for the year, but this result illustrates one of the risks in-volved when using a covered call writing program—upside profits are lim-ited unless I roll my positions in a timely manner. I’ve decided that makingmy target profit each month is more than acceptable, and if others do bet-ter when the bull market is alive, that’s OK. I know I’ll do better than other
4339_PART4.qxd  11/17/04  12:57 PM  Page 189
Covered Call Writing In Action
189
TABLE 15.11A December Expiration Trades
B/S/W
Qty
SYM
Price
Call
Prem
Comm
Invested
BW
W
W
BW
5005
2
1
3003
VTIVTI
MDYMDY
EFAEFA
OEFOEF
111.94
115.02
137.01
57.20
Dec 112
1.55
10.0017.50
($55,980.00)$757.50
Dec 115
1.80
13.00
$347.00
Dec 138
1.95
11.50
$183.50
Dec 57
0.90
10.0014.50
($17,170.00)$255.50
Invested
Cash StartCash Now
($71,606.50)
$73,068.00$1,461.50
investors  when  markets  move  lower  or  are  stagnant.  Besides,  I’m  not  incompetition with anyone else. I’m managing my money to fit my needs.My results for the month of December are listed in Table 15.11C.I see no reason to alter my investment style and will continue on the
same path for the final month of the year.
JANUARY EXPIRATION
The recent rally means I must repurchase my ETFs at much higher pricesthan before. I was assigned on all positions and have only cash remainingin my account. This is the equivalent of being forced to roll my positions tohigher strike prices. Of course, I can refuse to roll the positions by stub-bornly writing ITM calls. I won’t succumb to that trap because (I have to re-peat it to myself often to make sure I resist the temptation) I know I am notgood  at  predicting  in  which  direction  the  market  is  going  to  move  next.Thus, I’ll stay with writing options that are at the money for domestic in-vestments and one point out of the money for my foreign holdings.
The high prices present another problem. I no longer have enough cashto repurchase the full positions I owned last month. I’m cutting back myOEF investment to 200 shares.
4339_PART4.qxd  11/17/04  12:57 PM  Page 190
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191
        4339_PART4.qxd  11/17/04  12:57 PM  Page 192
192
CREATE YOUR OWN HEDGE FUND
January trades are listed in Table 15.12A.My positions are listed in Table 15.12B.The year-end rally continues for a few days, but after the New Year’sbreak, the market heads lower. The downward move is without conviction,and January expiration arrives with the market losing less than one-half of1 percent for the expiration period. This represents another good month formy covered call writing program. For the past 12 months I’ve been workingon my new investment strategy. I’ve learned a great deal and am going tocontinue writing covered calls next year.
The results for January expiration are listed in Table 15.12C.My  profits  for  the  year  are  12.32  percent,  while  the  S&P  500  indexgained 9.0 percent over the same time period. I have a busy weekend ahead.Besides making the usual decision about which ETFs to own, it’s time tomake my annual decision on how to allocate my assets. I want to decidejust how much of my overall portfolio should be invested in the stock mar-kets of the world. Thus, I’ll either be adding some additional cash to mycovered call writing program or removing some for investment elsewhere.I’m looking forward to another profitable year with my newfound invest-ment methodology.
In Chapter 16 we’ll take a similar (but less detailed) look at how writ-ing uncovered put options works. There are educational points of interest,even for investors who intend to stay with the covered call strategy.
TABLE 15.12A January Expiration Trades
B/S/W
Qty
SYM
Price
Call
Prem
Comm
Invested
BW
BW
BW
BW
5005
2002
1001
2002
VTIVTI
MDYMDY
EFAEFA
OEFOEF
117.49
121.00
145.48
58.91
Jan 118
1.45
Jan 121
2.00
Jan 147
2.00
Dec 59
0.85
10.0017.50
10.0013.00
10.0011.50
10.0013.00
($58,755.00)$707.50
($24,210.00)$387.00
($14,558.00)$188.50
($11,792.00)$157.00
Invested
($107,875.00)
Cash StartCash Now
$111,281.50$3,406.50
4339_PART4.qxd  11/17/04  12:57 PM  Page 193
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        4339_PART4.qxd  11/17/04  12:57 PM  Page 195
C H A P T E R   1 6
Uncovered PutWriting in Action
Writing uncovered puts has some advantages over writing covered calls:
• It is less expensive because commissions are reduced. The trade involveswriting one put option. Covered call writing consists of two trades: buy-ing exchange traded fund (ETF) shares and writing one call option.
• Initiating a position does not require legging into the position you want
to own because writing the put option is a single transaction.1
• It is easier to close a position when locking in a profit. Buying a put to
close a position is a simple one-step process.
