Stock Market Savings

Damage Control

You can’t say that you have unlimited risk in selling puts because the lowest the stock can go is to zero. That is your downside. If the stock is below the strike price, it will get put to you.

You have one other strategy that can be played right up to and through the expiration date. It is called “rolling out.” Here’s the way it works. Let’s say the stock is at $46. Last month you sold the $50 put for $2.25 when the stock was at $48.50. You had hopes it would go up. It hasn’t. If you have to buy the stock, your basis will be $47.75, as you have received $2.25. One problem is the heavy duty amount of cash you’ll need to purchase the stock—even $25,000 on margin.

You think you could find a better use for the money. The put is currently $4.25—buy it back. Actually, you’re just purchasing the same put (strike price, month) as you sold. This will close the position—it’s a wash on your broker’s computer. If you had ten contracts, you would have lost a little over $2,000 after you add up the commissions. You could just end it here, but don’t. There’s another play.

Remember, you liked this company’s stock at this price. Check it out. Is the story line still in place? Yes, it didn’t go above the $50 like you planned—at least, not yet. If you still think it will do so, roll on out to the next month.

Let’s continue. Try to catch the stock on a dip—even if in a roll or slam in trading. Say it’s going between $46⁵/8 and $46^3/4. It occasionally drops to$46²/8. At that point sell the November $50 put. It’s going for $4.50. That’s $4,500. You’re back in the money again, and you’ve made a profit.

If you don’t think it will go above $4.50, look at the $45 put. It’s going for $2′/8, or $2,125. If you sold this you’d about break even on the original loss. Yes, you have an open position to buy the stock at $45, but your homework says it will go up.

Another method would be to split the contracts. Say, sell five of the $50 puts and five of the $45 puts. You should and could consider purchasing $45 or $50 calls. Maybe the $45s for November, and the $50s for February.

It keeps going down. Believe me, there will be an end to this—you will eventually make money. The next month the stock is at $44. Let’s stick with the $50 puts as that will be most drastic. You sold the November 50 puts for $4.25. It will cost $6.50 to buy them back. This purchase will throw you back in the loss column. Not by much, though.

You’re sure, this time, that the stock will turn around. It just has to (or so you hope). So spend the money—$6,500. Now the December $50 puts are going for $8 and the $45s are going for $2. Sell the $45 puts. You’re profitable again. Also, look at the $40s—there might be some premiums there.

Now the stock moves back up to $47. Your December $45 put expires worthless, and you’ve made over $2,000 for all this trouble.

This could go on several months—but sometime (hopefully) the stock will turn around. When it does, you end it and keep the best batch of each. When you buy back this month’s put, you can always sell the next month out for more money.

And Finally

There are two more considerations.

1.    You may want to consider only selling, or at least primarily selling out of the money puts, i.e. you sell the $50 put when the stock is at $52. This gives you a cushion. The problem is that the premiums are smaller and you have to weigh out the amount of margin tied up for the smaller option premium.

2.    Stick with stocks in the $5 to $25 range. Selling puts and writing calls have a lot of the same risk/reward features—only in reverse. If you want nice premi­ums on stocks which won’t kill you to buy, the lower priced stocks may work better.

Remember, when you sell you have many ways of making money (see “Tandem Plays”). When you buy call options or put options you only have one. This rolling out strategy lets you stay in the game until you make money.

It’s simple: you generate cash whether you have to perform or not. If you do have to buy the stock, you purchased it at a less expensive price than otherwise. I love selling puts because you get the best of both worlds—cash now and wholesale prices.

Buying Calls

You buy calls (short and long term) when you think a stock (hence the option value) will increase within a certain time period. You do so to lock in a certain price for the stock or to sell the option at a higher price. Your risk is that the stock (option) won’t increase in value in the time allowed.

 

Selling Calls

You sell calls to generate income. When you sell a call, you are committed to perform. You’ve given someone the right to buy stock from you, whether you own (covered) the stock or not (uncovered, naked). The premium you receive adjusts the basis you pay (paid) for the stock. For example, if you bought a stock at $9 and sold the $10 strike price call for $1 and then had the stock bought from you at $10, your profit would be $2. Your basis is $8, as the $1 premium reduces your basis from $9 to $8.

You can systematically generate monthly income from writing (selling) calls. You sell naked call options when stocks are high and you expect them to go down or stay the same.

