Buy-Write
July 29, 2004
The Smart Profits Report: Issue #130
Thursday, July 29, 2004
Buy-Write: Predict Your Profits With 99.7% Accuracy
By Karim Rahemtulla
Investment Director, Mt. Vernon Research
One of the most rewarding options strategies for me has always been covered calls - writing an option against a stock you already own to, essentially, buy the stock at a discount (the premium you receive from selling the call subtracted from the stock’s price). But this strategy can be difficult to execute in real life. Why?
Well, because trying to get filled on your stock order AND your option order - both at your target prices - is nearly impossible. Impossible, that is, unless you understand the art of a little-known technique called a “buy-write.”
By learning how to use this simple, powerful options tool, you can ensure that you either:
- Get into each trade at the prices you want, and thus secure optimum profits from each trade
- Don’t get into the trade at all, and thus ensure that your trading capital is reserved so you can “fight another day.”
Let me explain…
Sphere: Related ContentCovered Calls and Put Options
July 26, 2004
The Smart Profits Report: Issue #129
Monday, July 26th, 2004
Covered Calls and Put Options: How to Grow Your Equity By Going Naked
By Karim Rahemtulla
Investment Director, Mt. Vernon Research
When I speak on covered call writing, someone from the audience will often chime in and ask about “the difference between writing covered calls and put options selling.”
Is it the same thing as covered call writing?
Yes and no. There are distinct differences, advantages and disadvantages to both. But to understand how selling put options works, let’s quickly revisit covered calls…
Covered Call Writing, Puts and IBM…
As I mentioned in a previous Smart Profits Report, covered call writing entails buying shares of a company and selling an option against those shares, effectively reducing cost by the amount you are paid for the option you sell.
The covered call investing strategy is best for those who believe that the upside potential of the shares is limited, or when a disciplined approach to investing dictates that the shares will be sold once a preset target price is reached.
Selling puts works like this: Say you like the shares of IBM, which are currently at $92. You think the stock is worth that and more, but the stock seems likely to fall. Instead of buying the shares at $92 and selling a $95 call option against your position, as we would have with a covered call, this time you don’t buy the shares at all…
You SELL a $90 put option, naked (meaning you don’t own the underlying shares). The premium on this put, for the sake of this example, is $2.50. Immediately, you receive $2.50 per share in your account to use as you please - free money, for now.
So You’ve Pocketed a Nice Sum… But the Trade’s Not Over
But you still have an obligation lingering. If IBM closes above $90, the money is yours, free and clear. Nobody is going to “put” the stock to you at $90 if it’s worth more on the open market.
But if IBM closes BELOW $90, then you are OBLIGATED to buy IBM shares at $90. This is called “getting put.” The only way out is to buy back the put.
In fact, when you sell naked puts, you’ll be making money even if the shares drop a bit. As long as IBM’s price is above $87.50 ($90 strike minus the $2.50 premium), you are profitable. But, if the shares close below $87.50, then you are losing money. So, in a sense you are betting the shares will stay above $87.50 until expiration.
This is a very popular strategy for many investors because it does not require you to own the shares, so you don’t have all that money at risk. You are required, however, to have enough money in your margin account to buy the shares in the event you are “put.”
How to Avoid a Serious Investing “Put” Fall
Getting put is not pleasant, unless you REALLY want to own the shares. Imagine waking up one day and hearing that IBM shares have fallen by 20%, to $75, because of a scandal or bad earnings. If the shares do not recover and the option expires, you must either buy the shares at $90 or buy back the option that you sold - a big loss in either case.
Now, I have nothing against put selling. In fact, I think it is an excellent strategy if you are disciplined, have the money and are genuinely interested in owning the shares at your strike price.
But that’s not the case with most investors. While selling puts is as conservative as covered call writing “selling” - in theory - either strategy can be misused. And this one usually is.
Gambling, Greed and Abusing Your Put Power
Instead of evaluating a stock realistically, traders sometimes look at put selling as “free” money, betting that the price of the company’s shares will not fall below their strike price. Instead of having the money or the investment base to sustain a major hit, they’re just trying to make a quick buck.
That’s gambling, and it’s a recipe for disaster - especially true with a volatile stock like Yahoo! or Amazon. With companies like those, the put premium is huge - reflecting the underlying volatility in price. That huge premium is a lure for many investors. And why not? There is a ton of money to be made… unless the shares really tank.
