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Derivatives- Stock Options and More

All center fielders are baseball players but not all baseball players are center fielders. In much the same way, stock options are derivatives but not all derivatives are stock options. A derivative is a financial instrument whose value is “derived” from the underlying asset. It is a contract between two or more parties and the value is determined by fluctuations in the value of that asset. The most common of these assets are stocks, bonds, currencies, interest rates, commodities and market indexes.

Types of Derivatives:

Option Contracts– a contract that gives the owner the right, but not the obligation, to buy or sell a security or an index (basket of securities) at a certain price within a specified time frame.

Futures Contracts or Futures) – A contract that obligates one to buy or sell a particular commodity or financial instrument at a pre-determined price in the future. This market is regulated by the Commodity Futures Trading Commission. These contracts may require the actual delivery of the asset while others are settled in cash. Futures can be used to hedge or speculate on the price movement of the underlying asset. For example, a farmer expecting a crop of 50,000 bushels of corn may opt to hedge his position by selling 10 futures contracts (5000 bushels/contract) to “lock in” the price. This market is regulated  by the Securities and Exchange Commission (SEC).

Swap– This is the transfer of risk through the exchange of payment streams. For example, fixed interest rate may be exchanged for floating interest rate. Also, maturtites may be traded  or stock and bond qualities can be exchanged based on new investment objectives. This market is UNREGULATED and is traded off-exchange on the over-the-counter (OTC) market.

Types of Derivative Traders:

1- Hedgers– These investors have a cash position in a commodity and need to protect against an adverse price change by purchasing an offsetting position. An example is the “corn crop” example I gave above or an owner of a stock who buys a put, giving him the right to sell the stock at a certain price even if the market value is much lower.

2- Speculators– These are investors who have no interest in the underlying commodity but will accept the risk the hedger is reducing FOR A PRICE. They assume this higher risk level in order to profit from an anticipated price movement. They provide liquidity for hedgers.

Covered Call Writers- Both Hedgers and Speculators:

That’s right. We are so special that we can be both hedger and speculator in the same investment. When we purchase an equity, we are speculating that the price of the stock will maintain or achieve a certain level so as to generate a profit. The risk is in the stock price falling to the point where we are losing money. That is the reason we have a complete set of exit strategies in place to activate if required. We then hedge this speculative position by selling the call option and creating downside protection. The protection for the position, in general, is the premium generated from the sale of the option. There is another protection we can access as well. That is the protection of the option premium itself which we can produce by selling in-the-money strikes. This “insurance” is paid for by the option buyer.

Conclusion:

All options are derivatives but not all derivates are options. Derivative contracts are bought and sold by both hedgers and speculators. We, as covered call writers, are actually both hedgers and speculators and that is why we have an opportunity to generate outstanding returns with minimal risk.

Flash Trading Update:

In August, I wrote an article regarding flash trading and how the SEC was investigating its impact on retail investors. This is where certain Wall Street insiders get to see an order a brief moment before the public does. Here is a link to that article:

/blog/the-yield-curve-trading-opportunities-and-economic-outlook-plus-what-is-flash-trading/

Recently a recommendation has been made to the SEC to end all flash trading on the stock exchanges. This is expected to be approved early in 2010. It is, however, unclear whether this will also apply to options trades. Flash trading plays a major role in what is known as options “step-up” orders. Here is how step-up orders work: An investor’s order to buy or sell an option contract is routed to one of several options exchanges, such as the CBOE or International Securities Exchange. If a better price for the option has been placed at another exchange, the CBOE will briefly “flash” the order to other traders on its exchange, giving them a chance to “step up” and match the better bid. If no such bid transpires, the order is routed to the other exchange. Many traders believe that step-up orders benefit industry insiders and destroy competition, resulting in poorer prices for investors.  Proponents of step-up orders claim that they provide a steady stream of volume thereby producing favorable prices for traders. Bottom line: Flash trading  will likely be eliminated on the stock exchanges but may not be for options trading. The trend politically and legislatively is definitely in our favor. This represents a small but palpable silver lining in the ugly sub-prime cloud that is beginning to dissipate. I will update this information when decisions have been finalized.

