Selling Put Options My Way
Page 2
I realized that most losing option positions required you to buy something to open a position. That is when I began to understand that there is a way to do options without buying them. Better yet, people will actually give you money at the opening of a position. It seemed to make perfect sense that if people will do that, the ones receiving the money must be those making most of the money. I joined the winning 10% and invite you to do the same. It really is easy, fun, and can be extremely profitable.
While hundreds of strategies exist for option trading, these are the ideas that have worked for me. I had to discover this style of investing through trial and error—along with some luck. As far as I can tell, this particular method is not taught or advocated by any of the conventional financial teachers of various investment methods.
So where do I differ from our author friend, the how-to artist? I am not selling any product or ideas but rather, I am sharing with you a style of investing that I have found to be very profitable. If it works for you, you are welcome to make some money as I have. Try to avoid the part where I traded without rules and lost well over a million dollars. That part was not fun!
I have presented my ideas and strategies so that you, the reader, can make some informed and objective decisions when selling puts. There are no right or wrong ways, except that losing money is usually considered one of the wrong methods. In fact, losing money is probably at the top of the “wrong” list.
You will note a certain amount of redundancy throughout. Please excuse this because some of the points need stressing. After reading this book, I hope that you can use the information to help yourself to some of the “free” money that is out there. It really is there for any of us to pick up. However, to be successful, you will need to follow a few rules and use some common sense.
In addition, for ease of understanding in my examples, I usually use just one option. I do not often include commission cost or tax implications while telling of trades and prices. All investors can, and should, shop for the best commission rates and must consider their own tax consequences.
CHAPTER 3
LEARNING SOME BASICS
To begin with, you will need some basic option facts and information. There are many books written for beginners by much better writers than I. These books will explain options clearly, and I advise you to get several of them and try to grasp some of the ideas, if for no other reason than to acquire a basis of knowledge and understanding when you start learning about all the various ways that are available to trade options.
One of the best option books in print is titled, Options as a Strategic Investment by Larry McMillan. This book does not recommend any particular style or method but tells you of the upside and downside of nearly any type of option trade that is available. It is a must-read book for option traders and is considered the bible of options. If this plug results in any book sales for Mr. McMillan, I hope he sends me my fair share. He is even welcome to send me more than my fair share if he is feeling generous! Before you can begin to trade options using my methods, there are some basic things that you need to know and do.
Setting Up An Account
You will have to set up an account at a brokerage firm that allows option trading, and it must be a margin account. You will also need their approval to trade naked. I know many of you already trade naked, but that is pretty much a personal thing. This type of account refers to selling things that you do not own, not what type, if any, of clothing you are wearing. As mentioned previously, to sell something that you do not own is called “going naked.” Once you do this, you are “short” the option. This means that your account is short of the items, and you must have the capital or the margin to replace it if required. Most full service and on-line brokerage firms offer this type of account. You can choose to trade on line or with a full service broker. I use one of the major on-line companies, but if I have something complicated or need clarification on any item or trade, then I can speak to a broker using their 800 number. The fees for on-line trading are generally much less than with a full-service broker. Trading on the web is fast, easy, and cheaper, so most home traders are now doing options on line. Unlike a full service brokerage, you will have to assume responsibility for your actions, as there will be no one looking over your shoulder when trading on line.
Each brokerage will require an account with a minimum amount deposited. When looking into various brokerages, make sure that you will be able to trade with all types of options. Most will have a ranking system for option trading called Level A-B-C-D, or 1-2-3-4, etc. These usually start at Level A, the most basic, and progress to Level D. To sell naked puts, you must have clearance all the way to Level D (or 4, etc). These positions expose you to the most risk, and most brokerages will require some experience before granting you approval to trade at Level D.
Before your brokerage will allow you to trade, they will require you to read the Options Clearing Corporation Prospectus, which states clearly that options may not be suitable for every investor. Certainly, there is risk in every type of investment and some option strategies may involve large risks. It is up to the individual investor to determine whether his financial situation, investment objectives, and knowledge of options are compatible with the strategy described. Knowledge is the key to understanding and profiting from my style of investment.
