Category Archives for Options

VIX

Todd MitchellCBOE Volatility Index (VIX), a measure of the implied volatility of the S&P 500 stock index, which skyrocketed after the global melt down began in earnest in August. You may know of this from the talking heads, beginners, and newbies who call this the “Fear Index”.

For those of you who have a PhD in higher mathematics from MIT, the (VIX) is simply a weighted blend of prices for a range of options on the S&P 500 index. The formula uses a kernel-smoothed estimator that takes as inputs the current market prices for all out-of-the-money calls and puts for the front month and second month expirations. The CBOE Volatility Index is the square root of the par variance swap rate for a 30 day term initiated today. To get into the pricing of the individual options, please go look up your handy dandy and ever useful Black-Scholes equation. Got all that?

For the rest of you who do not possess a PhD in higher mathematics from MIT, and maybe scored a 450 on your math SAT test, or who don’t know what an SAT test is, this is what you need to know. When the market goes up, the (VIX) goes down. When the market goes down, the (VIX) goes up. End of story. Class dismissed.

The (VIX) is expressed in terms of the annualized movement in the S&P 500. So if today’s (VIX) is $42, it means that the market expects the index to move 12.13%, or 137 S&P 500 points, over the next 30 days (17.62/3.46 = 12.13%). It really doesn’t care which way. If the S&P 500 moves less than that, you make a profit on your short (VIX) positions.

It gets better. Futures contracts began trading on the (VIX) in 2004, and options on the futures since 2006. Since then, these instruments have provided a vital means through which hedge funds control risk in their portfolios, thus providing the “hedge” in hedge fund.

But wait, there’s more. Now, erase the blackboard and start all over. Why should you care? You can use options strategies to create a cheap entry point and to limit your risk. Implied volatilities can be absolutely through the roof. So just buying the puts outright in those situations could be insanely expensive and risky. Better to make the trade volatility neutral.

Call Options

Todd MitchellCall options give the buyer the right, but not the obligation, to purchase an underlying asset. They are available in various strike prices depending on the current market price of the underlying instrument. Expiration dates can vary from one month out to more than a year (leaps options). Depending on the mood of the market, you may choose to buy (go long) or sell (go short) a call option.

If you choose to buy or go long call options, you are purchasing the right to buy the underlying instruments at whatever strike prices you choose until the expiration date. The premium of a long call option shows up as a debit in your trading account. The premium amount represents the maximum risk a long call strategy can incur. Profit is made on long calls when the prices of the underlying assets rise above the strike prices of the calls. You can then either exercise the calls or offset them by selling calls with the same strike prices and expiration date. By exercising long calls, you end up with 100 shares per option of the underlying stocks at the call strike prices. You can then turn around and sell the underlying assets at the current (higher) prices to garner a profit on the difference between two (current prices – strike prices = profit). If you choose to offset the call options, the maximum profit is unlimited. The call’s premium will increase in value depending on how high the underlying instrument rises in price beyond the strike prices of the call. As the price of the underlying asset rises, the long calls become more valuable because they give you (or the person you sell them to) the right to buy the underlying stocks at the lower strike prices of the calls. That’s why you want to go long call options in a rising or bull market.

If you choose to sell or go short call options, you are selling the right to buy the underlying instruments at particular strike prices to an option holder. Selling call options prompts the deposit of a credit in your trading account in the amount of the call’s premium-a limited profit. You get to keep this credit if the option expires worthless. Thus, to make money on short calls, the price of the underlying assets must stay below the calls’ strike prices. If the prices of the underlying assets rise above the short call strike prices, they will be assigned to an option holder who may choose to exercise it. This gives the option holder the right to buy 100 shares (per option) of the underlying stock from the assigned option buyer at the strike price of the short call. This means that the option seller must buy the underlying assets at the current prices and sell them at the calls’ lower strike prices to the assigned option holder, thereby incurring a loss on the trade (current prices – strike prices = loss). The maximum loss is therefore unlimited to the upside, which is why selling “naked” or unprotected call options comes with such a high risk. However, experienced traders who do choose to short call options would be wise to do so in a stable or bear market.

Call options give you the right to buy something at a specific price for a specific time period. However, if the current market prices are more than the strike prices, the call options are in-the-money (itm). If the current market prices are less than the strike prices, the call options are out-of-the-money (otm). If the current market prices are the same as (or close to) the strike prices, the call options are at-the-money (atm).

