Darwin's Finance » Stock Options

I Hedged This Insane Market Runup with a Put Spread – Here’s How

Darwin — Thu, 01 Apr 2010 12:00:31 +0000

I was reminded by a blogging buddy of mine Evan (via Twitter) about just how insane the market has been lately and that perhaps it’s high time to buy some insurance. While I don’t play games with the funds in my retirement accounts and remain fully invested at all times given the multi-decade time horizon, I also have a trading account that I’ve done quite well with by reacting to near-term over and under-reactions we’re so accustomed to in the market (here’s my last portfolio update). Given the unprecedented run stocks have seen which seems a bit overdone in light of how screwed up our economy is, I figure we’re long overdue for a typical retrenchment (market correction) since we haven’t seen one for months. In my initial article on How Options Work I introduced readers to the basics of put and call options. This week, I decided to buy some downside protection with a Put Spread on the broad market index the S&P500 via the ETF (SPY).

Why Hedge with a Put Spread Now?

The premise here is that I have a decent sized long portfolio with a market-neutral component (I make money regardless of market direction by employing Darwin’s Short Leveraged ETF Strategy). If I spend a little money on a downside hedge like a put spread and it expires worthless, no big deal since the market is still running or even. If the market runs up, I more than offset the few hundred bucks I spent on the hedge with my trading portfolio long gains (not to mention my 401K and IRA accounts with are much larger in magnitude and always long). If the market stays flat, my market neutral strategy performs optimally in the trading account. If the market dips, I make money on the hedge and buy more stock later. This has been a tried and true strategy I’ve employed for years. While my timing could always be better (imagine if I shorted Financials throughout 2008?), it’s nice to have some added flexibility and alternatives when the market tanks rather than just watching in horror as the market devours your portfolio.
The final consideration here is that I don’t want to throw a bunch of money out the window every month hedging against something that may never make me money.

Puts vs. Put Spreads

The most simple way to hedge against a broad market decline would have been to simply buy put options on the S&P500 ETF (SPY). In the past, I’d been a a big fan of Selling Options for Income when they were expensive because volatility was so high. Now, with volatility dropping through the floor (investors are surprisingly complacent which makes me nervous!), options are cheap, so I’m a buyer. Regardless, with SPY priced at about $117 per share, an underlying put option at the money with May expiry would cost about $300. What I’m looking for is a to spend a bit less money and capitalize more substantially on a mild decline or 5% ore more in the next month or two.

So, what I did was to buy an option slightly out of the money at $115, but then sell another one even further out of the money at $110. Why? Well, by selling the 110, that partially offsets the cash outlay to buy the 115 put and increases my ROI for a mild decline.

Here’s the transaction:

Buy 3 SPY 115 May expiry @ 1.98
Sell 3 SPY 110 May expiry @ 0.93

That transaction had a “spread” of 1.05 each. So,

1.05*3*100 = $315 Cash Outlay

My max gain would be the difference of 5 bucks on each position

(115-110)*3*100 = $1500

So, my Max ROI would be a 376% Gain

What Happens if the Market Moves up and SPY is over $115 at May expiry? The position expires worthless and I lose the $315 outlay. Chances are the rest of my portfolio will have moved well over $315 in the upwards direction in that case.
What Happens if the Market Completely Crashes? The one downside here is I capped my gains when SPY hits $110, so the SPY tanks to say, $90, I still just get the $1500. While I might be disappointed that I capped my gain, at least I’ll have had something – and I can use this $1500 to go pick up some new Apple shares or the next IMAX or whatever, at a significant discount from where it’s trading today.

Are Stock Options For You?

While many view options trading as complex and high risk, it can actually be relatively simple and low risk if you actually take the time to understand the fundamentals, what the possible outcomes will be and ensure that you understand and are accepting of your maximum loss.

If looking to get started, one of the best options-oriented online brokers is now offering an awesome deal. You can even start off with a $100 Signup Bonus at OptionsXpress with as little as $500 to fund the account.

Is it Wrong to Hedge Your Own Company’s Shares?

Darwin — Mon, 01 Mar 2010 13:00:23 +0000

Last year I wrote a somewhat controversial article on how to sell call options against your underlying company stock option grants or restricted stock grants in order to hedge against a potential decline while forfeiting massive upside should the shares take off (see How Options Work if this is Greek to you). The comments ranged from cries of conflict of interest to “that’s what our company specializes in – it’s normal”. My personal opinion was, and still is, that for a mid-level employee like myself, this is a rather moderate/conservative method of preserving income/asset values from my hard-earned work rather than seeing annual option grant after grant disappear into thin air as the company stock followed the rest of the economy in what was the “lost decade” where stocks basically went nowhere from 2001-2010.

