As covered call writers, we have all looked at option chains. That’s where we determine how much cash will be generated into our accounts when we sell our options. It’s fun! We first inspect the current price of the underlying security (stock or ETF). Then we check out the closest strike prices (I-T-M, A-T-M and O-T-M) and take note of the bid and ask prices. For I-T-M strikes, we will also look at the amount of intrinsic value that the option premium consists of. If we are interested in a particular option, we will make note of the option symbol, usually found to the left. Let’s look at a typical options chain for a stock (MELI – figure below) an equity that was in my portfolio at one time (note the original option symbology):
Options Chain for MELI
Current market price: $48.59
I have highlighted two columns that tend to be overlooked, Vol(ume) and Open Interest. Although many investors assume these stats are similar, they are, in fact, quite different. The purpose of this segment is to discuss that distinction and the significance of each figure.
Vol(ume):
This is a measure of the number of transactions that transpired for a particular options contract for that day. It signifies how many times a day a particular contract has been bought or sold. The higher the volume, the greater the liquidity. A contract with zero volume should NOT be considered illiquid because it takes time to build up volume during the day. Also, an exchange specialist or market maker will step in to take the other side of the transaction. On the above options chain, the volume for the O-T-M $50 call is 202 contracts bought or sold thus far that day.
Open Interest:
This is the number of option contracts that are open or outstanding on a particular day. This number is cumulative. Options with large open interest have a secondary market of buyers and sellers. This will allow that option to be traded at a reasonable bid-ask spread. The open interest for the $50 strike on the above chart is 2282 contracts.
The Mathematics of open Interest:
There are four types of options trades that can be executed (see the chart below):
Mathematics of Vol and Open Interest
Two will increase open interest and two will decrease it:
Buy to Open (BTO)- Increases open interest by creating a new long position
- Sell to Open (STO)- Increases open interest by creating a new short position
- Buy to Close (BTC)- Decreases open interest by closing an existing short position
- Sell to Close (STC)- Decreases open interest by closing an existing long position
Trading Activity and Open Interest:
| TRADING ACTIVITY | CURRENT OPEN INTEREST | VOLUME | |||||
| Trader A: B-T-O 6 contracts | 6 | 6 | |||||
| Trader B: B-T-C 2 contracts | 4 | 8 | |||||
| Trader C: S-T-O 8 contracts | 12 | 16 | |||||
| Trader D: S-T-C 3 contracts | 9 | 19 | |||||
Mathematics of open interest
As you can see, open interest is not the same as volume. With volume, both entries and exits cause volume to increase but in the case of open interest, entries will cause an increase and exits a decrease in open interest. Open interest is generally a higher number than Volume because it is cumulative whereas volume is reset to zero at the beginning of each trading day.
Significance of Open Interest:
Increasing open interest shows strength in the current price movement of an option in much the same way as a volume spike will enhance the significance of a change in a technical indicator like the MACD. Decreasing open interest shows a weakening of the current price movement. If the price is increasing on increasing open interest, the likelihood of continued price increases is greater. If open interest starts decreasing, that upward price movement is starting to weaken. Also, as mentioned earlier in this chapter, the greater the open interest, the more favorable the bid-ask spread is likely to be. Open interest of 100 contracts or less is thought to have relatively thin liquidity. I like to see an OI of at least 100 contracts and/or a reasonable bid-ask spread ($.30 or less). Keep in mind that a bid-ask spread of greater than $.10 can oftentimes be negotiated down by “playing the bid-ask spread”.
One time cash dividends and adjusted strike prices: For those who missed it there was a series of posts (8, 9, 11, 12, 13, 14, 15 and 16) in last week’s blog commentary relating to oddball (non-standard) strike prices resulting from one-time cash dividend distribution. For a strike price to be changed as a result of a dividend two criteria must be met:
- It must be a one-time only distribution
- The dividend must be for more than 12 1/2 cents.
The example discussed was for IGTE which distributed a $0.15 dividend. Another one of our premium watch list stocks, GES, also declared such a dividend, this one for $2. It goes ex-dividend on December 6th and that is when we will see the option strike prices reflect this dividend. Here is a chart showing the strikes before and after:
GES- Strike price adjustments
A free site where you can access information on contract adjustments is:
http://www.cboe.com/tradtool/contracts.aspx
New DVD Series now available at a DISCOUNT through December 20th: I recently wrote and hosted a NEW 3-part seminar series which were professionally filmed and now available in DVD format. The 4 DVDs include:
- Introductory DVD
- Basic seminar
- Advanced seminar
- Practical Application
- 121-page ALL-COLOR Companion Workbook with EVERY chart, graph and slide included in the course.
