Portfolio Diversification
March 30, 2006
The Smart Profits Report: Issue #296
March 30, 2006
Portfolio Diversification: Falling In Love With Investments Can Cost You MillionsBy Steve McDonald
Advisory Panelist, Mt. Vernon Research
Ten years ago, when I was working as a stockbroker, I had a client who did something pretty remarkable. Something, in fact, I may never forget… This investor steadily, over the course of 18 months, went about turning several million dollars into several hundred thousand dollars.
So how did he manage that sad feat? Simple… By not listening to good advice.
Fact is, one of the toughest things for a broker to do is not, as many investors think, simply provide well-researched investing ideas. No, the toughest thing is getting clients to listen to you…
Although I left the field long ago, the one rule I try to drive home to this day - and perhaps the most fundamental rule for making and retaining wealth - is this: portfolio diversification.
Although it may sound simple - and you’ve probably heard it a thousand times - putting this simple idea into play may do more to make and save you money than most other investing maxims. Let me explain…
One Nest Egg Is Not Diversification
Back then, my client refused to diversify his portfolio. And he paid dearly. Imagine putting all of your earnings - everything you had saved - into just one company. And imagine hitting the jackpot. That’s right, the stock was an extraordinary performer.
By way of instruction, here’s what happened…
My client had been a very successful businessman. He was preparing to retire and needed help transitioning from his 401(k), company stock options and company stock into a retirement-style investment program.
There was one hitch. Although he had assiduously saved money over the years and plowed a substantial amount into his retirement funds, my client had done something wrong: All of his money was tied up in one company.
I recommended he liquidate at least 75% of the stock and options and set up a diversified portfolio of blue chip, dividend-paying stocks and bonds. My plan would have given him much more safety, simply by spreading the risk. He would also receive the desired income in his retirement years.
My client’s response is as clear now as it was then. “Steve, I wouldn’t have anything if it had not been for this company. I will stick with them. I know them and I know how they do business. I appreciate your input, but I’ll stay put.”
A Falling Star - From $78 To $8 A Share
Between that conversation and the end of 2002, the stock dropped from $78 to $8. You do the math. The company also cut the dividend to almost nothing. I was no longer a broker when the stock market started its three-year correction, from 2000 to 2002. But I have thought many times about what I could have done differently. The answer is always the same: nothing.
My client’s thinking was focused on issues that had nothing to do with making money or portfolio diversification. Either one of these reasons is virtually impossible to overcome when you are working with a client.
First, he confused investments with feelings, memories and dedication. If you have any reason for owning an investment other than making money, you’re dreadfully mistaken. My client had a misty-eyed memory of a young man going to work for a good company that gave him every opportunity to excel and make a better life for himself. Very commendable, but it has nothing to do with making money.
Investments Are Not Collectables
Investments exist for one reason - to make money. And to make money with them, you must sell them, not hold onto them as you would your favorite collectables.
Second, at the time of our conversation, broker commission rates were much higher than they are now. Before the advent of online investing, the average stock trade cost a minimum of $100. To sell one stock and make dozens of purchases would have cost several thousand dollars. Most people want to believe they are getting something for nothing, especially in the investment business. My client was no different.
He focused more on the cost of doing business than the returns he would reap with diversifying his portfolio. Nine out of 10 clients think about cost before return. What many people end up doing is saving pennies and losing dollars. In this case, millions of dollars.
Good Trading,
Steve
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Today’s Smart Profits Cribsheet
- See our recommended reading section for books on trading derivatives. A great primer on options trading is Lawrence G. McMillan’s Profit with Options: Essential Methods for Investing Success. This is a course book that covers every phase of the options trading process. It takes a step-by-step approach, reinforcing concepts through quizzes at the end of each chapter.
- Which company first made IPO shares available to the public? Answer: the Green Shoe Company. And that’s why a “Greenshoe Option” is one that allows the underwriter of an IPO to sell additional shares to the public if the demand is exceptional. See the Smart Profits Glossary for other useful terms such as “diversification” found in today’s article.
Related Articles:
- Principal Protection: How to “Defend” Your Principal From a 50% “Bomb”
- Trading Index Options - Two Ways To Profit
- Fair Value Sheets: Quote, Trade and Hedge… In Less Than 30 Seconds
Option Profit-Taking
March 28, 2006
The Smart Profits Report: Issue #295
Tuesday, March 28, 2006
Option Profit-Taking: Making It Easy ToTake the Money and RunBy Steve McDonald
Advisory Panelist, Mt. Vernon Research
Option profit-taking, or selling options for a profit, is one of the most challenging aspects of options trading. Sadly, most of us are not very good at it. No trader alive is unscathed by hanging on to a paper profit, only to watch the price drop into the red loss zone.