I basically take in several hundred dollars per year in option premiums which works out optimally for a flat or moderate rise in company stock.

Where it becomes a bit more questionable is when an executive or CEO who is clearly in possession of insider knowledge (future earnings outlook, strategic direction, impending risks/upsides that will inevitably impact share prices) starts embarking on much more elaborate, and financially significant hedges to the tune of several million dollars per year. This week’s BusinessWeek did an article on more elaborate hedges with some disturbing statistics attached to the hedging timing. In essence, in companies where the executives embarked on major hedges of their own company stock (and rightly publicized in company filings), the shares tended to greatly under-perform in the period following versus both their peer group and the market at large.

What this chart is showing is that executives somehow tend to perfectly time the peak when they sell hedges against their underlying shares and then share performance suffers following. Inevitably, this leaves a bad taste in the mouths of investors, who didn’t enjoy the same market timing “luck”.

While the article doesn’t outline a similar strategy to the one I outlined where I sell calls against company stock outright, two variants that executives are keen on are the following from the same BusinessWeek article:

SCENARIO ONE: ZERO-COST COLLARS
This hedge puts a “collar,” i.e., a floor and ceiling, around the price an executive gets paid for stock
1. An executive wants to protect 2 million shares, currently worth $100 each, against a big drop in the stock.
2. He buys a put option on the stock from a broker, which gives him the right to sell his shares at a given price, say $95. If the stock drops below $95, he sells at that price and suffers no further losses.
3. To pay for the put, the executive simultaneously has his broker sell a call option on his stock. The call gives a buyer the right to acquire the shares at a set price if they rise, say to 110.
4. If the stock goes above $110 while the call option is in effect, the executive must sell his shares to the buyer; if the shares remain between $95 and $110 during the life of the two options, he holds on to all his stock. And during the life of the collar, he can borrow fundsÃ¢â‚¬â€generally up to 50% of the value of his shares.
SCENARIO TWO: PREPAID VARIABLE FORWARD CONTRACT (PVF)
This is the more popularÃ¢â‚¬â€and complexÃ¢â‚¬â€hedge strategy.
A PVF sale revolves around a contract established between a senior executive and an investment bank, and it frees up more cash without initially requiring that the executive sell his stock or pay capital-gains tax.
1. Now the executive hedges those 2 million shares worth $100 apiece with a three-year PVF. He agrees on a floor and a ceiling price with the bankÃ¢â‚¬â€again, say $95 and $110.
2. In the meantime, to protect itself from a loss if the shares fall below $95, the investment bank will generally short the company’s shares. It also collects fees on the contract.
3. At the end of three years, if the shares fall below $95, the executive simply turns over his 2 million shares. He keeps the cash he received in advance and has limited his downside.
4. If, on the other hand, the shares have risen, he can settle up with the bank in cash. He hangs onto the shares and profits from any further rise in the stock.
5. Or he can pay the bank back in stock; the exact number of shares will depend on how the stock performs. The better the stock does during the life of the hedge, the fewer shares he’ll owe.
6. The executive receives a cash advance from the bank that generally equals up to 85% of the value of his stock at the time of the hedge, or in this case, $170 million.

While these strategies are slightly more complex than the one I initially outlined and have followed myself, and all 3 of these are legal, don’t violate securities laws or company policies, apparently, the concept of hedging against your own company stock (some would call this “betting” on your company’s shares to decline) rubs many people the wrong way. Personally, I am a bit alarmed by what the data shows about the executive moves who clearly are aware of impending stock moves, but I still stand behind offloading some risk of underlying options for lower level employees that have no insider information, are making peanuts-type trades once per year and have a routine/recurring strategy for doing this annually, so there’s no “market timing” going on.

What Are Your Thoughts?
Is It Wrong For Executives to Hedge Shares?
Is It Wrong for Worker Bee Employees to Hedge Shares?

Does Switching Wall Street Compensation to Stock Really Decrease Risk-Taking?

Darwin — Thu, 14 Jan 2010 04:01:06 +0000

With all the public ire over Wall Street compensation and the public inquiry occurring this week demanding the heads of the major Wall Street banks testify (oddly, they’re grilling the heads of firms that survived rather than the ones that failed), one key theme has been Wall Street compensation.

Politicians are grilling executives over compensation and the risk-taking that ensued, which surely, at least indirectly, was a result of tying compensation to some of the behaviors that led to the financial crisis (notwithstanding the role of Congress and failure of oversight from regulatory bodies).

From Cash Bonuses to Stock and Options – Does it Matter?

