Selling Covered Calls
December 27, 2005
The Smart Profits Report: Issue #270
Tuesday, December 27, 2005
Selling Covered Calls - Getting Cash for Stocks You Already Own
By Lee Lowell
Advisory Panelist, Mt. Vernon Research
If you own at least 100 shares of stock, and you’re not selling call options against it, then you are throwing away free money. How’s that?
Well, there are other traders out there who will give you money today for the right to take your stock away from you if it reaches a much higher price.
Selling covered calls is such a great strategy for padding your bank account that I still can’t believe there are investors who aren’t taking advantage of it. It’s one of the best ways to take in extra cash flow that you never thought you could have.
Here’s how it works…
Selling "Longshots" On Intel With Out-of-the-Money Calls
Let’s say you own 500 shares of Intel Corp (INTC) that you bought in 1997 for $25.50/share. How have you done?
Well, if you didn’t sell during the tech bubble in 2000, then you are breaking even as of today, with INTC trading for about $26/share. Bummer. All that time and you still haven’t made any money on it. You probably could’ve used that money to invest in something else, or at least buy yourself a nice gift after all that time. Who knew? Nobody knows how an investment will turn out over time.
What could you have done in the meantime? Sold covered call options against your shares. There are two great things about this strategy:
- It allows you to passively accumulate income over time by having someone else pay you money. You become the option seller. For every 100 shares of INTC you own, you can sell one option contract. In this case, you can sell five option contracts.
- It reduces your cost basis of the stock by the amount of the option you sold. If you sell enough covered calls over time, your cost basis could be zero! Let’s look at an example.
Below is an option chain for INTC with an April 2006 expiration date. The last price for INTC was $25.97 (upper right corner).
What we want to do is concentrate on selling out-of-the-money (OTM) call options. An OTM call option has a strike price that’s higher than the current price of the stock. In this example, we will focus on the $30 strike calls.
We see from the "Bid" column that the $30 calls are bidding at $.25. This means that for every $30 call we sell, we will take in $25 ($.25 x $100 multiplier). Since we own 500 shares, we can sell five option contracts and net a take-home pay of $125.
This strategy is great if we really like the stock and want to keep it in our portfolio. The only way we give up the stock is if it moves a good deal higher. Instead of waiting to see if INTC will ever go up in price, we are taking a proactive trading strategy and making some extra cash on the side.
What happens when we sell the $30 strike calls? It means that if INTC trades above $30 by April 2006 expiration, and stays above $30, we will be forced to sell our INTC shares to someone for $30/share. It’s called getting "assigned on our short options." But is that a bad thing?
Well, considering that INTC hasn’t been above $30 in almost two years, and you don’t really want to give up your shares, I don’t think it’s a bad bet. Plus, the trade is only good until April 2006. If INTC doesn’t get above $30/share by April 2006 expiration, then the trade is over and we get to keep the $125 free and clear… and we also keep our long INTC stock. We can also repeat the trade for a different expiration month.
If you happen to get assigned on your call options and are forced to sell the stock, then so be it. You still came out ahead. Not only did you make $125 from the options, but you also have a gain on the stock from your original purchase price of $25.50. That’s a $2,250 gain.
Using The Force When Selling Covered Calls
Selling OTM covered calls forces you to take some profits along the way (assuming you are selling calls with strike prices above your initial stock buy price). Also, since we are selling the calls for $.25, it reduces our cost basis to $25.25. Do that enough times over the years and your cost basis could be zero!
Some investors will worry about causing a capital gains tax event if they are assigned and forced to sell their shares. That’s true. But in my opinion, it’s better to take a profit somewhere along the way.
Would you rather hold your stock just to avoid the IRS? Look at all the stocks that have imploded since the 2000 meltdown. I’m sure there are many folks kicking themselves for not selling at some point, either through a regular stock sale or by an option assignment.
In the case of our INTC example, if we had been selling covered calls all along, taking in $125 once every three months or so, we could have netted a nice sum while the stock lingered for seven years. It’s sort of like a consolation prize while you’re waiting. Everyone else who didn’t sell covered calls has nothing to show for it.
This strategy is a way to gain sideline income while you wait for an eventual sell price (you do have a sell point, don’t you?) Why not sell potentially worthless options, repeat the process many times during the year, lower your cost basis and enjoy the income?
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Today’s Smart Profits Cribsheet
- Lee spent seven years in the options pits of the New York Mercantile Exchange (NYMEX)… And he’s taken us behind the scences to help us understand the role of the market makers. Check out his Market Maker Series, Smart Profits #241, #243, #247 and #252.
- And if you haven’t looked into Lee’s special electronic report, How to Receive Instant Cash Payments for "Locking In" Lower Prices on Your Favorite Stocks, now is a great time to do so. It’s a handbook that can be e-mailed right to your inbox…
- For a better understanding of terms like "covered calls" or "margin", check out our Smart Profits Glossary.