Let’s face it. Most people are conditioned to take losses. When a loss becomes unbearable, we sell. A profit is a different ballgame. We play, “how high can it go” gamesmanship, losing our sense of proportion, even sanity.
The fact is, there aren’t any well-marked signs that tell us when we’ve made enough money on an investment. There are feelings and hunches that tell us to hold on and to sell, sometimes within the span of a few seconds. We vacillate, from hold to sell, and watch profits drain away. But here’s what you can do about it…
How To Define A Reasonable Profit In Options
The most experienced options traders are more apt to sell than the novices when they score a profit in options. They know that you are more likely to get singed by hanging around than if you hit your mental gain and sell. They also know that in options trading, like stock trading, there are other days and other options. In other words, they won’t allow their entire financial plan to rest on one trade.
Having said that, there are no fixed rules. I don’t have a magic formula. But I’ve got guidelines. And you should, too. If I’m holding an option that suddenly moves up 20% to 40%, I’m out. By sudden, I mean one to four weeks.
Here’s another way of looking at it. If you could average 20% to 40% on all your investments in one year’s time, you’d be performing better than billionaire investor Warren Buffett. So, why wouldn’t you sell an option that ran up that much in just weeks?
Could they go higher? Sure. Can they drop like lead weights? Unfortunately, that is the more likely scenario. I have watched a lot of money vanish while I waited for an option to move just a few dollars higher.
If you stay at this game long enough, you develop a sense of when to get out. You pay a heck of a price to get to that point, but you either adapt or get eaten alive.
Don’t Vaporize A Winning Trade: Take Your Profits!
If just learning to take the money and run wasn’t hard enough, there is another process associated with selling at a profit that haunts us. It’s the tendency to look back instead of forward. Instead of deleting from our files the trade that just scored a nice profit, we keep the option on our electronic portfolio page. Now that we’ve sold it, we’re hoping the thing tanks. Why we do that is anybody’s guess. And it would seem a harmless exercise. But it’s not. Here’s why.
The simple fact that we’ve watched a trade go up in value after we sold it will convince many of us to take corrective action the next time.
On the next trade that’s made 15% to 20% or more, we’ll be tempted to hang on just a little. A few more days, we’ll reason, could produce bigger bounty.
And then what happens? You guessed it. Your healthy profit has dropped to just 5%. Then what do you do? Mind you, I’m not suggesting that 15% or 20% is the magic number. Sometimes 7% or 30% will seem like the right choice. The point is to be a disciplined trader and have the ability to walk away.
There are enough challenges in trying to make money in the markets without second-guessing ourselves and creating problems where they don’t exist. So, keep it simple when your options are profiting - take the money and run.
Good Trading,
Steve
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Today’s Smart Profits Cribsheet
- Speaking of discipline, please see Smart Profits #279, The Options Bid: The Bid, the Bid, Always the Bid, on watching the options bid prices and strategic decision-making, like using limit orders, that can increase your returns.
- What’s a European Option? Options that can only be exercised at maturity, unlike American options, which can be bought and sold at any time before the expiration date. See the free Smart Profits Glossary for more useful terms.
Related Articles:
- Position Sizing Safeguards: Prevent Corporate Lies From “Cooking” Your Portfolio
- Option Prices: How to Get the Best Price on Your Options
- Limit Order Diligence - How to Limit Your “Excitement” for Winning Trades
Option Investing
March 23, 2006
The Smart Profits Report: Issue #294
Thursday, March 23, 2006
Option Investing: The Hottest Ticket On Wall StreetBy Karim Rahemtulla
Chairman, Mt. Vernon Research
Is option investing going mainstream?
You’d better believe it. For a full day last week at the annual Investment U conference in Delray, FL, Mt. Vernon Research had center stage.
The feeling - much like today’s options market - was electric. More than 300 people were in attendance. They were riveted by the ins and outs of option investing. The options market may sound like arcane stuff, but many investors have become much more savvy about options and other so-called derivatives.
A few years ago, when I asked audience participants how many of them used options, fewer than 25% raised their hands. Last week, the number was more than half. That’s good news. And here’s why…
Options: More Investment Choices, Lower Costs
Options are THE new investment vehicle of choice. There are several important reasons why. And there are important consequences of this trend.
First, the reasons why: Learning about how to put options to use - not merely as a speculative tool - is becoming more common. Options are far more accessible today than they were even 10 years ago. There are more exchanges and more choices for companies that have options traded on their shares. In addition, investors are seeking ways to boost their returns without undue risk. And with the cost of trading options declining dramatically, many people who were on the fence have climbed into the arena. In fact, most brokerages charge the same base rate for options as they do for stocks. Many firms, like Fidelity and Ameritrade, are charging $1 or less for each option contract.
