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Options for Beginners

Recently I've had a rather unexpected increase in the amount of folks asking me about options.  I think the reason is simple, with so many stocks trading at insane prices, people are thinking that maybe going the option route makes more sense...but they're afraid of them. So for the next few issues we're going to break down common options and make it so that anyone can understand them. ( AND NOT FEAR THEM!) Basic options are just a trading tool and anyone can use them once you understand them.

For those of you who are new to the concept of options, take heart. Everyone started out just like you with no idea of what these things really are. For years the common thoughts were that options were for the "big boys" only and the "big boys" tried their best to keep it that way. Years ago I remember analysts saying that the average person shouldn't even think about trading options because he couldn't ever really understand the workings. Baloney! There is no reason that the average investor shouldn't use the tools available to make money in the market and options are some very important tools. So right off the bat, get it out of your mind that options are too advanced or too anything for you to understand. They are simply another investment tool, and if you understand how they work, and use them correctly, they will put money in your accounts.

We’ve had many many calls asking if we might have the options tutorial all in “one place” instead of over several newsletters. So here it is! I’ve taken the options tutorial and condensed it into one long article that you can print out, or read at your leisure.  So, let’s get started….

 

 

Options for Beginners

Recently I've had a rather unexpected increase in the amount of folks asking me about options.  I think the reason is simple, with so many stocks trading at insane prices, people are thinking that maybe going the option route makes more sense...but they're afraid of them. So for the next few issues we're going to break down common options and make it so that anyone can understand them. ( AND NOT FEAR THEM!) Basic options are just a trading tool and anyone can use them once you understand them.

For those of you who are new to the concept of options, take heart. Everyone started out just like you with no idea of what these things really are. For years the common thoughts were that options were for the "big boys" only and the "big boys" tried their best to keep it that way. Years ago I remember analysts saying that the average person shouldn't even think about trading options because he couldn't ever really understand the workings. Baloney! There is no reason that the average investor shouldn't use the tools available to make money in the market and options are some very important tools. So right off the bat, get it out of your mind that options are too advanced or too anything for you to understand. They are simply another investment tool, and if you understand how they work, and use them correctly, they will put money in your accounts.

First off we have to separate options into their most common uses, and then explore what they are for. The most common options are "calls" and they are used when you think a stock is going up. The next most common options are "puts" and they are used for when you think a stock is going to fall. That being said, let's take a look at some mechanics of what these things really are without the "mumbo jumbo."

The financial world has come a long way in the past 50 years. New types of trading vehicles are introduced all the time. If you think of the possibilities that confront you every day we have mutual funds, IRA's, 401K's, Futures, options, DRIPS, SPYDER's, Baskets, HOLDRS, and a host of others. Of the more esoteric vehicles, options are one of the easiest to get a grip on. Options are bought and sold against almost every conceivable thing that is traded such as gold, copper, orange juice, gas, oil, etc. So what are they?? In a word they are an option! Think about that for a moment. An option in everyday life means a choice of some type. It stems from the word "opt" or to choose something. If you buy a car, you are granted an "option" list where you have to choose what things you want put in your new car. So we know that options mean making a choice about something. (How many times have you heard the phrase "What are my options?")

So now we know that buying into an option will give us some choices to make in the future. Just what are those choices? Well, let's see what the options are. In its most basic terms an option (and for this segment we are talking about a basic "call option") is the "right" but not the "obligation" to buy a particular stock, at a particular price within a particular time frame. For a favorite example of how an option works using real life familiar items, I like to use this one:

Suppose you are driving home and you see a car for sale parked in a yard. It's a real beauty and you know from experience that it should sell in the neighborhood of 25 thousand dollars. Just for fun you walk over to it and the sign reads "one owner, 1,000 miles, perfect condition...$10,000 dollars." Thinking this must be a mistake you run up to the house to inquire. The owner says the deal is for real; he just wants it gone. So you say to the owner something like this: "I would love to have that car, but I'm not sure my wife would approve of me spending 10K without her, so could I give you $100 dollars to hold this deal till Friday? If I get approval I will take the car for the 10K, but if she says no, you can keep my 100 dollars for all the trouble."

