by Jerry Lee
Another way to look at the PE is to think of it in terms of years. A stock with a PE of 25 would take 25 years of current earnings to get to the current stock price. Sometimes the PE is skewed somewhat by using what is called forward year earnings. That is how stocks like Amazon.com, got by with a PE of around 1000 during the “bubble.” The thought was, “Sure, they were not making much money now, but in a few years, with their business plan, the potential was enormous.”
7. Is the return worth tying up the maintenance funds that are required?
One more formula to write down. This is an easy one so bare with me. Once you have figured out how much maintenance will be needed to support an option position, you will now need to know if it is worth using your available maintenance on that position.
Example; You like ZZZ stock and it is trading at $125. You subtract your 20% to find an acceptable strike price and that is the 100 strike. You look on your options chain to see what is the 100 strike is paying, it now pays .75 bid and .80 ask.
So using the two ways to figure your maintenance needed, the 25% rule will say you need 7.05 per option or 705 per contract.
The 10% rule says that 10.75 will be needed per option or 1075 for each contract
In this case we will have to use the 1075 (the largest)
Now using the new formula, take the premium you would receive, .75 and divide it by the maintenance funds required. So .75 divided by 10.75 = .069 This is a good return on this trade. I generally do not usually open a position that is less that 2% unless I can find no better trades available. I am also very suspicious of any return that starts creeping up around the 6% level. A very high number would set off alarm bells and those bells alert me that something is out of order. This means I have probably missed something with the stock checklist. Remember, a high return is very tempting but definitely a danger signal.
After doing this for a short time you will develop a feel for the 20% rule regarding which strike to use and with a quick glance whether the premium is close to acceptable.
Example; a quick look reveals that ZZZ stock is trading for $84. Therefore, you will probably need the 65 strike price and it pays only .05 bid and .10 ask. No use wasting time as this position will not work! However, looking at RRR stock which is trading at $215 you quickly figure you can probably use the 170 strike price and a check of the option shows that is has a .80 bid and .90 ask. This will trade would give you a little over 4%. Ahhh, this is more like it. Forty-five points of cushion and a 4% profit.
8. Is there 100 or more open interest for this option?
I do not use options with less that a 100 open position. This information is listed on your option chain. I discussed the reasons for this rule in chapter 4. We want liquidity in case we want to change our position.
Recap of the filters used to pick a potential stock for the coming month option trades
Does the stock price fall within the allowable range?
Which strike price to use (current stock price minus 20%)? And this is just the starting place.
When do they report earnings?
History during this period?
What is the analysts’ sentiment about them and their industry?
What is their PE (price to earnings)? Not the exact number but is it reasonable.
Is the return worth using my available maintenance funds?
Is there open interest of 100 or more?
When picking stocks, there are many more things that you might want to watch, but these are good starting points. Your brokerage or the Internet is a great resource for acquiring this knowledge. When you become familiar with your brokerage web site, all of this information is just a mouse click away.
One fact that has helped with some of my decisions is to think of my stocks as inventory. Do not become convinced that because they have been good to you for several months, they are a guaranteed selection for the next month. One month, I made over $10,000 on one of my option positions. Nevertheless, that stock did not make the cut the following month. Use your filters. Stay objective and do not let yourself be fooled by sentiment or cocktail-party talk. The filter system is used to avoid potential problems, so use it to do that! It is very tempting to stick with a stock that has been good to you for a couple of months and then overlook a potential problem, such as an approaching earnings report or a company that always has a bad June.
It is that easy! It may take you a few hours during the weekend to gather the information and make some decisions. You will find that after using your stock list for a while, you will become familiar with many of these factors, and the monthly “filter check list” will go very quickly.
After going through the list of stocks that make the cut for that month, I rank the potential stocks by the percentage I will receive. I mark down the stock, the current price, the strike, the premium, and the return factor. Now my list of “maybe” stocks might look like the list below.
After I have developed this list of potential trades for the coming month, I will divide my account into several sections to know how much I can allocate to each stock. For round numbers, let’s assume I have $50,000 in my account. If I am using four stocks this month, I might use $12500 for each stock. So let’s do some math using the AMGN example from the table below.
Stocks current price strike premium return %
AMGN 54 42.5 .25 5.88
PPP 63 50 .20 3.8
ZZZ 95 75 .35 4.45
MMM 36 27.5 .15 5.17
AMGN:
Their current price falls within the boundaries of stocks I use.
There is a strike price available that works for this position.
Amgen reported their earnings last month and had good earnings so there should be no surprises coming this month.
