Though fundamental stock investing is the foundation of longer-term Market FIRE practice, options trading is an essential additional layer that should be incorporated into an investor’s Market FIRE approach in order to help smooth out the many volatile and declining or stagnant periods for the stock market. In the process, regular trading of covered call options, along with occasional trading of cash-secured put options, provides a more regular source of income for ordinary living expenses and also a regular source of funds for additional purchases of stocks in the Market FIRE investor’s portfolio, which in turn can compound and lead to further capital gains. This process amounts to using already owned assets in the form of stocks and cash and creating additional related assets in the form of short options that provide income, without (usually) ever having to sell the underlying assets, and when they are sold still being able to do so at a fair price. Underlying stock positions thereby serve a role similar in a stock investor’s portfolio as houses or other buildings owned by a real estate investor that are leased for rental income but still owned by the investor.
Even as options trading generally can be an indispensable part of the Market FIRE approach to financial independence, it could also be highly risky and potentially costly if conservative strategies are not employed. This is because of the inherent nature of options as essentially leveraged derivatives, based on shorter finite time periods and subject to much sharper changes in value relative to the stocks that underlie the options. If the underlying stock goes up by 5%, the related long option might go up by between 10% and 50% or more, depending on the proximity of the strike price and expiration date. Or the related long option price could go down by the same amounts if the underlying stock declines by 5%. The extent of this risk can be minimized by using conservative options trading strategies, mainly by using covered calls against one’s pre-existing long stock positions in one’s investment portfolio. Unless stated otherwise, the options strategies discussed on this site pertain to covered calls, or “short” calls sold against existing stock positions.
With covered call options, when the market price of the underlying stock DECREASES, the value of the corresponding short call options in an investor’s portfolio usually INCREASES (in terms of ability to close it at a profit) by two or more times the percentage amount that the stock price has decreased. Conversely, when the market price of the underlying stock INCREASES, the value of the corresponding short call options in an investor’s portfolio usually DECREASES (in terms of ability to close it at a profit) by two or more times the percentage amount that the stock price has increased. On the other hand, if the market price of the underlying stock remains generally stagnant through the duration of the option, then the value of the covered call will generally also INCREASE, though more slowly than if the price of the underlying stock has been decreasing during this time.
The Market FIRE approach discussed on this site does not envision the far riskier modes of speculating on short-term price movement by trading long call and put options. Although some traders may trade long call or put options responsibly if done on a very limited basis, the approach described in this website generally will not employ this type of risky options trading. Moreover, the Market FIRE approach discussed on this site also does not envision any selling of naked calls or naked puts, which both require trading on margin and therefore can result in far more financially dangerous outcomes than would occur by securing short call or put options with pre-existing stock positions or cash held in the investment portfolio. Naked short call or put selling will NEVER be described approvingly on this website.
Before using ANY type of options trading, an investor should of course thoroughly read all introductory training material from one’s own brokerage and should seek out additional information from trusted third-party sources explaining options-related terminology and concepts. An investor should also be aware of current events and recent developments concerning the stocks on which options are traded, as well as the shorter-term conditions in the macro-economy and stock market at large.
Below is the general methodology I have developed and used on my Market FIRE journey (subject of course to exceptions as justified by individual circumstances). Later posts will elaborate on certain points of this approach. There are a variety of approaches that different traders and investors may take to trading options, including covered calls. Because my Market FIRE approach emphasizes the importance of BOTH generating substantial options premium AND generating long-term capital gains, this approach describes options trading strategies that are meant to reduce the likelihood that the short call options will be assigned to the investor and the underlying stock positions would be “called away.” This Market FIRE approach nonetheless also describes a strategy that should generate income, in the form of options premium, to the extent consistent with the overarching objective of longer-term capital appreciation.
I. Covered Call Options Are Written With Expiration Dates Between One and Two Months In Advance.
In selecting which covered call option to sell, with this Market FIRE approach I generally select an expiration date greater than one month but less than two months into the future. The time decay of the extrinsic value of an option usually increases when expiration is less than one month. By writing options with more than one month until expiration, an investor is able to collect a relatively high premium without tying down the underlying stock position for an excessively long period of time (as would be the case with a longer-dated option). This type of period allows for ample opportunity to re-write the covered call before the expiration date, in order to collect additional premium, if market conditions allow. Additionally, unlike options of shorter duration, the investor will allow himself more time to make adjustments with the option (see Parts III and IV below) before being in the position where assignment of the call option might be probable, such as if it were “deep in the money.” At the same time, the time decay should intensify soon after the option is written such that the chances that the option can be closed profitably should be increased.