That, folks, is a perfect option. You have the right (he agrees to hold the car for the 100 bucks) but not the obligation (if I can't buy it, keep the hundred and sell it to someone else) within a specific period of time (by Friday). As you can see, many of you have entered into option deals without recognizing them as such. We use stocks instead of cars as the underlying issue we would use options against. But why use an option instead of the stock itself? Why? For one, a small amount of money will "control" a much higher priced issue. For instance, in our example 100 bucks controlled a 25K dollar car. In our world, 2-10 dollar options will control stocks selling for 10 - 100 dollars per share. But more importantly ... if you trade that option you can make some incredible profits.

Let's go back to our example. If indeed your wife allows you to buy the car, to realize any profit you would have to try and sell it for more than the 10 thousand you paid. That would mean advertising, and delivery, and all the things that go into it. So since you paid 10 for it and you know it's worth 25, maybe you can turn it over quickly for 20K. That would have given you a 100% profit on that car. But on the other hand suppose you sold your option? Let's say you went to a dealer known for selling that brand of cars and said ... "I have the option of buying this car which you sell on the lot for 25 thousand dollars, for 10 thousand. I don't want the hassle of buying it, registering it, insuring it, etc... just to sell it to you, so if you give me 5,000 I will let you buy it for the 10 K." If he agrees to buy your option look at what you just did! You bought the option for 100 bucks and sold it for $5,000!! Think of the percentage of return on investment there! This folks is the "leverage" that options bring to the table and why they can be such highly profitable tools.

So for the most part we don't buy options to actually "execute" them or in other words go through with the underlying purchase. We buy them to trade them as their value increases. In part 2 we will focus on step two of options trading...understanding the terms, as they relate to stocks

How do they Work?

We are going to dissect an option into its components so you can understand how they work mechanically, but first some terminology... For the balance of this section we are focusing on "call" options. These are options that you would purchase if you were thinking the underlying stock the option is written against is going to rise in price. One other big note that you must remember is that options "expire" on the third Friday of the month that you bought it for. So all options for the month of  say January will expire at the close of the 16th, which is the third Friday of the month. This means that for whatever month you buy the option for, you have between the date of purchase and the third Friday of that month to either sell your option or "exercise" it. (More on that later)

a) Options aren't available against every stock, but most of them for sure. A stock must be over 5 dollars per share to be optionable and the company has had to do the proper registrations to become optionable, but today almost every decent company has met the requirements and is optionable.
b) Not every stock will have an option available for every month. Quite often a stock may have options available for say...July, August, October, December...or some other strange sequence. This is normal and is simply set up in order of probable demand.
c) Options are sold in blocks of 100 "shares" called a contract. So technically you cannot buy one option, instead you would buy one contract. That contract would "control" 100 shares.

Now that you know those basic facts, let's take a look at what makes up an option. A call option has two component parts, one is the "intrinsic value" and the other is the time value. Don't let the big fancy word scare you; it is much simpler than it sounds.

When you buy an option you are buying the right but not the obligation to purchase the actual stock for a specific price within a specific time. So it's easy to see the time value portion of an option. For instance it must cost more to purchase an option that gives you a longer time period than a short time period. That makes sense in any real world application. For instance if you rent a car for a week it is cheaper than if you rent it for a month. Same with an option. It will cost you less to have an option that expires in January (only a few days away) versus one that doesn't expire until April. So we now know that one portion of an option cost is the amount of time we are buying and that the longer that timespan the more the option will cost. The next part is trickier...

The second portion of the cost of an option is the intrinsic value (if any) of the option. This is where the term "strike price" comes in. Here we need to take a closer look at what this really means. Suppose a stock is 50 dollars per share, but we think it may go to 60 in a few months. If you look at an options list you will see a whole list of options available for that stock. Why? Because along with the fact that you can select options depending on how long you want to hold it (time portion) you can also select a "strike price." So the first column will usually be the month, and then the next column is the strike price column and it will have a multitude of prices listed. For our 50 dollar stock we will probably see strike prices of 22.50, 25, 30, 35, 40, 45, 50, 55, 60, 65, 70, 75, 80, and 85 (or more). Now what is this all about??

