• In almost any market it makes sense to utilize puts and calls in your portfolio. My primary objective with respect to options is to sell them to increase my annual yield so this blog will look only at that strategy.

    Simple rules for selling (writing) Cash-Covered Puts

    1. Selling a put means you are selling someone the right (but not requirement) to sell you their stock at the strike price of the contract anytime until the expiration date.
    2. Write puts only on stocks you want to buy, at prices at or below your target prices.
    3. Maintain adequate cash balances to pay for any puts assigned. This is a conservative strategy and inconsistent with using margin leverage.
    4. Write short-dated put contracts. Option premiums are driven by duration and volatility. I prefer to write put contracts for 30-60 days but have gone out as much as 90 days.
    5. Make sure you consider the dual benefit for writing puts. The first objective is to get a minimum of 1% yield per month on the cash balance you are holding for puts written. The fall back outcome is you get to buy a stock you want below your target price by the amount of the premium collected.
    6. Summary: Write puts at prices close to your target price with a duration of < 90 days. Avoid writing premiums if the yield is less than 1% per month for the cash you have reserved against it.

    Simple rules for selling (writing) covered calls

    1. Selling a call means you are selling someone the right (but not requirement) to buy the stock from you at the strike price of the contract until the expiration date.
    2. Sell covered calls only on stocks you own, at prices at or above your target sales price.
    3. The primary benefit is to generate income on stocks you are holding.
    4. The secondary benefit is to help sell stocks that have become over-valued. This is typically the hardest part of retail investing where rarely is the golden rule (buy-low sell-high) of investing consistently observed.
    5. Premiums are based upon volatility and duration. Longer dated calls are attractive for investors that have limited time to manage their money. If you have more time, consider writing short dated call contracts instead. Writing 5-6 call contracts for 2 months will generate more income than say a one year contract but it takes more effort.
    6. Be selective. There are many times during the year where low volatility leads to unsatisfactory premiums.

    The above strategy is a conservative approach, but nothing is without risk. Markets correct and prices can move much higher or lower than your target prices. Consider volatility drivers when selecting expiration dates.

    1. Earnings release dates.
    2. Dividend declaration dates.
    3. Clinical trial data release dates.
    4. New product introduction.

    Measure performance

    Like anything else you need to measure your performance to improve it. Some dividend investors have a goal of doubling their portfolio yield using calls. If a given portfolio yields 3.5% they would expect to generate another 3.5% in premiums over the year. That approach usually trends toward higher strike prices and longer durations with less of an objective of exiting over priced stocks. My goal is similar though I write on a low percentage of my portfolio and believe getting assigned helps me buy lower and sell higher than otherwise would be achieved. My goals:

    • Increase portfolio performance by over 3% annually for option premiums that expire worthless. Considering that over 75% of option contracts expire worthless, this should represent the majority of my activity. Using a normalized 10% cash balance, that would provide a 30% return on cash.
    • Contracts that are assigned are written to enter or exit stocks at predetermined valuations. The premiums for those stocks either add to the capital gain or net to a lower basis in a new position.
    • I’m more active selling puts during/after market selloffs. These are emotionally harder because prices are dropping (to my targets) and the gurus (talking heads) are almost always predicting a market collapse. The best and hardest time to sell puts.
    • I’m more active selling calls that span earnings and ex-dividend dates. Rule of thumb: Always make sure the premium is greater than the dividend. My personal experience, especially with higher yielding stocks, is that stocks will run up into the ex-date. They will frequently sell off more than the amount of the dividend. In the few situations where a dividend stock gets called away, more often than not I can buy it back lower with an option premium higher than the dividend I forfeited.
    • As I stated above, I typically write calls on a low percentage of my portfolio (10-15%). That feels about right as it’s rare that any portfolio would much more closing in on target sell prices. Biotech stocks have the highest premiums and the hardest price targets to establish. They also will tend to get called away more frequently than about any other sector which works for my style.