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OPTIONS

Don’t leave home without them.

At this point I’d like you all to listen to a short audio clip, I want you to really understand what I’m going to write about here.

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Options for Beginners

Introduction

For those of you who are new

OPTIONS

Don’t leave home without them.

At this point I’d like you all to listen to a short audio clip, I want you to really understand what I’m going to write about here.

{ympr}http://www.investyourself.com/images/AudioRecs/Audio 4.mp3, LISTEN HERE{/ympr}

Options for Beginners

Introduction

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

This is Part II

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 January will expire at the close of the 21st, 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 August 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 August" 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 Wed. and they are still around 103 per share.

Not bad, but in percentage terms it isn't much of a gain. But let's say you bought the February 95 call option on XYZZ on Tuesday. That means you have the right to buy XYZZ for 95 per share by the third Friday of the month. But if you bought it on Tuesday it cost you about $4 per share. Today (Wed) they are 9.675. That is 125% gain in one day! Just the excitement and expectation of the power of a split announcement jacked those options up by double in a day. So most people wouldn't care too much of buying the actual stock for 100 and selling it for 103, but are more than happy to more than double their money on the option. 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.

This is Part III

What's a Put???

A lot of people 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, but in the option game we would buy puts. 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. 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 5 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 August.

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 11 or 12 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!

This is Part IV

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 closed Wed. at about 21 dollars per share. Why not sell someone the right to buy INTC from you at 25 dollars per share in February?

If you look down the option quotes to February with 25 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 25 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 25. You would miss the huge run up. But since it is trading today for 21, 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 "25" and today's price 21) means that you would still make over 800 dollars on the trade. What happens if INTC doesn't make it to 25 per share?

Well, no one is going to buy it from you at 25 if it's trading on the open market for say...22 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. 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.

This is Part V

You have all had a time in your trading career that you needed it. Maybe you held that stock for just a bit too long hoping for another point of profit, or maybe the moment you bought it they announced an accounting problem and they tanked on the news. In either case...you were left high and dry and wondering what to do. Well here is where the covered call comes in so very handy and as far as I am concerned it is the best use for writing covered calls. Nothing makes my blood boil faster than buying into an issue, not cutting my loss if it turns sour, and now I own it 10 or more dollars less than I paid. Although we preach about trimming your losses as soon as possible the fact is all of you have been in the same boat at some time. The difference is what you did about it. If you simply sat back and "hoped" the stock would regain its lost ground you very well could still be sitting with it. On the other hand you could go to work right away selling calls against it and slowly but surely you will either recoup your loss or at least trim the amount you lose. The key to deciding what to do is the "overall market mood, or "tone." Here is what we are talking about...

If the overall market is rising such as in a "bull" market, then it's a lot safer to hold onto a stock that gets pummeled because the overall market won't let it go to hell in a handbag. On the other hand if the overall market is in "bear mode" then by all means take the loss and move on. A stock that drops 10 dollars in a bull market may drop 50 in a bear. So please realize that the overall "trend" of the market is THE deciding factor in whether using call options to recover a loss or you should bail out no matter how bad the initial loss. We have seen stocks miss earnings in a bear market and drop 100 dollars per share. That, my friends, is horrible. But people thought it was horrible when the stock was down 10 dollars and they held.

As an example of using covered calls during a bull market trend, let's use a few examples.

Suppose you didn't believe in the theory that most stocks fall even when they beat their earnings and held through the earnings announcement. You had paid 50 bucks for the stock but when it opens the next day it's trading at 46 and heading lower. Well, naturally you could sell out and take a bit hit, that is one choice, but a better one is probably this...

Remember how I always say, "nothing goes straight up?" Well nothing goes straight down either. It will bottom out somewhere. Then it may just sit there, or it may start to move back up slowly and in steps like a staircase. In either case it would be a long wait for it to get back to where you paid. But if you help it out by selling covered calls against it, you can cut the time in half that you have to wait to get your money back.

For example, let's say you bought 500 shares of XYZ at 50 bucks a pop. Now it's trading at 43. A great strategy is to look at the option chain and see what you can get for the 50-dollar call options. Now here is where it gets important to pay attention...

