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This essay describes two special techniques that may help with selling or buying stocks.
People who try to earn money as option traders have a bad reputation. It is very risky to treat options as things to buy and sell while trying to follow the advice of "buy low, sell high". I certainly do not recommend option trading!
But there are times when options provide a sensible mechanism to do the buying and selling of stocks or ETFs that an investor will do anyway. Options can be used safely as a lever to pull to make a purchase or sale happen.
Consder two investors. Linus uses limit orders to buy and sell stocks. Ophelia uses options to buy and sell stocks.
Limit Orders
The typical way to buy or sell shares is with a limit order. The investor specifies a "strike" price which automatically triggers the purchase or sale. Nothing happens until the limit order is triggered. Like someone watching grandfather clock before it strikes noon, the account simply waits until the strike price automatically triggers the transaction.
Options
An alternative is selling options. Options give another investor the right (but not an obligation) to complete a transaction at any time until an agreed-upon date. There is again a strike price, but the other investor is not obligated to trigger the transaction when that price is struck. He or she might want wait longer, to make sure the stock's price remains reliably past the strike price. Someone who sells an option is paid the day the option is sold in compensation for providing another investor with extra flexibility.
Next consder a stock to sell. Linus and Ophelia both own 100 shares of AH and want to sell it.
A Stock to Sell
The company Advancing Holdings has been doing very well. The stock price has increased to $100 per share.
Because the price went up a lot, this stock now takes up too great a portion of Linus's and Ophelia's investment accounts. They want to sell 100 shares of Advancing Holdings to diversify their accounts. They will use that money to purchase other investments.
The chart for Advancing Holdings shows that the stock price is near its moving average but moving up towards the top Bollinger Band. Soon it should be an opportune time to sell. The top Bollinger Band is at $103, so a reasonably ambitious strike price would be $103 per share.
Linus tries to sell with a limit order. He creates a limit order with a strike price of $103 per share. This does not remove any of his flexibility. Linus can, at any time, reconsider the chart for Advancing Holdings, look at its moving average and Bollinger Bands, and try something else. He can freely cancel a limit order. He can at any time decide to try a new limit order with a different strike price.
Ophelia sells an option. She also uses a strike price of $103 per share, with a time frame that lasts until the end of the month. The other investor pays her $1 per share for this transaction. This type of option sale is named a covered call (she is selling the option to "call" the stock from her account, and it is "covered" because she already owns the stock).
Ophelia loses flexibility. Her transaction is fixed until the end of the month. To cancel it, she woud need to "buy back the option", which is possible but costs a little money. The cost to cancel is less than the $1 per share she just gained. But canceling would detract from her gain.
Notice that only Ophelia is already paid. Both investors are trying to sell 100 shares. Ophelia has already received $1 per share × 100 shares = $100.
If the price for Advancing Holdings stays about the same all month, neither transaction triggers. The strike price of $103 was too ambitious. Suppose the price for Advancing Holdings ended at $100.50.
Linus could have cancelled his limit order. But he probably did not.
Ophelia was bound by her covered call. The other investor never triggered the transaction. (No one would buy a stock worth $100.50 for $103.) But she did not mind. She keeps the $100 she was paid the day she sold the covered call.
As the month ends, both Linus or Ophelia reconsider. They could hold onto their shares of Advancing Holdings. They could create a new limit order to sell for $100.50 × 100 shares = $10,050. That decision involves not only how much they expect Advancing Holdings to eventually resume increasing, but how Advancing Holdings compares to the other investments into which they plan diversification.
Nether Linus and Ophelia got what they wanted. But compared to selling with a strike price of $100, neither lost money. Ophelia even earned some.
Suppose the price for Advancing Holdings increased to $103 by the month's end.
Linus's limit order triggered as the price reached $103. He earned $103 × 100 shares = $10,300.
Ophelia's covered call probably triggers. The other investor thought $103 was an acceptable price, and would not want to have paid Ophelia $100 for nothing. Ophelia also earns $10,300 for selling her stock, plus the $100 extra she earned the day she sold the covered call.