Chart of the Week- AIXG:

AIXG as of 12-4-09

AIXG as of 12-4-09

 This near-perfect chart shows the following:

  • Uptrending 20-d ema (red arrow top)
  • 20-d ema above the 100-d ema (100d ema denoted by blue arrow)
  • Price bars at or above the 20-d ema
  • MACD positive (green box)
  • Histogram positive (Red rectangle)
  • Stochastic oscillator above 80% but dipping (purple oval)
  • Positive indicators on significant volume (orange box)

Although this stock has dipped slightly over the past few days, the moving average seems to be a reliable area of support. I currently own this stock in two of my accounts and have sold both the $30 and $35 calls. In the world of Blue Collar Investing we realize that a strong chart is not a guarantee of success but it does throw the odds in our favor. It sure beats a hot tip at the water cooler! Put this together with only selecting equities with strong fundamentals, plus other more esoteric rules (ERs), an organized portfolio manager and watchlists and planned exit strategies, if needed, and we have a formula for success.

Last Week’s Economic News:

The unemployment rate decreased to 10% in November from 10.2% in October while payrolls shrank by merely 11,000, the best performance since the start of the recession in December of 2007. In addition to this GREAT news, the previous two months job losses were revised downward. Let’s hope this trend continues. Total construction spending was flat in October which was a positive surprise. The Federal Reserve’s Beige Book reported modest economic growth in 8 of its 12 districts and little change in the others. U.S. non-farm productivity rose an annualized 8.1% in the 3rd quarter, the largest increase since 2003. The only negative signal was from the manufacturing and service-sectors which showed a slight reverse in economic growth. For the week, the S&P 500 rose 1.3% for a year-to-date return of 25%.

This Week’s Economic Reports:

  • Monday: Consumer credit report
  • Thursday: International trade report
  • Friday: Retail sales and business inventory reports

Video currently playing on the homepage:

Green Alert: IBDs Enhanced Website

PREMIUM MEMBERSHIP UPDATE:

This aspect of The Blue Collar Website is currently under construction. I am hopeful to have it available by the end of this month or early in the new year. Those on my mailing list will get a first look. If you haven’t joined, here is a link to that list:

/joinfrnds.shtml

Wishing you all the best in investing,

Alan

alan@thebluecollarinvestor.com

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About Alan Ellman

Alan Ellman loves options trading so much he has written four top selling books on the topic of selling covered calls, one about put-selling and a sixth book about long-term investing. Alan is a national speaker for The Money Show, The Stock Traders Expo and the American Association of Individual Investors. He also writes financial columns for both US and International publications along with his own award-winning blog.. He is a retired dentist, a personal fitness trainer, successful real estate investor, but he is known mostly for his practical and successful stock option strategies.

24 Responses to “Derivatives- Stock Options and More”

  1. Brian December 6, 2009 11:20 am #

    Alan,

    Glad to see you mentioning aixg as I have this one too. I sold the 35 call. I do have a question though. Can’t seem to find much info on their past earnings. Any ideas?

    Thanks a lot.

    Brian

  2. admin December 6, 2009 11:39 am #

    Brian,

    AIXG is a German company and therefore trades as an ADR (American Depository Receipt). When it comes to ERs, foreign companies play by different rules and have less frequent filings. IBD will probably state: “no SEC filings”. You can go to:

    http://www.morningstar.com and hit “filings” once you have typed in the ticker. Look for filings “in English”. Here is the link for this stock:

    http://quicktake.morningstar.com/StockNet/SECDocuments.aspx?Symbol=AIXG&Country=USA

    Alan

  3. Don B December 6, 2009 12:47 pm #

    For Brian – post @1 – Fidelity shows AIXG earnings as follows:
    2009 Q3 .12 Reported, after .07 estimate. Q2 Reported .04, after .07 est. Q1 Rep. .06, after No Estimate. 2008 Q4 .04 after est. 06. Q3 .06 after est. .07. Q2 .08 Reported, after .06. Q1 .06 reported, after .05 estimated.

    Hope this helps.

    Don B

  4. Brian December 6, 2009 1:54 pm #

    Alan and Don,

    Thanks for the quick response.

    Brian

  5. Jeff December 6, 2009 9:27 pm #

    Alan,

    Enjoying your blog. How about a nit-pick? My preference is to characterize we covered call writers as “investors who hedge” rather than as “both hedgers and speculators.” The term speculator doesn’t necessarily have a risky connotation, but unfortunately it is often understood that way by many readers; and as such, it would not be a very accurate representation of the relatively conservative nature of covered calls (when compared with typical buy-and-hold for example).