Good trading,
Lee
Related Articles:
- Long-Term Covered Calls - The Best Way to Play Satellite Radio
- Covered Call Writing and Put Selling
- Sell First, Buy Second for 50% Better Odds
Emerging Markets of China
December 22, 2005
The Smart Profits Report: Issue #269
Thursday, December 22, 2005
Emerging Markets: Forget the Great Wall of China - Let’s Go Shopping
By Karim Rahemtulla
Chairman, Mt. Vernon Research
Each year at Christmas time, I buy a lot of presents for family and friends. I also buy myself something that I want or need. This is usually the most difficult present because I have just about everything that I need… and some of the stuff that I want I can’t justify buying.
Oh! To be Bill Gates for just a day! Or to travel to a distant land with dirt-cheap eyewear. Let me explain…
Christmas in China…
Earlier this year, I was in China. What I loved most about the country was the shopping. Sure, the Great Wall is something to behold. But I have been to China many times and have enjoyed the cultural experiences. This time, my focus was shopping. And I was not disappointed.
Thoughts of quitting my day job flitted through my mind. I could go to China once a month, buy a container load of stuff for next to nothing, and sell it for a huge profit stateside. (But, wait, Wal-Mart’s already doing that.)
Instead, I concentrated on buying things that were fun. I bought an antique camera for $100, about $2,000 less than a similar model I saw at a show in Florida. I bought some leather goods for family members for about $60 - two jackets and a vest. And, I bought a bunch of “junk.” A suitcase full of this stuff set me back about $20, including the suitcase!
My favorite purchase was a pair of rimless prescription glasses at the Pearl Market. And after realizing what they’d cost me in the States, I should have bought 10 pairs!
Capital Losses Back Home
About a week ago, I lost the rimless glasses… I ended up wearing my prescription sunglasses for two days of meetings at our Baltimore offices. I was interviewing several editors for the Agora Financial Year-End Forecast Series (see today’s Crib Sheet for details). It was quite funny… I am sure they thought I was trying to act cool.
Anyway, when I got home I went to the local Pearle Vision Center to look for a new pair of rimless frames and lenses.
The first thing they told me was that my prescription was more than two years old, so I had to get a new eye exam. I informed them that I could see just fine and that I would not have been able to find their store if my vision needed to be corrected. I also informed them that I have been using the same prescription for at least 20 years with no measurable, unusual side effects. There was no getting out of it - $39 for a new exam, or no new glasses.
Fine! I went over to the rimless frame section. “Those are for women,” the associate yelled out… maybe I do need an eye exam. He pointed me over to the men’s section. The selection was smaller. I perused the frames and the ones that I wanted cost $319. They were identical to the frames I bought in China.
“How much for the lenses?” I asked politely. Another $149 was the answer. I asked for the total for a pair. It came to just a tad more than $500, plus the mandatory exam. “Jeez, what a rip off,” I muttered under my breath. “Any discounts?”
“Only if you buy TWO pairs” came the reply. If I bought a second pair, I would get $100 off the total. Now, if I were my significant other, this would be a savings. “Look, honey, I just saved us $100!”
At this point, I was convinced that I would not be walking out of the store with new specs that day. But, I asked anyway: “Can they be ready in an hour?”
“Oh, no. These are polycarbonate and they need to be sent out so that they can drill directly into the lens, it will take at least two weeks.”
I was taken aback. Not only did they want to charge me for more than any other pair of glasses in the store, but they would not be ready for at least two weeks. And I would have to take an eye exam as well, just to pad their profits some more. I thanked them for their time and walked back to my car.
I thought back fondly about the Pearl Market experience in China. I bought my rimless glasses with lenses and a sunglass clip for $40 - a 92% discount! They got my prescription off the pair I was wearing. And they had the pair ready in 45 minutes. I need to get back there ASAP.
Using my partner’s shopping methodology, I could buy two pairs in China for $90, and save $900 compared to the price at home - enough to pay for a round-trip ticket and two nights at the five-star Hyatt in Beijing!
Happy Holidays from the staff of The Smart Profits Report, Mt. Vernon Research and the Xcelerated Profits Report.
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Today’s Smart Profits Cribsheet
- Today I mentioned the Agora Financial Year-End Forecast Series. This one’s a “must-know.” See what to expect in the markets this year…
Good trading,
Karim
Related Articles:
- Beating the Market Makers on Price
- Now, Something Completely Different - A Bond Play
- How I Suddenly Got Smarter than 98% of Investors… And You Will, Too
Principal Protection
December 20, 2005
The Smart Profits Report: Issue #268
Tuesday, December 20, 2005
Principal Protection: How to "Defend" Your Principal From a 50% "Bomb"
By Steve McDonald
Advisory Panelist, Mt. Vernon Research
Top Gun and other fighter pilot movies have done a great job creating a stereotypical image of an aviator - a daring and adventurous soldier with perfect vision and a propensity for never making a mistake. You’d think they could walk on water… One of the funniest things to watch when I was flying for the Navy was newer guys trying to live up to this Hollywood image of Naval Aviation.
But believe me, it’s not brain surgery. And neither is investing.
Picking stocks and options is a tough job, to be sure, but those of us who do it successfully on a consistent basis don’t walk on water. The truth is, after almost 25 years of stock trading, I have learned, usually the hard way, there are several rules written in blood. And one of them is that you can’t avoid making a mistake somewhere along the line.
