Selling Put Options My Way

by Jerry Lee

  CHAPTER 10

  LET’S START TRADING

  The first objective of this section is to enable the reader to take the following information and have a working knowledge of selling puts. The second objective is to explain my strategy of selling puts.

  In the very beginning of my option trading, I did a mix of buying stock and then selling covered calls and some naked puts. It has only been for the last five years that I have changed to nearly all put selling. The difference in my returns have been dramatic. This has encouraged me to share some of my trading ideas with you. When selling puts, you do give up the potential of making big, quick profits. Your goal with this method is for consistent income and growth. For information on selling covered calls, you can refer to “Options As A Strategic Investment” or other books.

  My “Crumb Method”

  This style of selling puts is what I call the “crumb method.” It is not new, exotic, revolutionary, or even uncommon. This way of selling puts is not a complicated technical system of charts and other odd information. All you will need to do is look up a few quick facts that are posted on your brokerage web page. You will look up a stock and within two or three minutes know if it offers any potential trades. However, this method of trading it is virtually unknown to the average stock trader. I use the term “crumb method,” as most people would think of this style of trading as picking up crumbs from a table. I sell puts at a strike price that seems as safe as possible, yet one that still produces decent returns. To be a safe trade, the premiums are generally small. I hope to show you how small “crumbs” can turn into quite a nest egg.

  Capital Needed to Start

  Although some brokerages will allow you to open a margin account with as little as $2,000, I recommend starting with as much of your trading capital as possible. This gives you some flexibility using different option positions. Whatever your account balance is, I recommend for the first few months you limit yourself to just a few trades to get the feel of option trading. As mentioned earlier, this does not mean that you should refinance your house or sell your children to the circus in order to build your account balance. You should always limit yourself, in any stock or other investments, to money that you can afford to lose in a worst-case scenario.

  Each brokerage will have a minimum for a margin or “going naked” account. You will need to shop around to see what each brokerage requires. When opening a new account, ask for the amount needed for opening a margin account and also, for the various stock and option commission cost, since a wide difference does exists. In addition, what is not publicized is that most brokerages have different scales of commission cost. These discounted commission costs are based on the volume of trades you might engage in. Before you have any bargaining power, you will need to establish a record showing that you do trade often.

  The capital with which you open your account will give you leverage. This can be a scary word unless you put it in the proper prospective. When you buy your home for $300,000 and put 20% down, or $60,000, you are using leverage. The house can go up in value 10% the first year, and you would make $30,000. That would be a 50% gain since you put down $60,000 and made $30,000. Therefore, you used a $60,000 down payment to tie up an asset worth $300,000. When you buy a house you are using leverage.

  The same idea works in your option account. Leverage allows you to control more positions with less money while using options. You will have more leverage trading options than leverage used for the purchase of stocks. Stock ownership does have the advantage that it is not on a clock as options are. If you buy a stock for $40 and it drops to $30, so what? If you like the stock, just wait for days, weeks, or years and it might recover. However, all options are on the clock and they will expire. Making the clock work for you is your job. The same idea is one of the reasons many people lose money with options. They let the clock run out. I have mentioned often that come expiration date, there will be certain results. It must also be understood that it is not necessary to wait for expiration day to open or close a position. Later, I will give you my rules that determine when you should close a position and some ideas on when to take money (profits) off the table.

  Always remember that leverage can be a great tool, but it can also be a sledgehammer to your account if you do not monitor it and follow some simple rules.

  How Many Options Can I Sell?

  This question comes up often. The answer is not easy as it is different for each current stock price and then which strike price you decide to use. Most brokerages use a similar formula to figure your required maintenance. Get familiar with your brokerage and how they compute your maintenance requirements. Within a very short time it will become second nature.

  As mentioned on page 33. My brokerage uses one of the below methods, the decision is based on which one requires the most maintenance.

  • 25% of the current stock price, minus the amount that the option is out of the money, then add the amount of the premium you will receive.

  • 10% of the strike price plus the premium received

  Whichever of the two above is the largest will be the one used. Using my method of picking a strike price of 20% below the current stock price you will find that usually the 10% rule will dictate the amount of maintenance needed.

  If you have $10,000 for ease of demonstration lets assume that we are only using one stock this month for our position.

  XYZ stock is selling for $121. 05

  To find a strike with our 20% rule. – 121 – 20% = 96.8 So we can use the 95 strike. The 95 strike pays .50 premium. Using the two above methods to find the maintenance needed (always using the one that requires the most)

  1. 121 x 25% - out of the money, plus the premium-

  121 x 25% = 30.25 – 26 = 4.25 + .50 = 4.75

  .2. 95 x 10% = 9.5 + .50 = 10

  So with the above example we would require 10 dollars of maintenance per option as that is the largest of the two.

