Options as a Strategic Investment » Financial Freedom

Creating Cashflow: Using Covered Call Strategy To Pay You Cash

admin — Sun, 27 Dec 2009 23:28:14 +0000

I’ll assume in this article that you already have the basic understanding of stocks and options. If not then it would be worthwhile to read about these investments first. The covered call strategy brings together stocks and options to form a third strategy…a cash flow strategy. The covered call strategy has a number of benefits that makes it an essential element of your wealth creation arsenal, namely it’s:
* Simple and quick to implement
* Easy to understand and track
* Produces fantastic cash returns on your capital
* Helps protect your portfolio from market fluctuations
* Fairly conservative…i.e. it’s not a high risk strategy
* A fairly hands-off investment once made which frees your time to concentrate on other things
So what type of returns should you expect from the covered call strategy? Well let’s examine the strategy and example first because this strategy has a range of possible returns. But before we rush out and implement this strategy I would like to highlight to you that the covered call strategy should only be used by those that already invest or intend to invest in stocks. Investors should not buy stocks simply to implement this strategy for one simple reason…there are better strategies available to you. That is not to say that the covered call strategy does not work for in this context…it does…it is just to say there are better strategies available. However, if you have a stock portfolio or intend to then the covered call strategy is a fantastic way of generating excellent extra income and at the same time lowering your investment risk.
Most investors simply purchase funds (whether actively managed or passive index trackers) and take a totally hands-off approach. Some more adventurous ones invest directly in stocks also in the hope that over time they’ll be able to enjoy watching their stocks rise in value. Their returns, also referred to as their payoff, is shown by a 45% line on a payoff diagram.
Informed investors…wealth creators…apply a different strategy.
The covered call strategy generates extra income by selling call options on stocks you own. You can think of it like renting your shares, much like you would rent out an investment property. Unsophisticated “investors” buy stocks and don’t rent them out. Would you buy and investment property just for it’s capital return and not rent it to someone to generate an income for you? Of course not…well the same applies to stocks.
When I say the word “options”, which are derivatives, many people instantly think risk. If you find yourself thinking these types of thoughts you don’t know options, and derivatives in general, well enough and you need to. Any investment is risky if you don’t know what you’re doing. As a former professional derivatives trader I know that derivatives need not be feared, but they must be respected. You need to thoroughly understand what you’re investing in if you ever hope to be wealthy. Ignorance is not bliss!
Selling, also known as writing, calls on stocks is not risky. It’s a conservative investment strategy. In fact, it is much less risky than just investing in stocks by themselves.
The mechanics of the covered call:
The covered call trade is a combination trade whereby you own a certain amount of stock and you sell call options of the same value. As the seller of the call options you receive a cashflow (the premium) from the buyer. You are effectively selling to the call option buyer the upside benefit of the stocks above the option strike price. You’ve agreed to sell your stock for a specific price by the option’s expiration date. They in turn pay you the premium for that benefit.
You are still exposed to the possibility of the stock price falls, but this is reduced by the premium income from the sold call, which is why it’s a more conservative strategy that owning just straight stocks.
Your potential income is also limited, as you cannot earn more than the capital increase in your stocks up to the call option strike plus the income from the sold calls. Above the option strike the buyer will exercise their option and you will have to sell them your stocks at the option strike price.
Covered call example:
Let’s say you purchased 1,000 XYX stocks for $50 each, totalling $50,000 in May and you sold 10 June $55 call options for $2.50 each, which expire 4 weeks from now. If XYZ stock goes above $55 to say $60 by the June expiry date you will be “exercised” and have to sell your stock to the option buyer for $55, which will be below the new June market price of $60.
Your compensation for this is the $2.50 premium on each call. Now the 2.50 call is actually $250 because the option in this example represents 100 shares. In the UK and Europe the multiple is usually 1,000, while the US is usually 100. Since, you’ve sold 10 options your total premium is $2,500, representing a 5% return on your $50,000 investment over 4 weeks (which is an amazing 89% annualized return!).