But being able to handle those mistakes and protect your principal is a skill you can master. Here’s how…
Three Rules To Protect Your Portfolio
#1: Accept that you will always have losers.
- If you are operating under the idea that there is some secret system that you haven’t found yet that will allow you to avoid losers, you’ll have to change your assumptions. Investing is a game of averages. You must plan for losers and have a way to deal with them.
#2: Get out early.
- Admit your mistakes early and often. Not only will you limit your losses, you’ll have a happier marriage. If the market says you’re wrong, then you’re wrong. Any effort to change the inevitable will only make you feel more foolish down the road.
#3: Have a system for dealing with your losers.
- We call these systems trailing stops, stop losses, stop limits, etc. Know what they are and use them. If you don’t limit your losses, you won’t have any money left when the market goes in your favor.
There is nothing more exciting or satisfying than investing in options. There is also nothing more painful than watching the losers tank.
This is as much a head game as it is a game of numbers. You must be prepared for the downs and be ready to deal with the emotional dips, or they will eat you up. Call it discipline, market savvy or whatever you like. The difference between the big boys and the rookies is how they deal with the losers.
Back To The Drawing Board
Let me give you an example…
Recently, I had a straddle I was following where both the call and the put were down. A straddle is when you buy the puts and the calls on the same underlying issue, at the same strike price and expiration. Then in this case, how could both be down
Well, it’s the market, and with so many variables, anything can happen. Besides, how isn’t the question we should be asking, as it is out of our control. The real question is: What should you do to protect your principal?
In my case, I sold. And I lost about 30% overall. But the point is, two days after I sold it, it was bombed even more, for a 50% loss. I prevented myself from taking a huge bath by having my stops in place… and they worked exactly the way they were supposed to.
Walking away is always tougher, but don’t look back. It’s part of the plan. Learning this simple fact about principal protection is a huge hurdle for most people. Be one of the smart ones.
Great Trading,
Steve
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Today’s Smart Profits Cribsheet
- Want more on straddles and strangles? Take a look back at Smart Profits # 257, Options Strangle Tips: Extracting Three Stranle Tips from a 515% Gain to see how these strategies to work.
- For more explanations of options terms like "position sizing" or "straddle," check out our free Smart Profits Glossary.
Related Articles:
- Option Losses: How to Grow Rich From Your Option Losses
- Position Sizing - The Most Powerful Investment Concept
- Option Position Sizing: How Much to Invest In Each Option Trade
Option Credit Spreads
December 15, 2005
The Smart Profits Report: Issue #267
Thursday, December 15, 2005
Option Credit Spreads: Sell First, Buy Second for 50% Better Odds
By Lee Lowell
Advisory Panelist, Mt. Vernon Research
Much of my own option trading occurs from the short side. I’m not referring to a bearish directional outlook, but rather a trading strategy that involves the selling of options instead of buying them. This involves either selling “naked” options, or initiating option credit spreads.
You see, you don’t always have to be an options buyer, and you don’t have to own something first before you can sell it. The great thing about the financial markets is that you can sell first and buy second, instead of the long-standing philosophy of buy first, sell later.
The reason I like to sell options is because I believe that you gain more margin for error if you are incorrect in your market assessment. But you have to know how to sell them correctly. You can’t just sell any old option and think you’ll have a profitable trade. You have to take into consideration the following:
- The general direction of the market or stock you’re trading
- The strike price
- Time to expiration
- Volatility of the options
Many people trade options under the assumption that because they think they know where the stock is headed, they can buy cheap out-of-the-money (OTM) options with little time to expiration. This is the downfall of most option traders. How many of us are actually that good at predicting where and when a stock is going to move? I know I’m not, but many investors still trade options that way. You’re giving yourself such a small window to be correct in your assessment since there’s not much time left before the option expires.
Let’s look at why the short side can be more profitable than the long… and how to set up a put credit spread for a 75% chance of winning.
Three Out of Four Chances to Win With A Credit Spread
When you buy an OTM call or put, you only have one way to be profitable, and that’s if the stock moves far enough higher or lower to pass your break-even point in the time allotted. When you sell an out-of-the-money call or put, or an OTM credit spread, you actually have three ways to become profitable.
For example, if you sell an OTM put option or put credit spread, you will be profitable if the stock moves higher, stays flat, or moves slightly lower, but not lower than your break-even. If you sell an OTM call option or call credit spread, you will be profitable if the stock moves lower, stays flat, or moves slightly higher, but not higher than your break-even. The only way to lose is if the stock moves well past your break-even price.
So that’s three out of four scenarios, or a 75% chance of having a successful trade when selling options. When buying options, you really only have a one-in-four chance of winning, or 25%. I like the odds better when selling options - you can be incorrect in your market assessment to a degree, and still have a profitable trade.
Let’s take a real-life scenario and see how I would set up an option trade:
Here’s a six-month daily chart of March 2006 Sugar. We can easily see that sugar has been in an uptrend for quite some time, so why try to rock the boat and trade any other way? Let’s stick with the trend and look for a bullish trade.
Instead of buying call options and trying to predict what level sugar might go up to, we’re going to look at selling OTM put credit spreads instead. Selling put credit spreads is a bullish strategy that lets us take advantage of our directional bias, but also gives us room for error if sugar retraces to the downside somewhat.
