ASX - A Systematic Approach to Selling Premium (1)

ASX - Systematic approach to selling premium

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A systematic approach to selling premium Introduction Many investors trade options for premium, usually writing call options against shares in their portfolio. Covered call writing, writing cash secured puts; selling credits spreads etc. have all proven popular with yield conscious investors. While the strategies themselves are relatively simple to understand the challenge is in managing the position. For their use to increase investors and advisers need to become better at handling the inevitable swings in the market. This article looks at solutions to ad hoc management of written positions Common premium selling strategies 1. Covered call writing Writing call options on a covered basis against an existing stock position is popular with investors that; 1. Own the stock and are looking to sell out 2. Own the stock and use it as a means of generating premium income without necessarily wanting to sell the shares Returns vary considerably depending on how frequently call options are sold, the amount of premium received, whether the shares are sold and at what level. Popular with investors that already own the underlying shares or are about to buy into a stock, this strategy is important in managing entry and exits. Several risks, some more costly than others are associated with covered writing. 1. The underlying stock falling. Writing calls options is not a substitute for buying put options as the premium received is usually only 2-3% of share price at any one time. Losses therefore result when the stock has a big drop. While rolling down the call for a credit is a consideration, the more reasonable move will probably be to get out of the stock. Many investors sometimes fall into the trap of purchasing stock to enter the “options writing business”. While returns are conservatively 10-15% p.a., more if the shares are purchased on margin, a big fall in the underlying stock can wipe out profits in an instant. Therefore, the strategy should be viewed in its correct context. On stocks that move up or a broadly stable it improves returns. Stocks should be able to hold their own in a portfolio regardless of whether covered calls are sold, instead of being there just because options premiums on the stock are attractive. 2. Rolling covered calls. The toughest thing to do correctly in an ongoing covered writing program is rolling the calls. A bad roll can turn a good covered write in to a disaster. Anyone who has used covered calls for a period of time has probably faced the prospect of rolling numerous times. It’s a tough, yet critical choice. Rolling is the process of adjusting a position in response to changes in the underlying stock price and the passage of time. Rolling involves the re- purchase of a previously written call and the sale of a new call as a replacement. Most often the reasons for rolling are that a previously written call is now in the money, it’s low on time premium, and the covered writer wants to avoid assignment and increase their profit potential. If there has been a big rally in the stock many investors will simply let the stock be called away. Others however will feel they’ve missed out on too much profit and want to roll the calls up. This is where more serious problems could develop. The advantage that covered writing offers is time premium income. The trick is to generate enough premium income to offset the disadvantage of a potentially limited profit or a large loss. The action of rolling up to a higher strike price usually involves a debit and is therefore contrary to the investor’s initial objective. Problems might also develop from rolling too far out in time. Writing longer dated contracts is less efficient than shorter dated options as the the relationship between time and premium in not linear. Selling shorter dated options more often, citers paribus, brings in more premium than selling than

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a longer dated option for the same term. Another problem, going longer term greatly reduces flexibility in making short term adjustments. Just above the call’s strike price In this case we have close a perfect covered write. We could do nothing and let the stock get called away; after all we haven’t missed out on much potential profit. On the other hand we have excellent prospects for rolling. First check the net credit for rolling out 1- 3 months at the same strike price. If the credit is acceptable, roll them. If not, let the stock be called away. An acceptable credit is generally in the 10-15% net annualised. Rolling up and out to a higher strike and 1-3 months out would only be advised if still fairly bullish on the stock. Paying to roll up and could really backfire if the stock is lower at the next expiry. In that case we would have gone from a nearly perfect position and have paid back some of the original profits, to roll up to a higher strike and watch the trade turn into a loser. In light of the extreme penalty for being wrong on a roll up in the first scenario, it is advisable for even the most bullish roller move up only one strike to the first of out- of- the- money option. 8-12 % above the calls strike price In this case we are securely in our maximum profit position. The stock has performed better than expected and we missed out on some good profit potential, but the scales have tipped more in favour of just letting the stock go. Ironically, it’s just this sort of situation that tempts more and more investors to take a chance on rolling up. The net credit for rolling out 2-3 months at the same strike is almost never enough to make it worthwhile. Conversely, paying to roll up two or three strikes provides and attractive ratio of cost to profit potential, but increases the chance of, and penalty for, being wrong. Assuming we are still bullish, rolling to the first in the money call is a reasonable compromise. If the roll is too expensive in terms of cost per dollar of new profit potential, then let the stock go and look for new opportunities Way up there Let it go. In such a case, you will probably wish you had never written the call in the first place. Don’t let your emotions lead you to make an even greater mistake by rolling up too far. Rolling to an in the money is probably too expensive and inefficient. Going to a longer term contract compounds the inefficiency. Better return potential will be available in a new position. 2. Cash secured put writing. The written put is analogous to the covered write as can be seen from the payoff diagrams for both strategies.

