The use of writing put and call options can be a highly interesting
topic.
Here is my take on how to make risk adjusted positive cash-flow returns by trading naked options.
The main reason is that when a trader is writing/selling an option there
is unlimited losses that can occur when selling calls. When selling put options
the stock can be exercised and the value of the stock can in theory go to $0.
The other side is that writing/selling options the writer
will receive a premium. This is a fantastic opportunity for option writers to
receive cash flow.
If used correctly I see the writing/selling of options an
opportunity for cash flow. Using my fundamental stock scanner (see:http://novitytrading.blogspot.com.au/p/trading-programs.html ) We have the ability to find stocks that are
currently trading below valuation. The user then can use the option-scanning tool to
provide an outcome with the best option trade for that stock.
We mainly target the
stocks where we have a high probability that the option will NOT end up
exercised at the end of the contract term. This means is we can then
start a new trade at expiry for further income. It is good for cash flow.
Therefore, what happens with this strategy if it is right
all the time?
Going wrong or being right is relative to the user’s perception.
I see being right as making money overall. Just because a stock option got
exercised, does not mean the trade was wrong. As long as we can continue to
make money from the stock, all is well.
This strategy is not the same as the Forex strategy, but the
underlying principles are the same, in the sense, that the outcome is to make
money overall, whilst reducing and managing risk and using statistical probability.
I believe that when trading it is all random, and all I am
doing here is providing information on how I view the markets and how there are
opportunities to make money, by placing as many probabilities and statistics on
the traders side to provide some sort of edge in the randomness.
Let us look at a couple of examples;
- Because I am writing options on stocks that are trading below valuation, I am banking that the value of the stock will increase in value. This means that my option will not be exercised, and I get to keep the premium. This is the benefit of my Option trading program which looks at all time data and provides me with an accurate probability of being exercised or not being exercised.
- Using a modified version of the Kelly formula, setup specifically for my options program, I can quickly determine which options are worth writing and which options are not. Within my modified Kelly formula, I have worked in the Draw-down and other various algorithms to work specifically for writing options. I had to custom make it, as I have not found anything that is close to being accurate to date.
Therefore, what happens with this strategy if it gets
exercised? Well let us look at a couple of examples;
- I am writing/selling options on stocks that are trading below valuation. This means that lets say based on my valuation models, I have a stock that is currently trading at $20 but the valuation model is showing that the stock is actually worth $25. You talk to any stockbroker and he will tell you to buy the stock and go long and make some money. Therefore, we can all see that just doing that is a good opportunity for investment.
- Nevertheless, I do not stop at that point; I then use my option strategy program. Using this example, I then scan the history of the stock from the first day of listing. Therefore, this period could be 5 years, 10 years, 30 years, or however long the stock has been trading. Looking at the probability over all time, we can tell at what price we have the highest probability of NOT being exercised. So let’s look at some examples; the program could say at $19 I have a 70% probability that the option will not get exercised, it will also then say at $18 I have 80% probability that the option will not get exercised; it will also say at $17 I have a 98% probability that the option will not get exercised. But each of these options provide a different rate of return, meaning that the further away from the current share price the option is the less it is going to be worth. Therefore, from this angle it is a balancing act in getting the correct distance and the correct value. I use a modified “Kelly Formula” for assistance with this, to ensure that I am not receiving too little income for the risk taken.
- If it goes wrong, it means that the share price is falling rapidly. Now let us say I have written an option at $18 because based on all the formulas from my programs I see that is the best return for the best risk. So, my stock is still valued at $25, but for some reason the market has fallen. This means I now left own the stock at $18. This is a long way from valuation and is a good buying opportunity providing that the fundamentals of the company have not changed. If at expiry, the stock price is $15 I have made an unrealized loss of $3. I can then wait for the rebound, or write a call option. Either way every time I am writing an option on the stock it is lowering my breakeven which is a good thing, which means I can get out at below purchase value and still come out in front.
We can go on and cover a lot more detail, but we can assume that the understanding is clear enough and/or provides enough ideas.
I assume the reader has read the terms “Renting Shares” and “Buying
share at wholesale” whilst these are not technical terms the original writer of these terminologies does provide a more simplistic view point on options, and this is my interpretation of this. In order to make it
more real and make it more accurate, I have used various algorithms to increase
the accuracy of these styles of trades.
