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Trading Deep-In-The-Money Covered Calls

October 27, 2004

The Smart Profits Report: Issue #155
Wednesday, October 27, 2004

Trading Deep-In-The-Money Covered Calls: Dividend Paying Stocks That Can Boost Income
by Karim Rahemtulla
Investment Director, Mt. Vernon Research

One of my most satisfying trades is when I can pull a fast one on the market.

My favorite options trading strategy is trading deep-in-the-money covered calls. In fact, I like it so much I even have a trading service dedicated to it.

Ordinarily, when I trade a covered call, I buy the stock and sell a call against it. This is usually done deep-in-the-money so that I can manage my downside in case the market or the stock heads south.

These days that happens more often than not. Still, I manage to rack up wins more than 70% of the time.

But every once in a while I intentionally take the market for a ride by using my strategy on high dividend paying stocks.

Today, I am going to let you in on a little secret that very few people know about - and I’ll show you how I recently used it to increase my income returns by 143%. Let me explain…

Boosting Income From 8% to 20% - With One Easy Trade

Earlier this year, I knew that General Electric was a good company, but I was not comfortable owning it at current prices. So after doing some research, I found that GE had plenty of attractive deep-in-the-money options to choose from. (The prices I’m using here are recent, but not current… and keep in mind that this is not a recommendation of GE.)

At the time I made the actual trade, GE stock was at $31. I bought GE at $31 and I sold the $25 GE calls against the position. The calls expired in six months and the premium was $7. So my cost for GE was $24 and my upside limited to $25 - not so attractive, right?

This trade was set to return 4.1% (about 8.2% annualized) in six months - no big deal.

Here’s how I made it a big deal… and increased that annualized return by about 143%…

Covered Calls Work With Dividend Paying Stocks

Remember, you can only play this trick on a dividend paying stock.

GE pays a healthy dividend, about 20 cents a quarter. So my possible return, if I collected two dividend payouts as well as my premium, was 6% in six months… getting better, but still not great.

But this is great: I knew that if GE continued to trade at $30 or above with less than three months to expiration, they would call the shares away early so that I couldn’t collect that last dividend. The market makers knew that the chances of GE dropping 20% or more in three months were slim. They were playing probabilities.

So, instead of letting me collect the dividend, they collected the dividend. And since three months had passed, the premium on the $25 option had fallen substantially as well.

At the end of the day, I made 5% in three months, or 20% annualized on my money - because I didn’t lose the last three months of time value on the option, and I was out of the trade in half the time.

Now 20% is not chump change, especially when the S&P 500 is in the red.

You should consider this technique with any new deep-in-the-money covered calls you do on dividend paying stocks - you could increase your returns by triple digits.

Good Trading,

Karim Rahemtulla

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Today’s Smart Profits Cribsheet

  • Option terms have you stumped? Check out our Smart Profits Glossary for definitions of words like, “deep-in-the-money” or “beta.”
  • Also, check out Smart Profits #180, Deep-In-The-Money Covered Calls - How to Beat Stocks with Less Risk, for more information on this type of option strategy.

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The Options Pit

October 21, 2004

The Smart Profits Report: Issue #153
Thursday, October 21, 2004

The Options Pit: Controlled Chaos In the Pits at the CBOE
By Karim Rahemtulla
Chairman, Mt. Vernon Research

I just returned from hosting Agora Financial Options Seminar earlier this month in Chicago. For options traders, Chicago is where the action is, literally.

I talk about market makers and the options pit or “the floor,” but once in every trader’s life it’s worth seeing your opponents in action… to see how they exist in an environment that would overwhelm the rest of us.

Trading with the Pros - On Their Home Turf

On the afternoon of the first day of our annual Chicago options conference, our entire group - Smart Profits readers included - was treated to a tour of the Chicago Board of Options Exchange, CBOE, and a “live” interactive trading session.

This was the first such session since 9/11 - and it was a hoot.

After passing through airport-like security we were hustled up to the fourth floor for a 30-minute sit-down seminar by one of the top traders at the exchange. We all received authentic badges with our names embossed on them and the exchange logo as a token of our participation. The we all donned our trading jackets… some proved to be a tight fit… Traders are a very trim lot.