In order to divert attention away from the enormous bonus pools by the likes of Goldman Sachs and JPMorgan that were estimated to average $600K and $400K per employee, respectively (don’t be fooled by statistics of course), many large firms are doing away with or reducing the amount of cash bonuses and instead using stock and stock options (see How Stock Options Work) as a primary form of compensation.

This begs the question as to whether this is even effective. Weren’t the 90’s and 2000’s wrought with stock option abuse and risk-taking to juice share prices? And remember the stock option back-dating scandals? By relying on leveraged returns from options or restricted stock, it’s somewhat incenting the same behavior, isn’t it? And as outlined in my article on Selling Covered Calls against company stock and options, executives with massive blocks of stock can still reap a near-term payday no matter what share prices do.

And as far as placating mainstreet, it may have the opposite effect. With many Wall Street firms doubling and tripling their share prices over the past year during the recovery, employees that were rewarded with stock instead of cash are looking at huge windfalls when the vesting period expires. So, instead of a Goldman senior trader taking in $700K in total compensation next year, it might be something like $2.9 million because of the unprecedented rise in shares from the grant price. Will Congress then start all over with the feigned outrage and question:

“Why are these Wall Street fatcats being compensated with so much stock”?

There is certainly something to be said for clawback provisions some firms have put in place, which surprisingly, during an interview today, Jamie Dimon said has already been executed on more than one JPMorgan employee. What a clawback provision does is it allows for the board/CEO to determine that previously awarded compensation can be taken back if the behaviors that led to such compensation were inappropriate. For instance, if the head of a unit took on excessive risks or inflated performance in some way to increase the value of shares that were exercised, then the clawback provision could mandate the return of those funds.

The thing about a clawback provision is that it could just as easily be applied to cash compensation.

I just really question whether it even matters. Because the government invoked this “too big to fail” mentality for financial firms, bailed out the auto industry, bailed out homeowners who took on exotic mortgages, and virtually anyone else with lobbying dollars or a voting base, there’s now a strong history of bailouts and bias toward risk-taking with the understanding that a safety net exists.

I also question whether paying in stock will actually do anything to address the compensation that so angers main street.

Perhaps if Congressional efforts were instead directed toward job creation and preventing terrorists from blowing up planes, we’d be more prosperous and secure. But instead, they’re focusing on banning loud TV commercials and how much people in private industry get paid (yes, they want oversight over banks that didn’t even need or participate in TARP).

Thoughts?

25 Best Personal Finance, Investing & Career Posts of 2009

Darwin — Tue, 12 Jan 2010 13:00:27 +0000

After sharing the best posts from around the blogosphere in Personal Finance and Investing with yesterday’s Carnival of Personal Finance I realized I didn’t do a look-back at 2009 from Darwin’s Finance. In this list you’ll find thousands of dollars in money saving tips, career boosters, investing tricks and tax deduction ideas you may have never heard of. I’ve intentionally selected articles that are still relevant and useful, even if they’re a few months old.

Personal Finance

How to Get a 0% Down Loan Even in 2010 – Amazingly, in the midst of the most substantial housing collapse we’ve seen in our generation, there are still 0% down loans being offered to millions of Americans under a USDA rural loan program. The thing is, there’s nothing rural about many communities that qualify – which means you! Find out more about the program if you’re thinking of buying.

The ONLY way to get your FICO Credit Score for free – Aside from learning how to do this, most people don’t fully grasp the implications their credit score has on their everyday life – from loan rates to employer screening trouble, the FICO credit score is far-reaching and a critical component of a successful personal financial plan.

Net Present Value – It’s not just for MBAs – This article shows how I used NPV to choose between multiple mortgage choices and how you should always perform a simple NPV analysis when confronted with tough financial choices.

What Statistics Really Mean – When someone throws out a fancy statistic, they often either don’t know what they’re talking about or they’re intentionally manipulating you into believing in their agenda. Understand the tips, tricks and implications of statistics and how to apply these concepts to everyday life.

Don’t be a Slave to Energy Prices – Be indifferent. By hedging your energy prices. This article outlines several simple and low cost methods to hedge against rising oil, electric and natural gas prices. Large corporations do this to avoid catastrophic impact to their bottom line, why don’t you?

What Would Happen if the US Dollar Were Replaced? Of late, there has been serious talk of foreign governments getting out of the US Dollar as their reserve currency. Can you blame them? Such an unraveling could have serious implications for all Americans.

Family Money – Fairness and Considerations in Gifting and Estate Planning – This uncomfortable topic is one many families choose to ignore. Do so at your peril. Consider your transparency and equity in how you treat your family members. You’d want to be treated the same way, right?

9 Money Habits to Live by – Check out these basic methods to ensure financial success in your family’s budget. Do you relate to these habits?

