or loses the entire investment whenthe option is out of the money when expiration arrives.2
The stock has moved higher, as the call buyer hoped. The stock
even moved higher within the allotted time frame. But the priceincrease was not sufficient and the entire cost of the option is lost.
Example 2: Bullish investor 2 buys an at-the-money option, the PQRMay 45 call for $320. The stock slowly rises to $48 over the next threemonths, and the option is worth $300 at expiration. In this scenario,the investor correctly predicts the price increase and the time framein which it occurs. But the stock rise is not sufficient to overcome theoption premium, and the investor has a small loss.
Example 3: The stock fails to rally before the option expires. Bothinvestors 1 and 2 lose their entire investment. Unfortunately, oneweek after the options expire, the company announces that earnings
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are going to be better than expected, and the stock rallies to $52.But it’s too late to help either of these investors, who have only aloss to show for their efforts, despite the fact that they correctlypredicted the stock price increase. In the options universe, timingis everything.
It may appear that these examples were constructed (as indeed theywere) to produce inferior results for the option buyer, but these situationsare common. When you buy options, the probabilities of making a profit arestacked against you. To show a profit, you must pick the correct directionfor the stock to move and must have the predicted change occur before theoption expires. In addition, the amount of the move must be sufficient toovercome the cost of the option. That’s a huge hurdle.
It’s common for options either to expire worthless or to be worth lessthan their original cost. So, why do so many investors buy options? The lurefor the options buyer is that an occasional large profit can more than offsetseveral losses. Option buying is a very difficult strategy and can be usedsuccessfully only by those who have the skill to select both the direction inwhich stocks are going to move and the timing of that move. Despite boaststo the contrary, only a very small number of investors or traders are able toaccomplish  this  feat.  For  these  reasons,  the  investment  strategy  recom-mended in this book does not include buying options.
Fortunately, there are always going to be investors who buy options.The possibility of earning large profits from a small investment is too en-ticing  and  remains  attractive  to  many  speculators.  An  entire  industry  ofnewsletter writers recommend options buying as the path to stock marketsuccess to their subscribers. That’s good news for you. It’s not our purposeto  dissuade  investors  from  buying  options.  After  all,  if  we’re  going  to  beadopting a strategy of selling options, it’s necessary to have investors whowant to buy them.
Before  moving  on  to  learning  why  this  author  recommends  writing(selling) options, let’s consider the choices available to the option owner.
WHAT OPTION OWNERS CAN DO WITH OPTIONS
Option owners have three choices:
1. Sell the option.2. Exercise the option.3. Allow the option to expire worthless.
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When an option is in the money on expiration day, it has an intrinsicvalue and should be sold. Of course, option owners have the right to exer-cise the option, but they should do so only if they want to own a position(long for calls, short for puts) in the underlying security. Most of the time itis far easier and more economical (lower commission costs) to sell the op-tion. Option owners should receive approximately the intrinsic value whenselling on expiration Friday.
When expiration day arrives, if an option is out of the money, it has nointrinsic value and is worthless. There will be no bids for the option, and theonly choice is to allow it to expire worthless.
But it’s not necessary to hold the option until expiration day. In fact, itis undesirable to do so. If you ever buy an option, you become the owner ofa wasting asset. Your goal should be to sell it as quickly as possible. Oncethe stock makes its move in the direction you predict, or if you decide thatyou were wrong and the stock is not going to make that move, it’s time tosell the option. One mistake inexperienced options traders make is to buyan option, hope for the best, and never sell it. Sometimes it’s a good idea toaccept a small loss and sell the option before it becomes worthless.
Next we’ll see why some investors sell options, then we’ll take a de-
tailed look at two conservative strategies involving the sale of options.
WHY WOULD ANYONE SELL AN OPTION?
As  mentioned  earlier,  I  am  a  strong  proponent  of  option-writing  strate-gies that  reduce  risk.  Note  that  the  term  “write”  and  “sell”  are  usedinterchangeably.