Learning to Shout In the Option Pits

We headed down to the pits after closing. What a sight. Thousands of monitors lined every available wall and thousands more hung suspended from 40-foot-high ceilings. Huge boards flashed the latest bid/offers on numerous options and the news tickers ran non-stop with all of the breaking news.

The option pits were sectioned off in areas that were set up to trade a number of options. (For example, in one of the bigger pits floor traders may be following 10 or 15 different companies at the same time.)

We then began the mock trading session. In groups of seven or eight, we were matched up with a professional trader who explained how to bid for options contracts and how to sell them. Hand gestures that would probably get you beaten up in some countries around the world were explained.

Then the bell rang…

“20 contracts to buy at the bid,” screamed one trader.

“50 for a nickel above,” screamed another. I kid you not: These guys were going at it at the top of their lungs for over half an hour, just for our session. Yells and screams came from every direction, papers were flying through the air as orders were marked and filled.

The Underbelly Of The Options World: The Options Pit

The traders were hyper alert - keeping one eye on the share price, the other on the option price. It was utter chaos… and yet this is how an open outcry market has functioned for decades. It’s picturesque, but…

While the open system is something to behold, fortunately many options are now traded electronically. I walked away not feeling very confident that the open outcry system works in our favor as individual investors.

After all, these traders know each other very well and there has to be huge potential for abuse. Everyone there reassured me that compliance was tough, safeguards were in place to prevent abuse and the traders operate under a very strict policy that ALWAYS puts the customer’s interests first. Much as I would like to believe that… all I can say is… RIGHT!

I put more faith in what I see every day… erratic pricing in options, spreads that mysteriously widen, prices on calls that go down as the stock goes up… Sure these anomalies correct quickly enough, but this look at the underbelly of the options world, the options pit, reminded me of why I write this Report: We can never protect ourselves TOO much from the chaos inherent in the options market.

Good Trading,

Karim Rahemtulla

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Can Your Portfolio Lie to You?

October 19, 2004

The Smart Profits Report: Issue #152
Tuesday, October 19, 2004

Can Your Portfolio Lie to You?: Professional Money-Management Investing Secrets
By Karim Rahemtulla
Chairman, Mt. Vernon Research

Can your portfolio lie to you? Yes! Without a doubt!

This is one of the money-management secrets I’ve learned from years of trading that I never see in any books. If you continue to track your options portfolio the way you have been tracking your stocks, you will always be misled.

So let me tell you how to keep a sharp eye on things the professional way.

Old Prices Are Right, But They’re Wrong

When you are using options, you better look at your portfolio carefully before coming to any conclusions about performance. What the broker sends or your online updating service tells you can lead you to entirely wrong conclusions. And when you are engaged in an options strategy, you need your super-powered glasses to see what is really happening.

I am an options trader. I live, breathe and sleep options… I do a few hundred options-related trades every year, so that must qualify me for something. In fact, I have been very successful at options. And still, whenever I look at my portfolio, I am dumbfounded by the number of mistakes in prices I see. Almost all of the mistakes are options related. And I know this is a universal problem, because I hear the same thing from my readers.

There’s always a little something that you need to improve, even when you are having great successes… but there’s one huge mistake you absolutely don’t need to make and shouldn’t - that’s the mistake of not knowing where you stand.

Most brokerage firms, even though they promise the moon as far as accuracy and service goes, cannot change the information that the market sends them - and with options that is often very stale information. Here is what happens…

Your Options Info Could Be Months Old - Here’s a Solution

When you look at your options portfolio, the numbers that affect what you’re doing are usually marked (recorded) based on the last trade. But that “last trade” could have occurred two months ago! Until someone else buys or sells the option, it is still listed at the latest price actually traded in the market. But it may not be the price you could get today - or anywhere close.

So, I find myself having to recalculate the value of my portfolio to reflect real life, and I have to do this often. Only those options that trade heavily on nearly every contract every day routinely have a “last trade” price close to what you’d be able to get right now.

It’s not hard to get your numbers right, but it can take some time. Here’s what you need to have so that you have a realistic evaluation of how well you are doing:

You have to track down a CURRENT quote - not the last price, but the current bid and ask prices. Watch how your portfolio’s value changes… You might find the situation very ugly when you thought all was well. Of course, you may also find you’re doing better than you thought.

The point here is that you aren’t going to get the last price unless it was made very recently. You will get the current bid or ask quote when you trade, and your results will reflect that, not some price someone else got two months ago.