The consequences are all good. More exchanges mean more competition. That translates to a tighter bid/ask spread. Put another way, options players are getting better prices.
As more traders see the appeal of options, the price of trading will continue to decrease. I can see a day in the next five years when options trading will result in more stocks that offer options. Since volume dictates whether a company issues options on its stock, the growing appeal of the options market means more and more stocks will have options.
Options Exchange IPOs: Profit From The Middle Man
In the coming years, we will see more options created for ETFs, like the Gold ETF, and more options of foreign shares that trade on U.S. exchanges. This will allow for better diversification of risk. Right now, for example, fewer than 30% of stocks have long-term options, or LEAPS. I believe that LEAPS will be available on all shares of listed stocks in the S&P 500 and the Nasdaq 100 within the next five years. Investors will demand it.
Remember, options market makers are not the ones who worry about which stock has an option. They only care about liquidity and the ability to make money from an active market. For investors, the increase in options trading can result in a financial bonus…
Buying companies that specialize in options trading can also be a profitable venture. Last year, I recommended my subscribers and audience members at Investment U to buy shares of an IPO, International Securities Exchange (NYSE: ISE). It was “hot” and we were able to get in at $26 a share. Today, it’s trading at $42.
In the coming years, you will see an increasing number of options-related IPOs, from exchanges to brokerages that specialize in options. Look to them for profits by either buying the IPO or waiting for a major correction. I’ll be doing the same.
Good Trading,
Karim
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Today’s Smart Profits Cribsheet
- Options As A Strategic Investment, 4th Edition is considered the bible of options trading. Now completely revised and updated with the latest trading vehicles and applications available. Click here to learn more or swing on over to our Recommended Option Books.
- Check out the Smart Profits Glossary for definitions of terms like “bid & ask” or “ETFs” found in today’s article.
Related Articles:
- Short-Term Options - Two Ways to Make Them Work
- Option Position Sizing - How Much to Invest In Each Option Trade
- LEAP Option Investing: The Best Options Play on eBay
Defensive Covered Call Strategy
March 21, 2006
The Smart Profits Report: Issue #293
Tuesday, March 21, 2006
Defensive Covered Call Strategy: What’s Better Than Making Money? Keeping It.
By Jim Stanton
Advisory Panelist, Mt. Vernon Research
I hate losing money - even more than I enjoy making it. And I’m sure many of you feel the same way. So, what can we do to avoid - or offset - our losses?
Well, we know that covered call writing is a way to generate additional income. But did you know you can put a defensive covered call strategy to work too?
It’s a strategy every investor should turn to when the market is experiencing a prolonged selloff or larger-than-expected drop. And here’s how it works…
Rising Markets Hinder Covered Call Writing
A defensive covered call option strategy works best in a stock market environment in which there’s not a lot of upside or downside. That’s because it’s a way to continually lower your average cost of the stock you own. You do that by collecting the premiums you receive for writing calls.
Rising markets can actually be a hindrance to covered call writing. That can force the covered call strategist to write calls too frequently. When that happens, the stock can get called away and the writer is faced with reinvesting money at potentially higher prices. That’s why timing is so important.
From October 1998 to March 2000, the S&P rose more than 60%. But if you were too active in your covered call writing, your return may have been considerably less than 60%.
In a falling market, short-term and intermediate traders can sell their long positions and either go short or wait for the next buying opportunity. But many long-term investors have a low cost basis on their stocks. They might not want to sell because of punishing tax consequences, and prefer to ride out the storm.
When you hear the Fed chief speak of “irrational exuberance” or you’re feeling exceptionally pleased with your portfolio’s performance and everyone is bullish, that may be the time to start thinking about protecting your gains. Here’s an inexpensive way to accomplish that.
Play Defense with Selling Covered Calls
To defend your portfolio in dramatic cases, like the 2000-2003 bear market, or in a prolonged correction, I would begin by selling covered calls.
Let’s assume the market is looking like it’s about to top out. And we want to lock in the gains we’ve racked up in, say, Proctor & Gamble (NYSE: PG). On March 17, 2006, PG closed at $59.10. We don’t want to sell a covered call that’s too close to the current price, so in this case, we’ll sell the PG October $65 call that’s trading at $1.
Pulling in an extra $1 per share is nice, but at times that $1 could be better spent on some insurance in case of a severe correction. The PG October $55 put is trading at $1.10. If we execute the trades at these prices, the insurance costs just 10 cents a share. If the stock goes up to $65 or higher, we’ve made an additional 10%. If the stock begins falling, regardless of how far down it falls, the maximum loss from its current level is less than 7%.