Let’s begin by adding two new words to your options vocabulary: cov-
ered and uncovered.
COVERED VS. UNCOVERED
When you write a call option, you are accepting an obligation to sell the un-derlying stock at some time in the future. If you are able to fulfill that oblig-ation by selling stock you already own, then you are covered. If you don’town any stock, or if you own an insufficient quantity to completely fulfillthat obligation, then you are uncovered or naked.
If you are initiating a new position and buy stock at the same time you
write call options (a buy-write transaction), you are covered.
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When you write a put option, you are accepting an obligation and maylater be forced to buy shares of the underlying stock. If you are able to ful-fill that obligation because you already have a short position in the stock,then you are covered.3 If you do not have a short position, or if the short po-sition is not large enough to completely fulfill that obligation, then you areuncovered. As with calls, if you write the put options at the same time yousell the stock short, then you are covered.
Example: You write 2 TUV Oct 45 calls. If you own at least 200shares of TUV, you are covered. If you own fewer than 200 shares(including owning no shares), then the position is uncovered.
Example: You write 4 Feb 60 MNO puts. If you are short at least 400shares of MNO, you are covered. Otherwise you are uncovered.
Writing  covered  calls  is  a  bullish  option  strategy  used  by  many  in-vestors. Writing covered put options is a bearish investment strategy and isa far less popular strategy. Although we will not be discussing this strategyin detail in this book, if you understand the principles behind the bullishstrategy of writing covered call options, you will be able to translate thatknowledge into the ability to write covered put options, if and when youchoose  to  be  short  the  stock  market.  But  be  aware  that  writing  coveredputs is riskier (for reasons discussed later in this chapter) than writing cov-ered calls, and many brokerage firms do not allow their customers to adoptthis strategy.
WHAT DO YOU HAVE TO GAIN BY SELLING AN OPTION?
When you write a covered call option, or an uncovered put option (theserecommended strategies are discussed in great detail in the next two chap-ters), your potential profit is limited. In exchange for accepting a limit onyour possible profit:
• You have more winning positions.• You have fewer losing positions, and losses (if any) are reduced.• The overall fluctuation in the value of your investment portfolio is less.
If  you  are  able  to  accept  limited  profits  and  recognize  that  you  nolonger will be able to make a killing on any single investment, the odds are
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that your overall performance is going to improve. Chapter 12 presents ev-idence to support that statement.
INVESTMENT OBJECTIVES
Option writers have different investment objectives, depending on the spe-cific option strategy chosen.
Naked call writing is a bearish strategy adopted by investors who ex-pect time to pass, the stock to remain below the strike price, and the optionto expire worthless, enabling them to keep the entire proceeds from thesale of the option as their profit. This high-risk strategy (potential losses areunlimited) is too risky for our purposes and is not discussed further.4
Naked put writing is a bullish strategy adopted by investors who have
one of two objectives in mind:
1. Collect the option premium. If the stock is above the strike price whenexpiration day arrives, the option expires worthless and writers keepthe entire premium as the profit.
2. Buy shares of a stock they want to own at a discount (to the currentprice). If the stock is below the strike price when expiration arrives,put writers are assigned an exercise notice and buy stock at the strikeprice.
Some  investment  professionals  consider  naked  put  writing  to  be  asrisky as selling naked calls, but they are mistaken.5 In fact, as you will see,this strategy is significantly less risky than owning individual stocks—andalmost everyone considers owning stocks to be a prudent investment.
Chapter  11  covers  the  strategy  of  writing  uncovered  put  options  in
detail.
Covered call writing (discussed in detail in Chapter 10) is a strategy
adopted by investors who have three investment objectives:
1. Increase the likelihood of earning a profit.2. Reduce the frequency and size of any investment loss.3. Reduce the volatility of their investment portfolio.