To view an outline of the content, use the following link and then the back arrow to return to this article:
http://www.thebluecollarinvestor.com/dvds_cds.shtml
To view a short video with a few highlights from the DVDs and member testimonials:
http://www.thebluecollarinvestor.com/store.shtml
Click on “Watch Informational Video” and then use the back arrow tom return to this article.
We have placed the DVD series on sale from now through December 20th and will be offering FREE SHIPPING on this DVD package. If you are sending this as a holiday gift fill in the shipping address (different from billing address) where you want it sent and include any note (under “comments”) you would like included). ***PREMIUM MEMBERS: Enter the store from the premium site (lower right corner of premium home page) and you will receive your premium member discount IN ADDITION TO the sale price.
Market tone:
I was pleasantly surprised at the resiliency of the stock market on Friday after it was announced that the unemployment rate rose to 9.8% in November. Aside from this negative report economic news was positive:
- U.S. manufacturing expanded for the 16th straight month in November
- Construction spending rose 0.7% in October, beating analysts’ expectations
- ISM manufacturing index (services sector) reached its highest level since May
- Consumer confidence reached its highest level since June (54.1)
- The Department of Labor revised productivity growth higher in the 3rd quarter
- The Federal Reserve reported that economic conditions improved in October and mid-November in nearly every Federal Reserve district.
This week I created a 6-month chart of the S&P 500 using the 50-d and 200-d simple moving averages:
6-month chart of the S&P 500 as of 12-4-10
Note the following:
- The S&P 500 moves above the 50-d sma- green circle
- This begins an uptrend that is still in place (blue arrow)
- The 50-d sma moves above the 200-d sma (red circle)
- The 50-d sma serves as support (red arrow)
Summary:
IBD: Market resumes confirmed uptrend
BCI: We remain moderately bullish utilizing mainly O-T-M strikes
My best to one and all,
Hi Alan,
I havent got your new dvds, but if they are anythng like your original set of DVD’s/ CD’s and workbook they would be brilliant!
I listen to them and watch them all the time…
TSL
Check out the MSN stock scouter rating on this stock. ONLY 2! Compare this to the IBD ratings which are very good and it dont make no sense…
Alan, just a question regarding your system. Are you ever concerned that your buying a stock at resistance level? How do you evaluate this?
Also, do you pay any attention to candlestick patterns? For example, say a stock you wanted to buy showed great fundementals and technicals within the context of your system, but a chart also showed a very recent bearish candlestick pattern. Would you take this into consideration? What would you do in this scenario?
Thanks
Dave
Premium members:
There is a problem accessing the IBD website since last night. This may delay publication of this week’s stock screen and watchlist. All premium members will receive a direct email update regarding this matter and then a followup email when the report is uploaded to your premium site.
Alan
Dave,
The SmartSelect and Scouter screens are proprietary screens that factor in some similar but many different parameters in their screening process. That’s why I use both (among others). A stock with a Scouter of “2″ means that based on 10 years of historical data, the information relating to this equity makes it a risky investment. Just like implied volatility high risk can mean high reward but this is not for every investor. Conservative investors (I’m guilty as charged) would probably shy away from this one at this time. Those with a higher risk tolerance who may have identified a technical signal (like your candlestick pattern) may look at it as an opportunity to generate significant returns.
Relating to a stock at resistance: Some stocks just keep going up: AAPL, FFIV , NFLX (until we bumped it last week) and many others. If the general market otne is bullish, I’m still selling O-T-M strikes. If a neutral or slightly bearish market I will sell I-T-M strikes. You’ll be amazed how this common sense approach can both protect you and generate great returns.
Back to TSL: Below is a 1-year chart I created. Please note the following:
1- The red arrows show the wild ride this stock has given its investors over the past year. Many folks love roller-coasters. I prefer an escalator (going up, please).
2- The black line shows no share appreciation in that time frame.
3- The green circle highlights the short-term moving average dipping below the longer term moving average. This may turn around but I demand proof.
4- The blue circle shows a bearish MACD momentum indicator.
Based on this technical information, a case can be made for this being a risky investment. Different strokes for different folks.