II. Covered Call Options Are Written With Strike Prices Slightly Above Where The Investor Believes the Stock Is Likely To Be Priced By Expiration Date, With General Preference For 0.30 to 0.40 Delta Ratios (Unless Option Is a Roll Over).
In order to balance the competing objectives of collecting substantial premium income and maintaining long stock positions for ultimate capital appreciation, Market FIRE investors may generally write covered call options at strike prices above the underlying stock’s current market price at a level where the investor believes the price is likely to settle by the expiration date if the stock price moves upward. Of course the actual stock movement may go higher or lower than this forecasted price, and the option can then be managed accordingly (see below). Because the options are able to be managed with a wide variety of future price fluctuations, the initial price forecast does not need to be made with scientific precision or with great levels of confidence in its accuracy. In making this shorter-term forecast, however, an investor may take into account the recent past volatility of the underlying stock, the current sector and macro-economic situation, and future events forecasted to take place by the expiration date (such as an upcoming quarterly earnings report or directional change in a significant related commodity price).
In a generally upward trending market or one in which the underlying stock has been outperforming the market, an investor may consider writing covered call options with strike prices that may be on the higher end of any range for the forecasted underlying price for the stock by the expiration date (such as at least 10% above the current market price, or more for an upward trending growth stock). Conversely, in a downward trending market or one in which the underlying stock has been depressed relative to the market, an investor may consider writing covered call options that are “near the money,” with strike prices that are only slightly above the current market price of the underlying stock.
In the absence of a clear basis for forecasting the near-term movement of an underlying stock, an investor might consider using the Greek delta ratio for stock options in selecting a strike price for covered call options. Delta is the ratio that is an estimate for the percentage likelihood that a given option will be “in the money” at the time of expiration, meaning the approximate likelihood that the stock’s price would be at or above the strike price at the expiration date, thereby subjecting the short option seller to assignment pursuant to the option. (It should be recognized that call options are subject to assignment before expiration if they are in the money, but this is not exactly what delta approximates.) Without clear conviction for a different forecast for the stock price by expiration, an investor may consider selecting a covered call option at a strike price that would have a delta of between approximately 0.30 to 0.40, meaning that the option would have an estimated 30% to 40% likelihood of being in the money at the time of expiration.
A more assignment-adverse investor, however, may consider writing covered call options with deltas of between 0.20 to 0.30, indicating that the selected options would have an estimated 20% to 30% chance of being in-the-money at expiration.
A roll-over of an option that is in-the-money and that the seller does not wish to be assigned (because the seller wants to hold onto the underlying stock) does not need to have a strike price selected according to the above methodology. Indeed, as further explained below, it may often be desirable to select strike prices that are below the current market price of the underlying stock at the time of the roll-over in order to avoid losing money from the covered call options trading.
III. Buying-To-Close Covered Call Options Back Before Expiration May Lock In Profits And Allow Re-Writing Covered Call Options At New Strike Price and Expiration Date Soon Afterwards.
In order to maximize the opportunity for covered call options premium, Market FIRE investors generally may prefer to NOT wait for expiration of even short call options that are out-of-the-money or otherwise could be considered to be profitable. Instead, investors generally may buy-to-close their covered call options before expiration if and when doing so would lock in a gain of a pre-determined rate of gain relative to the initial price of sale for the covered call options. I generally use 67%, or two-thirds, as the amount of profit that will justify buying-to-close covered call options.
Of course, in order to buy-to-close covered call options, the Market FIRE investor must always maintain a sufficient cash balance that will not be used for regular living expenses or other personal expenditures and that will always be available for buying back covered calls. The amount that can be considered a “safe amount” for this purpose will vary based on the size of the portfolio and specific stocks held therein, but a general rule of thumb is that the investor should hold in reserve at least the amount expected to be generated in net premium each month for use in buying-to-close covered call options.