A fourth, often underestimated, benefit is the psychological boost in-vestors experience when earning good profits in a stagnant stock market.Covered put writing is adopted by bearish investors with goals similarto those who use naked call writing. This high-risk strategy is essentiallyidentical to selling naked call options and is too risky for our purposes.
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Option writing is part of an investment philosophy that accepts hedg-ing as a method of reducing both the profit and loss potential of an invest-ment. (Hedging reduces the risk of owning an investment by taking on aposition  that  partially  offsets  its  risks  and  rewards.)  In  return,  investorsearn a profit more often and experience losses less often. It’s a trade-offthat  increases  the  chances  that  investors  can  outperform  the  market.  Ofcourse, if your stock selection skills are outstanding and you always earn abetter return than the market benchmark (e.g., the S&P 500 index), thenyou don’t have to hedge your portfolio.
The best way to illustrate the advantages and risks of writing options is
by examining some examples. We’ll do just that in the next two chapters.
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C H A P T E R   1 0
Option StrategiesYou Can Use toMake Money
Covered Call Writing
It’s time to move beyond the basics and discuss how you can use options inthe real world. Because our goal is to adopt a strategy based on the teach-ings of modern portfolio theory (MPT), we want to find a strategy that re-duces  the  risk  and  increases  the  rewards  of  holding  a  well-diversifiedportfolio  of  stocks.  We’ll  concentrate  on  two  options  strategies  that  canhelp you achieve those goals. The first of these strategies is covered callwriting. The second is uncovered put writing (see Chapter 11).
Options are versatile investment tools that can be used in many ways,ranging  from  very  conservative  to  wildly  speculative.  Our  discussion  fo-cuses on two of the more conservative options strategies available to the in-vestor who wants to put money to work in the stock markets of the world.After a thorough discussion of these strategies, we’ll see how to use themas a significant part of your overall investment technique (Part IV).
Let’s begin by examining covered call writing and the reasons why in-
vestors would consider adopting this strategy.
COVERED CALL WRITING: THE STRATEGY IN A NUTSHELL
Covered  call  writing  is  an  investment  strategy  in  which  you  (the  optionseller) enter into an agreement with another party (the option buyer). Youagree to allow the other party to buy 100 shares of your stock at an agreed-on price, called the strike price. That agreement is effective for a limited pe-
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riod  of  time.  You  have  no  say  in  whether  (or  when)  that  other  personchooses to buy your stock, as that decision rests entirely with the optionowner.  Because  the  maximum  price  you  can  receive  when  selling  yourstock is limited to the strike price, you give up the chance to earn a bonanzaon your stock. Some investors, holding onto the dream of owning the nextstock that performs like Microsoft, Intel, or Wal-Mart, choose not to writecovered calls. If that’s your dream, this strategy is not suitable for you. If,however, you are interested in increasing your stock market performanceyear after year, and if you believe that steady growth over time is the pathto building wealth, this strategy is made to order for you.
The person who buys the call option has a different strategy in mind.Rather than attempting to build wealth over the years, that investor is mak-ing a short-term wager on the price of your stock. The investor is hoping thestock price soon moves much higher than the strike price. If that happens,the owner of the call option can sell the option and earn a profit.
It’s important to remember that no strategy produces the optimum re-sult every time. Your goal with covered call writing is to increase your prof-its from investing in the stock market. And you want those increased profitsyear after year. Don’t be concerned with making the maximum profit fromeach and every trade. When you own individual stocks, it’s highly unlikelythat you would sell at the high, and selling at the high price is the only wayto achieve the maximum possible profit.
Thus, if the stock price does move significantly higher than the price atwhich you agreed to sell it, that’s okay. When that happens, you earn themaximum profit this strategy allows. Writing covered call options enhancesthe returns you can expect to earn on a consistent basis, but it cannot pro-duce the best possible result every time. After all, if you want to continueto  sell  options,  there  must  be  investors  to  buy  them.  There  would  be  nosuch investors if they didn’t make money at least part of the time.
