Deciding Which Options to Sell

06/21/2010 10:59 am EST

Focus: OPTIONS

Mark Wolfinger

Educator, MDWoptions

When trading options, there are often many reasonable alternatives, making it important that you learn how to select "good" options.

There is almost never a "best" choice, because each investor has a different objective and tolerance for risk. When writing covered calls, the first part should be fairly easy. That's the purchase of stock. Anyone who adopts this strategy must be willing to own stock. The following may seem obvious, but please take my word for it that it's far from obvious. When you own stock, there is always the possibility of taking a substantial loss. Thus, it's important to only own stocks that you really want to own.

Don't be trapped into buying some stock just because the calls have a nice, juicy premium. Those calls have a high premium for a reason. Option buyers are not paying high prices just to make it easy for covered call writers. Such stocks are volatile, and that means there's a good chance the stock is going to make a substantial move. Of course, if that move is higher, that's good for you, the covered call writer. Your profits may be limited, but you can still earn excellent profits.

If the stock tumbles instead, you are going to lose money. It's foolish to own randomly chosen stocks, so please accept the warning that deciding which stock to buy is the major decision that affects the results for covered call writers.

Choosing the Option and Strike Price

Most investors automatically write (sell) options that are out of the money (OTM). That seems to make sense. You bought the stock because you believe it's worth holding, and that must translate into a bullish feeling. The normal method for non-option traders to make money from such stocks is to buy and then sell at a higher price. Obviously, that works for option traders also.

That point of view is continued when most traders decide to write covered calls. By selling calls with a strike price above the current stock price, they gain two benefits. First, if the stock rallies, the covered call writer participates in that rally. Second, if the stock is eventually sold (via being assigned an exercise notice), the writer not only has that capital gain, but he/she keeps the option premium—and that adds to the profits.

Sounds good. The problem is that the option premium is not too hefty and affords only a small amount of protection against loss when the stock does not behave as hoped.

There is nothing wrong with writing OTM options, but I don't believe that the choice should be automatic. The alternatives are worth considering, especially for more conservative investors.

Although automatically dismissed by the majority, writing options that are in the money (ITM) is a sound and far more conservative approach. When you adopt this method, you may sell stock below your purchase price. But that's not a problem. The true sale price (strike price plus premium collected) is higher than your cost, and that means a profit. This concept is difficult for some novices to grasp.

In-the-Money Covered Call Example

Buy 100 shares of XYZ at $72
Sell one XYZ February 70 call, collecting $6.50

When expiration arrives, you are assigned an exercise notice and sell the shares at $70 (strike price). However, your net proceeds are $70 from the sale and $6.50 from the option. Net sale price is $76.50, and that yields a profit of $450.

When writing ITM calls, the rewards are smaller. As an example, traders who pay $72 for stock are far more likely to write calls with a strike price of $75 or $80. However, choosing to sell the 70s affords a much higher option premium. If the stock does tumble, that extra premium often makes the difference between coming out of the trade with a profit instead of a loss. The profit potential is less than when selling OTM calls, but that is the usual trade off when owning a less-risky position.

Please consider the potential profit available when writing options that are in the money. You may elect not to write them, but evaluate the potential before making a final decision.

Writing at-the-money (ATM) options is very attractive to many because these options contain the most time premium. That time premium represents your potential profit. If undecided between the merits of OTM and ITM options, writing ATM options may be appropriate for you.

Choosing the Option and Expiration Date

The expiration date is far more important than most realize. It seems natural to sell front-month options and collect the most rapid time decay. Do that successfully month after month and it's true that at the end of the year, you will earn more money by selling these near-term options.

So, what's the problem? The problem is risk. Front-month options are lower-priced than their longer-term cousins and offer the least downside protection. I know you are bullish when using covered calls, but I trust you recognize that most traders are not always correct on their stock selections (or timing).

Longer-term options offer more protection on a decline, and they decay at a slower pace.  Again, it's a risk/reward decision. Longer-term options are less risky to write (when risk is defined as dollars at risk).

When we consider that the typical newcomer to the options world is likely to latch onto covered call writing (as soon as he/she becomes aware of this strategy) and that these investors tend to write OTM near-term options, it's no wonder that they either learn to love this strategy and sing it's praises (in a bullish market), or quickly blow their accounts (in a bear market) and blame options for being too risky. In fact, their poor results occurred due to taking the most risky approach to their chosen strategy.

By Mark Wonfinger of Options for Rookies

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