If the stock price falls below $50 your stock losses will be partially compensated by the extra $2.50 income from your sold options. This is why it’s a more conservative strategy than just holding pure stocks. If the stock remains at $55 you will receive your $2.50 and no capital gain returns on your stocks. Anywhere between $50, where you bought XYZ stock, and $55 where the option strike is, you will receive the same $2.50 and an increasing capital return on your stocks.
The maximum return you can hope for is always where your option is exercised. At $55 and above you will receive $2.50 in option premium and $5 in capital appreciation on your stocks. This is a total of $7.50 in 4 weeks, or 15% (which is a truly amazing 515% compound annualized return!).
Covered call variables:
The key variables are how long in the future do you sell you options, and what strike should you sell?
The further you look into the future the higher the sale price for an option. For example, in our XYX call option example the June $55 call was selling for $2.50. The July $55 call would be selling for slightly more than this, say $3.50. However, what tends to happen is that as you look further into the future the increases become smaller and smaller, so the August $55 call might only be only $4.00. So to get the maximum daily benefit from selling a call you should sell calls nearer to expiry, say up to maximum of 60 days. You can calculate and compare alternatives at the same strike by looking at the “per day” income. So in the case of our $2.50 option it would be paying us $0.09 per day ($2.50/(4*7), which is much higher than the $3.50 option return of $0.06 per day ($3.50/8*7).
The choice of strike is a more difficult question and depends largely on your view of the future movement of the stock. The higher the option strike you sell the lower the premium you will be paid, but the benefit is the less likely it will be exercised so you could earn more if the stock price increases. So where the $55 call was selling for $2.50 the $60 call might be selling for $1.00. If the price of the XYZ stock rises to say $60 you would earn $7.50 in the case of the $55 calls ($5+$2.50) and $11 in the case of the $60 calls ($10+$1).
The downside of the higher strike calls is that you loose more and more of your protection as you move to higher and higher strikes. For example, if the price of XYX dropped from $50 today to $47.50 at expiry, in 4 weeks you would have broken even on the $55 call as your $2.50 loss on the stock would be fully offset by the $2.50 option premium you’ve earned. However, in the case of the $60 call you would lose $1.50.
A good rule of thumb balance of downside protection and upside gain is to sell slightly out-of-the-money calls like the $55 call.
Another good rule of thumb is the strategy of buying your calls back if you can purchase them for 25% or less of the original sale price because the stock has fallen in price, and then reselling new calls for the original price. For example, say the price of XYZ stock falls from $50 to $45 and you can buy the $55 calls back for $0.50 and resell the $50 calls for $2.50. You have effectively increased your option return by $2.00 to a total of $4.50 almost entirely offsetting the $5 (i.e. 10%) fall in the stock price.
Covered calls for your wealth journey:
One of your key aims on your wealth journey is to generate a passive or portfolio income that will exceed your expenses. When you’ve achieved this you are no longer dependent on your job for an income and you can concentrate on building you wealth rather than working for someone else. You may not have a wealthy lifestyle but you are self-sufficient.
The wealthy sell calls on their existing portfolio, but those on the wealth journey may not have that luxury. In their case they may actually buy stocks so they can sell options to generate fantastic incomes returns. However, as I stated at the beginning the covered call strategy may not be the best option strategy to implement if you do not have an existing portfolio. That is not because it does not work, but because there are simply better strategies. However, let’s examine it anyway in this context.
Let’s say you’re able to accumulate $100,000 in cash perhaps from your investments or your home. Your $100,000 cash would allow you to buy $100,000 worth of stocks and sell the equivalent value of calls. If they generated a 5% monthly return for you, like our example, that’s $5,000 per month or $60,000 per year. This is before any capital appreciation or compounding is taken into account on your stocks. Those who want to take the wealth journey need to use strategies like this to give them the cashflow they need to live and invest, which provides you with the freedom to concentrate on finding more income producing opportunities.

