

2) The price is below 189,6 = the contract closes with a loss

For the case 1) I have the chance to roll the contract and repeat the entire process, and do that again, until one day the final price will be above my strike and the option expires. This means that the uptrend continues, so I must check that the price does not reach a value for which the stock in no longer undervalued

For the case 2) now the trend in no longer UP, meaning that I can either think:

A) It is temporary, the stock will go up again, I keep the stock

B) There is an inversion of trend, now is at 185, will go lower. I do not want to close with a loss, I must roll the contract, making it a PUT OTM? So close the first option buy buying back the initial PUT and sell a PUT say at 180

I hope you can bring some light on these whole “case-study”

Thanks

[Ramy Taraboulsi, CFA]

@Saviolino, your case study makes good sense. The only thing that I would suggest is that you should close your position only if your fundamental analysis indicates that the stock is overpriced. As long as it is underpriced, you should continue rolling it forward (if it is assigned) regardless of whether you are profiting or not. As a result, you might be able to simplify the process a bit from what you described above.

Hope this helps.

[Make good choices]

@Saviolino and Attn: Ramy Taraboulsi, CFA
This looks like a bad trade to me. IMHO.
The strike is $220. The current stock price is $189. The difference between $220 and $189 is $31, But you only get $30.40 premium?
What happened to the intrinsic value?
What happened to the extrinsic value?

You don't mention the expiration date of the itm put option, but shouldn't the premium collected be MORE than the $31 difference between the strike price and the current stock price, when the itm put was sold? Shouldn't your breakeven be BELOW $189?

Looks like you got skunked by the bid/ask spread on the put.
As soon as you made this trade, the stock price is already below your $189.60 cost basis, and you start off in a loosing trade.

I sell a lot of otm cash secured puts, so I am only selling extrinsic value as premium, so maybe I'm missing something. If I sell a put with an otm strike of $185, and collect $1 premium, then my breakeven, if assigned, is $184

[Ramy Taraboulsi, CFA]

@Make good choices Thanks for your comment; your argument makes sense.

@Saviolino how did you get a premium less than $31 (unless it is the week of the expiry where the market maker puts bids and asks around the intrinsic value for low volatility stocks). Am I missing something here?

[RedRock Asset Management GmbH]

Dear Ramy, thank you very much for this article. I have read it several times and yet I do not understand it very well. It will be due to the fact that I am Italian and do not clearly understand everything ot that I am a newbie in this topic (options) or both. Hence some questions that, I hope, you will have the patience to read and answer:

1) In the quadrant inherent NOT having a stock, you mention that if is OVER & UP-trend you should write a CALL OTM. Basically you are shorting the stock, but who would ever short something that is on an uptrend. Expensive can become more expensive and overvalued more overvalued. So if I am not mistaken and selling a call OTM means that the Strike price (say 200) is far above the current price (say 180), if the price goes up and goes beyond the strike (say arrives at 210 at expiry date), the buyer will call his right to have me sell and I will be forced to buy at 210 and sell at 200. Wouldn´t it be better to chase the trend but not to risk to own the stock in the end? Basically I suggest to sell a put OTM (say with a strike at 170), so that if price continues its trend, I take the premium and not the stock.

2) Similar to above, I do not understand, in the same quadrant, why you do not short a stock that is UNDER & DOWN-trend. In fact you suggest to write a PUT OTM, saying that you do want to minimize the risk of ending ITM. But if price falls (was 200, bought a PUT with Strike of 180) to 170, you will be ITM and will receive a stock that you do not want. Who wants a stock that is on DOWN-trend, even though undervalued? Basically you are betting against the trend that, for my very little knowledge and experience, you should never do. The first thing I have been thought is that you buy on uptrend and sell on downtrend. So why not writing a CALL OTM (say at a strike of 210).

The quadrant inherent “how to manage a short position” almost drove me crazy :)

I still do not get why someone would decide to short something that is on Uptrend, hence I do not understand both the upper quadrants of that topic.

Finally the quadrant inherent “how to manage a long position” I do not understand why you write a CALL OTM. Basically you are exposing yourself to the risk of shorting something (low risk, being OTM, but still risk). If price hits the strike you lose a stock that is undervalued and has momentum. Why don´t you buy more? Selling a PUT ITM for example?

