Option writing is not as easy as it sounds. There are many decisions that the investor must make before jumping into this business. Just like any other business, it requires some training in order to give you a better chance of succeeding.
To open up shop and begin our option writing business, we should have some specific objectives to guide us, and the two which I feel are the most important to the covered option writer are:
1. To maximize the flow of income per month.
2. To minimize the risk to the portfolio.
In order to maximize the flow of income from the covered option writing business, the covered option writer should attempt to extract at least a 20% annual return on the value of each 100 shares of stock held in his or her portfolio.
The second objective is to continually gather enough option premium to reduce the downside risk of holding common stock, and to sell off stock positions that become unattractive because of changes in their inherent price trend.
With these objectives in mind, we must make some important decisions in choosing which stocks we will purchase for the purpose of option writing.
Many investors are in the position of already owning a portfolio of common stock that they definitely plan to keep for tax reasons or other considerations. These stock positions will greatly influence their flexibility and profits when writing options. Others will have the freedom to select stocks that are more conducive to option writing.
Guidelines For Stock Selection:
In the search for the correct stocks for covered option writing, consider the following guidelines closely to aid you in attaining the objectives that we have set.
Select stocks with a high volatility.
There are conflicting arguments over this point. Many option players believe that stocks with a low volatility are far easier to handle, are assigned less often and require less watching. But stocks that maintain a low volatility normally have poor premiums, and it would be difficult to use these types of stocks in your portfolio and attain the goals we have set for operating our business.
On the other hand, you will find as you get into this new business that stocks with a high volatility have much higher premiums in their listed options. These stocks normally have better liquidity, as do their listed options. Normally, stocks with high volatility also act in a much healthier and predictable manger. Further, volatile stocks will create a good income flow — one that can generate up to a 30% to 40% return per year.
Select stocks that are in an uptrend and sell any stocks that show a reversal of trend.
In covered option writing, we buy stock and sell call options against each 100 shares of stock. Therefore, it is important for the reduction of risk to insure that the stocks that you do purchase and place in your inventory are in an uptrend.
In a bear market, you cannot write options fast enough to protect your behind. If the stock is moving down at a rapid pace, you are going to take a loss.
Volatile stocks provide good premiums, and normally you can write fast enough to protect some of that downside risk, although it is very difficult to protect all of it. Therefore, you should only stock your shelves with common stocks that are in a bullish trend, and when a stock price changes its trend, you should divest yourself of that position.
Investors locked into a situation where they cannot afford to divest themselves of stock positions must, of course, take their losses during the periods when their stock is moving down significantly. But it is far better to be writing options during this period than to be sitting on your stocks praying for the next bull market.
Diversify your inventory of common stocks — hold at least four different stocks in different industries.
The wise covered option writer will always have a good range of common stocks in his portfolio. This diversity greatly diminishes risk.
If you have only one position and the stock dives downward in price, your performance will suffer, as you would not be able to write options fast enough to protect the total downside risk.
To smooth out the peaks and troughs of the stock values that are held in your portfolio, attempt to hold at least four positions. This number has been academically proven to provide good diversity.
Favor low-priced stocks over high-priced stocks.
Low-priced stocks, in the neighborhood of $10, $15 or $20 a share, have a tendency to have higher premiums per the value of that stock as compared to stocks that are running at $100 or $200 a share.
Commissions are another area in which the writer of low-priced stocks has an advantage. If you use your funds to purchase 1,000 shares of a $20 stock, rather than 100 shares of $100 stock, you can reduce the commission costs of writing options because you can work with 10 options rather than just one option.
Purchase stocks on margin — fill your stores as full as possible with merchandise.
When you begin your option writing business, set aside a lump sum that you will use to purchase your merchandise, i.e., the common stock that you will be writing options against.
If you are aggressive, you should attempt to get the maximum leverage from your investment. If you have $20,000 to invest in covered option writing, you should be purchasing as much stock as you possibly can with that money, even if you have to buy stock on margin (borrow money from the brokerage firm to buy stock).
The going interest rate for borrowing money to buy stock normally runs 8% to 10%. But by following the guidelines I have provided, you will generate better than 10% return from writing options, making marginal stock profitable. Thus, the option writer will buy as much stock, or merchandise, as he or she can on margin.
Another great advantage of covered option writing is that when you write options, you receive the premium from that option back immediately in the form of cash, which goes directly into your account, and can help to finance the purchase of more stocks.
Then, as you continue to generate more and more premium from your option writing business, this premium should be used to reinvest and obtain more and more stock, while at the same time making more margin available to purchase additional merchandise.
By holding a philosophy of expansion, you will obtain attractive return on your investments and see your portfolio grow rapidly.
Select stocks that have the highest yield.
A final consideration in the selection of which playable stocks should fill the shelves of your portfolio is the yield of that stock. Again, our objective is to maximize the flow of income per month. Dividends, of course, would be part of that income flow.
Therefore, the option writer should not only look at what kind of a premium he is going to obtain from writing options against 100 shares of stock, but also at the dividend of that stock, adding the dividend to the return that he will receive from his other option writing premiums.
Selection options that show the maximum income flow per month.
This guideline is critical. In measuring the income generated by an option, the only thing that we can consider is the time value, or the premium value of that option. The intrinsic value of the option should not be considered in this analysis.
You should only consider the intrinsic value of an option when you are attempting to provide some downside protection, but are not looking for actual income generation from that portion of the option.
Ken Trester started trading options when the first exchanges opened in 1973. He has been a computer science professor at Golden West College in Huntington Beach, CA, where he also taught a course on stock options trading. Ken is also widely quoted in publications such as Technical Analysis of Stocks & Commodities and Barron’s.