See my comment below as I have also created a price comparison chart. NOTE: New members- click on the charts to enlarge and then hit the “back arrow” to return to this blog.
Alan
Dave,
TSL:
Below is a price comparison chart with DECK a stock I alluded to on last week’s blog commentary and an equity on our premium watchlist. I use this stock not as a specific recommendation but rather as a tool for comparison. Please note the following on this chart below:
1- In the past year, TSL has lost 1.8% in share value while DECK has gained 159%.
2- TSL’s industry is up 77.3% in the last year, defining TSL as a laggard within its industry.
3- The relative price strength of TSL (compared to all other stocks) is in the 36th percentile while that of DECK is in the 96th percentile with 99% being the best.
That being said, I’m sure that if you utilize other technical tools a brighter picture can be found. You must use the fundamental and technical parameters which have proven to work for you over the long run.
One of the mission statements of this forum is to stimulate discussion which will result in more education for all of us and ultimately enhancing the level of our investment skills. In this regard, you have been a long time and important contributor in this forum and we all thank you for that. Thanks also for your generous remarks regarding the DVD series.
Alan
Ah – a good, solid explanation of the Volume & Open Interest data. Now if only I can remember it, so as to know how to use it all the time…………………….. Another arrow in the quiver.
Thanx much.
Don B
Alan,
Thanks for the detail in your response…
Alan, do you take into consideration other fundemental information IBS gives about a stock. For example,
TSL
EPS % Chg (Last Qtr) 116%
3 Year EPS Growth Rate 72%
EPS Est % Chg (Current Yr) 62%
Sales % Chg (Last Qtr) 104%
3-Year Sales Growth Rate 69%
How would you interpret this fundemental data? Im not an expert when it comes to looking at fundemental analysis but to me the above data looks very positve…
Thanks Alan
Dave
Oops, I ment IBD, not IBS
Dave,
You are 100% spot on when you analyzed this stock fundamentally. As a matter of fact the SmartSelect EPS rating for TSL is in the top 1%. However, I demand much more than that for my investment selections. The price pattern and other technical indicators are not the best of the best. It’s like the baseball player who hits 40 home runs and knocks in 120 RBIs but can’t field or run the bases. He’s real good but not the best of the best so he can’t play for me.
Alan
Alan,
Are all the stocks on the premium list that show “% dividend yield” regular dividends and not 1 time cash dividends? I want to be sure that I don’t have to be concerned about changing strike prices with these stocks.
Thanks a lot.
Chris
Chris,
All stocks on our premium watch list with listed “% dividend yields” are regularly scheduled dividend distributions and will NOT effect strike prices and will not NOT result in non-standard options. Thanks for giving me the opportunity to clarify this issue.
Alan
Am just getting started. I love the vocab list down the side of your blog page!!!
Just as a further request: when you write could you make sure some of your terminology is included in that vocab list or you explain in Parathesis(sp).
Ex: short position and long position.
Also, intrinsic value is defined, but a extrinsic isn’t.?????
Thanks for all you do to help us!
Linda
Linda,
Welcome to the BCI community. It’s great to have you aboard.
Since our group is predominantly average retail investors (although our membership of professionals is growing and we welcome these members as well) I make every effort to define terms that may be new to many of us. Thanks for pointing out a few that I missed. Also, you will find a fairly thorough glossary in the back of my books that should be helpful in this regard as well.
In the interim:
EXTRINSIC VALUE: The time value of an option premium. The equation you should know is:
Option value = intrinsic value + time value (extrinsic value)
If a stock is $47 and we sold the $45 strike for $3, $2 is intrinsic value and $1 is extrinsic or time value.
Long position: Buy a security (stock, ETF, option) in expectation that it will rise in value.
Short position: (stock) the sale of a borrowed security in hopes it will fall in value.
Short position (option): The sale of an options contract. In covered call writing, we buy a stock (long) and sell the corresponding option (short). We are long the stock and short the option.
I hope I haven’t given you a headache!
Thanks for the suggestion.
Alan
Today I saw the opportunity to do one of Alan’s famous ‘Hitting a Double”.
I had some shares of MSB in my account which I bought for 41.97 in October and made some good money with it with selling the Nov. covered calls. (2.8% ROO)
I bought back my calls 2 days before expiration very cheap on a dip and sold them again for Dec one day after the 3rd Friday in Nov. (3.6% ROO)
Again a good deal.
