How Not To Lose Money
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If you need a tutorial, the web is full of them. The Chicago Board of Options is recommended. I “made my bones” with their interactive tutorials.
www.CBOE.com
For a number of free online option calculators which you can use to estimate future option values, profit/loss characteristics and so on, check out
www.OptionTrading.nl.
Before we get into covered calls, let’s talk about options. Options are a tool used extensively by professionals. Call and puts can be combined for a variety of strategies. The end results include some pretty cool names such as: Strangle, straddle, iron condor, butterfly, mountain range, lookback among others.
When average, everyday traders (like me for instance) enter the game, the SEC estimates about 80% will lose money. Why is that? Most amateur traders will go for the basic call option. That’s a tough strategy to win. Here’s why:
• The underlying stock price must rise considerably to profit. Not only must the stock rise above the strike price, but you have to cover the cost of the option plus commissions.
• “Time waits for no one.” You be correct in the direction of the stock price and the rise (or fall)of the price must happen before the option expires. Let’s face it. This is educated gambling in its purest form.
An investor would buy Merrill Lynch and say “I’m gonna own this stock because within the next couple years the price will double.” A call option holder would say “C’mon Merrill! You’ve got three months to rise 8 points. Let’s move!”
• Go towards the volatility. Steady, conservative stocks won’t move much within your options time frame. The price of the option may be cheap, but you need movement. Volatile growth stocks or commodity stocks are a good place to look.
• Liquidity. Make sure the option you’re choosing has a good amount of volume and open interest. The bid-ask spreads are higher with low volume options.
Sell an option against a stock you already own…collect money seconds later. It’s that simple. This is the strategy I play most often. It's possible to make more money with other option strategies; especially a basic call or put option. But the chances of being consistently successful are slim.
If I can make smaller amounts of money time after time, that's got to be better than making more money "once in a blue moon". If I'm lucky. What's the rush? Over the long term I’m better off. This is how it works. And I’ll finish off with an indicator that just might predict the future. Stay tuned.
Let’s say I own 300 shares of Ebay. My average cost is $31. I like Ebay and believe it has potential in the short term and definitely the long term. While I wait for these shares to bring me newfound riches, I might as well put them to work. I sell three $35 October call options (100 shares = 1 option) in the open market. I receive $1 premium for each option. Actually I receive $100 for each option I sold ($1 x 100 shares) for a grand total of $300......since I'm covering all 300 shares.
If the stock ends up below $35 in October, I pocket $300. The shares will not get "called" away. If month after month the stock stays below the strike price (whatever price I choose) and I keep selling covered calls.....I keep collecting premium. The shorter the option expiration period the less premium I receive.
If Ebay goes to $36, the buyer of the option will exercise the call and my shares will be sold. I certainly won’t cry over it because I made money. My average cost was $31. I received a $1 premium for each share I owned. So my cost is now effectively $30. The strike price was $35, that’s what I’ll receive when the call is executed. I made $5 per share.
The downside is, if Ebay goes to $45 per share before October, my profits are capped at the strike price, regardless of how high Ebay goes. What kind of shares would you use a covered call strategy on? A neutral to slightly bullish view.
If Ebay stayed below $35 for lets say, nine months. I could nicely pad my account.
Although the way this chart looks, I'm not too sure.
The Put / Call Ratio is the ratio of put options to call options. It’s used as sentiment indicator. If the indicator shows a high volume of calls, then the market is bullish. The higher the blue line the more puts being bought. The lower the blue line, the more calls.
How can we use this indicator to predict the direction of a stock? It would be a miracle for a mathematical equation to predict what the market plans to do. But right now it’s all we got. The Put / Call Ratio is not perfect. It shows what the rest of the world thinks a stock will do.
Included in this indicator are the puts & calls of the professionals. Hopefully, the percentage of professionals is higher than the general stock market. I'd say it is.
Let’s check out Yahoo! The blue line represents the volume of options traded and the red line shows the stock price. When the blue line climbs to a peak, the stock should rise. When the blue line drops to the bottom, the stock should be falling. A ratio above 0.8 is extremely bullish. As the ratio falls below 0.5 get your shorts ready.
The higher the blue line goes, the more puts are being purchased. That's actually considered a bullish sign. The lower the blue line goes, the more calls. And that's considered bearish.
Based on that, why would we expect the price to rise if the blue line indicates more people are buying puts? Aren't the masses always right?
We're only interested in the extremes. This is a contrarian indicator. If it demonstrates an extremely high level of puts, you can be sure everyone including the food delivery guy has a bearish view. When everyone is selling their shares(or buying pts), you should be going long.
The crowd is rarely right. Wall Street likes it that way. Three caveats about this indicator:
• It jumps to extremes quickly. Many professionals use either a 10 day or 21 day moving average to smooth it out.
• Not all put buyers are bears. Institutions buy puts to hedge their large holdings. Many of these are index puts. Based on that, this indicator is more effective on individual stocks as opposed to a Put / Call Ratio on an index.
• Timing can be off. If the stock is in a strong trend, it can last for months. The whole world could buy call options, the Put / Call Ratio might be screaming "We're headed for a reversal! Get ready to short!"; and the price could keep rising.
Options can be profitable no matter what strategy you take. If you plan on trading calls, puts and other strategies I recommend the Value Line Daily Options Survey. For $149 per year you get analysis and ranking of over 130,000 stock and stock index options. There’s an option screener that finds the best trading opportunities.
Try the Value Line Daily Options Survey and get 2 free reports. Click here.
Think of the time you’ll save not having to futz around with the Black-Scholes formula. The company has been around for over 75 years. Their research is one of the top sources used by institutional money managers. If these guys use it, it can't be that bad.