  Possible Returns

  You started with 10,000 in your account and assuming you are using all of the available maintenance you would have 10,000. divided by 10 = 1000 or ten puts (10 puts) with a premium of .50 you would have made $500. this month for a return of 5%

  I do not often make that high of return but it does happen. As I said earlier, I try to maintain about a 2.5 - 6% a month return.

  As you have probably guessed, I use a calculator often. I have one of those “big number” ones as I find it easy to use. These simple formulas may seem somewhat complicated but they become second nature very quickly.

  Regarding how to figure your profits, I have had this discussion with many people over the years.

  I prefer to look at my account and how much it went up for the month, and that is my profit for that month. I know that the IRS does not ask how much I had at risk during the previous year; they just want what they consider their “fair share.”

  As I have called this style of selling puts the “crumb method.” Let’s see just how “crummy” it can be. A monthly income of $500 does not seem like the road to riches. However, compounding shows a very different picture. Using a $10,000 starting balance with a 3.5% compounded monthly return in a year would turn into an account value of approximately $15,110, or a 51% annual return.

  In two years, your account would be about $22,800. Still not rock star money, but we have more than doubled our account in only two years. In three years, it would be approximately $34,450. In four years, it would be about $52,000. In ten years, it would be $617,500. Therefore, to round off numbers, after you pay your taxes and your commissions, it might take you approximately fifteen years to become an outright millionaire. What is nice is that after taxes, etc, in the fifteenth year, you would gross around $400,000 annually. It is human nature to think, “Darn, I do not want to wait fifteen years to be a millionaire!” Well, then start with $50,000 and you might do it in eight years. Better yet, in ten years, your account might be worth over $2,000,000.

  This demonstrates the gro
wth potential of compounding when matched with patience and a plan. If you must draw on this money to supplement your monthly income, it would of course reduce the growth dramatically. However, if someone told you that you could operate a small start-up business at home that needed $10,000 start-up funds and required an hour or so a day, and in fifteen years you might be a millionaire, I think most people would at least explore the possibility. The point is that with discipline, patience, and some work, your money will grow much faster than you think.

  My Personal Goals for Long-Term Profits

  Some months I make 7-8% selling puts and others as low as 2%. I plan on, and try to maintain, at least a 2.5%-6% per month profit. Many times, I will make more, and sometimes, I make less. I have found from experience that a monthly return of 3.5% is a reasonable goal. If you follow my rules, pay attention, and do not get greedy by pushing the envelope, you might have similar results with the “crumb method.” Keep in mind that the fellow on the other side of the trade is just as interested in making a profit as you are. However, since you have taken greed and the desire for unreasonable results out of the picture, you now have the edge.

  Do not get greedy. This is Rule # 1 of option trading.

  That sounds simple. Do not get greedy. Because of the large potential profits with option trading, it becomes easy to start bending the rules and forget the basics. I have been doing daily option trading for over ten years and still fall into the trap of stretching the envelope. I know how easy it is to fudge a little here and there to try to pick up a better return. When I do this, it usually comes back to haunt me. In the next few chapters, I am going to tell you the rest of my rules and ideas for trading options. When I am done, you will be surprised how few rules there will be. Option trading is complex and yet simple. All of the main ideas that I will share with you can be written on one page and put near your trading desk. If you follow the simple rules, you should be successful. If you do not, problems can, and will surface. So let’s finish this chapter with the most important rule to remember while trading options with the “crumb method.”

  Do not get greedy!

  If you look at a position and, WOW, it has a return of 8.5%. don’t do it! You are getting greedy. Drop down one strike price and look again. You might have to drop down two strike prices. Get back into the 3 or 4 % profit range to open a position.

  CHAPTER 11

  SHOCKING IDEA

  Here is a shocking idea, and it goes against all the current advice that most professional advice givers will give. You, of course, are advised to fully investigate and decide for yourself if this is good or bad advice, but here goes.

  I do not buy the idea that “for safety, you have to diversify.” I know it is the common thought and you will hear this quite often. I always feel it is a “cover your @*#” idea, told (sold) by financial advisers. Yes, if you want total safety, assuming that is even possible, then diversify. I do not buy the idea of stocks, bonds, and money market for a “balanced return.” I cannot understand investing in a method that gives a low annual return when I have one that might produce a 50%-or-better annual return.

  #@ Let me say that I do diversify in the stocks I use. You have probably heard the old saying, “Don’t put all your eggs into one basket.” Different from the old saying, I do put all of my eggs in one basket. I just use different kinds of eggs inside the basket. That is also why I recommend that you start with the largest account balance as possible. That will then let you diversify your various option positions (eggs).