Example: A local newspaper advertises a sale on VCRs for only $129.95. The next day Jane goes down to the electronics store intending to purchase a vcr at the advertised price. Unfortunately, by the time she arrives, the vcr is already out of stock. The manager apologizes and gives her a rain check entitling Jane to buy the same vcr for the advertised price of $129.95 anytime within the next two months. Jane has just received a long call option which gives her the right, but not the obligation, to purchase the vcr at the guaranteed strike price of $129.95 until the expiration date two months away.

Scenario 1: A few weeks later, Jane return’s to the store to exercise her rain check. The same vcr is now in stock, priced at $179.95. Jane approaches the store manager who agrees to honor the rain-check and sell her a vcr for the advertised price of $129.95. Jane has just saved $50. Her long call option was in-the-money.

Scenario 2: A few weeks later, Jane returns to the store and finds the vcr on sale for $119.95? Her rain check is now worthless because she can simply purchase the vcr at the reduced price. In this case, Jane’s call option expired worthless because it was out-of-the-money. Just because you own a long call option doesn’t mean you are under any obligation to use it.

Scenario 3: Jane’s friend Jeff phones and mentions that his vcr has just broken. She tells him about her rain-check and agrees to sell it to Jeff for $5 (the option premium). The strike price is still $129.95 and the expiration date is 2 months out. However, Jeff is taking a risk. The vcr might be priced lower than the $129.95 strike price in which case the rain-check is worthless and Jeff loses $5.

Call Option Review

1. Call options give traders the right to buy the underlying stock at the strike price until market close on the 3rd Friday of the expiration month. A call option is in-the-money (itm) if its strike price is below the current price of the underlying stock. A call option is out-of-the-money (otm) if its strike price is above the current price of the underlying stock. A call option is at-the-money (atm) if its strike price is the same as (or close to) the current price of the underlying stock.

2. Buying Calls – If bullish – believe the market will rise – buy (go long) calls. Buyers have rights. A call buyer has the right, but not the obligation, to buy the underlying stock at the strike price until the expiration date. If you buy a call option, your maximum risk is the money paid for the option, the debit. The maximum profit is unlimited depending on the rise in the price of the underlying asset. To offset a long call, you have to sell a call with the same strike price to close out the position. By exercising a long call, you are choosing to purchase 100 shares of the underlying stock at the strike price of the call option.

3. Selling Calls – If bearish – believe the market will fall – sell (go short) calls. Sellers have obligations. A call seller has the obligation to sell 100 shares of the underlying stock at the strike price to the person to whom the option was sold, if that person chooses to exercise the call option. Sellers have obligations. If you sell a call option, your risk is unlimited to the upside. The profit is limited to the credit received from the sale of the call. When selling calls, make sure to choose options with little time left until expiration. Call sellers want the call to expire worthless so that they can keep the whole premium. To offset a short call, you have to buy a call with the same strike price to close out the position.

Exiting an Option Position

Todd MitchellOnce you own options, there are three methods that can be used to make a profit or avoid loss: exercise them, offset them with other options, or let them expire worthless. By exercising what you have purchased, you are choosing to take delivery of (call) or to sell (put) the underlying asset at the option’s strike price. Only buyers have the choice to exercise an option. Sellers, on the other hand, may experience having an option assigned to a holder and subsequently exercised.

Offsetting is a method of reversing the original transaction to exit the trade. If you bought a call, you have to sell the call with the same strike price and expiration. If you sold a call, you have to buy a call with the same strike price and expiration. If you bought a put, you have to sell a put with the same strike price and expiration. If you sold a put you have to buy a put with the same strike price and expiration. If you do not offset your position, then you have not officially exited the trade.

If an option has not been offset or exercised by expiration, it expires worthless. If you originally sold an option, then you want it to expire worthless because then you get to keep the credit you received from the premium. Since a seller wants options to expire worthless, the passage of time is a seller’s friend and a buyer’s enemy. If you bought, the premium is nonrefundable even if you let the it expire worthless. As it gets closer to expiration, it decreases in value.

