by Jerry Lee
I will check it again at night to see what has happened in the market. The evening check will tell me if I have any pressing situations that need addressing the next morning. I will also update my records if I have done any changes to my account during the day. My type of trading can be exciting, fun, and very profitable, but it is not for traders who are not interested in monitoring their positions and staying on top of daily market activities. By that, I do not mean that you must memorize the current DOW Jones industrial position or the value of the yen, but as an example, you should be aware of major housing news or interest rate changes if you are using homebuilders in your stock list. Teamwork can also be very helpful. I have heard of many couples who agree on a strategy, and while one partner might be at work, the other can monitor or make trades during the day.
Each year, my wife and I go for a two-month trip throughout Mexico. Before leaving home, I close all of my positions and do not open any new ones. Even though I have my laptop with me, I do not want to be worried and scrambling around trying to find cyber cafes or Wi-Fi everyday.
There are times when I am away from my computer for a shorter period, and I do get out of touch with the market. However, before doing this, I make sure that my positions are as secure as possible or I might put in an order that will be activated by a price trade trigger, even if I am out of contact.
CHAPTER 6
BUYING AND SELLING PUTS
Let me give a brief description of how puts are used. You might find that you want a more detailed description of puts or calls. McMillan’s book, Options as a Strategic Investment, will give a very thorough definition of each and every term associated with options. Remember that when doing puts, you can buy or sell them. I am a seller of puts, but you should know something about the person on the other side of your trade and what results they expect.
Buying a Put, (what the person on the other side of our trade might be thinking)
If you buy a put contract, you are the holder of that put. It gives you the right, but not the obligation, to sell the underlying security at the strike price you have chosen at any time during the life of that put. Also when buying a put, your total risk is known up front. It cost you “x” amount of money, and that is your total risk. When bought, unless used in some type of combination, a put is normally a bearish play for the underlying stock, meaning that the most money will be made if the price of the underlying stock falls in price. A put, when bought, is usually used for one of two reasons.
1. As insurance in case the stock you own drops in price.
2. A bet that the underlying stock is going down in price and used as follows.
Example: ZZZ stock is now trading at $41 on the 25th of July. For different reasons, you feel that ZZZ stock is positioned to fall in price. You buy one option for ZZZ stock at the August 35 strike. We will assume that it cost you thirty cents for each option. Your cost to buy the one option would be $30 (100 x .30 = $30). Now assume that ZZZ does fall in price, as you had expected, all the way to $34. At expiration, you could make $100. You go on the open market, buy ZZZ for $34, and then exercise your put. This means that someone has to buy the stock from you for $35 (the strike price). Another good side of the above trade is that you have only the thirty-cent per option, or $30 total at risk (remember each option is for 100 shares). Looking at the profit picture for the above trade, you will have received $100 at the completion of the trade. When you opened the trade, you incurred a cost of $30. This is a net profit of $70, or 233% profit (invested $30 and made $70).
The attraction of buying a put is that you tied up 100 shares of ZZZ stock for a $30 investment. Now let us say the stock dropped a long way, say to $22. You would have made $13 per share times 100 x 13 = $1,300 with only a $30 investment. Remember, you can now buy the stock on the open market for $22 and force someone to buy it from you for the 35 strike price. Ah, the lure of easy money has a very strong appeal.
Now let’s look at the downside of buying a put. Say that the stock price of ZZZ Company did not fall as you expected. In fact, it rose in value to $44. You certainly would not go on the open market and buy the stock for $44 and then sell it to someone (exercise your put) for the 35 strike price. No, you would just quietly let your option expire. The trader that pocketed your $30 investment was me (the person who had sold the put.)
Remember that when trading options you are not dealing with an individual. Your trades go through the Option Clearing Corporation and might involve many traders throughout the world. Another point that must be understood—and this goes for either buyers or sellers of options—you do not have to wait for the expiration day to close or open a position or to exercise the option.
To demonstrate this point, let us go back to the example shown above where the stock was at $41 and you buy the August 35 put for thirty cents. Let’s assume that the stock moved down $2, three days after opening the position. The options might be now selling for sixty cents. Well if you had bought the put, you could now sell it for double your money, and you only held it for three days. Most would have to agree that 100% profit in three days is a great trade.
The same theory goes for a seller of a put (me). If the stock went up $2 on the second day after I sold it, the premium might drop to twenty cents. I could then buy it back (close the position) for approximately ten cents profit. The point is that options are often traded back and forth throughout their life.