These folks are what we call the strike price and it is a bit confusing at first, but let's break it down ... Remember our stock is 50 bucks right? So if we buy the February 50 dollar strike price we are saying, "I have the right but not the obligation to buy this stock at 50 bucks by third Friday of February" Okay, that sounds simple enough but why do it? Because if we think a stock is going from 50 to 60 in a month, having the right to buy the stock at 50 when it's trading at 60 is pretty attractive right? Right! This would be called an "at the money" option because the strike price is the same as the stock's actual price.

But then we also see strikes that are lower than 50 dollars, like 45, 40, 35, etc...what's up with these? These are called "in the money" options. This is where the "intrinsic value" comes in. If our actual stock is at 50 and we buy the 45-dollar strike price option, we have the right to buy the stock for 45 bucks. But since it's trading at 50 on the open market we are already 5 dollars "in the money" right? Right. So that option would have to cost a minimum of at least 5 dollars more than the 50-dollar strike price. It has to because no one is going to sell you the right to buy a 50 dollar stock for 45, dollars without charging you at least 5 dollars per share right? Right. If we bought the 40-dollar strike, we are already 10 dollars in the money right? Right; and that option has to cost at least 10 dollars more than the 50-dollar strike.

On the other side of the coin we have those 55, 60, 65, 70 etc...strikes. These are called "out of the money" strikes. These obviously don't have any intrinsic value because the stock hasn't gotten that far yet. So the out of the money options are always the cheapest to buy. So now you know you can buy an option depending on the amount of time you wish to hold it for, and whether you wish to have one "in the money, at the money or out of the money."

So why buy an "in the money" option, or even have them listed at all? Good question. It has to deal with how fast the option will increase in price, in relation to the stock's movements. In basic terms the deeper "in the money" you buy, the more closely it will mirror the actual stock's movements. It is called the "delta" but forget that for now and just remember that in the money options gain the fastest when a stock is rising. On the other hand "out of the money" options may not gain anything even if the stock moves up.

Say we buy the 60-dollar strike (which gives us the right to buy the stock at 60 bucks) but our stock only goes from 50 to 54. Guess what? Our options are NOT going to make us much, if any, money. Having the right to buy a stock at 60 isn't very attractive when the stock is sitting at 54 and you won't get much for it! So the higher cost of an in the money option is reflected by the bigger gains that can be realized when the stock moves.

Very few call option contracts are ever purchased with the idea of actually executing them. A full 92% of all options are bought for the idea of selling the option for a profit versus using the option to buy the underlying stock. Why? Because even if you are right and the stock you buy the option against rises, it won't give you the type of return that you would get using the leverage of a call option. Let's say you bought XYZZ stock on a Tuesday in anticipation of stock split announcement, for about 100 dollars per share. Well here it is the next Wed. and they are still around 104 per share.

Not bad, but in percentage terms it isn't much of a gain. But let's say you bought the February 100 call option on XYZZ on that  Tuesday. That means you have the right to buy XYZZ for 100 per share by the third Friday of that month. If you bought it on Tuesday it cost you about $4 per share. Today (the following Wed) they are 9.675. That is 125% gain in one week! Just the excitement and expectation of the power of a split announcement jacked those options up by double in a week. So most people wouldn't care too much of buying the actual stock for 100 and selling it for 104, but are more than happy to more than double their money on the option. Because they are so much cheaper to buy, you can buy a lot more of them. That is why most options are actually bought with the idea of making money on the option, not for the idea of actually execution the option and taking possession of the stock. That being said, let's look at puts next time. Puts rise in price if the stock falls, something that confuses a lot of folks.

 

What's a Put???

 

Because of an increased interest in "stock options" lately, we've been doing a bit of an introduction to options recently.  On Sunday we explored the idea of what they are and how they function. We discussed the fact that options are no more risky than stocks, and how you shouldn't be afraid of them at all. They're simply another tool to use in trading. Then we talked about the basic "call" option.

 

Today we're going to look at the other side of the coin, which is called a "put" option.

A lot of people still don't know that you can make money when a stock is falling. That is unfortunate because if you only play the upsides, you are missing out on 50% of the game. (Stocks go up and down) The fact is that there are several ways to make money on a falling stock such as short selling it, or buying an inverse ETF. But in the option game we would buy "puts."

