W/O question

I,m hoping to start doing some W/O trades so I've been reviewing all my WSB materials on the subject. In the manual, Gary recommends selling OTM calls; however,on the CD's(Denny's session dealing with W/O)), he gives an example where he sells ITM calls($30 stock,$20 call). Can anyone tell me which is the preferred method?

What helped me was doing the math on a few examples and then deciding what would be best given various possible outcomes.



Edited 1 time(s). Last edit at 12/08/2014 10:33AM by NCTrader.

I hate being vague but I am also very hesitant on answering as I do not want to imply what is the best course of action to take. I had to make mistakes along the way before I figured out what was best for me regardless of what may or may not have been provided in the discussions. I originally posted two examples and took them down. I will put them back up but please understand this is for example purposes only and I am only touching on few possible outcomes. I am not implying what you should do. My intent is to get the creative juices flowing. My suggestion would be to go find several examples where you would have bought the stock possibly around mid-October that are at a point where you would sell about now. This only works if you have real examples that are at a point of selling now. Pull up the option chains and do the math as below thinking about all possible outcomes. Finally ask yourself what actions would help you sleep better at night. The appropriate course of action does not always make you the most money. It should be a healthy balance of maximum profit and appropriate risk management IMHO. There is so much more to it than what I am providing. Once again, I am not implying what you should do or suggestion appropriate strike/month selection but thought this might help get you thinking so that you can do your own research and form your own opinion.

***** EDITED BY NCT12/9. Removed table due to calculation error. See below for update. *****



Edited 1 time(s). Last edit at 12/09/2014 10:03PM by NCTrader.

NC Trader - thanks for the examples. In your ITM example, I think the "Remains Flat" and "Drops $5" numbers are double counting. I think the total gain for both is $10, the premium you receive for selling the calls. You wouldn't make $7 or $2 for the stock in those sceanrios, because you would be called out of the stock for $30, correct?

Yes, my numbers are off and double counting but I have not had a chance to go back and update. I knew someone would call me out. That's what I get for cutting back on caffeine and trying to post while doing other things. My apologies to the forum. Next time I will leave out the visual and get straight to the point :-) If you sell OTM and the stock drops back to your entry then you still have the premium received. Your breakeven is the entry - premium received. In the example above the breakeven on OTM would be $27. If you sell the deep ITM around your entry then you are locking in your profits. Breakeven is still original entry minus premium received but this time you were paid $10. You now have a larger cushion if it falls hard against you.

A more realistic example would be the same assumptions above except that you get paid $3 for the $40 OTM and only $8.00 for the deep ITM ($7 + $1 in time premium). The question is whether or not you want to lock in $8.00 today with protection down to $22.00 (breakeven) and expect to be called at so that you can move on to something else or lock in $3 today for the $40 OTM with total downside protection to $27.

No worries

I totally agree with your last post. The other possiblity is just selling the stock when it's time to sell (charts turning over), instead of selling options. I've started doing that sometimes. Obviously, you don't get any extra premium from selling calls, but there is also no risk. And I can move on to the next trade immediately.

Agreed. At one point I strictly sold the stock and moved on but have been trying to sell the calls and get comfortable with the process. An effort in teaching myself to be patient.

I hate leaving things undone. Next time I will stick to a verbal explanation. I appreciate the feedback trendtrader. Below is an update. This time I used a slightly more realistic example. Deep ITM calls will generally have less extrinsic value. I say generally because I am oversimplifying option models and not considering potential upcoming binary events. Again, I am not suggesting which way to go. OTM appears to provide better returns if stock rises after you sell but keep in mind there is no reason to sell if you think the stock will continue to rise. You sell because you think the rise is over and possibly time to fall. Deep ITM locks in profits, provides more downside protection / mitigates risk, and provides more flexibility. Here is something else I didn't address. What happens if you sell Deep ITM and the stock has a nice fall over the next 5 to 10 days, stays above your original entry, and then starts to rise? Something to think about that I did not address in the updated table below. I also didn't address the simplicity of simply selling the stock as trendtrader pointed out. Finally my example is not to suggest you should sell the closest strike to your original entry in the deep ITM example. I simply picked $30 for this example. Only providing for those that have never really pulled out pen and paper to do the math. Also wanted to correct in case I confused anyone previously.




I strongly encourage anyone that is researching W/O to do as I suggested before. Find a few stocks that have had good recent moves up, about ready to pull back, pull up option chain and practice selling. Write down the option prices for where you would sell OTM and ITM. Then track the results over the next few weeks. That is the only way I know to learn beyond actually doing.

Best of luck!

NCT



Edited 1 time(s). Last edit at 12/09/2014 10:39PM by NCTrader.

NCTrader, your insight is very much appreciated

Anytime It took me some time to figure out what is best for me. Last caveat is that I only provided one view from a pure numbers perspective. I did not touch on appropriate stock selection or your chart analysis. The chart should also be considered when determining strike selection. Finally, ask yourself if you want to put a significant amount of your capital into a very volatile pharmaceutical stock that is waiting for results of a drug trial, some type of upcoming FDA approval, etc. There is not a lot you can do if you buy at $30, rises to $37, sell the calls, and wake up one morning to find that the stock dropped to $20 overnight. One of the options mentioned above will help mitigate some of that risk. I am not necessarily suggesting that you totally exclude pharmaceutical for this type of trade but providing something else to consider. What if you buy at $30, rises to $33, still waiting to sell, and then wake up to find that FDA did not approve and stock is at $20. You now have a 33% loss in our retirement money.

NCT