writing new IWV options is less than the premiumI receive from writing options on my other ETFs. Lower option premiummeans less downside protection as well as lower potential profit.
One of the reasons I prefer to own shares of IWV is because of its re-duced volatility. It is safer to own IWV shares than it is to be an investor insome of the other ETFs. In return for that extra safety, I must accept loweroption prices (less risk = less reward). This is one of those areas in whicheach investor’s individual tolerance for risk enters the picture. If you preferto seek higher returns and are willing to own a more volatile investment,
4339_PART4.qxd  11/17/04  12:57 PM  Page 202
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           4339_PART4.qxd  11/17/04  12:57 PM  Page 203
Uncovered Put Writing In Action
203
then  the  mix  of  ETFs  in  your  portfolio  can  be  shifted  to  reflect  thosewishes. For example, if I were interested in trying to earn a higher return, Iwould own fewer shares of IWV and more shares of IWM.
Note: Indexes are composed of many stocks and are less volatile thanmost  individual  stocks.  One  reason:  When  some  stocks  in  the  index  de-crease  in  value,  others  increase.  These  price  changes  offset  each  other,making the overall index less volatile. Thus, if you are seeking even higherreturns from writing covered calls or writing uncovered puts, then you caninclude  some  individual  stocks  in  your  portfolio  mix.  Just  be  aware  thatdoing  so  significantly  increases  overall  risk.  Here’s  why:  Any  individualstock can have a surprise announcement at any time, and that announce-ment can have a large influence on the stock price. It is far less likely thatthe price of an index will undergo a rapid price change; such a change re-quires a news event that affects the whole stock market. This is more of thesame old story—seek a higher return on your investment if you choose todo so, but you must accept a higher risk in an attempt to earn that return.Having decided to roll my positions, the trades are listed in Table 16.3C.My positions and optimal results are listed in Table 16.3D.The  IWV  numbers  represent  one  of  the  potential  unhappy  outcomeswhen  forced  (for  safety  considerations)  to  roll  a  position.  The  potentialprofit is negative. Thus, if the best possible result is obtained—the put ex-pires worthless—the position still loses money for the month. This occursbecause it cost more cash to roll the position than I received when writingthe puts in the first place. Thus, I have a net debit,6 and there is no way torecover that cash from the current position.
The market continues to drift lower and then rallies. Expiration arriveswith the major market indexes lower by about 3 percent for the month. TheQQQ  calls  expired  worthless,  and  I  was  assigned  on  my  short  IWV  put options.
But  something  unusual  happened  with  my  IWM  position.  Two  puts expired  worthless,  and  I  was  assigned  on  the  other  two.  This  situation doesn’t occur often, but whenever the option is within a few pennies of thestrike price, it’s possible for options to expire worthless, even if they are inthe money.
There  are  several  reasons  why  slightly  ITM  options  can  expire 
worthless:
• When options cease trading a few minutes after the market closes onexpiration Friday, there is usually no bid higher than zero for these op-tions.7 Thus an investor who still owns these options is unable to sell.• If the option owner decides to exercise the option, there are expenses
and risks involved.• The option owner must pay a commission to exercise the options
4339_PART4.qxd  11/17/04  12:57 PM  Page 204
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                                  4339_PART4.qxd  11/17/04  12:57 PM  Page 205
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                                                  4339_PART4.qxd  11/17/04  12:57 PM  Page 206
206
CREATE YOUR OWN HEDGE FUND
• The option exerciser incurs the risk of owning a position—long ifthe option is a call and short if the option is a put—in the underlyingasset  until  the  market  opens  next  Monday.  The  market  can  easilymove in the wrong direction, resulting in a significant loss.
• The  option  exerciser  must  pay  another  commission  to  close  the 
position.
• Two  commissions  plus  market  risk  make  it  easy  for  the  investorwho owns the option simply to allow it to expire worthless. There istoo much expense and risk involved in attempting to capture the fewpennies of intrinsic value in the option.
Results for July are listed in Table 16.3E.July was an interesting month. Not only did I earn a small profit whenthe market was lower, but I also discovered for myself that I cannot makeany  assumptions  regarding  assignments.  I  now  know  it’s  important  tocheck  with  my  broker  before making  any  trades  on  the  Monday  follow-ing expiration to verify which options expired worthless and which wereassigned.8
AUGUST EXPIRATION
I am still long my QQQ shares and am writing new call options against them.I now own 200 IWM shares, so I have two call options to write. BecauseI want a position representing 400 shares and because I prefer to write putoptions, I’ll also write two new put options. Thus I’ll have two separate po-sitions in IWM: two covered calls and two uncovered puts. That’s equiva-lent to two covered straddles.9
I was assigned on my IWV shares, and I am writing calls to hedge theposition. But after writing new options this month, I’ll have enough excesscash to increase my investment in IWV. I plan to purchase 100 additionalshares of IWV and write an additional call. There are two points of interesthere.