But this is exactly the kind of greed that gives selling naked puts a bad reputation.
The major advantage of selling puts is being able to pursue a conservative strategy with less money.
The major disadvantages are:
- You cannot sell puts in your retirement account.
- You do not receive dividends, because you don’t own the shares.
The first disadvantage is the most important. I like covered call writing because the gains from the trades are tax-deferred, since I can trade them in my retirement account. This is a key differentiator between a covered call investing strategy and selling puts.
A Great Way to Build Equity for Small Investors
Still, put selling is a powerful tool. It is one of the most conservative options trading strategies, if executed properly.
If you are just starting out and have a smaller portfolio, it is an effective way to build up equity. But you must have the same discipline as a trader using any other system. You must have a stop loss in place, you must position size and you must do your homework about the investment.
Good Trading,
Karim Rahemtulla
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Today’s Smart Profits Cribsheet
- Check out our Smart Profits Glossary for detailed explanations of options-trading terms such as “covered calls” and “naked options.”
Related Articles:
- Position Sizing: The Most Powerful Investment Concept in the World
- How Much to Invest In Each Option Trade
- Limit Orders vs. Naked Puts: Getting Paid to Place Them On Your Favorite Stock
Writing Covered Calls
July 23, 2004
The Smart Profits Report: Issue #128
Thursday, July 23, 2004
Writing Covered Calls: How to Double Your Profits with Stock Options
By Karim Rahemtulla
Investment Director, Mt. Vernon Research
Writing covered calls is one of my favorite options techniques. At any given time, I’ll have more than 60% of my portfolio “covered” for one simple reason: I’m conservative.
I believe in mitigating as much risk as possible when I am investing in anything. Here, I want to show you how writing covered calls do just that.
Oh, and did I mention they’ll increase your profits, too?
How to Get “Premium Income”… By Renting Out Your Stocks
A covered call combines two instruments: an option and a stock.
It works like this: You buy shares of a company like Coca Cola at, let’s say, $50. You think Coke will go no higher than $55 in the next 12 months. If it goes higher, you will sell since that is your target price.
So far, that’s just normal investing. Well, if you can handle that, then why not make MORE money than just the $5 that you projected to make?
To do this you would WRITE (or sell) a $55 call option against your Coke position. You can sell one option for every 100 shares of stock you own. When you write a covered call, you will be obligated to deliver the shares if requested. That may or may not happen. Nonetheless, you will be sure to receive something for the option you sold. It’s called a premium. And it can amount to a good deal of money.
One way to view this premium is as rental income on your stock. You get the “rent” the minute you sell the option.
The transaction you entered - when you sold your call and collected your premium - has one consequence you have to find acceptable. It limits your upside gain on the stock to $55, since that is the strike price at which you’re obligated to sell your shares.
Writing Covered Calls - The Safest Way to Buy Stocks at a Discount…
That’s the way I see it. Writing covered calls is one of the best ways to make steady, conservative gains. Why should you care if the strike price is hit and the option buyer calls away your shares? You’ve already made the disciplined decision to sell at $55. So you’ll have all the profit you originally wanted from the stock… and more. (The premium you would receive in this case would be around $1.50.)
You can look at this as additional gains. I prefer to think of the money I collect writing covered calls as a way to reduce the cost of my stock. It goes like this:
The Coke stock costs $50. Your $1.50 option premium reduces your cost in Coke to $48.50. If the shares hit the strike price, your upside is now $6.50 (the $55 strike price minus $48.50, your base price per share) versus the mere $5 ($55 strike minus $50, the stock cost to you without an option).
You can see the difference. Buying Coke at $50 and selling at $55 is a nice 10% profit. When writing a covered call for another $1.50, it becomes a 13% profit… and that’s a very conservative example.
By writing the covered call you have accomplished two things:
- Reduced your cost
- Increased your upside.
All the while your target price has not changed.
If Coke closes below $55 at expiration, you keep your shares as well as the premium you received. If Coke trades above $55, then you’re obliged to sell at $55. This transaction (the sell at $55) will be done automatically by your broker.
Multiple Profits on the Same Stock
While the example I just gave obliged you to sell at the $55 level, there are ways to continue to build on your profits or to get out of the position early and profit again.
