Stock Market Savings

This formula requires volatility, but we also like predict­ability. I’ll encourage you once again to subscribe to a charting service. (I use Telechart 2000® by Worden Brothers. Wade Cook Seminars has a start-up kit for sale. Call 1-800-872-7411. It’s inexpensive, but invaluable.)

To begin, you track a stock. Let’s say it continues to peak (hits resistance) every time it gets to $35. Obviously it could break out at any point and go to a new high, so make sure you can stand the risk, but for the past while it hasn’t gone above $35.

 

Stock Price	$30 put	$35 put	$40 put
$34.75	$1.50	$3.00	$6.75
34.00	1.25	3.375	7.25
33.00	1.75	4.00	8.125
32.00 30.00 28.00 27.00	2.50 4.00 6.00 6.75	4.75 6.50 7.875 8.75	9.00 10.50 12.50 13.50

 

For quite a few months $35 has been the high. Buy the $35 put, or if you think the stock is going to go way down, play the $30 put. Let’s say the stock is at $34³A. The $35 put is $3. That’s a fairly high premium. Very little of the option premium is in the money with this put. “In the money” means the stock is below the strike price. In this case, just 25c is in the money. We check the $30 puts and they’re going for 75$. They’re cheap because the stock, at this strike price, is so far out of the money. The stock has to take a big move down­ward for you to get to the $30 strike price. Now remember, the stock doesn’t have to get to $30 to make money on the option. Depending on the time left to expiration, your option could double to $1.50, then go to $2.50 on a one or two dollar down-tick in the stock. You can sell at a profit anytime, and you can sell the option anytime before it expires.

Now check the $40 put. (To check if one exists, see if a bid and an ask are being written.) It might be going for 6V2 x 6³/4 bid and ask. Think of this: the stock is at $34³A. It’s $5.25 in the money ($40 strike price minus $34.75 = $5.25). Part of your put option premium is intrinsic value ($5.25). The balance is time value. You’re paying $1.50 ($6.75 – $5.25 = $1.50) for time. This is also referred to as extrinsic value. It’s what you’re paying for the time needed for this stock to do something.

This strike price is so far in the money that the relationship between the stock movement and the option movement may be in close ratio. (See Delta Formula in the Wall Street Money Machine.) The stock goes to $33 and your $6.75 option goes to $8. (A $1.75 downward movement in the stock increases your option value of $1.25 up to $8.) Now the stock goes to $30 and your option is worth $11. A nice relationship—a nice profit. Sell it for a nice gain. Even if the stock continues down you have a nice profit. (If you still think it hasn’t hit bottom and you still have time before the expiration date, you may want to wait and try to get $12 or $13.) You’ll kick yourself if the stock starts back up. As the stock price rises, the value of your $11 put option decreases.

Take the profit and use some of it to buy a $30 or $35 call option, or get in on a different play.

1.    Options are a fixed time investment.

2.    You should be doing this with money you can afford to lose.

3.    You should choose a month far enough out for the stock to perform as you hope.

I really like in the money options, but not too far in the money. The $40 put in the last example looked nice, but to double our money we need a large movement in the stock.

$6.75 to $12 or $13 requires a stock at $27 or $28.

No, I don’t have to double my money on the option to be happy—a 20 to 40% profit in a few days is just fine—but it is a calculation I make in my head. Some stockbrokers have a computer model which gives a “% to double” to see how much of a movement is needed in the time available.

 

Stock Price	$30 put	$35 put	$40 put
$34.75	$1.50	$3.00	$6.75
34.00	1.25	3.375	7.25
33.00	1.75	4.00	8.125
32.00	2.50	4.75	9.00
30.00	4.00	6.50	10.50
28.00	6.00	7.875	12.50
27.00	6.75	8.75	13.50

 

The $35 put and the $30 put require much smaller move­ments to be profitable. Look at the previous diagram to see a comparison.

Look at the tremendous leverage in the $30 put. Obviously you can lose if the stock doesn’t move way down, and obvi­ously there’s some safety in the $40 put—because it’s so far in the money, but you get your greatest bang for the buck on the cheaper options.