Investing Now to Live the Life You Dream of

admin — Tue, 22 Dec 2009 23:38:03 +0000

Have you ever wondered why you haven’t achieved the financial success you so desire? Do you understand what it takes to reach that elusive destination, financial freedom? Anyone can have the success they desire. I dare you to become financially free.
A good definition of financial independence, by the way, is the control of an income stream sufficient to support your current standard of living.
You do not just fall into financial independence. More than anything else, the secret to real wealth is the mindset of wealth.
So you see, my dare is not really as outrageous as it might sound at first. By accepting the challenge, you are taking the first step to acquiring the mindset of wealth. You must be resolved to the fact that with wealth building, there must be dedication. And I guarantee that the opportunity to become financially independent is waiting for you, but you have to make the decision to go for it.
It’s up to you to take that step across the threshold of opportunity facing you now. It’s a decision you should have no hesitancy for. And when you do, you’re on your way to financial independence.
There are four major hurdles you must jump to become financially independent. I could go into a deep explanation of each step but I will save that for another time, I really want to discuss a powerful investment strategy. But I will briefly outline the four steps to financial independence.
So to get started, lets begin with the first of our skills of wealth building and that is earning. You must understand the two basic components controlling your earning power.
The first of these is our ability to perform our chosen line of work, that is, how well do we do what we do. The second and probably the most important factor controlling our earning power, is the demand in the marketplace for whatever it is we’ve chosen to do.
Second, you must build a financial protection account to cover all your expenses in case of an emergency, such as the loss of your income source. Saving is really the second important skill for acquiring wealth. You must have the discipline to build a protection account that will cover all your living expenses for your family, for a period of a year or two.
The third step in becoming financially independent is to begin an investment program. You want to achieve the highest returns on the money that you have designated for your investment program. Your objective now is to accumulate a mass of capital that will generate sufficient income to support your lifestyle without your having to work.
The fourth step to financial independence is too develop enough investment prowess to earn the extra income that allows you to fill your wants and desires. You have your needs met, but now you want to create the extra income that allows you to become financially free, this is where you can basically satisfy most of all your wants.
There, now that we have the four basic steps to financial freedom. I would like to carry on with the main focus of this article.
But I must make it clear that I had set up multiple Avenues of Income first, to put me in the financial situation that affords me the ability to test the waters of many different financial opportunities.
So, now I would like to discuss a powerful investment strategy. This is an investment strategy that has worked well for me in all types of market conditions. And by no means is this a strategy that I designed. In fact, it’s one that has been used successfully from a time long before the modern market and the stock exchange even existed. It’s called value investing.
Value investing is the best long term strategy for creating wealth that’s ever been devised. The theory behind it all is remarkably simple. You can become a value investor by investing your money only in under-valued assets. You can find under-valued assets in stocks and bonds, real estate or a wide variety of other investment opportunities. But whatever the investment asset may be, value investing boils down to the equivalent of buying dollar bills for pennies.
Now, I am sure you are saying “If it’s really that easy, everyone would be doing it.” I want to assure you easy as it actually is, everyone is not doing it. As with all great ideas in the world, only a few recognize them for what they are, and fewer still then decide to act on them.
Under-valued assets exist for reasons that range from fluctuations in the economy to fluctuations in human emotions.
It’s important to understand, however, that you can always find undervalued assets if you are willing to look for them. And, you don’t have to do this all by yourself. Look for investment professionals who operate investment funds and companies using this strategy. Through study and practice you will learn to accurately assess values as a basis for profitable investment.
Another key mindset of wealth is thinking and acting like a business person as well as an investor. Remember the better business person you are, the better investor you’ll be. And the better investor you become, the better business person you’ll be.
Please also keep in mind that value investing may offer important opportunities to take an active role in creating value in your investments. For example, you might turn an unwanted piece of real estate into an income producing asset, or turn a failing business into a thriving business, or create a new product or service based on a need or want you see in the marketplace.
Another form of value investing is investing in yourself and your abilities. There are many ways of increasing the cash flow into your families finances.
Setting up avenues of income that could hold the possibility of creating a passive and/or residual stream of income. If you take the opportunity to set up another stream of income, you would really be increasing your ability to grow anyone of your other investments. And, there are many ways of creating an extra souse of income that doesn’t consume every spare minute that you have. To the contrary, making such a move in your life would possibly result in you’re having even more free time to do the things you love.
The options are endless. The possibilities of a whole knew future are there for the taking.

Millionaire Habit 5: Love What You Do

admin — Sun, 06 Dec 2009 11:26:16 +0000

The most common question that people ask about getting rich is, ‘What is the best career or business that will make me the most money?’

Should I go into education? Food? Insurance? Network marketing? Heathcare? Options trading? Property? What’s the best industry to be in right now?

Well, you will find that in ANY industry, there will be a minority who will be making plenty of money, while the majority will be struggling to survive.

So my answer to that question is that you can become a millionaire in ANY INDUSTRY, only if you are one of the best! If you are not one of the best, you will never become rich in ANY industry.

You CAN become a millionaire in insurance, property, options trading, children’s education, pest-control, retail, food or Internet marketing ONLY when you are one of the best.

So, how do you become the best in the market? The answer is by being totally, absolutely one hundred percent committed towards your particular career or business.

