Risks to Consider with Options
While selling cash covered puts and covered calls are among the two lowest risk option strategies available, nonetheless there are some risks involved you need to know about, specifically: event, financial, and opportunity risk.
Event risk is the probability that the underlying share price will move sufficiently to trigger the exercising of the option by its buyer. In other words, the chance that you either end up buying the shares or having them called away.
This is why it’s imperative not to write options in a speculative, short-term fashion, but rather as part of a broader, long-term, dividend growth strategy. Specifically I mean never write options on any shares that you don’t mind selling (for calls), or buying and holding for the long-term (puts).
Event risk is also why it’s best to use puts or calls with a certain goal in mind, such as buying discounted shares or trimming a position at a higher sale price. This way event risk becomes a feature, not a bug.
Financial risk is the risk of the share price falling far below the strike price. For example, with cash secured puts you could end up assigned shares at a substantial paper loss, right from the start. Now remember that you are still better off than had you simply bought the shares at the market price, since your cost basis is reduced by the premium.
However, cash secured puts are not a strategy that helps in the event of a massive market correction. If this is a major concern for you then I recommend you do further research on Bull Put Spreads, which involve buying a lower strike price put that acts as a hedge against a crashing share price. That’s because puts appreciate in value as shares fall, and so a put spread will cap your overall loss, or allow you to buy extremely discounted shares in the event of a market crash.
Finally, opportunity risk is involved with all option strategies, and is unfortunately not something you can avoid. This is the risk of option sellers’ remorse, when the share price moves in the direction you anticipated but to such an extent that you end up leaving a lot of profit on the table.
For example, when selling a cash secured put, the optimal profit occurs if the underlying share price is above the strike at expiration. However, imagine selling a put and then watching the market rally strongly, the undervalued shares of a company you like rocketing upwards. In such a scenario the premium you receive might appear pitifully small in comparison to the gains you miss out on by not simply buying the shares in the first place.
Similarly, selling a covered call has both financial and opportunity risk. Imagine that you sell a covered call on a stock you think is highly overvalued. If the share price then plunges then you potentially stand to lose a lot of patiently accrued unrealized capital gains.
Or the share price could soar far above the strike price, but your profit would be capped at the strike price + premium per share. With options, as with all investing, there are opportunity costs that come from an uncertain future. As the saying goes, “you pays your money and you takes your chances”.
Details to Keep in Mind
In addition to the three risks described above, there are four important details to remember about options.
First are trading costs. While my examples excluded commission costs, in reality investors should always remember to factor these into their reward/risk calculations before selling any options.
Trading costs vary by broker, ranging from $0.70 per contract with a $1 minimum at Interactive Brokers (IBKR), to $12.95 for the first 10 contracts, and $1.25 per contract beyond that at Options Xpress.
Remember that a good rule of thumb is that trading costs should be kept to a maximum of 1% to 2% of your investment. For example, the Nov 11 $32 Pfizer puts that pay a $0.38 premium will net you $38 per contract. So if you can only afford to buy 100 shares of Pfizer then the $1 minimum commission at Interactive Brokers comes to a commission of 2.63%. That means you want to sell at least two contracts to spread the cost over both and lower the commission to $1.4 / $76 =1.84%.
This brings up a second point, selling options for income generation is most profitable if you spread out the lowest possible commission over as many contracts as you are comfortable selling. Of course, because each contract represents 100 shares that means potentially obligating yourself to buy several hundred, or even thousands of shares, which requires massive amounts of capital.
Similarly, selling even a single covered call assumes you have at least 100 shares of a stock you are willing to sell. In the case of Johnson & Johnson even one covered call represents over $12,000 worth of shares.
And speaking of costs, let’s not forget taxes. All option income, even that generated by selling contracts with a duration over one year, is taxed as short-term capital gains. That means at your top marginal income tax rate.
And since this is a highly capital intensive strategy, best used in large portfolios, that might mean that the IRS will get as much as 39% + 3.8% (Obamacare investment income surcharge) = 42.8% of the premium.
Which is why income generating options strategies are best done in a tax sheltered account, such as an IRA. Of course since those have contribution limits, most people’s accounts are smaller, which might limit how many contracts they can write.