Living Paycheck to Paycheck is Costing You Thousands – The hidden costs of not having excess cash on hand every month. Life Happens – and when it does, a hand to mouth financial lifestyle can put you further in the hole.

Puppy Love? Think Twice, That May be a $100,000 Dog Over its Life – I was personally blown away when I actually calculated what our dog Jack will eventually cost us over his lifetime. My wife and I went to college for less than Jack’s expenses over his lifetime. Please make sure you understand and calculate your costs before buying that cute puppy on an impulse buy.

How FSA Plan Account Contributions Can Save You Thousands – If you have a Flex Spending Account at your disposal and you’re not using it, you’re leaving thousands of dollars on the table. See all eligible expenses and how to take advantage of this tax deduction.

Start Investing Today: An Amazing Comparison of 25 vs 35 Year Old Starters – A picture can tell a thousand words. Well, this has words and pictures showing an amazing difference in outcomes if you start investing at 25 vs. 35…even if the 25 year old STOPS investing completely when they hit 35!

Investing

How Stock Options Work – They’re not as complex and costly as you may think. And they’re NOT just for speculation. Options can provide income and hedging in a conservative portfolio as well if used right.

How Covered Call Options Work – Understand how to generate income and smooth out market returns by selling covered calls.

3 Low-Cost Option Strategies for Stock Market Speculation – Using stock options to speculate on a biotech approval or pending court case that could wallop a small tech stock doesn’t have to be expensive. See how these low-cost methods allow you to profit over 1000% on event-driven trading days for under $100 invested.

Investment Club Aspirations? Consider This…While an investment club was a positive experience for me overall, there were significant cost, tax, governance and performance issues that we didn’t consider at the outset. Make sure you understand all the barriers before you embark on a partnership.

Leveraged ETFs are Evil – If you don’t understand daily rebalancing. Please read before you EVER consider buying a 2x or 3X return ETF.

Advanta 11% Yield Notes Sound Great, Right? Find out what to watch for in an investment that seems too good to be true – and what happens to investors that ignored the warning signs.

Structured Notes – How they Work and Why You Might Want One – What if you could attain guaranteed ranges of returns that are MUCH higher than the crappy savings and CD rates out there today? You can, with Structured Notes.

Wall Street Violated Nature’s Laws – A fun look back and how Wall Street violated the most basic laws of physics in their behavior and reaction to the financial crisis.

2009 Returns for Every Country – See what you missed by investing only in the US (or by avoiding stocks altogether in 2009). Some countries returned over 100% on the year, with a financial crisis along the way.

Every ETF on Earth (Over 800 Listed) – If you can think of it, there’s probably an ETF for it. Scan this list of 800 strong to see if there’s an ETF constructed for your strategy.

Want More on ETFs? Visit ETFBase (my latest project dedicated solely to ETFs)

Career

Project Managers – Tips and Tricks – If you’re a current or prospective project manager, check out these tips and practices I follow as a Project Manager.

What’s the Best College Degree for Today’s Economy? It’s no longer Business. See what the up and coming careers are in demand in this new economy.

Your Employee Stock Options Don’t Have to be Worthless – By executing option strategies against your underlying collateral, you can guarantee yourself a hefty return regardless of what happens to your company’s share price.

Make sure to stay tuned via email updates or RSS so you don’t miss similarly themed articles in 2010 and beyond!

3 Low-Cost Option Strategies for Stock Market Speculation

Darwin — Thu, 29 Oct 2009 12:43:15 +0000

While stock market speculation is frowned upon by many main stream investors and journalists, options strategies that seek to exploit market volatility or complacency can reward investors handsomely under the right conditions. There is a fine line between speculation and hedging though, right? Airlines hedge their fuel costs (heck, I hedge energy costs for our family), multinationals hedge their currency (which has been especially important given recent currency volatility), and investors like myself hedge against a market downturn following an unprecedented 60% runup in equities with options (see How Stock Options Work). Are all these “hedging” examples really just speculation? If oil prices drop, that airline loses all the money it spent on those forward futures protecting against oil spikes. Does it really matter?

What does matter to me is that most novice investors start off on the losing end of options strategies because they’re chasing speculative returns without fully understanding the implications of the transaction they’re entering into. Depending on the exchange and timeframe you’re referring to, the prevailing data suggests that ~ 70%-80% of all options held to expiration actually expired worthless. This is grim news for enthusiastic neophytes looking to turn $400 into $4000 because they overheard some “hot stock tip”. The overarching message is that there’s no free ride. If it were that easy to make 10 times your money in a month, efficient market arbitrage would ensure returns would drop and retail investors would never gain an edge over the pros. So, rule #1 – don’t think you’re smarter than everyone else and think you’re going to get rich with stock options – in general. However, there are occasional “special situations” like when I predicted a buyout the day before it happened and the options contracts I recommended returned 6,000% overnight. Of course, I’m not too proud to admit that the dope I was, I didn’t follow my own advice and buy the options and I missed out on turning $400 into $24,000 overnight. But, once in a while, retail investors have a good call or want to only dabble with 50 bucks instead of 500 to speculate on a particular market move.