Both Linus and Ophelia got what they wanted and are happy. Ophelia got a bit more than Linus.
Suppose the price for Advancing Holdings increased to $105 by the month's end. Both Linus and Ophelia wish they had picked a higher strike price. But they should not really be disappointed. They had decided they would be happy with $103 per share, and they got what they wanted.
Linus's limit order triggered as the price passed $103 on the way up to $105. He earned $103 × 100 shares = $10,300.
Ophelia's covered call need not trigger until the other investor decides to buy the stock from her account. This could happen as soon as the price increases past $103. More likely, the other investor would wait longer to make sure the price seemed to be reliably staying above $103. If he waited until the end of the month, he would be able to call in shares worth $105 for only $103! (In other words, waiting allows the other investor to get such a good deal that it more than compensates for his or her paying to buy the covered call from Ophelia.) Since the other investor would be foolish not to trigger the transaction at all, we trust it happened. Ophelia also earns $10,300 for selling her stock, plus the $100 extra she earned the day she sold the covered call.
Both Linus and Ophelia got what they wanted and are happy. Ophelia got $100 more than Linus.
Suppose the price for Advancing Holdings decreased to $99 by the month's end.
Linus could have cancelled his limit order. But he probably did not.
Ophelia was bound by her covered call. The other investor never triggered the transaction. (No one would buy a stock worth less than $100 for $103.)
As the month ends, both Linus or Ophelia reconsider. They could hold onto their shares of Advancing Holdings. They could create a new limit order to sell for $99 × 100 shares = $9,900. That decision involves not only how much they expect Advancing Holdings to eventually resume increasing, but how Advancing Holdings compares to the other investments into which they plan diversification.
Nether Linus nor Ophelia got what they wanted. Compared to selling with a strike price of $100, Linus has lost money. Ophelia has not lost anything, because her loss is compensated by the amount she was paid the day she sold the covered call.
Suppose the price for Advancing Holdings decreased to $95 by the month's end.
Linus probably cancelled his limit order. Perhaps he lost hope at $98, and cut his losses by using a new limit order at that price. He sold his stock for $98 × 100 shares = $9,800.
Ophelia was bound by her covered call. The other investor never triggered the transaction. (No one would buy a stock worth less than $100 for $103.) She cancels her covered call by buying back the option for $60, which slows her down compared to Linus. She cuts her losses by using a new limit order at $97.50, which sells her stock for $97.50 × 100 shares = $9,750.
Nether Linus nor Ophelia got what they wanted. Compared to selling with a strike price of $100, Linus has lost $200 and Ophelia has lost $210.
Actually, most of that was baloney.
Uness Advancing Holdings suffered special good news or scandal, the entire market went up or down while Linus and Ophelia were selling to reinvest.
If they received more for selling Advancing Holdings, they probably will also pay more when they diversify their portfolio.
If they received less for selling Advancing Holdings, they probably will also pay less when they diversify their portfolio.
The most meaningful difference was when the price stayed about the same. A flat market probably means both Linus and Ophelia wait to reinvest. And Ophelia had $100 of extra income when Linus did not! Earning 1% in less than a month when the market is flat is a great deal.
When Opehlia lost more, it was only very slightly more. This was the cost of an amateur investor using an option. If she were a professional investor who monitored the market all day long, she could have cancelled her covered call quickly and used the same new limit order of $98 that Linus used. But Ophelia was doing something else that day (which was worth more to her than the $10 extra loss) and did not check stock prices until she got home at dinner time.
In all the other situations, Ophelia earned a bit more. But Linus had more flexibility, and might have been able to do his diversification with slightly better timing, to make up the difference.
Our only strong conclusion is that for amateur investors, selling stock with a covered call makes sense when we expect the market to be flat.
Of course, covered calls do not pay much when most people expect the market to be flat. So perhaps we should rephrase our summary. Covered calls make sense when the market is increasing but you are more pessimistic than most people about its continued increase.