Buying-to-close profitable covered call options, rather than waiting for expiration, generally allows for an investor to collect more aggregate options premium. This is because this action will free up the underlying stock to allow the investor to sell a new covered call option against stock in advance of (and potentially substantially in advance of) the prior closed call option’s expiration date.
Buying-to-close profitable covered call options ahead of expiration also locks in profits before conditions have the potential to change and result in the option becoming unprofitable or less profitable prior to expiration. Because the stock market is inherently volatile and options trading based on stocks are even more volatile, any currently profitable covered call option has a significant likelihood of changing course and becoming unprofitable before expiration, potentially threatening to result in the option being assigned and the underlying stock being called away. This outcome can be avoided by buying-to-close short call options at a pre-determined profit level (such as 67%).
Even if the covered call option cannot or is not likely to be bought to close at the predetermined preferred profit level of 67% or other comparable figure, it should generally be closed about one week prior to expiration if profitable at some lower level for similar reasons. There is still some prospect that market developments could cause the underlying stock to drastically increase in price and result in the short option becoming in-the-money, thereby threatening that the underlying stock position would be called away. Because the one-week mark prior to expiration is generally when an in-the-money call option is most susceptible to being assigned, that is a good timeframe to close a slightly profitable covered call option.
One potentially significant caveat to the above description of appropriate timeframes for closing profitable covered call options is for the somewhat limited category of profitable options that nonetheless are in-the-money and also concern options linked to stocks that pay dividends, if the short option is held immediately before the ex-dividend date for the declared dividend payment. The holder of a long call option has a financial incentive to exercise the option to buy underlying stock prior to the ex-dividend date so that this trader would become entitled to payment of a declared dividend. To avoid assignment of a covered call option for a dividend-paying stock, an investor should strongly consider buying-to-close a short call option at least two days prior to the ex-dividend date for a dividend payment. The investor then may sell a new longer- or same-dated call option against the underlying stock position on or after the ex-dividend date.
IV. Consider Taking Action to Avoid Being Assigned Call Options To Protect Future Capital Gains By Vigilantly Rolling Over (And Up, When Realistic) Well In Advance of Expiration Dates.
On the other hand, if a covered call option is on the verge of potentially being assigned, resulting in the underlying stock potentially being called away, from a balanced Market FIRE perspective that encompasses capital appreciation it may be best to roll over the unprofitable option into a new option with a later expiration date. If possible, depending on the specific dynamics of the options available, a higher strike price can be selected for a premium that is similar to the amount paid to close the prior unprofitable option. This is because the time-value of the longer-dated prospective new call option will be greater than the option that will be rolled-over, which necessarily would be experiencing a greater level of time decay that exists when an option is closer to expiration (less than one month usually). Otherwise, a new option at least can usually be written at the same strike price as the prior option for the same or usually somewhat greater premium that the amount paid to close the prior option.
It should be noted that any kind of roll over of an option that was unprofitable will result in a “realized loss” for accounting purposes, but that it should ordinarily NOT result in a loss on a cash basis. This is because the money paid to buy-to-close the prior option (which is greater than the premium initially generated by having already sold that option) should be balanced by the premium generated by selling the new roll-over covered call option. Because one of the primary purposes of the covered call options strategy is to generate consistent income, a roll-over option should generally not be selected unless the premium is at least as must as the premium paid to close the prior unprofitable option.
Essentially, rolling over a covered call option allows the investor an extension of time without having the underlying stock called away. Whether that new rolled-over option will ultimately be profitable (and whether it results in a realized gain or loss) of course will not be determined until that rolled-over option is later closed.
The issue that usually will cause a roll-over to be appropriate is an underlying stock price that increased more than expected over the relatively short period of time before the prior option’s expiration date, usually with that prior option having been “in the money” and in many cases “deep in the money.” With the volatility of the stock and options markets, it is usually true that the underlying stock may be over-heated after a strong run-up and may be due for a pull back at some time in the near future. Even if the rolled-over option is at a strike price that is still below the market price, that rolled-over option may become sufficiently profitable to close after a sharp enough period of decline or stagnation for the underlying stock. At least further downward movement however is usually needed before a new option for comparable premium can be written that is out-of-the money.
