Stock Market Savings

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.

You just purchased this stock for $13. You see, your cost basis is adjusted by the premiums you’ve received for selling the put. If you’ve ever wanted to buy wholesale, you’ve done so. You’ve taken in $2 for selling the put and now your $15 purchase price is adjusted by this amount and you have a $13 cost basis. Just think, this stock could be selling at $14.50. You could take the stock and sell it immediately and have a $1,500 profit. You could also:

1.   Hold onto the stock for awhile. Remember, you thought this stock was going up. Is the story line still true?

2.    Sell a covered call on all or part of the stock. You could now sell a call option at a $12.50 or $15 strike price, or wait for the stock to strengthen and sell the $15 call option for more money (hoping to get called out or not) or even the $17.50 strike price if it moves up a lot.

3.   Go short on the stock, so you don’t have to actually purchase it. I’ll explain this later.

One thing I learned from my real estate days is that if you buy wholesale, all kinds of good choices present themselves. You can sell immediately and your payments are lower so you can rent at a profit, et cetera. The same is true with stocks. You have good choices if you buy wholesale.

If the stock is $13.50, you get at least $1.50 for the $15 put because that’s how much the stock is in the money. Let’s say you sell ten contracts. That will generate $1,500. However, that is all intrinsic value. Depending on the time to expiration, there will be added to this the time value, perhaps another 50c. That’s $2 or $2,000. The cash will be in your ac­count   the   next trading day.

You now are obligated to purchase 1,000 shares of this stock at $15. I’ll discuss movement and what we have accomplished, but to do so we need to see the relationship between the stock and put option prices.

Obviously, these prices are a snapshot in time. The option prices would be significantly higher if we went out several months, and significantly lower if the stock is not close to $15, or if it’s just a few days until the expiration date.

Back to the strategy. Again, we have obligated ourselves to buy this stock at $15. We have made $2,000 cash and it is in our account. We now play the waiting game. The big question is this: Are we willing to buy the stock at $15, or do we want to buy the stock at all? If the answer is no, then you probably should not have sold the right to someone to sell it to you at $15. Simply put—you had better like this company, AND LIKE IT AT THAT PARTICULAR PRICE, or you should not have done this.

Okay, you have $2,000 cash in your account, now what do you want to happen? If you don’t really want to buy the stock (which is my desire in about 99% of the cases where I’ve sold puts), but wouldn’t mind, then you hope the stock goes up.

If the stock moves above $15 (or close to $15), the stock won’t get put to you and you get to keep the money ($2,000). Remember, that was a deciding factor—you thought this stock was going up.

If the stock doesn’t perform this way, then you will now own the stock. It will be in your account, the Thursday after the third Friday of the expiration month. Before we explore briefly what you can do with the stock, let’s look at what happened.

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.

It’s about cash flow and a rather unique way of getting it. Everyone has heard that you can make money in any market, but the people saying so fail to give details on how to do it. More specifically, “they” say you can make money whether a stock is going up or coming down. I want to give some specifics on how to make money in options where the stock is increasing or decreasing in value. This is an option chapter. We will explore a cash flow generation strategy which will deal with stocks that you hope are going up—or will at least stay the same. Note: see the chapter “Tandem Plays” for doubling up these strategies.

Selling (naked) puts is a very unique and seldom-used strategy with a host of benefits. We will put some flesh on this skeleton, and some muscle, give it a brain and put it to work for you.

Definitions are in order. Stock option investing gives an investor the right, but not the obligation to buy or sell a particular stock at a set price (strike price) on or before a certain date. Call options give the investor the right to buy a stock. These options can be bought or sold. Put options give the investor the right to sell a stock. They, too, can be bought or sold.

Strike prices for all options are the same. They start at $5, and go up by $2.50 increments to $25, in $5 increments to $200 and in $10 increments thereafter. Options are written in 100 share contracts. Hence, a 75cent option will cost $75 for one contract. Options are derivatives. A derivative is a proxy investment based on an underlying security. Stock options are different than most derivatives in that the investor actually has the right to take control of (own by purchasing or selling) the underlying stock.

Options end—they expire. Because they are a fixed-time investment, investors should not only be wary and very cautious, but should invest in options by keeping an eye on the time clock. You may have the best horse on the track but if it falls behind or gets a bad start, the race may be over before it begins. The price of the option is broken into two parts. Part of the premium is actually purchasing the time until the option expires. This is called time value. If the stock price is above the strike price (call options) or below the strike price (put options), the option is said to be “in the money.” That portion of the option which is in the money is called intrinsic value. I will use several examples and this definition will come to life. Understanding time value (extrinsic) and intrin­sic value is not only important, but sine qua non to effectively making decisions on which option to purchase on a particu­lar stock.

Put options, and a particular angle to using them, is the topic here. Let’s keep exploring them. If you purchase a put option, you are thinking (hoping) that the stock will go down. What if, however, you don’t think the stock is going down? In fact, you think the stock is a winner. Is buying the stock or buying a call option on the stock the only way to take advantage of an increasing stock value?

No, selling puts is another strategy which accomplishes two major objectives:

1.    It generates new income.

2.    If you have to buy the stock, it lets you buy wholesale.

There are other minor strategies which allow for even greater returns.