2- Why You Should Care

Let Me Sell You on Options

Learning how to trade stock options? Selling covered calls to make money by portfolio overwriting? Why would I want to do that? Sounds exhausting.

Selling Covered Calls Makes You Money.

I guess I’ll open with the biggest selling point– covered calls make you money.

More interestingly, selling covered calls makes you money in a flat market (!). If you own shares of anything and aren’t excited about this prospect, I’m not sure you’re technically alive.

In fact, the covered call seller does best in situations with no appreciation or a small amount of appreciation over time. The covered call seller also outperforms the buy-and-hold investor if the
price of the shares the call was sold against declines. The simple reason is that the covered call seller has made a premium that the buy-and-hold investor hasn’t, and if the price of the underlying
stays below the strike price of the call contract, the covered call seller has not incurred upside risk¹ and will not have to sell their shares.²

Selling Calls Provides Immediate Liquidity

The money that selling a covered call gets you is also deposited directly into your account, immediately. This liquid cash is fundamentally different from share price appreciation; until you sell your shares, profits are never locked in, and their value could decline to zero. Contrast that with actual funds you can use to buy and sell, or transfer to your checking account.³

For this reason, the cash you receive when selling a covered call can be considered a form of income, and some investors sell calls monthly and treat it that way. There are even ETFs that sell
covered calls to generate monthly “dividends” for you . This book aims to teach you how to do the same thing yourself and avoid the fund management fees!⁴

Options Are A Tool You Should Have In Your Toolbox.

I consider a basic knowledge of single-leg⁵ options an invaluable tool for anyone’s investing, even for mostly passive traders. If you understand how a call works, and then you figure out how puts⁶ work, every other option trading strategy is just a combination of the two! Even better, a call is just the opposite of a put, so learning one gives you a fundamental intuition for the other.

Not knowing how options work seems almost irresponsible to me if you are an active investor (or an investor, period). Trading stocks without trading options is like playing a sport and not knowing how to lift weights. You might have all the talent and practice in the world, but you could probably be better if you added some explosiveness, strength, or endurance to your game. 

Options Offer More Control.

I cover this again in later chapters about emotional investing, but I have to touch on it here. Trading options, to me, is a lot more enjoyable than just buying stocks and hoping they go up. Because of the myriad of ways you can set up an options trade, you have a lot more control over what happens with your trading, and can buy and sell options that make money when a stock goes up, down⁷ , or sideways.

To me, this feels much better than just buying a stock and hoping it goes up, hoping you bought it at the right time, and then wondering when you should sell. Options let you make moves and dance around your positions instead of passively observing.⁸

Investing in the market can be like swimming in rough seas. When things look choppy, knowing how to surf changes the game. You can see what’s coming, catch your breath, time it and paddle in, and try to go with the waves rather than be thrown by the currents. Options can be the board that helps you ride the wave.⁹

“Options Are Too Risky” Is Flat Wrong.

“Options are risky” is a wildly misinformed statement. I cringe when I hear it.

Some types of options are very risky- covered calls are not.¹⁰

Fact: Selling covered calls has less downside risk than owning a stock or index. This is simply because the premium you are paid when you sell a call offsets a loss of share price of the same
amount. Compared to buy and hold, you will have always “made” the premium in returns.

Additional Fact: There is more upside risk, which is a form of lost profits (i.e., missing out on gains you could have had), and I cover this thoroughly. In fact, I believe my biggest responsibility is
showing you the risk, because I myself have read and own A LOT¹¹ of books about options trading and too many of them present an overly rosy view of the endeavor, which leads to over-optimism and eventual letdowns.¹²

Other options strategies are risky, but most, including portfolio overwriting as described in this text, have an explicit and known risk at the outset. If you buy a put, you make money if the stock
goes down, but never lose more than the price of the put you purchased. Compare that to shorting¹³, where if the stock you shorted goes to the moon, you might have to take out a second mortgage on your home in order to pay your broker when you get margin called.

Your Money Makes Money in Real Time

Understanding delayed gratification is one of the major struggles we face as an intelligent animal. Pop psychology has the famous ”marshmallow test”, and we know from FIRE that frugality now
leads to outsized rewards later. Although this is easy to understand abstractly, it’s hard to really internalize the benefits that years of self-control will have far, far in the future. But when you sell a call, money is deposited into your account right away, and it can be a game-changing motivator for people who aren’t as easily swayed by the promise of a better tomorrow in exchange for restraint today.

Finally, Learning = Good

Learning keeps your mind limber, and if you’re interested in a topic and it’s your choice to learn it, learning isn’t hard at all. As a FIRE investor, I’m assuming you have the same motivation and desire to think outside the box as the rest of the community, which is more than enough of the moxie required to grock¹⁴ covered calls. Also, the only math you need to know in order to understand and sell covered calls at the retail level is arithmetic.

Above is a graphical representation of the risk vs the reward of reading this book and learning portfolio overwriting. Spoiler alert: it’s roughly the same as a long call risk-reward graph.¹⁵

Hopefully I made a good argument for continuing on this series. Assuming I motivated you to move on, let’s lay out a roadmap so you know what’s in store.

