Writing Covered Calls and Cash-Secured Puts

Risk Management

••• Example of a Trading Plan. Mark Wolfinger

Question from a reader

"I adopted a strategy for my trading (non-retirement) account that began with selling cash-secured puts. Then, If assigned an exercise notice on those puts, I wrote covered calls. I know that these strategies are risky, especially when there is a prolonged bear market. I am buoyed by the knowledge that this strategy involves less risk than simple stock ownership.

"My dilemma arises If I am assigned on a short put -- and the market continues to decline.

For example, if I were short an SPY 190 put, assigned an exercise notice, and the market tumbled to 140: which calls should I write? 

"My first thought was to stay the course of my original plan (write calls with a strike price near 190). That plan offers an opportunity to recover all losses, if and when the stock market moved higher and I was on those 190 calls. However, those 190 calls would not carry much premium when SPY is trading near 140. And even worse, if the stock market performed poorly for an extended period of time, I would not be collecting much premium during all those months (years).

"Not too long ago, I had the opportunity to look at an SPY chart from 1992 to 2014. I've seen this chart before, but this time, it really awakened me to the reality of relentless negative market movement. SPY moved up and down and up and down. It was at the 140/150 level in early to mid-2000, then plummeted to the 100s in late 2000 & 2001.

It continued into the 90s in 2002 and moved to the 80s in 2003. In 2008, the market crash was even worse. Yes, the market recovered and moved to record highs. But I realize that the recovery could have taken much longer.  

"I know this much: I am sure that this market volatility will occur again in the future.


"Today I am short SPY 202 calls. If SPY were to dive to 150 again, could I really stay the course and continue to write calls struck near 202? 

"History shows that markets do not always recover quickly. It took a long time for SPY to make new highs.  Do I have the patience to wait? And even if I do, is waiting the best strategy?

My comment:

Good questions. Patience is one strategy. It is the same method used by buy and hold investors. They buy stock and never sell their holdings at a loss. To me that is inefficient because an investor's portfolio should contain only stocks that he/she wants to own NOW.

As I say, it is one way to trade. My preference is to recognize that the market has declined and SPY is currently 150 (your scenario). The fact that I bought my SPY shares at 200 is no longer relevant to my current situation. I lost money and there is nothing I can do about that. My objective is to do the best I can right now, and in the future, with my holdings. If I do a good job, then the loss probably will eventually be reversed. But earning money is my goal. Breaking even is not on my mind.

One thing remains true: I chose writing covered calls as my strategy. Therefore I want to collect premium every month and must write calls after every expiration.Those could be at the money (strike 149-151), slightly in the money (strike ~146-8), or options that are not-very-far-out-of-the money (152-155).

We each have a method for selecting strike prices, but in the scenario you propose, I encourage you not to think in therms of very far OTM calls and to concentrate on options with a higher premium -- i.e., calls that afford some downside protection. In other words, do not sell calls for $0.25 when the underlying asset is $150 per share. 

I know that the market will rally at some point in the future and I will be sorry that I sold whichever specific call I sold. But, not being a skilled market prognosticator, I have no idea when that will happen. I know that if I write new calls around the current SPY price, I will collect a decent premium each and every month. Who knows how long it would take to recover my loss by waiting? I want to collect option premium for all the months in which the market does not rally.

If you agree with this philosophy and if you pull the trigger on the call sales -- knowing that the current loss will change from unrealized to realized (when you eventually sell your SPY shares via assignment) at some point, then your long-term results should be better. Obviously the results depend on just how long it takes for the market to recover this time.

Bottom line: We all hope to earn money and avoid losses. When the emphasis is on minimizing losses -- rather than recovering from them -- it is highly likely that your current investment/trading portfolio will be one that makes you comfortable to own. In other words, both risk and reward have been considered when deciding exactly which positions belong in that portfolio.