Let’s say that Coke was trading at $54 a month from expiration. At this point, it looks like the stock is going to go to $55 or more by expiration. You have two choices:
- You can surrender the shares when they’re called away, as in the example above.
- You can buy back your option so that you’ll be able to keep your shares and do it all over again.
Why would buying an option you previously sold make sense? After all, you decided you’d be fine with selling the shares at $55.
Well, here’s where an option seller takes advantage of time. When there’s only a month left on the option, you could now buy back your $55 call option on the cheap - for about 50 cents, this close to expiration. Then, you write another covered call going out another six to 12 months with the same $55 strike price.
Since the current share price is $54, you would pick up about $3 in premium for a 12-month option this time. (The closer the current market price of the stock is to the option strike price, the more valuable the option.)
Doing The Math When Writing Covered Calls
Now your adjusted cost per share would be:
- $48.50
- + $0.50 (cost to buy back the option)
- - $3.00 (premium received from selling the new option)
- = $46.00 (your cost per share of Coke)…
So, you’d be paying and your upside would still be capped at $55. Now, instead of a 10% profit on owning the shares alone, you would make a 19% profit after selling calls twice before surrendering the shares at $55.
This type of strategy is especially effective on stocks that trade in a very narrow range or in a flat market environment.
Oh, and you may be wondering… Who is buying those options that you are writing? It’s the gambler who thinks Coke will go higher than $56.50 at expiration. His cost of owning Coke is $55 plus $1.50 (the amount he paid you for the right to buy your coke shares at $55).
I’m betting you’ll come out ahead on the deal…
Good trading,
Karim Rahemtulla
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Today’s Smart Profits Cribsheet
- Check out our Smart Profits Report Glossary for detailed explanations of options-trading terms such as “covered call” and “premium”.
- To check out more information on covered call options, visit Mt. Vernon Research and view “The Income Trader - A Covered Call Strategy.”
Related Articles:
- Covered Calls and Puts: How to Grow Your Equity By Going Naked
- Deep-In-The-Money Covered Calls: How to Beat Stocks with Less Risk
- American Options, European Options & Synthetic Options: Threefold Profit Potential
Trading LEAPS
July 20, 2004
The Smart Profits Report: Issue #127
Tuesday, July 20, 2004
Trading LEAPS: How to Get 1,100% Returns from Your IRA
By Karim Rahemtulla
Investment Director, Mt. Vernon Research
Until about a year ago, the only type of option that you could trade in your self-directed retirement account (your IRA, for example) was a covered call - an option sold against a stock you already own. And that made perfect sense. Covered calls are among the most conservative, consistently lucrative option strategies. In my own experience, these plays - which use both leverage and hedging - are profitable about 80% of the time. So covered calls and safe cash have always gone hand in hand.
But what if you could trade any type of option in your IRA account? What if you could, say, double the average returns in your IRA in the next 12 months? Most of the investment world hasn’t yet caught on (and maybe that’s a good thing - see below), but with last year’s changes to the IRS codes, you can now trade virtually any option from your IRA account. And that includes trading LEAPS options such as the Lockheed Martin play that produced a 1,100% return for my readers last year…
However, before you rush out and drop your retirement savings on a non-covered option play, a few words of warning…
Trading LEAPS & Your IRA: Would Any Sane Investor Do It?
The rationale for trading high-risk options in your IRA account is not hard to understand - to a point.
After all, if you can use your IRA account to buy common shares in a two-room AIDS vaccine company… or a fuel-cell company… or even a junior mining stock on the Toronto exchange… then why can’t you put your butt on the line buying naked options, as well?
The risk is about the same, except your options losses will look like a quick kill compared to the long, drawn-out torture (say, a week’s worth) of losing money in a penny stock or a speculative biotech.
So, sure… It is now possible to trade LEAPS and even naked options through your IRA using a reputable broker. But would you really want to?
For me, the answer is no. I’d prefer to let my IRA perform the unglamorous task of providing me with safe, steady returns. For the higher-risk stuff, I’ll use money I can safely afford to lose… not money that will hopefully be standing between me and manual labor once I retire. (Although I would - and do - trade covered calls from my “safe” accounts.)
If You’re Going to Risk It, Have a System
However, each investor has his own risk-tolerance for different parts of his portfolio. So if you do decide to trade options with a small portion of your IRA - for whatever reason - by all means use a system.