Also note: in rare cases there may be $32.50 puts and $37.50 puts. You could check and see.

Next point: you should check the option price for several different expiration dates. Look at your charts and make sure you give the stock/option plenty of time to move. If it goes through adverse swings, you still have time to recover.

What if the value of your option goes down? You have three choices:

1.    Wait it out (perhaps get in your order to sell at a price you like, so you don’t have to check on it every day).

2.    Sell it at a loss and lose all or some of your money.

3.   Buy more at the lower price. Jump back in if you still like the story.

 

Examples:

Ford (F): Rolls between $27 and $33. At the time this chapter was written it had broken out to $35. Maybe it will go back down, or maybe it will establish a new roll range or climb to an all time high.

Synopsys (SNPS): This has been a per­sonal favorite. Before it split (2:1) in the sum­mer of ‘95, it was rolling almost weekly between $56/$57 and about $64/ $66. It was incredible. Since the split it has established several ranges. $32 to $36 and $28 to $32, and $38 to $42.

G a y 1 o r d Container (GCR)rWehave also used thisone as a covered call stock. It’s very good. Look at the rolling range between $8 and $11.

Microsoft

(MSFT) is so often in the news that it’s a natural. When this chapter was written it was rolling between $98 and $104. This has been a great cash flow machine. I wish it would never quit—except for perhaps a new stock split just seconds after it dips and I’ve loaded up on call options—well, I can have dreams, too.

The development of this formula has its genesis in my rolling stock strategy. Play options on stocks trading within a specific range. I like the less expensive stocks because it doesn’t take too much movement to make a great profit. However, most stocks that are doing nice, steady rolls between a high and a low are in higher dollar amounts, say between $27 and $33, or $98 and $104. It would take a lot of cash to buy them, and there just may be better uses of our money. If the roll continues, there is definitely a better way to play the roll: proxy investing. Do options on stocks that trade within a certain range.

The strategy is simple: buy call options when the stock is low and wait for the roll up. Next, sell the call option and then buy put options when the stock peaks. Take your profits when it rolls back down. I’ve written about this concept elsewhere so I won’t belabor the call play here. Let’s explore the put strat­egy-Volatility and predictability and using the extra cash you can afford to lose, bring a higher degree of certainty to this risky arena. This is a tremendous formula in which you can get to be an expert.

Stock options are different from other options in that you actually control the right to buy or sell the underlying security.

Let’s keep exploring the “put” option. Keep in mind, if you are following the Wade Cook formula, you are not purchas­ing the option to purchase the stock, but to have inventory to sell as the option increases in value. Look at the following chart and you’ll see an increas­ing put value.

Example: it’s October and we purchased the January $35 puts.

Your put option increases in value as the stock moves away from the strike price. If the stock is $31 and the strike price is $35, the value of your option has to be at least $4. Indeed, you could buy the stock at $31 and sell it to someone for $35. This put option gives you that right.

Options expire on the third Friday of the month, but you may exercise your option at any time on or before the expira­tion date. Or, you may sell your option anytime there is an open bid. Options have a bid and an ask like stocks. You can sell at any price you choose, and one of those choices may be a market order (which is also known as the current bid).

 

Stock	Strike	Put Option
34	35	$2.00
33	35	$2.50
32	35	$3.25
31	35	$4.50
30	35	$5.75
29	35	$7.00
28	35	$8.00

 

The sentence which brings options to life and the one I repeat in all my seminars holds true for put options as well.

Here it is:

 

 

Revisit the previous diagram. A move of $3 in stock price, about 10% down in the stock, took the option from $2.50 to $4.50, a huge percentage move. With a call option you don’t need to double the price of the stock to double your money on the option, and with put options you don’t need a stock to drop half of its value to double your put option value. Frequently, small stock movements equal large option movements.

When the options start moving, you have several choices.

