In an earlier post, entitled Generate More Income From Dividend Stocks, I discussed some simple option strategies to generate additional income, which involves writing out-of-the-money (OTM) put and call contracts. This post delves a bit more into the details of these strategies about how market conditions can favor or play havoc on the contract writer. I discuss details below on when not to use these strategies and the some of the disadvantages of these strategies.
The recent downturn in the market has revealed a lot of option strategists out there getting caught with their pants down. Over the last couple of years, we have experienced a tremendous run in the stock market. The year 2013 turned out to be one of the the best performing years in recent history, all thanks to the Fed keeping low interest rates, flushing the economy with cheap money and buying bonds, thus bolstering the stock market. Investors have been encouraged to take on risk and have been rewarded; But when times are good, bad things arent as obvious as normally should be.
Writing OTM Put Contracts
Writing OTM put contracts provides the writer with options income and works great as a strategy in secular bull markets. The writer is only obligated to buy the underlying security if the stock falls below the strike price. This is the situation that a lot of people have been caught in recently during the ongoing correction. Option writers have had to buy back the put contracts to minimize the loss.
Writing put contracts should not a strategy for the weak-at-heart trader. A company’s success and a rising stock requires a lot of hard work and it only takes a little stumble for the stock to come crashing down. Remember that a stock never crashes up, it always crashes down. In addition, some other uncontrollable events may throw a wrench in an option writer’s strategy such as – an analyst downgrade, political conflict, threat of war or recession or simply the fact that a stock belongs to an index and there is a broad market selloff.
Writing OTM Call Contracts
Writing OTM covered call options provides the writer with options income and the writer only needs to sell the underlying security if the stock closes above the strike price. While this can be a good strategy in a sideways or bear market, this strategy does not work too well for the writer in situations such as: secular bull markets or rapidly rising stock values, analyst upgrades, positive earnings catalysts etc.
The other major problem with this strategy is that you are obligated to sell your shares for a company that is doing well and limits your upside potential for returns.
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