Again, you can write covered calls and uncovered calls. If you write uncovered calls you qualify the investment for an infinite rate of return, as you have no cash tied up. You also have an added risk in that you may have to purchase the stock for resale if the stock rises above the strike price and you get called out. Obviously, this risk is mitigated by the pre­mium you’ve received. For example: if you’ve sold a call (when the stock was at $11) for a $2 premium at a $10 strike price, you’d hope for the stock to go below $10. You’d only sell the call if you thought the stock would go, or stay, under the strike price, so you could keep the premium with no further obligation. For other variations, attend the Wall Street Workshop.

I really like to sell uncovered calls. It takes experience and more cash in your account to do these, but it’s fun and very profitable.

 

Buying Puts

Now, let’s get on to puts. The right (option) to sell a stock to someone increases in value as the stock moves downward and away from the strike price. If the stock is $38 and you think it will go down, you could buy a put option with a $30, $35, $40 or $45 strike price. The one you choose depends on:

1.    How far down you think the stock will go.

2.    How much you want to risk (your option pre­mium).

3.    How much time before the expiration date.

4.    Other important factors: a) whether the stock rolls between certain ranges, b) news regarding debt, mergers, new (good, bad) management, et cetera.

A $2.50 premium to buy a $40 put will increase in value as the stock moves to $36, $35 and lower. You can sell or exercise the option any time before the expiration date.

 

Selling Puts

If you sell a put, everything turns upside down. You are selling the right to someone to put the stock to you at the strike price. Why do this?

1.    To generate immediate income. Think of it. If the stock goes above the strike price you won’t get it put to you and you get to keep all of the premium.

2.    You buy the stock wholesale. Let’s say the stock is at $13 and you sell the $15 put for $2.50, the stock doesn’t rise above $15 (maybe it is $14.50) and you get it put to you, your basis is $12.50. You’ve just bought a $14.50 stock for $12.50.

When do you do this?

1.    When you want to own stock in a company, or, at least, you wouldn’t mind owning it.

2.    When you wouldn’t mind owning it at that price— and wholesale, to boot.

3. you want to generate income—now!! Crossover

Now that we’ve established the four plays, look at the following diagram.

You see, there are three things which can happen to the stock (and we assume this movement will affect the option price to a certain degree): it can stay the same, or about the same, it can go up, and it can go down. However, if you sell a call or a put, a lot of opportunities open up. You should see here that you could sell a put in the situation where you normally would think of buying the call (you think the stock is going to rise) and sell a call when you would buy a put (you think the stock will fall). The difference and the key point is that when you sell something you generate income.

So, if you think a stock is going up, you can sell a put rather than buying a call to put dollars into your account instead of spending it. That’s cash flow: selling rather than buying. If you 1) buy back the option you sold at a lower price, or 2) let the option expire, you get an infinite rate of return. By selling options, two out of the three possible scenarios (stock rises, stock stays steady, or stock falls) are profitable. When you buy options the stock must move one way. Only one profitable scenario exists. Look at the follow­ing examples:

 

Naked Calls

The stock is, say $9, and you write the $10 call and receive $1.50 premium. If the stock rises above the strike price and you are called out, you keep the premium, but you have to deliver the stock.

If the stock stays steady at $9 or falls below $9, you can either buy back the call at a lower price when the time value decays, or you could wait for the option to expire. In either case, you would receive an infinite rate of return.

 

Naked Puts

The stock is, say $11, and you write the $10 put and a $1.50 premium. If the stock stays the same or rises, you keep the premium and you can either buy back the put at a lower premium or wait for the option to expire. Either way, you get an infinite rate of return.

If the stock falls below the strike price of $10, you have the stock put to you. You would have to accept the stock at $10.

 

Covered Calls

If you purchased the stock at $9 and wrote the $10 call for $1.50, you would receive a $1.50 premium. If the stock rises above the strike price ($10), you would be called out, and you would keep $1.50 premium plus make $1 on the sale of the stock.

If the stock stays steady, you would not be called out. You would keep your $1.50 premium and you could write more calls the next month.

If the stock falls, you keep the $1.50 premium which can offset the loss on your stock. Then you have to make a choice, do you wait for expiration or buy back the call at a reduced price? You can find more information in the Next Step and the Wall Street Money Machine.

 

Covered Puts

Covered puts are an odd concept to explain. In a covered call, you own the stock, so you can deliver it if the option is exercised against you. In a covered put, you have to have a place in your portfolio prepared and ready to accept stock if it is put to you, i.e. you must have a short sale position in that stock. This is a very advanced strategy that we cover in detail at the Next Step Wall Street Work­shop.

