Good suggestions

Check these out. These points really do make a lot of sense. We are treading in a really uncertain territory here and although that happens to be a rich area for option traders, if not done properly, you can get burned easily.
By following a few simple rules, we can try our best to minimize damage.

Good rules to follow.

Excellent article about covered calls and alternatives

Jeff has written an excellent post on this. Thanks for sharing Jeff.

I sincerely urge all of you to go through it. He talks about alternatives to covered calls based investment strategy and analyzes each of those with some rigor.

A great read overall. Here is a link to the original post:

Stay with covered calls

Establishing a position -- How to?

I had promised that I will write a post about it. So here it goes.

My criteria for choosing a position is fairly straightforward. It consists of following:

1. There should be a good amount of buffer available to weather a potential downside.
2. There should be decent returns for the initial investment

In reality, these often contradict with each other and thus one needs to find the right balance.

Doing this requires some analysis and is quite painful if done manually. So, to do this efficiently, I have put together a system. My requirements were

1. The system should be completely automated (or automated at least for majority of the work)
2. The system should be very simple (and based on simple calculations)

In exchange, I am willing to monitor the positions fairly regularly (and act on them if deemed necessary).

So, here is my work-flow for choosing a position:

1. I have developed some scripts that fetch the data for both stock quotes as well as options quotes on a regular basis for a list of securities (Right now, my list is about 1000 tickers. I plan of expanding this soon.)
2. Once step #1 finishes, another set of scripts start looking at each stock (and corresponding options). Then for each stock/option combination (Note that there are multiple such combinations for a single stock), this step first computes max number of days a position may stay open for. After that, it computes two ratios: The break-even buffer percentage (expressed as current stock price) per day and max percentage gains this position may yield (if called of course) per day. A score (which is a monotonic and continuous function) is assigned based on these values for both ratios. Then a single score is assigned to each such position using a fairly simple formula, which combines these two scores into a single one based on relative importance with respect to each other. There is no exact science behind doing so. I have expressed these formulas using my beliefs/knowledge and I constantly tune them based on observed data points. So at the end of this, a score is assigned to all positions. Note that the score is normalized at this point (i.e. it is between 0 to 1) so that any two positions can be meaningfully compared. For me, higher scores indicate better positions.
3. Next, based on certain pre-determined thresholds, these scripts generate a list of about 10-20 positions on a daily basis that are deemed "best" according to their scores.
4. At this point, the process becomes manual. I personally look at each such position and decided whether to accept/reject it. I mostly look at very simple stuff like fundamentals of the company, market cap, cash position, eps etc. etc.

About 90% of this work is automated. These are really simple scripts that I coded up over an evening.

So that is it. If you are interested in any of the specifics, email me. We can start a conversation.

Hope all of this makes sense.

Some more resources

You may find these both valuable and interesting. Enjoy..

• http://www.cboe.com/strategies/DefaultEquity.aspx
• http://www.optionseducation.org/strategy/default.jsp
• http://www.options-calculator.com/
• For the mathematically inclined folks, http://en.wikipedia.org/wiki/Valuation_of_options
• http://corporate.morningstar.com/ib/documents/MethodologyDocuments/IBBAssociates/CBOE_SPBuyWrite.pdf

Let me know if you know of any more resources that you would like to share.

How are options priced and where do gains come from for these trades?

I am no real expert on this. I can talk about my own understandings, but then I could be grossly wrong :)

As far as I know, the following 5 factors affect the price of an option.

1. Price of underlying stock also referred to as security or asset
2. Option strike price
   
3. Volatility of underlying stock.
• This is amount of uncertainty associated with the stock's expected returns. Higher the volatility, more expensive the option will be.
4. Time to expiration
• The price of an option decreases as it approaches the expiration date. This ties in with the volatility. Closer the option is to the expiration date, less volatile it becomes.
  
5. Risk free rate
• I will not get into this. Usually, this is the amount of interest earned by U.S. treasury bills.

The option prices are determined by using a fairly involved formula proposed by Myron Scholes and Fischer Black in 1973.

So, assuming that the market does not move too much, there are a couple of things an investor can do to hunt for gains.

1. Look for volatile stocks. These are riskier kind, which means you could end up in big trouble by trading on these stocks. But if you can craft a careful strategy around these and if you are willing to watch the price movements very closely, the chances of a catastrophe can be reduced a bit.
   
2. Make time value of an option act in your favor. This can be done by being on the "selling side" of the options trade. The price of an option decays with time, thus acting in favor of the seller (which means if everything was to say the same, the seller can close the obligation by purchasing the sold option from the market and earning a profit by doing so)

The above 2 points form the basis of "stock picking" strategy for my portfolio. Are these risk-free in any way? Absolutely not. At the end of the day, I am trading risk for reward.
So, lets see how the portfolio does. I will keep you updated.

Structure of a closing trade

All of the open positions are of the form (Buy stocks for company XYZ, Sell an equivalent number of calls)

A position will be closed because of one of the following reasons.

1. Expiration in the money
• The sold call option gets exercised (or called). This can happen anytime up to the expiration date of the sold option. This will happen only if the market price of underlying stock (also known as security) happens to be above the strike price of the sold option (otherwise, the shares could just be bought off the market). When a call option gets exercised, the seller of the call (in this case us) are obligated to furnish shares of underlying stock to the buyer of the call (one who paid us the premium). In addition to the already paid premium, the buyer will also pay us an amount equal to strike price of the call option for this transaction. If the sold call option gets exercised, then the position will realize maximum profit (This number is posted on the blog when such a position is opened)
2. Expiration out of the money
• The sold option does not get exercised. This will happen if the market price of the underlying stock happens to be less than the strike price of the option. It does not make sense for the buyer to exercise this option because he/she can obtain shares from the market at a lower price if interested in doing so. In any case, the premium that was paid earlier is ours to keep. There are multiple actions a seller can take under these circumstances such as
1. Exit the position by selling the shares. Depending on the break-even point for this position (This number is posted on the blog when such a position is opened), this may or may not end up in profit.
2. The seller can also chose to sell future calls for these shares and receive premium for the same. This is equivalent to opening up a new position (where the initial price of establishing the position needs to be adjusted to account for gains/losses incurred by current position)
3. Safety Check

• I decide to close the position because it is not doing so well before the expiration date. I watch all of my open positions very closely and the moment a position starts hovering around its break-even point, I will close it. It can be done by selling the shares and buying the call options back from the market to close out any obligation.

