Stock Market Savings

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.

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.

Most of my stockbrokers are so busy they won’t do this strategy, however, the ones who really watch out for my best interests, will.

WANGO means Watch And Get Out. Let’s say a stock is having a nice run up. You are quite profitable on your option but want to get out at maximum profit. Ask your stockbroker to keep an eye on it. If it peaks and you can catch it at or near the peak, then you can get out with an even greater return.

An example: the stock was at $80 after a slam, or other bad news, or even after good news. It goes to $81. You call your stockbroker and buy the $80 calls for $3 and the $85 calls for $1.25. The stock goes to $83, then $84, and one hour before the market closes it’s at $85—almost $86. The stock hangs around $86, seems to have stalled, backs off to $85.50 with 10 minutes before the close—this is it—(yes, there is tomorrow but this is today). Carpe diem. Seize the moment. Sell and take your profits. The $80 call is $6.25 and the $85 call is $3.75. That’s a $3.25 profit on the $80’s and a $2.50 profit on the $85’s. It’s been a nice day.

Yes, it may still go up tomorrow, but many times they fall back. This stock had a 3%, then 4%, then 5% run up in one day. Surely I can’t tell you what to do, but I usually take my profits and wait for another dip.

Two more points:

A. The options market closes ten to fifteen minutes after the stock market. If you are willing to buy at the ask and sell at the bid (buy or sell at the market), you can still trade options at 4:05 pm, 4:10 pm, sometimes even 4:15 pm (Eastern time). Why do I bring this point up here? Many times, stocks go up or down a few dollars right at the close. If the options have a corresponding move, you could get out at a higher price or get in at a lower price.

However, unless there is really spectacular news (good or bad) which comes out over night, the options are usually pretty much the same the next morning. Just once in a while, I do option trades after the stock market closes.

B. If you have a good profit you could sell part of your position and keep part active. You don’t have to sell all four contracts you’ve purchased. Sell part to capture some profits now and keep some to cap­ture larger profits later.

You might even be profitable enough on the ones you’ve sold to regain all the money spent on all four contracts—you now own the two contracts you’ve kept, for free.

I know this sounds ambiguous but it’s important to realize that there is not just one time to get out. If you have invested $2,000 in ten contracts of a $2 option and one hour later it shoots up to $3 or $3,000, you have an hour profit of $1,000. If YOU’RE HAPPY, then get out. Take your profits and go to a movie.

Of course you shouldn’t get out if there’s more potential, but if this was initiated as a quick play, then take your profits and look for another deal—dips, new stock splits, et cetera. So what if it goes to $4. The next day it could be at 50tf.

Stocks and options are like ocean waves. They ebb in, they flow out. Nothing stays the same.

I don’t want to wear out this concept, but for many plays it’s very important. Here we’ll deal with a few option plays. We’ve already covered rolling options. Let’s now cover a peak or a slam.

Peaks

When a stock has a tremendous run up, say in one day it goes from $52 to $63, because of good news, unless there’s more good news coming out, it will probably back off. If you own the call options, get out. If you want to get in and play the downturn, buy puts on the stock and ride it back down. If the increase stalls, or even comes down a little, you could sell the options and buy back in on the dip.

If you own the stock, you could also write a covered call and again, ride it back down. You collect the premium and you also keep the stock.

Slams

When a stock takes a hit, you could buy a call and get out with a profit in hours. Here’s how it works. The company comes out with lower than expected earnings (it’s still highly profitable, but not up to what analysts expected). The stock falls from $62 to $54. The next day it finds support and even goes back up to $55. Consider buying the short term option and purchase the $55 call. It needs to be close. It’s going for $2. (Note: the $50 call is $6: $5 in the money and $1 time value. This costs more but may be a better play. Think it through.) A move to $56 or $57 could easily drive your $2 option to $3. Then get out.

You could have gone further out (two to four months) on the $55 call or the $60 call but that was not this play. This is short term. You should have placed the order to sell at $3 (especially if you can’t sit and watch it) right after you purchased it for $2. You know your exit before buying.

I have covered exit strategies on covered and uncovered calls and on selling puts elsewhere. I’ll only add this here: They are options. They have a fixed life. If you’ve sold a call or put and generated cash you have two choices.

A.   Let the option expire and keep the cash.

B.    If the option shrinks significantly and you think the stock might bounce, then you could buy back the option and sell it again as it gets more profit­able.

The best “out” enhancement strategy is to have gotten in at a bargain in the first place.