 

One of the things you might want to remember about your personal investing is this...stocks fall faster than they rise in general. While you might buy XYZ and over a few months it has climbed from say 44 to 50, when the rug pull hits, it can fall from that 50 down to 40 in "no time". I'm talking a couple weeks, not months.  I've always found that well played shorts make more money quicker than almost any long side trade.

 

 Now what is a put? Well, a put is the exact opposite of a call. Remember what a call option was? The right but not the obligation to buy a specific stock for a specific price within a specific time period. So you buy a call option...the stock goes up...your option increases in value...and you sell the option for a profit.  Simple concept.

 

But what do you do about a stock that you are convinced is going to tank?? You can buy a put. (There are other option plays but we will get into them later) The mechanics work about the same way as a call in where puts are bought in contracts and each contract is the control of 100 "shares." You can also buy in the money, at the money or out of the money puts just like calls, so for the most part the trading mechanics are exactly alike.

 

 So let's say you think the XYZ company is going to sink like a rock soon because their sales are slipping. XYZ is trading at 50 dollars per share. You could buy the February 50 dollar put and if you are correct and XYZ falls to 44 dollars per share, your put option will probably have almost doubled. You would then sell it and pocket the profit. (Naturally if the stock rises instead of falling, the option you may have paid 4 bucks for is going to be worth less in a hurry resulting in a bad trade and a monetary loss).

 

One of the common questions I get concerning puts is this "why does the put increase in value while the stock is falling?? Why would anyone pay you for that?" What a great question and the reason is that the mechanics of the trade are reversed. Remember with a call option we are buying the right but not the obligation to BUY a stock.... Well, with a put, we are actually buying the right but not the obligation to SELL a stock at a particular price within a particular time span. So let's use the example above with XYZ. We bought the 50-dollar put giving us the right to SELL XYZ (the actual stock) for 50 bucks by the third Friday of February.

 

Let's say you bought 1 contract and paid 4 dollars "per share" or $400 for the contract (100 shares) It doesn't matter that you don't own any XYZ because we have the "right" but not the "obligation" to sell XYZ. So if XYZ falls to 44 bucks, you have the legal right to SELL it at 50, which is a 6-dollar difference. Someone has to make up that difference, and that is what the market does. They make up that difference by increasing the value of your put. So that 4-dollar put you bought could easily be 8 or 9 dollars in a few days. Remember a put is a legal right. They must pay you if you are correct, which is how the system is designed. So the big difference between a call and a put is how your "rights" are aligned. With a call you have the right to buy a stock and with a put you have the right to sell a stock. To keep it really simple just remember puts increase in value if the stock actually falls. It is that simple!

 

I get a lot of questions about options and many of them follow the same themes. A common one is this .."why use options instead of the stock itself?"That's a good question on the surface, but reflects the idea that the person asking the question really doesn't understand options that well. Because if he really understood what they are and how they work the answer is very clear. The reason one uses options is 1) the lower cost to be involved and 2) the leverage gained in a percentage basis.

 

Let's use a real example. I'm writing this Tuesday morning and the market is having a bad start, down  150 points, so by the time you read this the data could look pretty weird, but just go with it.  AAPL is about 110 dollars a share. That's a lot of money and boy you wish you could have 500 shares of that because you think the Santa claus rally is going to come and carry into the new year. But 500 shares of AAPL will cost you a staggering $55,000. Ouch.

 

So we pull up the options chain. The AAPL 110 dollar calls for February  are 6 dollars. So you could buy 5 contracts (100 shares to a contract) and "control" 500 shares of AAPL for a total cost of  $3000.  That's quite a difference in cost outlay. Now, lets say your theory is correct and AAPL blasts off in a year end run and somewhere in January, AAPL is now 125 dollars a share. The option you bought for 6 bucks is now going to be considerably higher in value. You have the right to buy it at 110. Now it's 125. So you're going to get at LEAST 15 dollars for your calls, plus any remaining time value. Let's say you get another 1.50 for that too.

You bought 5 contracts for 3000 dollars. You're selling those 5 contracts for 8,250. That's a 175% increase. Right there you see the enormous returns that options CAN give you. Granted I've used a perfect scenario, but you see the point. Can AAPL run 15 bucks in a few months? Sure, it's done it many times.  If you get it right nothing can give you the returns that well placed options can give you.

