Power of Option Writing

"Options are risky." That is one of the most common phrase you may hear among investors, if you talk about options . It is absolutely true...that is only if you "buy" them. There is a flip side to this. Options can be the greatest tool out there at your disposal for the safety of your portfolio and consistency of its returns; if you "sell" the options. Here is how it works.

By definition, buying an option gives you a right to buy a particular security at a predetermined price for a specific period of time, just as the word "option" implies. However, there is a price to pay for this option. This is precisely why they are risky. There are two types of options: calls and puts. A call option gives you a right to buy and a put option gives you a right to sell at the predetermined prices. This in turn makes a call option akin to a lottery ticket and put option an insurance policy in the layman's terms.

Since, one has to pay for a lottery ticket and an insurance policy, they may become worthless in absence of hitting a lottery or a need for filing an insurance claim. All they did is that they served their purpose; which is to allow you to play a lottery (for call option) and allow to buy a peace of mind (for put option). Obviously, there is a cost associated with either of these two. That is the worst case scenario. One may recover part, if not all, of their original investment depending on the magnitude of the move of a particular security.

So, how about if you do the opposite? One can sell a call or a put option and collect the premium, instead. The key here is to "not pay" a premium, but instead "collect" a premium. This allows you to become a lottery agent or an insurance company. As you know, the lottery agent, be it a state government or a store owner selling a lottery ticket are the ones making money on a consistent basis, not the lottery buyers. Similarly, insurance companies are the ones that make money selling insurance. Buyers of an insurance policy have nothing but the cost of protection and protection of value in case of a disaster.

Investor keeping the above concept in the mind can devise an investment strategy that can give them relatively steady and consistent performance as opposed to leaving investment returns to the vagaries of Mr. Market. In terms of specifics, a covered call strategy has been an age-old and a proven strategy that has delivered relatively consistent, thought not magnificent, returns. A cash secured put writing strategy can be utilized in a similar manner as well. That allows an investors to utilize not only one side of a coin, but both sides of a coin.

In order to improve returns, more sophisticated approach can be employed in a portfolio via a combination of covered and uncovered positions to exploit the world of options even further. However, risk management is the key here. Under no circumstances, the risk should be higher than the market as a whole. The portfolio risk must not exceed the risk of an overall market. If it exceeds, potential returns are higher, however, at the same time, risk of loss is greater, too.