It is Important to note that most options traded on u.s. exchanges are American style. In essence, they differ from European options in one main way. American style options can be exercised at any time up until expiration. In contrast, European style options can be exercised only on the day they expire. All the options of one type (put or call) which have the same underlying security are called a class of options. For example, all the calls on ibm constitute a class. All the options that are in one class and have the same strike price are called a series. For example, all ibm calls with a strike price of 130 (and various expiration dates) constitute a series.

Buy High, Sell Low Part Three

A Simple, Proven Cash Flow Investing Strategy

D. M. LukasThis is the third and final installment in our Cash Flow Investing Series.  In the last article we detailed the 2 types of trades that you will be using in the Cash Flow Investing Strategy.

 

The first type of trade we will use is selling “covered calls” on the stocks that we own to provide a consistent cash flow.  The second, type of trade that we will use is “selling puts” on stocks that we want to own at a lower price.

 

In this article, we are going to cover a few examples of how to manage these trades depending on what the stocks that you are playing this strategy with are doing.

 

Trade Management #1:  Covered Calls

 

In the last article I used the following example:

 

Using the example of Halliburton from our first article, let’s say, I purchased the stock at $34 and after checking the options chains at 3 mos and 6 mos out, I see that the 36 call 3 months from now is selling for $3 per share.  I could sell that strike and would pocket $300 right now, about a 9% return on my money…in just 3 months!

 

Imagine if you did that 4 times per year!  You would have a whopping 36% return on your money!

 

So, what happens in 3 months, if Halliburton is at 36 or  higher?  Even better!  Now in addition to the $300 I made, I will make an additional $200 (I owned one hundred shares at $34 and it is now $36 or greater.  The call was for $36, so they would pay me $36 and take the shares).  That is $500 in 3 months or approximately a 15% return on my money.  No bad, huh?

 

You are probably thinking, “That’s great, but what if Halliburton drops like a brick?”  Well, that is equally as good for us.  I will explain more about what to do if your stock drops in our next and last article.  Just always remember, that movement = opportunity.

 

As you can see from the example, if you sell the covered call on Halliburton and it is at or above that call strike on the expiration date, then there is nothing you need to do as they will take your shares from you at the higher price, giving you more return ($500 from above).  Great!  Turn around purchase 100 more shares and “lather, rinse, and repeat” or purchase another one of your chosen stocks and do it with that one.  Also, if the price is below the strike (in this case $36), you get to keep the original money ($300) and the stock and turn around and sell again!

 

But what happens as in the bottom part of the example if you purchase Halliburton at $34, sell the $36 call, pick up the $300, and then Halliburton drops to $29?  If you think about it, by being paid the $300, you actually reduced your cost basis on the stock from $34 to $31 (100 shares x $34 = $3400 -$300 (call sale) =$31).  That means your “breakeven” price is now $31, so at $29 you are losing $200 on paper.  At this point, you have a few choices:

  1. First, you can just leave it alone, especially if it is in the first 2-4 weeks of the trade.  Your call period is for 3 months and as you probably know stocks fluctuate up and down every day.   Halliburton could go up to $33 tomorrow.
  2. If you are in the later stages of the call period (maybe a couple weeks to go before expiration), you could simply buy the call back and then resell another one 3-6 months out, reducing your “breakeven price” further.
    1. The beauty of options is that they have a time limit, so the closer you get to expiration, if the call is not near the price you sold it for ($36), then it will lose value and the price will go down.  For example, you had sold the call for $3 and picked up $300 in your account.  If you are 2 weeks from expiration and Halliburton is at $29, the market will price in the fact, that the chance for it to hit $36 is low and thus the call will go down in price, so instead of $3, it may only be $.50.  Great!  That means that you can buy back the $36 call for $50, keep $250, and then turn around sell another one 3-6 months out and pick up another $300 or more.
    2. In this case, you breakeven cost is now $31.50 ($34 per share -$2.50 you kept after buying the call cheaper), so  if the stock is at $29, you would want to sell your next round of calls at or above your breakeven ($32) or above.  This works perfectly as you are only a couple strikes away from the $32.
    3. You can do the same thing over and over again as the stock stays the same or goes down some…continue to buy and resell and lower your breakeven.
    4. Eventually you will hit a point where the money you have collected from buying and reselling pays the original stock purchase costs ($3400) and you are playing with the “house’s money” and not your own.
  3. What happens if you buy the stock and sell the call today and tomorrow it drops immediately?
    1. Same strategy as above only you get to do it sooner!
    2. You can simply buy the call back for a lower price and resell another one or you can do what I do…
      1.  I know that stocks fluctuate, so movement = opportunity
      2.  If I made the trade and this happened to me.  I typically will buy the call back and wait for the stock to go back up (usually in a matter of days) and then I will resell the strikes again and pick up more money!
      3.  If you have the time to watch things closely, many times you can do this multiple times a month and make exponential returns!