But which price do you use: bid or ask? There can be a large spread between the two.

Using the Bid Instead of the Ask Price Will Give More Accuracy

The other thing that I hate almost as much as stale prices, especially when marking my covered call positions, is how the standard portfolio updating from my broker always marks the ASK price instead of the BID price. Sometimes there could be a 10% spread between the two.

That means my entire covered portfolio value is wrong until I fix it to show the BID price.

I guess the rationale behind services using the ask price is that if you had to buy back the option, you would have to pay the bid, or offer, price. But that’s not my goal. I only buy an option back if the trade has gone against me and I have to get out of it.

But my goal is to sell the option to close. And when you do that, it is the BID price that will end up in your pocket. That’s the one you need to have in your records to have a realistic picture of how well you are doing.

If you keep track of your progress by using the ASK price after you are already in a position, everything in your record will be overvalued! You get the BID price when you are selling to close a trade.

Here’s the bottom line…

When it comes to tracking your real portfolio results, you are going to have to do the legwork yourself… But this extra bit of work will mean a lot more profits - because you’ll have a more realistic picture of where your options are at any given point in time!

Good Trading,

Karim Rahemtulla

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Today’s Smart Profits Cribsheet

  • For more on options trading terms, check out our Smart Options glossary of option terms.

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Understanding Bull Spreads

October 13, 2004

The Smart Profits Report: Issue #151
Wednesday, October 13, 2004

Understanding Bull Spreads: Make 1,000% or More by “Spreading” the Wealth
By Karim Rahemtulla
Chairman, Mt. Vernon Research

Buying an option and watching it soar because the underlying stock moves is the best-known and easiest strategy to understand… but it sure as heck is not the best way to make money with options. In fact, the “straight” buy of an option could be the ABSOLUTE worst way for most people to try to make money. It requires a lot of expertise and risk tolerance to trade options like that, especially for the short run.

I’ve said it may times before, and I am sure I will say it many times again: If you don’t have a system to trade options, you ought to just buy your significant other a nice present with the money you were going to spend. At least someone will walk away happy!

This week I want to show you a way to make some big money with very low risk by understanding bull spreads.

How the Pros Preserve Upside AND Cut Risk

That’s right, I used “big money” and “low risk” in the same sentence… about options no less.

It’s a strategy that is called a bull spread. It sounds a little painful, but it is a strategy that many professional traders use to cut down on risk while still preserving upside. There are two times that a bull spread can be used effectively.

  • On an expensive stock where even the options cost a lot
  • When your options are already profitable and you want to go the rest of the way without losing what you’ve made

When Options are Cheaper But Not Cheap, Bull Spreads Are Key

For starters, what is a bull spread? It’s a simple combination of two options: you buy a call at the current price of the stock and you sell a call at your upside target price.

That strategy means that if the stock goes up, you’ll make money… but the amount you can lose is limited. The call you sold not only earns you a bit of change, but it cuts your risk short.

Let’s look at a sample trade to see how this works. Here’s what I mean about using bull spreads with an expensive stock…

Let’s say you are hot on Amazon.com. You love the stock, but it’s expensive. You could buy a call option for a fraction of the price of the stock, but even that fraction is very expensive. That’s the time to look at a bull spread.

The first step is to figure out how much you are trying to make (your target exit point) because that’s the strike price you are going to use on the call you will sell. But before we get that far, let’s look at how a regular stock trade might work out for you so we see how much better the bull spread is.

Anatomy of a Bull Spread - And How It Beats a Stock Trade

If you were trading the stock, you wouldn’t just look at your potential winnings if you were smart. You’d also set up a stop loss.

Let’s assume that Amazon is $42 today, and your target is $50 in a year. That’s about a 20% gain. Nice. But to own 1,000 shares of Amazon you would pony up $42,000 - not small change for most investors.

As for your stop loss, let’s say you set it at 15%. If Amazon fell from $42 to $36 you would get out of the position, with a $6,000 loss on your 1,000 shares.

Okay, now you know what you stand to make on the underlying stock - up 20% if you’re right - and what you’d lose if you had to bail: 15%.

As you can see right away, that’s a lousy proposition.