How The Option Credit Spread Works
Ideally, we’d like to wait for sugar to pull back a little to one of our trendlines before initiating the trade, but I will show you the strategy so you understand how it works. Since we believe sugar won’t retrace much lower than the $1,270 level, we’ll use that as our support area, and the place in which to pick the strike prices for the put spread. We’d like to sell the $1,250/$1,200 put spread (not a recommendation - educational purposes only!). Let’s check the option prices below.
We can sell the March 2006 $1,250/$1,200 put spread for 9 points. Here’s how it breaks down:
What we’re doing is selling the $1,250 put (for a credit of 21 points) and buying the $1,200 put (which costs us 12 points) as a single trade for a net credit of 9 points. If you look in the “Last” column, you’ll see the prices for each strike. Just take the difference between the two and you get your net price.
In the sugar market, each point is worth $11.50, so our initial credit is $103.50 (9 x $11.50) for each spread we sell. Since we are bullish, we don’t want sugar to go lower than our break-even price of $1,241. In order to figure the break-even, you take the upper strike in this case and subtract the net credit ($1,250 - 9 = $1,241). As long as sugar stays above $1,241, we will retain the net credit and have a profitable trade. Sugar can go higher, stay flat, or go lower, but not lower than $1,241 for us to win. Since sugar is currently at $1,381, we have much room for error and three out of four chances to win.
Based on our technical analysis, I think it’s easier to predict what level the market WON’T get to, rather than the level it MIGHT go to.
Good Trading,
Lee Lowell
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Today’s Smart Profits Cribsheet
- So now that we know that you can improve your odds of success by 50% selling options instead of buying them… swing over to Smart Profits #221, Using a Probability Calculator - Know Your Trade’s Exact Chance of Success Up Front. Also,check out Smart Profits #226, How to Enjoy Guaranteed Monthly Income With Options.
- And if you haven’t looked into Lee’s special electronic report, “How to Receive Instant Cash Payments for “Locking In” Lower Prices on Your Favorite Stocks”, now is a great time to do so. It’s a handbook that can be e-mailed right to your inbox… Click here.
Related Articles:
- The Bull Calendar Spread: How To Use This Trading Strategy To Bag 133% Now Or 4,900% Later
- Spread Trades: Bull vs. Bear
- Spread Trading: Lower Your Cost And Hedge Your Risk In One Profitable Bull Spread Trade
A Bond Play
December 13, 2005
The Smart Profits Report: Issue #266
Tuesday, December 13, 2005
A Bond Play: Now, Something Completely Different
By Karim Rahemtulla
Chairman, Mt. Vernon Research
Every so often, something I see in my research The Volatility Traderme to alert you, even though it is not options related. Especially if there’s an opportunity to make some money…
A few months ago, I wrote to you that Bill Gross, the guru of fixed income investing at Pimco and the country’s largest bond fund manager, was buying shares of Pimco Municipal Funds. Not surprisingly, he - and you - should be up more than 15% on that bond play, including dividends received.
But what is surprising is that interest rates have moved up almost 200 basis points since he began buying, yet he’s made money.
A Rising Interest Rate = A Nice Bond Play?
Normally, in a rising interest rate environment, existing bond portfolios tend to lose value (because newly issued bonds have better coupon rates, therefore decreasing the demand - and value - of existing bonds).
Gross’ belief, and I agree with him, is that the Fed will stop raising rates in a couple of months. This opinion is based on historical rate hikes and the fact that the consumer and housing sector is not as strong as one would believe from the headlines. Already, housing in many parts of the country is losing steam.
Last week, I read that prices in some Boston neighborhoods had seen prices decline by 15% and more - not a soft landing.
What About The Almost Inverted Yield Curve?
Here is some insight from Gross’ notes in his latest investment outlook… Bill Gross thinks lower rates on the longer-term bonds are here to stay.
His argument centers around the flow of funds from countries like China, and the effect that lowered manufacturing costs have on inflation. He says that these factors have actually reduced the yield on bonds by as much as 200 basis points.
Basically, the 10-year bond at 4.6% today is equivalent to 6.6% in the past. So, we are approaching the top-end of the rate cycle, and the next trend, likely to set in a few months from now, will be neutral to easing.
Putting Money Where Your Mouth Is
What I like most about Bill Gross is that he puts his money where his mouth is. He recently purchased 1,000 shares of two Pimco closed-end floating rate funds - PFN and PFL - both listed on the NYSE. To no one’s surprise, both are trading near their lows and yielding close to 8%.
When he was buying the Pimco Municipal Funds, they were near their lows as well, and he managed to put away quite a chunk. It looks like history just might repeat itself.
Good Trading,
Karim
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Today’s Smart Profits Cribsheet
- Bill Gross’ full investment outlook can be found here.
- Today, I mentioned that Bill Gross was picking up shares of Pimco Municipal Bond Funds a few months ago… Read the details here: Smart Profits #201 - What Does Bill Gross Know?
- Check out the Smart Profits Glossary for definitions of terms like "options" or "commodities" found in today’s article.
Related Articles:
- Basic Trading Rules: The Four Rules of All "Smart Money"
- What Does Bill Gross Know?
