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1.31.2018 - Free Investment Newsletter Bookmark

I promise that this is going to be the last options tutorial for a long time. Each time I think I’m done talking about them, several people will write in with questions about something I’ve mentioned. Last week I mentioned that along with buying call options and put options, the only other sort I’d recommend is the occasional “sale” of an option. So let’s explore that and see how it works. 

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.

The Market:

Things are getting interesting folks. Monday we put in a soggy trading day, and when the session was over, the DOW had lost about 177 points. Not a washout by any means, there were quite a few stocks that not only held up, they rose on the day. Frankly several of the stock we were holding did really well in a bad tape. 

Tuesday however that wasn’t to be. We opened poorly, we saw them attempt a couple flurries higher, but they all faded off. When the final bell rang, we were down 326 points. Hmmm. 

So what was that about? There’s a lot of reasons it could have happened. They were getting nervous about interest rates rising, they were getting nervous that Janet Yellen would leave her position with a really “hawkish” tone, they were nervous about the State of the Union speech, and of course the Infamous “memo” we’ve a heard so much about. 

Or was it simply 12 billion worth of funds that had to be rebalanced? In other words, let’s say you're a fund manager and your funds charter says that you have to keep a 60/40 split between stocks and bonds. But because the market has risen so fast you find that your fund is now priced at 70/30 ratio. 

Well a lot of funds found themselves in that situation. So there was just north of 12 billion worth of stocks that had to be sold, or bonds bought. With the interest rates rising, no one wanted to buy the bonds, so some of them did indeed sell stocks. 

However I think you could add the whole combo-platter to the equation. Yes they' worried about interest rates, yes Yellen made them nervous, yes the "memo" had the ability to reach a lot of people with a lot of skeletons, and yes some funds were rebalancing. 

Added together and shaken ( not stirred) you had the recipe for a pretty soggy day.

So we heard the Presidents SOTU speech and frankly it was very good. Naturally the Democrats thought it was horrible, but in polls afterwards, his speech was roundly accepted. I wondered if it would help the market’s futures. 

Today the futures were up sharply. What ever they were worried about yesterday appeared to be over. Then, Boeing announced earnings that were miles above the estimates. Instantly the futures doubled and we were going to be looking at a very big open. We got it. 

The market opened and ran straight up. It looked like it wanted to get back all 300+ points it dropped yesterday. I had told my paying members before the open that I was concerned about the possibility of a “pop and drop” day. Well sure enough as the day wore on the indexes came down. At one point the DOW was up just 14 and the S&P was red by 6. 

But they weren’t willing to let it fall any further and late in the session they clawed the DOW back up +72 and the S&P eeked out a gain. Of ONE point. 

In fact, if it wasn’t for Boeing, the DOW would have been RED today. By a lot. 

There’s a lot of cross currents flowing out there right now. The market feels heavy, and there’s no end to the political fighting going on in Washington. While it’s almost ludicrous to suggest that maybe this market is ready for its first 5% correction in over 2 years, it sure seems ripe for it.

We got lucky with our holdings. We took some seriously wonderful profits over the past couple days on WMT, and CSCO. Today we sold our last short term “long” side hold, PEN. In at 95.12, when it lost 100.00 at 2:45ish today, we pulled the trigger and sold that. 

So right now I have nothing in the short term holds bucket. If the market wants to go back up, we’ll buy some things and go with it. But, if the market wants to prove to us it’s ready to sink some more, we will employ a short or two. Good luck out there folks. 

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