1.    Sell it for a price you’re happy with.

A.   This could be done by placing a sell order anytime after you own the option, even im­mediately—usually at a higher price.

B.   You can wait and watch the stocks, trying to plan your exit to maximize your profits.

Which one do you choose? In my case it usually depends on how busy I am. If I have a lot of plays going on, or if my other business endeavors take up my time, I usually place the sell order when I make my purchase. I place it high enough to get a nice large profit. If the option doesn’t move that high, I move the price down or just go ahead and sell. Note: pay attention as the expiration date nears.

2.    Exercise the underlying stock (buy or sell), but again, this is not why I play options.

3. Sell part of your position, five contracts out of the ten. Ride the five you keep to greater profits. It’s possible to get a free ride, in that the profits from the five contracts you sold could “get back” all or most of your investment. Now, you have nothing to lose.

Before I get into specific strategies, let me remind you of the underlying current of my trades—it is to make millions by executing minor trades, even on the same stock, at different strike prices and expiration months. Why?

1.    I don’t have a lot of cash tied up in any one deal.

2.    I can take advantage of frequent, small swings and not wait for rare, “killer” moves.

3.    I like the cash flow. There are always other deals. Take all or some of your profits and jump back in if the stock moves back up, choosing a different strike price. If you sold your $35 strike price and more bad news came out, maybe a purchase of the $30 strike price would be in order. If the stock has dipped way down and you’re highly profitable, take some of your money and:

A.   Buy some of the stock—hoping for a re­bound.

B.   Buy call options and ride the stock back up.

C.   Generate more cash flow by selling puts (see the section on selling puts).

There are three put formulas which you can use for gener­ating income. I hope you’ll note that inherent to these formulas are the “risk eliminators,” which, hopefully, will keep us out of trouble.

Options are fickle. They don’t always mirror the exact stock movement.

1.    The volatility of the stock. What does the options market know? Sometimes, it seems they know more than the stock market.

2.    The time remaining before the option expires. After all, when buying an option, you are paying for two things: time (extrinsic value), and part of the price of the stock (intrinsic value) if you are purchasing an “in the money” option.

If you purchase a $2 call option on a $35 strike price when the stock is at $33, and the stock moves to $36, your option could easily be worth $4 to $6, depending on the time left before the expiration date. However, if the stock goes no­where, and then rises to $36 with ten days to go before the expiration date, it may only be worth the same $2. If the stock halts at $36 and the time elapses to the point that there is only a day or so left, the option may trade for just the one dollar and the option is in the money. In this example, a $36 stock with a $35 strike price is $1 in the money. When investing in options, time is both our friend and our enemy. The value of the option has a direct and distinct relationship to the expiration date. All other factors: price, volatile movement, and market maker maneuvering, aid and abet the “fixed time” aspect of the option value. Hence, options can be extremely profitable, yet very risky.

Stock options are sold in 100 share increments. When you purchase one contract, you are actually purchasing the right to buy or sell 100 shares. Strike prices are the same for calls and puts. Stocks priced in the $5 to $25 range are sold in $2.50 increments. Stocks priced in the $25 to $200 range are sold in $5 increments, and stocks priced above $200 are sold in $10 increments. Note: as the options market becomes more popular, there are more strike prices added. For example, if a stock has a high trading volume, the option “market maker” may add an additional strike price, such as $32.50 or $57.50.

This article was written to dispel the mystery of “put” options and give several serious strategies for generating cash flow from either buying or selling puts.

A put option, as opposed to a call option, gives an investor the right to sell a stock. We will be concerned with stock options only in this chapter. A put option could be defined in street jargon as the right to “put it to someone.” You would want to put a stock to someone when you can purchase the stock at a lower price and sell it (immediately) at a higher price. For example, if you notice a stock consistently climbing above $30 to $33 or $35, and it not only has a hard time getting to the higher level, but also has a hard time sustaining the higher price, then you may want to buy a $35 put. As the stock comes back down, your “right” to sell the stock for $35 increases in value. As with call options, I do not buy the option to sell the stock. I buy the option to sell the option.