Please forgive me for not being concise but this entire topic (options) is tough for me

Thanks, Michele

[Ramy Taraboulsi, CFA]

@Saviolino, I see exactly where you are coming from.

One of the popular approaches in the market is "follow the trend". I personally never subscribed to this approach over the last 30+ years of investing. While in some situations it resulted in short term losses, on the long term, relying on the valuation and going against the trend, always resulted in healthy gains.

Let me explain with an example: Assume that you look at a stock, and your fundamental analysis (adjusting the financials based on the latest news, mark-to-market the assets, estimate the WACC and growth, and calculate the estimated discounted cash flow) indicated that the stock is highly over-priced.

However, the stock is on an up-trend; the current "mindset" of investors, most of which have yet to experience a bear market, is to buy the stock hoping that a bigger fool will buy it back from them at a higher price.

But you are different: This uptrend, based on your analysis would NOT continue for an extended period of time, and eventually there will not be enough fools to buy the stock back at a higher price. Trying to time the market to write the call option at the peak is a virtual impossibility, so the approach that you write call options out of the money.

If the trend continues, and the stock is about to be assigned, you would roll it over to a future date, at a higher price, and make a small amount of cash while doing that. You would continue doing that as long as my fundamental analysis indicates that the stock is over-priced. Eventually it will drop and the options would expire worthless. Of course, the risk

Michele, this is what I have been doing, and many years of experience confirmed that this conservative approach to shorting does work.

Please let me know if this helps.

[RedRock Asset Management GmbH]

@Ramy Taraboulsi, CFA that helps a lot. Finally an author that answers to people who raise questions, explains clearly and make himself understood. you´ve got a new follower, 100%

[Ashland Heights Investments]

Options Pair Trade Idea--

TELL Short Call 4/19/21 2.5 strike 0.15 premium 160% IV (shares at $1.5)

GLOG Long Call 5/21/21 5.0 strike 1.15 premium 60% IV (shares at $5.4)

Use the income on the short to pay for the long.

[Ramy Taraboulsi, CFA]

Don't know @Ashland Heights Investments about shorting Tesla; Looking today at what Mobileye is doing (out of CES-2021 Intel Keynote Presentation), I can see how more advanced Tesla is. Shorting Tesla is playing with fire.

My personal prediction is that within 10-15 years, 50% of the world cars will come from Tesla.

[Godspeed Trader]

** If you want to buy a new stock => Sell naked put option instead

I don't understand.

I want to buy ZM stock let's say at $500 (because i think it will go up to $1000)

so i proceed to 'sell the right to sell ZM shares at $500', become an insurer myself

who will buy my naked put?

If it goes up to $1000, i miss the boat

and my naked put is out of money because nobody is going to exercise that $500 when ZM is already $1000

I do, however, collect a premium on my naked put.

What am i missing here?

seriously an option noob =/

[Ashland Heights Investments]

Sell a Put that is already in the money (for the buyer). It will likely be exercised, but not a sure thing.

[Ramy Taraboulsi, CFA]

Hi Alex,

What you are missing here is that there is a "market maker" for options, not really an investor, but someone who is willing to buy the options at a price slightly lower than the mathematical option valuation (Black-Scholes model, for example) and ready to sell the shares at a price slightly higher than the mathematical options valuation.

With the presence of the "market maker" you do not need to find a matching party like we normally do in actively traded stocks.

And, yes, if the stock becomes a runaway stock, you will miss the boat, unless you continue rolling it over to future dates, assuming that you have enough margin to do that.

Please let me know if I answered your questions.

[Jon Brien]

Thank you. Exceptional article. One of the best I've ever read on Seeking Alpha. Five stars easily.

[Ashland Heights Investments]

@Ramy Taraboulsi, CFA do you know of a place where you can sort all market Options according to I.V. (i.e. highest to lowest)?

[Ramy Taraboulsi, CFA]

I am not aware of such a site. If you find it, please let me know.

Having said that, I think I would primarily use it for pointing me to new companies that deserve studying.

[Ashland Heights Investments]

Agreed, it would be useful also perhaps for comparing IV's of similar companies/strikes side-by-side.

