Pros often use advanced options as one of their market strategies to manage portfolios. While professional options strategies require advanced knowledge of quantitative sciences, simple options hardly require any such knowledge. In fact, buying some calls to take advantage of the rising markets or buying some puts to hedge downturns is quite straightforward.
More importantly, the practice of writing covered calls, meaning selling calls against existing positions, to create cash-flows when market gets overbought or is ready for an imminent correction is considered an excellent market strategy even for the individual investors in stocks, bonds, commodities, foreign exchanges and real estate.
Considering the safety of writing covered calls, it is even allowed in IRA accounts.
Buying vs. Selling Calls
While options-approved individual and professional investors often buy calls to take advantage of the rising markets, buying calls carries an inherent risk if the market suddenly turns negative or moves sideways, thus making those calls worthless or at least significantly eroding their time value. Of course, if the market behaves as expected those calls gain in value. Therefore, buying calls is a speculative strategy, if not a total gamble.
On the other hand, writing covered calls could be a very sound investment strategy to hedge market downturns or overbought conditions. For example, if you bought 1,000 X stocks at $30 (cost basis) at the bottom of the last correction and the same stock is now trading at $45, you may consider writing up to 10 covered calls (each option covers 100 shares) to create some temporary cash-flows, without having to liquidate the position.
Of course, the mere fact that your stock has made a decent run-up should not force you to sell some calls. Make sure your research shows that the market is ready to correct or is way overbought, or at least, your stock is way ahead of the market and is showing clear signs of an overbought condition. One such sign could be the breach of a statistically significant trend-line, e.g., the 200-day moving average. In such a changed market situation, writing some covered calls is an excellent way to create some meaningful cash-flows.
Ideally, calls should be written against 50% of the covered positions, positioning the rest to ride out the market or to take advantage of the further upside potential in the market just in case your research turns out somewhat ill-timed. Of course, any such options strategy must always be reached in consultation with a registered investment professional to minimize speculation.
Again, while I am opposed to buying options – calls or puts – I am always in favor of writing limited calls as long as the aforesaid market conditions are met and proper professional help is part and parcel of the decision-making process.
In the money vs. At the money vs. Out of the money
Options have two value attributes – intrinsic value and time value. Option contracts that are expiring shortly, say in six weeks, will have lesser time value than those expiring in six months. Therefore, while buying options it is always advisable to buy with adequate time, preferably six to nine months remaining on the contract.
Likewise, while selling options, immediate contract months are preferred as market conditions are more predictable. Therefore, if your research shows the market could decline or remain range-bound and choppy in next 3 months, consider writing your covered calls keeping the option’s expiration in mind. Of course, the equally important question you would face is: Should you write those calls in the money, at the money, or out of the money?
Since your stock is now trading at $45, the $45 strike price would be at the money, while $40 would be in the money and $50 would be out of the money. In other words, in the money options have higher intrinsic value than their counterparts. Again, if your research shows your particular stock has recently made a significant move – well ahead of the competition – and is therefore expected to retrace more than the overall market and the competition, consider writing the covered calls in the money, factoring in the potentially bigger pull-back. On the other hand, if you are expecting a pull-back in line with the market as well as the competition, stay with at the money or out of the money covered calls.
Either way, as market trends lower dragging the time value down, you can always cover (buy back) your position at a fraction of your original selling price. You can repeat this process again at the top of the next bull-run. Conversely, if your research proves wrong and the market continues to trend up subsequent to the writing of the covered calls, your other unencumbered 50% position will participate in the market.
Always consult a licensed investment advisor before engaging in any options activity as it involves significant risks.
- Sid Som MBA, MIM
President, Homequant, Inc.
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