Our mindset needs to be slightly different when selling these OTM strikes in that a 2-4%, one-month return is too lofty a goal. I would set it more at 1-1 1/2% per month, ensuring that the implied volatility of the option is not too high. A high IV means that the market is anticipating a large price movement and that increases the possibility of the option ending up ITM. So settle for a lower premium and therefore less chance of assignment.
As a guideline, I like to see the share price at least 5% lower than the strike sold. As an example, if I sold a $50 strike, I would want that equity to be currently trading @ $47.50 or less, with the option premium generating 1 to 1 1/2% for the month. Let’s look at the options chain below for GMCR, one of the stocks often found on our premium watch list:
If the share price remains below $40 by expiration Friday (the third Friday of the month), no action is needed on your part and you’re free to sell another option the next month. If the share price is above the strike price ($40), you can roll the option (buy it back and sell the next month option). If you need cash to buy back the options and don’t have it in your account, you can sell enough shares to buy back the options and retain a majority of the original shares. In keeping with our cash allocation and portfolio rebalancing requirements we would tend to sell shares that have appreciated the most and have a dominant position in our portfolio.
Why Some Portfolio Overwriters Sell ITM Strikes
This is a riskier strategy if keeping the stock is important to the investor, but there is a case that can be made for it. It is generally used when the stock or market, in general, is declining and the ITM strikes will generate greater returns with more protection. Also, the higher delta of the option (amount the option changes with a corresponding $1 change in the stock price) will make it easier to close or roll the position (buy back the option). Investors also use the ITM approach in conjunction with technical analysis where support and resistance points are identified and ITM strikes are sold at resistance and closed or rolled if still ITM near expiration Friday.
What If Early Assignment Occurs?
This will not occur often, but it could eventually happen. In these cases, purchase an amount of shares equal to the obligation to deliver and notify your broker that these newly acquired shares should be indentified as the shares delivered to meet the option obligation. Check with your broker, before the fact, as to the best way to manage such scenarios.
Portfolio overwriting provides many of the advantages of the buy-write strategy, but because of tax implications, income goals, and strike management differ and need to be fully understood before taking action.
By Alan Ellman of TheBlueCollarInvestor.com