Selling Puts (What I do)
If you sell a put, you agree to buy the stock for the strike price that you have chosen at any time during the life of the option. When selling a put it is usually a bullish or neutral call for the underlying stock. If you have sold a put, you do not want the stock to fall to the strike price. In the above example, the person that sold the put made $30. He invested no money up front. He needed only to have the maintenance available to be able to open the position. He can purchase the option and close the position at any time if needed.
When selling a put, the negative side is that, unlike when buying one, the seller has unlimited risk. Not fully understanding the potential risk and not having rules to follow resulted in my large losses earlier in my trading career.
Using the above example, you sell a put for ZZZ Company, using the August 35 strike when ZZZ is trading at $41. You immediately receive $30 in your account. Over the coming month, ZZZ gets into a legal battle over its patent rights. The stock falls all the way to $10. Well, friend, you are now going to be put to, meaning that someone exercised his or her option and you were assigned the put. You will have to buy the stock for $35 even though it is only worth $10 on the open market. I will show you how I avoid such problems, but you need to be aware of the potential risk. Disasters like this example demonstrate why so many people have heard that options can be such a risky investment.
CHAPTER 7
WHO SHOULD SELL PUTS?
For you to be a successful option trader and put seller, some of the things that you must understand are as follows.
As in all investing, you should use only funds that in a worst-case scenario, you can afford to lose.
• As a put seller, you should be active in your account daily.
• You should understand the various risks and how to control them.
• You should be aware of the factors that affect option prices.
I have found that since I have been selling puts with rules and a plan, my instances of losing positions have dropped to around 5%, and I probably break even on 5% and, best of all, I win on 90% of my trades. I have been averaging between 3% and 6% income per month. If you average 3% a month, it will take twenty-four months to double your money. An interesting look at numbers will give a dramatic example of how fast your money can grow when it is compounded.
$100,000 @ 3% per month = $203,000 in two years
$100,000 @ 3% per month = $412,000 in four years
$100,000 @ 3% per month = $838,000 in six years
If you compare those numbers to the S&P, which might make 6
% a year, it would take you about thirty-six years to equal those returns. Those are dramatic numbers. They do not measure the effect of commissions or taxes, but they do demonstrate the power of compounding your money. The level of risk tolerance for each individual will be different, and stocks you pick using this method might pay different premiums. If these numbers look interesting to you, and if you understand the risk and rewards, then selling puts might fit into your investment strategy.
How You Make Money Selling Puts
You receive money as incoming premiums. When you sell a put, you will receive a premium that is listed, for example, at fifty cents. As each single option equals 100 shares of stock. Then one option traded at a fifty-cent premium will equal $50. (.50 X 100 = $50). Once you sell a put, you will receive this premium as payment for obligating yourself to buy the stock at the chosen strike price. The money will be instantly deposited into your account.
Where Does The Money Come From?
The issuer of all options is the OCC, the Options Clearing Corporation. The OCC acts as a sort of intermediary and market maker. There is no direct connection between the buyer and seller of options. The OCC keeps the market in balance and opens up the secondary markets that now exist. All options are now held in a large pool. If you want to sell fifteen options on ZZZ Company, three might go to a buyer in Chicago, one to a buyer in Los Angeles, etc.
Every time you make money, you are getting it from someone else. The option market is just an auction based on perceived value and movement of the underlying stock. Many of your trades may occur with a brokerage house buying or selling options. Your trades also might come as a move by a hedge fund or other individual investors. For each trade you win on, someone loses.
CHAPTER 8
THREE OF THE MOST COMMON QUESTIONS
Over the years I have heard these questions so many times that it no longer surprises me to hear them.
1. If this works so well, why doesn’t everybody do it (usually asked with a negative connotation)?
Tell the truth, have you thought of this? When I tell people what I do for a living, this is the question most often asked. The answer is hard to give. I have shown these ideas to possibly two hundred people, and only about ten percent have followed through. Why? Because selling puts may be beyond their risk tolerance. Maybe they cannot grasp the ideas. Possibly they do not want to spend the time learning a new way of investing. Some have told me that they had a friend who lost money once with options. Others just think that it is crazy and confusing, this selling something you do not have. However, it is a misunderstanding to believe that you are selling something you do not have. Remember, you really are selling an obligation for a contract on the underlying stock. You are entering into a contract, and you receive a payment (the premium) for entering into this contract.
Another point to remember is that hundreds of thousands of traders are doing this and making millions. Of course, the other side is that thousands of traders are doing this and losing millions. The simple answer is that greed, ignorance, or poor choices usually results in a person becoming one of the losers. Later I will tell you my rules that help prevent losses from mounting and running away from you. Because this strategy seems odd, different and unusual, it does not mean that it is not a viable way to make a great living. There is a thriving options market doing billions of dollars of business monthly. The Wall Street Journal has page after page of listed options.
