Hi Barry, It's fine that you asked the question. To illustrate the problem of selling Call options when you are low on cash, let me first describe a situation:
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The market was doing just fine then a severe correction came along. It managed to strip the AIM accounts we manage to very low cash levels on everything and zero cash on many. We don't know if/when the recovery will be at hand, so decide to sell some Calls against our holdings to generate a bit of cash flow.
Let's assume one of our holdings has active Options trading. We take a look at AIM and it says we should sell 100 shares of the stock when it reaches $35. It's currently $25 but has risen in the last week or so. This recent rise has generated a bit of a premium in the October calls, three months away. Currently someone's willing to pay us $1.50 for the rights to buy our shares from us at $35. This means we'll be paid $150 right now (less commissions, taxes, etc.) even though we might not have to give up the shares until mid-October. Sounds Very good! Take the wife to dinner or stick the cash in our near empty accounts.
So, with the option sold we sit back and wait. We don't want to sell those shares ourselves because we know there's a chance that they will be called away from us in the next three months. Well, to our surprise, the price/share of our stock continues to rise and even managed to get to $37/share by mid September! We are obliged to keep those 100 shares around for the person with the rights to call them from us, so don't sell any. Our next sell price should those shares be called away is $40, so it's not quite high enough to sell the next "lot" of shares. Still, we feel pretty good about the rally that's taking place.
Suddenly, Mr. Clinton decides to challenge Mr. Bush over the presidential election because he feels his good friend Mr. Gore should have won. He goes so far as to get the entire media of the country on his side and nearly starts riots in all major cities. The stock market wary of any type of uncertainty falls and falls fast. By mid-October the price per share of our favorite is now down to $20/share.
The contract expires unfulfilled. We have $80 net after commissions and taxes in the account for cash from selling the option. We never sold the shares because we really thought they would be called away from us. Now the price/share is so low that AIM's actually instructing us to buy shares but we don't have the money to do so.
Since the option expired, we've short-changed AIM's purchasing power by attempting to collect the premiums when we should really have let the shares go. If we'd sold the shares and not repurchased the option (which could be profitable or not) then we might have had the shares taken from us twice. Once by the option and once by our selling. Then we would have sold too much at that price.
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I've had this happen to me in the past when I was beginning to learn about options. So, I figured that the option strategy worked best when it didn't inhibit AIM very much. Now, I only sell Calls when my Cash Reserves are nearly fully funded. Then I don't miss the purchasing power as greatly if the market does what we just described. If the shares get called away, great. If they don't, that's fine, too because there's plenty of cash on hand already.
Please let me know if this helps. I've enjoyed learning about options over the years, and this is the way that I feel it works best with AIM.
Best regards, Tom |
