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Beware of Too Much of a Good Thing

In previous articles, here and here, I discussed ways an investor could produce some extra income by writing options. As the market goes through its ups and downs, when managed properly, an option-writing strategy can be a low-risk way to boost a portfolio’s return.

However, sometimes too much of a good thing can be a bad thing. Investors should be careful not to write too many options at once.

Let’s say you sell a few options and the underlying stock prices move in your favor, you will probably feel joy because chances are good that the options will expire worthless. You may feel tempted to sell more options so you can collect more premiums, but you could end up with too many option positions at once relative to your account size.

This would significantly increase the risk profile of your account.

Although most options will expire worthless so as an option seller your probability of success is high, there are no guarantees when it comes to trading and investing. If the market moves against you, most (or even all) of the options you have written could move into the money. You could find yourself scrambling to unwind many positions or coming up with the cash to cover the positions.

If one option moved into the money against you, it likely won’t be a big deal, but if 10 options moved against you at once, that will probably cause problems.

In the case of put writing, for as long as the short position is open, the broker will usually lock up enough cash reserve to cover the position in the event the put is exercised. (This can vary by broker and type of account.) Again, if you only write a few puts at once, this likely won’t be a big deal, since you may want to keep a certain percentage of your account in cash anyway. But, if you had many puts open at once, then that would require a lot in reserves.

If you write more puts than your cash position can cover, the broker will force you to sell something to raise cash and you could end up making trades you don’t want to make.

One way to reduce the chance of an option exercising is to sell options that are quite out of the money. The premiums you collect may be smaller than if you picked an option that’s closer to the money, but you reduce the risk of an option exercise. When you write options to generate extra income, every worthless expiration is a success.

The key is to continue to collect premiums and avoid big mistakes.

At the end of the day, like with most investing strategies, writing options will work best if you understand your goal and risk tolerance and stick to a plan. It’s important not to get too greedy and take on too much risk. Even a low-risk strategy like option writing could backfire without risk control.

Editor’s Note: My colleague Jim Fink has developed a system of generating of steady income from options. Click here to find out more.

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