Next- Article 3: The Outline

Previous- Article 1: An Example, to Start

1. The buy and hold investor would outperform the call seller once the price of the underlying security rises past the strike plus the amount of premium the call seller received. [↩]
2. If the price of shares is above the strike price of the call the day the contract expires, it will automatically be exercised, meaning your shares will be sold to whatever anonymous counterparty owns the call you sold. Buyers of call contracts who do not wish to buy shares are not “presented with the option to exercise on expiration Friday- instead they would simply sell-to-close their contract if they did not want to have it automatically execute and buy shares at the strike price. [↩]
3. To be clear, selling an option creates a short position in your account equal to the premium you receive, so it’s not entirely magical money from nowhere, but it does increase your cash balance immediately. The call you sell is considered short because you have created an obligation in your account you
   must fulfill in the future if the contract is exercised, namely providing shares at a certain price. For the covered call seller, this is not a risky proposition, as you are “covered” and own the shares that you may have to provide. For someone selling a “naked” call (where they don’t own shares), it is a risky proposition indeed, as they must in the future buy shares on the open market to fulfill the naked call contract if the price rises above the strike, no matter how high it rises. I do not practice, advocate, or describe this type of trading, which presents a theoretically unlimited risk. [↩]
4. “Expense ratio” is a four-letter word. [↩]
5. The options available to a retail investor are the call and the put, and you can trade one or many options at once, up to four per position. Buying or
   selling just a call or a put is considered a “single-leg” strategy. Trading many options at once to create a complex position is called a “multi-leg” strategy. [↩]
6. A put is the right to sell someone a stock at a specified price. You can buy the right to “put” stock to someone or sell the right to have stock “put” to you. Conversely, a call is the right to ”call” stock from someone. When you sell calls (the topic of this tome) you are selling someone the right to “call” a stock from you. A call buyer, by extension, owns the right to “call” stock from someone else. [↩]
7. As mentioned, covered calls actually make money when the price of an underlying security decreases, and it’s frankly quite nice seeing some green on a red day. [↩]
8. Selling covered calls can be as time consuming as you want it to be. Selling a call at the beginning of the month takes less than a minute on most brokerage apps, and you can simply let it run to expiry knowing your initial profit and loss risk. You can also spend lots of time attempting to squeeze out extra profits by buying back your calls and selling new ones if you so desire, the how-to of which (called position management) is covered in a major portion of this book. Chapter 42 is a parable of 3 investors, featuring more detail on the different types of investors and style of portfolio overwriting and corresponding time commitment that is best for them. [↩]
9. Cowabunga.
   I was really torn about including a surfing metaphor, yet here we are. It’s actually quite an apt analogy, because standing in the surf and trying to predict the characteristics of the next ten waves that will hit you is on par with the level of difficulty of predicting (random) price movements in the market. [↩]
10. Traditionally, covered calls were the first type of options any retail account would be approved for, and investors would only be able to trade more complicated and risky options once they had traded covered calls for some duration. At the time of writing this, however, many new app-based brokerages have an online options application form that allows people to state that they have any level of experience without any burden of verification, and immediately begin trading very risky options with little or no actual prior experience. [↩]
11. At this point, I have compiled what could be considered a small library on the topic of options trading. [↩]
12. Because I’m not trying to sell any subscriptions to investing services, I am in the unique position where I can genuinely present the risks and downsides,
    and not have to market myself as a guru with any extra secret knowledge you’ll need to pay for. Everything I know is in this book, which is intended to be a standalone guide to selling covered calls. [↩]
13. When you own a security (stock or option) it is referred to as being “long”. A position in your account that you do not own is referred to as “short”. This is a very confusing concept initially. In the case where you ”short” stock, you borrow shares from a brokerage at the current price to create your “short” position. If shares decline in price, you can buy them at a lower price to fulfill your “short” position, and you make the difference between the price you borrowed them for and the (now lower) price you paid to fulfill your short position. If the price of the stock goes to a million dollars a share, you still have to buy those shares on the open market to fulfill your short position at some point, which is why “shorting” has theoretically unlimited risk. I say theoretically because share price doesn’t usually go to infinity. When you sell a covered call, the option is short in your account, but your short call is “covered” because you own the shares and can deliver them at any time. Unless you are approved for margin and higher levels of option trading, your broker will not allow you to make an unlimited risk trade. Sidenote- I do not trade on margin or make unlimited risk trades, ever. [↩]
14. Meaning to understand intuitively, grock (alternate spelling: grok) is one of my favorite words, coined by author Martin Heinlein in the 1961 novel Stranger in a Strange Land. Primarily it has found use as part of the hippie lexicon. [↩]
15. A long call (or “being long a call”) is when you own the call. This book primarily focuses on when you sell a covered call, which would be referred to as being “short” a call.
    Profit and loss (aka P&L) graphs like this are a great tool for understanding how much money you stand to lose or make when you enter an options trade based on the price at expiration, and will be used and will appear one more time in chapter 23 to help visualize ”upside breakeven.” Although we don’t use them much for portfolio overwriting, they are invaluable for understanding more complex strategies, as they can visually represent the combination of two or more different profit and loss trades, combined into one. [↩]