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Strategies & Market Trends : Swing Trading With Options -- Ignore unavailable to you. Want to Upgrade?

To: underdog430 who wrote (38)	8/6/2001 11:41:24 PM
From: Dan Duchardt	Respond to of 88

Mark, Thanks for those articles. Definitely written from the perspective of a trader with even an acknowledgement of a lack of statistical significance for the example. Actually the CC's don't do too badly in the comparison. They just don't do a lot better. Comparing CCs to stock trades in a month when the markets run up 13% is not the most favorable time for the CCs, to say the least. Even in that context there is the following paragraph: So, why do people persist in trying to make Covered Calls work? The biggest reason is the lure of monthly cash generation. If you already own the stock, selling calls against those shares permits the investor to gain some cash short-term, particularly if the stock does not move very much. In fact, Covered Calls are a very good way to increase the profits on your basic investment portfolio—generate additional income from good stocks that you have stuffed away into a retirement portfolio, for example. If you get called out on any particular month, you immediately re-purchase the stocks, and if they actually drop in price, well you weren't planning on selling them anyway. This is the situation for many people attracted to CCs. They are trying to enhance the gains on stocks they intend to hold. I take exception to his last sentence though. One of the biggest dangers of writing CCs is the pressure to get back in a stock after being called out. Paying up to re-purchase a stock after locking yourself out of a gain is a recipe for disaster. If you can't stand to let it go, or wait for it to come back to you, don't write CCs. Once in a while if a stock makes a nice move off a deep low it may be worth the risk, but you can't do that very often and win the game. There is a lot of good basic stuff in the article, but as many options assessments do it focuses entirely on the end game, assuming that once written a CC position is carried to expiration. Effective CC writing involves more than that, and it can include stopping out of a position going bad. He is right that most people don't do it, but there is no law against it, and it can reduce losses compared to just buying stock. The second article that examines the diagonal spread fails to look at the alternative of selling the LEAPS and buying the stock if the near term call is assigned. The logic leads you to believe that you need to buy DITM LEAPS to assure at least break even if you get called out. That really is not the case. Yes you pay time premium for higher strike LEAPS, but it does not evaporate during the time the short call is open. In his GE example, the fair comparison would be to look at what the 2004JAN40 would be worth at the expiration of the SEP45 and determine the closing price at which you would actually lose money. You need a nice model to forecast that, and we have one :) I don't have time now to plug it in, but I've done it for similar scenarios. Forty probably is a bit high for the LEAPS strike, but 30 or even 35, and 2003 instead of 2004 makes it look a lot better. The final argument that a spread is a better way to go has merit, but notice he is looking at a near term expiration. Long term spreads take a long time to evolve into profits. The deltas on adjacent strikes are close, and the farther out you go the more stable they are. It takes huge moves in the underlying to capture an early profit from a long term vertical spread. I also just noticed he made an error in the article where he says Also, the maximum risk for this trade is the cost, or $1.40 per share—considerably less than the risk for any of the other trades. Afraid not. $1.40 is the maximum potential profit on his bull spread trade. The cost and the maximum risk is $3.60. That risk-reward ratio is not all that great, and GE only has to drop 10+% to take the maximum loss. The diagonal spread fares no worse in the face of such a decline, and does a bit better in absolute terms if the stock goes nowhere. I would not want to do a lot of near term vertical spreads w/o keeping a significant cash reserve, so the % comparison he makes may not be the best. Dan