 

 

Trade Management #2: Selling Naked Puts

 

In the last article I described selling puts and gave an example in the following way:

 

The way you sell a put is simply to look 3-6 mos out in the put options chain on a stock you would like to own and then “sell” the option at a lower price and get paid the option price.  Sticking with our example of Halliburton from the first article, the stock is at $34, but the $30 put 3 months out is selling for $2 per share.  Halliburton is a great buy at $30, you be happy to own it if it came down that low.  So, you “sell” the January 30 put strike.  Immediately 2 things happen, you get paid $200 or approx. 7%.  Remember, if you had to buy the stock it would be at $30, not $34 (so $200/$3000 is about 7%).  The second thing that happens is that the $3000 is set aside in your account by your brokerage firm to cover you buying the stock if it got down to $30 by January.

 

That is one reason why I state at the beginning of this series that this trading style is not for everyone.  It will work for anyone, but only some have the money to be able to do this on a large scale.  You can, however, start out just doing either strategy on 1 stock and create the income to do either strategy on your next stock, and so on.  Again, this is a long-term, steady cash flow way to invest.

 

So, what happens if you get “put” the stock or even more importantly, if the stock drops below the price you sold the put at?

 

 

In this example, if you sold the put at $30 and picked up the $200 and 3 months later the stock is above $30, you get to keep the $200 and  your $3000 set aside in your brokerage account is now freed up to sell another put!

But what happens as in the bottom part of the example where you get “put” the stock or even more importantly, the stock drops below $30 at expiration?

Well, there are few things. 

  1. First and foremost, remember, just like in our call example above, by initially getting $200 or $2 per share, we have reduced our breakeven on the stock to $28 ($30 per share put strike -$2 =$28).  So we could actually get “put” the stock at $28 per share and we are at breakeven.  Great!  Now that we own it, we turn around and sell a covered call on it picking up more cash!  From there we can follow the management techniques described in the call section above.
  2. What happens if it is at $26?  Same thing as above, you will get put the stock and now you can sell calls and pick up some cash to bring you to breakeven.  Just be conscious that your breakeven is at $28, so you will want to sell your call at or above that strike.  Also, remember that the cash you get from that sale will reduce your breakeven amount as you are getting paid again.

Stop here for second.  Do you see how over time you actually can use this strategy with both trade types to pay yourself back what you paid originally to buy the shares?  It is so awesome when over time, you pay yourself completely back from these trades and again, and are playing with the “house’s money!”

Another thought:

Patience is very important. People are always anxious once they get “put” stocks to turn around and sell the calls right away.  We discussed at the beginning of this article series that you need to pick stocks that you are willing own for a long time and I talked before about how stocks fluctuate.  If a stock has come down so far that you are going to get “put” the stock or it is lower than your put strike, it means that stock has had significant movement to the downside. 

Don’t think that other people haven’t noticed and aren’t thinking it is a great buy at those levels as well.  Why? Because as we have discussed when you are initially picking your stocks, they are good stocks, with good track records, probably dividend payers, so people will take the opportunity to scoop up the shares. 

If you are willing to wait a little while (typically within a week), the stocks will go up and you can sell your call strikes at an even higher price allowing you the chance to not only get paid on the calls, but also get taken out (in the future) at a potentially even higher strike price making more money than if you have sold right away.  I have done this many times after getting “put” stocks and the patience has helped me as I am able to get the same call amount paid to me, but usually 1-2 strikes higher!

