From Investor to Banker

Last week we discussed about Option buying and what to look into while buying options. This week we shift our focus to option writing. You can write options against your underlying position, MF exposure or write naked options. Let’s discuss it at length today.

The option markets provide that rare opportunity for the individual investor to be the bank, casino or legal bookie. In other words, you have the opportunity to take the bet rather than make the bet. Taking the bet refers to option writing—the direct opposite of option buying. The option writer is the one who takes and guarantees to pay off on the bet made by the option buyer.

You have the opportunity to be a writer, an option writer, where instead of buying an option, you sell an option and the option premium (price) goes directly into your trading account. Now, you have to pay off if the underlying stock moves across the strike price and into-the-money. The beauty with an option writer over a bank, casino or bookie is that you have the ability to close the door. In other words, you have the ability to close out your position and obligation at any time by buying back the option.

Option writing can be played by all types of option investors from the conservative to the high risk-takers and in all cases can provide an decent source of income. In fact, to be a professional option trader, you must do some option writing because it provides a consistent source of income.

The secret advantage of option writing is that you can enter trades where you have a very high probability of winning no matter what the market or a stock does. In fact, you can sometimes enter a trade that has a 99% chance of winning. In a sense, at times, they are giving money away on the exchanges. Why? The option writer usually wins if the underlying instrument moves in the direction you expect or stays still or moves against you very slowly. The only time the option writer gets hurt is when the underlying instrument makes a big quick move against you. The disadvantage to the option writer is the chance of a big loss, for you face unlimited risk.

Unlike option buyers who have to wait and pray for a big return and rarely see a big winner, option writers sit back and collect the money and let the passing of time work for them.

The most aggressive option strategy is to write puts and calls naked without any type of hedge, such as owning the underlying stock or futures, or without buying some other options to hedge the risk. Of course, you have the greatest potential reward, but even when you have a small position, the risk can be sizable. The greatest danger to writers occurs during a crash.

When one writes naked puts and calls for speculation, wait until you find an ideal situation. Having this ideal situation is necessary because, though naked writing can be a true advantage with a lot of reward, it is so dangerous that minimizing the risk as much as possible becomes very important.

However, a word of caution here is. When an option is extremely overpriced or extremely underpriced, there is probably a reason. In fact, ironically, buying and selling stocks based on this premise can be a profitable trade.

You see, the option writers who write out-of-the-money options have two factors going for them: time and distance. To get writers in trouble, the underlying price must move against them fast enough to beat the expiration date and far enough to hit their stop-loss or strike price, sometimes an almost impossible task.

As option writers you are on the hot seat, and try to get out of the hot seat as quickly as possible. Consequently, write out-of-the-money options and that I will buy back immediately when they lose most of their value. You don’t want to be in an option position that is almost worthless and then surprise volatility comes along and the underlying stock or index jumps into-the-money, hurting you big time. Also don’t be in the hot seat when I see a major change in the underlying stock, index, or overall market.

Surprise volatility can bite you at any time. As a result, it is imperative that you always check your portfolio to see if you have option writing positions that have lost most of their value, and if they have, then act accordingly; as soon as you find an opening, get out! The hot seat concept also applies to option buying when you have a profit. Preserving a big profit puts you in the hot seat. Don’t let the profit slip away. When the underlying stalls or reverses trend, get out of the hot seat. Take the money and run.

Whenever you are writing options, especially naked options, you must always be considering the worst case scenario. When you write options, you win quite frequently and, as a result, tend to relax when you should be in a disaster mode all the time, for all you need is one bad hit to wipe you out. Always ask yourself, “What is the worst thing that can happen to the position? Can I handle it? What can go wrong?” Here are some defensive steps that I take to protect my portfolio from a disastrous hit:

1. Use stop-losses.
   2. Enter only high probability trades.
   3. Write only overvalued options.
   4. Cover positions when the option loses most of the value.
   5. Never be afraid to take a loss.
   6. Take small positions.
   7. Exit a position when you feel uncomfortable.
   8. Exit a position when the underlying scenario or trend changes.

Happy Trading.

Cheers!!