Usually,  you  will  be  very  pleased  with  the  results  produced  by  this
strategy.
• You make money when the stock market is going nowhere and every-
one else is breaking even.
• You may make money when the markets decline, but even if you don’tshow a profit in a declining market, your losses are reduced when youadopt a covered call writing strategy.
• You  make  money  in  rising  markets.  Often  you  make  more  than  in-vestors who do not use your new strategy, but sometimes they makemore than you.
When expiration day (the last day the agreement is valid) arrives, if thestock price is above the strike price, then the option owner elects to buy
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your stock at the agreed-on price, and you are obligated to sell. If the stockprice is not higher than the strike price, then the option owner elects not tobuy your stock, the option expires worthless, and your obligation to sellyour stock at the strike price ends.
If  you  are  giving  up  the  opportunity  to  make  a  huge  profit  on  yourstocks by writing covered calls, you must receive something of value in ex-change. In return for limiting your potential profit, you are paid a cash pre-mium. You receive this money up front, and it’s yours to keep, regardless ofwhether the other party ever buys your stock.
Those  who  are  considering  adopting  covered  call  writing  generally
have certain questions. For example:
• Isn’t it foolish to accept the option premium in exchange for forfeiting
all potential profit beyond the strike price?
• Wouldn’t I be better off trying to find stocks to buy that can provide anexceptional return on my investment? Isn’t the purpose of investing inthe stock market to find stocks that double in price again and again?• If my goal is to accumulate wealth over the years, don’t I have to own
some stocks that provide outstanding returns?
For most investors, the answer to each of these questions is no.
• Over the years, you earn more money on average, by repeatedly col-lecting option premiums than by owning stocks that increase in value.• As discussed in Part I, it’s very difficult for individual investors to findstocks  that  provide  spectacular  returns.  Attempting  to  do  so  is  awasted effort for the vast majority of investors.
• A person whose goal is to achieve the steady growth that comes withoutperforming the market on a consistent basis is much more likely tobe  successful  than  one  who  attempts  to  hit  the  jackpot  on  a  singleinvestment.
In summary, investors who own a well-diversified portfolio of stocks
can make more money by adopting covered call writing.
COVERED CALL WRITING IN ACTION
The  easiest  way  to  understand  the  advantages  of  adopting  covered  callwriting as your primary investment strategy is to closely examine some ex-amples. At the same time, we’ll take a look at how you can vary the method-ology to suit your needs.
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No investment in the stock market is without risk, as bear markets area  fact  of  life.  But  covered  call  writing  is  a  strategy  that  significantly  in-creases your chances of outperforming the market and earning better re-turns than are available from U.S. Treasury bills (risk-free rate of return).When choosing your investments, you still must choose among:
• Conservatively aiming for smaller potential profits. This goal has a highprobability of success and comes with extra protection against loss incase the market declines.
• Aggressively shooting for higher profits. This goal requires that you ac-cept less protection against loss and a lower probability of earning asmuch profit as you hope. One tenet of investing is that higher rewardsrequire accepting higher risk.
• Choosing a strategy that falls between the extremes. This is likely to besuccessful for most investors. Higher profits and reduced risk are avail-able as a package.
The following examples illustrate factors that go into making your choice.More conservative strategies are appropriate if you are nearing retire-ment or if you will need some of your capital in a few years (e.g., to pay forcollege for the kids or to buy a new home). If you believe the market is en-tering into a bearish phase (remember—MPT tells us not to make such pre-dictions), you may find a more conservative strategy to be appropriate.
Aggressive methods may be suitable for both very bullish investors andyounger investors (who have many years to recover if they incur losses try-ing for those big profits). These investors probably already own an aggres-sive portfolio of stocks, so adopting covered call writing reduces their riskwhile maintaining the opportunity for very significant profits.