Within that understanding, the payment for selling a covered call is some optimist's wager against your pessimism. (Recall that if the price rose to $105, the other investor got such a good deal that it more than compensated for paying to buy the covered call.)
What if our scenarios changed slightly? Imagine that Linus and Ophelia were not selling one investment to diversify, but were retired people who needed to use the proceeds for daily expenses. They have a cash "cushion" in their bank account but know they will need more within a few months.
If that were true, then selling a covered call becomes much more attractive than using a limit order. The immediate $100 that Ophelia received would probably be more useful than the extra flexibility Linus had.
Recall our main conclusion so far: covered calls make sense when the market is increasing but you are more pessimistic than most people about its continued increase.
So, when can we expect to be more pessimistic than most people when the market is increasing?
The standard way to detect when most investors are too optimistic is to examine how the S&P 500 is doing compared to its RSI, Bollinger Bands, and MACD. A six-month chart of this comparison is available here at StockCharts.com.
The sample chart pictured above shows three causes for concern. The RSI is diving down from a time above 70 (the central black line coming down from three green peaks). The MACD is below its moving average (at the bottom, the lower black line below its friendly red line). The stock market has been staying above its moving average (the candlestick graph stays between the moving average and upper Bollinger Band). When all three of these signals happen at the same time, it may be time to use options instead of covered calls.
Some investors claim that a measure of "realistic optimism" is dividing P/E by VIX. Search online for the phrase "pe to vix ratio market confidence" and look for news and images. A ratio above 1.2 when the stock market is bullish may be a fourth signal that most investors are too optimistic.
Again consder our two investors. Linus uses limit orders to buy and sell stocks. Ophelia uses options to buy and sell stocks.
Next consder a stock to buy. Linus and Ophelia want to buy 100 shares of Promising Endeavors.
A Stock to Buy
The company Promising Endeavors meets our criteria for an investment. The stock price has recently decreased and is now at $100 per share.
The chart for Promising Endeavors shows that the stock price is near its moving average but moving down towards the bottom Bollinger Band. Soon it should be an opportune time to buy. The bottom Bollinger Band is at $97, so a reasonably ambitious strike price would be $97 per share.
Linus tries to buy with a limit order. He creates a limit order with a strike price of $97 per share. This does not remove any of his flexibility. Linus can, at any time, reconsider the chart for Promising Endeavors, look at its moving average and Bollinger Bands, and try something else. He can freely cancel a limit order. He can at any time decide to try a new limit order with a different strike price.
Ophelia buys an option. She also uses a strike price of $97 per share, with a time frame that lasts until the end of the month. The other investor pays her $1 per share for this transaction. This type of option sale is named a put (she is selling the option to "put" the stock into her account).
Ophelia loses flexibility. Her transaction is fixed until the end of the month. To cancel it, she woud need to "buy back the option", which is possible but costs a little money. The cost to cancel is less than the $1 per share she just gained. But canceling would detract from her gain.
Notice that only Ophelia is already paid. Both investors are trying to buy 100 shares. Ophelia has already received $1 per share × 100 shares = $100.
If the price for Promising Endeavors stays about the same all month, neither transaction triggers. The strike price of $97 was too ambitious. Suppose the price for Promising Endeavors ended at $99.50.
Linus could have cancelled his limit order. But he probably did not. As the month ends, Linus can reconsider. He could hold onto his cash and wait to buy Promising Endeavors. Or he could create a new limit order to sell for $99.50 × 100 shares = $9,950.
Ophelia was bound by her put. The other investor would trigger the transaction and put the hundred shares of Promising Endeavors in her account. She only received $97 for each, even though they were each worth $99.50. Fortunately, the $100 she was paid the day she sold the put covers a significant portion of her $250 loss.
Nether Linus and Ophelia got what they wanted. But Linus lost nothing, and Ophelia lost about $150.