Just a few moments ago I said that nothing goes straight down, and that is true. But nothing goes straight up either. But if you look at the price of a call option while a stock is falling, it is often very cheap. Too cheap to do us much good. BUT take a look at that same call option after XYZ has moved higher for a day and the premium for the option will be much higher. That is the key, folks. When you are trapped in a stock at much less than you paid for it, you want to sell covered calls against it when it is climbing, not falling. So as it's falling sit back, get nervous, say nasty things, but don't write your calls against it yet. Wait until it bellies out and turns up for a day or so. That way the price will be much more and you will get a better return.

So we bought XYZ for 50, now it's at 43 and it's sitting there. On the first strong uptick day, look at the 50 dollar call as a possible sale because on the day the stock is rising it will be worth more. Remember we have 500 shares and let's say on the day the stock makes a good move we can get two dollars for the August 50's. Well since you have 500 shares you could sell 5 contracts and that would give you an income of 1,000 dollars. Basically someone paid you 1,000 dollars for the right to buy XYZ from you at 50 bucks per share by the third Friday of August. That is darned good money, friends. Now your cost to buy the 500 shares of XYZ was 25,000 dollars. 500 X 50 per share = 25,000. But you just took in 1000 for selling the calls so you cost is down to 24K. Now let's say XYZ closes out on August 20th at 47 dollars. You get to keep the shares and of course the 1,000 for selling the option. Now you can go out to the September options and sell the 50 or even 55 calls. Suppose we get another 2 bucks for the September 50's? Well that's another 1,000 dollars, which brings the cost of owning XYZ down to 23,000.

Now suppose September comes but XYZ is only at 46 per share? Guess what? You could sell it right then and have NO loss on the trade! How's that you say?? Sure enough. Guess what 46 times 500 is? $23,000 dollars! That is exactly how much we have into XYZ now that you have taken in two thousand dollars selling the covered calls. See how effective selling calls are in reducing a loss? In our example our stock NEVER got back to what we paid for it and yet we didn't lose a dime. All we did was wait 2 months. This folks is a very effective use of covered calls.

Finally I have a psychological item to go over. Too many times I hear something like "Well the idea is good, but if I have to wait two or three months to get my money back, I have no cash to trade with. I would rather sell out and buy something else." WRONG. That would be absolutely correct IF you are sure you have the discipline to do the right thing next time, but too many times we don't.

When you didn't do the right thing by taking a tiny loss quickly, and held on as the stock fell 7 bucks, Chances are very high that you will "push" yourself into the next trade trying to make your money back and it very well could be another losing trade. It doesn't take too many losing trades to knock you out of this game folks. So when you get trapped in something, consider yourself an investor in that stock and start working covered calls. Again we are talking about a flat to rising overall market. Don't take 10-point whacks by taking the hit. Exercise some patience and more times than not you will get back every penny of that bad trade. DO NOT start forcing trades to make up for bad ones because that is a viscous cycle that often spirals downward.

Granted, if we are talking about a market that is in "downtrend" then you HAVE to bail out with your loss. You have to realize that when bear markets strike, they can be devastating. In 2000We saw Internet stocks go from 200 to 50 cents. They will never come back. In 2008, we saw banks go from 98 dollars to under 5.

This is Part VI

As you probably know there are so called "gurus" out there that teach that you should buy certain stocks just to get the rich premium for selling the covered call against it. We have gone over why that isn't always such a good idea. But there is a great use for covered calls other than damage control and that is... use them to increase your portfolio holdings.

Quite a few of you have pretty extensive portfolios of stocks that you maintain. You do your own buying and selling and most of it is designed for very long-term growth such as a retirement account. But very few people either know that they can sell covered calls or simply don't, but in any case you should and here is why.

Let's suppose you have an account with 500 shares of Microsoft, 500 shares of IBM, and 1000 shares of CSCO in it. (We will stop at just three to keep this simpler.) Naturally you believe that over the long haul all of these will keep appreciating in value and if you throw in some split's along the way they will really make you some substantial profit's. Well, if all you are doing is letting these stocks sit...you are missing a lot of money each and every month that you could be adding to your account. Here is the bottom line folks, "If you are not going to sell these stocks, then you should be making money on them." Period. For instance we are talking about 2000 shares of stock between the three companies listed. If we only, and I mean only got fifty cents per share for selling the next months "out of the money" calls, that is 1000 dollars of "income" to you.