Capital Needed to Start
All brokerage houses will require a minimum deposit to open a margin account. You will need to shop around to see what each one requires. When deciding on a brokerage firm, three of the main points you will need to find out are (a) the amount that will be needed to open the margin account, (b) what are the various commission costs for option trading since wide differences in these requirements exist at various brokerages, (c) can you get full trading privilege to trade naked options.
Over the years, I have used just about all of the on-line brokers. During tax season, you will find that changing brokerage firms is time consuming since you will have year-end reports from two or more companies for the past year, and each is a little different. This makes tax season somewhat complicated, but the savings can be important. I now have been with the same brokerage for several years. A surprising fact is that if I hear of a cheaper rate somewhere, I tell my brokerage that if they cannot match the new price, I will have to take my business there, and so far, they have matched or beat all of the other brokerages. When you deal with thousands of options annually, you do get good commission rates but will often have to ask for them. Commission rates are usually determined by the number of transaction you have done or will expect to do.
When opening an account, I recommend that you have as much money as possible in your account. This gives you some flexibility using different option positions but does not mean that you should refinance your house or sell your children to the circus. You should always limit yourself, in any stock or other investments, to money that you can afford to lose in worst-case scenarios.
Some Things to Ask a Brokerage Before You Open an Account
Do you allow option trading (some do not)?
I would like to have full option trading privileges. What are your requirements?
How much capital do you require to open a margin account? (My brokerage is $10,000.)
What are your commission rates for stocks and options?
Do you have a web page that I can use to practice trading?
Does your brokerage have a system of “trade triggers?” **
** TIP: A trade trigger allows you to set a point for an action to take place, even if you are away from your computer. This is a very nice safety point, especially so if you are not always on line (more on how to use trade triggers in Chapter 4).
I am sure you will think of many more questions regarding the various ways to open your account. Just the titles offered are confusing enough: individual, joint tenants with rights of survivorship, tenants in common, community property, and many more.
Once you decide on a brokerage, talk to on
e of their representatives about your goals and your personal situation. They will help you set up the account so that all of your needs are covered. You might decide that a full service brokerage is the way to go. They certainly have many benefits for beginners, and there will be someone there to look over your shoulder and give you advice as needed or requested. Their fees are higher, but if they save you some money by helping you avoid bad trades, they can certainly pay for themselves quickly. Many time if working with a full service brokerage you will find it easier to get full privileges at all levels of trading.
Option Terms You Might Hear
You may hear various words and terms regarding ways to trade options and evaluate options. Here are just a few of them.
Black-Sholes model
Delta
Spreads (many types of these)
Implied volatility
Those mathematically inclined, and maybe others, can play with all the formulas and use calculators until they wear down their index finger. However, I will go out on a limb and say, who needs that information?
When Delta was first explained to me, I was instructed that, before I made a trade, I should call my broker and ask for the Delta of the particular option that I was interested in. I did call my broker and, trying to sound intelligent, I asked for the Delta of an option. The broker asked, “Why would you want that?” I have never forgotten that question and still do not have an answer after thousands of trades. After thirteen years of trading options daily, I find I do not need that confusing technical or mathematical information.
For the record, Delta is the amount by which an option’s price will change for a corresponding one-point change in the price of the underlying stock. Do not feel bad, I don’t get it either—there are just too many variables.
I do not utilize any of the various types of spreads. I do not use a volatility factor other than knowing that volatile stocks do have higher premiums on their options. I certainly do not use the Black-Scholes model to figure the value of an option. Many traders do use all of these various methods to evaluate a trade, but personally, I try to keep each trade as uncomplicated as possible.
With the ideas that I am going to share with you, I cannot see the value of any of this complicated figuring. What I do is make things simple and try to use common sense. I am sure that a broker on Wall Street would need to justify his poor decision after a trade went south by saying to his boss, “I don’t understand it. The Black-Scholes model looked so darn good!”
Read about these terms and get a feel for all of them. Maybe some will really help you in your trading. I decide on a trade after using my filters and then do the trade. It is that simple.
CHAPTER 4
OPTIONS AND RELATED DEFINITIONS
First, you should know that not all stocks will have options available. You may find that you really like a certain stock’s history and want to look at options for that stock. You will ask for the option chain and nothing comes up. Your stock probably has no options available.