MSB has been climbing since then and was at around $53 today.
$12 more than I bought it for.
Looked like a good “double” candidate to me.
I checked our premium list and found RVBD as a nice replacement.
But first I had to buy back my MSB Dec $40 calls.
I missed the early morning low of MSB but later-on it was jumping between $52.50 and $53.70.
Today they have an ER and it might be positive, but who knows what the stock might do. . .
So, I bought back my Dec $40 calls when the stock was down at $52.85 for $13.20 and about 15 minutes later sold the stock for 53.25
Meaning, I did not have to give back one cent from my previous deal.
Hurrahh!
Now I had to catch Riverbed (RVBD)!
I used almost the same money I sold MSB for and I bought RVBD for $34.96 and sold the Dec $35 call when the stock was at $35 a few minutes later for $1.25
If all goes right that will be a 3.5% ROO in 11 days.
All in all this day was not too shabby!! :>)
Cheers
Dirk
Owen, where are you???
I know, it is Monday today, but that is no reason not to be in the blog here. . .:>):>)
I have one request and maybe others would like to join:
We talked a while ago about a guest article her you might do about taxes.
That would be a good time now.
December 31 is arriving quickly and everybody is interested to position themselves for the tax season:
How to report the deals, which deals belong together, pure option trading, cc trading, long and short term gain review, a review or update on how to use the schedule D in the calculator etc. etc. just to name a few things we might be interested in.
I promise, I’ll light an extra red candle on our Christmas Tree for you. . .:>)
Cheers
Dirk
I’m here, Dirk. I just had nothing to add to this particular post, and the discussions, at this point. I am working on a tax article which Alan may post for next week. It will include discussion of how to report sales, exercises (both sides of a put and call), when to report sales, what are short sales, etc.
I will take this opportunity to ask that any reader send me specific questions you want answered to OSARGENTCPA@AOL.COM. I will include the discussion for everyone’s benefit and, hopefully, cover pretty much all of the issues you may encounter.
For those of you from Canada, Australia and other countries, I will attempt to answer some of your questions, but bear in mind that I am not a tax expert for income taxes in other countries. Some of you even think the year ends April 10 (England). Weird.
Dirk,
Congratulations on these outstanding investment successes. I can’t tell you how good it makes me feel when I receive emails and posts like yours. Thanks for sharing.
I also look forward to posting Owen’s tax article once I receive it. Owen has been and important contributor to this forum and we are all extremely fortunate he is willing to share his unique expertise with the BCI community.
Alan
Hi Allan,
I am a new member. Read your two books. Your latest report puts HANS in pink- could not undrrstand why?
Also DECK has notes of MACD neutral and Sto (upright triangle)- not sure what they mean
Apologies if the questions seem too daft
Regards
DK
DK (Post #17),
HANS failed the Smart Select Fundamental/Technical screen…it had two “yellow lights,” a failing grade. As for DECK…the MACD was approx. at the signal line…hence neutral or side ways arrow and the STO had an upward pointing arrow signaling that the Slow Stochastic line is above the signal line.
Barry
A note for new BCI members:
This is a forum for learning and sharing. Although some members are less experienced and some more, everyone has questions from time to time. PLEASE, do not sit on the sidelines for risk of thinking your question is silly. You have already bought Alan’s books and dvds. Alan tries to make them as easy to understand and complete as possible for the average blue collar investor.
In spite of Alan’s best efforts, some of you still need a question answered, either because you don’t understand something, or something was not explained to your satisfaction. I promise you, you are probably not alone, but if nobody asks, nobody will not learn.
We want the blue collar investors to be able to look at news of the Wall Street bigwigs and smile, knowing that we know how to make money in an up market, a down market, and a sideways market. Remember, on the stock market’s worst days, there is usually at least a couple of stocks hitting new highs. Alan has taught us to find the best of the best, but that does not mean that we can’t learn to avoid a hit here and there, from the observations of a few friends on this blog.
GES
I would like to go back to the one-time-cash-dividend and the corresponding adjustment of the strike prices.
Does this have any significance for us in regards of ROO?
We lose in this case $2 of the strike price and get it paid back on the 23rd, right?
The drop on the price on Monday on the stock itself is based on what?
Just the selling, or did they adjust the stock price too?
Cheers
Dirk
Dirk,
GES issued a special dividend of $2. Holders of the stock will receive the cash dividend when it becomes payable. It appears that the dividend is payable to holders of record yesterday, so even if the stock gets called you will get the dividend.