 

Covered calls

So now we know the basics about calls and puts and why we use them. Next we are going to explore the most overlooked tool that a investor can use--the covered call. This will be a long one folks because I am a real believer in using them in certain circumstance.

There are thousands of people who write (sell) covered calls as a profit making tool, there are "gurus" that teach how to become wealthy by using them, there are others who consider them a waste of time and yet others who don't know they exist. What the heck are they?

A covered call is a tool like any other option. It is a tool that we can use in certain circumstances to increase profits and that is why you are trading stocks...to increase profits. So knowing they exist and using them correctly will indeed help your portfolio. Forget anything else you have ever heard about covered calls and remember this simple line... a covered call is a way to sell someone the right to buy a stock from you, a stock that you already own. Period. Okay so why is that such a good tool? For many reasons, let's look...

If you own a stock wouldn't it be nice to generate some income on that stock instead of just letting it "exist" in your account? Even if the stock has been performing for you, you can increase its performance with the use of the covered call. Do you have any stocks that you bought thinking they would rise but instead they have fallen and if you sold them you would take a loss?? Enter another reason for using covered calls. Actually there are a number of ways to use them, but for this installment we will explore just what the heck the mechanics of them really are.

If you don't know where to get options quotes, a good place to get them for free is at www.cboe. Now remember a covered call means that we are going to sell someone else the right to buy a stock from us that we already own. For this example, let's use Intel...symbol INTC. Suppose you have 1,000 share of INTC in your portfolio. You don't really wish to sell it but it would be nice to make "extra" money on it right? Right. So what you can do is this…sell the right to someone to buy Intel from you at a much higher price. For instance INTC traded Friday at about 36 dollars per share. Why not sell someone the right to buy INTC from you at 40 dollars per share in February?

If you look down the option quotes to February with 40 dollars as the strike price you see they are bidding 0.40. That means that you could take in $0.40 for each share of INTC you own simply by giving someone the right to buy it from you at 40 dollars per share by the 3rd Friday of February. That isn't bad because in our example you already own 1,000 shares so you would take in $400 dollars for placing the order. So for making a phone call, you have just received 400 hundred dollars.

What's the catch?? There really isn't any catch, but there are rules. If INTC announces some fantastic news and flies to 50 per share by Feb…you will still have to sell it for 40. You would miss the huge run up. But since it is trading today for 36, taking in $400 for selling the option and getting the extra $4.00 per share from the stock's run up (the difference between where you have to sell it "40" and today's price 36) means that you would still make over 800 dollars on the trade. What happens if INTC doesn't make it to 40 per share?

Well, no one is going to buy it from you at 40 if it's trading on the open market for say...38 so guess what? We keep the $400 we got for selling the option and we keep our stock! This is why they are so attractive for long-term hold stocks. Once option expiration day passes, if the stock hasn't made it past the strike price we sold, we keep the stock, all obligations go away, and we can do it again! Not bad eh?

One thing you may consider a "catch " is this ... Once you sell that call, or in other words the right for someone to buy your stock at a certain price, you MUST keep ownership of the actual shares, just in case you have to deliver them at some point. So if you sell someone a call like in our example and the stock falls like a rock, you are still going to have to hold that stock. What you do at that point is this: "buy back" the calls you sold. If we sold them for 40 cents, and the stock crashes, they will soon be worth 10 cents, so you buy them back for 10 cents, cancel out the trade, and then you are free to sell the stock.

A lot of stock gurus teach how to make a killing writing covered calls, but I find most of it to be a bunch of hooey. I find they work best for adding money to a long-term portfolio, and for what I call damage control. Here is why ... The guys who set the options prices are wizards at it. When you find a ten-dollar stock that is getting 3 dollars for a call option, you can bet there is tremendous volatility involved in that stock. Too many "gurus" say, "buy that 10-dollar stock and sell the covered call...see you'll get 3 dollars per share instantly." That is correct, but what if the stock itself plunges to 5 bucks per share because the news that made the options so expensive turned out to be false??

