Section 4 Option Writing TTHHEE OOPPTTIIOONN WWRRIITTEERR TTAAKKEESS TTHHEE BBEETT IINNSSTTEEAADD OOFF MMAAKKIINNGG TTHHEE BBEETT Secret 40 TAKE THE BET INSTEAD OF MAKING THE BET The option markets provide that rare opportunity for the in- dividual 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 oppo- site of option buying. The option writer is the one who takes and guarantees to pay off on the bet made by the option buyer. When you go to the sports book in a casino in Nevada, the job title of the person who takes your bet on a football or basket- ball game is called a sports writer. The person who takes your bets when you play Keno in a casino is called a Keno writer. Now 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 account. Now, you have to pay off if the underlying stock or futures moves across the strike price and into-the-money. The beauty with an option writer over a casino or bookie is that you have the ability to close the casino door. In other words, you have the ability to close out your position and obligation at any time by buying back the option. For example, let’s say that the IBM Dec 110 call is priced at 2 when the stock price is 100. You would write this option by en- tering an order to sell the Dec 110 call at 2 to open. When the order is executed, $200 goes into your account. However, for the $200 you are obligated to deliver 100 shares of stock at $110 a share to an option buyer if he exercises your option. That would occur if IBM is at or above 110, espe- cially at expiration. If IBM is below 110, the option will expire worthless; in either case you keep the $200. Of course, you can close the position out at any time before expiration 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 excellent source of income. In fact, to be a profes- sional option trader, you must do some option writing because it provides a consistent source of income. OPTION WRITING 120 Secret 41 THE SECRET ADVANTAGE OF OPTION WRITING The secret advantage of option writing is that you can enter trades where you have a very high probability of winning no mat- ter what the market, a stock or a futures 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 in- strument 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. [...]... example, if your tar- OPTION WRITING get for Pfizer was 45 , you receive $200 as you wait for the stock to exceed 45 If the stock does not get to 45 , you can write another option with a strike price of 45 and collect more premium as you wait If the stock is called away at 45 , you receive 45 +2 or $47 a share When you don’t want to sell the stock, follow the guidelines that we presented in the previous chapters... priced at 40 and write the Pfizer Jan 45 call at 2, you receive $200 to your account but are obligated if Pfizer is above 45 and you are exercised to deliver the stock at 45 Covered call writing is ideal when you have a target where you wish to sell the stock Then you are getting paid as you wait for the stock to hit your target In our Pfizer example, if your tar- OPTION WRITING get for Pfizer was 45 , you... Electric fell through, Honeywell dropped to 37 With one day before expiration, the HON Aug 30 put had a bid of 3 and an asked of 8 Frank put in an order to sell 10 HON Aug 30 puts at 40 ( $40 ), and at the end of Thursday’s trading, the order was filled This is a 99% play Honeywell would have to drop 7 points in one day after already hitting a temporary bottom before Frank could lose Of course, Frank pocketed... profit Preserving a big profit puts you in the hot seat Don’t let the profit slip away When the underlying stock or futures stalls or reverses trend, get out of the the hot seat Take the money and run 1 34 Secret 47 EXPIRATION WRITING One play that can generate almost sure wins is to write options that will expire in just a few days (You still want to write options that are comfortably out-of-the-money.) After...Secret 44 PROBABILITY— THE FIRST SECRET FOR OPTION WRITERS From my experience the secret to winning at the naked option writing game is to find very high probability plays I write naked options for speculation... put); don’t write covered calls Some studies suggest that in the longer term, call writing does not increase your returns, but does neutralize some of the short term risk and volatility of your portfolio 144 Secret 51 COVERED CALL WRITING STRATEGIES One covered call writing strategy that can generate much better returns is to write calls on low priced stocks, priced under $15 a share Here you can sometimes... option One warning here, make sure you have enough capital to buy the stocks that you write puts on 148 Secret 53 NAKED PUT WRITING CAN CREATE A WIN-WIN STRATEGY A win-win game situation is when you win regardless of what happens Let’s take an example to show how win-win put writing works If Pfizer is at 40 and you want to buy the stock if it falls to 35, rather than placing a limit order to buy the stock... expiration One word of caution, one danger with all naked writing plays with stocks is that they have surprise volatility and can move in a chaotic pattern, so there are no absolute sure things 136 Secret 48 DEFENSE, DEFENSE, DEFENSE 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... go wrong?” Here are ten 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 short term options OPTION WRITING 4 5 6 7 8 9 Write only overvalued options Cover positions when the option loses most of the value Never be afraid to take a loss Take small positions Exit a position when you feel uncomfortable Exit a... Without a stop-loss, the option writer is doomed Small positions will prevent you from taking a hit that will wipe out your portfolio Remember you want to be able to return to fight another day! 138 Secret 49 WHEN TO USE COVERED CALL WRITING One conservative way to write options is to do covered call writing This is a way to generate additional income for your stock portfolio Covered call writing refers . Section 4 Option Writing TTHHEE OOPPTTIIOONN WWRRIITTEERR TTAAKKEESS TTHHEE BBEETT IINNSSTTEEAADD OOFF MMAAKKIINNGG TTHHEE BBEETT Secret 40 TAKE THE BET INSTEAD OF MAKING. .3 and an asked of .8. Frank put in an order to sell 10 HON Aug 30 puts at .40 ( $40 ), and at the end of Thursday’s trading, the order was filled. This is a 99% play. Honeywell would have to drop. becomes very important. How to find the ideal situation will be forthcoming. OPTION WRITING 126 Secret 44 PROBABILITY— THE FIRST SECRET FOR OPTION WRITERS From my experience the secret to winning at