But as young investors become seasoned investors over time, they start to realize they’ve been leaving money on the table for years. They haven’t been maximizing their talent or their opportunities. For some, they discover cover call writing. At least initially they find themselves writing out of the money (OTM) covered calls. Some never mature past this strategy.
I first discovered this strategy in the 1980s when I found out that most covered call at the time were sold in the State of Florida. I thought that was odd but I soon discovered that the covered calls were being sold by retirees who had been sitting on large numbers of shares of companies. While many just enjoyed retirement living off dividends, others looked for ways to augment their income. And the answer they found was the sale of OTM covered calls. Most sales were far OTM because most retirees really didn’t want to lose their shares, they just wanted additional income. Selling covered calls performed that function almost flawlessly.
For others it only took a couple of downdrafts in the markets. Retirees became fearful that whatever wealth they had accumulated owning shares of companies could easily be threatened by a market pullback. And that directly threatened their security and way of life. They needed insurance in order to secure their lifestyle. And that’s when they discovered puts. Puts provided the security that the markets simply couldn’t. It was exactly what those seniors needed.
Very quickly a few of those investors discovered that a select combination of covered calls and puts could provide both income and protection. If you could figure out how to make more with the covered calls than was spent buying puts, you could both increase you income and sleep well at night too!
If that was the end of this story then all would be fine but found all sorts of combinations of calls, puts, and expiration dates. Books were written and software was written for program trading. It all got rather sophisticated and that took the edge away from traders and put it in the hands of brokerage houses. Options trading became more difficult as it became more complicated, and those who stayed with the basics tended to do better than the more sophisticated investors.
But options remained centered on the equity. It’s always been a second order effect of the underlying security and virtually no one thought any different. But with a little thought things could be turned around. Or rather inverted. Instead of thinking of options as additional income or insurance, think of the option first and the equity second.
It’s easy to do this with puts. The most conservative strategy of puts is to sell puts but have then secured with cash. It allows the investor to buy shares cheaper than he could or make money for waiting. Now think of equity as be the vehicle that secures calls. Just as we look for the best puts and secure them with money, we can now look for the best calls and secure them with stock. It puts the emphasis on the option rather than the stock.
The emphasis now focuses on the premium of the call option. The strategy now is to find the best premium and that usually happens with the equity is at the strike price. And since premium deteriorates the fastest near expiration, the shortest time to expiration becomes the best strike price.
The intent of this strategy is to emphasize cash over securities. Entering securities and options is only temporary. The main emphasis of this is to sell the best premium and cash out. Find stocks with an upward bias, sell just OTM options, and then get exercised back into cash. The advantage of this strategy is knowing the percentage return on investment when exercised. Finding options that return more that 10% in a month is pretty easy and most will be 3-5% OTM. If exercised, that’s just a boost to the option money.
This strategy keeps the investor in money as long as possible and as often as possible. It is this being in cash that provides an additional layer of financial security. Cash doesn’t go down in value (except for loss due to inflation) like a pullback in the markets. Getting in and understanding or estimating your expected return up front and your length of involvement provides a level of confidence not found in a strategy of buy and hold (often referred to as pay and pray).
If you’ve always thought of options as an additional supplemental strategy of investing, you should probably take the time to understand options as a strategy in and of itself. It might just be another tool in your tool box as you continue down that road toward financial freedom and security.