 

Well, there you go.  A simple Cash Flow Investing strategy to help you build wealth consistently over time.  Keep in mind that this is a very basic description of this strategy and is meant to inform you of what is available out there for you to do.  It is not financial advice.  There are many other tactics and management techniques that you can learn to help you make this strategy even more effective.  In the future, we will be releasing a detailed program that shows you step by step how to do this strategy complete with video tutorials, necessary tools to help you, and complete management techniques.  Until then, if this strategy appeals to you, start employing some of the thoughts from this article and “paper trade” or trade in a play money or fake account to test it out and develop your own strategies of Cash Flow Investing.

Buy High, Sell Low Continued

A Simple, Proven Cash Flow Investing Strategy

D. M. LukasAs we discussed in the last article, buy high, sell low is a strategy that works no matter what price you buy a stock at.  If you remember, the strategy is designed to work for you no matter what stocks do and to produce consistent cash flow.  It is called Cash Flow Investing for that reason.

 

In the last article we covered 3 steps to start utilizing this strategy.  First was to “think like a real estate investor.  Second, was to pick companies that you would be willing to hold the stocks for 10-20 years or more.  Third, was to narrow those picks to the ones with higher “implied volatility” by looking at the options chains and making sure that if you bought or sold a call/put that you would be getting a 6% or more return in a 3-6 month period.

 

In this article, we are going to cover the 2 types of trades that you will use in Cash Flow Investing.

 

Trade #1:  Covered Calls

 

You have no doubt heard of covered calls before.  A covered call is simply “selling” a call on a stock that you own.  It is one of the least risky forms of trading.  In Cash Flow Investing, since you are purchasing stocks that you are willing to hold for 10-20 years, covered calls are an easy way to create a consistent revenue stream.  You simply, sell a call strike that is at least 2-3 strikes above the current stock price that you own.  You will want to do this for the call expiration 3-6 months in the future, depending on how much the options are selling for.  Remember, you are looking for a 6% return or better for the period.

 

Using the example of Halliburton from our first article, let’s say, I purchased the stock at $34 and after checking the options chains at 3 mos and 6 mos out, I see that the 36 call 3 months from now is selling for $3 per share.  I could sell that strike and would pocket $300 right now, about a 9% return on my money…in just 3 months! 

 

Imagine if you did that 4 times per year!  You would have a whopping 36% return on your money!

 

So, what happens in 3 months, if Halliburton is at 36 or so higher?  Even better!  Now in addition to the $300 I made, I will make an additional $200 (I owned one hundred shares at $34 and it is now $36 or greater.  The call was for $36, so they would pay me $36 and take the shares).  That is $500 in 3 months or approximately a 15% return on my money.  No bad, huh?

 

You are probably thinking, “That’s great, but what if Halliburton drops like a brick?”  Well, that is equally as good for us.  I will explain more about what to do if your stock drops in our next and last article.  Just always remember, that movement = opportunity.

 

Trade #2: Selling Naked Puts

 

You may or may not have heard of selling puts before, but the concept is simple and is another way to create consistent cash flow.  Selling a put is a simple idea.  It is my favorite way to purchase a stock at a lower price or create income off of a stock without owning it.  Again, since we have found stocks that we would be willing to own for 10-20 years, we are selling puts against them to create income or if we get “put” the stock, we are happy to own it.

 

The way you sell a put is simply to look 3-6 mos out in the put options chain on a stock you would like to own and then “sell” the option at a lower price and get paid the option price.  Sticking with our example of Halliburton from the first article, the stock is at $34, but the $30 put 3 months out is selling for $2 per share.  Halliburton is a great buy at $30, you be happy to own it if it came down that low.  So, you “sell” the January 30 put strike.  Immediately 2 things happen, you get paid $200 or approx. 7%.  Remember, if you had to buy the stock it would be at $30, not $34 (so $200/$3000 is about 7%).  The second thing that happens is that the $3000 is set aside in your account by your brokerage firm to cover you buying the stock if it got down to $30 by January.

 

That is one reason why I state at the beginning of this series that this trading style is not for everyone.  It will work for anyone, but only some have the money to be able to do this on a large scale.  You can, however, start out just doing either strategy on 1 stock and create the income to do either strategy on your next stock, and so on.  Again, this is a long-term, steady cash flow way to invest.

 

So, what happens if you get “put” the stock or even more importantly, if the stock drops below the price you sold the put at?