You will end up with a stock you didn't want to own, and in a losing position. So you have to be very careful about buying a stock with the sole purpose of selling a call against it. Sure it will work at times, but overall it can be a losing proposition. We find it better to write calls against stocks that we own because we like the stock, not because we bought the stock for the rich option premiums we could get.

Writing a covered call simply means you are selling someone the right to buy your stock from you. Options are bought and sold in 100 share lots called "a contract" So if you hold 1,000 shares of something you could sell 10 contracts against it, and if you owned 200 shares of something you could sell 2 contracts. Your ONLY obligation is to hold the underlying stock past expiration day. You never have to add any money for extra expenses. Only sell a covered call that is "out of the money" In other words if you own XYZ at 50 don't sell the 45 call because it will be snatched away from you quickly! You would sell the 55, or 60-dollar call with the hopes the stock never makes it that far and you simply keep the premium and the stock.

So why don’t more people utilize such a wonderful tool? Many still don’t know they exist, some are frightened about the whole “options thing” and others have used them incorrectly. By that I mean…if the market trend is down, it is NOT a good time to sell covered calls.  In a falling market, the premiums on the call options are greatly reduced bringing in less bang for the buck. Often what happens is that as soon as a market starts to weaken, people sell covered calls, but then the “dip” is shallow and the market runs higher and they get the stock called away from them… a stock they wanted to keep. So only use covered calls in a flat to rising market and you’ll do fine. 

Okay folks, we’ve discussed what options are, how they work and the three basic ways of using them. You can buy a call, buy a put or sell a covered call. Those three strategies will be more than enough for most people. From there you can indeed get crazy. You can create synthetic butterfly spreads, and condors and you name it. Forget all that until you’ve become a good options trader for a year.  That said, there’s one more thing I’d like to talk about concerning basic options trades. That would be “naked” selling. Yes it is much more advanced, but it is an incredible tool, and not nearly as complicated as some of the more esoteric ideas. So on Wednesday, we’ll talk about going naked. ( sounds naughty, no? Ha!)

Naked positions

I’m going to wrap up our two week tutorial session about options. We’ve discussed what they are, how they work, ways to use them, etc. Today we’re going to end with one of the riskier aspects of options trading, called “selling naked”. While it is indeed more risky, meaning you have to really manage that risk, along with the risk comes big rewards. So, let’s get to it…

As you know if you think a stock is going to rise you can buy a call option and if you are right your call option will appreciate in value. On the other hand, if you think a stock is going to fall you can buy a put on it and sure enough if you are correct and the stock falls your put increases in value and you have made a profit. That being said ... there are other ways to play this option game and in this section we are going to look at one of them. As a technical term it is called "selling a naked put" and although the name sounds a bit kinky...believe me that is the true name. The first thing to keep in mind as we go forward is that this technique is very profitable if done correctly and any time the market is going to reward you with higher profit's...instantly you should think higher risk.

If you are confident that a stock is indeed going to move higher, instead of buying a call option against it, we can sell a put option. Whoa now...this is obviously a completely different approach so let's go slow. If a stock is going up, what is happening on the put side? (Remember you buy a put if you think a stock is going to fall because it increases in price) It goes down in price value right? Right. This is the key here and it is a bit confusing because you have to think somewhat reverse.

Let's try using a fake example to get the idea under our belt. Suppose we think XYZ is going to fly this week. It is trading at 50 dollars and we look at the 50-dollar February Put and see it is getting 4 dollars per share. Let's say we SELL 10 contracts of the Feb. 50 puts. Since they are sold in blocks of 100 shares called a contract, we have just sold 4,000 dollars worth of puts. That $4K goes right into our account. Now let's also assume we are correct and XYZ flies to 55 dollars in a few days. What do you suppose happened to the Feb. 50 dollar put price? It fell and probably pretty hard. Let's say they are now getting only 2 dollars for them. What we would then do is simply buy back the puts we sold and the difference is our profit on the trade. In this case it is $2,000 dollars. This is the basic idea of how it works and you should study that example until it is clear what we are doing. We are selling an option for some amount of money and then buying it back for less than we paid. The difference is ours.