Yes, the option strikes were adjusted by $2. The Dec $35 became Dec $33, etc. As for the ROO, it should come out the same if you get called. It’s just that you will get the results in pieces.
Thanks Owen!
Cheers
Dirk
NFLX
Thanks again Alan, your system got me out of this at just the right time. It’s falling further in the afterhours tonight.
Mark T.
NFLX CFO resigned effective December 10. Keep an eye on it. It is delivering streaming video through Wii, Xbox 360 and a few other devices. Let’s face it, $8 a month for video anywhere you are is some kind of service. Call Cablevision and ask them to match it.
Allan,
I am a new member and becoming familiar with all the information you provide. I was wondering if your weekly report can also be used for just buying and selling stocks.
Thanks for your great service.
Frank
Owen,
I agree with you to watch it. It is just stumbling some, we’ll get back to it soon.
Frank (#25),
Before I started investing with covered call options, I was consistently beating the overall market by using similar screens buying and selling stock. I would add the following points to consider:
1- Our premium reports fully scan only stocks that have options associated with them.
2- If you are a short-term trader, the technical parameters we use in the BCI are appropriate. If you are a long-term investor you may want to use longer term moving averages (for example 50-d and 200-d simple moving averages).
3- Earning reports become less of an issue because you will gain all of the upside of a positive surprise.
The main focus of our premium list, however, is to provide a list of the greatest performing stocks in the greatest performing industries that represent outstanding 1-month covered call candidates.
Alan
LULU:
This stock has been on our premium watchlist for the past 4 weeks and has been a frequent member of the BCI select list of covered call candidates. You may have noticed that it didn’t pass the risk-reward screen (Scouter) after market close last Friday. I wanted to point out that these screens are updated on a regular basis and today IS showing 6 green circles. All screens and technical analysis provided by the BCI team in these weekly reports are published after market close on Friday (Thursday if there is a market-recognized holiday) and before market open on Monday.
LULU reports earnings tomorrow so it is possible that the fundamental rankings could change. If this stock remains on this week’s IBD 100, we will re-screen the equity and publish then information on our next premium report.
Alan
Does anyone know of a site to check to see if an earnings report was favorable or not?
Thanks,
Phil
Phil,
Here is a free site to access earnings surprises:
http://moneycentral.msn.com/investor/invsub/analyst/earnest.asp?Page=EarningsSurprise&Symbol=avgo
Type in the ticker on the upper right and hit “go”
You will also know the market reaction to the report by the price movement after the announcement. For example, LULU which I alluded to in #28 is scheduled to report BEFORE the market opens tomorrow. Check out the price action and you will know how it was received…good, bad or indifferent.
Alan
Alan
LULU update:
The initial market response quite positive. Up $4.60 in pre-market trading.
Alan
Phil, any quote screen will let you know if the earnings were good or bad. Ok, seriously, the problem with earnings reports is the market expectations and reactions. A company can have a poor earnings report but it goes up because everyone thought the report would be worse and had already taken the stock down. Many good reports have caused the stock to drop because they were not “good enough”.
When we trade covered calls we look at the reaction and decide if now is the time to buy and sell a call, or pick another stock off our watch list. You should probably give the stock a day or two after the earnings report for the “froth” to settle. The BCI rely on reasonable trading prediction to profit from the call writing.
Thanks Owen and Alan. Great info as always.
Phil
TRW:
This is not an IBD 100 stock but one I came across while investigating companies that may have benfited from the resurgence of the automotive industry. This company is one of the largerst auto suppliers in the world and is trading at a 5-year high. On November 3rd it beat quarterly earnings and has done so for the past 4 years! John Plant, the CEO, stated that much of the success has been related to sales in emerging markets. I have created a 6-month chart at the bottom of this post and you will note a declining share price, bearish MACD and stochastics signals on high volume in late November (red circles). This was due to a large shareholder announcing the sale of his stake in the company. The green arrow shows how rapidly the price recovered and has reached even higher levels.
TRW is trading at a reasonable 9x forward earnings and has an eye-popping price to sales ratio of 0.44.
I will ask my team to include this stock on our premium watch list if it meets all our system criteria after market close tomorrow.
Alan
Alan,
In line with the auto theme, TRW looks nice from an IBD point of view. I’m also watching Borg Warner (BWA)…but it has 1 yellow. I’ll keep watching it.