That being said, investors are going to speculate. However, they often speculate on those 80% of options that expire worthless. They often buy out of the money calls on the cheap looking for a big pop. Example: Apple’s recent earnings announcement – speculators thinking that Apple’s earnings were going to blow away the estimate were met with disappointment when the shares barely broached $200 and now they’re dipping below if they bought out of the money November 210 Calls. Those calls may very well expire worthless.

If you’re going to engage in speculation – in hedging – whatever you want to call it, would you trade off some of the possible unlimited upside gain for a much lower cash outlay, or even a net neutral cash outlay? What I’m saying is, you can employ stock option strategies for much less money than the several hundred dollars it usually costs to buy at the money or close to the money puts and calls outright. Here are a few methods and examples with different mechanisms but similar concepts – less cash out, respectable return potential, fewer hard feelings when the option strategy doesn’t pan out as you had hoped.

Hypothetical Speculative Option Strategy

Example Stock: Amgen (AMGN)

Current Share Price: $54

Situation: It is in the public domain that in early January, the FDA will be ruling on a much anticipated monoclonal antibody that has blockbuster potential. There’s a relative quiet period expected for the next couple months until the ruling. While the safety data is so-so, the efficacy is off the charts. If the therapy is approved, it could easily become a front line therapy and analysts anticipate peak sales of $7 Billion. Therefore, in the near term, there isn’t expected to be much volatility since the data has already been digested by analysts on the street and the FDA submission is under review. However, with a ruling on the submission expected in January, you expect that shares could rally substantially – in early January, before options expiration on the third Friday of the month.

The novice investor may buy 5 option contracts with a Jan expiry and $55 strike for 2.65 ea = $1325

However, by employing some of the lower cost option speculation strategies below, an investor could enjoy a decent return for a much lower cash outlay, in one case, even if shares don’t reach $55.

How’s $1325 Sound vs….

1. Stock Option Strategy for Speculation #1 – Debit Spreads

Investor buys and sells the same number of options contracts simultaneously and limits upside, but decreases cash outlay:

- Buy 5 contracts January $55 strike @ 2.65 ea while Selling 5 contracts January $60 strike @ .95 ea

5*(2.65-.95)*100 = $850

Max Cash Back is $2500; any run over $60 is capped.

Max Profit = $2500-$850 = $1650

Max ROI ~200%

Commentary: If said investor feels the stock wouldn’t run much past $60 anyway, why pay 2.65 per position instead of 1.7 per position? Only downside risk is the initial outlay if options expire worthless – $850.

2. Stock Option Strategy for Speculation #1 – Ratio Spreads

Investor buys 1 Call near the money and sells 2 Calls further out to offset the price of the 1 they bought. Very low initial cash outlay BUT – risky, in that there is unlimited loss if shares run uncontrollably since investor sold more calls (2) than they hold long (1).

-Buy 5 contracts January $55 strike @ 2.65 ea while Selling 5 contracts January $60 strike @ .95 ea

5*(2.65-2x.95)*100= $375

Max Cash Back is $2500; any run over $60 can initially still be a net profit, but after a few dollars, losses start to add up – model this out like I did and understand your risk if considering this strategy. See my real-life example of a ratio spread (or 2by1 put spread) I employed to hedge against a market downturn in the S&P500 for demo whereby my max return was 2200% on a $42 outlay.

Max Profit = $2500-$375 = $2125

Max ROI ~566%

3. Stock Option Strategy for Speculation #1 – Calendar Spreads

Investor Sells calls at a particular strike for a close month while buying calls at a later month for slightly more (due to time value) and hopes that the front month option expires worthless while adequate value still remains on the outer month long option. If shares run up early, it’s still possible to break even or make a profit since both options have value. If shares drop (and implied volatility as well), it’s possible both will expire worthless and the initial investment is lost.

- Sell 5 contracts on Dec 55 Call @ 2.05 ea and Buy 5 contracts on Jan 55 Call @ 2.65 ea

5*(2.65-2.05)*100 = $300

This could play out a few ways. If shares are still trading at say, $54 in December at expiry, the initial December options expired worthless, but investor still holds long January 55s which still have value. While impossible to predict exactly, I’ll assume $113 each since that’s the current Nov expiry and it’s now late Oct. These 5 could be sold for $113*5 = $565

Another way this may play out is that shares dip to 50 by December expiry, investor holds the long 55s Jan awaiting the approval and shares spike to $62. In January, they could then be sold for the $7 intrinsic price plus time value (say, at least $1) for 800*5 = $4,000

Let’s base on more likely scenario though where the front month options expiry worthless and the January options are still close to the money.