2. Why is someone buying your sold puts?
There can be any number of traders with many different reasons! It could be someone who thinks ZZZ is poised to fall. It could be someone setting a “protective” put in place as a type of insurance for a worst-case scenario. Traders who had a protective put in place for a stock like Enron or WorldCom were well rewarded for their insurance.
It might be someone setting up an unusual trade, or it might be as simple as someone who had sold the put a while back for, say, seventy-five cents and now wants to get out with a profit by buying his way out of that position for the thirty-five cents, or wherever you are opening the position. It is futile to try to understand what the other side of your trade is doing. Do your homework, decide if the trade is right for you, and if so, then make the trade.
Here is an example of a trade that was recently available. Google stock was trading at $402.50. There is one week (five trading days) left until expiration. I can now sell a put at the strike price of 340 and it sells for ninety cents.
There are traders out there betting that GOOG will fall below $340 within five days. That means that GOOG will have to fall over $62.50 this coming week. I, as a put seller, do not think this will happen! This trade turned out to be as close to free money as I will ever get.
This same question could be asked of any stock transaction. For every trade of stock, someone thinks a positive thought and the other side is thinking a negative thought.
However, the question remains: Who and why is someone buying your sold puts? Only the person on the other side of the trade could explain his reason for entering any trade.
3. Can I sell puts in my IRA?
Some options can be traded in IRAs. These are usually limited to covered calls, which are considered the least risky type of trades. These rules change, so check with your brokerage or your CPA. Currently, selling puts is not allowed in your IRA account. It is a good question and should be presented to your accountant often to keep updated on the latest tax rulings.
CHAPTER 9
INTRISIC AND RELATED TIME VALUE
Intrinsic Value of Calls
As discussed earlier, intrinsic value is the real value of an option. For a call option to have any intrinsic value, the underlying stock price must be above the strike price you are using.
It is easy to determine how much of a call premium is “intrinsic value.” For instance, if you buy a call option for ZZZ Company and the current stock price is $41, let us assume that you buy the call option at the 40 strike price. You would then have $1.00 in current intrinsic value. You might hear someone say it was “in the money” by a dollar. If you paid $1.50 premium for the option, then $1 is intrinsic value and the other fifty cents would be the time value. If nothing changed with the stock price by the expiration day, then the option would still be worth $1, which is the real (intrinsic) value of the option. If you owned this call come expiration day, you would exercise your call option and be able to buy the stock for $40, and then sell it for $41 and make the $1 of “intrinsic” value.
The .50 would just evaporate because the “time” factor has also evaporated with the expiration of the option. A call buyer is hoping to buy that call for the $1.50 at the 40 strike and then the stock climb to, say $47. They could then exercise their option and acquire the stock for $40. They could then keep the stock or sell the stock for $47 on the open market, and make $7. That profit must be reduced by the $1.50 they initially paid for the Call option, for a net profit of $5.50. The reason that people buy calls is obvious, as the percentage of profit on the above trade is approximately 350%. That is a huge profit. That potential big profit is one of the reasons amateurs continually buy calls and continually lose money.
The other side of “in the money” is “out of the money.” If the current stock price was $39 and you bought the 40 strike price, then the call would be completely “out of the money.” Any premium you paid would be made up of time value only. It would have no intrinsic value. The proof of this is obvious when you look at expiration day. Say you owned the 40 call on expiration day. You certainly would not exercise your call to buy the stock at $40, when it is only $39 on the open market. As the call premium was total time value, the time value just evaporated.
Intrinsic Value of a Put is opposite that of a Call.
For a put to have intrinsic value, the underlying stock must be below the strike price that has been chosen. I know these terms can seem confusing, but my trading is nearly all in puts and all of them have only time value.
Here is an exam
ple of a put option having only time value and no intrinsic value. ZZZ Company is now at $41. You sell the option at the 32.50 strike, and you receive a .30 premium.
Let’s review this trade and what it means.
When you sold the put at the 32.50 strike price, you entered a contract that you would be willing, if needed, to buy the stock from someone for $32.50 per share. To take on this obligation (contract), you received thirty cents per share or $30 per option. This put has no intrinsic value and is all time value.
To prove this, let us assume nothing changes by expiration date. On that date, the buyer of the 32.50 strike does not want to sell the stock to me for $32.50 (the strike price) when the same stocks sells for $41 on the open market. Any premium that had been available for the option was all time value, and the time value leaked out as expiration day approached.
