WRITING COVERED CALLS

I prefer to begin discussions about learning various option strategies with Writing Covered Calls because it is easy to understand and because it will feel natural to stock market investors.

First, a definition: A covered call is a position consisting of two parts:

·         Long (that means you own) 100 shares of stock.

·         Short (i.e., you sold) one call option whose underlying asset is that same stock. 

WHY BEGIN WITH THIS STRATEGY?

Although it is not true for every new option trader, most people who come to the options world have some prior trading experience -- specifically, buying and selling stock. Writing covered calls is an extension of that investment strategy. I recommend beginning an options education with this strategy for one basic reason: It is a natural extension of something that most new option traders are already familiar with (buying stock).

That makes it much easier to glide into using options.

This is not the appropriate space to talk about whether an individual investor is better off choosing individual stocks or sticking with index funds or specific exchange-traded funds (ETFs).  I have a deep dislike for traditional mutual funds because of their steep sales charges (loads and/or redemption fees) and excessive management fees. If you are someone who already invests in individual stocks, then the strategy described below is likely to be very useful during the early stages of your options-trading career.

STRATEGY DESCRIPTION

Covered call writing (CCW) is a method for reducing risk associated with owning stock. Stockholders may earn a very large profit when the stock price soars, but they are subject to large losses when the stock price tumbles.

If you prefer to hedge that downside risk, then selling (writing) one call option for each 100 shares of stock owned is an efficient hedging method. 

WHY IS A COVERED CALL A HEDGED POSITION? 

As a reminder, when you sell a call option, the buyer is granted the right to buy your stock (at the strike price) at any time before the option expires.

Therefore, if the stock is trading above that strike price when expiration arrives, the call owner will exercise her rights to buy the shares, and you are obligated to sell. Profits are limited because you cannot sell your stock at any price higher than the strike price as long as you remain short that call option. In other words, you sacrificed the possibility of selling stock at a higher price in exchange for the cash premium that you were paid when selling the call.

SUNK COST AND RISK MANAGEMENT

LOSING MONEY? WHAT NOW?
If you find yourself thinking along these lines [placing a wager that recovers lost money and gets you back to break-even status is so important, that taking extra risk is acceptable], then don’t worry, you are like the majority of people in the world today.
Just remember that though it can be very tempting to take a big risk in order to break even, that risk might put you much further in the hole. Before you take that gamble, think very seriously about the consequences of losing.
If you can consider it rationally, you will realize that it’s much better to stop before you do further damage. Sometimes it’s better to accept a loss and walk away—much like sunk money.
It is very difficult for most people to walk away from a situation in which money has been lost. The temptation to continue playing the game is so strong -- not only for financial reasons -- but because it is psychologically unsatisfying to end the game as a loser. Getting back to break even is almost addictive.
In different language: Consider this scenario: You play poker, bet at the racetrack or invest in the stock market, and find yourself losing $100. You can walk away or continue to play. For most people, the possibility of recovering that $100 is so tempting that they may wind up losing far more money than they can afford to lose -- just in an attempt to recover losses.
This is the important part that is difficult for rational people to recognize: When people make an investment, earning $100 has a certain amount of pleasure associated with it. However, if they first lose $100, then earning $100 is far more satisfying -- despite the fact that it has the same financial value. "Not losing" is more satisfying than "winning" -- and that may lead to taking more risk than is prudent.
SUNK COST
When money has been lost and cannot be recovered, there is nothing that can be done. That is the sunk cost.

THE APPEAL OF BINARY OPTIONS

There is a type of option that is not offered by the "regular" options exchanges (such as CBOE or ISE). It's the binary option. 

Binary options are very easy to understand. The gambler (sure, there is an effort to describe players as stock-market investors, but trading binary options is gambling) places a bet. It works like this: Some future event will either be true or not true -- and you can take either side of that bet.

Another way to state the gambling proposition: Your wager will be worth $100 or $0 when the option expires. There are no other choices. If the event comes true, those who bet on "come true" can cash in their wager for $100. Those who bet it would not come true lost, and their "investment." is worth $0 (i.e., it expires worthless).

For example: "The S&P 500 Index will be up more than 6.00 points today." In the morning, before the market opens, let's assume that the futures markets are neutral. In that scenario, it is more likely than not that the proposition will turn out to be false because the index rises by more than 6 points less than half the time, or "not true" when the day ends. Thus, people who want to wager that the proposition will come true will get a little bit better than even money odds. Those who bet it will not be true must accept odds of less than even money (i.e., they can win less than $1 for each $1 wagered).

Binary options can also be used for longer-term situations, such as:

• Donald Trump will be elected President of the USA in 2016
• The stock market will close lower on Dec 31, 2016 that it did on Dec 31, 2015

• Hillary Clinton will be elected president of the USA in 2016.
• The Chicago Cubs will play in the World Series in 2016.

It's very easy to understand how binary options work. Most people like to predict things. When you have a strong hunch, it is tempting to place friendly bets with friends.