Max Profit = $565-$300 = $265

ROI = 88%

Commentary: This is good for range bound trading or an anticipated leap out in January such as the situation described in the example. Allow the front month sold call to expire worthless and then sell the long call remaining.

These are just a couple examples based on a hypothetical situation. The permutations are infinite and investors should both model out the situation they’re considering and also FULLY Understand Their Risk before entering into any option strategy. You could actually take on ratio spreads that are net even by assuming even more risk, or you could take on debit spreads with a larger cash outflow but with higher ROI potential. It’s really up to you to determine the situation, assess what’s likely to happen with a stock’s volatility, the likelihood of the binary event you’re considering and whether range-bound trading is likely over a relatively long period of time (a lot can happen in a few months).

So, what are your thoughts? Was it worthwhile discussing these strategies? Have you tried any of them?

How Stock Options Work Series: Covered Call Writing

Darwin — Sat, 12 Sep 2009 02:39:01 +0000

Covered Call Option Writing is the subject of this edition in a series on how to trade stock options for income, hedging or pure speculation (see How Stock Options Work: Puts and Calls for intro). As outlined in my introductory article, a call option grants the holder the right to exercise the option when a stock is “in the money” after the call seller had captured a premium for initiating the transaction. The call option owner (for all practical purposes) then captures the difference between the current share price and the strike price times 100 since an options contract controls 100 shares.

What is a Covered Call?

In the case of covered call option writing, the investor holds 100 shares of the underlying stock for each option sold. If you own 100 shares of corporation XYZ trading at $50 per share and sell 1 Call Option Contract with a strike price of $60 and January expiration for $500, as long as shares are below $60 upon expiration in January, you’d keep the $500 because the contract would expire worthless. If shares move past $60 and the option holder exercises the option (which they generally do at the very last moment, unless there’s a dividend date in play), you can either buy back the option or when exercised, your shares will be unloaded at $60, regardless of where the stock is trading.

Covered Call Option Writing Example – Real Life: Apple

Here’s an example I actually employed with Apple earlier in the year (and I continue to roll the same position as Apple shares continue to appreciate). Note that even though Apple shares DECLINED during the period of the transaction, I actually made money! $600 in 3 months time for holding a stock I wanted to hold anyway.

Bought 100 shares APPLE (AAPL) at 94.6 = $9460 Outflow
Sold a Call with April09 Expiry 110 strike for 11.30 = $1130 Inflow
Closed out Call (bought back) for $120 = $120 Outflow
==================================================
Purchase ($9460) – Current ($9050) = $410 loss on shares
Option Inflow ($1130) – Outflow ($120) = $1010 gain on option
Net Gain of $600 in 3 months when shares declined!!!

When shares move in the right direction, such as the move from when this was first published in Feb09, the gains are astounding. You can get both the capital appreciation AND the option income.

The details of the initial article: Apple Covered Calls

Benefits of writing covered calls

Selling covered calls works out great in a flat or moderately declining market. The investor captures income from the sold calls while holding the underlying stock that they want to hold anyway.

Tax Benefit Strategy - Let’s say you’re sitting on a huge gain on shares of a particular stock and it’s September. For tax reasons, you don’t intend on selling the shares until next tax year to avoid having to pay taxes next April. You’re resolved to hang on to the stock into the new year whether it moves up or down. So, why not sell a covered call with January expiration? In addition to the capital gain you already have and any additional gains, you can guarantee yourself the income from the sold call as well. If the share prices have run up significantly, an options contract is going to carry a nice premium for income.

If the stock moves past the strike price, it’s trouble right? Well, only if you sit on your hands – and even then, you’ve just reached your max gain, but you still made money – don’t we all wish we had that problem! You can always “move the chains”. This is what I’m doing now with Apple shares since they’ve almost doubled from when I first began this strategy. As long as there’s still some time left on the option, the holder at the other end isn’t going to exercise it because they’re leaving money on the table. There is plenty of “time premium” left on the option. They will ride it out. For full disclosure, I’ve been selling covered calls against Apple shares for some time now and at this point, shares have risen so quickly that the sold call is actually in the money now. I have a Jan 160 call outstanding against my 100 shares. But that’s OK! I’m sitting on a $7000 gain on the shares and I’ve made a few thousand dollars now selling covered calls on the way up. And what happens between now and January? Who knows – read on…

What do I mean by time value being left? Take a look at Apple as of 9/11/09. Share price is 172. The January 160 strike Call is 21.1, which means it’s worth $2100. The difference between 172 and 160 is 12. So, 12 (or $1200) is the intrinsic value (this is easy to calculate yourself). However, 21.1 minus 12 is 9.1. There’s $910 in extra value left on this option. If the holder exercised the 160 Call that I had sold, they’d be leaving all that time on the table, and I’d be given a free $910 today because I could just enter into the same exact position again.