    Regards,
    Jeff

  6. admin December 7, 2009 12:49 am #

    Jeff,

    I don’t consider your comment a nit-pick but a valid perspective. I agree that CC writing is an extremely conservative form of investing . That, along with the impressive returns ,is why I am so passionate about it. However, it is critical for me to convey to investors, particularly those new to the market, that there IS risk in this strategy. That risk lies in the value of the underlying security declining in value. I emphasize this point, ad nauseum, in both my books and will continue to do so in my seminars and blogs.

    For this reason, I would prefer to define our position as both speculation and hedging, while highlighting how conservative this strategy is compared to most others. In this regard, I fully understand your perspective. However, I do not want to equate what we do with, let’s say, an investor who purchases T-bills who is truly not speculating. Thanks for your comment.

    Alan

  7. admin December 7, 2009 7:26 am #

    HLF:

    I will NEVER buy a stock soley on an analysts say-so. However, when I note several analysts recommending a particular equity, I will oftentimes “check it out”.

    HLF is near a 52-week high and has outpaced the S&P 500 by 130% in the past year. It is fundamentally sound with a PE ratio of 13, a net profit margin of 8% (compared to an industry NEGATIVE margin), and an industry-leading dividend of 2%.

    Check the chart to see if this equity has a place on your watchlist and take a look at its “industry colleagues” to avoid duplication in your portfolios.

    Alan

  8. admin December 7, 2009 2:03 pm #

    KINDLE:

    As of TODAY, both of my books are now available in kindle format as “Cashing in on Covered Calls” was added to this technoogy. here is the link to that site on Amazon.com:

    http://www.amazon.com/s/ref=nb_ss?url=search-alias%3Dstripbooks&field-keywords=alan+ellman&x=9&y=21

    Alan

  9. Amy December 8, 2009 10:26 am #

    Take a look at the chart for MED. Looks even better than the chart in this article for AIXG. I have them both this month!

    Amy

  10. admin December 8, 2009 10:49 am #

    Amy,

    Congratulations on locating this winning stock and a big money-maker for many of us the last few months. It is also ranks # 3 on the IBD 100 this week, just behind HMIN and GFA.

    Speaking of charts, some stocks with a mild beta (near 1) will have a lot of short-term price swings and therefore a high implied volatility (IV). This means that over time, it will perform close the S&P 500 but will take us on a wild roller-coaster ride while doing so.

    Take, for example, RAX. Excellent fundamentals and currently positive technicals but look at the price swings during the year. The bad news is that it may be hard to sleep if you are on a downturn. The good news is that the high IV results in higher option returns and that is why you can still get a 2.5%, 8-day return with downside protection for the December contracts. A stock like this is not for everyone but its chart pattern and option premium teaches an important lesson.

    Alan

  11. Barry Bergman December 8, 2009 11:56 am #

    Just D/L the Kindle version of “Cashing In On Covered Calls”. Now have both books on my Kindle!

    Barry

  12. Paul December 9, 2009 5:55 am #

    Alan,

    I’m half way through your DVD series and really learning a lot about options. You stress how important it is to avoid earning reports. My question is what we do about earnings pre-announcements?
    Thanks.

    Paul

  13. admin December 9, 2009 10:14 am #

    Paul,

    Great question, simple answer. We are extremly meticulous when it comes to matters that we have control over: fundamentals, technicals, ERs, exit strategies etc.

    When a company decides to pre-announce, it is the same as an unexpected news item. We have no control over this. Therefore I give it no thought and concentrate on matters that I can control. This falls under the umbrella of the risk involved in this strategy. It will be a rare occurence and when it happens it could be positive or negative. If negative, check to see if there is an apprpriare exit strategy to implement.

    Alan

  14. admin December 9, 2009 10:18 am #

    KIRK:

    I have had a few offsite questions asking if there are many inexpensive stocks appropriate for CC writing. I have found the “sweetspot” to be between $30 and $70 per share. But a quality watchlist WILL have some less expensive. KIRK made it onto my watchlist and portfolio a few weeks ago. It is a low-beta stock (below 1) with great fundamentals and a decent return.

    Alan

  15. Joshua December 10, 2009 8:17 am #

    Very good Info, Alan. Keep up the good work. I still have to digest some of the points better by googling them myself.

  16. admin December 10, 2009 9:24 am #

    Joshua,

    A lot of great information can be obtained directly from the CBOE website:

    http://www.cboe.com

    The more esoteric info like for flashing trading updates is best obtained directly from financial publications like “The FinanciaL Times”.

