IN APRIL of 1999, The Matrix was in theaters, Columbine was in the headlines and the Dow Jones Industrial Average traded near 10500. Now fast forward to present day, where the movies and news have all changed, but the Dow is still hovering near 10500. Of course, there’s been plenty of movement this way and that in the meantime, but if you’ve been a long-term investor in the Dow stocks, your money has been dead for over three years. Sometimes stocks go up, sometimes they go down. But often they go nowhere at all.
A technique called “systematic writing” is one way to make money in trendless times. It’s a neutral to bullish strategy that requires no upfront investment, has limited downside and can be highly profitable in times when there’s no clear direction to the market. It’s also a great way to dip your toe into options trading and begin integrating income-oriented strategies into your tool kit of technique.
First, a quick review of some basic options terminology: A stock option is the right to either buy or sell 100 shares of a stock at a predetermined price (the “strike price”) within a specific period of time in the future, any time before what’s known as the “expiration date.” A “call” option represents the right to buy, while a “put” represents the right to sell. Buying an “XYZ Sept. 50 call” gives you the right to buy 100 shares of XYZ at a price of $50 a share anytime before the end of the third Friday in September. Buying the put would allow you to sell 100 shares of XYZ at $50 a share anytime before that date.
Many sophisticated stock jocks are familiar with buying both puts and calls. Systematic writing, however, doesn’t involve buying options, but selling them. In the options world, “writing” means “selling” — and it all starts with a put.
A put, you’ll remember, represents the right to sell. It’s a form of insurance policy: Traders buy puts when they think the market is going to drop. Systematic options writing starts with the sale of a put. Instead of buying insurance — you are selling it. And as Warren Buffett explained in his 1997 shareholder letter, the insurance industry has a pretty nifty business model.
When you sell short a put (sell a put you don’t own), you are obligating yourself to buy 100 shares of XYZ stock at the strike price, any time before the expiration date. In exchange for making that promise, you receive the option’s premium, or the price at which it’s currently being traded.
For example, let’s say that with XYZ at $50, the January 2002 XZY 45 put is trading at $2, or $200 per 100 shares of stock. Sell short the put, and you will receive the $200 upfront. The only catch is that you’ve obligated yourself to buy 100 shares of XYZ at $45 (the strike price) anytime before trading ends on the third Friday in January. Depending on your broker, you have to have anywhere between 20% and 100% of the equity needed to actually buy the stock sitting in your account — in this case, $4,500. Because the cash is simply collateral and not actually invested, you’ll continue to earn interest, making this strategy another great way to give your cash some flash.
After you sell the put, one of three possible scenarios will occur. The stock will move higher, lower or, like the Dow over the past three years, remain basically unchanged. Systematic writing gets its name because there’s a specific, almost automated follow-up trading maneuver, no matter which possibility unfolds.
Let’s say that when expiration day rolls around, XYZ has moved higher or at least stayed above $45 a share. The put option you sold for $2 ($200) will be worthless — after all, why would someone want to exercise the right to sell you XYZ at $45 when it’s trading for more on the open market? As long as XYZ is above the strike price at expiration, you’ll pocket the entire premium. This is the preferred scenario. At that point, you start the process over again and write another put.
On the other hand, let’s assume that XYZ drops from $50 to $43 by expiration. The bad news is that you’ll be “put” the stock — forced to buy XYZ at $45 a share — even though it’s trading on the open market for only $43. The good news is that again, you’ll keep the $2-a-share premium you initially received for selling the option. So although you’ll be assigned 100 XYZ at $45, you’re essentially buying the stock for $43. ($45 – $2).
Now you own 100 shares of XYZ at $43. Your maximum risk is $4,300, because the lowest the stock can go is to zero. But it’s not the goal of the systematic writer to bet on the market’s direction, but to profit regardless of its direction. It’s a way to get paid without having to be terribly opinioned on the market’s next move.
So as a follow-up to being put the stock, the systematic writer will then sell a straddle, or both a call and a put. Let’s see how that will affect the position’s risk-reward profile moving forward.