PREPARING FOR A MARKET DECLINE; HEDGE RISK WITH PUT OPTIONS

Experienced, sophisticated investors have a huge advantage over beginners. One of the prime reasons is that the novice tends to jump from one strategy to another, taking advice from whomever has a hot hand. What those new investors fail to understand is that past performance is seldom worth much in predicting future performance and thus, those who have recently performed well tend to do poorly as soon as market conditions change.
Instead of following an advisor who made money last month, last week, or yesterday, it makes far more sense for each investor to adopt a long-term basic methodology for putting his/her money to work.
USING OPTIONS
One of the best ways for investors to have a less rocky ride -- as markets soar and plunge -- is to use options as a risk-reducing investment hedge.
One such strategy is buying puts as portfolio protection. If you like that idea, it is essential to have those options in your portfolio before the decline picks up steam. The reason why this is so important concerns the way that options are priced. If you are new to the options world, then the simple explanation is as follows:
Option prices are based on several factors, such as the stock price and the strike price of the options. However, the most important factor in option pricing is the expectation of just how volatile the market is expected to be in the future. When markets are calm or rising, most traders see little reason to expect market volatility to suddenly increase. For that reason, there is no special demand to buy options, and the supply is sufficient to match the demand.
As a result, option premium (price of options in the marketplace) makes it painless to buy options.
The problem is that, most traders/investors see no need to own options when markets are calm.
When markets are falling, investors tend to get nervous. Because markets (on average) fall faster than they rally, whenever any decline threatens investors with large losses, (think late 2008 or Jan 2016), there is suddenly a demand for put options.
Unfortunately for people who want to buy those options, the supply diminishes and it becomes necessary to pay much higher prices to get any options. There are two reasons for that. First, as stocks decline, puts are worth more. (Think about a stock that falls from 90 to 85. The right to sell stock at a specific price, a put option, is worth more when the stock is 85 than when it is 90). Second, fear that markets will become more volatile and that the decline will continue makes people raise their volatility estimates for the future. And volatility plays a very large role in the price of options. 
Those who wait to buy options until a decline is well underway are forced to pay big prices for their put options. And the price increases are not trivial. Using the CBOE Options Calculator for a stock priced at $100 per share, and paying no dividend, compare the estimated future volatility (referred to as the implied volatility of the option) of put options vs. the calculated fair value of the option.
IMPLIED VOL VS. OPTION PREMIUM

IV	Premium
20	$ 3.91
30	$ 5.89
40	$ 7.86
50	$ 9.83
60	$11.79
70	$13.74

The bottom line for investors who want to own put options as part of their portfolio, is that waiting until you need the puts can be very costly. That's especially true when the decline begins suddenly and demand overwhelms supply.

DON'T LET THE MARKET'S VOLATILITY SEND YOU INTO PANIC MODE

No one can argue with the fact that we’ve seen extreme volatility in the stock market over the past week.  At times like this, it’s not uncommon to feel fear and panic.  We’re all human and too many of us have lived through challenging financial crises in the past.  While I can’t predict the future or tell you definitively that everything is going to absolutely be alright, I think it’s critically important to keep a few things in mind during this time. 

WHAT'S CAUSING THE VOLATILITY?

First, it’s important to understand why the stock market is acting this way. Fundamentally, the U.S. economy is doing well.  But due to a confluence of events including fears of a slowdown in China, currency devaluation from emerging market countries (China, Vietnam, Kazakhstan, etc.), and uncertainty about the Fed’s pending rate decision, the market has seen a huge sell-off.

 In addition to these events, our market is finally nearing correction territory, and this is a correction that is long overdue. 

UNDERSTANDING STOCK MARKET CORRECTIONS

Corrections are a lot like a circuit breaker.  They usually occur when a hot market gets hit with worrisome news- such events cause the market to pause and fall back as institutional and individual investors reassess their positions based on the new information.  These respites are actually good for the market.  Looking back to historical data beginning with the year 1928, the market typically undergoes a five percent correction about every 10 weeks, and a 10 percent correction every 33 weeks. Our research shows that the market has not seen a full 10% correction in 46 months, which is the third longest in history, so we are definitely due.

IRON CONDOR

The iron condor is a strategy that can be a good introduction for beginning options traders to option selling. It can be a relatively safe way to sell options because you can’t lose on both sides of the trade. Here, you pick a likely trading range for an underlying asset and sell out-of-the-money option spreads around that range, “If you collect a total premium of $2 for selling two $5-wide spreads – both an out-of-the-money call spread and an out-of-the-money put spread, your total risk is only $3 because the commodity can’t go through both spreads at expiration. You have spread the risk across a wider range of possible prices. If your trading range thesis changes or volatility explodes and threatens to put one of the spreads in-the-money, you can exit one or both spreads at any time. Collecting $2 against $3 of risk offers you a potential return on risk of 67%”.
The market outlook for the iron condor is neutral. “You’re trying to be strategic with your use of leverage. You’re trying to be systematic and probability minded, looking at what the best odds in the long run [are] if you did this consistently,”.
An iron condor can be entered from the short side or the long side, explains Charlie

“A trader who enters a short iron condor is looking to profit from a range bound underlying asset. As long as the underlying asset stays within the inside strikes by expiration, the trade will be profitable. If it moves outside of the inside strikes by expiration, the trader will take a loss, which could be as high as the difference between the sold call/put and the purchased call/put”. A trader who enters a long iron condor is looking for the exact opposite, or, a large move in one direction or the other by expiration.