The timing of when to roll-over a covered call option in relation to the initial option’s expiration date is a matter of art more than science, and generally depends on the extent to which the option is in-the-money. If the option is “deep in-the-money” to the extent that the current market price of the underlying stock is more than 50% above the strike price of the call option, that option should generally be rolled-over at about one-month prior to the option’s expiration. This is earlier than most short options usually should be closed because the benefit of time decay would not be realized. Nonetheless, it is often the appropriate course of action because such a deep in-the-money option is susceptible to being called away even that early simply because of significant intrinsic value that already exists for such an option.
On the other hand, if the option to be rolled over is in-the-money to a significant but not as substantial extent, with an underlying stock price that is more than 20% but less than 50% above the option strike price, then the roll over can more safely be done between two and three weeks prior to expiration of the option to be rolled over. This would allow for the benefit of some additional time decay for the option to be bought-to-close (allowing for the option to be closed at a somewhat lower relative amount compared to longer-dated options with the same or higher strike prices). This time frame would also generally allow for the roll-over to be executed before it it would be expected that such an option would be assigned by the traders on the other end with the corresponding long options. Generally based on past experience it has been unlikely that such an option would be assigned more than two weeks period to the option’s expiration.
If the option to be rolled over is in-the-money but not to as substantial an extent, with the underlying stock price less than 20% above the option strike price, then the roll-over can be mostly safely done by approximately one week prior to the option’s expiration. Based on past experience it has been unlikely that such an option would be assigned more than one week prior to expiration.
One potentially significant caveat to the above description of appropriate timeframes for rolling over an unprofitable in-the-money covered call options concerns options linked to stocks that pay dividends, if the short option is held immediately before the ex-dividend date for the declared dividend payment. The holder of a long call option has a financial incentive to exercise the option to buy underlying stock prior to the ex-dividend date so that this trader would become entitled to payment of a declared dividend. To avoid assignment of a covered call option for a dividend-paying stock, an investor should strongly consider buying-to-close a short call option at least two days prior to the ex-dividend date for a dividend payment or at least two-days before the ex-dividend date. The investor then may sell a new longer- or same-dated call option against the underlying stock position on or after the ex-dividend date.
V. Despite any planning to the contrary, any in-the-money covered call option is subject to being assigned and resulting in the underlying stock being called away and liquidated at the agreed-upon strike price
Regardless of prior planning, an investor should always keep in mind that any in-the-money options CAN be assigned at any time before expiration. This assignment can take place for in-the-money covered call options despite the best-laid planning by a covered call investor. This is true whether the covered call option is considered profitable or unprofitable for the investor at the time of assignment. The above Market FIRE investment and trading descriptions are meant to minimize the odds of assignment taking place. The odds can also be reduced through conservative selection of strike prices (resulting in collecting relatively lower options premium) at the start of selling-to-open a covered call position. Nonetheless, an investor should always be prepared for the covered call option to be assigned if the option is in-the-money.
Such assignment, if it occurs, should be relatively rare if the portfolio is diligently managed. If assignment happens, as long as the portfolio is well-diversified, it does not need to constitute any significant setback to the investor’s Market FIRE objectives. After all, with assignment the investor still receives the money to liquidate the underlying stock position at the agreed-upon strike price, which frees up those funds for the purpose of acquiring a new stock position. That new stock position, which can be purchased directly or done indirectly through a cash-secured put option (see below), can either be for stock in the same underlying company or any number of other companies that the investor has determined to be a suitable investment.
Additionally, assignment of a covered call option results in at least the partial consolation of closing the short call position without needing to devote any funds to buying-to-close that short call option. That means that the affected investor who wrote the covered call will be able to keep the entirety of the most recently received options premium without having to pay anything to close the option.
VI. After Buying-To-Close Prior Profitable Options, Consider Strategically Waiting To “Re-Write” Call Option When Underlying Stock is Not Oversold
Buying -to-close profitable covered call options essentially locks-in a significant portion of the premium generated prior to expiration. It also allows the investor the freedom to deal again with the underlying stock. In the instances when the investor has determined that the fundamentals of the underlying stock no longer justify holding the long position in the company, then the underlying stock can be sold. In most instances, it will instead be desirable to “re-write” the call option by selling a new call option against the underlying stock position.