- Index Options: A Billionaire’s Trading Tool Anyone Can Use
Back-Testing Strategy
December 6, 2005
The Smart Profits Report: Issue #264
Tuesday, December 6, 2005
Back-Testing Strategy: 1.8 Billion Ways to Improve Your Trades
By Dean Albrecht
Advisory Panelist, Mt. Vernon Research
As the editor of a trading service, I’ve got a pretty big responsibility to generate hefty results for my subscribers. And because I need to be confident about the direction of my trades, I make it a point to use as much information as possible. One type of information that consistently generates good results for me is historical data.
Yesterday, the New York Stock Exchange saw nearly 1.8 billion shares change hands, which is pretty close to its average. But over the weeks and months, you’re talking about a ton of information! So, why not use this tome of historical trades to our advantage?
Today, let’s look at how to use recent market data through a back-testing strategy to get an edge in your trading.
The Three Questions “Back-Testing” Can Answer
One of the reasons I trade options is to enjoy the higher percentage gains compared to stocks. But there is also inherently more percentage risk. That’s why back-testing can play an important role. It allows us to put our strategies under the microscope prior to using real money on our ideas.
It’s usually very tedious work - punching loads of buttons, changing parameters and writing codes. But something we get excited about.
How important is back-testing? Well, as I said before, I like to have a pretty good idea about how my trades are likely to go… before I pull the trigger. Then, I’ll run tests in real time to see how the strategies do with real money.
For example, we have an exchange-traded fund (ETF) strategy that we follow quite closely. When we created the system, we knew that the swings in the near-term, in-the-money calls and puts were significant. But we wanted to know the answers to three questions before we put any money on the line:
- Will our entries and exits be good?
- Will they be high-probability trades, with percentage swings in the options upward of 30%?
- At what point do we take our losses and lick our wounds before we lose too much of our capital?
The Back-Testing Strategy = Confidence In Trading
What we ended up creating was a system that is right more than 65% of the time, and has 20% losses once a month and 20% gains two to three times per month. The numbers work, but we didn’t deploy the strategy until we did the back-testing to make sure that our idea had a good chance of winning over the long run.
Once we had the confidence to run the strategy, we deployed it with real money and worked out the real-time kinks, ultimately creating a winning strategy. And back-testing enabled us to do it more quickly.
While we don’t base our whole belief system on back-testing, it can give us substantiated confidence, or at least a shot of reality to keep us out of a bad trade. Either way, we get more than a good idea of where we may end up.
Good Trading,
Dean
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Today’s Smart Profits Cribsheet
- Speaking of strategies, check out what Mt. Vernon Research’s Steve McDonald has to offer on straddles and strangles in Smart Profits #260, Trading Index Options: Two Ways To Profit; and #257, Option Strangle Tips: Extracting Three Strangle Tips From a 515% Gain.
- Check out the Smart Profits Glossary for definitions of words like “exchange traded fund” or “historic volatility” found in today’s article.
Related Articles:
- In the Money Options: Make Mondays Your Discount Stock-Buying Day
- How to Use Puts and Calls: For Systematic Short-Term Profits
- Short-Term Options: Two Ways to Make Them Work
Position Sizing Safeguards
December 1, 2005
The Smart Profits Report: Issue #263
Thursday, December 1, 2005
Position Sizing Safeguards: Prevent Corporate Lies From “Cooking” Your Portfolio
By Karim Rahemtulla
Chairman, Mt. Vernon Research
It’s been several years since the Enron, Worldcom and Global Crossing stories surfaced, and the market is a better, more honest place, right? Wrong!
The level of executive mismanagement and outright fraud is rampant in corporate America. Companies still lie, cheat and rip off their shareholders with bold promises of better growth, debt reduction, “plans” for a turnaround and rosy projections for future quarters.
What drives these executives to at best mislead investors, and at worst commit outright fraud, like that at Adelphia? The answer is simple. Too simple. So let’s look at how and why they do it… and the most important rule of thumb: to safeguard with position sizing.
Loading Up on One-Time Charges
The simplicity of this common deception is what makes it work every time. Executives know, for the most part, that their jobs and incentives are based on short-term performance. Earnings have to be good - or they must be projected to be good - just long enough for the bonuses to be paid, and the stock options to be vested and cashed out.
How does it work? Well, just sell a bunch of phony baloney to Wall Street and get the little guy to bail you out by buying into the hype. And when the time comes to reveal the ugly numbers, throw in a bunch of “one-time” charges and blame the weather.
These charges are never one-time events, but are recurring in some form or another, so that investors never know the true earnings or condition of the company. Then, hungry investment banks come along and finance the bogus companies to collect the fatter fees that can be extorted from companies in dire need.
After all, the real money is coming from other people, not the investment banks. And by the time the banks are found culpable, they will have made a ton of money trading the shares to the ground, and then more money from bankruptcy fees - enough to cover any slap-on-the-wrist fines they receive.
What You Can Do About It… Using Position Sizing
Make sure that if there is one rule you follow, it is to position size. Do not overload into any one investment idea. No matter how much of a “sure thing” you may think it is, know that the information that you are investing on is often tainted by the company before it is released to the public or the investment analysts. It’s a rough world out there, and investors are more often the prey and not the predator.
