Many traders assume that options are a way to enhance returns via risky leverage. This is true when you are the buyer of an option. The opposite is true when you sell options. The seller earns income while reducing risk. The Lizard King is going to show you how.
Raptors like sure things. So we are going to go with a big slow moving blue-chip widely regarded as a safe long term play – McDonald’s Corp. (MCD). You could have bought MCD on Friday at the market price of 92.44. This puts 100% of 92.44 at risk per share. A raptor might try to get into MCD for only 92.00 a share by writing a put. For example, MCD150220P00092000 last traded at 1.28. So a raptor that wrote the 92 20FEB2015 put would have received 1.28 times 100 shares or a hundred twenty eight dollars in instant income. The shares would not be assigned unless MCD traded below 92 on expiry. So your breakeven is actually 92-1.28=90.72. That gives you 1.86% downside protection in the trade. And you got paid 1.39% for capital at risk over three weeks or 24.12% annualized return. A raptor can grow mighty fat on 24+% annual returns and it comes with reduced risk!
More or less the same applies to writing a call on the buy-write strategy. A raptor could have bought a 100 shares on Friday for 9,244 and written MCD150220C00092500 for 1.52 per share. That is a hundred and fifty two dollars worth of downside protection. (If shares decline you keep the 1.52 to offset your capital losses.) So your breakeven price is 90.92 or 1.64% downside protection. At the same time, your earnings on capital at risk annualize to 28.50% if shares are called away at expiry.
A quick word about chasing yield. Don’t do it raptors! It is tempting to write options on whatever is paying the most income. Sometimes you can get over 80% annualized returns. But you have to understand that the options market is basically a big insurance market and as the option writer, you are the underwriter. Those fat premiums are to compensate you for taking on big risks on high flying names. Stick with blue chips and never write options on anything you aren’t comfortable with owning for the long term if the trade moves against you. That way, you hold something you want anyway, but you got a little extra bonus payment from the insurance market that the traditional buy and hold crowd is missing out on.
Devour your prey, raptors!