You get Paid to Wait Around and do Nothing - With $910 of time value on the option and about 5 months to go until expiry, (this is a rough calc), I’m making about $910/5 = $182 per month for riding it out. The risk/reward toward January is such that a holder of that call option just might get around to exercising it though. If Apple shares are at 200 and there’s only $100 left in time value, they’ll give up the $100 to capture the $4000 gain (200-160)*100. So, that’s why I need to keep my eye on that position toward the end of the year, but for now, I’m just letting it ride.

What are the Risks of Covered Calls?

There’s no free ride. If there were, everyone would be doing it and market equilibrium being what it is, any easy gain would quickly be wiped out through arbitrage. Some obvious and not so obvious risks include the following:

You need to buy 100 shares of stock to be fully protected with a covered call. This puts many stock plays out of reach of investors. With Google shares in the stratosphere, do you want to be dropping $50,000 to start a covered call position? There are cheaper stocks and there are ETFs as alternatives (see this list of ETFs with their mid-year performance for some ideas).
You shares can decline. While obvious, if you weren’t doing a covered call strategy, perhaps you would have purchased only 30 shares of something. Now you’re buying 100. Keep in mind that you won’t lose “as much” money because your stock losses are offset by the option premium you received. However, to write another call option once your shares have already taken a haircut requires you to distance yourself from the purchase price emotionally and sell another call for what might be a net losing position.
You CAN have your shares called away. This can happen at any time. While it’s unlikely to occur with a lot of time value left on the option for the reasons I mentioned above, you do have to engage in a little dance with risk/benefit and perhaps close the position yourself.
Fees – Not only do you incur a trading commission each time you sell a new call option, but if your shares are exercised out from under you, you can incur significant fees as well; plus you need to buy back shares again if you want to start over and then you’re subject to the Wash Sale Rule.

Here are the top online options trading brokerages based on reviews and costing:

optionsXpress – Awesome $100 Signup Bonus Running Now. Plus, $12.95 for 1,5, or 10 contracts – flat fee if hitting 35 traders/quarter. Otherwise $14.95/trade. A good price for newer/smaller options traders. Stocks are $9.95 per trade if greater than 8 trades per quarter or $14.95 for 8 or less trades.

Zecco – Another incredible pricing scenario -

Get 10 free stock trades every month with $25,000 balance or 25 trades each month $4.50 otherwise

tradeMONSTER – $7.50 Stock Trades across the board. $12.50 Options Trades for up to 20 contracts.

OptionsHouse.com – An incredible $2.95 Stock Trading Price and $9.95 Options Contract Pricing.

Tradeking is widely knows as best in class for service and cost. I endorse TradeKing and I have an account myself. $4.95 stock trades and competitive on everything from Options to Margin. Check it out!

How do Stock Options Work? Trade Calls and Puts – Part 1

Darwin — Tue, 11 Aug 2009 02:50:05 +0000

Since I routinely post about stock options trading, investing, hedging and income generation and get the occasional question, “How do Stock Options Work?” or “How to Trade Stock Options“, I figured I’d do a series on the various types of stock options strategies out there (they are numerous!) by starting with the most basic stock option strategies: Trading put and call options. I’ll start with some definitions and then get into some real-life examples.

Stock Option Trading Basics:

A Stock Options Contract is a contract between a buyer and a seller whereby a CALL buyer can buy a stock at a given price called the strike price and a PUT buyer can sell a stock at the strike price.
1 Stock Option contract represents 100 shares of the underlying stock
Think of a CALL and a PUT as opposites.
You can be a CALL Buyer OR Seller
You can be a PUT Buyer OR Seller
Given Puts/Calls and Buyer/Seller status, there are 4 main types of transactions we’ll cover today – Put Buyer, Put Seller, Call Buyer and Call Seller
If you are an option buyer, you pay the listed “premium” for the option; conversely, as a seller of an option contract, you derive income equivalent to the “premium”

Key Options Terms are the following:

Strike Price: This is the key price that drives the transaction. For a Call option, if the underlying share price is BELOW the strike price, the option is “out of the money” and if so at expiry, it will expire worthless. For a Put option, if the underlying share price is ABOVE the strike price, the option is “out of the money” and if so at expiry, it will expire worthless.
Expiration: This is the last date the option can be traded or exercised, after which it expires. Generally, there are options traded for each month and if they go out years, they are referred to as LEAPS. The same concepts hold for LEAPS as the stock options contracts we’re discussing here.
Premium: This is just another word for the price of the option contract.
Underlying Security: For our purposes, we will be discussing stock options. If you’re holding a contract on Microsoft, you have the right (but not the obligation) to exercise 100 shares of MSFT.
Buyer or Seller Status: If you are the buyer, you have control of the transaction. You purchased the option contract and can execute the transaction or close it out or you can choose to allow the options contract to expire (usually only in the case where it is worthless). If you are a seller of an options contract, you are at the mercy of the buyer and must rely on the holder at the other end of the contract. There is the opportunity to “close out” the position

Stock Options Trading Example #1 – Call Buyer:

People trade stock options for myriad reasons. Often times, it is purely for speculative reasons. For example, if you believe that the Swine Flu pandemic is going to become particularly troublesome and a stock with a vested interest in supplying vaccines in large quantities would stand to benefit from such a scenario, then perhaps you purchase an out of the money call option on Novavax. If shares are at $4.28 today and you think they could rocket past $10 on a massive epidemic, then perhaps you buy the January (expiry) 10 (strike) Call option. The cost (premium) is .70. The .70 is “per share” so .70*100=$70. This means it’s going to cost $70 to buy a single option contract, plus whatever trading commissions exist. Since you paid .7 or $70 and the strike price is $10 per share, by January expiry (the third Friday of every month), NVAX shares would need to be at $10.70 in order for you to break even. In order to have made money (in lieu of commissions), shares would need to exceed $10.70. If, for example, shares rocket to $20.00 at expiry and you sell the options back to close it out just prior to expiry, you’d pocket the difference between $20 and $10 and reap (10*100shares) = $1000. Given your initial $70 investment, even though shares only went up about 5-fold from $4.28 to $20, the option returned over 14-times the initial investment ($1000/$70). As you can see, utilizing these leveraged instruments can lead to big gains quickly. However, most options actually expire worthless – about 2/3 by most conventional estimates. There’s no free ride. For everyone looking for a speculative home run, there’s a seller on the other side deriving income from a speculative buyer thinking that the stock WILL NOT reach the strike price they sold at, so they’ll get to keep that .7 at the end of the expiry in January. Note that at the other end is a Call Seller which is often someone engaging in covered call option writing strategies – this can be a lucrative option strategy worth checking out as well.

Stock Option Trading Example #2 – Put Buyer:

When wondering if anyone actually made money during the economic collapse, the answer is a resounding YES! People who were holding puts on Financial and Real Estate stocks especially, made large returns on investment given the precipitous declines in shares of those companies. If for example, you feel we’re in for another economic calamity due to commercial mortgages collapsing next, and all Financials are going to fall, you could buy a Put option on the Financials ETF XLF, which is representative of the Financial sector at large. With a share price of $13.34, let’s say you buy a Dec09 expiry Put with a strike price of $10. That means that you expect the XLF ETF to drop well below $10 per share by December. The premium (or your cash outlay) for such a play is .25, or $25 per contract. That’s relatively cheap. But keep in mind that you’re talking about a 40% drop to just break even. If the XLF collapses and returns to its March lows of around $6 per share, your put would be worth about $4 at expriy (10-6). That represents a 16x return on investment. Imagine the players that had the foresight to buy out of the money puts in 2007 and 2008?

How to Trade Stock Options?

There are various online brokerage outfits that allow you to trade stock options. For most outfits, you can buy options without any special requirements. If you’re looking to sell options, because your risk is much greater (or unlimited for selling naked/uncovered calls), you generally need to sign up for a margin account and agree to risk notifications.

Here are the top online options trading brokerages based on reviews and costing:

1. optionsXpress – Awesome $100 Signup Bonus Running Now. Plus, $12.95 for 1,5, or 10 contracts – flat fee if hitting 35 traders/quarter. Otherwise $14.95/trade. A good price for newer/smaller options traders. Stocks are $9.95 per trade if greater than 8 trades per quarter or $14.95 for 8 or less trades.

2. Zecco – Another incredible pricing scenario -

Get 10 free stock trades every month with $25,000 balance or 25 trades each month $4.50 otherwise

3. tradeMONSTER – $7.50 Stock Trades across the board. $12.50 Options Trades for up to 20 contracts.

4. OptionsHouse.com – An incredible $2.95 Stock Trading Price and $9.95 Options Contract Pricing.

5. Tradeking is widely knows as best in class for service and cost. I endorse TradeKing and I have an account myself. $4.95 stock trades and competitive on everything from Options to Margin. Check it out!