I like selling puts on a stock that I would like to own in a long-term position even through market turmoil. By selling a pricey put, you can take advantage of the speed of options and, if it all goes well, you can buy it hack at a profit. If it doesn’t all go as planned and it gets put to you, you will just own a stock you wanted anyway. You can start selling covered calls at the strike price you paid (after adjusting for the premium collected) for the stock when the stock has regained strength before a dip. Then, when it dips, you buy the call back. Continue to sell these perhaps deep-in-the-money calls until you get called out.

J have been doing this with Ascend Communica­tions (ASND). It seems to work well because it is such a great stock for this strategy. This strategy could be disaster for someone who tried this with Micron Technology (MU) a while back. Perhaps buying some cheap puts at the same time may work as a safety hedge. Options can be risky this year. I find that buying options when the McClellan Oscil­lator is in an oversold condition can help me not get stung by a correction or market rotation. Keeping track of future event dates like jobs reports can be helpful, too. The bad thing is that one can wait a long time between these safer trading periods. A strong, long-term, up-trending stock can make a big differ­ence.

Some of you have read elsewhere about DUCks—or Dip-pingUndervaluedCalls. This is when a company, usually after a split, that has been climbing, pulls back temporarily as investors take their profits. The company is solid and growing, but the stock dips 5-10% for no reason other than profit taking. Around our office, we have a word for this. We call it a “SALE.” The price of the stock and also of the options, has just dropped below value. It is a perfect buy opportunity.

Obviously, any buy opportunity or any rising stock also presents a great opportunity to sell a put. If the stock turns and rises (as it should) you keep the premium and that’s it.

Of course, you want to pick the stock near the bottom of the dip and sell the put for the very next expiration date. And the strike price should be very near the stock price.

That way, if you’re wrong and the stock gets put to you (you are required to buy it), you get it at the sale price where it can rise. And when you buy a rising stock, you can easily sell later at a profit, sell calls, or just hold it. So a DUCk really presents a great opportunity to enhance your cash flow.

Okay, here we go. A stock is at $13.50. You really like the company. You think this stock could easily go to $18 or $20. You think this because:

1.    The stock is rolling between $13 and $20, and has done so frequently. You know this from looking at its chart.

2.    You have heard good news from the company— i.e., new products, expansion, great earnings, et cetera.

You could buy the stock or buy the $12.50, $15 or even $17.50 call options. If the stock rises as expected, the value of your investments increases. Both of these choices require an expenditure of money. If you buy the stock on margin, you only have to put up a percentage of the money (in most cases 50%). I bring this up here because margin requirements will be necessary when selling puts—see the section on “cash requirements.”

Let’s not buy the stock or call options. Let’s sell a $15 put, or even the $12.50 put, if you think the stock may go down further. What does this mean? Let’s use the $15 put example first. If you sell a $15 put, you are literally committing yourself to buy the stock at $15. You no longer have just the right (as in buying an option), you now have the obligation to perform, if the stock gets “put to you.”

You see, by writing a put (selling), you have given someone the right to sell you the stock at $15. They don’t know who you are—all they have done is purchase a put option—giving them the right, not the obligation, to sell the stock to someone at $15. When would they do this? When the stock is below $15. Now, if the stock is at $14.75 or $14,875 on the expiration date, it’s iffy whether or not it will get put to you. (See “Selling Calls” in the Wall Street Money Machine for more information on the execu­tion of these close orders.) However, if the stock is at $14 or $13 it will get put to you at $15.

What did you get for selling the put? And when will you get the cash? The premium you receive is determined by how far the strike price is in the money or out of the money, and how long until it expires.

If you want to play more options on this same company, consider the following:

Wait for dips—be patient. Study the charts and pick the most opportune strike price and expiration date.

Sell out, take your profits, and buy back in at a higher strike price. Once again, the assumption has to be that the stock will increase.

 

Selling the option profitable opens up another possibility. If you sell part of your position, and if you think the stock has peaked (you still own a few call options) then buy a put with the profit. You now have created a straddle for FREE.

A pure straddle is one where you own calls and puts on the same stock, at the same strike price, and for the same month. Your straddle does not have to be pure. You can buy a call at one strike price, and buy a put at another strike price.

Either way, as the stock moves up you sell the call, as the stock moves down you sell the put. Something for nothing, I can’t add more. It’s a great way to enhance your cash flow and/or add to your portfolio.