So what did we really do here? We sold the right to someone to buy our stock from us at a much higher price than it is trading now. If we don't get "called out" or in other words have our stocks exceed the strike price we sold and actually have to sell the stock to someone ... all obligations are over and guess what? We do it again only we would then sell the next months calls. This is found money folks. We own the stock anyway. Why not let it make us some money?? Well you should. Now often I get asked "what happens if MSFT goes higher than my strike price and I get called out?

Well that could happen for sure but think about this ... for you to get called out of an "out of the money" call, MSFT has to really be moving. That's a lot of movement, but even if it did make it that far it would seem obvious that to get there it was really moving and a pull back is probably in the cards. We have found that if you go out two or three strikes, more times than not you won't be called out and even if you do in very little time the stock falls back on profit taking, almost to where you got called out and you can buy back in for the same price.

Folks the moral of this story is that if you have holdings that are simply sitting around, even if you go out 3 strike prices and only get a half a point per share, that is still found money for doing no more than making a phone call. You should be doing this!

One very hot tactic for building a great portfolio is to buy the best of the best like INTC, IBM, MSFT, etc... right after a split. That way you are getting in low, and then sell covered calls against it as it retraces back to its old highs. I know of no other tactic that is as safe and yet returns so much money to you. Most splitters retrace to their old highs within 18 to 24 months, which means you are doubling your money. By selling the calls also you can increase your profits from 100% on investment to upwards of 150%. NOTE: Naturally we are talking about a flat to rising market. In the bear crunch of 2000-2001 not many companies split and even if they did their stock went down. Bears aren't finicky about whom they devour! In the crash of 2008, often there were no splits announced, and again the ones that did…fell like rocks.

Another good thing to consider is that since the money you generate came from the market, you may as well put it back in the market and put it to work. Take our example above. We took in about 1000 dollars for just selling next month's calls. Those 1000 dollars allow us to buy "X" amount more of IBM, MSFT, INTC, etc. In other words you can use the money you take in on selling the calls to buy more stock.

This is Part VII

Naked positions

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.

I am going to go over selling puts and calls more since this is a more advanced concept than a simple options buy. If you are really getting interested in serious options trading please read through this a few times to get a good handle on the mechanics.

This is Part XIII

This 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.

This is Part IX

Whenever you are dealing with options there are always two important parts to the price of that option. First if there is any intrinsic value to it, or in other words if the option happens to be "in the money." The second portion is the time value part and that is why selling a put gets an added bonus to the profit potential bottom line. Let's take a look...

Suppose we are looking at an optionable stock and we see that the options are available for the months of Oct, Nov, and Dec. Like all things...you pay more for a longer time period. Just like if you rent a car it costs more for 1 month than for 1 week and in options it's the same, you pay more for a Dec. option than an October option. Now what gets interesting is that when we sell a put option we are getting the premium (the cost of the option) at the time of the sale. So let's suppose we sold the November puts and just for example let's say we got 8 dollars for selling that put. Remember about half the price of that put is in time value or in other words about 4 dollars or even more of the 8-dollar price value is for allowing so much time to go by. So let's say the underlying stock is 100 dollars and the first week goes by and the stock doesn't move much. Not much probably happened to the price of the option either. But suppose a whole month goes by and our stock is pretty much still at 100? Now we have lost 30 days worth of time value that was in the original option. So maybe now instead of the option being priced at 8 dollars it is down to 7. See? Even though the underlying stock hasn't drifted away from where it was when we sold the put, the put decreased in value by 1 dollar, which means we could then buy back the put we sold...and profit a dollar. This time erosion is what helps add to our chances that the put we sell will go down in price along with the hopes the underlying stock is moving higher. But again even if your underlying stock doesn't go higher your put will erode in price giving you a chance to buy it back cheaper.

With a call option your stock has to move higher (and sometimes much higher) for you to realize a gain. When you sell a put it only has to stay the same or go higher giving you one more "chance" than with just buying a call. So now that we understand that, you can see that by selling a naked put (this was the technical name for this for years. We have noticed that in this time of Political correctness it is now being referred to as a "cash secured put") against a stock that you feel will rise in price ... You will make money as long as the stock doesn't fall below the strike price you sold. If it stays the same you make a profit, if it rises you make a profit. That being said, there is a significant risk involved with selling the naked put simply because if the stock falls below the strike price you sold, you may have the actual stock "put" to you. That means you will have to have the cash on hand to buy as many shares of the stock as you sold options against. Because of this obligation not everyone can get approved to sell naked puts. You must have a minimum cash balance on your account that is determined by the individual brokerage.

