Mark
I've been 80% successful in writing put options even thought I will limit it in the future because the math does not support it very well. My question is on setting exit points vs. gaps. With the poor quality of CEOs and a casino element in the investor mix, how in the options writing (covered call and cash secured puts) business can you be profitable if 1 out of 5 trades gap down 20-60%. Premiums for the other options may avg 5% * 4 = 20%.  Picking the right stocks cannot take into account CEOs mistakes or lies (no one knows....well Martha Stewart did). I would like to know how you would set up a business plan in options trading to account for this factor.
Thank you.
Doug

Hello Doug,

Excellent question.  Let me preface my reply with some comments:
First, these two strategies (covered calls and cash secured put selling)are bullish strategies, and every investor in the stock market has that same worry about owning stocks that gap down.  At least investors who adopt these strategies have reduced risk, compared with those who do not.

Second: One good way to reduce exposure to owning bad stocks is to diversify, and that can be accomplished by owning a mix of exchange traded funds (ETFs).  Then you can use your favorite covered call writing strategy on many of those funds. (Create Your Own Hedge Fund is a book I wrote that discusses this idea in detail.)

But to me, the single best way to minimize the fear of owning stocks that might gap down is to buy insurance.  That means selling put spreads, rather than simply selling puts.  For example, if you want to write puts with a strike price of 60, you can protect yourself by buying the 55 put.  Yes, this cuts into your potential profit, but it does two good things for you.  First it affords absolute protection.  The most you can lose on the spread is the difference between the strikes ($500 in this example), minus the option premium you collect.  Second, the margin requirement to hold this position is significantly less than it is to hold the cash secured put (except in retirement accounts).

I know it may be difficult to plunk down the cash to buy puts that are so far out of the money, but insurance is always expensive.  If you do decide to sell spreads rather than puts alone, the good news is that you will be able to continue using your option premium selling strategy and your major worry will be severely reduced.

By the way, if 20% of your stocks are making significant gaps down, you are trading stocks that are way too risky.  Consider aiming for smaller option premiums and safer stocks.

Mark