That’s a safety net that most investors would be pleased to have in a falling market.
Good Trading,
Jim
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Today’s Smart Profits Cribsheet
- For another good example of using covered calls, see Advisory Panelist Lee Lowell’s article, Selling Covered Calls - Getting Cash for Stocks You Already Own. Lee introduces ways to make some nice sideline income on your stocks.
- And don’t forget: In options, each “contract” controls 100 shares of the underlying stock issue. For other useful terms and phrases, like “covered calls,” see the Smart Profits Glossary.
Related Articles:
- IBM and Google Covered Calls: Tracking These 2 Giants For An Income Jolt
- Deep-In-The-Money Covered Calls - How to Beat Stocks with Less Risk
- Limit Order Discipline & Two Other Simple Rules For Making Money In Options
Buying Options
March 16, 2006
The Smart Profits Report: Issue #292
Thursday, March 16, 2006
Buying Options: Like Owning a House Without Monthly Payments
By Lee Lowell
Advisory Panelist, Mt. Vernon Research
“Trading options is like buying a house, only better…”
That’s what I often tell people who are trying to grasp the concept of options trading for the first time. They’re often confused about whether they have to exercise the options, or how they make money. What happens, they ask, if no one buys their option from them?
The fact is, buying options uses the same concept as a mortgage; but with options, you don’t have monthly payments. Let me explain…
Would You Pay Cash for Your House?
Most people buy the number of stocks they want and pay for them up front, in full. Or, they trade on margin, and only put up 50% of the full amount. This could be the equivalent of paying all cash for a real estate investment, or making a 50% down payment.
Let’s look at how using options could stretch your money even further, in this case. As a longtime reader, you know that utilizing call options in lieu of stock is the smart thing to do. It not only lets you control the same amount of stock, but it lets you do it with a much smaller up-front cash outlay. And with that smaller up-front cost, it lets you use the extra cash to invest in three, four, or maybe even five other stocks.
How does this compare to buying a house? When you buy a house, you sign a mortgage contract, make a down payment, and make monthly payments to the bank for a fraction of the house’s value. Even though you don’t own the house outright, you still get all the same benefits - you get to live it in, use the water, electricity, cable, phone, yard and anything else that comes with the house. Yet, you only have to pay a small amount each month to stay there.
With options, you get that and more. You only have to pay the up-front cost, just like a down payment when you buy the house. But with options, you never have to make another payment again until expiration (if you decide to exercise an in-the-money call option). You can control 100 shares of stock for every option contract you buy, but you never have to pay for the stock in full. You’re leveraging yourself by putting in a little to control a lot.
Buying Options: Excercising Your Mortgage
At the end of the option contract expiration period, you can either sell the option back into the marketplace (if there’s value left to it), or you can exercise the option and turn the contract into actual shares of stock. In that case, you’d have to pay for the balance at that time. Exercising options would be the equivalent of making a balloon payment on your mortgage contract. Just as you can sell options before they expire, you can always sell your house before the mortgage is paid in full.
The only investment difference between options and real estate is that options can become worthless if they’re out-of-the-money (OTM) at expiration. (Let’s hope that your house never becomes worthless!) The point is that you when you buy options, you get to control something very large for a small down payment. The premium that you pay for the options is similar to the down payment on a house. But options don’t require ongoing monthly payments.
For my money, options are simply the best way to use investment dollars. Why pay for something in full, up-front, when you can get all the same benefits for a fraction of the cost? That’s what options can do for you.
Good Trading,
Lee Lowell
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Today’s Smart Profits Cribsheet
- Do you know the meaning of a “breakout?” It’s a price movement of a stock through an identified level of resistance or support, usually followed by heavy or increased volatility. Once the initial level of resistance is broken, it is then regarded as the next support level when the underlying asset falls back. This style is used within technical analysis. For more useful terms, please see our Smart Profits Glossary.
- Or check out Smart Profits #179, Breakout & Resistance: How to Anticipate and Profit From These Twin Concepts.
- Also, check out Smart Profits #282 by Steve McDonald, Option Trading Strategies - Option Plays That “Earn” Their Keep.
Related Articles:
- Trading Options: The Six Key Tools for Options Trading
- Stock Options: How to Buy $2,446 Worth of MSFT for $1,270
- Sell to Close Options - How “Patient” Trading Turned $8,000 into $192,000
Head And Shoulders Pattern
March 14, 2006
The Smart Profits Report: Issue #291
Tuesday, March 14, 2006
Head and Shoulders Pattern: A Proven Sell Signal Called Breaking the “Neckline”By Jim Stanton
Advisory Panelist, Mt. Vernon Research
Study stock chart patterns for a long time and you’ll come to one inescapable conclusion: They are a picture of fear and greed.