So since we have two ways they can make us money, what do we do if we get stuck with "door number 3" where you sold your put, but the stock didn't rise or hold...it starts falling? Buy back that put at the higher price. Cut your losses fairly quickly. Unless you want that stock put to you, stay on top of the game and just like a regular stock trade, determine how much you are comfortable losing and make the decision to buy them back and stop the bleeding.

This is Part X

We talked about the benefits of selling puts to get into a stock you wish to own for the longer term. Since our last few tutorials have been about selling puts on stocks you think will rise in the short-term. Here we will reverse the thinking and talk about selling calls.

As you have seen recently the markets volatility has created some great shorting opportunities over the years and if you are an option trader...some great put buying opportunities. Remember that if we think a stock is going to fall we can short sell the stock itself, or we can buy put options. Now we will look at the exact reverse of selling puts, and that is of course selling calls.

Remember how we went over the fact that a put option will decrease in value quicker on a stock that is rising than the corresponding call option would increase? And that is why selling puts on some rising stock makes so much sense. Well, the exact reverse thinking is what we are now looking at. If you think a stock is going to fall, a call option will decrease in price faster than the corresponding put option will increase in price! So, let's use an example just to get the feel of it...

Suppose you think that techs are overbought and they are headed down. You think that the ABCD Company has moved too far too fast and is ripe for a fall. It is trading at 100 per share and you see the stock has options available. Naturally you could short the stock, or you could buy some puts. But you can also sell calls and this is what we will do...

We could sell the Feb 100 calls and for our example let's say they get us $3 per share. So if we sell 10 contracts we have now just gotten 3,000 dollars in our account. Now suppose you were correct and by about Feb 18th ABCD is trading at 94 dollars, what do you think happened to the value of those 100 dollar calls? They went down like a rock and are probably trading at about 25 cents. In other words they are going to expire worthless, and you get to keep the premium that was paid to you for selling the calls.

So again we have a couple things working in our favor when we assume the risk of selling an option. First we have time on our side which means the option price will be eroding a bit just because time is ticking away, and if you couple that with the fact that the call option will lose value quicker if the stock is declining that the corresponding put would gain value...you can see the profit potential.

So where is the "catch"? There is none actually, but there is always risk and when you are selling an option you are assuming a responsibility and an obligation. When you sold that call option, you are giving someone the right to buy ABCD from you at 100 dollars per share. If ABCD doesn't sink, and instead rises, you will get called out and that means you will have to purchase ABCD on the open market (for let's say 105) and give it to the call buyer for 100. Ouch. Naturally we don't want this to happen so what we would do is this... If you sell a call option and the trade goes sour and ABCD starts rising instead of falling...buy the call back for the increased price and move on. Nowhere is the idea of cutting your losses more important that when you are selling calls or puts.

Finally, we will focus on LEAPS. Please pay particular attention to this segment folks because there are some very interesting opportunities waiting there.

Moving along in our series about options, we are now in Part XI, "What's a LEAP?"

In it's most basic form a LEAP is nothing more than an option with a long time period until it expires. If you look at an option chain it is very common to see August, September, October and even November options. But LEAPS are sold out to three years in time! So for an investor LEAPS offer the opportunity to get in a big position for not a lot of money (comparatively) and hold it for a considerable period.

So, just what is a LEAP?? It stands for Long-term Equity AnticiPationS (Can you believe it?) Back in 1990 they designed a long-term option chain in response to investors who wanted the type of trading options provide, but with a much longer time horizon. Hence...LEAPS were born. Interestingly not too awful many people know they exist and that is sad because they offer a lot to the individual. Believe me professional investors know of them and use them quite readily. Why? Let's look...

As you know if you buy a call option you are "locking in" a stock's price for a fraction of the cost of the stock. So, for people who may believe that we are going to new highs in the market, since the old mantra is that stocks go up over the long haul, wouldn't it be neat to pay a few bucks now, to guarantee some big profits later? Sure it would. Here's the thinking. Let’s look at MSFT for example. For a year they've gone nowhere fast, but we all know they have 70 billion in cash just sitting around doing nothing. Suppose you thought that they were finally going to put that war chest to work and over the course of a couple years, MSFT was going to double in Price. Well right now it would cost you about 29 grand to buy 1000 shares of MSFT, and hold it for two years. But, the January 2013 25 dollar LEAPS are under 6 bucks. With MSFT trading at 28ish, they are going to let you lock in a buy price of just 25 dollars for what is right now, 2 dollars in time premium.

