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How To Avoid the Option Premium Trap

Many investors get too excited while seeing the high potential return based on high premiums.  There is always a reason that a call premium is higher than normal.  It may be a fad stock, potential takeover target or expecting some news release that may affect stock price.  The time premium on these stocks is big making them tempting to write.  It is best to pass up these volatile stocks for more stable and fundamental stocks.  In call writing, your gains are topped but loses are not limited to just the net proceeds of the trade.

There is no option premium large enough to protect you from a big downside break.  When you hear stories of investors being wiped out in writing calls, it is usually because they were writing for fat premiums.  The basic rule is to stick to stable stocks that you would feel comfortable at the net price paid for the optionable stock.

The exchanges are filled with potential stocks to write calls on.  The best way to find candidates is through a process of elimination.  For example, start with a list of stocks ranked 5 stars by S&P.  Then eliminate those with a high volatility such as 50% or higher.  Then determine which stocks you want to own to sell calls on the stock.  Then you can diversify the stocks you select from different sectors and industries for more safety.

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