All successful individuals have one thing in common. They love what they do. And because they have such an intense passion for their particular career or business, they do not distinguish work from play.

Their work is their play and vice versa. As a result, they spend every single day and every waking hour working (to them it’s not work), and that is why they become so good at it that they become market leaders and experts.

Have you ever wondered why Bill Gates, the richest man in the world who is worth US$46 billion still works 18-hour days, every single day? Why doesn’t he just sit back and relax on the beach?

The reason is because like all millionaires, what drives him is never really the money per se; it is the love of being at the forefront of technology.

It was his obsession of ‘putting a computer in every home running Microsoft software’ that made him the best in the field.

Many people have the belief that millionaires are people who are just naturally more motivated, disciplined and focused.

The truth is that when anyone does something he or she loves, the motivation, focus and discipline always comes naturally.

If you find that you lack the motivation and discipline to become successful in what you do, the reason is very obvious. It is not your passion!

Think about it. Do you have a natural passion for something? Do you have a hobby? Like playing golf? Looking at beautiful women or men? Computer games? Football? Playing with children? Haven’t you noticed that whenever you are doing what you love, the energy never stops?

It’s like no matter how tired you are, you will always find the energy to do what you love. Well, this is the secret that will lead to your success and wealth!

You have to find something you are extremely passionate about and build your career or business around it!

When you do, you will find that you will be naturally focused, committed and energized to work at it. When you give your best to whatever you are crazy about, you will become the best!

So start asking yourself:

·’What do I love to do?’ ‘What would I do even if I didn’t get paid?’

·’If I had all the money in the world, how would I spend my time?’

·’Who are people who have made their fortunes around this passion I have?’

I guarantee you that when you start looking for them, you will find no lack of role models you can learn from. Remember, do what you love and you will never work another day in your life!

Selling Options… Is It Really One Of The Best Ways To Wealth?

