Two Advanced Covered Option Strategies
We use a protective option to protect the cash, futures, or stock position. The protective option is put in place to protect against any sudden drops or jumps, but with a little more imagination an option can be sold on either type of position to generate income to add to the overall profit of the position.
Selling an Option against a Synthetic Option
This strategy is slightly advanced because there are three moving parts, but it is another way to initiate a covered option position, and thus it’s important to expose you to the idea. As we know, a synthetic option is the combination of an “at-the-money” option and a futures, spot, or cash market. Whether you go long or short, the protective option is purchased to protect against any risk of loss.
There is no set rule that the position the option is covering has to solely be the futures, spot, or cash position. In fact another option can be added to the mix. An option can be sold “out-of-the-money,” a few points away from the synthetic’s protective option. If the position is working in favor of the underlying asset, then the extra premium is added to your overall profits. If the position fails, the protective option covers any price move that may occur in the sold option. You give up the profits from any market move against your position, but at the same time you have a way to capitalize on your protective option or at the very least have a way to pay for part or all of it.
Selling an Option against a Collar
The very nature of a collar is based on the “covered option” concept and the synthetic option combined. Even though the sold option is a far “out-of-the-money” option, once the underlying asset breaks through the strike price it immediately turns into a covered position.
But the fact that a synthetic option is the core component of a collar means that an option can be sold out of the money against the purchased option to produce a little extra income as well.
Conclusion
Selling options can be a complex proposition. Myths, like the belief that 80percent to 90 percent of options expire worthless, do more harm than good when making an informed decision to sell options. Add to that the impact that margin rules have on the ability to sell options, plus the effects that volatility has on choosing the right option to sell, and it's easy to see that in the wrong hands option selling can be disastrous.
Selling options requires a healthy dose of respect and discipline. Once it is accepted that the option has the potential for unlimited losses, the proper measures can be taken to minimize or eliminate that loss. Proper measures can mean selling an option against a futures or spot position, tying a sold option to the tail of a synthetic option, or being aggressive with a straddle or strangle position. As long as a trader is willing to step out of the box when it comes to selling options, its liabilities can become assets over time.
As with all of the strategies present, the goal is to put you in control of how you interact with the market. Whether that means combining various tools so the odds are in your favor or avoiding this strategy altogether, then so be it. Whatever will make you ultimately feel comfortable with selling options is exactly how you should employ them in your trading. This strategy is solely a means to an end— increased profits coupled with diminished risk. If you fail to see an opportunity, don't force it. Just let it flow.