However, there is one disadvantage to writing uncovered puts that is moreimportant than the advantages: Some brokers do not allow their customers towrite naked put options under any circumstances. If your broker prohibits thisstrategy, it’s strongly recommended that you find a more cooperative broker.However, if you wish to maintain your account with that broker, covered callwriting is an equivalent investment strategy. (See Chapter 15.)
One  word  of  caution  is  required.  When  writing  naked  put  options,  ifyour positions are cash backed then you never have to worry about receiv-ing a margin call from your broker. A position is cash backed when there issufficient cash in the account to pay for stock if you are assigned an exer-cise notice for the put options you sold. If the cash is in your account, themaximum risk for the position is known (and is essentially equivalent tothat of any other shareholder).2
If you do not have enough cash, and if you are assigned an exercise notice on puts you wrote, it’s possible your broker will issue a margin call,
195
4339_PART4.qxd  11/17/04  12:57 PM  Page 196
196
CREATE YOUR OWN HEDGE FUND
requiring  you  to  (immediately)  deposit  additional  cash  or  securities  intoyour  account.  This  is  a  situation  you  want  to  avoid.  Some  brokers  don’tprovide any warning and simply close positions (of their choosing) to raisethe needed cash.
If you are writing naked puts for the first time, begin by having cash toback all your positions. As you become more acquainted with writing un-covered  puts  and  the  risks  involved,3 you  may  decide  to  borrow  moneyfrom your broker and own uncovered put positions that are only partiallybacked  by  cash.  Using  margin  provides  an  opportunity  to  increase  yourprofits, but it also enhances risk.4 Trading on margin is not for everyone,and a discussion of this topic is beyond the scope of this book.
You must be certain not to write more uncovered puts than your finan-cial situation allows. This is especially true if you are trading with borrowedmoney from your broker (margin). Please reread the warning in Chapter 11.
QUICK REVIEW
Consider two positions:
1. Covered call
Buy 200 shares of MDY at $118.
Write 2 Dec 118 calls at $2.00.
2. Naked put
Write 2 Dec 118 MDY puts at $2.00.
Table 16.1 lists the risks and rewards of owning each position. Noticethe risk profiles are identical. The maximum potential profit and the down-side  break-even  point  are  the  same.  Neither  position  is  riskier  than  the
TABLE 16.1 Compare Covered Call with Uncovered Put
Long PositionShort PositionMax ProfitMax LossMax ProfitExtra Gain if above 118Downside B/ELoss if below B/E
B/E: Break-even point
Covered Call
Uncovered Put
100 MDY @ 1181 MDY Dec 118 call @ 2$200$11,600MDY above 118$0.00116$100 per point
None1 MDY Dec 118 put @ 2$200$11,600MDY above 118$0.00116$100 per point
4339_PART4.qxd  11/17/04  12:57 PM  Page 197
Uncovered Put Writing In Action
197
other,  regardless  of  well-meaning  investment  advisors  who  tell  you  thatwriting naked options is dangerous.
Let’s take a closer look at a hypothetical three-month trading period.The purpose is to illustrate the thoughts that occur to the investor/traderand how potential problems are resolved.
JUNE EXPIRATION
I have $100,000 to invest. After careful consideration, I’m going ahead withthe naked put writing program. I’m going to concentrate on the Americanstock market. Yet with thousands of stocks, I feel sufficiently diversified.I’ve had success investing in small-capitalization stocks over the years, so Iam  going  to  emphasize  those  in  my  portfolio.  I’m  also  investing  a  smallamount  in  high-technology  stocks.  I’ve  decided  to  take  positions  in  theseETFs:
• IWV (Russell 3000 index consists of the 3,000 largest capitalized stocks)• IWM (Russell 2000 Index consists of the smallest 2,000 stocks in the
3000 index)
• QQQ (Nasdaq 100 index)
My plan is to be virtually 100 percent cash backed, but I’m not going to beconcerned if I fall a few dollars short.5 There are currently five weeks untilthe June expiration.
I found it simple to make my trades, and the positions are listed in Table16.2A. I’m writing put options that are slightly out of the money, positionsthat are equivalent to covered call positions that are slightly in the money.