Do the math here. For 6 grand you will have the right to buy 1K "shares" of MSFT at 25 dollars between now and January of 2013. So, if they do something incredible with their money horde, and the economy doesn't blow up as I suspect it might, those 6 dollar calls could be worth 30. 40. Who knows, maybe 50. This is why long term investors use these things. If they get it right, they can hit some huge home runs. One big note, folks...LEAPS trade exactly like a regular option. You DO NOT have to wait until expiration day to sell them. You could buy 10 contracts of MSFT Jan 2013 LEAPS this morning and sell them 1 hour later if you wanted. There is no obligation to hold them until expiration. That is another thing that makes them attractive. Just like shorter term options, if they rise enough for you to like what you see, you can take the money home.

This is Part XI

"Selling calls against a LEAP"

Please pay attention to this one folks because if you haven't heard about this concept, you are in for a treat!

We are going to look at one of the most underused tactics available to us as "investors." Now that is an interesting term because like our header says, our newsletter is really designed for the short-term trader. There really is a huge difference between investing and trading, and to be one without at least some of the other is a mistake. So although we focus on the short-term momentum and news plays that jump a stock in the one-day to three-week period, we like to give examples of good long-term investing. In fact we are considering creating a completely new product designed expressly for long-term investing but with a unique spin. We would trade our holds a bit more than what is thought of as "common" for investment stocks, but we would also be using a host of tactics that would allow us to maximize the returns we could get from our investments. Along with a model portfolio, and exact timing on when to buy and sell, we would also be offering a very unique service that would track the most attractive LEAP options that are available as well as which ones are most attractive in relation to the theoretical valuations. As if that weren't enough, we would also have one more very exciting investment technique... first let's talk about what this investment technique is.

As you know we were looking at the advantages of using LEAPS for our long-term investment strategies. We discussed the basics of what they are and a few ways to use them. Now we are going to look at something that all of you should get familiar with, and that is selling a covered call against your LEAP. Now that may sound strange, but believe me folks it isn't strange and it can be wildly profitable for you. First we have to get over the stumbling block that most people come up against which is;

How can you sell an option against an option?? Even though technically a LEAP is simply a long-term option, you are allowed to write a covered call against that holding. Here is how it works...

Most of you have heard the term "spread" such as a bull put spread or credit spread etc. Well, when you buy a LEAP you are in essence in a "long position" and they will allow you to also have a short position by selling a covered call against it. What you are doing is creating a "spread" and it is universally accepted, which is good meaning that you don't have to be as rich as Bill Gates to do this. Almost every brokerage that allows options trading will let you do a LEAP spread. That is the good part. The "fun" part is what you can do in terms of returns. Let's watch.

Let's suppose you buy a January 2013 100 (strike) LEAP on the XYZ Company for 24 dollars per share. But you can sell the January 2012 for LEAP for 12 dollars. See what you have just done? You have already gotten 50% of your original cost back. Or another example would be to buy the Feb. 2012 LEAP and sell the October call. If done correctly you very often have the ability to get 20% of your original cost back and more...every month. Eventually you can get to own the rest of your LEAPS term for free! If you do the math, and get good at which LEAP is priced the best (cheapest in comparison to theoretical value) and sell the call that is best (highest in theoretical value) very often you can buy a 2013 LEAP and sell a 2012 LEAP and get back almost all your money. Then you basically own the 2013 LEAP for free for a year or so giving it a lot of time to make your investment a big return.

Here is another thought for you. Suppose we buy 10 contracts of the January 2013 100 LEAP on XYZ and XYZ is trading at about 103 dollars per share. We spent 25 dollars for the LEAP. Now XYZ moves up to 120 and split's 2 for 1. Well a LEAP is just an option so indeed your LEAP split's also. So instead of having 10 contracts of XYZ Jan 2013 100 LEAPS you have 20 contracts of January 2013 50 LEAPS. Well do you suppose that XYZ may move back up from that split price back to near 100 again in the next 18 months? Probably. In fact let's say that by June 2012, XYZ is back up to 80 dollars. You could sell 10 of your 20 contracts which at that time would give you back all of the money you originally spent (plus a small profit) but you would still be holding the right to buy 1,000 more shares of XYZ at 50 dollars per share for another 6 months for free! Not bad right? Better yet, you could have been selling covered calls against all 20 contracts as XYZ was moving back to its pre split price. Then sell half your holdings and continue to sell covered calls also on the remaining 10 contracts until just before expiration. By aggressively selling the correct covered calls, your final return on your investment can often exceed 200%. That isn't bad, folks.