Dos and don’ts 
As with any type of trading, with beginning options strategies, having a trading plan and having an exit strategy are crucial. “Everybody has a plan for when to get into a particular stock or index, but few think it through to the point of when to take profits or cut losses”.

CALENDAR/TIME SPREADS

another strategy used in options is calendar, or time, spreads. In a calendar spread, you establish your position by entering a long and short position at the same time on the same underlying asset, but with different delivery months.
The point of this strategy is, time decay happens much more quickly the closer we get to expiration. The theory is that when you short the front-month option, you’ve got that quickly-evaporating time premium working with you, faster than the decay in the further out option that you bought. “Just like the call and put spreads, you’re paying a debit for the spread and the further out you go in time; the bigger that debit’s going to be. You’re looking for a stock at expiration to be at the strike that you have put this spread on”.

BULL CALL & BEAR PUT SPREADS

Bull call spreads and bear put spreads also are called vertical spreads because they occur in the same month and they have two different strikes. Unlike with the covered call strategy, your risk with the bull and bear spread strategies is more easily quantified, says Joe Burgoyne, director of institutional and retail marketing at the Options Industry Council.

OPTION STRATEGY; COVERED CALL

Options are excellent tools for both position trading and risk management, but finding the right strategy is a key to using these tools to your advantage. Beginners have several options when choosing a strategy, but first you should understand what options are and how they work.
An option gives its holder the right, but not the obligation, to buy or sell the underlying asset at a specified price on or before its expiration date. There are two types of options: a call, which gives the holder the right to buy the option, and a put, which gives its holder the right to sell the option. A call is in-the-money when its strike price (the price at which a contract can be exercised) is less than the underlying price, at-the-money when the strike price equals the price of the underlying and out-of-the-money when the strike price is greater than the underlying. The reverse is true for puts. When you buy an option, your level of loss is limited to the option’s price, or premium. When you sell a naked option, your risk of loss is theoretically unlimited.
Options can be used to hedge an existing position, initiate a directional play or, in the case of certain spread strategies, try to predict the direction of volatility. Options can help you determine the exact risk you take in a position. The risk depends on strike selection, volatility and time value.
No matter what strategy they use, new options traders need to focus on the strategic use of leverage. Being systematic and probability-minded pays off greatly in the long run, instead of buying out-of-the-money options just because they are cheap, new traders should look at closer-to-the-money option spreads that have a higher probability of success.

Example: If you are bullish on RELIANCE and want to use the NSE exchange, which is currently trading at 1024, instead of spending 15000 Rs on the JAN 1020 call looking for a home run, you have a greater chance of making profits by buying the JAN 1040/1060 call spread for 7500 Rs.

Picking the proper options strategy to use depends on your market opinion and what your goal is.

COVERED CALL

HOW TO HANDLE STOCK MARKET CORRECTIONS

What is a Market Correction?

A market correction is typically defined as a drop in stock prices of 10% or greater from their most recent peak. If prices continue down to the point where they are down 20% or more, it is then called a bear market.

Frequency of Market Corrections

·         Stock market corrections occur, on average, about every eight to twelve months.

·         On average, a market correction lasts about 54 days.

According to Fidelity (as of May 2010) Since 1926, there have been 20 stock market corrections during bull markets, meaning 20 times the market declined 10% but did not subsequently fall into bear market territory.

How to Handle Stock Market Corrections

If there was a way to “time the market” and figure out when it was going to go up, and then sell before a market correction occurred, well, who wouldn’t do that?

It seems there is plenty of information on the internet that suggests this is possible. Let’s think about this: if you had this skill, would you be writing articles on the internet... or sitting on the beach somewhere with your laptop, drinking a Corona and making money?

Most people lose money by trying to move their money around to participate in the ups and avoid the downs. This is a documented behavior which I discuss in Why Average Investors Earn Below Average Returns.

As a professional financial advisor, when we build a portfolio, we expect that one out of every four calendar quarters it will have a negative return. We control the magnitude of the negative returns by selecting a mix of investments that has either more potential for upside, which comes along with more potential for market corrections, or a mix that has less potential for high returns, and also less risk.

If you are going to invest in the market, it is best to understand that stock market corrections are going to occur, and it’s often best to just ride them out.

Think of it like going to an amusement park; you can’t get on the roller coast only for the up, and avoid the big downs. That isn’t how the ride works.