by Jerry Lee
Situations that might affect the price you paid for the stock while doing naked calls.
The stock is trading at 25 so you sell the strike price of 30 for .25 cents premium.
Example: You put in a buy order to be triggered if the stock reaches 29.75 or higher. You think that if the stock makes a good move, your brokerage will fill your order at approximately 29.75 and you will have a covered call. Well, the stock might move so fast that your brokerage puts in the order, but by the time the order is filled, the stock moves above 30. Usually the fastest moves are for stocks dropping, but it can and does happen occasionally for stocks moving up. You brokerage will make no guarantee at what price your buy order is filled. They will do their best, but things happen.
CHAPTER 19
WAYS TO MAXIMIZE YOUR PROFITS
Rolling Into Different Stocks
There will be times in your trading when everything will go as planned. When that happens, you are in the golden zone. However, do not let your guard down. Use your filters and adjust them to the amount of time left during the option period. Here is an example of a trade that I recently utilized.
With ZZZ at 64.44, I sold twenty puts on the opening day of this option month for .55, using the strike of 50. Filters = 50 x10% = 5 + .55 = 5.55 maintenance. needed, so the 50 strike worked. All other filters passed inspection. I did the trade and I pocketed .55 x 2000 = $1,080.00 after commission.
This was a five-week option period. The underlying stock moved up and then down some during the first four weeks. The start of the fifth week will be this coming Monday. With the stock now at 62.61, or approximately twelve over my strike price, I find that I can buy the puts back for five cents. This would mean that it would cost me approximately $100 to close the position leaving me with a net profit of approximately $980.
My decision of whether to keep the current position or move into another one is based on the following criteria.
1. I find that I am using $12,900 of maintenance funds to make the last .05 ($100) during the next week. Certainly, there is a better use of my money. I start looking and sure enough, I find a better trade.
2. Therefore, Monday I will buy the twenty puts back for $100. Now I need to use my newly- available $12,900. of maintenance to make more than $100.
3. I go through my list and find a stock that will give better returns. I will violate my 20% strike rule as there is only one week remaining in the current period.
Remember, while doing the crumb method of trading, we do not get greedy. We just continue to pick up the crumbs from around the table, (lots of them).
The first set of options with ZZZ brought in $1,080 but that was reduced by $100 because of buying my way out of the position.
First position: Profits, $1,080 -100 to close = $980
Second position: Sell 46 puts for fifteen cents each: ($4,000 x .15) = $600
Therefore, instead of waiting for the expiration date with the first position and making $1,080, I now have $980 + $600 = $1,580. A bonus of $500 over my original position.
I try to do this kind of trade with most of my positions that have moved correctly. Many times, I cannot make the kind of move as above, as there are no opportunities that offer satisfactory risk versus reward.
Now the Downside of the Above Move
1. I had a good position that acted correctly and I was happy with the initial profit, so why put all my profits at risk with a new position.
2. Yes, I can make $600 more, but is it worth losing sleep over when my first position was very safe?
3. I have violated my 20% rule. There is only a week to go, so why are the premiums so good this late in the period for ZXZ stock? Remember, we like and expect to find opening positions that pay approximately 3% or better with four weeks to go. I know that 6% (.15 premium divided by maintenance required 2.49 = 6.02%) this late in the cycle is suspicious.
After doing more homework based on the above downsides, I am still happy with the trade, so I do the trade on the following Monday. Sometimes, rolling into different stocks is not necessary, as you might be able to utilize the same stock by using the next higher strike price. A benefit of doing that is that you have already done your homework on that particular stock. This is called “rolling up.”
Example: You own ten puts with ZZZ stock for the 40 strike price. There is a week left in this period and ZZZ is still trading at $50. You might buy back the puts at the 40 strike price and sell puts for the 42.50, or even the 45 strike. One downside of “rolling up” is that you use more maintenance for the higher strike price. Therefore, you must receive a decent jump in premiums to make this trade worthwhile.
Rolling Out or Down
I am now going to show you two ways that might help you turn a bad position into a better one. I do not recommend either of these, but both ways are a viable strategy. My recommendation is nearly always that if you have a bad position, close it!
One method is called “rolling out.” This is when you trade your option for a similar one with the same stock for a future month.
Another method is called “rolling out and down” where you go out to another month but use a lower strike price with the same stock. Example of rolling out: you open a position on ZZZ stock with the stock priced at 40. You sell the put at the strike of 32.50 for a premium of twenty-five cents. As the month progresses, the stock starts slipping in price and is now at $34.
