JohnM,
I'm glad you found my reply helpful. I will try to address your observations, hopefully concisely though the "half position" discussion will take a bit of space .
I assume the same could be said for downward trend as well. Risks are different but the result would be comparable
Yes, It cuts both ways.
I think, for the moment, one of the advantages of short time limits is to make it easier for me to get a good grasp of the option market dynamics by limiting, at least a bit, the number of variables in play. I'm feeling more comfortable with each purchase and each post. Once I reach a bit more, I'll begin experimenting further out.
The last thing you want is to be below water with no certainty of support lifting you back up. Every time you are at or near your net investment level you are forced to decide among the choices of doing nothing and hoping for the best, stopping out- usually at a loss, or rolling down to capture premium to soften the blow, but eliminating any chance of a profit. Every time you are at or above your short call strike price you have to decide if you will let yourself be called out, or if you should roll up and/or out. The more premium you collect up front, the more range you can tolerate before you have to act. Writing farther out lowers the anxiety level and gives you a better window to absorb short term swings. I would suggest you start with 3 to 4 month out calls while you are trying to get comfortable. Alternatively, restrict yourself to low volatility stocks, which unfortunately offer very little time premium.
Second, the paragraph which begins with "Finally, . . ." I understand to mean that one should not write ccs on stocks in which you have reasonably serious expectations of sharp downward movement (just sell the stock, instead) or sharp upward movement (step aside from ccs, just hold the shares). McMillan makes this point quite frequently. Thanks for making it again.
You got it, and it ties to what I said above. There needs to be a balance between the possible range of movement of the stock and the time premium you collect for CCs to make sense.
However, just to remind myself why I made the post in the first place, it was to sketch a scenario in which I was surprised by, had not anticipated, a sharp upward movement.
This is a good point. There is sometimes a big difference between what we anticipate and what actually happens. However, option premiums are based on reasonable expectations that what has happened in the past is likely to continue. High volatility stocks have high option premium, but you always need to ask yourself if the premium is worth it. My observations about QCOM were based on the range of movement relative to the premiums available. At the moment, many of the QCOM options are undervalued based on the historical volatility. This is not good for call writers. These days even fairly valued options (theoretically) can seem awfully cheap when you are selling them.
I understand that paragraph save your reference to holidng half a position rather than writing ccs. I think I get the point of the paragraph without getting that point. So, unless you consider it essential, never mind.
Actually, it is one of my pet points so I don't mind talking about it. It might even be an original idea, but I have not searched the literature of the option gurus, so Im not sure. It is most striking when you consider the pros and cons of writing ITM calls, but it applies in any case where time premium is small.
Consider the case of a $50 stock with a strike 45 call that you can sell for $6.50. Now probably this stock will retreat, and maybe it can go up, but you really don't want to risk a big loss so you play it safe and sell the call.. What are the possibilities? If you hold this position until expiration, you might get called out for a gain of $1.50 on a $43.50 net investment. If the stock falls, you will not lose any money unless it closes below $43.50. But if it should fall harder than you thought it might, you lose dollar for dollar as it drops below your net investment. You are heavily weighted for downside protection at the expense of profit opportunity.
Being well ITM, this call is going to have a delta of around 70- it's value is going to change $.70 for each dollar move in the stock- unless the stock goes up, in which case the delta goes up and the call gets more expensive more quickly, or goes down in which case the delta gets smaller and the call gets cheaper more slowly. The net effect is that initially the value of your investment (neglecting bid/ask spreads which hurt you even more) goes up or down at the rate of 30 cents per dollar move in the stock. That rate gets smaller as the stock rises- 20 cents, 10 cents, and finally nothing, and the rate of fall increases as the stock drops- 40 cents, 50 cents (when the stock slips just below the strike price of 45), etc etc until the call becomes worthless and you are losing dollar for dollar. Worst case is some terrible news hits the stock and it drops to $20 or $15, and you have a big time hurt there is no escaping.
How else could you protect yourself against a loss, and leave better upside potential?. There is a way you can set the same initial parameters, 30 cents on the dollar, and maintain that rate no matter what happens to the stock. If it goes up to 60, 70, 80, no matter how high, you still make 30 cents per dollar moved. If it falls, to 40, 30, 20, no matter how low it goes you lose 30 cents on the dollar, never any more than that. And your net investment is only $15 instead of $43.50. Even if the stock falls to zero you would only lose $15. That other $26.50 can be in a safe place where it cannot be lost, or in some other investment that might pay off. It's really easy to do; you simply hold only 30% as much stock as you would hold if you had the CC.
Now of course you don't get something for nothing. You have expanded your upside potential and increased your long range downside protection, especially against any sudden moves. What it has cost you is the $1.50 in time premium you would have collected by selling the calls against the bigger stock position. It is a lost opportunity, and it is no worse and often less than the lost opportunity of being called out of a stock that closes above your short call strike. It takes away from your downside protection against a slow small move, and diminishes the gain on a slow small up move, but it greatly improves the situation for any large or fast move. In this example the two are equivalent at a closing price of about $40.70 to the downside, and $55 for an upside move. If the price ever gets outside of that range you will be in a better situation with the smaller stock position than with the CC, especially if it happens fast.
I mentioned in passing above that the rate of fall reaches 50 cents on the dollar for an ATM call. That is typical for near months. You might consider this to be the biggest acceptable rate of loss and up your investment from a 30% to a half position. That gives you a nice improvement in upside potential. It lowers the point where the half position has the same loss as the CC to $37 and increases the worst case loss from $15 to $25. But it lowers the point where the half position is as good as the CC to just $53. Anywhere above that, you are better off with the half size uncovered long, and of course the higher it climbs the better off you will be.
The moral of the story is that TIME premium is the key ingredient in any CC strategy. If you are looking deep ITM to collect a big premium you are looking in the wrong place. That fat premium is full of your own money, and precious little of other people's money, but by taking it you are leaving a larger amount of your money at risk in a place where it cannot work for you. It is a far better thing to do, IMHO, to look for fat premiums full of other people's money if you want to sell options, and that means looking farther out in time, or near OTM where the premiums are a sensible fraction of the potential stock movement.
Dan |