Probably, you'd have to code an API to do these.

In essence, if you're shorting calls, you're looking for the IV's that are over-valued. Meaning the quoted IV is greater than your calculation of "intrinsic" IV. Conversely, if you're a buyer, you want to buy volatility for cheap and sell it higher.

Nearly finished with your book.

Great thread here.

[Nick Mumford]

@Ashland Heights Investments In Interactive Brokers TWS system you can scan stocks with an implied vol filter. Not perfect but a useful screening tool.

[Raymond W L Lee]

As much as this article is relatively thorough compared with others I have read, I would still strongly advise anyone who are considering employing options within their portfolio to go through some serious education. This may include courses, online videos and articles, or even time to observe how price of options move with the underlying security. The hidden dangers that most retail investors encounter when employing options include leverage, convexity and lack of awareness on the option greeks. This article does a good job but there is only so much one can learn from a single article. I would say there are plenty of free resources in the open internet so on the theory side it should cost precious little.

[Ashland Heights Investments]

@Ramy Taraboulsi, CFA to that point, any good books on Options that you recommend?

[Ramy Taraboulsi, CFA]

@Ashland Heights Investments , I have written a book about options investing about 20 years ago, and I am providing a link to the book near the end of the article. The examples in the book may be old, but the principles have not changed. Have you had the chance to review it?

Personally, I would suggest attending lectures about options investing on YouTube. There are tons of them, but most of them are not deep enough.

[Greg_Maryland]

FWIW, I got a lot out of Options for the Beginner and Beyond by W. Edward Olmstead. The author is a math professor at Northwestern and is writing style I found easy to understand.

[Denis Trofimov]

@Ramy Taraboulsi, CFA errata:

> Writing options (the transactions on the right) are less risky than the transactions on the left

I see now on the first pucture that writing options are in the lower half, not the left one.

[Ramy Taraboulsi, CFA]

@Denis Trofimov , thanks for your comment.

Yes, you are right when it comes to the picture. My statement was however referring to the list of the transactions just above it rather than the diagram, specifically:

** If you want to buy a new stock => Sell naked put option instead

** If you want to cover a short position => Write covered put option instead

** If you want to short a new stock => Write call option instead

** If you want to sell an existing stock position => Write covered call option instead

Please let me know if this addresses your comment.

Thanks again.

[Denis Trofimov]

Hi @Ramy Taraboulsi, CFA ! Thanks for a clarification.

My eyes got attracted to a picture above.

PS. The trade MOEX in Russia is trading "marginal" options, when the writer don't receive a 100% premium debit to her account but instaed starts with zero (0) and get debit slowly "drop by drop" at each daily trade clearing session. I guess each day I as a write got to receive a time value won if theta is positive.

This way the trade outsmarts traders giving no premium to invest in fixed income securities.

[Emma2013]

@Ramy Taraboulsi, CFA re: "The company has a high volatility (higher than 60%, and the higher the better)." Where do you find this statistic? That is different than the IV for a specific contract, correct?

[Ramy Taraboulsi, CFA]

@Emma2013 , good question. Let me try to answer it.

First, I am talking about the implied volatility, not the historical volatility. The historical volatility is practically irrelevant as it does not get used in the calculation of the option premium.

Now, you are raising an important point: If the implied volatility is much higher than the historical volatility, then it would be an indicator that writing options would be the right thing. There are many other issues associated with the volatility including the volatility smile for both the term and the strike price and which historical volatility needs to be considered. This may be the topic of another article.

As for the 60%, it is based on my own personal experience and you can consider it a rule of thumb. I don't have any references for it.

[jf31]

I like to write cash secured puts on nvidia stock. It is very volatile so I usually go with a 15 delta. I can get $10 a contract at that level which is about 1% a month return on my money. This way I get a good return on my cash, I’m more than willing to pick up nvidia in a steep sell off. I repeat this process with Microsoft, apple, Facebook, etc. good premiums and these stocks get a good bid on small sell offs.

[Owen213]

thanks for the article, just starting out in investing and options, that was a fascinating read

[Retired Investor]

@Owen213 You might appreciate my article explaining the data available for option traders. seekingalpha.com/...