By that I mean: a system that imposes discipline and elevates your trading above the level of gambling or “playing the hunches.”
If you do have a system that’s worked in the past, and you use it in your IRA, you might save your retirement account from decimation. Or, you could even boost your IRA returns by an obscene amount this year - through trades with payoffs as high as 1,100%.
Good Trading,
Karim Rahemtulla
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Today’s Smart Profits Crib Sheet
- Check out our Smart Profits Glossary for detailed explanations of options-trading terms such as “naked options” and “LEAPS.”
- Above I mention the importance of trading with a system… To check out two proven systems for low-risk options trading, visit www.mtvernonpublishing.com and view “The LEAPS Option Trader” and “The Income Trader - A Covered Call Strategy.”
Related Articles:
- Stock Option LEAPS: Buying LEAPS Or Stocks… What Should You Do?
- Position Sizing: The Most Powerful Investment Concept in the World
- Smart Profits Trading: Four Critical Truths
LEAPS Options
July 14, 2004
The Smart Profits Report: Issue #125
Wednesday, July 14, 2004
LEAPS Options: Making 30% While Others Make 3% On the SAME Stock
By Karim Rahemtulla
Investment Director, Mt. Vernon Research
In my opinion, anybody would be nuts not to trade LEAPS options as proxies for stocks when these unique options are available.
- LEAPS options - Long-term Equity AnticiPation Securities - are options that expire a year or more from your date of purchase.
- LEAPS options cost you 10 to 15% of the underlying share price and give you just as much chance to profit - even more of a chance, on a percentage basis. Plus, they limit your potential loss.
Too Much Money At Risk? Use LEAPS Options
Unless you are planning on holding the shares for more than a year or two, I believe you are putting too much money at risk in the current market buying large blocks of shares.
Why spend $50,000 on 1,000 shares of Merck when you can buy LEAPS options at the same strike price and control just as many shares for two years - for a mere $6,000?
Worst case: Even with a 25% stop loss on the shares, you’d lose more than twice as much on the stock if it went the wrong way and hit your stop loss. If you think Merck will return you 30% or more in two years, then LEAPS options are your best bet.
Now for another twist on the LEAPS story… One that’ll surely help you to increased options profits in coming days…
Scoring Without “Going All the Way”
The S&P stock index has gone up only 21% in two years, and practically nothing in the last six months. But you have a much better chance of making gains in this market with LEAPS.
If you think your stock is going up 30%, that’s a pretty ambitious move in a market like this.
But your stock doesn’t even have to reach your target 30% gain to make you that much and more with LEAPS options. You only need the share price to move in the right direction for a few days or weeks to clean up.
Let me give you a couple of examples…
Some Real-Life Examples of LEAPS Options as Proxies
A few months ago, through my LEAPS service, we bought LEAPS options as proxies on General Electric. The shares were at $30 and we bought the $32.50 LEAPS. Within three days, the shares moved to $30.90 - a whopping 3%.
However, we cashed out of our LEAPS options for a 30% gain in three days.
Why did the LEAPS move up so much with such a small move in the share price? The answer lies in the time-value component of the options-pricing model.
It goes something like this: If the stock can move up 3% in three days, it can keep climbing at that pace for a couple of weeks. And if it does, it could rise to, say, $33 or $34, and the LEAPS options would then be worth more.
That’s because the market, if it senses such a surge in the stock price, re-prices the option accordingly. Thus, the more time left until the option expires, the more it will cost… and the more you will get for it when you sell.
Not An Isolated LEAP Of Faith
A few weeks later, we did the same thing with a defense stock. The underlying shares moved up about 4%, and we made 36% in less than a week.
In both cases, the shares did not even approach the strike price on our LEAPS options, yet the options made us a ton of money.
My point is: When you use the right type of option and the right system, you can dwarf the returns from the stock market well before the stock reaches your target.
Good Trading,
Karim Rahemtulla
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Today’s Smart Profits Crib Sheet
- Today we talked a good deal about LEAPS options. For more on this strategy, check out Smart Profits #177, LEAP Options: The Intel Bargain & A Potential 566% Return.
- Check out the Smart Profits Glossary for detailed explanations of options-trading terms such as “LEAPS,” “strike price,” and “time value,” found in today’s article.