Position sizing allows you to risk only a small portion of your capital in every trade. This way, if one investment goes sour, the impact on your portfolio is relatively minor. Invest a little to make a lot - not the other way around.
Good Trading,
Karim
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Today’s Smart Profits Cribsheet
- For some additional guidance before your next trade, head back to Smart Profits #229, Option Position Sizing: How Much to Invest in Each Option Trade.
- If you’re not familiar with position sizing techniques, head to Smart Profits #193 right now - Position Sizing -The Most Powerful Investment Concept in the World. Every investor, no matter how experienced, can benefit from this principle. It’s the best way to control the fate of your portfolio.
Related Articles:
- Implied Volatility - The Impact of Beta on Your Option Positions
- Portfolio Position Sizing: The “10% Rule” for Safe Option Profits
- Options Straddle - Using A Straddle to Harness “Uncertainty”
Options Leverage
November 29, 2005
The Smart Profits Report: Issue #262
Tuesday, November 29, 2005
Options Leverage - How to Use Delta to Maximize Leverage
By Lee Lowell
Advisory Panelist, Mt. Vernon Research
The best weapon in the financial world is leverage. Applying this principle allows you to control a large amount of goods with a very small investment. That’s the smartest way to use your money. While you’re saving dollars on one investment, you can use them to buy more investments. And there’s no better way to apply this method than in the options arena. I’ve said this to many people time and again: If you want to buy stock, make sure you do it by using options, specifically deep-in-the-money options (DITM).
Buying call options in lieu of buying the actual stock is a great way to leverage your money. You pay the small upfront cost of the call option and you get to control the stock until option expiration. The up-front cost of the call option can sometimes be 20 times less than buying the stock. That’s leverage!
But with such fantastic leverage, you also need the stock to make a large move to become profitable. This is where picking the strike price is critical to balancing out your leverage with making a profitable trade.
Let’s take a closer look at how you can increase your leverage (and your profits) using deep-in-the-money calls.
How to Get Dollar-for-Dollar Moves on Your Options
Many investors will settle on buying an out-of-the-money (OTM) call option when they want to use leverage to get in on a bullish expectation for the stock. An OTM call option’s strike price is higher than the current level of the stock. For instance, if Intel (Nasdaq: INTC) is trading at $26.98, an OTM call option would be one whose strike price is $27.50 or higher. (See the option chain below.)
If you bought the July 2006 $30 call for $1.05, you wouldn’t see a profit until INTC gets above $31.05 (if held to option expiration). That’s how you calculate your breakeven point with options - you add the strike price to the cost of the options ($30 + $1.05 = $31.05). You’re certainly using leverage with this trade. Instead of buying the stock and shelling out $2,698 for every 100 shares, you would pay only $105 to control the same 100 shares. The only issue, as we just mentioned, is that you wouldn’t make any money until INTC goes up another $4.05 per share. This is fine for someone who wants to spend a little money on the hopes that INTC goes up that amount in the time allotted.
Now, let’s look at a different way to leverage your money and profit immediately when INTC makes any kind of move - using a deep-in-the-money call option. A DITM call option has a strike price far below the current price of the stock. In the case of Intel, we’d be looking at strike prices of $25 and lower. The key to having a successful trade with DITM call options is the “delta.” Delta shows you the correlation between the movement of the option to the movement of the stock. You want a delta value of at least 90 or higher.
Look at the Delta column in the option chain above. We see the July 2006 $15 call option has a Delta of 100. This tells us that the July 2006 $15 call will move 100% in tandem with any move that INTC makes (up or down). If INTC goes up $1, the $15 call should go up approximately $1. That’s what you want. You want your option to move just as much as the stock. So how much does the $15 call cost? According to the option chain, it costs $12.25 (splitting bid/ask). That’s $1,225 for one option contract. Yes, that’s about $1,100 more than it costs to buy the $30 call, but it’s still about $1,500 less than it costs to buy 100 shares of INTC outright.
Leverage Benefits of Buying Calls
Here are the benefits to buying the $15 call:
- As we mentioned, it will cost you almost $1,500 less than buying INTC shares.
- You’re going to get 100% of the same movement (up or down) as INTC.
- With the $1,500 you saved, you can go out and buy some other DITM options on other stocks you might like.
- The most you have at risk is your $1,225 initial investment. If for some unknown reason INTC tanks to $0 per share, the most you can lose is $1,225. All the holders of the stock can lose all of their investment.
With the $15 call, your break-even point, or cost basis, is $27.25 ($15 strike + $12.25 = $27.25). Contrast this with the $30 call where your break-even is $31.05. A much better deal in my opinion, even though the option costs more.
Weighing Your Cost vs. Your Profits
When you buy options, you need to weigh your cost versus your profitability. If you’re okay with waiting for INTC to get above $31.05 before seeing a profit, then the $30 call might be for you. But, if you want immediate gratification, then you should look to purchase a DITM. Remember, we want to substitute a call option for the stock. In order to do that, you must choose a strike price that has a very high Delta (90 or above). That is the key to giving you all the same movement for a fraction of the cost.
