Stock Market Savings

There are four major strategies for determining when to get out of options. I’ll cover these as I blend in specific formulas on option plays. We’ll look at:

- Peaks

- Slams (“Dead Cat Bounce”)

- 90 degree angles

- Covered Calls

- Selling Calls

- Selling Puts

- Stock Splits

A quick explanation would be in order. A stock option gives you a chance to purchase or sell an underlying stock. It’s not a pure gamble in that you can actually act on the underlying security. Small movements in the underlying stock can produce, on a percentage basis, drastic moves in the option. I’ve seen a stock move up $3 and an option on that stock move up $2.50. You ask, so what? Well the stock went from $74 to $77. The $70 call option went from $5.25 to $7.75. Talk about a great proxy investment. The same can happen with puts.

Investors buy options for:

1.    Maximum bang for your buck—the expiration month and various strike prices should be ana­lyzed.

2.    Quick return on your money.

Again, we’re not here to discuss entrance strategies. You can read about those elsewhere. I only bring this up as a lead in to the next point. Is time a friend or foe? If we want to get out at not just a nice profit, but at the best possible profit, we need to explore this question.

An option may be comprised of two parts: intrinsic value and time value. Intrinsic value is that portion of the option which is in the money. Time value is that portion of the option which is out of the money. For example, if the stock is $26 and the $25 call options are going for $1.75, $1 of the $1.75 is intrinsic value and the 75cent of the $1.75 purchase price is time value. 75cent pays for one week or two months, or whatever time is left before the expiration date.

The reason I said “may” at the beginning of the last paragraph is that the option may be all time value. If you’re after the $30 strike price, and the stock is at $26, and the option is 50cent, the whole 50cent is time value. Time value could be called extrinsic value as it is extrinsic to the value of the stock.

At first, time is a friend. Your 75cent has purchased you a month and a half—six weeks. If the stock rises, the option value increases. You could sell at anytime. If you had pur­chased a call option with a $30 strike price, the op­tion value in­creases up to a point. If the stock goes above $30, you’ve made a nice play and you can get out at a nice profit.

If, however, the stock moves toward $30 and you’ve seen a nice run up in your option, but then the stock stalls, you may want to be careful. Time becomes the enemy. The option (stock) needs time to move up, and more specifically, move to the strike price, or it may become worthless.

Look at the chart. Note the dates. Note how in the last few days before the expiration date the stock is still going up a little but the option goes nowhere and then down. Time runs out. We’re purchasing the November $30 call options for 50cent.

Do you see how fast the time value deteriorates when there is no time left? As you look at this chart you can obviously see several exit points where you could have made a nice profit. Also note: the time value of in the money calls also evaporates as you get near the expiration date. Look at the chart. This is the $35 call option. The stock starts at $26.

Sometimes we, “tongue in cheek,” refer to time value as fluff. When there is ample time before the expiration date, the time value portion of the option premium is large. In the above example it was 75cent back on October 20, but only 25cent two days before the November 19 expiration date.

There comes a time when you get less bang for your buck. I would have sold this option at a double or triple. Be careful.

If it gets to be No­vember 10 and the stock takes a two dollar dip, the value can erode very quickly.

When the stock has less time to re­cover it may not regain its previous value. A lot of money can be made in the expiration week but only for someone with a stout heart. I hope you see how easily the “friend” can quickly turn to “foe.”

If you choose to purchase puts on the way down, do everything in reverse. Wait for the stock to peak out, check for other news, including where the market in general is heading (don’t fight trends), and buy a put. Sell it as the stock decreases in value. On a $25 stock, purchase the $22.50 put or even consider the $25 or $20. The $25 put will cost more because it’s in the money, but you have some insurance. The $20 (or lower) strike price will cost less because it’s way out of the money. Pick an exit point that you’re comfortable with and upon selling the put, watch for the true bottom (or support level) to sell the put, then jump back in with a call option and ride it back up. Keep the cycle going.

I took the Wall Street Workshop in October of 1995. I bought options in a few companies and was ahead at the end of the year by a little over $9,000. You know, this year has been thrilling. My gains thus far in 1996 exceed $86,000! All of your courses have been wonderful, but your Wall Street Workshop has been the most rewarding financially. Thank you.

Sandi—Bellevue, Washington

Exiting a position on rolling options is quite similar to a plain rolling stock play. If you find a stock which rolls (channels) within a certain range, and if the stock is optionable, then as it hits its low figure you purchase a call option at the next higher strike price. If it’s a stock under $25, you may want to purchase it two strike prices higher.

EXAMPLE: a stock rolls between $18 and $22. When it gets to $18 and bottoms out, purchase the $20 call. Its price is 62.5(2. Ten contracts would cost $625. Now wait or put in your GTC order to sell. Try to guess when to get out. After you’ve done it several times you’ll just know a good exit point. If the stock hits $21 (remember don’t get greedy) and the option then goes for $1.50 you could sell for $1,500 and have a cool $875 profit. Nice and predictable.

If the stock has frequently bumped against, and even gone over $22.50 (the next higher strike price), you may want to purchase the option at that strike price. It would be really cheap if the stock were $18. How does 12.5c (^!/8) sound? If you go to the next higher strike price, you should probably consider going out one or two additional months.

Instead of 12.5c the option may be 37.5(2, but that addi­tional quarter may well be worth it. And frankly, the stock may need more time to get close to, or over, the $22.50 strike price.

Realize also, you’re not doing this to buy the stock. You’re doing this play to wait for an increase in the value of your option so you can sell at a profit. Now where do you sell? Probably the same place as before—in the $21 plus range. It won’t take too much of a move for you to double or even triple your money. And again you could have a GTC order in place or watch and wait and sell at an optimum time.

You can also sell part of your position at one price and part at another. If you bought 1,000 shares at $3, you could place your GTC order on 500 shares at $4 and 500 shares at $4.25.

This is obviously personal to you. I can’t begin to tell you what to do, just as I can’t tell you all the ramifications of what you can do.