Once I became a seasoned chart analyst, I noticed similar patterns in a number of different stocks. They were not only present in the intraday charts, but in the daily and weekly charts, too.
Since then, I have developed a proprietary trading model based on advanced pattern recognition. But the one pattern I go back to time and again has been around for many years. It’s the Head and Shoulders pattern. Here’s how it works…
The Unmistakable Time to Get Out
Below is a daily chart of American International Group (NYSE: AIG), which is setting up a potential “head and shoulders” sell signal. This pattern consists of three successive peaks with the middle (the head) being the highest and the two on either side of the head (the shoulders) at slightly lower levels. When connected, the reaction lows at points #1 and #2 form support at what is referred to as the “neckline” (see the red line in the chart).
A head and shoulders “topping pattern” usually appears after an uptrend line has been broken and a subsequent low is tested. That forms the neckline. In AIG’s case, the uptrend line was broken on January 20. The stock then tested its previous low, at point #1, in early February. The test of the January lows was successful and the stock appears to be forming the right shoulder of the pattern.
While symmetry is preferred, it is not an absolute requirement. At times, the right shoulder will be slightly above or below the peak of the left shoulder, as it is in this case. Occasionally, the neckline has a slight up or down slope. A down-sloping neckline indicates a more bearish pattern than a horizontal or up sloping line.
As the head and shoulders pattern unfolds, volume often plays an important role. Ideally, volume during the advance of the left shoulder should be higher than during the advance of the head. The drop in volume, along with new highs that form the head, serve as the first warning sign. The second warning sign occurs when volume increases on the decline from the peak of the head. Final confirmation to sell comes when volume increases during the decline of the right shoulder.
The Head & Shoulders Top
At this point in time, we don’t know if AIG is forming a head and shoulders top or just consolidating its recent gains. The head and shoulders top is not complete and the uptrend is not reversed until the stock closes below the neckline. Ideally, this should occur in a convincing manner with an increase in volume. Once the support at $64.60 is broken, it triggers the sell signal and the $64.60 level now becomes resistance. At times, the stock will bounce back up to the resistance level, offering a second chance to sell the stock.
Once the neckline support is broken, the projected price decline is found by measuring the distance from the top of the head to the neckline. This distance is then subtracted from the neckline to reach a price target, which in AIG’s case is $58.30. The stock could drop to either side of $58.30, so traders should watch that general area for signs of a reversal.
Stay tuned for more pattern tips in the coming weeks. And until then, keep an eye out for “head and shoulders” patterns forming in any stocks you own, and be sure to track that right shoulder to see if it’s time to cut your losses.
Good Trading,
Jim
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Today’s Smart Profits Cribsheet
- Is now a good time to buy an option? Or should you opt for the stock instead? Check out Smart Profits #145, Market Volume & Liquidity: When to Buy the Stock And NOT the Option, for guidance on this sometimes-difficult decision.
- It’s not enough to get to know chart patterns if you’re planning on using them to trade for profits. After all, knowing when to get into a trade is only half the battle. See Smart Profits #286, Understanding Option Trading: Cut Your Losses… And Watch Your Gains Run, before you enter your next trade.
- Unsure of option terminology such as “volume” or “trend” used above? Check out the Smart Profits Glossary, chock full of over 150 different option terms!
Related Articles:
- Breakout & Resistance: How to Anticipate and Profit From These Twin Concepts
- Technical Analysis - Two Simple Tools for Spotting a Technical Trend
- Quantitative Research - An Interview with Dean Albrecht
Correlation Strategy
March 9, 2006
The Smart Profits Report: Issue #290
Thursday, March 9, 2006
Correlation Strategy: Identify the Tide And Ride It To Profitability
By Dean Albrecht
Investment Panelist, Mt. Vernon Research
In wrestling, where the head goes, so goes the body. Similarly, where the markets and indexes go, so go the stocks.
When indexes are choppy and directionless, so are stocks. Let’s take a look at the all-important “correlation strategy” to determine the direction of the markets when we’re searching for ideal entry and exit points. Why?
When the markets move, so do most stocks. As a rule, I like to see a move of 3.5% to 9% prior to entering a position.
Easy As Watching A School Of Fish
For you fishermen, if you see the Spanish mackerel swimming in one direction, there is a good chance the kingfish are not too far behind.
The trick is to have an entry point and identify which sector is leading the stocks within them. That means spotting the move of a stock to the upside or downside and the point at which the move is likely to slow down, end and turn around.