Your possible actions are:
Close the position.
Wait and hope that the stock does not fall anymore.
Roll out, or roll out and down.
To roll out, you buy back your put position to close, and then you sell the next months option on the same stock. You can use the 32.50 strike price or better yet sell the 30 strike or maybe the 27.50. One of the determining factors when rolling out will be the premiums that are available.
Example: Rolling out and down
You had sold the first put at the strike of 32.50 for twenty-five cents
You now buy it back for .50 (loss of .25)
You sell the next month’s put at the strike price of 30
You take in .75 premium (+.25 -.50 +.75 = +.50)
Bottom line is you gave yourself more time and more cushion, and you are now up .50 on the whole situation. Generally, before I ever roll out, I will look at my current positions that are performing correctly, to see if I can use any of those to make up for the loss in the present position. One of the major advantages is that you have already done your homework on the current positions that are performing correctly. I must add that I have not rolled out or down to try and salvage a position for over three years. Many traders do this and maybe it works for them, but my feeling is “why should I stick with a stock that is disappointing me?”
I go through these mental gymnastics for all of my moves. It is not hard but it does take some time. Maybe this answers one of the original questions: “If this is so easy and profitable, why doesn’t everyone do it?” Well, these trades and the thought behind them do take time, but it is time well spent.
CHAPTER 20
PAPER TRADING
If you have not heard of this term, it has nothing to do with trading stocks that are in the paper industry. It refers to trading options without using real money. It is a form of practice trading. You do all of your trading using all of my filters, but you do not use cash. You do it all on paper. It is practice and it will help you feel confident when you make your first real trade. Do not fudge and use the incorrect parameters such as the wrong strikes prices, etc. Pretend the family farm is on the line. Do several of these paper trades the first month, sit back, and watch what happens. If you can put yourself into a position where you really feel like your family nest egg is on the line, you might find that the stress is not for you. If so, options and you can part company as friends.
After a month or two of paper trading, you might find as I do that trading options is fun, profitable, and very rewarding. You can also do this paper trading whil
e waiting for your account to get full trading privileges. Do not hesitate to roll into different stocks with your paper trades and try to tweak the profits. You can do paper trades without having an account at a brokerage. Just use your daily newspaper or the Wall Street Journal to find some stocks and their options.
While doing your practice trades on paper, remember these important points about option buying and selling.
Options are a very time-sensitive product. Therefore, with puts, the less time that your positions are exposed to bad news the more your options should dwindle to nothing and expire worthless. Always remember the two most basic rules regarding the trading of options.
1. When buying a put or call, buy lots of time, as you want your dream to have as much chance (time) as possible to happen. An example would be, if it is July when you open the position, you might “buy” the January call or put.
2. When selling a put, allow as little time as possible for the other person’s dream to happen. The buyer on the other side of your trade is betting your stock will drop. I am going to give him only a maximum of thirty days for this to happen and then, using my rules, it has to drop more than 20 %.
I know that I have repeated the above points and others often and stress them to make sure you understand them. There is a fine line between winners and losers in the option market. The trader on the opposite side of your trade is probably smarter than you are, has more software on his computer, and subscribes to ten different “option hotlines.” He might even be better looking than you. However, you have some rules and guidelines that work. In addition, you are a much nicer person than he is! I should also add that your choice of reading material is proof that you are an astute trader!
Therefore, make sure you understand the rules and the filters. Follow them, and the odds are that you will be successful.
CHAPTER 21
OPTION TRAPS THAT MIGHT MISLEAD YOU
The following is a small list of the many possible temptations that will encourage you to disregard some of the basic rules. Many times, several of these traps present themselves at once.
There is a coming stock split, so I can use a closer strike because the stock is sure to move up.
The stock is becoming a candidate to be bought out, so the stock is sure to move up.
There are no good premiums that fall within the guidelines; therefore, I will use an “incorrect” strike price.
The stock continues to go up, so a different strike price is okay in this situation.
Conditions are perfect, and it is a chance for me to make a large profit.
The stock and the premium have both dropped through my “close the position” point, but I will hold on to the position since it is such a good stock.
All of my instincts tell me to close the position, but I will give it a few more days.
You will find that one of the most common temptation while trading options is using the wrong strike price. It is a temptation that exists each time you go through your list of filters. However, any or all of these traps can cost you lots of money. While trading options for a living, you will find that a fine line separates winners from losers. Use my rules or those that you develop, but use rules.
