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Option Writing Strategies Are Not Sure Bets

Richard Croft
April 8, 2013
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Is there a particular option strategy that works all the time? The answer of course is no just as it is with stock picking or asset allocation metrics.

Despite that many investors focus entirely on option writing strategies. The logic seems sound given the potential cash flow and the fact that most options expire worthless.

There is also ample evidence supporting the long term success of covered call writing over various market cycles. The Mx Covered Call Writers Index which writes one month at-the-money calls against an underlying position in the S&P-TSX 60 Index Fund (TMX: XIU) is an excellent case study.

The MCWX index has data back to 1993 and for twenty years has outperformed buy and hold with less risk. In fact the MCWX has generated better long term returns than buy and hold without accounting for risk.

Excellent stats to be sure but they do not prove that covered call writing always works. Only that over long periods the strategy delivers alpha when measured against buy and hold. In fact covered call writing has as much to do with the performance of the underlying stock as with the sale of covered calls. When the underlying stock declines the covered call strategy will lose money.

Still most investors understand the risks associated with covered calls but should not extend that logic to uncovered option writing strategies. Take uncovered put writing as a case in point.

Selling puts to acquire an underlying stock has the same risk reward characteristics as the covered call. But naked put writing requires margin which in a major sell-off could force the investor to close out a position because of a margin call.

Then there are the risks associated with a spike in volatility which would cause the puts to lose value. These risks are not germane to covered calls assuming one has not used margin to purchase the underlying shares.

Selling uncovered straddles or strangles is another higher risk strategy that works over most market cycles but can generate significant losses in the wrong environment. Short straddles or strangles are volatility trades where you are betting that the underlying shares or index will trade in a range bounded by the strike price of the call and the put.

The rationale for volatility trades is that most of the time markets oscillate in a relatively narrow range interspersed with short sharp spikes either up or down. Unfortunately when dealing with uncovered options short term bursts typically result in large losses.

The challenge is the many nuances that go into pricing volatility strategies that are designed to value sentiment. To that end short uncovered straddles or strangles are nuanced strategies that are hard to understand with the potential for unlimited loss. That’s a bad combination no matter how sure the bet.

If you are intent on seeking out option writing strategies consider covered calls or credit spreads where the loss is limited and volatility has less of an impact. At least you will not be stuck having to make decisions based on fear or greed.

Richard Croft
Richard Croft http://www.croftgroup.com/

President, CIO & Portfolio Manager

Croft Financial Group

Richard Croft has been in the securities business since 1975. Since February 1993, Mr. Croft has been licensed as an investment counselor/portfolio manager, operating under the corporate name R. N. Croft Financial Group Inc. Richard has written extensively on utilizing individual stocks, mutual funds and exchangetraded funds within a portfolio model. His work includes nine books and thousands of articles and commentaries for Canada’s largest media channels. In 1998, Richard co‐developed three FPX Indexes geared to average Canadian investors for the National Post. In 2004, he extended that concept to include three RealWorld portfolio indexes, which demonstrate the performance of the FPX portfolio indexes adjusted for real-world costs. He also developed two option writing indexes for the Montreal Exchange, and developed the FundLine methodology, which is a graphic interpretation of portfolio diversification. Richard has also developed a Manager Value Added Index for rating the performance of fund managers on a risk adjusted basis relative to a benchmark. And In 1999, he co-developed a portfolio management system for Charles Schwab Canada. As global portfolio manager who focuses on risk-adjusted performance. Richard believes that performance is not just about return, it is about how that return was achieved.

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