The management of the two strategies however differs quite markedly. When the underlying price rises the written put can either be repurchased and another at a higher strike sold or simply let to expire. So in the case of a rising share price the management of the written put is straightforward. As with the covered write, where the underlying stock falls the easiest and perhaps most effective course is to buy back the put and close the position. Although many covered writers continue to hold stock despite falling, cash secured put writers do not usually have the same level of attachment to their position. Short in- the-money puts and long stock are broadly equivalent (delta approaching 1 in the case of the put v of 1 for long stock) however stock has already been purchased, whereas the short put is just a liability to do so. Ultimately the decision to hold the short put, roll it out or be assigned depends on a favourable view of the stock. No amount of rolling will result in an in the money put expiring worthless unless the stock recovers. Rolling out several months simply obligates the writer for longer financially and in time and energy spent monitoring the position. Putting it all together Many premium writers start in options selling covered calls against optionable stocks in their portfolio. Once familiar with covered writing and options in general, the next logical step is to get paid a premium to buy shares. Cash secured put

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selling follows and in some cases many more shares than was originally intended are acquired. These purchases become profitable when the underlying price rises above the investor’s breakeven (put strike less premium) although if more shares were purchased than really intended the investor will have been exposed substantial risk. A solution to buying too many shares is to keep strictly to the limits. The following chart helps in this regard providing a step by step approach to selling premium in pursuit of buying 2000 shares.

Step 1. A cash secured put is sold. If the put expires out of the money revert to step 1 and sell another put. Step 2. Once assigned on the short put the writer holds 1000 shares. At this point if the view on the underlying stock remains positive another 1000 shares can be attempted to be purchased selling a put. At the same time the put is sold the same strike call is also sold on a covered basis against the 1st 1000 shares. If the stock falls the put is assigned and the 2nd 1000 shares purchased completing the investors buy order. Step 3. Now the full quantity of shares have been purchased covered calls are written against 2000 shares. The choice of exercise price /expiry month or timing of the sale is determined by the investor’s outlook. For example if the expectation is for the stock to move up strongly in the short term the investor may chose to wait for the move before implementing the covered write. Once assigned on the calls the investor sells their 2000 shares. Depending on their outlook at this point they can either revert to step 1 and sell a cash secured put to repeat the process or look at doing the same on another stock. The benefit of strictly adhering to this process is no matter how attractive put premiums are at the time or how financially able the investor to buy stock if need be, only the required number of shares are purchased. The sale of options with expiry dates, usually in 1-3 month range, also imposes a checking mechanism on the preparedness of the investor to hold the

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stock on an ongoing basis. Monthly or quarterly “spot checks”, on the underlying stock improves the chances of the taking action. Summary Writing covered calls and cash secured puts is a relatively conservative approach to selling premium. It is also an important mechanism for reweighing portfolios. If an investor is happy to sell stock, covered call writing sets a selling price. Cash secured put writing does the same for buying stock and can be thought of as equivalent to a good till cancelled order where the seller receives a premium. Problems arise with both strategies when the original intention is overlooked. If the covered call writer is no longer prepared to let the stock go they are in effect writing uncovered calls (naked) using the stock simply as collateral cover for the option. The same is true with cash secured put writing where cash is the cover although the writer never actually want to buy the stock. Writing puts on stocks for the sake of earning an attractive premium, makes little sense if the writer doesn’t want to eventually own the underlying stock. As long as the purpose of these two fundamental strategies is not forgotten both strategies can add considerably to returns.

References The contributor would like to acknowledge the following references: > Rolling Covered Writes, A.G. Edwards and Sons

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9/8/2008 9:20 PM

ASX - A Systematic Approach to Selling Premium (1)

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