A positive history during this period.
Major analysts are recommending them as a “buy.”
Their PE is in line with their industry.
The return percentage I will receive is worth using my maintenance funds.
The open interest is over 100.
I am going to use the 42.5 strike. So I divide the portion that I have allocated to each option position, (12,500) by the amount needed for maintenance.
As the 10% rule is in effect for this trade, the maintenance needed is 4.25 + .25 = 4.5 I would divide 12,500 by 4.5 and I know I can do 27 option contracts. 2700 x .25 = 675
Therefore, I receive $675 for this position. I now have a month to wait and see if AMGN falls below the 42.5 strike price. My theory is that with AMGN now trading at $53, it has to fall to below $42.5 for my position to be endangered. That is a fall of 20%. I do not expect AMGN to fall 20% in one month. I do feel safe, but I monitor it, and all of my positions, each day.
These choices might be just “crumbs” to the big traders, but I do approximately ten to twenty-five of these positions monthly, and my money keeps growing and growing. When selling these puts, I very seldom go past the current option month, also known as the front-month. I prefer to be exposed to danger (time) as little as possible.
Some traders would probably look at the AMGN trade and then pass on it, as I have potentially $114,750 at risk (the cost of buying 2700 shares at a price of $42.5) for a $675 profit. Yes, that is true, but there is little chance that this trade will go bad, and if it does, I use stops to prevent disasters. (More on stops later). The stock market is full of examples like these. There are thousands of stocks traded on Wall Street. All you have to do is find a few of them to fit this method.
A possible trap in the above table is, you might think to yourself, why not just use all of the maintenance with the AMGN position? This gets back to why you diversify your positions. It will be tempting but you must diversify your positions to avoid meltdowns.
I am always ready to learn of, and about more stocks that have a proven record of accomplishment and continue to move up. At different times, I will not use some of my favorites for a year. At a future date, if they pass my filters, I will start using them
again. I caution you to be very careful of jumping on each “hot” stock that you hear about. I look at some of the hot stocks and my mouth waters because the option premiums might be quite large. However, I usually let them pass because I know nothing about those stocks. There are dozens of cases of the newest IPO that has gone from $15 to $100, and within a year or so, it is trading at $2. I want some demonstrated history. In addition, newer stocks often do not trade options and if they do, they might have a low volume (open interest).
Regarding Premiums.
The problem is deciding at what price to sell the option, or “open the position.” You will look at the option chain and see two prices. One is the “bid” and one is the “ask.” I use this idea when I want to open a position or as my strategy dictates, “sell a put.”
This is my thought process: am I happy with the current bid price (3% or better)? If so, I make the trade at the bid price and it goes through. If you only want the trade at the better price, then it is at the “ask,” or somewhere between the two of them. When using the “ask,” it might go through and it might not. If this is confusing, you might think of it as an auction. If you are selling an item for which somebody is willing to pay $100, you can offer to sell the item at $110. It will be an impasse unless either the bidder or the seller changes his position. If you really want to sell the item, you will take the lower price, and it will sell immediately.
There is a general rule that fits most trading situations. When opening a position, you can ask any price and just wait. If closing a position, especially when it has turned against you, close it by taking the price that is the “ask” price. If the stock has turned against you and the option premium is rising, you want to close it at any price. Remember, now that you are closing the position, you become the buyer. You have sold the put and now you have to buy it back. There have been many times when I have tried to buy my way out of a bad situation, and I was behind the curve for several attempts.
Example: I have sold the 40 strike on ZZZ stock when the stock was trading at $46. Well, the stock started slowly dropping in value as the month progressed. With four days left, the stock was now at $42. The premium was at .40 bid and .45 ask. I tried to get out at a near wash by buying the option to close at .40 cents. The stock dropped a little more and my offer did not go through. To make matters worse, the premiums now went to .45 bid, and .50 ask, so I took the .50 cent ask and got out of Dodge. I do not like chasing a price that continually gets away from me. So trying to get the better price, cost me a nickel more on each option by not taking the .45 at the beginning.
When closing a position, if you have plenty of time and are not very worried, then you might put in an offer for a better price. However, if you really want out, then do the trade at the ask price and you will get out. Whether you are buying or selling, when you look at the bid and the ask price, you nearly always get the worst of the two. If you want to make sure the deal goes through immediately, you will be selling at the lowest price and if buying, you pay the highest.