So why do it instead of simply buying the call? Well first, a put will decline in price faster than a call will increase in price on a rising stock. Second we always have two sides to any option...the intrinsic value and the time value. So every day that goes by that put is declining in value simply because time is getting eaten away. Even if XYZ doesn't move a dime in either direction from 50 dollars, your puts will be decreasing in price simply because time is ticking away. This is the beautiful part of it, and if you combine the time value erosion with the mechanics of how a put price will erode on a rising stock you have the makings of a very fast price change. This is why this tactic is so profitable if your assumption about the direction of the underlying stock was correct. The down side to all of this is that if you are wrong and XYZ doesn't rise, but instead falls like a rock...you are going to lose money just as fast.

There is another problem and this is where the big risk comes in. Remember when we BUY a call option we have the RIGHT but NOT the obligation to buy a particular stock at a particular price, by a particular date. When we SELL a put option we are taking on a responsibility and an obligation. Basically what we are doing by selling a put is giving someone the right to "put" the stock to us at a certain price. That is right folks you are doing a legal deal here and you are selling the right for someone to "make you buy" the stock at the strike price you sold. For example we sold 10 contracts of XYZ 50 dollar puts for 4 dollars per share right at that moment we entered an obligation and what happens if XYZ doesn't rise like we thought and instead falls to 45?? Someone can "make us" buy it (the actual stock) from them at 50 even though it's trading at 45 on the open market! This is something you must avoid and to do that, what you would do is simply buy back the puts you sold at a higher price. Remember puts increase in value if the stock falls so those puts we sold for 4 dollars per share when XYZ was at 50 are going to be much higher (maybe 10 dollars) now. Hopefully you didn't wait that long and you bought them back when the stock was falling and only lost a small amount of money!

So as you can see selling naked puts is a very profitable thing to do if you are right in your assumptions of where the stock is heading. If the trade goes sour though...you will lose money quickly.

Selling puts relates ESPECIALLY to you long-term holders or "investors." One of the more beneficial reasons to sell put options is to "get paid" for buying a stock you actually want to own anyway. How's that?? Okay, let me explain ... If you aren't in a huge hurry to buy into a position, selling a put is a great way to get the stock at a reduced price. This is how it works... Suppose you want to own 1000 shares of the XYZ company really bad, but you think it's trading a bit too high right now. Let's say it is trading at 48 dollars per share and you think it will fall back to about 45 and that is where you would buy it anyway.

So we look and see that the Feb 45 puts are selling at 2 dollars per. So what you can do is sell 10 contracts of those Feb 45 puts. This will generate 2,000 dollars into your account immediately. Now, let's say your assumption was correct and XYZ falls to 44 .70. You have sold someone the right to "put" the stock to you at 45 so sure enough...you own it now. (If the stock only fell to 45 even you may or may not have the stock "put" to you but if it falls further than 45...the option will get exercised and the stock will be delivered to you) But look at what just happened closely. You wanted to own XYZ, but while it was trading higher than 45 you considered it too expensive. By selling the puts against it, you took in 2 thousand dollars, and on Feb 18th the stock you wanted at 45 anyway was indeed given to you! So now your actual cost basis in XYZ is 43,000 dollars not 45,000. (1000 shares of XYZ at 45 dollars per share cost 45,000 dollars. But you were paid 2,000 dollars by selling the puts, so 45,000 minus your 2,000 = 43,000)

By now it is obvious that this is a very effective way to buy stocks that you really want to own. One very interesting thing to watch is this... Quite often right after a stock split's it enters a period of directionless wandering. It may flounder around for two or three weeks before really kicking in and moving higher. Since buying stocks in great companies that have just split is a fantastic profit maker, selling puts right after that split gives you the chance to get the stock for even less. If you can find a good company that split's with just about 2 weeks left before option expiration day...selling the put against it gives you a really good chance of getting the stock at a bargain price...before it starts to retrace to it's old highs.

 

With stock prices in the stratosphere, options give the average trader a shot at participating in this market for a fraction of the costs. While there are dozens of esoteric options strategies one can use, if you just use puts and calls, you can do very well for yourselves. I’ve been hounded for years to put options plays in the Insiders Club and always resisted, mostly because the bulk of the investors still don’t understand them. But I am leaning towards the idea of doing options plays along with stocks in 2015.

 

 


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