Buy One Call at the Current Price; Sell One at Your Target

Now let’s look at the option version. You pull up the options chain - a list of options and their prices - for Amazon. The $40 call option expiring in a year is $6 per option - pretty darn steep. But it’s the strike price that is closest to the stock. You want a slightly in-the-money or right-at-the-money strike price for the bull spread.

That takes care of the first of your two options, so you know which call to buy.

Figuring out which call to sell is even easier: it’s your target for the stock. You think the stock is going to $50 in a year, so you sell a $50 call. It’s that simple. As it happens, the price on the $50 call is $2.

I repeat, buy a call near the current price, sell a call at your target - that’s a bull spread. For this trade you bought a $40 call and sold a $50 call.

Now what?

Let’s review the equation. You now own the Amazon $40 call at a net price of $4 - 33% less than your cost. And your upside is $10 (50 minus 40), less the $4 you have at risk. So you stand to make 150% on your money or $6,000 in profits if Amazon closes at $50 or above.

Your total risk is $4 for the call, or $4,000, versus $42,000 if you owned the shares. Not bad.

Charging Forward, for 900% Profits

Here is another way to play the bull spread. Let’s say you own the Amazon $40 call option for $6. Six months into the trade, Amazon is at $48 and your option is trading at $10. You could sell your option and take your money off the table or let it ride and risk all of your profits AND your investment.

Here’s a better solution. Hold on to your starting position and sell the Amazon $50 call expiring at the same time. For that option you will get about $5, reducing your cost to $1 per contract.

You have done two things. First you have limited your upside to $50 (your original target). But your cost in the trade is now $1 instead of $6. And instead of making 66% if Amazon is at $50 at expiration (or before), you now stand to make over 900%. With the spread, you stand to make $9 on every $1 at risk.

How often can one make profits like this?

Using bull spreads, more often than you might think…

Good Trading,

Karim Rahemtulla

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Today’s Smart Profits Cribsheet

  • In the Leaps Option Trader portfolio we closed out a Lockheed Martin trade for 1,100% this year, along with… a triple-digit profit on Yellow Corp. We are now sitting on gains of more than 150% on Placer Dome and over 2,500% on Chesapeake Energy. To read more about the LEAPs Option Trader, just visit us.
  • For more on options trading terms, check out our Smart Profits Glossary where you can find more information on “bull spreads” or “bear spreads.”

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Risk In Investing

October 11, 2004

The Smart Profits Report: Issue #150
Monday, October 11, 2004

Risk In Investing: Don’t Take Insane Risks When You Have Options
By Karim Rahemtulla
Chairman, Mt. Vernon Research

Am I insane? I am sure that all of us - at one time or another - have asked ourselves this question after taking a bath on a “sure” thing. As human beings, we have one major disadvantage compared to other animals: We can think AND we can react illogically at the SAME time.

Consider this: As investors, we are literally at risk at all times. Then consider that we can reduce our risk in investing significantly and still remain fully allocated - but most people don’t. Let me show you how to change that…

Most investors - over 95% - prefer the high-cost, high-risk, low-return investing choice: buying stocks for huge money down.

The market offers the opportunity for the savvy investor to win while minimizing risk. But, in order to take advantage of this opportunity, you have to become a savvy investor first.

Controlling $87,000 Worth of Stock for $10,000

Here are two choices:

  • You can buy 1,000 shares of IBM today for $87,000 ($87 per share) - the choice most people will make.
  • Or, you can buy a two-and-a-half-year option to buy IBM at $90 per share for $10,000 (10 contracts at $10 per contract to control 1,000 shares).

Even if you think you are playing it safe by using a 20% stop loss on the stock trade, you stand to lose less money with the option - even if IBM tanks.

The difference is that you limit your risk in investing with the options. When you buy calls, you can only lose the premium you paid for them - $10 per share. That would be a maximum of $10,000 for your whole 1,000 shares if IBM dropped beyond all reasonable expectations.

With the stock you would lose $17,400 if your stop were hit. And the possibility that it will be hit is good. In the last five years, IBM has fallen 20% or more from its high eight times! It’s headed downward again this year.

And if you only put $10,000 in the options, you’d have $77,000 that you DID NOT invest in IBM…

How about putting it in a money market account paying 2.5% for two years? That would earn you about $5,000 over the same time period. So now your cost is only $5,000 to own IBM for two and a half years at a price of $90.

