Where's the Logic?

"A sane mind should not be guilty of a logical fallacy, yet there are very fine minds incapable of following mathematical demonstrations." Henri Poincare

While there are many books on options, few of the authors advocate selling naked options. Most authors are quick to point out that selling naked options involves "unlimited risk". Traders are urged to consider combining short and long option positions ("spreads") to take advantage of the trader's market outlook, while at the same time limiting risk. Other authors stress the risk-reward advantages of selling calls on long stock positions (covered calls). Many of the same authors who warn against selling naked options correctly point out that covered call writing is a more conservative strategy than owning stock outright. What you are seldom told is that a covered call position is the equivalent of a naked put (assuming adequate capitalization in your brokerage account). How then could a covered call be a conservative investment strategy when its equivalent position, a short put, is risky? The authors usually don't explain. Each of the two strategies theoretically involves substantial risk. If the stock price goes to zero, a person would lose the amount paid to purchase the stock less the call premium collected. The holder of a short-put position would incur the exact same loss. While it is true that a covered call and its synthetic equivalent, a naked put, can result in a substantial loss if the stock rapidly declines in value, either strategy is less risky than simply owning the stock outright due to the premium collected.

If covered call writing is a conservative strategy and naked put writing is an equivalent strategy, why should we be encouraged to do the former and discouraged from the latter? Well we are told that the reason lies in leverage. In other words, you can generally sell more naked puts than purchase covered calls due to the different margin requirements imposed by your brokerage firm. While that may be true, having the ability to leverage more investment with your dollars is a good thing not a bad one at least so long as you do not overextend. It can also be less costly since you are paying only one commission when selling a put versus two separate commissions when establishing a covered call position. In addition, you are typically paid interest on the cash proceeds realized from the sale of the puts. Once you realize the illogic of the paradoxical claims that covered call writing is conservative whereas naked put writing is risky, you can begin to open your mind to the exciting new possibilities of the POWER strategy, a strategy that features selling equal numbers of puts and calls. If selling a naked put is the equivalent of a covered call position, is it possible that selling the same number of short calls and short puts with the same strike (a straddle) or with different strikes (a strangle) can not only be made less risky but potentially more profitable at the same time? You bet! Utilizing these strategies has enabled me to earn consistently high rates of returns over many years and achieve an alpha, which would be the envy of most money managers (more on alpha later).

One of my favorite subjects in college was a course in logic which has guided me throughout my career both as a lawyer, judge and financial advisor. Aristotle is credited with developing the concept of the syllogism from the Greek word syllogismos meaning "conclusion" or "inference". Syllogistic reasoning applies logic to arrive at a conclusion based on two or more propositions that are asserted or assumed to be true. A categorical syllogism is an argument consisting of two premises and a conclusion, in which there appear a total of exactly three categorical terms, each of which is used exactly twice. The most common example involves the following argument:

"All men are mortal (major premise). Socrates is a man (minor premise). Socrates is mortal (conclusion)." Socrates further proved the validity of the syllogism by dying in Athens in 399 B. C. at the age of 71. Applying logic to the main thesis of this book, I would make the following argument: admonitions warning you against the practice. Furthermore, you will discover that when you simultaneously sell puts and calls with the same strikes (straddle) or different strikes (strangle) with the same expiration, you extend the range of profitable expiration outcomes.

When you sell options, you are selling time premium. The price of an option is made up of two components, the intrinsic value plus time premium (option price = intrinsic value + time premium). The intrinsic value for an in-the-money call option is the difference between the stock price and the strike price, where stock price > strike price. For out-of-the money call options (i.e. where strike price > stock price), the option has no intrinsic value. In such instances, the entire premium represents time premium. Conversely, a put option has no intrinsic value if the stock price exceeds the strike price (stock price > strike price). No rationale investor would exercise the right to put (sell) a stock for less than it is worth nor to call (buy) a stock for more than it is worth. The price of an out-of-the money option, whether a call or put, is entirely made up of the time premium.

Time premium is greatest for at-the-money options. Since we are sellers of options, it only makes sense to capture as much time premium as possible. As we shall see, we best accomplish our objective by selling at-the-money (or near-the-money) puts and calls.

It has been my observation that most advocates of option writing, suggest selling far out-of-the money options since those options have the best chance of expiring worthless. While that may be true, by selling far out-of-the money options, the seller is leaving a lot of time premium on the table. I prefer to put that time premium in my pocket. The POWER strategy allows me to do just that.

Do You Have An Edge?

"May the odds be ever in your favor."

The Hunger Games

Most investment books on options offer strategies for profiting if you know which way the market is headed. If you are bullish on the market or a stock, you are presented with various ways of placing winning trades with options (the simplest involving the purchase of call options). Conversely, if you are bearish, you can profit from a short position (the simplest involving the purchase of put options). More complex option strategies, such as calendar spreads, butterflies, and condors, are offered to further take advantage of the decay in time premium and to limit losses. That's all fine and well but unfortunately, for...