Although an option can be re-written immediately after buying-to-close the prior option, it may only appropriate to do this if it is believed that the underlying stock is only part-way through an extended period of short-term decline. Otherwise, the investor might consider waiting until the price of the underlying stock has increased to at least a moderate extent before re-writing the covered call option for the stock position. A general rule of thumb is to wait until the stock has increased in price on two consecutive days before re-writing the option. If the stock has bounced back and increased by an unusually large amount on one trading day, then that may be a satisfactory time to re-write the call option.
Another approach is to wait until the technical indicators indicate that the stock price is in an upward momentum short-term trend or is even approaching overbought conditions, or at least is far enough removed from oversold conditions. Although not absolutely necessary, the investor may find it helpful to learn more about specific technical indicators, such as RSI (Relative Strength Index), MACD (Moving Average Convergence Divergence), interpretation of stock patterns (such as head and shoulders, double top, and cup and handle formations), and other similar indicators typically used in short-term trading. None of these indicators of course can forecast short-term stock price movements with complete accuracy and all involve some degree of arguable interpretation, but they generally do have an objective historical empirical basis and may to a certain extent be self-fulfilling based on wide reliance by short-term traders.
Whenever an option is re-written under any of the above approaches, the investor should have some degree of confidence that he will receive a reasonably substantial amount of premium for the re-written option and also preferably that the price of the underlying stock will not rapidly surpass whatever strike price is selected.
The strike price and expiration date for a re-written covered call option should generally be selected according to the process set forth in Parts I and II in this section above. An exception occurs under circumstances when (usually for roll-overs) the amount of premium to be earned with a conservative strike price and expiration date is less than the amount paid to buy-to-close the prior option. Because the idea of this covered call strategy is to generate consistent income, the premium generated by the re-write should be AT LEAST the amount paid to buy-to-close the prior option. In that case, the strike price might be somewhat less than the underlying stock market price, but it should be closer to the market price than the prior option’s strike price was from the market price at the time the prior option was written.
VII. Consider Using Excess Cash Position to Write Cash-Secured Puts for Prospective Additional Long Stock Positions.
As covered call premium is consistently generated, and also as some stock positions are occasionally liquidated as part of portfolio rebalancing, the investor may again have a significant excess cash position. While immediately attractive additional investments in new or expanded stock positions of course can be taken advantage of, it may often be advantageous for the investor to hold the substantial additional cash position over a short-to-medium amount of time to consider how best to deploy the cash position. For cash being held, the investor might consider selling cash-secured put options for stocks that he may be interested in acquiring, BOTH as a means of earning a high rate of return on the cash and potentially acquiring new stock positions at a discount to the current market price.
The management process for cash-secured put options for a Market FIRE investor is similar to the process for covered call options, with the important distinction that the investor need not generally take diligent measures to roll-over unprofitable short put options and avoid assignment. This is because the cash-secured puts may be used as a primary means to acquire additional stock at a fair discounted price, with the premium generated as an additional incentive. If the underlying stock price declines and settles below the strike price, then that may trigger assignment and the resulting purchase by the investor of shares in the underlying stock at the designated strike price. On the other hand, if the underlying stock appreciates beyond the strike price and the put option is not assigned, then the investor still benefits by getting to keep the premium initially paid without acquiring the stock. Under this scenario, the investor would then have the ability to sell a new put option on another or the same stock, thereby generating additional cash.
Strike prices can be chosen from prices below the current market price of the stock based in part on the delta values for potential put options. Generally put options with -0.20 to -0.40 delta may be preferred, depending on the investor’s desired level of discount for stock price market price, desired premium amount, and future anticipated short-term stock movement.
Because an investor generally may not like to tie up the cash needed to secure a put for more than one month, he may usually choose to write put options with expiration dates of approximately 30 days in advance, and no more than 45 days in advance. If the underlying stock substantially appreciates, then the put option can be bought back for a small fraction of the initial premium generated so as to free up the secured cash for other efforts, if there is more than approximately one week before expiration. Otherwise, if the option is considered profitable (and not likely to be assigned) until within a week before expiration, then the benefit of buying back the put option may be considered to be minimal and the option can be allowed to expire worthless (barring the slight chance that the underlying stock may have a sudden increase in price above the strike price.)