  CHAPTER 12

  TRADING STRATEGIES

  How to Pick a Stock That Fits My Strategy

  Over the years, and through many sources, I have developed a list of stocks that I watch. I keep the list to approximately seventy-five to a hundred stocks that I follow closely. Once I hear of a stock, I research it to see if it fits into my strategy. If it does, I will add it to my active list and usually remove one of the stocks that has preformed poorly. You will need to develop your own list of potential stocks that work while using my method of option trading. These stocks need not be obscure stocks that only a few “in-the-know-people” have heard of. My list of stocks has names such as AMZN, RIMM, GOOG, AAPL, NFLX, POT and many other stocks that are quite well known.

  Sources that might help you develop a trading list of stocks might be the S&P 500 list, or a list of stocks your brokerage is now recommending. These are easy to obtain using the web as a resource. In a very short period of time will find that you will have all the stocks you need to make your monthly choices.

  On the list that I use and check monthly will be stocks that have enough volatility so that their option premiums fit into my strategy. Every month, on the weekend after expiration (the third Friday of each month,) I go through each of these stocks. I use a filter system (listed below) to decide if I will use them for my next month’s option trades. The following list is very important and is the basis for my success. Let’s now discuss the filter system.

  The Eight Filters I Use to Select a Stock and an Option Position for This Month’s Use

  1. I usually use stocks in a price range of $50 to $500

  There are exceptions to this particular filter. However, the general reason is that stocks that are below $50 usually require that when you are using my method of strike price selection, you would need to use a strike price that is very close to the current stock price. A relative small movement of the underlying stock can then endanger your sold put position.

  Example: Let us say you like a stock that is currently trading at $14.75 dollars. Well, $14.75 minus 20% = 11.80 so you could use the 10 strike (the 20% is explained in #2 below). However, if the stock drops only $5 on company or world news, you are in a situation where you have just lost money.

  If you were using a stock that has a current price of $77, you would be using the 60 strike price. Therefore, any unexpected news can allow the stock to go down seventeen points in one month before your position is precarious.

  2. The strike price filter is 20%

  Now that you have started to narrow the stock list down to those that fit your filters, you need to know which strike price to use. Through trial and error, I have come up with a percentage number that seems to be a compromise between safety and potential return, and that is 20%. I do not sell a put at a strike price that is within 20% of the current stock price.

  Example: If the stock price were $57, I would not use a strike price that is above $45.60. (57-

  20% = 45.60). This would usually mean that the first available strike price below 45.60 would be a 45 strike price. Always keep in mind that the 20% number is just a starting point. It should always be kept in mind that the more cushion you can get the better.

  3. Will earnings be reported in the coming option period?

  Caution should be used if a company is scheduled to announce its quarterly earnings during the coming option period. If earnings will be reported, then I seldom take an option position that is within 20% of the current stock price. If I use one of these companies, I try to allow for danger by looking at past similar earnings periods to forecast trouble, but even then, I nearly always avoid these stocks. There are enough stocks to use without taking on the extra risk of an earnings month.

  4. I look at a chart showing the previous two years of the same month to see if there is a history of the stock falling during that period.

  Some stocks have a time during the year when expectations are either higher or lower. An example might be a company that always has good Christmas sales but may have a history of terrible summer results. Some companies will always be seasonal, and this must be considered.

  5. I look at analyst’s recommendation.

  If analysts are bullish, that is a plus in my choosing that stock as a potential option trade. If they are bearish, I will not use that stock until it gets a better rating from analysts. I also avoid stocks that have a lot riding on one product such as a new drug. One rejection from the FDA, and ouch! Stocks that ha
ve this kind of exposure can wreak havoc on carefully thought-out plans. At this time, I will also check for any current news regarding the stock such as a coming split, pay out of a dividend or possible merger talks, etc.

  6. Price to Earnings, or PE.

  I do look at the PE of each stock to get a quick idea of whether a stock is overvalued or undervalued. Some stocks that are mature might have a PE of 6 or 8, etc. Others that are new and growing might have a PE of 40 to 50, or even higher. Some will not have a PE at all because the company is not yet profitable. Companies with a high PE can often fall quickly on any bad news. During the Internet bubble, some stocks had a P.E. in the thousands. The price-to-earnings is calculated by dividing the current per-share stock price by the per-share earnings. You will not have to do this calculation, as it will be posted on your brokerage web page. I use the number as a caution sign if a stock seems out of order compared to its peers. For example, most banks have a PE of around 10. If you were looking at a bank stock as a potential option play, and it had a PE of 25, you would know something was odd.