Devoted to understanding the basics and fundamentals of investing

Re: Options Risk

You write about writing naked options and ask for our comments about this level of risk. If I understand the practical application of such a strategy, you might use the sale of one option to pay for the other if you don't have stock or money; i.e. sell a naked call to buy several puts, in the hope that the stock goes down and you make a killing. If you are wrong, of course, you get the green weenie when you have to deliver stock on your naked call. Or you might sell some naked puts to buy a call in the hope that the stock goes up. If you are right, you make a nice profit on the call. But if you are wrong, you get the shaft when stock is put to you. I think this strategy is only for those with brass balls and a cast-iron stomach. It's probably the highest potential profit strategy, but it certainly is also the highest risk strategy that you can employ in options trading. Furthermore, your broker must be a very trusting soul to let you do this in the first place. Since the stock market crash in October of 1987, brokers are generally very reluctant to let all but their deepest-pocket customers write naked options. (I guess if you've got enough reserve capital, your broker might allow you the freedom to either get rich quickly or to crash and burn. However, it is very likely that your broker will be very nervous and watch your activities like a hawk. Naked options traders put several brokers into the deep six during the crash of '87, and nearly wiped out Schwab & Co. Wouldn't you consider this particular option strategy a pretty advanced one?

Re: Options Risk

You write about buying covered call options and contend, if I understand correctly, that the one scenario where you make a profit on your call option is when the price of the underlying stock appreciates about the value of the premium you paid for the option. While I would certainly agree that this is one way to profit from using a call option, I believe it is worth noting that it is certainly not the only one. For instance, (1) by simultaneously purchasing a call option and a put option (the long straddle), you might make money if the stock goes up or down. Sometimes the option premiums are cheap enough to justify buying BOTH a put and a call. If the stock goes up, you make your profit on the call option, as you have explained in your example. But if the stock goes down, you would also make your money on the put option. You lose a small amount of money (only what you paid for both options) only if the stock doesn't move at all. Conversely, (2) if you simultaneously sell a call option and a put option (the short straddle), you can make money if the stock does not go up or down. If it just sits there, you can make a profit. Sometimes the option premiums are expensive enough to justify selling both a put and a call. If the stock doesn't change very much until the options expire, you win and keep the premiums from both the put and the call options, as they expire worthless. If the stock goes down a lot, you will get the stock put to you. If the stock moves up strongly, you are forced to sell stock at the strike price. And just as you can insure a stock against loss by buying a put option to protect yourself from loss if your stock should plunge (ideal for the frequent trader), you can also (3) insure a stock sold short from loss if it should suddenly shoot up in price by buying a call option (ideal for the frequent short seller). The short hedge is a strategy much like buying some insurance to protect the short seller's position against any loss. Under the safety net of a call option, the short seller can short stock with impunity many times during the lifetime of the call option. The first few trades pay off your insurance cost, and all trades remaining in the next five months are safe and virtually risk-free. How many short sales can you do in five months? Heh, heh. This is a call option strategy that will help you sleep at night! You might (4) reduce the cost of your call option by selling a put option (buy the call and sell the put). If you want to buy a stock at a bargain price, but don't want to miss the move if you don't get the stock (i.e., have your cake and eat it too), you can buy a call option so you won't miss the action and, at the same time, sell a put option. The cost of your call option is reduced by the premium collected from selling the put option. Your primary goal in this instance is to make a killing with the call option, while your put option expires worthless when the stock takes off like a scalded dog, but your fall-back position is to get the stock at a bargain price if the big move up should occur much later than you expect. Note: Because call premiums are normally more expensive than are put premiums, this strategy is likely to result in a debit to your trading account! But this strategy allows you to buy a call option for a fraction of what you would normally pay. Just consider the possibilities:
(a) If the stock doesn't move at all, you lose only what you paid for the call option, less the money you received for selling the put. (b) If the stock drops below the put strike price, you win by getting the stock at a bargain price. You win even bigger if the stock then soars after you get it at a bargain. (c) If the stock stays below the put strike price, and never moves up, you are still ahead, since you were going to buy this stock anyway "at the market" at a higher price than you actually paid. You bought the stock you wanted at a bargain. It's just your back luck or bad timing that your stock went down instead of up, you poor bastard. But that would still have happened without the options stategy being employed, and you would have actually lost even more by just buying the stock at the market. (d) If your stock goes down and it is put to you and then it goes up while there is still some life left in the call, you are a double winner. You make money on the call and on your newly acquired stock too. (I admit, unfortunately, having a stock put to you before expiration is a pretty remote possibility, since most people would just rather sell their put than exercise it). You might also (5) sell your stock at higher than market price or make a huge profit on a correction buying two puts and selling one call. This strategy would be ideal for the long-term investor who is sick and tired of watching his stock go way up, only to fall way back down again. This strategy gives an investor a chance to sell his stock at a higher than market price, and/or to make huge profits if his stock again falls back into a correction. And this strategy will frequently cost nothing! In fact, you may even end up with a small credit to your trading account, since you can usually buy 2 or 3 puts for the proceeds received from selling one call. (People are such perennial bulls). If you think that one of your stocks has run up too far, too fast, you could just call your broker and sell it at the market. If you sold your long term position, you could end up paying income tax on a substantial gain. Even worse, you would just be forced to buy the stock back again later, because it is after all, a great stock. Far worse, you might do nothing and watch helplessly as your stock drops 30% while you are kicking yourself for having done nothing. But there is a better way: using options. The spread comes to your rescue! For free, or for a very small cost, you could have the following advantages: (a) You were wrong about a correction, and your stock just keeps going up and away forevermore. You get a higher than market price for your stock. You were going to sell at the market anyway, right? You win. Your puts expire worthless: no big deal.
(b) You were right about a correction. Your two (or three) put options give you a substantial profit. For every point that your stock drops below the strike price, you make a profit on one of your put options. Your remaining put options give you a clear profit! You are a substantial winner, and it cost you little or nothing to get into this enviable position. (c) The call option that you sold may get exercised (very unlikely), and while you still own the put options, the stock goes into correction. Score a big one! You just made big money in a declining market with no risk and at no cost to you, proving that you can have your cake and eat it too! Or you could go for broke and (6) take the ultimate gamble by employing an option pyramid ($300 in, $300,000 out!). If it works, and it sometimes does, you can make incredible amounts of money with a very small investment. This extremely risky strategy depends upon a large sustained move in the price of a stock. Your strategy is to trade up your option every 5 points. Assume that you buy a premium 5 points out of the money for 3 and sell it for 7 when it is right on the money (i.e. right at the strike price). For simplicity, this same price growth in the option premium will be assumed. The actual gain in premium could be more or less, depending upon crowd psychology. You buy the call in increasing multiples of 5 for every 5 points of stock price appreciation, selling successively at each next 5 point level for a proceeds price which is over twice the purchase price of the call. You repeat this all the way up to the top of the stock's move. Then this same strategy can be repeated on the way down, using put options. It quickly becomes apparent that a string of winning options can be pyramided and played like a bet at the race track. You can also (7) reduce your income tax liability using call options. Turning profits into losses can sometimes save you a great deal of money on your income tax return, thereby increasing your net income. There are certain conditions when this strategy is feasible. Suppose that you had written a covered call option, and the stock ran up in price. It is clear that the option will be exercised upon expiration. You changed your mind, and you really want to keep your stock. (In other words, you want to back out of the option and keep your stock). (a) You could let the call option get exercised. Your stock is sold and you are now liable for 33% tax on a $5,000 capital gain. You buy your stock back. (b) You could buy your call option back. This would indeed generate a loss since you had to buy it back for far more than you sold it for. However, in buying back your call, you must also pay for the premium (time value left in the option), which could be several points. (c) You could buy new shares at the market, and deliver those at a lower price to close the contract out (buy high and sell low). This is the best approach, since you keep your original stock, and avoid paying taxes on them. By delivering new stock at a loss, you have converted a taxable event into a tax loss. Finally, you can (8) sell stocks for more than their market price by writing a covered call option against the shares you own (or buy stocks for less than market price by selling a put option). This last strategy is my absolute favorite (selling puts): You get paid cash up front if you are willing to buy a stock at a bargain price. If I liked the stock in the first place, I would have been willing to buy it at the market price. Instead, I buy the stock at less than the earnings multiple for which it is currently trading in the market, after collecting the premium on the put option up front. It is like taking candy from a baby! Undoubtedly, I have forgotten to mention other examples of how employing call option strategies can make you a profit or otherwise benefit you in your trading success, but the eight I just mentioned came to mind as those most obvious ideas worth sharing.