BB
Alan,
I previously sold 3 December 35s on RVBD. The price is now 36.21. Is there any action or exit strategy to consider in this situation?
Thank you- I’m really enjoying this!
Barbara
Barbara,
This stock has been on our premium watch list for 16 weeks and has been a huge cash generator for many of us. I normally don’t like to use a rolling strategy until we get a little closer to expiration Friday. The less time obligation we have, the less risk we incur.
At this point you have a nice realized and unrealized gain (me too!). Let’s say you generated a 3%, 1-month return on the short option sale and another 2% unrealized share appreciation. That potential 5%, 1-month return is now protected by $1.21 of share value or 3.3% ($1.21/$36.21). If the stock remains above $35, you have a realized total profit of 5% for 1 month.
There are times I will unwind my position mid-contract when the time value of the option premium approaches zero. The pre-market quotes show the December $35 buy back will cost $1.80. Intrinsic value is $1.21, leaving a time value debit of $0.59. This represents a 1.7% loss ($0.59/$35). There is little chance we can generate more than 1.7% in the week to expiration Friday unless you use a highly volatile stock with a near-the-money strike.
I am holding my position now with an eye to rolling strategies next week.
Alan
NFLX is up because it was added to the S&P 500 effective Dec 17. Looks like my put spreads on NFLX will expire worthless, and I will make between 18% and 30% for the month.
Is this a great country, or what?
Remember our discussions of short squeezes? For thos of you who don’t, that is where someone who sold a stock short, and is now watching it go up, can’t stand the pain any longer. He goes back into the market and adds to the buying pressure to cover his short position.
Well, read this article: http://247wallst.com/2010/12/10/short-sellers-mass-exit-in-high-priced-leaders-amzn-aapl-bidu-brk-b-ffiv-gs-goog-ibm-isrg-ma-nflx-pot-pcln-crm-vmw-wynn/?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+247wallst_partners+%2824%2F7+Wall+St.+-+Syndication+Partners%29
This week’s blog article:
We have all enjoyed and learned from Owen’s commentary over the years. This week we are in for a special treat as Owen has agreed to “guest author” an article related to the tax consequences of covered call writing and stock and option investing. Don’t miss it…it’s a must-read.
Alan
Hi Owen,
I have been looking into Put options, sold as Straddles, where the near-expirations are concerned. Am led to wonder whether you have done Put straddles, as well as Put spreads (which I interpret you to mean strangles). I have actually done a small amt of STO put writing, always successful – or at least “never lost”. Never did a straddle or strangle tho.
A treatise from you on the subject would be asking too much – but have you a favorite approach to the Put spreads?
Also strikes me that the weeklies may lend themselves to spreads.
Always enjoy your writings.
Don B.
Don_B,
I don’t like to go too far afield from covered call writing, because that is what Alan teaches, and what he has found has worked very well, for him, for years. However, there are some people on this board who are reading option books with exotic terms and trading techniques, and it would be unwise if we ignore that.
I am a firm believer in the KISS principle. Keep It Simple, Stupid. It generally works in every endeavor. I am not a fan of strangles, straddles, iron condors, lead jockstraps, gold nipple rings, etc. Okay, some of those terms you won’t find in option books, but you get my point. The real ones involve multiple parts of a trade that can go for you in several ways, and against you in several ways. Too complicated for me.
A spread is actually pretty simple to understand. Let’s start with a covered call. Why do you buy the stock and then sell a call option? Because just selling the call option is extremely risky. If you sell a $45 call option without owning the stock, and the stock goes to $100, you will lose around $55. So, you “take out insurance”. You BUY the stock, and then sell the option.
A spread is simply a covered call, where you buy another call as “insurance”. If the trade goes in the wrong direction you can exercise the call you bought, which will give you the stock you did not originally buy. Why is this a reasonable idea? If I want to sell a $50 call on a $48 stock, I can buy the stock at $48 and sell the $50 call, or I can buy a $40, $45 or even a $55 call as part of a spread. If the $50 call is exercised, I can exercise my long call and then I have the stock that I need to fulfill my obligation to sell the stock at $50 to the short call buyer. Simple, I buy the stock at $48, or I buy the right to buy the stock at $45, and then I sell a $50 call. This also allows me to go after option trades on stocks like Apple or Google. I don’t have to come up with $32,000 to buy 100 shares of Apple, or $59,000 to buy 100 shares of Google, in order to sell a single call option contract.