 

I will cover what to do and how to capitalize if these things happen in our next article.  For now, take some time to make sure you understand the 2 types of trades you will be doing with Cash Flow Investing and if you a haven’t already started, begin narrowing down your 3-5 Cash Flow Investing stocks and start looking at the different trade options for each one.

 

See you in the next article!

Buy High, Sell Low?

A Simple, Proven Cash Flow Market Strategy

D.M. LukasBuy high, sell low?  You are probably thinking, “That doesn’t sound right…”  Well, according to most experts and years of advice, it doesn’t.  But what if I told you that you do not have to be “right” to create a consistent revenue stream from investing in the market, you just have to understand a few simple concepts and diligently put them to work for you?

 

This article is the first in a 3 part series that will detail the first investment strategy that I learned to use and still use today.  This strategy is not for everyone, because it takes having initial cash to be able to do.  In other words, this is not a strategy where you can start on a shoe-string and make exponential profits. 

 

What it is, is a strategy that you can use once you have set aside some cash and would like to use it to grow a nice revenue stream over time.  You can do this strategy starting with about $2500 or so.

 

This strategy is based on a simple premise, cash flow.  As such, I call it Cash Flow Investing. 

 

Step 1:  Think Like a Real Estate Rental Investor

 

When I started my investing career, I began by investing in real estate.  I had always had a passion for the investing in the markets and had “dabbled” in them, but I was especially fascinated with real estate in my early years and spent all of my extra time learning about the advantages of real estate and how to create great real estate investments.  The thing that appealed to me most was the fact that, as a real estate investor, if your purchase right and review your tenants correctly; you can create a nice monthly revenue stream while having your tenants pay for your investment.  Furthermore, the tax system is set up to reward investment property owners.

 

Ok, so how does that relate to this trading strategy?  There are 2 lessons important to investing in real estate.  The first is that if you are going to make a decision to purchase a property, you better be willing to keep it for at least 10-20 years because it is not a liquid asset, there is no guarantee that it will go up in value in the short term, and by keeping it that long, you will reap the tax benefits and your rents will pay it down enough so that if you had to get rid of it, you would be very close to break-even or eke out a small profit.

 

The second and most important lesson is to invest for “cash flow.”  That’s right, no flipping, no quick money, just a nice consistent, monthly revenue stream.  Nothing flashy, just a nice 8-10%… or more return on cash invested.

 

So, to translate this to Cash Flow Investing…  First, you will only pick companies in which you will purchase shares, if you are willing to hold them for 10-20 years.  Which means, you like them, you believe in them, maybe even use their products, and they are established.   Second, you are going to invest for consistent returns through these stocks over time.

 

Step 2:  Buy High, Sell Low

 

I use “buy high, sell low,” because it grabs attention, but in reality, following step 1; if you know that you are willing to purchase and hold a stock for 10-20 years, it does not matter what price you buy it at for this strategy.  In fact, as you will see, sometimes the strategy works best when a stock has run up for a while.  So, step 2 is really, once you have picked a few stocks that fit the parameters above, to go out and prepare to buy 100 shares of them.

 

Step 3:  Look at the Options Chains

 

Once you have picked a few companies that you are willing to own for the next 10-20 years or so (3-5 is enough), you will want to look at their options chains, calls and puts.  You are looking for stocks that have a higher “implied volatility” or that have “rich” options chains meaning that their options are paying a decent amount.  You will want to look at the prices that are 3 or 6 months out from now.  What you are looking for is return relative to the stock price.  You typically will look for a 6% return or above.  For example, if I am looking at Halliburton, the stock is currently at about $34 per share.  Right now, it is October, so if I look at the January options chains, I see that that January $36 Call is selling for about $3 and the January $30 put is selling for around $2.  If, I sold either of those strikes, I would receive the credit, either $3 or $2, which would be at least 6% or great return on the price of the stock.

 

So, for step 3, once you have found your group of stocks, you want to check the options chains 3 and 6 months out to see if they have a decent payout within a few strikes of where the price is now.

 

Next week, I will continue with the 2 types of trades that you will be doing to make this strategy work for you and create consistent cash flow.  Until then, please take some time to research and find YOUR 3-5 companies that you want to own for 10-20 years and look at their options chains to make sure they are paying out at least a 6% return within a 3-6 month period.

 

Here’s to the beginning of your Cash Flow Investing Career!

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