TABLE 16.2A June Expiration Trades
B/S/W Qty
SYM
Price
Put
Prem
Comm Net Credit
CashBacking
WWW
447
IWV65.10IWM 118.0038.22QQQ
$0.90 16.00
Jun 65$344.00 $26,000.00Jun 118 $3.00 16.00 $1,184.00 $47,200.00$574.50 $26,600.00Jun 38
$0.85 20.50
CollectedRequired
Cash StartCash Now
Excess Cash
$99,800.00
$2,102.50
$100,000.00$102,102.50
$2,302.50
Net Credit: Cash collected from writing put optionsCash Backing: Cash required to maintain each position, if not using marginRequired: Total cash required to maintain all positions, if not using marginExcess Cash: Cash above requirement
4339_PART4.qxd  11/17/04  12:57 PM  Page 198
198
Methodology
CREATE YOUR OWN HEDGE FUND
If the put expires worthless, then I’ll achieve the same result I would haveachieved with a covered call position. That means I’ll have the same profit(in  reality,  a  slightly  higher  profit  due  to  reduced  commissions)  and  noresidual position. I’ll have to reinvest in a new position after expiration.
If the put finishes in the money, I’ll be assigned on my position and ownthe ETF shares, paying the strike price. This is the identical result as thecovered call writer has when the call options expire out of the money (andworthless), leaving that investor owning the ETF shares. Just as the cov-ered call writer writes new calls after expiration, I plan to do exactly thesame.
If  those  covered  call  options  expire  worthless,  I’ll  continue  to  writenew calls the following month. If I am assigned and forced to sell my ETFshares, I’ll continue with my investment strategy by initiating a new posi-tion—writing naked puts for the following expiration period.
Thus, if my puts expire worthless, I’ll continue with my plan to writenew puts. But if I’m assigned and own the shares, I’ll revert to the coveredcall writing program. This method is flexible.
Note: When writing naked puts, the profit potential equals the premium
collected from those sales.
The  positions  and  the  profit  potential  for  each  position  are  listed  in
Table 16.2B.
June (this is not the same year as used for the covered call writing ex-amples) is a mixed bag for the market. The S&P 500 is unchanged, but tech-nology stocks take a beating and I am assigned on my QQQ puts. However,the  good  news  is  that  my  other  puts  expire  worthless.  Overall  my  firstmonth writing naked puts is profitable. The results are listed in Table 16.2C.
JULY EXPIRATION
I own shares of QQQ so am writing call options against them. I’m also initi-ating new positions in IMV and IMW put options.
The  market  opens  almost  unchanged  from  last  Friday’s  close,  and  Iquickly open my new positions. The trades are listed in Table 16.3A. TheJuly  expiration  is  only  four  weeks  away,  so  option  premiums  are  lowerthan last month.
There was enough excess cash to allow me to buy an extra 100 sharesof  QQQ  and  write  eight  calls,  instead  of  seven.  I  chose  not  to  make  thistrade, even though I want to remain as fully invested as possible. Here’swhy: I feel I already have enough invested in the technology index and pre-
4339_PART4.qxd  11/17/04  12:57 PM  Page 199
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                                 4339_PART4.qxd  11/17/04  12:57 PM  Page 201
Uncovered Put Writing In Action
201
TABLE 16.3A July Expiration Trades
B/S/W Qty SYM Price
Option
Prem Comm Credit
Backing
Net
Cash
WWW
447
65.02 Jul 65 Put
IWV$0.85 16.00IWM 118.06 Jul 118 Put $2.95 16.00$0.75 20.50QQQ 36.70 Jul 37 Call
CollectedRequired
Cash StartCash NowExcess Cash
$324.00 $26,000.00$1,164.00 $47,200.00
$504.50
$1,992.50$73,200.00
$75,482.50$77,475.00$4,275.00
Option: Call or put
Cash Backing: Cash required to maintain each uncovered put position
fer to put my money to work by buying additional shares of the Russell 2000index. I’ll use idle cash to buy 100 shares of IWM at my first opportunity.
My current positions are listed in Table 16.3B.July  is  a  losing  month  for  the  market.  The  decline  starts  slowly  andpicks up momentum as the days pass. Within two weeks the S&P 500 indexhas declined almost 3 percent. My positions are still reasonable, as two ofthe three ETFs I own are trading near my break-even prices. I don’t want toroll the positions but will do so in the interests of protecting the value of myportfolio.  If  I  don’t  roll,  I’ll  be  betting  the  market  will  recover  its  recentlosses. I don’t want to find myself betting on the direction of the next mar-ket  move.  By  owning  a  bullish  portfolio,  I’m  already  positioned  to  profitwhen the market rallies, so buying additional protection against loss is aprudent investment choice.
Notice my downside protection for IWV is only about half that for theother ETFs (Table 16.3B). Here’s why: The Russell 3000 index is not veryvolatile, and the implied volatility of the options is fairly low. As a result, thepremium I collect when