As a writer of covered call options, you make investment decisions fre-quently  (perhaps  monthly),  and  it’s  a  good  idea  to  maintain  a  consistentstyle, but it’s not necessary to adopt the identical strategy every time youwrite new options. The ability to modify the strategy prevents this methodfrom becoming tedious (not that making more money can ever be tedious),and it also allows you to adjust your strategy according to your investmentobjecives at any given time.
Comparing Results
When discussing the earnings potential of covered call writing, it’s neces-sary to compare the results with an investment method that does not uti-lize  this  strategy.  For  the  purposes  of  our  discussion,  there  are  twoassumptions:
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1. The covered call writer holds the position until the option expires.2. The investor who is not a covered call writer also holds the stock posi-
tion through the options expiration date.
It’s a simple matter to compare how writing the call option affects thereturn  on  your  investment.  The  details  are  illustrated  in  the  followingexamples.
When  using  covered  call  writing,  there  are  two  possible  outcomeswhen expiration day arrives: either the option you write expires worthless(the option owner chooses not to buy your stock), or the option owner ex-ercises the option and you sell your stock.
Most, but not all, of the time you achieve a better investment result bywriting the option. If it expires worthless, you are better off by the entireamount you collected from the option sale. The only time this strategy failsto provide a better result (compared with simply holding the stock) occurswhen the stock increases in price beyond the upside break-even point (seebox on next page).
STRATEGY 1: WRITING OUT-OF-THE-MONEY CALLS
Writing out-of-the-money calls is the most bullish (and aggressive) coveredcall writing strategy. The investor who adopts this method has two main in-vestment goals:
1. Profit from a rising market.2. Earn money by collecting the option premium.
When should you consider writing out-of-the-money call options?
• When protecting your investment against a market decline is less im-
portant than giving yourself a chance to earn higher profits.
• When you are very bullish and willing to accept less option premium in
return for the chance to sell your stock at a higher price.
Deciding you are bullish and attempting to profit from higher marketprices goes against the teaching of MPT. But it’s your money, and you haveevery right to use covered call writing in this manner.
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Break-Even Points
ExampleYou own 200 shares of FGH (currently $47) and write 2 Nov 50 calls at $3.The upside break-even point is the stock price at which you make thesame profit regardless of whether you write a covered call option or sim-ply own stock. That point equals the sum of the strike price plus the optionpremium. In this example, the upside break-even point is $53 (strike price= 50; premium = 3).
Here’s why: When FGH is $53 per share, an investor who owns 100shares has an investment worth $5,300. If the stock moves higher, that in-vestor makes money.
To the covered call writer who owns 100 shares, the position cannotbe worth more than $5,300. The investor already received $300 from theoption sale and can receive no more than an additional $5,000 when as-signed an exercise notice. That sum, $5,300, represents the covered callwriter’s  maximum  value  for  the  position.  If  the  stock  moves  higher,  thewriter makes no additional profit. Thus, in this example, $53 is the upsidebreak-even point. Above that price, the covered call writer earns less thanthe investor who does not write call options.
Note: The only situation in which the call writer does not make moremoney than the investor who adopts a buy-and-hold strategy occurs whenthe stock moves higher than the upside break-even point.
The  downside  break-even  point is  the  stock  price  at  which  you  nolonger earn any profit from the position. At lower prices, you have a loss.That point occurs at a price equal to the current stock price at the time theoption is written, less the option premium received.
Here’s why: Your cost to buy stock is reduced by the option premiumyou received. You incur a loss only if the stock goes below your reducedcost.
For this example, the downside break-even point is $44 (current price =
47; premium = 3).
Note: The upside break-even point compares your result with that ofthe buy-and-hold investor. The downside break-even point has nothing todo with the buy-and-hold investor, as the covered call writer always doesbetter than the buy-and-hold investor when the stock declines in price.
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You own (or buy) 500 shares of BCD, currently priced at $32.50.
You write 5 BCD Sep 35 calls (expiring in one month) and receive $90for each.