Gambling
Do not fall into the trap of gambling with your account. Many stockbrokers, futures traders and options traders have severe gambling problems. You will find yourself using a lot of money and making decisions that most of your friends have never experienced. It is intoxicating to be monthly dealing with thousands of dollars worth of options. Do not let this feeling overcome good judgment. I mentioned earlier that you might experience losses that seem to be out of proportion to the number of trades you have done. If this happens to you, step back and be objective about your recent trades. Analyze and learn from your mistakes. Traders that do not learn from their mistakes are sure to repeat them.
CHAPTER 22
WHERE DO I FIND THE STOCKS THAT I USE?
I am always looking for new and better stocks. I keep a notebook of about 100 stocks and add new ones often. I watch the business channels and listen to their stock ideas. I will often look at my brokerage web page for stocks that have moved quite a bit recently. I even listen at cocktail parties. Who knows where the next great stock idea will come from?
After hearing of a potential stock, I first make sure it has options and that it falls within my price guidelines. If the stock passes all of my other filter rules, then I might use it in the next month or sometime in the future.
I will often find that stocks that were moneymakers for me at one time now seem to have no volatility. They become too flat (no volatility) to have premiums that I can use with my crumb method. A classic example of this is Microsoft. There were times that I made and lost many thousands using good old MSFT. However, for several years now, MSFT stock has been off my trading list.
Once you have found some stocks to use, remember these points.
Selling naked puts is considered a bullish play on the underlying stock. You want the stock price to go up or to hold near it present price.
Selling naked calls is a bearish play, as you are hoping that the stock is falling in value or holding steady.
One very important advantage we put sellers, have over stock buyers is that our underlying stock can go up, can stay the same, or can even fall some, and we still make the full premium on our put option. Also never forget that at times the best filters and planning will not rescue a stock that wants to fall. Again, if the underlying stock is disappointing, do not try to mentally force it to perform. Close the position and open a new one that does work. If you cannot find a new one that falls within your guidelines, do not open any! Failing to follow this simple rule can cost you your profits and may cause a disaster in your account.
As previously mentioned, volatility can be both a friend and enemy. Be cautious of a premium that is “too good.” Anything over a final value of a 6% (premium divided by the maintenance needed) is suspicious. Either you are to close to the present stock price or you have missed something while using the filters. If you are finding that you received a return of over 6% drop down one strike, this will add a safer ‘cushion’ to your position.
Greed causes nearly all option disasters. If you cannot watch a position that is getting close to being in trouble, at least put in stops to prevent a disaster. Making money using my trading rules while you are selling puts is that easy.
I hesitate to use the word disaster. It is such a powerful word and it scares many would-be investors. Many “advisers” who know little about options—and some who know plenty—cannot help themselves when it comes to warning investors of the “dangers” of options. Options are just an investment like stocks, bonds, or real estate. You do your homework, you make sure that you have guidelines, and you follow them.
CHAPTER 23
SOME THOUGHTS
After doing options for a while, you might find yourself wanting to share some of these ideas with friends. Be prepared for odd looks and expressions that say, “Wow, are you ever crazy to gamble like that.” Over the years, I have met many stockbrokers and other people with financial backgrounds. I would have thought that they possessed some of this information. I have talked to very few who said something like, “So you sell puts? I’ve been doing that for years also.”
I live in a golf course community. Many of my golfing partners and associates are professional people. Many are doctors, lawyers, pilots, successful business people, former and current stockbrokers, and even financial advisors. Not one has ever been able to talk to me about what I do. Many know of puts and the “mechanics” of using them but few, if any, have used them as an active part of their investments.
I am not sure what this means. Either it was such a foreign idea that people did not care to learn the basics or they believed all of the “advisors.” However, I believe it comes down to ignorance of the basics.
I am going to tell you about a book I have had on my bookshelf for several years.
The author is a well-known writer about financial matters. The book is over 1,000 pages long and covers everything regarding investments, from accident insurance to zero coupon bonds. In this 1,000-page book, there is a single half-page reference to options. I will quote from the page and leave it for you to figure the meaning.
“But no individual seriously trying to build net worth should use options, period. Even if you win at the start, you will lose in the end.”
Was this written because the author did not have the time to write a full description of options? Maybe the author assumed that most of the readers would not investigate and learn how to manage their option positions. Maybe the writer knows nothing about options. Instead, the author could have stated, “Options are leverage and can lead to problems if you do not know what you are doing.”