Suppose the price for Promising Endeavors decreased to $97 by the month's end.
Linus's limit order triggered as the price reached $97. He buys the stock at the price he wanted.
Ophelia's put probably triggers. The other investor thought $97 was an acceptable price, and would not want to have paid Ophelia $100 for nothing. Ophelia also buys the stock at the price she wanted, plus she earned $100 extra the day she sold the put.
Both Linus and Ophelia got what they wanted and are happy. Ophelia got a bit more than Linus.
Suppose the price for Promising Endeavors decreased to $95 by the month's end. Both Linus and Ophelia wish they had picked a lower strike price. But they should not really be disappointed. They had decided they would be happy with buying at $97 per share, and they got what they wanted.
Linus's limit order triggered as the price passed $97 on the way down to $95.
Ophelia's put need not trigger until the other investor decides to put the stock into her account. This could happen as soon as the price decreases past $97. More likely, the other investor would wait longer to make sure the price seemed to be reliably staying below $97. If he waited until the end of the month, he would be able to put into her account shares worth $95 for the price of $97! (In other words, waiting allows the other investor to get such a good deal that it more than compensates for his or her paying to buy the put from Ophelia.) Since the other investor would be foolish not to trigger the transaction at all, we trust it happened.
Both Linus and Ophelia got what they wanted and are happy. Ophelia got $100 more than Linus.
Suppose the price for Promising Endeavors increased to $101 by the month's end.
Linus could have cancelled his limit order. But he probably did not.
Ophelia was bound by her covered call. The other investor never triggered the transaction. (No one would sell stock worth more than $100 for $97.)
As the month ends, both Linus or Ophelia reconsider. They could hold onto their cash and wait to buy Promising Endeavors. They could create a new limit order to buy for $101 × 100 shares = $10,100.
Nether Linus nor Ophelia got what they wanted. Compared to buying with a strike price of $100, Linus has lost $100 of potential capital gains. Ophelia has not lost anything, because her missing out on capital gains is compensated by the amount she was paid the day she sold the put.
Suppose the price for Promising Endeavors increased to $105 by the month's end.
Linus probably cancelled his limit order. Perhaps he lost hope at $102, and cut his losses by using a new limit order at that price. He bought his stock for $102 × 100 shares = $10,200.
Ophelia was bound by her put. The other investor never triggered the transaction. (No one would sell a stock worth more than $100 for $97.) She cancels her put by buying back the option for $60, which slows her down compared to Linus. She cuts her losses by using a new limit order at $102.50, which allows her to buy the stock for $102.50 × 100 shares = $10,250.
Nether Linus nor Ophelia got what they wanted. Compared to selling with a strike price of $100, Linus has lost $200 of potential capital gains and Ophelia has lost $210 of potential capital gains.
Selling a put for 1% of the stock price seems to be a great deal. Unless the price of that stock shoots up, you do better than with a limit order.
Of course, the other investor is hoping for the price to decrease greatly. (Recall that if the price fell to $95, the other investor got such a good deal that it more than compensated for paying to buy the put.) The other investor is probably unwilling to pay 1% for a put unless he or she is quite pessimistic about the stock price.
In other words, selling puts makes sense when most people expect the market to continue crashing downward. So perhaps we should paraphrase our summary. Covered calls make sense when the market is decreasing but you are less pessimistic than most people about its continued decrease.
Within that understanding, the payment for selling a put is some pessimist's wager against your optimism.
Unfortunately, there are no reliable ways to determine when most investors are too pessimistic while the market is decreasing.
Yes, we could look at signals as before. The opposite patterns of RSI, MACD, moving average, P/E, and VIX could indicate general over-pessimism.
But most decreasing ("bear") makets fall so quickly that predicting when the bottom is about to happen is pure guesswork. The patterns change too quickly for chart-watchers to have any advantage.
Instead, start selling puts when the market is going down and an investment has decreased enough that you would be happy to buy it. You might not gain much more than with a limit order. But you will probably do slightly better.