Come expiration time, you have two choices: You can sell the call back to the open market, and the trade will be over and done with. Or you can exercise the call, in which case you will be required to come up with the rest of the payment for the stock. The advantage of the DITM is that you only have to put up a small down payment up front. After you pay for the rest of the stock, you will see the 100 shares deposited into your trading account on the Monday following expiration.
In my opinion, this is a no-brainer. When interested in buying stock, why not buy some DITM call options which will cost you less, give you all the same movement, lower you total risk, and also allow you to put some of that saved money into other investments?
Good Trading,
Lee Lowell
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Today’s Smart Profits Cribsheet
- Lee spent seven years in the options pits of the New York Mercantile Exchange. Check out his Market Maker Series (Smart Profits #241, #243, #247 and #252), which details the action on the floor of the exchange.
- While today’s Smart Profits Report focuses on buying deep-in-the-money calls, Lee’s put together a special electronic report on how to profit when investors buy out-of-the-money options. The report, How to Receive Instant Cash Payments for “Locking In” Lower Prices on Your Favorite Stocks, is a handbook that can be e-mailed right to your inbox… Click here.
- For definitions of words like “expiration”, “leverage” or “excercise price” check out our Smart Profits Glossary, full of over 175 options terms!
Related Articles:
- Sell to Close Options: How “Patient” Trading Turned $8,000 into $192,000
- Credit Spreads With Options: How Option Credit Spreads Give You a Better Chance to Win
- Buying Put Options & Covered Calls: Two Ways To Play A Downside Trend
Option Prices
November 22, 2005
The Smart Profits Report: Issue #261
Tuesday, November 22, 2005
Option Prices: How to Get the Best Price on Your Options
By Steve McDonald
Options Specialist, Mt. Vernon Research
My first day as a stockbroker, my advisor told me what he loved about the business. “You learn something new every day,” he said. And he was right.
I often take for granted how much information stacks up over time. In the 20 years I’ve been trading, most of what I know is the result of having made every mistake imaginable… without somehow ending up broke or unemployed.
And one of the biggest lessons I’ve learned is that if you don’t get the right option prices, no matter how much homework you’ve done, you may never realize gains, even if the trade goes your way. But you don’t always have to pay a premium to buy your options contracts.
Today, I want to show you why the best way to get competitive options prices is with a full-service broker. Let me explain…
First Benefit of a Full-Service Broker: Accurate Option Pricing
I was putting together some option picks recently, and one of the option prices I found online was ridiculous. It had an ask of .55, a bid of .45, and was last traded for .10.
That didn’t seem right to me. Why would I pay .55 for an option that just sold for .10?
I wouldn’t. So in this case, I put the option on my waiting list with hopes its pricing would come down to reality.
As I always do, I checked several other sources online for several hours after the option started trading. No change. On a whim, I called one of the brokers I know to see if he could offer any help.
After giving him the symbol, he came back to me with an ask of .10. In fact, there were several offers on his screen at that price. So, what gives? Why is my screen telling me .55?
Brokers have access to all of the outstanding offers on the market. They can see what all the sellers are asking. So, even though the bid and ask online were far above the last trade, there were still plenty of offers at .10. None of this information was available on the usual online sources.
Not only could the broker tell me what the ask was, he knew how many I could buy at that price and what I would have to pay for more of it. That was news to me. We did not have that ability when I was a broker. We could see the bid, ask, last trade and volume. That’s it.
Guess what price you would have paid if you had put in a market order for this option? .55. And you would have had to pay the same price if you tried to buy five, 10 or even 20 contracts.
Second Benefit of a Full-Service Broker: Lower Option Pricing
Being able to buy anything in large quantities usually gets you a better price. Stocks and options are no different. Brokers can get more competitive pricing, but they can also fill larger orders… and get a discount.
Buying options in small numbers, five or 10 contracts, is the costliest way to trade. This is what is called a “booked trade.” A booked trade is where a small trade is put in by the trader, at the highest price they can legally give you. In the case of my example, that would have been .55. What a deal!
A broker is able to put out an offer to buy a certain number of options at a certain price. Usually, since he or she is buying for several of his clients, they are offering to buy more than an individual investor can. This gives the broker a huge price advantage.
In just about every instance, the broker will get you a better price than you can get online. Even if it’s only .05 less per trade, over a year of trading, that’s huge.
Third Benefit of a Full-Service Broker: A Safety Net
What none of us like to admit are the really big mistakes we’ve made investing. Yes, we saved a few dollars on the commissions doing it ourselves, and yes we lost 10 times that amount as a result of the errors we’ve made. I have some real horror stories about members who have lost thousands because they misunderstood an alert and sold an option instead of buying one.
The most common example I have is of people who buy way too much of a single option, and get crushed when it goes against them. This is almost always the result of inexperience.
Brokers are required by law to tell you when you are doing something that is not in your best interest. In fact, they are required by law to refuse to do something you ask them to do, if they know it is not in your best interest. You can ignore their advice, but you’re fixing something that isn’t broken.
They’re also responsible for any mistakes they make. If a broker enters a sell instead of a buy, it’s his problem, not yours. If they enter a trade for 100 contracts, instead of 10, which is quite easy to do with an online broker, the broker owns the other 90 contracts, not you.
