Options Investing

Some readers have expressed interest in options investing blog topics.  So I’ll pontificate a bit about options investing.

I view options as generally “zero-sum” hedging tools.   When I buy and sell (mostly sell) options my first thought is not making money on the options trades.  My main goal is transforming and reshaping my portfolio.

In my IRA portfolio option trades cost me about $8.00 each.  Since IRA accounts generally cannot be margin accounts, I have only 4 basic ways to play options: 1) write covered calls, 2) write cash-covered puts, 3) buy calls, 4) buy puts.

The tactic I’ve applied in my IRA is a basic covered-call approach applied primarily to SPY.  In a nutshell, I started by buying 100 shares of SPY and selling a single at-the-money call 2 or 3 months out.  That call option either expires worthless or I buy it back just before it gets exercised.  I then repeat every couple months; selling 4-5 option contracts a year.

The primary advantage of this approach is that it provides extra return during sideways markets and softens market dips.  The trade off is missing out much of the upside return during bull markets.  Setting the option strike price near the stock price eats into portfolio upside, but gives larger option premiums.  Choosing a higher strike price, more out-of-the-money, allows you to retain a larger share of market upside but provide you a smaller premium.

The other factor to keep an eye on is implied volatility.  The most common way to track implied volatility is via the VIX.  When the VIX is higher, you can expect to get more money for the calls you “write” (create and sell a call option).  I prefer to sell call options when the VIX is 18 or higher.

So if you are interested in dabbling with options I recommend starting with selling covered calls on a highly-liquid ETF like SPY.  Real time bid/offer quotes are almost essential and allow you to make limit order trades.  I recommend starting near the option midprice when selling a covered call.  For example if the Jan 2011 SPY 125 call has an ask/offer of 2.16/2.20, you can started by offering your call at 2.18. [Depending on the exchange, your brokerage account, and the price you may only be able to bid in $0.05 increments; in other cases you can price options in penny increments.]

To make things a little more confusing, most options are quoted with a 100x multiplier.  So that means that an option quote of $2.18 actually sells for $218.00.  Each option contract transacts 100 shares of the underlying security (the “underlying”).  So exercising one SPY 125 call contract requires paying $12,500 in order to buy 100 shares of SPY at $125 per share.

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