Option Writing Strategies

As promised, I'm going to detail my experience with the first plain vanilla option strategy of my life: the short strangle. It could actually be a mix between a short strangle, short straddle and variable write strategy...because it's a hybrid creation by my father who has been using it for 30 years. I've bought and sold puts and calls before...but maybe 5 times in total. So what I'm going to do is explain the rationale behind what I'm doing, so you can give you own thoughts and/or your own spin on the same idea.

1. Option Writing Strategies

First we need to start with idea behind "selling" options on common stock or on indices. I shall try to keep things as basic as they can be, since I'm also no expert in the field yet. So basically, you sell options to:

a) collect premium (you get paid to sell things) hence generating current income; in options lingo, this is called "playing the theta decay".  Since options have time value (i.e. the closer to expiration you get, the les value there is in the option), if you sell a longer dated option and price goes nowhere, you collect time value each day tha passes. This is "theta decay".

b) deploy a neutral view on the underlying asset.  Many writing strategies are "neutral", in as you don't expect the underlying asset to move much by the expiry date. You might call it a "range bound strategy" to make things simple. 

c) reduce basis. This is applicable to naked writing strategies, on an underlying asset that you believe will rise in value. So you are not afraid to write naked options, hence being at risk of exercize. What does this mean?

- if you write a call, you SOLD someone the RIGHT to BUY the stock FROM YOU at the strike price. So

- if you write a put, you SOLD someone the RIGHT to SELL the stock TO YOU at the strike price.

So for example, if you wanted to generate some income, you could sell naked puts on the stock and simply continue to roll the strategy until you get "put" the stock. So you've generated premium over time, before you got handed the stock, that now has effectively lowered your price of the stock itself. And this has proven to be a good strategy, over time. 

2. Buying Stock & Selling Options

So what have I been suggested to do?  Pick up a good stock, and use options to generate some passive income from it. So far, how am I doing this?

a) which stocks? As I have written in the "equities" section of this blog, I use "value" stocks as a preferred scenario, but in case there aren't any "cheap" stocks out there at the time of necessity, I'll go for "quality" stocks that have better long term fundamentals than their peers.

So cheap - relatively high quality stocks.

b) stocks rise on average over time. So it's tricky to short single stocks, even if there's some "technical reasoning" for it. I use an index overlay. For example, my first stock is Telecom Italia (Tlit.MI) so I use the FTSE-MIB as the index of reference. I only take longs if the index is trending up; I only consider shorts if the index is trending down.

c) the options overlay. So now I have a stock I "like" and I think will outperform over time. Can I not enhance the yield on it? Buy & Hold is a little passive and risky. Plus, being a coin flipper, I'd like to believe that years of directional play is useful somehow. So here's what I do.

- sell OTM puts so long as the market is in an uptrend.

- if/when put the stock, sell ITM calls and OTM puts, with more than 50 days of time value left.

- Protect the premium received via directional option buying.

The fact is that you never know what the market is going to do. So given that this is a "range trading" strategy, when the market tells me it's ready to rise or fall, I need to hedge the leg of the strategy that will lose money. So when the market drops, the sold puts are going to lose money, so I need to buy puts to hedge that risk.  When the market rises, it'll be the calls that lose money. Sure, I have the stock in hand, so the upside loss is covered...but IF I can predict directional moves, why not buy some calls as well and enhance the return?

3. My stock + short straddle since inception

I need to say...this was not the ideal scenario for starting the strategy. The stock at hand was NOT a value stock NOR a high quality stock. It is only a stock that will be around for some time. Telecom Italia is nowhere near a 5x or 3x EV/EBIT (which is where "value premium" lies):

Telecom vs. EV/EBIT

Source: Metastock Xenith/Reuters Eikon

So why is Telecom Italia rising, from a fundamental perspective? If you've read through my blog posts, you'll know the answer... it's making more money now than in the recent past.

Telecom vs. Net Income

Source: Metastock Xenith/Reuters Eikon

So this was a good "baptism of fire" for me, considering that the ideal situation would instead be:

a) having a stock I like, picking if up when it's cheap
b) writing options on it
c) defending the theta profits.

Here is how I played it:

On May 26th Long Telecom Italia 4000 shares at 1.1260
Short 1.10 Calls at 0,070 July
Short 1,10 Puts at 0,044 July

Real time source: Netdania.com

On June 11, long 2 1.10 calls July at 0,085 spot ref. 1,1460
On June 11, close 1 Call at spot ref. 1,1700 for 0,099

On June 12 close 1 Call at spot ref. 1,1500 for 0,082

On June 16, buy 2 puts spot ref. 1.1110 for 0,0705
On June 16 close 1 put spot ref 1,0880 and the other closed 1,1100

On June 18, buy 2 puts spot ref. 1,1120 for 0,0653
Close 1 at 1,0950 for 0,076
Close other scratching at 1.1100 for 0,065

On June 24, bought 2 puts at 1,1800 for 0,456
Closed both at 1,1680 for 0,0516

On July 7th bought 2 puts spot ref. 1.1100
Closed 1 at spot ref. 1.0950
Scratched the other at par.

Currently no hedge is on, strategy still active.

Hope this first introduction was enlightening!