I intend to publish the following information about each closing trade.

Type of closing trade (whether it was due to reasons 1, 2 or 3. See above). For reason 1 and 2, there is no need to buy any options to offset any obligations and thus all values will be 0 for that leg. Right now, I do not intend to resell call options (see second bullet point under reason 2) on any shares. This is mostly to keep things simple. If I start doing that in the future, I will write an updated post about it.

Stock Leg (Sell)

• Stock ticker
• Company name
• Number of shares sold
  
• Price per share
• Total money received

Option Leg (Buy)

• Call Symbol
• Strike date
• Strike price
• Number of calls bough
  
• Total money spent

Transaction

• Total money in
  
• Initial Investment
• Net returns
  
• Percentage returns
• Annual percentage returns (Normalized returns over 365 days)

All of the prices will adhere to conservative view in terms of bid-ask spread. This means that a "buy" transaction will be recorded at "ask price" and a "sell" transaction will always be recorded at "bid price". In reality, an investor can do better than this by appropriately placing limit orders.

Al always, if you like any other fields to be added to this, please leave a comment or send an email.

A few good reads for understanding covered calls better

These folks do much better justice to explaining the topic than I :)

Readers may find these links interesting and useful.

General information:
http://www.numa.com/derivs/ref/os-guide/os-035.htm
http://www.smartprofitsreport.com/archives/2008/covered-call-investing.html
http://www.optionseducation.org/strategy/covered_call.jsp

Deep in the money covered calls:
http://www.smartprofitsreport.com/Archives/2005/deep-in-the-money-covered-calls180.html

LEAPS & covered calls:
http://www.investopedia.com/articles/optioninvestor/04/021104.asp
http://thefinancialwhiz.com/2007/02/04/selling-covered-calls-against-leaps-positions/

Let me know if you know of any other links and I will update the post.

How to compute current value of the portfolio?

A lot of you have asked about how I intend to compute value of the portfolio at any given time. I will use a very simple method to determine that.

Let me explain:

At any point of time, the portfolio has some free cash and a list of currently open trades. The value of the free cash stays the same for determination :). Now, each trade is of the following nature:

1. Buy XYZ stock
2. Sell equivalent number of calls on XYZ stock.

The value of this trade would be the cost incurred to close it (at the current time) Closing this trade would mean:

1. Selling XYZ stock
2. Buying an equivalent number of calls for XYZ stock
   

As usual, I will consider conservative points of the bid-ask spreads for both of these legs. In reality, a better price point may be reached by appropriately placing limits on the orders.

Does this sound good? Do you have any better ideas to measure the value? I would love to hear from you. Please either leave a comment or send me an email in case you have any further suggestions.

Structure of an opening trade

For all opening trades i.e. (buy stocks and write calls), the following information will be posted.

Quick Summary view

Stock Leg (Buy)

• Stock ticker
• Company name
• Number of shares bought
• Price per share
• Total money spent

Option Leg (Sell)

• Call Symbol
• Strike date
• Strike price
• Number of calls sold
  
• Total call premium received

Transaction

• Total money out
• Initial Investment
  

Returns if call gets exercised

• Absolute returns
• Percentage returns
• Annual percentage returns (Normalized returns over 365 days)

Break Even Information

• Break-even point (Below which the position loses money)
• Break-even buffer (in terms of percentage of current stock price)
  

All of the prices will adhere to conservative view in terms of bid-ask spread. This means that a "buy" transaction will be recorded at "ask price" and a "sell" transaction will always be recorded at "bid price". In reality, an investor can do better than this by appropriately placing limit orders.

If you like any other fields to be added to this, please leave a comment.

What do you mean by selling covered calls anyway?

As quoted by the relevant wikipedia entry, selling covered calls is a process in which one owns shares of a stock or other securities, and then sells (or “writes”) a corresponding amount of call options. By selling a call, an investor is selling a right to the “buyer” for being able to purchase the underlying stock till a future date (strike date) at a pre-determined price (strike price). For this, the buyer pays a premium to the seller.

The return curve looks like (image from http://www.optionseducation.org/strategy/covered_call.jsp)

As indicated by the above graph, selling a covered call lowers the break even point a bit by letting go of possibility of infinite gains in the upward direction.

Advantages:

1. Lowered break even point. In case of stock price movement in the southern direction, the investor is better protected compared to just holding the stock. The premium received from selling the call serves as an additional buffer.
2. Lowered initial investment. Again, the premium received from selling the call lowers the initial investment compared to that required for just buying and holding the stock.

Disadvantages:

1. Cap on maximum gains. If the underlying stock happens to surge beyond the strike price of the call option, then the investor will not realize any profit beyond the strike price (which he/she would have realized in case of just buying and holding the stock)
2. Higher commissions. More individual legs to the overall transaction means higher commissions. These eat into the profits.
3. More complex taxation rules. The rules are definitely more complex compared to those for simple stock based transaction. Search for these on the Internet if you are interested.

Fair amount of material is available on the Internet for those who wish to learn about these further.