My put spread trades are equally simple. When I sold the Apple NOV $300 put in October I did break one of Alan’s cardinal rules, but I was confident in my analysis. The trade was made on Friday, October 14. Apple’s earnings report was the following Monday morning. On Friday, Apple traded between $300 and $302.47, and closed at $302.31. I was absolutely convinced that the earnings report was going to be a blockbuster, because it was the first to include the sales of the I-pads. I sold the Nov $300 put for $11.66, giving someone the right to make me buy their Apple stock at $300 per share. I was convinced that Apple would not see $300 again for some time.
Now, I could have collected the $1,166 and put up $30,000 cash as collateral with Schwab, just in case the put got exercised. That would have given me a 3.89% return ($1,166 / $30,000) for the month.
I decided to give up some of the option premium to be able to use that cash somewhere else (or, if I didn’t have the $30,000), so I bought a Nov $290 put for $7.66. What that did was to limit my possible loss to $1,000. If I was forced to buy the stock at $30,000, I could turn around and force someone to take it from me at $29,000, if Apple dropped below $290.
It turned out that Apple went to $318, actually returned to hit $297.76 on November 17, just to make me sweat, and closed on November 19 at $300.50. Both calls expired worthless. I kept the $400 difference in the option premiums, and Schwab released my $1,000 collateral. I made 40% for 5 weeks.
I like the spreads because it conserves my investment cash. The big risk is obvious. “Well, if you have $20,000, why didn’t you put on a 20 contract spread? You could have made $8,000 on $20,000, instead of a paltry $400 on $1,000.” That is true. And Apple could have gone to $289.90 on November 19, and I would have lost the entire $20,000.
People, our option trading is about CONTROLLING RISK, not MAXIMIZING RETURN. If you want to maximize your return, put $10,000 on your favorite number between 1 and 36 on a roulette wheel. You could win $360,000. Better yet, buy $10,000 worth of Power Ball tickets. You could win $85 million. Even if you just put the $10,000 on the red, on the roulette wheel, you could double your money. Didn’t think so. Okay let’s discuss my spreads.
Spreads have the same inherent risk that a covered call does. Actually a little more. If I buy a call, and sell a different call, both could expire worthless. If I buy the stock, and sell a call, at the worst, I still end up with the stock, and I can wait until its price recovers.
Right now, I have a Dec $300-$290 put spread on Apple. (Pray for me) I also have a Dec $190-$180 put spread on Netflix. (Pray harder) (Hey, Cramer, SHUT UP!) It’s simple for you tell if they worked. If Apple stays above $300, and Netflix stays above $190, through next Friday, I win. See what I mean by keep it simple? You sell a covered call, you want it to close above the strike price and your stock gets called away. You win. I entered a put spread where I just want the stock to stay above a certain price. I don’t care if Apple closes at $300.05 every day for all of next week. I just don’t want to close below $300.
I know this has been long winded, and I hope a few people have learned from it. Mostly I hope that, if you decide to get a little creative with options, that you be VERY careful, and you be absolutely sure how the trade will make you money and lose you money. Most of you should just stick to writing covered calls. It’s simple. It’s safer. Stock does not expire on Friday. Options do.
Good luck.
Owen –
I could not have asked for a finer or better answer to my post. Thank you very kindly. I have printed it as a keeper. And your KISS concept is where its at.
Adding, it looks like I will be assigned this weekend and be the proud owner of 200 shares of GDX , as a result of 2 contracts (Puts) . Well, .46/62.00 for this last week is not to sneeze at., equaling abt 3% monthly equivalent. And overall small money, but the percentage & concept is great.
Monday morning I shall be writing calls on the two positions, for maybe 75c for Dec. Wonderful, hey?
This week there is really no weekly, as the monthly and the weekly are the same, of course.
Thanx again.
Don B
Don,
I have also used naked puts to actually try to buy stock at a lower price. Example: I would like to own Johnson & Johnson. I really don’t want to pay the $61.91 price it closed at on Friday, but I would buy it at $60. (I know, small difference. It’s an example. Bear with me.)
The Apr $60 put is currently trading for $1.65. So, let me see if I have this right. I sell somebody the right to make me buy 100 shares of the stock at $60 (which is what I want), and they will make me accept $165 for the privilege. Wow. Where do I sign up? Oh, yeah, at Charles Schwab.