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Option Business aka Insurance Business

Published on March 10, 2009

Option Business aka Insurance Business

March 10, 2009

A bounce is due, no, I think overdue. We have all realized that Mr. Market can remain irrational longer than one can remain solvent. So though the probability of bounce is high, don’t count on it for long term bull market till there are sign of economic improvement. The primary trend is bearish, as clear as that could be.

However, this market is bringing its own unique rewards. I would like to compare it with insurance business and let’s apply their business model to option trading.

As the risk is rising, Options’ premium is rising as well and as an option seller it is to our advantage. So why not start building positions that are going to give regular income stream. An example of that strategy is called Covered call (Covered Call is an option strategy in which a call option is written against long stock on a share-for-share basis).

I earlier shared a real trade example of covered call on SRS, where I was able to keep full 17% of profits for 4wks. I again opened it this month and have done a few changes to maximize my yield. Of course I can’t expect to have 17% month after month, but even 5-7%, month after month via credit generation from short roll over, can result into substantial gains. Alright, Ultrashorts are not for weak heart. Let’s move on to a company like Caterpillar (CAT).

cat-covered-call-apr09 Currently CAT is selling for $23.92 (Yesterday’s close). A price level, where it was about a decade ago. You could pick-up shares for US$23.92 and sell April 25 calls for $1.85. Let’s continue to diagnose.

By April’09 option expiration cycle, here are 3 scenarios-

  1. CAT is above $25 – I get to keep $1.85 + $1.08 ($25-$23.92)= $2.93 for $23.92 investment i.e. 10% for 5 wks holding, not bad for a strong but beaten down as CAT which might benefit from stimulus package. I can then repeat the same for next month by simply rolling 25s over to $28s or so. If I have portfolio margining, my returns are double.
  2. CAT is below $25 but above $23.92- I shall not be assigned and therefore stocks will remain mine but I get to keep Apr 25s full premium and whatever is upside above $23.92.
  3. CAT is falling- My downside break-even point is $23.92-$1.85= $22.07. If it falls below $22.07, I could choose to buyback my shorts calls and sell another call.

What’s the catch– While this may sound simple, one needs to have a full trading plan including risk mitigation plan. Making sure these are the stocks you are absolutely in love and would like to hold so you can continue to write covers time and time again so probably in a few months (a little more) time your shares are free. One may also have to considers which strikes to sell.

The gains cam also be maximized by buying in the money calls vs stocks, sort of diagonal spread. You may also choose to sell puts, sell calls and buy stocks, all together. But that’s the topic for other day.

Have fun and profitable trading, OP

3 Comments

  • jerry says:

    I was following your comments — good job except the covered calls articles — that is a terrible strategy —- 1st one I learned many years ago and still dislike — but it may be good for some I guess — I am just not sure for who — huge risk….

    anyway just my two cents — thanks Jerry

  • OptionPundit says:

    Jerry, covered call is not bad as a strategy per se; the execution maybe. It’s a terrible strategy for markets where there is lot of complacency which is reflected via low premiums due to low IVs. It simply doesn’t payout for the risk to be taken. That’s why it become quite important to choose the appropriate underlying and use the strategy at an appropriate time.

  • […] covered call example that I shared in the free trade section is up +10.9% (as my account uses portfolio margining) and for account without margining it […]

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