    Alan

  17. admin December 10, 2009 11:04 am #

    PRGO:

    A recent positive earnings surprise has caused a lot of analysts to jump onboard with this stock. Yearly revenue is up 16%, with annual growth projected to be 29%. It sports a PE ratio of 16 and a PEG (PE/Growth) of a neat 1.0 with a $0.25 annual dividend.

    Check the chart to see if this equity has a place on your watchlist.

    Alan

  18. Don B December 10, 2009 1:21 pm #

    Hi Alan,
    Went to sell a call this morning – tried to set a limit order @ .89. Lo and behold, the Fidelity software would not let me do so, saying I needed nickel increments. Yet, Last was showing at .89, while bid was .85. So I set it at .90 and got filled. What gives? If it requires nickel increments, how is it that Last was .89??
    Don B

  19. admin December 10, 2009 1:51 pm #

    Don,

    You have experienced what’s referred to as “Price Improvement”. This is NOT the same thing as the “Penny Pilot Program” I wrote about a few months ago:

    http://www.thebluecollarinvestor.com/blog/category/penny-pilot-program/

    With price improvement, you must enter in the increments stated in the options chain, usually .05 apart. Sometimes a market-maker or specialist wants to take the other side of the order and “move ahead” of the others. For example, if there are 1000 contracts offered @ .90 and the specialist want to get rid of his ASAP, he may make them available @.89, move ahead of the others and we benefit from this “price improvement”. This can work both ways, when both buying and selling stocks and options.

    Alan

  20. Sara December 11, 2009 7:44 am #

    Hi Alan,

    I bought AIXG for $34.50 and sold the 35 strike price. For the 3 contracts I made $607 after commisssions. The stock is now at $36.70 and I was thinking of closing my position. It will cost $2.55 to buy back the option. Your thoughts would be appreciated.

    Sara

  21. admin December 11, 2009 10:03 am #

    Sara,

    My favorite subject…math! I will sometimes close a “winning position” prior to expiration Friday if the time value of the premium has eroded significantly. The remainder of the B-T-C premium is intrinsic value which you get back in “buying up the value of the stock”.

    In your current situation, the true value of your shares are $35/share because of your option obligation. If you buy back the option @ $2.55 and your new share value is $36.70, the time value lost in premium is $0.85 ($2.55 – $$1.70). This represents a loss of 2.4% (85/3500) per contract. You currently have downside protection of 4.6% (170/3670) to preserve your GREAT profits for this cycle on this stock. For this B-T-C to make sense, AIXG would have to drop more than 7% (4.6% + 2.4%) in ONE WEEK for this to be a winning trade. Is this possible, yes. Is it likely, no.

    Bottom line: Calculate the loss in buying to close your position versus the likelihood of the stock dropping in value by more than that amount.

    Alan

  22. admin December 12, 2009 1:14 pm #

    Check out tomorrow’s blog article which explores the option chain and looks at the chart of another GREAT performer. Also, the homepage is CURRENTLY showing a new video showing how to calculate expiration Friday exit strategies using the ESOC (Ellman calculator).

    Alan

  23. Mark December 12, 2009 7:53 pm #

    Alan,

    Your books are excellent. I had 2 questions re. p. 142-144 (Chapter 13 Mathematics) in Cashing In on CC:

    1) The examples show 8 positions with $100k, and 5 positions with $65k. Assuming reasonable diversification, would you say, in general, that an optimal position size is $10k to $12k ?

    2) Are you opposed to buy-writes on $10 to $20 stocks, given the comment on p. 173 re. look only at stocks valued at $20 or more ? These days, there are still a few big names like GE, BAC, and AA trading in the mid teens after last year’s drop.

    Thanks for your help!

  24. admin December 13, 2009 2:55 am #

    Mark,

    I appreciate your comment about my books, thank you. My responses:

    1- $10k to $12k is reasonable for portfolios of those sizes. Those who have portfolios of $200k and higher (there are several investors in our group who invest $1M and up in this strategy) would have more equities with larger positions per stock. By paper trading for a few months you will be able to determine your comfort level in the # of stocks you can manage. The more diversification, the better. The minimum is 5 stocks in different groups (industries or sectors). As time goes on, you will be enhancing the value of your portfolio and expand the number of stocks and contracts you manage and this becomes easier with more experience.

    2- EXCELLENT POINT! 2008 did knock down the value of many quality companies. I still find the “sweet spot” to be between $30 and $70 for most of my watchlist stocks but there ARE quality companies less than $20 per share. KIRK is (currently) one such company that I recently alluded to in my comments.

    Alan

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