An important point regarding the premium for all options
The highest premium is near the present stock price. As my strategy is all about selling “time,” this makes selling naked puts at a strike price that is close to the current stock price so tempting. Resist the temptation! It is a trap that lures in many investors with potential disastrous results.
Example: ZZZ stock is currently at a price of $88.
Using our 20% rule, you can use the 70 strike.
The put premium for the 70 strike might be .45 cents (a good return with a “safe” strike price)
The put premium for the 75 strike price might be .75 cents (great return, scary strike price)
And even more tempting, the put premium for the 80 strike might be $1. (this is trouble)
When you are looking for a strike price that fits within the 20% rule, you will have to search for these gems. They are out there, but the temptation will be to use a strike price that is too close to the current stock price. Resist that temptation and stick with your rules.
Cushion
From now on, I will use the term “cushion,” which refers to the difference between the current stock price and the strike price you have chosen.
Example: With the stock at 48, you use the 40 strike price. You then have eight points of cushion. Just like your bed, cushion is also a “sleep factor.” The more cushion you have, the better you will sleep.
CHAPTER 13
ANALYZING A PREVIOUS TRADE
Speaking of hot stocks, earlier in the book I gave an example of using Google stock with a LEAP option trade. Now that you are learning to use your filters and you are able to decide on an acceptable return, let’s go back to an early example of a trade I made. Let us review some of the points of that trade, and using the “percent return” factor, see if it fits in our game plan.
***********THE SITUATION***********
On June 20, I sold January put LEAP’s (long-term equity appreciation position) for Google, at the strike price of 220 for a premium of 7.68 after commission. GOOG was then trading around $290. On July 25, I closed the position for 3.80 (I bought back the same number of them that I had sold) for a net profit of $3.88 on each option. I had sold sixty-five of these puts (equal to 6500 shares of Google.) The profit was approximately $25,200 in thirty-five days. I did not invest a penny except for using some of my available maintenance. The point of that example is that not all trades will go until the expiration day.
Let’s dissect this trade using our trading guidelines. I did this trade with the idea that Google was the darling of the stock world. Google (GOOG) was rising rapidly each day. The stock had opened about a year before and started trading at approximately $100. Day by day, it was rising, with no bad news on the horizon. Analysts were forecasting 400 soon and GOOG was heading quickly towards that goal. I researched all of the news I could find, and all reports were projecting great things. I normally do not like to use stocks that are heading straight up without a proven track record. However, the whole world was crazy about GOOG. On this trade, I ended up having approximately seventy points of cushion. I could have used a strike price around 250 and received a premium of 15. However, caution ruled and I did the right thing. If you do these kinds of plays, please leave plenty of room for the unexpected.
The stock was trading at the price of $293 and 293 minus 20% = 234. Therefore, the next strike I can use is the 230 strike. Remember, once over the 200 strike price, the strikes are usually listed in increments of 10 points.
The 230 strike price did fit the 20% rule, but for more safety I looked down the option chain and saw that if I used the 220 strike, the stock would have to drop over seventy-three points to use up all of the cushion. I opened the trade with the bid price at 7.68 premium. The reason for the great return compared to a normal trade is that it was a LEAP [Long Term Equity Position] for the next January. I opened the trade in June and it could have run until the next January. However, I had no plans of keeping it for the seven-month duration. Leaps are the only exception where I do not use the “front” month.
I sold sixty-five of these LEAP puts for a net in my account of $49,920 (6,500 x 7.68 = $49,920). On July 25th, I closed the position at a cost $3.80 each option. (I bought back the same number of them that I had sold) for a net profit of $3.88 on each option (7.68 - 3.80 = 3.88), $3.88 X 6,500 = $25,220 total net profit when I closed the trade. Therefore, I had over $25,000 profit in less than thirty-five days. If we continue to take the trade apart, you might see my reasons for closing the trade early. I had started with $49,920 profits, but I made $25,200 after closing the position. You might say that I left $24,720 on the table. However, I would have had to wait 175 more days to make the last $24.7 thousand. That would have been over five months. When I divide the $24,000 by 5.5 months, I would have averaged only about $4,300 per month and tied up a lot of my available maintenance funds. Another advantage to closing the trade early is that I actually have a profit in my p
ocket. Always remember that you are never wrong to take profits. By letting the trade run for the next 5.5 months, I would have been exposing my position to the unknown (time).
Again, while trading options nearly every position will present the problem of, should I close this position and take profits or wait for a better return. If the market or world situation is shakey, then take profits if all is well in the market and you have lots of cushion, then you might decide to let it ride. But you are never…NEVER wrong to take profits.