With a full service broker, you have an advisor who can answer your questions about your personal investment issues. They are licensed by the federal government to do exactly that.
Trading options is a tough business. You need all the help you can get. Don’t start each trade in the hole.
Good Trading,
Steve McDonald
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Today’s Smart Profits Cribsheet
- Getting the best price on your options trades also has a lot to do with knowing the role of the market makers. Karim Rahemtulla, chairman of Mt. Vernon Research, shows us a few tips in Smart Profits #212, Beating the Market Makers on Price, and Smart Profits #191, Outmaneuvering the Market Maker’s Hidden Bid.
Related Articles:
- How To Effectively Handle Any Broker: Secrets To Getting Started In Options
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Option Trade Execution: Two Simple Steps for Getting Filled At Your Price
Trading Index Options
November 18, 2005
The Smart Profits Report: Issue #260
Friday, November 18, 2005
Trading Index Options - Two Ways To Profit
By Steve McDonald
Options Specialist, Mt. Vernon Research
In the 20-plus years I’ve been trading index options and stocks, it seems the market always runs when you least expect it. Consider how long it’s been since we’ve had any good news. Not just about the market, but good news in general - Hurricanes, interest rate hikes, volatile gas prices, wars in Iraq and Afghanistan.
We’ve spent five years in a lackluster market, and it hasn’t been easy to hang in there. But every bit of my market sense tells me we are on the verge of a great ride…
- Corporate earnings reports have been exceeding estimates two to one.
- The Fed has done a great job of controlling inflation.
- Energy prices are back to a reasonable level.
- Interest rates are still at historic lows.
This looks like a very good place to start a run in stock prices.
Still, we’re not quite there yet, and a haunting voice in my head is whispering caution. In the meantime, then, how do I take advantage of uncertainty, without losing the farm?
In a tough market like this, index options are a great way to come out on top by using less cash up front. Let’s look at two ways to trade them for a profit…
Naked Calls and Strangles for Index Options Profits
The Nasdaq 100 Trust (Nasdaq: QQQQ) is the best way I know to follow the ups and downs of its namesake index. And it can be very volatile, which is good for trading.
The following is a play that makes a lot of sense to me for this type of market. (As always, this is just an example, meant to illustrate some of the techniques and mechanics of using this option. It is not a recommendation.)
On November 2, QQQQ was trading at $39.19, and we’ll use the pricing from that day in our example. Since we don’t want to be too aggressive and outsmart ourselves on the time value, let’s go out about eight months, to June of 2006, and look for an option in- or near-the-money.
The June 2006 call, with a strike price of $41 (QQQ FO), was trading at $1.65 on November 2. That’s a good buy because the strike price was $1.81 from the current price of the shares, which means you’d get a discount of 16 cents. If you wanted to be right at-the-money, you could have looked at the $40 strike for $1.95, but this had a hefty premium to it.
For a classic valuation, the QQQQ would have to move 4.6%, or $1.81, between now and June to reach our strike of $41. If I’m right about the market sitting on the edge of a solid run, a move of $1.81 in eight months is more than reasonable. Ideally, we’d like to see a move beyond the $41 price, which would give us a dollar-for-dollar move in our option above the $41 price. So, if the QQQQ moves up to $44, our option should be worth $3 from $1.65, plus any time value - an 81% gain in eight months.
That, of course, is if the market plays out the way I think it will. But what if you don’t see the market going one way or the other?
That’s where the second way to the index comes in…
How to Use a Strangle to Capitalize on Uncertainty
First, remember that with a strangle, you’re buying the calls and the puts with the same expiration, but with different strike prices.
Since we’ve already bought the call in our example, we need to buy a June put to complete the strangle. We’ll go with a strike of $37 (QQQ RK) that would have cost $1.05 on November 2.
Now that the strangle is in place, keep in mind that the trend is your friend. If the index starts moving up, it’s time to dump the put. Don’t dig yourself a hole by assuming you’re right and the market is wrong. Let the losing side of the trade go, and let your winner run… That’s the key to a strangle.
The QQQQ is only one of the indexes available. If you like the idea of using options to bet on market (or sector) moves, and think you’d like to get away from the tech-heavy Nasdaq, there are numerous ETFs (Exchange-Traded Funds) that allow you to implement the same type of strategy.
The bottom line is when you aren’t positive about the market’s direction, you can use options to play your hunches without betting the farm. I find I sleep better that way.
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Today’s Smart Profits Cribsheet
- For more of Steve’s strangle and straddle tips, revisit Smart Profits #251 and #257
- Lee Lowell, our Commodities Options Specialist at Mt. Vernon Research, explains different ways of trading ETF’s in Smart Profits #230, EMinis & ETFs - "Trade" E-minis With Less Risk Using ETFs.
- You can always use our free Smart Profits Glossary to get up to speed on trading terminology like "strangle" or "index options."
Good trading,
Steve
Related Articles:
- Options Strangle - How to Strangle Profits Out of an Imperfect Market
- Options Strangle Tips - Extracting Three Strangle Tips From a 515% Gain
- Take the Big Guys’ Money - With Their Own Weapons
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