‘Covered option writing’ - An effective but often misunderstood longer-term Trading Strategy.

Strategy definition; ‘long term action plan to achieve a goal’

We all know that to achieve most things in life, we need a plan. And trading is no exception. In our world, our goal is to make money and our action plan needs to be clearly defined in order to achieve that ultimate objective.

Gone are the days when trading profits would fall into your lap; not that it always happened to me, but the markets are so much more competitive than when I started my trading career…the date of which will remain anonymous…but it was before the ‘Big Bang’, the one in the 1980’s that is! Even then, strategy was important but more opportunities and greater profit margins meant there was room for error more often, whether that be from an inappropriate strategy or insufficient discipline. Today those profits margins are smaller and opportunities fewer, so a robust strategy and regimental discipline is essential if we are to have long term success in trading today’s financial markets.

Choosing a strategy

We know that defining, creating and testing a trading strategy has never been easier, as technology is readily available to do all the number crunching for us, and when defining our strategy, we have to take into account our individual lifestyles. To try and copy someone else’s strategy, will by no means guarantee similar profitability, as the ‘style’ of trading has to suit the lifestyle of the individual executing it.

For example there is no point following a day-trading strategy that potentially generates 10 trading signals a day, when you have a full time job, with only lunchtimes or after work to check the markets. This is obvious I know, however it is amazing how some system followers close a system which shows great profitability, but they are not available to actually execute the signals when they are generated!

In broad terms, strategies come within 3 main shapes & sizes; long-term, swing and day-trading.

Long-Term Trading

In professional terms this is normally associated with speculation over a period of weeks or sometimes months. The analysis for such a time period is often both fundamental and technical, being appropriate for those speculators who are not full time traders and therefore not able to analyse their exposure on an intra day basis.

One way to increase the profitability of long-term trading is to write options against the direction of the position. I am sure you are all familiar with ‘Covered call writing’ however this concept of option trading has greater versatility than just shorting call options against a long stock position.

For example we may be bullish of the FTSE 100 Index as a whole, as opposed to just a single equity. Say our expectations for the rest of 2010 are of a rally from current levels at 5200 to levels close to 5600. So what we can do is BUY 10 FTSE 100 futures at 5200 and sell (short) 10 FTSE 100 December 5600 calls at 80. This means that if the index gets up above 5600, we have sold the right to someone else to buy the FTSE 100 at 5600, for a price of 80 points. If the market fails to rise above 5600 by the middle of December (option expiry date) then the calls will be worthless and we will receive 80 points credit.

If the FTSE is above 5600 at expiry then the calls we have sold will be exercised against us and as a result we will be selling our long futures position at an equivalent price of 5680 (5600+80), which we would be happy doing anyway, given that this was are target price when we put the trade on.  If the market fails to rally and is the same price (5200) in December, then we will receive the option premium we shorted (80). The chart shows the P&L profile for this trade.

The key advantage of selling call options against a long futures positions is that we make an extra 80 points in this case, for essentially doing nothing (as long as we are happy exiting our long position at the option level of 5600)

Conversely, if we were bearish we may sell 10 of the FTSE 100 futures and additionally sell 10 of the December 4800 puts for 150 for the same effect, but on the downside. So by selling the 4800 puts we have given someone else the right to sell the FTSE 100 at 4800 (therefore we will be buying at this level). Here is a chart showing the P & L for this bearish trade.

The simple logic behind selling calls against a long position or puts against a short position is that you would be happy closing out your position if it gets to a certain level (target level); however if it does not make your target price (option strike price), then you receive the option premium, in addition to any gain/loss achieved by the underlying position, when the option expires.

When executing a covered call write in single stocks you are essentially increasing your yield, which is surely attractive for any long term stock holder; especially when many dividends are being cut with uncertain economic times ahead. But option writing is not just limited to equity or index products but often used in commodity and FX markets too.

N.B.  Even with covered option writing, it is important to remember that your loss is unlimited, as it would be if you had just bought or sold the futures or equities on their own, but using options in this way equates to a partial hedge in that you take receipt of the option premium should the market not breach the option strike price. It is also unadvisable to sell more options than your long/short futures position, as this would further increase your exposure if the underlying price was to move beyond the strike price.