I'm on the road a lot presenting at various educational seminars, as many of you know. I presented the following trading idea at a CBOE-TradeKing event and thought it might make for good blogging, too. Maybe you've read my previous posts about cash-secured put selling and my more recent series on how to sell, or "write" covered calls successfully. (That one starts here.) You can actually combine these two in a step-by-step strategy that can generate some nice income while incurring relatively contained risk.
Here's how it works -- you can follow along in the diagram below.
1. Sell a put. You should do so on a stock you wouldn't mind owning in the long-term, but that you don't feel a pressing need to acquire immediately.IMPORTANT: Don't forget to set aside enough cash required to buy the stock! In other words, if you sell 1 put at strike price of 50, you should have $5000 on hand to buy the stock in the event that you're assigned. Naked put selling is extremely risky, so don't skip this part.
2. If the put expires worthless: you get to keep the premium you earned. If you're still interested in owning the stock, you can either buy it outright or repeat this maneuver from step 1, hoping you get assigned this time.
If you're assigned instead: you buy the stock with the cash you've set aside, as you'd hoped to do. Plus you get to keep the premium, lowering your net cost basis for the position. If that happens, you can consider moving on to step 3...
3. Write a covered call on the stock you just bought. You'll earn premium again for this move. At that point one of two things can happen:
If the call expires worthless: you get to keep the premium you earned, plus you keep your stock position. If you like, you can sell another covered call and earn more premium, as described above.
If you're assigned instead: you sell the stock, keeping the premium earned and closing out your stock position. At this point, you've earned two premiums, plus or minus the movement in the underlying long stock position.
One last caveat: don't just follow the steps blindly. Make sure you evaluate the stock at every step; if your opinion of the stock has changed, you can always end the chain right there. For example: say you've sold the cash-secured put with the original intention to buy, earning the premium, but in the meantime your assessment of the stock turns negative. There's absolutely no reason then to follow through with the steps as if nothing's changed. In the worst-case scenario, you're assigned on the put and have to buy the stock you now don't want. You can always halt the steps there and sell the stock to close out your long position.
I'll try to keep a stream of ideas like these coming your way; let me know what you think. It's one thing to learn strategies in isolation, but it can be very useful to see examples of how they can be put to action in combination, too.
Regards,
Brian (OG)
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options.