Enjoying Safer and Higher Returns: $43,000 in Two Years

This is lower risk in investing, but it also sets you up for a much bigger return. If IBM shares were to move to $130 per share in two and a half years, you would make $43,000, about 17% a year - not unheard of. That’s quite a chunk of change.

Now, let’s look at what would happen with the two-and-a-half-year option…

Your strike price (where you have the right to buy the shares) is $90. Add the cost for the option, another $5 (remember, we get $5 back from our money market account) to the share price, for a cost per share of $95. At $130, you would make $35,000 on your net $5,000 investment, or about 600% - now that is what I call a phenomenal chunk of change.

Good Trading,

Karim Rahemtulla

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Today’s Smart Profits Cribsheet

  • This type of low-risk investing is what I try to do regularly with my LEAPS Option Trader. I suggest you seriously consider using this system in your own portfolio or sign up for the service. Either way, you will take some of the insanity out of investing in the current market! To read more about it, just click here.
  • Check out the Smart Profits Glossary for definitions of terms like “contract” or “call options” found in today’s article.

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Black-Scholes Model

October 8, 2004

The Smart Profits Report: Issue #149
Friday, October 08, 2004

Black-Scholes Model: Finding Fair Value And 30% Returns in Two Days
By Karim Rahemtulla
Investment Director, Mt. Vernon Research

You’ve probably heard of the Black-Scholes Model for options pricing. It is the guide by which all options - including those issued by companies to employees - are priced.

Of course, just because there is a model out there for pricing an option, it does not mean that the option price you see on any of the exchanges is accurate.

No, no, no - that would be too easy and too clean.

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Travelzoo Stock

October 5, 2004

The Smart Profits Report: Issue #148
Tuesday, October 5, 2004

Travelzoo Stock: My Kingdom for an Option
By Karim Rahemtulla
Investment Director, Mt. Vernon Research

Richard III’s famous lines on the battlefield after he lost his horse (made famous by William Shakespeare in his writings) reminded me of the action in Travelzoo stock that I wrote to you about last Monday.

Here’s what I said a week ago:

  • “Travelzoo (Nasdaq: TZOO) is a disaster waiting to happen. If you can, you should short it.
  • Problem is, it is an expensive short at $70 per share. And there are NO put options available on TZOO at all, so a short option play isn’t even possible.”

Well, TZOO was poised on the brink of disaster. In fact, Travelzoo plunged $14 per share the other day. As the chart here shows, it had soared to well over $70 before the big crash…

Travelzoo

I knew it would likely nosedive, but I did not know when, and I was powerless to act. Why? Because there were no bleeping options available. I could not buy a put if my life depended on it.

And a put option, in this case, was the ONLY way I would have shorted TZOO. Because traders who sold the stock short have been caught in a nightmare, as I’ll explain below… First let’s look at where TZOO is now that it has “corrected” downward so dramatically.

TZOO Has Crashed, But It’s Still Overvalued

Even after falling $14, Travelzoo is monstrously overvalued.

Just look at this recent bit of news, and compare the numbers.

Orbitz, an online travel service, was bought for $1.2 billion by Cendant Corp. That valuation is at about 4 times sales of $280 million.

Travelzoo, by comparison, is selling at a market cap of $1 billion, with sales of - drumroll, please - $30 million.

What’s wrong with this picture? How could TZOO soar so far above a reasonable valuation, then crash so hard, yet still be so overvalued? (And why would I still avoid selling the stock short right now?)

I’ll tell you…

The Rush to Short TZOO Caused the Run-Up

There is a massive short-squeeze going on in Travelzoo shares, and it will end badly for people selling the stock short.

A short-squeeze occurs when those who sold a company’s shares short (hoping they would go down in price) are unable to buy back enough shares quickly enough to cover their positions as the shares move up in price.

Out of desperation, and to limit losses, they buy shares at any price to cover their positions, creating artificially induced demand on a micro-cap stock and sending the shares to the moon.

Think about trying to squeeze a herd of elephants into an elevator - the explosion was waiting to happen, and in this case, it was the share price that exploded.

Lessons to learn from Travelzoo:

  • Never short a company with a tight float (very few shares outstanding).
  • Look for an option, thereby limiting your losses if your shares move against you.
  • Never believe that Wall Street has reformed!

Good trading,

Karim Rahemtulla

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