Stock Market Savings

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 heard me tell the story of a certain gentleman in one of my early seminars who was disagreeing with me and dominating the seminar for two full days. Finally, someone asked me, “Wade, what is the single best investment strategy you know of? Where can you generate the richest returns?”

I saw the chance to make a point, so I turned to my heckler and handed him the question. He said, “Easy. Sell puts.” And then I said, “I agree, but now aren’t you people glad you paid me to teach you investment strategies instead of attending this man’s seminar, because he would have spent two days teaching you to sell puts, and you would have gone home and discovered you couldn’t do it. You can’t sell puts until you have both a lot of experience and/or a substantial reserve of cash set aside in your account.”

Well, people have always been grateful that we teach them eleven strategies at our seminars which they can imple­ment immediately to generate cash flow. And many of our students have done just that. In fact, they have gained so much experience and generated so much cash that they are ready now to sell puts! And so the time has come for this chapter.

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.

If you think the stock is going up, why not buy a call option? My standard answer is, “You can do that too.” Think about it. You’ve bought a call and sold a put on the same stock. Why both, or why sell the put? Simply because selling gener­ates income. Buying costs money. It’s a way of getting more cash into your account more quickly. Look at Interdigital Communica­tions (IDC) and Gaylord Con­tainer (GCR). There are too many to list.

The  only hang-up is this. Many beginners reading this chapter will not be allowed to sell naked puts (a covered put would be a situation where you’re in a short position on the underlying stock) until you have more experience and/or more cash in your account. You see, you have the obligation to perform if the stock is put to you so your broker will require you to keep that amount of money (or 20% plus if you are on margin) on hold until the expiration date.

If you are just getting started, you may want to stick to call options. I did and it worked for me quite nicely. But once you get familiar with rolls, peaks and valleys and predictable stock movements, the put option tool gives you a way to truly enhance your income stream. Indeed, you can make twice as much as you catch the stock coming and going.

I’ve written on this in another chapter entitled “Selling Puts.” But in this chapter on puts, it is necessary to mention the gist of the strategy.

Like calls, puts can be bought and sold. Up until now, this chapter has only dealt with buying puts—then selling (closing out a position) on puts we’ve previously purchased.

Now let’s explore selling put options we don’t own. If buying a put gives us the right to put the stock to someone else, then selling this right would allow someone to put the stock to us. We would have an obligation to purchase the stock. (This is the exact opposite of writing a covered call.)

Why would we do this? Two reasons.

1.    To generate cash. When we sell a put we get that premium into our account tomorrow.

2.    We want to own the stock at a lower price, or at least be willing to buy it at the put strike price.

I love this strategy. An example would be in order. A stock is at $13.50. It’s been rolling between $12 and $15 but you think it may break out and go way up.

You sell the October (one or two months out) $15 put for $3.50, or the $12.50 put for $1. One contract would generate $350, the other $100. Ten contracts would get you $3,500 $1,000.

What have you done? You’ve agreed to let someone sell you the stock at $15. (We’ll just use the $15 strike price for the balance of this example.)

If the stock stays below $15, you will get it put to you. But think: your cost basis is $11.50 because you received $3.50 from the put premium. You bought the stock wholesale.

If the stock goes above $15 (remember this is what you thought would happen), the put option becomes increasingly worthless—you get to keep the premium and you don’t have to buy the stock. Why would they sell it to you for $15 if it can be sold on the open market for $16 or more.