[Ramy Taraboulsi, CFA]

@Retired Investor , looks like a very good article (and deep one too). I like these types of articles. It requires time to study and I put it on my list of articles to read over the weekend. Thanks for sharing...

[Ashland Heights Investments]

"When writing put options, the company should not be distributing dividends, or should be distributing minimal dividends (yield less than 1%)."

Why is this @Ramy Taraboulsi, CFA ? Is it just that you miss out on the dividend before expiration or is there something more complex going on that makes dividend-paying stocks not worth to write-puts?

[Ramy Taraboulsi, CFA]

Very good question @Ashland Heights Investments .

There are two reasons:

(1) Once the dividend is distributed, the value of the stock drops by the amount of the dividend, and the value of the put option would increase by this amount increasing the risk for the investor.

(2) The option valuation is inversely proportional with the distribution of the stock. The higher the dividend, the lower is the time value of money of the options. While this might sound counter-intuitive for put options, it is true primarily because of the call-put parity.

Please let me know if this answers your question.

[Ashland Heights Investments]

Makes sense. Maybe this is oversimplifying, but you could adjust the premium income downward by the amount of cum. div's until expiry.

This becomes the "true" income.

[Ramy Taraboulsi, CFA]

@Ashland Heights Investments , I don't think it is "true income"; It would be recorded as capital gains which is more advantageous from a taxation perspective.

[Emma2013]

Hello Ramy,

Thank you for the article AND the free book - that is generous of you to offer it for free.

I have some limited experience with selling put options to acquire stocks I want to own at a discount so deciding on the strike price has been relatively easy - I never paid attention or bothered to learn about greeks, IV etc - I just decided on the max I was willing to pay, picked the closest monthly expiration & either got assigned or pocketed the premium and rinse/repeat.

Now I want to try writing puts for income & have identified a stock with price trending strongly upward. Does the put writing strategy you describe work well with weeklies? Also would you roll the option if close to getting assigned on expiration?

[Ramy Taraboulsi, CFA]

@Emma2013 , that for your comment and kind words. You seem to be doing the right thing with your approach.

The weekly options are really not different from the monthly ones. When I select a particular term, I don't take into consideration the weeklies versus monthlies. The challenge is that if it is deep in the money you may not find the strike price in the weeklies and you may need to go to the monthlies.

Yes, I normally do roll the option if it is getting close to be assigned. The timing for the roll out is tricking. If it is deep in the money, I tend to roll it over to a future date a few days before the expiry date.

Please let me know if this answers your questions.

[grasul_x]

@Ramy Taraboulsi, CFA "When to let a written option get assigned versus rolling it over to a future date is a complex decision and may be the topic of another article." Please can you post this article ASAP? :)

[Ramy Taraboulsi, CFA]

o.k. @grasul_x . It would be my article after next; I tend to alternate between writing articles about options and articles about specific stocks.

Thanks for the suggestion.

[Value living]

After loosing money in direct buying put or call options, I changed to this passive strategy.

I sell cash secured put option on tesla, if assigned will sell calls. This working like charm. No brainer. Good premiums.. depending on assignment I may have to sell call for 4 weeks ahead. Now I plan to 4 active trades in a month. I.e 1 week out, 2 week out, 3 week out, 4 week out.

[Ramy Taraboulsi, CFA]

@Value living , instead of letting the put option get assigned, you might like to consider rolling it over to a future date, possibly with a more favourable strike price, and earning some cash on the side...

[Value living]

what is the advantage of rolling instead of getting assigned or closing for loss. could you site an example. I never did rolled before.

[Ramy Taraboulsi, CFA]

If you still believe in the stock, and there is a sharp economic downturn (rather than a fundamental problem with the company operations), I would roll over the option to a future date, usually at a more favourable strike price, and even make money out of it.

Recently, I rolled over Zoom. I believe in the company prospects, and tend to write in-the-money put options on it. These options are 2-3 weeks away. If they expire worthless, I would write other contracts. If they are still in the money at the time of expiry, I would roll them over to a future contract (close my position and open a new position) so that I generate cash out of this transaction. I have done that at least 10 times over the last year on Zoom, and so far, these rolled contracts end up expiring worthless. Sometimes I have to roll it a few times to get it to expire worthless.

@Value living , please let me know if I answered your question.