I know this is going to take a bit of "getting used to" so we will revisit this again. For now I want you to go over the idea a few times and get used to it. You can indeed buy a LEAP "which is an option to start with" and then sell a covered call against it.

This is Part XII

"A Q&A on LEAP's"

 

Q and A on LEAPS

Question: "Are LEAPS available for every stock?"

Answer: No, just like any option, a company has to register and do the paperwork and have the necessary requirements to carry them. Even some companies that have options do not have LEAPS attached to their chains. You will find LEAPS listed on just about every "major" stock, though.

Question: "Why haven't I ever heard of LEAPS before?"

Answer: Great question. LEAPS were only begun in 1990 and they didn't carry the "press" that short-term options got. In fact most LEAPS are bought and sold by professionals, which is also why some brokerages are pretty ignorant about them. But they are indeed available to the trading public, they are definitely successful to the exchange, and they won't be "going away" any time soon. I suggest you go to the Chicago Board of Options site at www.cboe.com and read more about them.

Question: "IF I buy a LEAP do I have to keep it until the expiration day?"

Answer: Not at all. You can buy a LEAP and sell it ten minutes later if you choose. The expiration date is just that... that is the day the option itself will expire and by then you will have had to either sell it or exercise it. But if you buy one for say 25 dollars today and next week it is trading at 30 and you want to take that 5 bucks home...by all means it is yours to sell.

Question: "I started looking at LEAPS and found one where I can buy the January 2006 LEAP for 5 dollars and sell the January 2005 LEAP for 5 dollars. Am I correct in assuming that if I did this deal, and the stock doesn't make it past my strike price by January 2005, I get to keep the entire 5 dollars and still have my January 2006 LEAPS for another year for free????"

Answer: Absolutely! Bingo! You got it! That is the best possible deal, and I applaud you for finding it. Every day as the option wizards adjust the LEAP prices, you have a chance to find a deal just like that where you can sell a call that gives you back your entire purchase price. Generally when I find one like that, It gets funny as I am hoping the stock doesn't move up too much the first year and then explodes the year I am riding the longer term ones up for free. In all actuality, getting dollar for dollar returns like that doesn't happen too often, but they happen enough, and when you can locate one it is a blessing. More times than not the scenario is more like you will get closer to 50% on a trade.

I hope that you’ve all enjoyed the tutorial series on options. As I said, I first wrote that series back in 1998, and except for adjusting some of the prices, nothings really changed, the fundamentals of options trading have been the same since they were first introduced.

Granted at my advanced age of decrepitude, I don’t do much of anything with them except for Puts and Calls. I really don’t see the need because I don’t hold for the long term, etc. But for you younger folks, with a lot of time to play with, or you folks that have a huge stock holding and simply will not actively trade your account, explore the different strategies. Some of them will make you money.

At this point it’s “time over and out” . We have explored how we look for stocks, how we enter stocks, how to short, what options are and how to use then and a hundred other things. The bad part is that I could go on and on an on, but it would all just turn into mumbo jumbo. I don’t want that.

I have given you all the tools to use to spot a trend, find sectors, look for entries, etc etc. If you focus on what you’re doing, get your head right, you can do this, and do it better than 90% of the so called brokers out there.

The following are some basic tools we use daily, if you need a resource, consider them

Bigcharts.com

Stockcharts.com

Bullsector.com lists all the stocks in any particular sector, great site

Tulving.com good place to buy silver and gold

Drudgereport.com for interesting news bits that don’t make the media

Thedailybail.com great site for seeing the lunacy of our Central banker

Zerohedge.com good insight on numerous topics

Kitco.com for historical charts on gold/silver and other commods

Think or swim is the trading platform I use; it’s a beast to master but works okay. Interactive brokers is maybe better, hard to say.

 

Go to Part 5 | Go to Part 1









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