We last discussed selling covered calls within the context of hedging. A call, as you remember, is the right to buy. Selling short a call, therefore, is an obligation to sell. So the systematic writer, now long 100 shares of XYZ at $43, would sell a $43 call, obligating himself to sell 100 shares of XYZ at $43 anytime before the expiration date. He would also sell another put option, with a $43 strike price, obligating himself to purchase yet another 100 shares of XYZ at $43.
Let’s get specific. With XYZ at $43, the June 43 call might have a premium of $3 ($300). The XYZ June 43 put, which obligates you to buy another 100 shares of XYZ at 43 anytime before trading stops on the third Friday in June, might have a premium of $2. So in exchange for selling both options, the systematic writer would receive a total of $5 ($500) in option premiums. Once again, only three possible scenarios can unfold. XYZ can rise, fall or stay exactly the same.
Now expiration rolls around once again. On the off chance that XYZ ends up at exactly $43 a share, both the put and call options you wrote will expire worthless and you’ll keep the $500 in premium. You are still long 100 shares of XYZ at $43, but because of the premium received, you’ve lowered your cost basis to $38 a share. The stock hasn’t moved, but you’ve still made money. At this point, you could sell the stock, or even better, write another straddle and collect another round of premium.
Let’s assume that, at expiration, XYZ has rebounded back to $45 a share. The put option will expire worthless, as XYZ is trading above the $43 strike price. You’ll keep the entire $2 premium. The call option, however, will be assigned, because the stock is trading above the call’s strike price. You’ll be forced to sell your XYZ at $43. Again, you’ll keep the $3 premium, netting you a total of $500 and leaving you “flat.” Now it’s back to the beginning — time to write a brand new put.
Worst-case scenario? Let’s say XYZ falls again, this time to $38. The call will expire worthless and the put will be assigned, forcing you to buy another 100 shares of XYZ, this time at $43. But because you’ve collected $500 in premium, you’ve again lowered your cost basis, this time down to $38 a share. You’ve been put 100 XYZ at $45 and 100 more at $43, and with the stock now at $38, you’re down some money. After all, you’ve been wrong twice in a row and seen XYZ drop from $50 to $37, or almost 24%. But because of all the premium received, you’re down only $500 on the entire position. Now your maximum risk is limited to $7,600 (200 shares of XYZ at $38 a share).
Now you’re long 200 shares of XYZ with a cost basis of $40.50 With the stock at $38, the December $38 calls might be selling for $3 or $300. By selling two calls, you’re obligating yourself to sell all 200 shares of your XYZ at $38 a share, anytime before the expiration date. Once again, you’ll receive a premium in exchange for selling the calls — this time, $600 (two calls x $3 ($300)). This now lowers your cost basis to $34.50.
If the stock is above the strike price before expiration, your calls will be exercised and you’ll be forced to sell your XYZ at $38, leaving you a $100 profit on the entire trade. If the stock drops to $34, you’re down only $50 on the trade, even after having been wrong three times in a row. XYZ has dropped 28% since you first began writing puts, and you’re only fractionally in the red.
A major factor in determining your success with systematic writing is commissions. Unfortunately, the cost of trading options hasn’t yet dropped the way the cost of trading stocks has. Expect to pay at least $15 a trade, which makes it advantageous to deal in slightly larger lots positions if possible. If your account size allows it, try doubling up. Instead of selling one put off the bat, sell two. Choose a position size that’s appropriate for your account.
The standard disclaimers: Selling options, even when there’s limited risk as in systematic writing, is most appropriate for sophisticated investors or bored stock traders looking to up their game. And because this should be considered only an elementary introduction to such tactics, the first order you place shouldn’t be for a option, but for a book. One of my favorites is “Options: Essential Concepts and Trading Strategies,” published by the educational division of the Chicago Board Options Exchange. For the absolute beginner, “How I Trade Options” by John Najarian is an ideal introduction. More savvy stock pros will appreciate Larry McMillan’s beefy “Options as a Strategic Investment.” No matter what your level of expertise, reading the CBOE’s boilerplate risk disclosure document is a must.
It’s a tough world out there, and nobody knows the future. But when used appropriately as part of a diversified investment program, systematic writing is an efficient and low-risk way of getting the market to pay you not to have an opinion, rather than ponying up to the greedy SOB for the privilege of having ‘em in the first place.
– Originally on Jul 19, 2001 by Jonathan Hoenig