Related Articles:
- LEAPS Call Option: How to “Swap” LEAPS Call Options For 300% Returns
- LEAP Option Investing: The Best Options Play on eBay
- Option Losses: How to Grow Rich From Your Options Losses
Option Trade Execution
July 1, 2004
The Smart Profits Report: Issue #123
Thursday, July 01, 2004
Option Trade Execution: Two Simple Steps for Getting Filled At Your Price
By Karim Rahemtulla
Investment Director, Mt. Vernon Research
There is nothing that bothers me more about electronic brokers than their poor option trade execution.
When I first began trading options I used a full-service broker. At the time, the cutting-edge technological advancement in this country was the touch-tone telephone.
There were only three exchanges that traded options and everything was priced in eighths and quarters.
Fast-forward to today… I now use both full-service and electronic brokers. For the purposes of this rant I am going to talk only about electronic discount brokers. Specifically, I’m going to talk about how they can route your trade to go against you - and how you can fight back using two simple steps…
Why Hatchets and Options Don’t Mix
I remember placing a sizeable covered call trade three years ago. I bought the stock first (you must do this in your retirement account - unless you do a “buy/write”).
Then I placed an order to sell the corresponding number of options. Well, the stock trade executed in seconds. The option trade, however, was not executed in a timely fashion. In fact, it was a complete hatchet job on the part of my broker.
I placed a limit order to sell the options based on the best bid, which was on Exchange A. (You have to remember that once you buy the shares on a covered call, you must sell the options pretty quickly in order to get your stated return. Any delay, and the trade could go against you. The share price could move lower and the option price may follow, reducing the amount of premium taken in.)
To my surprise, the order I placed showed up on Exchange B as the offer price. Imagine that! A bid and offer of the same amount!
In truth, an order to sell an option CAN appear as on offer, since I am putting up the options for sale. What should have happened is that my order should have smacked the bid on Exchange A - end of story.
A few minutes later, I called a live broker and asked him for a status report. He said - this is the technical term - “nothing done.” I proceeded to tell him that I was looking at the same screen that he was looking at and that my order should have been filled by Exchange A because it was bidding the same as I was offering. He said that he would check…
I waited.
How a Broker Can Route Your Trade Execution to His Advantage
While I was on hold, the bid on Exchange A fell by a nickel. Now, I would get at least 5 cents less on the sale - about 2% based on the transaction. I was not livid yet, but I was getting there.
He came back on the phone and said that my order was no longer at the bid. Well… No kidding!
I asked him why the order did not automatically go to the best exchange. And then it slipped out. His company automatically routed the executed trade to an exchange that it preferred.
Why did it prefer that particular exchange? One word: payola. The exchange was paying my brokerage a certain sum to have trades routed in its direction.
Well, needless to say I made the broker pull a time log that showed the time I placed the order and what all the exchanges were showing as bids and offers at the time.
And there it was in black and white: Exchange A was showing the same bid as my order. I was then filled by the broker even though the price had moved.
Two Steps to Avoiding Broker/Exchange Shenanigans
Ok. So what can you do to avoid or combat a similar situation?
- Use a full-service broker or the live broker at the discount firm and spend the extra five bucks to direct the trade to a specific exchange. If your broker won’t direct the order, then fire him - don’t hit the computer!
- Ask for an investigation into the transaction log. They might dissuade you by telling you it will cost $25 to do it or that they will check on it later. Insist on it and speak to a supervisor - their calls are taped and you should take notes with names and times. You will win.
Today, I make sure that I get my price either by making the broker very edgy by staying on the line until I am filled, or by using a specific strategy for covered call writing called a buy/write, which requires simultaneous execution at my limit prices.
More about this strategy another time. For now, be sure that your broker is on your side before you place an order. And don’t be shy about watching him like a hawk… It’s your money on the line, after all.
Good Trading,
Karim Rahemtulla
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Today’s Smart Profits Crib Sheet
- For definitions of terms like “buy-write“,”leverage” or “covered calls,” see the Smart Profits Glossary.
Related Articles:
- Buy-Write: Predict Your Profits With 99.7% Accuracy
- Limit Order Diligence - How to Limit Your “Excitement” for Winning Trades
- Become a Better Trader: Small Changes You Can Make for Big Profits
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