Below is a shot of the XBD. XBD is the symbol for the Broker Dealer Index. It started on a tear during the last week of October 2005, and has been going quite strong since then.
Now, check out the chart of Ameritrade (Nasdaq: AMTD) below. It started on an up-move at about the same time as the Broker Dealer Index. It followed suit and continues to be highly correlated to the Broker Dealer Sector.
As you can see below, Lehman Bros. (NYSE: LEH) started the move at the same time and has continued to follow suit.
Clearly, correlation is a very strong and valuable tool to determine the entry or exit point of a position.
Correlation Strategy: How to Pick the Right Stock
Ask yourself this question: Are the stocks within the sectors going up or down, and are they following the sectors? If the answer is yes, then you stand an excellent chance of being right about your direction of the stock.
How do we pick a stock in our correlation strategy?
Let’s assume the markets are going up. Let’s also assume we have a sector that is trending up, like the Broker Dealer Sector in the first graph. Then we identify a highly correlated stock or group of stocks that follow the sector and we buy them using the sector as our lead. When the sector finishes its run and retreats, it’s time to sell.
Good Trading,
Dean
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Today’s Smart Profits Cribsheet
- Speaking of fish, do you know the meaning of “underwater” in the options trade? Definition: Also referred to as out of the money, underwater is the circumstance an option is in when its strike price is higher (call) or lower (put) than the market price of the underlying stock. For more useful terms and phrases, see our Smart Profits Glossary.
- Getting a sharper angle on market sectors can pay off handsomely. To find out how to hone in and isolate option-trading opportunities in a sensible way… so that you know why you’re trading (long or short) and how to give yourself the best chance at success, check out Smart Profits #253, Options Trading Strategy: A Five-Question Screen to Find the Perfect Option.
Related Articles:
- Fundamental Analysis - Three Screens For Technical Traders
- Options On ETFs - Increased Safety and Profit Potential
- The CBOE: The Website Every Options Trader Should Know
In the Money Options
March 7, 2006
The Smart Profits Report: Issue #289
Tuesday, March 7, 2006
In the Money Options: Make Mondays Your Discount Stock-Buying Day
By Lee Lowell
Advisory Panelist, Mt. Vernon Research
A good option investor never pays full price for a stock. That’s why some of the best options players - yes, even Warren Buffett - know how to use options to their advantage.
I’m a big proponent of selling out of the money (OTM) put options as a way to buy a favorite stock below current market prices. It’s a strategy that lets you get paid the option “premium” upfront while you wait to see if you’re assigned on your put contracts. This is a great way to gain income as an option seller, and it also gives you the opportunity to buy a great stock that you like.
But there’s one drawback: By selling OTM puts, you may forfeit the chance to get the shares. That’s because the stock may not drop below the strike price. If you want to focus just on income, this strategy is useful. But if you really want to own the stock, in the money options are a better way to go about it…
Investor’s Advantage: In the Money Puts Options Get You “In the Stock”
So, let’s deviate a bit from the OTM strategy. I’m going to show you how to sell in the money (ITM) put options, which can almost assure that you will be assigned the shares of stock.
The transfer, or “assignment” of put options into stock shares, occurs on the Monday after options expire. If your short put options are still ITM at option expiration, the buyer will exercise his long put options against you, and you will be required to fulfill your obligation of buying the stock at the stated strike price. This is a good thing if you want to own the stock.
How to Buy Your Stock Below “Book Value”
Below is a current option chain for Yahoo! (Nasdaq: YHOO) at the close on February 28, 2006. An ITM put option has a strike price above the current price of the stock. So, all strikes from $32.50 and higher are ITM.
If we sell the $35 ITM strike put option for $3.50 (splitting bid/ask), we’re almost assured of being assigned the put options. This means that we will be forced to buy 100 shares of YHOO at $35/share if YHOO ends up below $35/share on options expiration day.
Why would we want to buy YHOO at $35 when it’s trading at $32.05 today? Because you’re getting $3.50 per option contract up front, which lowers your cost basis to $31.50/share ($35 strike price - $3.50 = $31.50). So as of today, you’d actually be buying shares 56 cents lower than their trading price now.
How To Go Deeper In the Money Using Options
As long as YHOO stays below $35 through the April 2006 option expiration, you can count on being assigned the shares below “book value.” That’s because you’d be buying 100 shares of YHOO at $31.50/share cost basis. The other great thing about this trade is that you get the $350 up front to deposit in your account, which will start to earn interest (not all brokers pay interest).
