TAKING THE PROFESSIONAL’S SIDE OF THE MARKET
- WHY OPTIONS?
- INVEST LIKE THE PROS
- PUT WRITING IN ACTION
- ROLLING OUT OPTIONS
“OPTIONS” is a “four letter word” to most investors. Based on most investors personal experiences this is not undeserved. The typical options novice begins by buying puts and calls and losing money. After a few such experiences many people give up on options and never return.
The first key point to remember is that almost all option buyers lose money!
The second key point is that “Options” is a zero sum game. For each dollar lost there is an equal dollar (less commissions) gain.
Thus if virtually all option buyers lose money, then they lose their money to the people who sold them the options. This is the key concept.
Be a seller, not a buyer, and the odds will be heavily in your favor. It’s similar to being “the house” at Las Vegas or Atlantic City but without their overhead expenses. While some gamblers can get lucky in the short run, over time the house advantage will prevail and the casino’s gross win percentages vary little from the statistically projected results. The same is true in options writing (or selling). The odds will always be in your favor if your strategy is sound and your pockets are relatively deep.
Option writing, done conservatively, is less risky than owning the same stocks outright. You will know your “worst case” scenario prior to establishing each position.
WHO BUYS OPTIONS?
WHY BUY OPTIONS?
- Limited Risk: Limited to a loss of 100% of your money!
- Big Potential Gains: Unfortunately, they generally stay potential.
- Small Capital requirements: This is one of the real lures.
WHO SELLS OPTIONS?
- Professional floor traders. They’re very happy to accommodate the public’s demand
- Mutual funds. (Mainly covered calls)
- Astute individual investors. Like me and my clients!
WHY SELL OPTIONS?
- High probability of success.
- Increased income stream.
- More conservative than outright buying of shares of the same stock.
INVEST LIKE THE PROS
My favorite strategy, Put Writing, first requires the identification of good underlying stocks. Choosing the proper stocks means selecting shares which will go up in value, stay the same, or at least not decline significantly over the term of the option period. This, obviously, is not a new concept. The difference here is that by writing at or below the market puts we can show gains even if the stock selected does not move up, or even goes down slightly. By lowering our break-even point to under the current market price, we have tremendously increased our chances of winning and reduced paper [or real] losses when positions move against us.
WHAT DOES A PUT WRITER WANT TO HAPPEN?
- The seller of a put wants the stock in question to go above, or stay above, the strike price through the set expiration date.
- Maximum profit equals the premium received upon sale of the option
- Maximum risk is to purchase the required number of shares of the designated company at the strike price less the premium per share received.
- Ideally, the put writer wants to collect as much premium as possible without ever being asked to purchase any shares. In many cases, but certainly not all, this is exactly what happens.
Just like the farmers who get paid NOT to grow crops, you can often be paid NOT to buy stock.
BENEFITS OF PUT WRITING
- Either you get paid not to buy, or you own shares at a price you judged in advance to be very attractive.
- It gives you the discipline to fight your emotions and buy when shares are cheap.
- Put writing requires no initial cash outlay and it provides positive cash flow from the next business day. Used conservatively, option writing can be a better income vehicle that CD’s or bonds for clients who understand the process.
- You have a high probability of profitability!
- “Time”, the raw material you are selling, costs you nothing. “Time” is always on your side.
- Many times you can be wrong and still make money.
RULES FOR WRITING PUTS:
- Only write puts on stocks which represent good value.
- Write only as many puts as you would be comfortable having exercised in a worst case.
PUT WRITING IN ACTION
STOCK TRADING BELOW STRIKE PRICE
ABC Corp. now sells for $19.
We can sell a March $20 put for $2.25 per share.
For selling the put we receive $225 per contract (less commission).
Our “break even” is reduced to $17.75 per share.
POSSIBLE SCENARIOS FOR ABC STOCK:
- If ABC goes up to 20 or above: We win the maximum possible.
- If ABC stays unchanged: We win paper gain of $1.25 per share.
- IF ABC declines to $17.75: We break even.
- If ABC falls below $17.75: Paper loss.
Please note that in the first three scenarios, with the stock going up to infinity, staying level or dropping up to 6.6% in value, the results to the option seller were highly profitable in most cases, and neutral at worst.
STOCK TRADING ABOVE STRIKE PRICE
XYZ Corp. now sells for $11 per share.
We can sell a December $10 put for $1 per share.
For selling the put we receive $100 per contract (less commission).
Our “break even” is reduced to $9 per share.
Possible scenarios for XYZ stock:
- If XYZ goes up: We win the maximum possible.
- If XYZ stays unchanged: We win the maximum possible.
- If XYZ declines to $10: We win the maximum possible.
- If XYZ declines to $9: We break even.
- IF XYZ falls below $9: Paper loss.
In the last two situations we could either purchase the shares at a net of $9 per share and wait for a price rebound or we could close the options (if they have not yet been exercised).
Please note that in the above scenarios, with the stock going up to infinity, staying level or dropping up to 18% in value, the results to the option seller were highly profitable in most cases and neutral at worst.
This certainly covers the most likely events to occur if the underlying stock was chosen well.
Assuming they had not been exercised previously we could “ROLL OUT” these puts to a later expiration date to allow more time for the shares to come up in price.
“ROLLING OUT” OPTIONS”
When share prices go down despite our projections, we will need to attend to put options which are (hopefully) temporarily unprofitable. By rolling out put options we obtain more time for the shares to pick up and achieve out price objectives. Best of all, in most cases we also get paid extra for trying again. Where else in life do you not only get a second, third, or forth chance to succeed, but also profit financially from having missed on previous efforts?
HERE’S AN EXAMPLEOF A “ROLL OUT”:
When XYZ was selling at $11 per share we sold 10 contracts of the December $10 Puts for $1 per share. We received $1000 (less commissions) into our account and had an obligation to purchase 1000 shares of XYZ at $10 per share through the third week of December.
Shortly before expiration XYZ shares are at $8.75. If we have not been “PUT” yet, we can close out our December puts by buying them back at the current market price. The market price with little time left until expiration will be the intrinsic value plus a small time premium in most cases. This would typically be $1.375 per share in this case ($1.25 of intrinsic value plus a 12.5 cent time premium.)
To finish the “Roll Out” we will (simultaneously, in most cases) sell 10 new $10 puts on XYZ for a later month. A June $10 XYZ put would typically bring in around $2 per share or $2000 (less commissions) for out 10 puts.
Our obligation after all this is done is to purchase the same 1000 shares of XYZ at $10 per share. The only difference is that the option period extends through the third Friday in June, rather than December.
Sold 10 puts: Collected $1000
Obligated to buy 1000 shares XYZ at $10 per share, Dec. Expiration
Bought 10 puts: Paid $1375
Canceled obligation to buy XYZ shares in Dec.
Net Dollars: (-$375)
No obligation to buy XYZ shares.
Sold 10 puts: Collected $2000
Obligated to buy 1000 shares of XYZ at $10 per share, June Expiration
Net Dollars: +$1625
At the completion of the rollout the obligation is the same as it was to start: Buy 1000 shares of XYZ at $10 per share. However, if by June, the shares have recovered to above $10 (as we expect) we will now have a profit of $1625 instead of the $1000 profit which would have been realized if the options had expired in December. If, by June, the shares remain below $10, or if they are “PUT” to us earlier, we have lowered our bread even point from $9 originally, to $8.375 per share.