Downside break-even point: $31.60 (32.50 – 90)
Upside break-even point: $35.90 (35.00 + 90)
Maximum  profit  (per  100  shares):  $340  ($90  from  option;  $250  fromstock increase)
What Happens Next?
After you sell the options:
1. You receive the proceeds from selling five options, or $450, less com-mission.1 The cash goes into your account, is yours to keep, and beginsto earn interest.
2. You still own the stock. If it pays a dividend, you receive it.23. That’s it. The only change you notice in your brokerage statement is
that you now have a short position of five call options.
Expiration Possibilities
Although it’s possible to be assigned an exercise notice prior to expiration,it’s unlikely. Assume one month passes and that it’s now after the marketcloses on expiration Friday (third Friday of September). Let’s look at thepossible results for this investment.
Scenario 1 BCD is below $35 (the strike price). The call option is out ofthe money. Whoever owns the option will not elect to pay $35 per share foryour stock. Anyone wanting to own stock could have purchased it (beforethe market closed) at a lower price. The options you sold are going to expireworthless. You are no longer under any obligation to sell your stock. Whenthe market opens next Monday (or any time thereafter), if you choose to doso, you can write another five call options against your 500 shares.
This is a satisfactory result. By writing the options, you earned $450
that you would not have earned otherwise.
Scenario 2 BCD stock closes at $35, and the option is at the money. Youdon’t know whether the person who owns the calls will choose to buy yourstock. You must wait until next Monday morning to find out if you have
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been assigned on your call options. Some brokers are not efficient when itcomes to giving you this important information, so be certain to call yourbroker next Monday, before the market opens.3
This is a satisfactory result. You keep the $450 from the sale of the op-tions. You also made money because your stock increased in value by $2.50per share. If you are assigned, that’s a good result, since you both sell stockat your price and keep the option premium. If you are not assigned, that’salso a good result because it leaves you well placed next Monday when themarket opens. You can either sell your stock or continue to hold it. If you de-cide to hold, you can write call options again, collecting another premium.When the stock closes very near the strike price, you must wait to learnwhether  you  get  to  keep  your  stock  or  must  sell  it.  That  decision  is  notyours to make. The option owner must make that decision on (or before)expiration Friday, and your broker learns of that decision when notified bythe Options Clearing Corporation (OCC).4 Your broker must pass the in-formation along to you before the market opens on the next business day.Once you learn if you are assigned, your situation is identical to that ofsomeone whose options finished out of the money (not assigned) or in themoney  (assigned).  Thus,  in  the  next  examples,  we  ignore  the  possibilitythat the option is at the money when the market closes on expiration day.
Scenario 3 BCD is above $35. You are assigned an exercise notice andmust sell your 500 BCD shares at the strike price. If the stock is above, butvery close to, the strike price, you are not always assigned. (Why this ispossible is discussed in Chapter 16.) Be certain to check with your broker.This is a satisfactory result and the result you hoped to achieve fromthe position, as it provides your maximum possible profit. You earned $2.50per share on 500 shares (stock was $32.50 when you initiated this position,and you sell at $35) plus you keep the option premium ($450). Your totalprofit is $1,700. That represents a return of 10.8 percent in one month (129.1percent annualized) on your $15,800 investment.Note: The investment is $15,800 because:
You placed 500 shares at $32.50 into the position. That’s an investmentof $16,250.
You collected $450 from the sale of the options. This cash is used to re-duce the cost of your investment, making the net investment $15,800.
All possible results appear to be satisfactory. So, why doesn’t everyonedo this? What can go wrong? What are the risks? These are good questions.Before looking at the answers, let’s discuss additional covered call writingexamples.
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STRATEGY 2: WRITING-IN-THE-MONEY CALLS
Writing  in-the-money  calls  is  the  most  conservative  covered  call  writingstrategy and is for investors who have two main investment objectives:
1. Increase the chances of earning a profit.2. Gain protection against loss, in addition to