Now that my entire portfolio is underwater, I am resigned to holding most or all of my positions for the next 1-2 years. However, due to the dramatic upswing in volatility recently, many options are now priced at incredibly expensive levels, especially the puts. While I wait for the market to recover, I have decided to take a leaf from Buffett’s playbook and sell some options to get paid while I wait.
I have just sold some $12.00 Jan 17 puts on DELL at $1.09, and have a GTC order to sell $37.50 YUM Jan 17 covered calls for $1.00. I have set aside sufficient money to actually purchase DELL at $12 is the puts are exercised, and I would have bought DELL at that level anyway. Being paid $109 to lock up $1200 for about 3 months translates to an IRR of around 36%, certainly better than buying a CD or Treasury.
The worst-case scenario in writing puts is that the underlying stock will plummet catastrophically, therefore this strategy is best used with stocks that you know well and have great confidence in, and the strike price should preferably be at levels where you would have purchased the stock anyway. I also strongly advocate setting aside sufficient cash to purchase the stock in question if the put is exercised. The worst-case scenario when writing covered calls is a meteoric rise in the underlying stock, which will cause you to miss out on most of the gain because your stock gets called at the strike price. Therefore, the strike price should ideally be at a level where you would have sold the stock anyway. Somewhat non-intuitively, you should also have great confidence in a stock and intend to hold it for the long-term before you write covered calls on it. If the stock in question should take a sudden dive, you will be prevented from selling it before you cover the call you sold. Although the calls would have declined in price if the underlying stock sinks, typically the loss on your stock will far outweigh the small gain on the calls. Selling covered calls and “covered” puts are generally low-risk ways to play the options market, and option writers have time working for them, since the vast majority of options expire worthless. Nonetheless, it is only prudent to ask for a large IRR before you take on the risk of dramatic moves in the underlying stock.