Option Contracts
Officially, the listed options went public in 1973. Every year, the volume grows as more and more people use them as hedges or, as I do, as the basis for all of their investments. Normally, each option is a contract regarding 100 shares of the underlying stock. This is important to remember: one option represents 100 shares of the underlying security.
If you sell an option relating to Microsoft, then Microsoft will be the underlying stock for that contract, which will be to either buy or sell one hundred shares of that stock. Options can be sold or bought at any time during their life. You can buy one and then sell it five minutes later if desired. Or you can sell an option and buy it back at any time during the life of that option as I do.
If you own a call option, you have the right, but not the obligation, to buy the underlying stock at the strike price at which you purchased the call option.
If you own (bought) a put option, you have the right, but not the obligation to sell the underlying stock at the strike price at which you purchased the put option.
I must add that options can be used in so many ways that it would take several books to describe them all. Most libraries will carry books that fully explain the differences between puts and calls. I use about 95% puts and 5% calls in my style of trading. While you are learning my methods, concentrate on selling puts. Later in the book, I will show you how I sometimes use naked calls.
Underlying Stock
If you use Microsoft (MSFT) as one of the stocks you want to research for option trading, then MSFT will be the underlying stock. As it moves in price, the option price will also move. Also, the closer the strike price is to the current underlying stock price, the larger the movement of the option price.
Example: MSFT is at $30 and you are using the 30 strike price. Assuming that MSFT drops a dollar in price to $29, the option will also move approximately one dollar. If you were using the 25 strike price and MSFT was again at $30, then dropped one dollar, the option price might move only twenty-five cents.
This example demonstrates the value of having a large cushion between the current stock price and the strike price you are using.
Premium
Premium is the total value of an option at a given strike price. It is the amount at which the option can be bought or sold. When you look up an option in the option chain, you will see a bid and an ask price. Both of these make up what is called the premium. Assume that the bid was thirty cents and the ask was forty cents. You might close the trade at thirty-five cents, which is your received premium. The difference between the bid and the ask is called the spread. When buying or selling options, you will nearly always complete the trade in increments of nickels or dimes and normally, you will not see a trade go through at twenty-six cents, or twenty-eight cents, etc. The premium can sometimes be divided by intrinsic and time value. When selling puts, all of my positions are pure time value.
At times, your brokerage might get a better deal while putting a trade through. They will pass the better price along to you, so occasionally you might see an unusual number.
Strike Price Codes
When you buy or sell an option, it will be for a specific strike price, which represents dollar amounts related to the underlying security. Normally, strike prices start in increments of 2.50, i.e., 2.50, 5, 7.50, 10, 12.50, 15, 17.50, etc. until the 25 strike. At that time, it continues at five increments until the 200 strike price. It then continues in ten increments. Many times, you will find differences in strike prices from the above guidelines. Examples of odd strike prices can occur once a stock has split. A stock that split at a three-for-one rate and had a strike price of 110 before the split would now have a new option available at the 36.66 strikes.
(110 div by 3 = 36.66)
Exchange officials often make more strikes available for heavily traded options and quite often, strike prices will continue in increments of 1 or maybe 2.50 increments until the 50 strike price or even higher. Generally, strike prices are usually near a current stock’s price. For example: ZZZ stock is at $24. You might have strike prices available at 17.50, 20, 22.50, 25, and 27.50. Some stocks that have made a large run such as Google might have a strike price available from 100 all the way to 400.
Expiration Dates
Each underlying stock that has options available is on a quarterly cycle.
The January cycle is January / April / July / October
The February cycle is February / May / Aug / Nov
The March cycle is March / June / Sept / Dec
All options expire on the third Friday of the expiration month. Therefore, a February option would expire on the third Friday of February, etc. Options are available for the current month, (also called the front-month) and for the next month. After that, it will be for the next month of the cycle.
Example: ZZZ stock is on the February cycle. Let’s assume the current date is January 5th. There will be options available for January, as that is the current or “fron
t” month. There will also be options available for February, as that is the next month, and as ZZZ is on the February cycle, it will not have March options available at this time. There might also be options available for May, August, and November.
Also, note that once the January options expire on the third Friday of January, the following Monday morning, you would now still have the February options available (the new front-month), but now the March options will also be available, as that is considered the “next month.” In addition, the May options will now be available. If it sounds confusing, remember that 99.9% of my trading is for the current or “front” month.