Educational Programming Video
The Value Line Daily Option Survey
Program 5: Writing Uncovered Options
In this session, we are going to discuss writing uncovered options.
For every option that is purchased there has to be an option seller or "option writer." Did you know that, as an investor, you can write options? Did you also know that The Value Line Daily Options Survey recommends certain calls and puts for writing?
As an option writer, you receive a fee known as the premium in return for taking on the obligation of the option contract. In the case of a call, this is the obligation to sell the stock at the strike price. In the case of a put, this is the obligation to buy the stock at the strike price. While a large number of options are written by options exchange members who trade their own capital (these members are known as market makers), many others are entered into by the investing public.
For now, we will focus on so-called "uncovered" option writing. These options are written by someone who doesn't own the underlying stock. This is not the situation with covered call writing, which we will cover in our next session.
When you write or sell an "uncovered" option, you must cover your risk by posting and maintaining a margin with your broker. This margin consists of the premium you have taken in, plus a percentage of the value of the underlying stock. This margin requirement can never be less than 10% of the value of the underlying stock. As a writer of options, you should realize that your potential losses could be well in excess of the original margin.
Why do you write an option rather than buy one? You write an option because you believe that the option's premium is overpriced with respect to future stock price movements. When you write an option and the stock is unchanged at expiration, the option will either be worthless, in which case you can keep all the premium, or it will be worth only its tangible value, in which case you can buy it back for less than you sold it for. If you feel you know where the stock might end up and you believe that collecting the premium will be enough to offset your risk, then option writing is for you. On the other hand, if you feel that a big move is likely, then you should buy the option instead.
When you write a call, you are basically bearish because you want the stock to end up below the strike price. When you buy a put, you are basically bullish, because you want the stock to end up above the strike price. After the fact, if the stock has made a very big move, you are likely to wish that you had bought an option rather than sold one.
In the graphs that accompany this report, we plot out the potential gains and losses of writing uncovered calls and puts on a $100 stock. These options are in-the-money ($90 strike for the call, $110 strike for the put), out-of-the-money ($110 strike for the call, $90 for the put) and at-the-money ($100 strike for both).
You will see that the in-the-money calls and puts offer you the most profit potential but require the stock to move to the strike price for you to realize this potential. In addition, the sale of these in-the-money calls and puts offer relatively little protection against the stock moving against you.
With the at-the-money calls and puts, you take in the maximum amount of time premium. Therefore, if the stock stands still you can still make a substantial profit. With the out-of-the-money calls and puts, you take in the lowest amount of premium. However, the stock will have to move to beyond the strike price at expiration before you start to experience losses.
Every day, our Value Line options model selects hundreds of calls and puts that we recommend for uncovered writing. The calls that we recommend are overpriced calls on stocks that Value Line expects to decline (e.g., common stock rank of 5, worst). Those puts recommended for put writing are overpriced puts on stocks that Value Line expects to rise (common stock rank of 1, best). Our track record shows that "uncovered" call and put writing can be quite profitable at times when there is little movement in stocks. However, when there are very big moves, loses can be quite large.
In our next session, we will introduce you to writing covered calls. This strategy requires no margin and can be very profitable for holders of stocks that are highly ranked by Value Line.