You can choose any in the money option strike you want. If you go deeper in the money, you will get more of a return upfront. But your cost basis will be closer to the current price of the stock. If you sell the $45 put, you will get $1,290 deposited into your account. But your cost basis as of today would put you at $32.10 ($45 - $12.90 = $32.10). That’s higher than the current price of YHOO. I like to stick to strikes that at least allow me to buy the stock lower than the price at which it’s currently trading.
Good Trading,
Lee
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Today’s Smart Profits Cribsheet
- Do you know what a credit spread is? If you’re trading options, you should. Take a look at Smart Profits #267, Sell First, Buy Second for 50% Better Odds. In it, I explain the downfall of most option traders and why the short side of options can be much more profitable than the long by using put credit spreads.
- What in the world is an “Alligator Spread?” In the options business, the term “See ya later, alligator” isn’t cute. It refers to an unprofitable spread regardless of encouraging market movements. This trouncing is due entirely to large commissions. For more useful phrases and terminology, like “in the money” or “out of the money“, see the Smart Profits Glossary.
Related Articles:
- Using a Probability Calculator - Know Your Trade’s Exact Chance of Success Up Front
- Option Position Sizing - How Much to Invest In Each Option Trade
- Deep-In-The-Money Covered Calls - How to Beat Stocks with Less Risk
Sell To Close Options
March 2, 2006
The Smart Profits Report: Issue #288
Thursday, March 2, 2006
Sell to Close Options: How “Patient” Trading Turned $8,000 into $192,000
by Steve McDonald, Advisory Panelist, Mt. Vernon Research
The most difficult decision an investor makes is not which stock or option to buy or when to buy it. It’s when to sell to close. It is a nagging problem that has only one solution: Let your winners run and dump your losers. Oh, if it were only that easy.
In 25 years of trading, I have found that more investors struggle with the decision over when to take a profit, as opposed to when to take a loss. The most veteran traders sell once they hit their trailing stop. But no such stop exists on the upside.
That’s why it’s important to have a strategy for letting winners run and taking profits. While the following example may be unconventional, you’ll soon see what happens when you do, in fact, ride out the winners.
A “Welcome Home” 958% Gain
I recently received a phone call from an elderly business acquaintance I’ll refer to as Mrs. B. She asked me if I could help her understand an item on her brokerage statement. I told her she should call her broker, but she said he didn’t understand her question.
Mrs. B told me the item on her statement showed the following: 100 contracts of XYZXX, with a purchase price of $8,000 and a market price of $192,000.
I asked her what the question was. She said, “Is this correct?”
I said, “It sounds very high, but let me check the option symbol online.”
I looked up the symbol and multiplied the bid by 100. It did, in fact, come to about $192,000. Something else caught my attention - the option was set to expire in three days.
Mrs. B then asked me what she should do. Since I couldn’t give personal advice, I did the next best thing. I told her she should transfer the account into my name, immediately. (Only kidding.) I ran through the choices available to her and told her to contact her broker and have him advise her on the next move.
Before she got off the phone, I asked her why she held the options so long. I explained that it was very unusual for anyone to be so disciplined as to let a winner ride to within three days of expiration. Her answer is one of the best I have heard in all the years I’ve been involved in the money business.
Mrs. B said she had been in the hospital for an extended stay of about three months. She purchased the option sometime before being admitted to the hospital. About a week after returning home, she began sorting the mail. She came across the brokerage statement and was certain the $192,000 value of the account was erroneous.
It was no mistake.
Sell to Close Options…and Keep Walking
When an underlying stock price hits the strike price of an option, as it did in her case, the option price moves up dollar-for-dollar with the stock price. So, the higher the stock climbs, the higher the option goes.
Most of us are unable to watch an option go as high as Mrs. B’s. We have this itch that makes us sell, usually too early. We sell because we have seen too many winners turn into losers. Or we don’t understand what is happening. It’s very tough to let the market do its thing.
Letting a winner ride drives us crazy. How many times have you been about to sell a position, just to second-guess yourself, and then sell it anyway and regret it forever? This is where the real torture begins.
Traders Often Track Their Closed Options Positions…
Invariably, the options continue to climb. And that creates more of a problem the next time one has to make a decision to sell.
Call it human nature, but many people re-live what they believe to have been an error. That affects their decision-making the next time around. And that’s simply not the best mindset for making money.
Don’t look back. Period. Whether you lose or profit, keep walking.
Mrs. B was admittedly a bit lucky. The rest of us have to learn from our mistakes and continually sharpen our trading skills. Let your winners run, dump your losers and, probably the toughest part, never look back.
I wouldn’t recommend checking into a hospital to try and bump up your returns. Your insurance company wouldn’t understand.