Under this description of the Market FIRE investing approach, rolling over and down cash-secured put options might not be done as frequently as rolling over and up similar covered call options. However, such a tactic can be used if the market price of the underlying stock has declined more substantially than expected and is significantly below the strike price of the put option. Closer to the expiration date, generally within one week, the same time decay dynamic from covered call options may allow the investor to buy-to-close the short put option and write a new put option with a lower strike price for a similar premium amount. Even if the new rolled-over short put option is ultimately assigned, this practice may allow the investor to still acquire the stock but to do so for a lower price, while still obtaining the cash-generating benefit of the short put option.
VIII. Balance Should Be Maintained To Allow Premium Generated From Writing Options For Use As Income For Regular Living Expenses and Future Planned Expenditures.
With the net premium generated from writing covered call options and cash-secured put options, the Market FIRE investor may well be able to generate sufficient cash regular living expenses, provided the total invested balance is approximately 7 to 10 times estimated annual living expenses. In making investments within the brokerage account, care should be taken to maintain sufficient funds for use within the next two months (or the next six months if a separate emergency fund is not maintained in a different account). Regular living expenses can then be funded by transfers to a separate checking or savings account every one to two months. This time frame may well allow for a sufficient cushion in the event of unfavorable near-term market conditions without unnecessarily tying up an excessive amount of assets that would hinder investment returns.
IX. Long Call or Put Options Should Only Be Bought With Excess Cash If Investor Has Strong Conviction About Likely Short-Term Price Moves and With Amount Limited To Small Speculative Position in Portfolio.
The Stock Market FIRE approach to options trading depends on the more conservative options strategies of covered calls and cash-secured puts. It does not envision the riskier mode of speculating on short-term price movement by trading long call and put options. Trading long options is the most risky type of options trading (along with selling naked calls or puts, which requires trading on margin and is NOT envisioned to any degree by this Market FIRE approach).
While a covered call or cash-secured put strategy can at times go astray, the amount of loss is essentially limited to having stocks called away at below-market prices or having stocks put to the investor at above-market prices. In either of those cases, the strike price was pre-selected and gives the investor a strong measure of control over the course of the trade, as does the ability to roll over options trades that appear to be unprofitable.
On the other hand, for trading long call options, the investor may well lose the entirety of the dollar amount put forward to buy the underlying long options. Because of the leveraged quality of options as trading instruments, the amount used to buy long options indeed can quite rapidly decline to near zero if there is a quick adverse movement in the price of the underlying stock. The likelihood of the value of the long option going to or near zero is far greater than for an underlying stock position that, short of bankruptcy or other similar extreme circumstances, has the theoretical prospect of recovery from even a steep downward move. Furthermore, any quick downward movement of long options can also make rolling-over such options an unrealistic proposition, because the only type of new long options available to purchase for the minimal remaining amount of the premium received from the older option to be closed may have a wildly off-base strike price and/or expiration date.
Nonetheless, there are some limited circumstances in which even a Market FIRE investor may want to trade in long stock options for strategies unrelated to covered calls or cash-secured puts. In rare cases in which the investor has a strong conviction about a short-term price movement about only one or a few underlying stocks, then trading long options positions may be profitable. It is not appropriate that anything more than a small (less than 10%) part of an investment portfolio that is earmarked for speculative investments be applied in this fashion.
For more-advanced investors, using long call or put options as part of a credit or debit spread may also sometimes be appropriate. This may especially be appropriate if a covered call has been, or has a strong chance of becoming, unprofitable by itself because of a rapidly appreciated underlying stock price that is anticipated to continue appreciating. In such circumstances the additional funds that could be generated from the long portion of a credit or debit spread may mitigate the situation with the covered call and allow that covered call to be rolled up to a higher strike price than would otherwise be feasible based solely on time decay, through use of the gains from the long option portion of the spread.
Nonetheless, because of the inherent riskiness of trading long call and put options, the Market FIRE approach to investing does not require or even contemplate such trading, which therefore will not generally be discussed on this site.
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