1. I prefer writing a put option, but because I already own 400 shares andam writing four call options, it’s easier (and saves money in commis-sions) to add to my covered call position than to write a new uncoveredput position. If I were buying more than 100 shares, then I would prob-ably choose to write put options.
2. To ensure that I have enough cash to make this new trade and to mini-mize commissions, I plan to make this transaction last. First, I’ll sell allthe options I’m selling this month. (This generates some of the cash I
4339_PART4.qxd  11/17/04  12:57 PM  Page 207
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               4339_PART4.qxd  11/17/04  12:57 PM  Page 208
208
CREATE YOUR OWN HEDGE FUND
need to make the trade.10) Then I’ll buy 100 IWV. Then I’ll write five calloptions. If I write four options initially, buy 100 shares, and then writeanother  call  option,  most  brokers  charge  an  additional  $10  commis-sion because there is a $10 fee per order.
The market is still drifting as I make my trades for the August expira-
tion period (see Table 16.4A).
My positions and the potential profits are listed in Table 16.4B.August is an ideal month for uncovered put writers. The market driftshigher, then lower, never moving significantly in either direction. Expira-tion arrives with the S&P 500 index up less than 0.25 percent. It appearsthat I am going to be assigned on all my short calls and my puts are goingto expire worthless. My account has no remaining positions, only cash. Theresults are listed in Table 16.4C.
I’m ahead by over 3.6 percent for the three months, when the markethas declined in value. I’m pleased with my performance. I plan to continuewriting uncovered put options and switching to covered call writing if andwhen I am assigned on any puts.
Because my account contains only cash, next month I’ll continue my in-
vestment program by writing puts on each of my three ETFs.
TABLE 16.4A August Expiration Trades
B/S/W Qty SYM Price
Option
Prem Comm Net Cash
Cash Backing
BW
WW
W
100 IWV5 IWV
62.85
Aug 63 Call
10.00 ($6,295.00)$407.50
$0.85 17.50
2 IWM 114.98 Aug 115 Call $2.75 13.00Aug 115 Put $2.60 13.002 IWM
$537.00$507.00
$23,000.00
7 QQQ 35.20 Aug 35 Call
$0.95 20.50
$644.50
CollectedRequired
CashStartCash Now
Excess Cash
($4,199.00) $23,000.00
($4,199.00)$23,000.00
$28,885.00$24,686.00
$1,686.00
4339_PART4.qxd  11/17/04  12:57 PM  Page 209
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      4339_PART4.qxd  11/17/04  12:57 PM  Page 211
Uncovered Put Writing In Action
211
SUMMARY
Cash-secured put writing is a conservative options strategy that provides amethod  of  accumulating  investments  (stocks  of  ETFs)  at  below-marketprices. If the market does not decline, and if you are unable to buy yourETFs  at  the  discounted  price,  this  strategy  provides  a  constant  incomestream. Coupled with covered call writing, this strategy allows you to op-erate  your  own  hedge  fund—providing  you  with  reduced  risk  and  an  in-creased chance of beating the market.
4339_PART4.qxd  11/17/04  12:57 PM  Page 212
C H A P T E R   1 7
Odds and Ends and Conclusion
In Chapter 15 we discussed rolling a position either to prevent losses or
to reduce the likelihood of incurring a loss. We also looked at rolling aposition in an effort to achieve additional profits. Rolling a position may
be appropriate in two other situations.
ROLLING A POSITION TYPE III.ROLLING TO PREVENT AN ASSIGNMENT
When  the  call  option  you  wrote  is  in  the  money  and  expiration  is  ap-proaching, you know there is a strong chance the option is going to finishin the money and that its owner is going to exercise. Sometimes you mayprefer not to sell your exchange traded fund (ETF). To prevent being as-signed, buy back the option you sold and immediately sell another option toreplace it, choosing an appropriate strike price and expiration date.
This temporary solution prevents being assigned immediately, but the
same problem may arise next month.
The question arises as to why you may not want to be assigned an ex-ercise notice. One answer is that selling the security may place you in anundesirable tax situation. If you prefer to collect a capital gain next yearrather than this year, one solution is to roll the call you write so it expiresin the following year.
212
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Odds and Ends and Conclusion
213
ROLLING A POSITION TYPE IV. ROLLINGTO COLLECT AN ATTRACTIVE PREMIUM
Let’s consider an example:
Suppose you own a covered call position on an ETF, ETFQ. Assumeyou hope to earn a time premium of approximately $200 each month whenyou write a call option. Assume there is still one week remaining before thecurrent option expires (June) and these prices obtain:
ETFQ is $40.36.
ETF Jun 40 call can be purchased for $0.65.
ETF Jul 40 call can be sold for $3.00.
You have two choices:
1. Wait for expiration and hope the July call maintains a high premium.2. Take advantage now by buying back the June call for $65 per contractand simultaneously writing the July call, collecting $300 per contract.The  result  is  you  receive  $235  (before  costs),  when  you  would  havebeen pleased to receive $200.