Good trading,
Steve
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Today’s Smart Profits Crib Sheet
- When you buy a put or a call, your goal is to make money. And preferably, lots of it. But instead of buying the shares outright, you’re employing leverage by using options. For more on getting the most out of your investment dollars, check out Smart Profits #103, Understanding Options Leverage - The Power Of Leverage Is Bigger than You Think.
- In options trading, it’s important to use the correct terminology. “Sell to Open” is a phrase used by brokers that represents the opening of a short position, while “Sell to Close,” means the closing of a short position. For more useful phrases and lingo, see the Smart Profits Glossary.
Related Articles:
- Limit Order Diligence - How to Limit Your “Excitement” for Winning Trades
- Options Trading Strategy - A Five-Question Screen to Find the Perfect Option
- Short-Term Options - Two Ways to Make Them Work
Emerging Markets of India
March 1, 2006
The Smart Profits Report: Issue #287
Wednesday, March 1, 2006
Emerging Markets - Two Plays In India… With Caution
By Karim Rahemtulla
Chairman, Mt. Vernon Research
The Sensex (the benchmark index of the Bombay Stock Exchange in India) is up more than 80% over the past two years. India’s “economy,” it’s been said, is roaring. Recently, I traveled to the country to see firsthand just how big its economy’s blaze really is…
My colleagues at the Daily Reckoning sent me a message the other day from one of its readers. The reader questioned their wisdom of “sending” me to India, since I never had anything good to say about the country.
In fact, the last time I was in India, in 1997, the Asian currency crisis had barely begun. And after a three-week tour of the country, I concluded that I would not invest a dime there. Here’s why…
One Billion Reasons To Be Bullish?
When I returned to the States, I attended a major investment conference where I shared my skeptical view. The next speaker was less wary. As an emerging market specialist, he was bullish on India. How could you go wrong with a country that boasted a billion people? he said.
After his speech, we talked and he scoffed at my skepticism about the country - the lack of infrastructure, the grinding poverty, widespread corruption, the continued negative imprint of the caste system and lackluster leadership. India would be the next powerhouse of Asia, he claimed. I was confused. Not about whether I would invest in India, but rather, what he had seen there that made him so positive.
He mentioned the strong monetary inflows, including mutual funds, and the move in stock prices. At the time, the Indian stock market had half the market capitalization of Microsoft.
I asked him about what he made of life on the street. He paused, and then said he had actually never been to India!
On my recent trip there, I saw improvement. The top 10% of wage earners are now enjoying a standard of living comparable to the United States in the 1950s. Two-wage-earner families have become commonplace. The introduction of credit has blossomed, as has the greater supply of Western goods. In a sense, India is undergoing a renaissance. Just take a look at “Silicon Valley” in Bangalore and you’ll be amazed at the sprouting number of nightclubs and Western coffee shops.
Two Promising Plays in India
I do like a couple of sectors; namely, infrastructure and air transportation.
The country will spend billions in the coming years on roads and air transportation. And Indians love to travel. The airport in Delhi, a city inhabited by 15 million (of which about 2 million can afford to travel by plane) has a terminal building and infrastructure more appropriate for a city the size of Albany. Mumbai is not much better. Planes are packed and delays are common. Competition is beginning to heat up.
But even if you want to invest in these sectors, guess what? As a foreigner, you are limited to investing in India in a mutual fund or one of the 11 ADRs listed in New York. You could invest in the local market, but only through a proxy. So, for all intents and purposes, unless you want to invest in the IT sector, you are shut out.
India is still an enigma. It has huge potential but it is still stuck in the past. The vast majority of the population cannot live on less than $100 per month, and continue to live without access to purified water, health care or decent housing. So, if you are willing to bet on a country in which only 10% of the people are going to work for your investment, then look to India for growth.
Here’s what’s changed in a decade: About 100 million people have credit cards. Disposable income is up. The chance of having a “Western” lifestyle has improved.
But here’s the bad news: More than 1 billion people are still dependent on the services of a broken welfare system. When that shows signs of true reform, I will be the first to jump on the investment train.
Good Trading,
Karim
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Today’s Smart Profits Cribsheet
- For a discussion of another emerging market, please see Smart Profits #269, Emerging Markets: Forget the Great Wall - Let’s Go Shopping.
- If you’re like me, and the investment risk in India appears to be a bit too high for now, check out Smart Profits #275 to see what types of investments are worth looking into… especially in 2006 - Using LEAPS: These Options Are Set to Run Full Tilt
Related Articles:
- Option Position Sizing - How Much to Invest In Each Option Trade
- Inverted Yield Curve: Now’s the Perfect Time For LEAPS Options
- Option Trading Strategies - Option Plays That “Earn” Their Keep
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