COMBINATION WRITING
Q. I can see the case for writing out-of-the-money uncovered combinations because it provides a "window" in which to safely operate. But are there cases where it would make sense to write at-the-money or in-the-money combinations?
A. Unless you are a very well informed and nimble investor, this is not recommended. If you had a very strong reason to believe that the share price of the underlying stock/ETF was going to end up at or around your strike prices at expiration, you might dare to give it a try. If it doesn't work out, you may be at substantial risk. Example: XYZ is currently selling at $50. You write uncovered puts and uncovered calls, both with strike prices of $50 to expire in one month, as you believe the stock will remain at its current level. You will collect two sizeable premiums for the risk you are taking...let's say a total of $6 per share. As long as the share price does not close below $44 or above $56 on the expiration date you will make some profit (the closer the price to $50 the greater the profit). If the share price closes below or above those prices, you will lose $1,000 per contract for each dollar below or above. You also need to be aware that the day-to-day calculation of the margin requirement will increase and decrease more substantially than if you write out-of-the-money combinations. Regarding in-the-money combinations, I can't envision a situation where the average investor would do this. Let's keep things as simple as possible!
Q. Is the investment opportunity with uncovered combination writing worth the added risks compared with covered call writing?
A. That depends entirely upon your temperament and your ability and willingness to watch the markets regularly. By collecting two option premiums for one margin requirement, the ability to leverage can increase your investment return substantially if your combination writing decision turns out well. If it doesn't turn out well, it can be a disaster. That's why it is critical to have an exit strategy for every combination writing situation you are involved in to limit losses. This requires constant monitoring. If you have practiced covered call writing and put option writing with good results for some time, you may wish to try one combination write to get the feel for it. I would recommend starting with a low beta stock (below 1.0) and write the put strike price well below the current market price for the underlying security and the call strike price well above it. Use the Excel template so you know what commitment you are making. Watch it regularly (not just daily...more often). Take it slow and see if you have the stomach for it and can sleep at night. Don't forget that you are taking a different kind of risk with uncovered calls than you are for uncovered puts. If the price of the underlying security declines regarding an uncovered put, you can always just have the stock put to you and then write covered calls on the shares. An uncovered call that becomes in-the-money has to be bought back before expiration (possibly at a loss) or you will be short the stock following the expiration. This is not a position in which most investors wish to find themselves.
Q. After writing covered calls and doing put writing successfully I'd like to try combination writing to increase my returns even further. Will this require more time and active management on my part?
A. Since an exit strategy is needed for all combination writes, it will require that you regularly monitor your options positions to determine if it is necessary at any given time to execute the exit strategy trades. Since combination writing can involve hefty potential investment returns, there is accordingly the potential for a lot of action as the underlying security's price moves up and down. Your margin requirements can materially on quick notice. Gains can become losses, and vice versa, rather quickly. Frequent (more than daily) monitoring is absolutely essential. If you do not have ready access to real-time market information, do not try combination writing. You need to be prepared to drop whatever you are doing and take action on your positions if things move against you.
Q. What is a reasonable investment return to strive for with uncovered combination writing?
A. I think this is a backward way to look at it. Returns are available anywhere from low double-digits to solid triple digits, depending on the beta of the underlying security selected, the strike prices, expiration dates and volatility of the market in general. I think all investors should decide what level of investment returns they need, then go looking for investment vehicles that have the potential to create those returns. For example, if you are looking for 50% annual returns from covered call writing, you are likely to be very disappointed. Only by selecting the riskiest stocks, writing at- or in-the-money calls and being very lucky could you ever hope to realize such returns consistently with covered call writing. With uncovered combinations such potential returns are much more likely to be realized if you are prepared to take the additional risk and spend the requisite time monitoring your position. If your return expectations are low to moderate double-digit annual returns, I would recommend covered call writing or put option writing. If you desire somewhat higher returns, using margin to buy stocks/ETFs for covered call writing or using put writing can provide that opportunity. If you desire even greater returns, say 25% to over 100%, then combination writing can provide realistic opportunities to realize such returns if the markets act in agreement with the choices you make. My recommendation is that you select the least risky strategy that will potentially provide you with the returns you hope to achieve. If you wish to strive for 30% annually by writing uncovered combinations, you can likely have a shot at achieving that by writing puts and calls that are well out of the money on low to medium beta stocks that are no risker than the market in general. Why would you want to take on more risk by selecting higer beta stocks or use strike prices that are closer to the market price of the underlying security if you don't need to do that to achieve your investment return objective?
Q. Why is an exit strategy for uncovered calls necessary when it doesn't seem to be necessary for covered call writing and put option writing?
A. The recommendation for put writing, which is uncovered, is that you be prepared to acquire the underlying shares subject to the put if the market price falls below the strike price on expiration. Unless you've changed your mind about the stock/ETF, I find that buying the shares and then writing covered calls on them is a preferable strategy to buying back the puts, potentially at a loss. So, if this fits your thoughts, then an exit strategy for the put side of the combination transaction is not necessary. One will always be necessary for the uncovered call side of the transaction. Theoretically your loss potential is infinite on the call writing side of a combination. While a stock will never rise to infinity, we of course don't know when it will stop rising if it starts to do so. Therefore, you can't just wait forever to see how much your losses accumulate. You naturally want to limit them. Also, as the price of the underlying security rises, the margin requirement will also rise. Most of us don't have unlimited resources to cover large increases in margin requirements, so we are going to want to limit how much of our funds we deploy into one option writing transaction and how much we are willing to lose (and you will have losses if you write combinations...you just have to manage them so that you make a good return overall). If the market price of the underlying shares is greater than the call strike price on the expiration date (in-the-money), you will end up with a short position in the shares on the Monday following expiration. Most investors don't want this to happen, which means that you would need to liquidate your uncovered call position on or before the expiration date when the share price goes above the strike price. All of these machinations require a pre-planned exit strategy so you know in advance what you will do if the share price reaches certain targets. Then you need to watch very regularly to see whether you remain in the "safe zone" or if you need to execute your exit strategy.