What can go wrong if you choose to wait for expiration instead of rolling?
• If the ETF drops in price before expiration, the Jul 40 call may be much
lower than $2.00 when it is time to sell it.
• If the ETF makes a substantial increase in price before expiration, youmay not be able to collect a time premium of $2.00 when you write theJul 40 call.1
Thus, if you find the spread between the option you are short and theoption you plan to sell is attractive, you can elect to collect that spread dif-ference early, rather than waiting for expiration to arrive.
TOO BUSY?
Taking care of finances is a very important consideration for everyone. Un-fortunately, people many don’t recognize that fact until much later in life. Theearlier you get started, the better your future financial condition is going to be.If  you  like  the  ideas  presented  in  this  book—attempting  to  beat  themarket  by  collecting  option  premium  on  a  portfolio  of  exchange  tradedfunds—but are far too busy to devote the necessary time to this project,
4339_PART4.qxd  11/17/04  12:57 PM  Page 214
214
CREATE YOUR OWN HEDGE FUND
there is still a way for you to participate. Work with your financial planneror  stockbroker.  This  must  be  someone  you  trust—someone  who  has  in-tegrity,  the  ability  to  understand  this  investment  methodology,  and  whocan devote the time necessary to making intelligent decisions for you. Workwith that person to build a suitable portfolio of ETFs. But insist on thesepoints. (After all, your advisor is merely that—an advisor. Make the final de-cisions yourself.)
• Buy ETFs only in round lots (increments of 100 shares).• Buy only optionable ETFs (see the lists in Tables 13.1 and 13.2).• Be certain your advisor understands:
• Your desire to write covered call options on every ETF you own.• Your desire to write new calls immediately (early Monday morning
after expiration).
• Your desire to write new options EVERY month. There is to be no at-
tempt to time the market.
• Your preference to write options expiring in the front month (or two).• Your preference for choosing the strike price of the options to besold—at  the  money  (ATM),  out  of  the  money  (OTM),  or  in  themoney (ITM).
• To discuss it with you before rolling a position. You must be certainyour advisor understands the process well and is not rolling merelyto generate additional commissions. Be aware—when using a bro-ker, commissions are going to be expensive.
If you prefer to do the work yourself, but feel it is too time consuming,there  is  a  compromise  choice.  By  choosing  options  that  expire  in  threemonths or six months, there is much less work to do, as it is necessary tomake investment decisions less often. Note, though, that it’s still importantto check your portfolio once in a while—perhaps every week or two—justto be certain no major adjustments are necessary.
INVESTMENT CLUBS
Investment clubs are composed of individual investors, often beginning in-vestors who want to learn about the stock market. The goal is education.You can form a more sophisticated group composed of people who alreadyunderstand  the  workings  of  the  market.  If  you  find  like-minded  investorswho want to adopt covered call writing (lend colleagues a copy of this book,or better yet, buy them their own copy) and if you want company when get-ting started, forming an investment club is the perfect way to proceed.
Each member invests money each month. The group opens an accountwith a broker, meets (suggestion: meet over the weekend following options
4339_PART4.qxd  11/17/04  12:57 PM  Page 215
Odds and Ends and Conclusion
215
expiration) to select investment choices, and invests the money. Your clubcan write cash-secured uncovered puts or covered calls. Of course it’s OKto buy individual stocks, but I hope the advantages associated with choos-ing to invest in exchange traded funds convinces your group to build a port-folio consisting of ETFs.
Remember the purpose of the investment club is to educate your mem-bers. But being profitable is also a goal. The methods described in this booktake  some  of  the  risk  out  of  investing  and  significantly  increase  yourchances of beating the market.
If  you  do  form  such  a  club,  I’d  love  to  hear  about  it  (mark@
mdwoptions.com).
CONCLUSION
Making the decision to write covered call options against a portfolio you al-ready own leads you on a path of reduced volatility, as the value of your ac-count fluctuates less. It’s also one road to enhanced earnings, despite thefact  that  you  will,  on  occasion,  have  to  settle  for  reduced  profits  if  andwhen  one  of  your  holdings  explodes  in  value.  However,  this  investmentmethodology  enhances  your  stock  market  performance  over  the  years,helping you achieve financial goals. Your portfolio outperforms the marketaverages under the majority of stock market conditions, comparing unfa-vorably only when the market surges.
Writing uncovered put options is an equivalent strategy that providesthe same reduction in portfolio volatility and the same enhancement of re-turns as covered call writing. The risk profile is identical with that of cov-ered call writing, if positions are cash backed.
Using options in the relatively conservative manner outlined in this vol-ume along with adopting the teachings of modern portfolio theory (MPT)should enable you to outperform the market averages in the years ahead. Ifyou recognize that it’s extremely unlikely that you can beat the market av-erages by selecting your own stocks, and if you accept the conclusion ofMPT that indexing provides the best opportunity for your investments toprosper, then the recommended investment strategy provides an excellentpath to earning market-beating returns on a consistent basis. Thus:
