# BONUS REPORT#5. The Sell-Write Strategy

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1 BONUS REPORT#5 The Sell-Write Strategy 1

5 THE CONSTRUCTION There are two components of the covered put strategy, the stock component and the option component. The stock component consists of a short stock position (you sold the stock short). The option component consists of selling one put per every one hundred shares of stock sold short. Remember, one option contract is worth one hundred shares of stock. For example, 1000 short shares of stock equals 10 put contracts or 200 short shares equals 2 put contracts. The chart below shows more examples of the proper construction of sellwrites. Please take special note that the ratio of short stock to short puts must be exactly one short put option contract per every 100 shares sold short. Number of Shares Sold Short Number of Put Contracts to Sell HOW IT WORKS The covered put strategy takes advantage of the fact that an option is a depreciating asset because its extrinsic value or time value goes to zero at expiration. The process by which an option s extrinsic value dissipates is called time decay. Time decay, also known as theta, is defined as the rate by which an option s value erodes over time into expiration. The value of the option over parity to the stock is called extrinsic value. Since an option is a depreciating asset, meaning it has a limited life, the extrinsic value in the option will wither away daily until expiration. This decay is not a linear function meaning it is not equally distributed among all of the days to expiration. 5

6 As the option gets closer to expiration, the daily rate of decay increases and continues to increase day after day until expiration of the option. At expiration, all options in the expiration month, both calls and puts, in-themoney, at-the-money, and out-of-the-money are completely devoid of extrinsic value as noted in the time value decay charts below. Observe that as more time goes by, the options extrinsic value decreases progressively. Again, it is important to note that the rate of this decrease is not linear, meaning not smooth and even throughout the life of the option contract. An option contract starts feeling the decay curve increasing when the option has about 45 days to expiration. It increases rapidly again at about 30 days out and really starts losing its value in the last two weeks before expiration. 6

7 This is like a boulder rolling down a hill. The further it goes down the hill, the more steam it picks up until the hill ends. By selling the put option and shorting the stock, the covered put seller captures the extrinsic value in the option by holding the short put until expiration. Hopefully, the option expires worthless and you have the premium paid for its sale. As mentioned earlier, an option s loss of extrinsic value over its life is called time decay. In the covered put strategy, the option s time decay works to the seller s advantage in that the more that time goes by, the more the extrinsic value decreases. Key Points The covered put strategy provides the investor with another opportunity to gain income from a short stock position. The strategy not only produces gains when the stock trades down, but also provides above average gains in a stagnant period, while offsetting losses when the stock increases in price. Remember that one of the covered puts components is the short stock. Keep in mind that this position can be entered into in two ways. You can either sell puts against stock you are already short (Covered Put); or, you can short stock and sell puts against them at the same time (Sell-Write). Here is how the P&L chart of the Sell Write / Covered Put strategy looks: 7

8 PERFORMANCE IN DIFFERENT SCENARIOS Example 1- You sell short 1000 shares of IBM at \$ The stock has been running up aggressively and has finally settled down around this level for a little while and volume has declined steadily over the last several days. Now you feel that the stock has exhausted itself and is likely to stagnate here or even pull back a bit. Seeking to take advantage of this perceived opportunity, you sell the stock short and sell the front month (December for example) at-the-money puts. The at-themoney puts would have a strike price of \$100 if the stock was trading at \$ You sell the puts at a \$3.50 premium per contract that creates a \$ breakeven point. In a sell-write, the breakeven point is calculated by adding the stock sale price plus the option premium. Let s look at what our returns will be in each of the three scenarios. The down scenario In the down scenario, the maximum gain that can be realized is when the stock closes at \$ or lower at expiration. At \$100.00, you would profit from the full value of the extrinsic value of the option, which is \$3.50, and you would also have \$1.00 of capital appreciation from the stock for a total of \$4.50. This represents a 4.5% one-month return or an annualized return of 53.5%. It is not realistic to expect this type of return every month but remember, recent studies show that premium selling works approximately 80% of the time, which is still very good. We stated earlier that the maximum return of this sell-write will be actualized when the stock reaches \$ or below and the maximum return will be \$4.50, and no more than \$4.50. As the stock goes lower than \$96.50, the put option will actually start to lose but in direct proportion to the increase in capital appreciation thus fixing your maximum gain at \$4.50. For example, if the stock closes on December expiration at \$95.00 you would lose \$1.50 from the sale of the put option. The option would now be worth \$5.00 because with the stock at \$95.00, the December 100 put would have \$5.00 of intrinsic value. 8

12 For a complete breakdown of these three scenarios, please refer to the table below. Covered Put Example Return Table Stock Price Stock P & L Option P & L Total P & L LEAN Now that we have discussed how to construct a sell-write strategy, and how it will provide returns in the three different scenarios, I would like to talk about lean. Professional traders use the term lean to refer to one s perception about the directional strength of a stock. As a trader/investor you may follow a stock until you feel you know how the stock will behave. At some point in your confidence you may short the stock. When you short a stock and intend to hold that position for a period of time (to earn capital appreciation), you are aware that you will probably be holding the position while the stock goes against you from time to time. The stock may take a little time to start its movement in the direction you have anticipated. During that period, the stock s normal gyrations may take the stock to a point where your confidence level may change. 12

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