admin — Sun, 29 Nov 2009 01:20:38 +0000

Warren Buffet has become something of a modern day financial icon. A beacon to the success that can be achieved in the free markets. He has just been officially named as the richest man in the world, worth a staggering $62 billion. His company, Berkshire Hathaway, has beaten the S&P 500 index by 14.65% over the past 30 years. His investment strategy has been closely examined yet few follow his incredibly successful investment style and as a result miss these stellar returns. Why? Because his investment style is boring. What I mean is long term in nature and rather inactive. It’s steady as she goes. It’s not a fast paced, action packed ride to riches. It’s a slow consistent walk to wealth.
So what does all this have to do with option selling? I’m glad you asked. While Warren Buffet does not sell options to generate his wealth, the concept of option selling is also slow and on the whole rather boring. It is not fast paced nor will it result in a fortune being amassed overnight. But sure as the sun sets at night and rises in the morning it will provide the educated and patient investor with fantastic returns and wealth.
Selling options mean selling either calls or puts (or both). If you recall the definition of an option is a contract which conveys to its holder the right, but not the obligation, to buy (calls) or sell (puts) shares of the underlying security at a specified price on or before a given date. This right is granted by the seller of the option. So it is the option seller who has the obligations because they have sold the rights to the option buyer.
The option seller receives the option premium in return for giving the right to the option buyer. The option premium represents the entire income the option seller can hope to achieve, while his losses are theoretically unlimited. The option buyer on the other hand can only lose the option premium while his return is theoretically unlimited. So why would anyone sell options? Why doesn’t everyone just buy options if they have limited loss and unlimited profit potential. The main reason is probability!
Options are very much like a raffle ticket. When you buy a raffle ticket it costs you very little and the vast majority of times you don’t win anything. You simply say to yourself that it’s cost you only a few dollars and if you were the lucky winner you’d have won big. But why do raffles exist? They don’t exist with the winner in mind. They are not altruistic games designed to give more than they take…oh no, quite the opposite. They are designed to offer the raffle holders a nice return on their raffle.
They know that the cost of paying the winner is less than the income they earn. The same rules apply to options. Investors who understand options know that over time that the loses they have to pay to option buyers will be less than the income they earn from the premiums the buyers pay. Studies suggest that between 75% and 80% of options held to expiration expire worthless. This means that option sellers win 75% to 80% of the time!
In addition to probability there are other reasons in that make selling options incredibly attractive as a wealth creation strategy. They include:
* Excellent returns
* Set and forget
* Inbuilt safety factor
* Consistent income
* Win in all market conditions
* Less risk
* Time is on your side
Let’s quickly look at each of these in turn…
Excellent returns:
Selling options can provide a knowledgeable and experienced investor amazing returns…returns like 30% to 50% per annum. One of the best ways to look to understand this is to look at a simple example. Gold in February 2008 had just broken $900 an ounce and all the news was majorly bullish for gold. It had already seen a spectacular rise over the past few years but market conditions meant there was every chance it would continue to rise…but most importantly it was not about to fall…at least not beyond a natural pull back.
Someone was willing to buy the 01 June 08 $525 put options for $0.10. I guess they figured “what the hell it’s only 10 cents per option…it’s worth a punt.” Fantastic! I knew that each option I sold represented $10 (100*$0.10) in income and the initial margin was $34 per option. Gold would have to fall by a whopping $400 an ounce in a little over 3 months to be exercised. Now I’d probably have better luck winning the lottery than being exercised on these options (and odds on winning the lottery in the UK are about 14 million to one!).
Now $10 may not sound like much but we need to look at this in terms of return on capital invested. If you can generate $10 on $34 worth of capital invested you are returning nearly 30% over 3 months, which is nearly a 250% compound return per annum. I’ll take those odds and that return!
Set and forget:
While I never suggest that you ever invest in anything and totally ignore it from then on, selling options is about as close to this as it gets. When you sell an option you target options that have very low chances of ever being exercised. How? You look for way out-of-the-money options and you apply sound fundamentals. For example, the Dow at the end of Feb 2008 was 12,700 and all the news was incredibly bearish for the markets. Inflation was at record levels, the dollar was in free fall, house prices were plummeting, consumer sentiment was falling, retail sales were stalling, credit markets were frozen, profit warnings were occurring daily and so on.
I was totally comfortable that the Dow was likely to fall, but what I couldn’t predict was when and by how much and whether it might go up slightly before it went down. What I was certain was that it was not about to trend upwards. Selling futures, CFDs, spread bets etc requires excellent timing. You might be correct on the overall direction, but without deep pockets you could get stopped out first before the market moves your way. The solution? Sell deep out-of-the-money Dow calls. I sold 15 May 13,500 call options for $140 premium. That means that the Dow would have to rally above 13,640 before I would start to lose money. That is not far from its all time high! At writing the Dow is at 12,200 and my calls are now valued at $17 giving me $123 profit per option. I don’t have to watch my calls minute by minute, hour by hour, day by day. I’m totally comfortable that they will expire worthless and I will earn $140 per option.
Inbuilt safety factor:
One of the biggest problems with using stocks, futures, CFDs, spread betting and other financial products that have a linear type return (i.e. their value moves up and down at the same rate).This means that you need to have excellent timing and deep pockets to use them effectively. While I love the adrenalin that these products give me they do not have the type of safety factors that help me to sleep well at night.
How many times have you bought a stock, futures contract etc on the expectation that its price will rise and sure as night follows day the price immediately starts to fall. Soon you find yourself stopped out only to see its price turn around again and rally just as you originally predicted. Essentially these products give you only a small margin of error. If you have more money to play with you can afford to place wider stops, but the fact still remains…you need to time your entry and exist points fairly accurately.
We all know that markets do not move from point A to point B in a straight line…they zig zag their way there…sometimes with quite violent corrections. The more volatile the market the more difficult using linear products becomes, because your likelihood of being stopped out increases. Options give you that margin of error that means you don’t need to worry about timing to anywhere near the same degree.
Option sellers have a much higher degree of staying power. They can withstand the zig zagging of the markets much better. For example, if a market is in an uptrend you can sell an out-of-the-money put at a level that gives you a very large level of comfort that the price will never fall to a level where your option will be exercised. Timing the market is much less important.
Consistent income:
Those that sell options can enjoy a regular income month after month. It will not provide you with a 1,000 percent return in a year, but with education, practice and good option selection you can enjoy 30 percent to 50 percent annual returns. But there is a lot to be said for receiving excellent, regular and fairly stress free income. Everyday your options are getting closer to expiry and time decay is eating away at their value. Every month you can receive income from your options expiring.
Win in all market conditions:
It is said that markets go up, down and sideways. In actual fact they go up a little, up a lot, down a little, down a lot and sideways. With linear products you can only win with one third of the movements. For example, if you are bullish, then you will loose if markets go down or sideways (or at least not gain anything). However, if you sell a deep out-of-the-money put option to take advantage of your bullish view then you will win with four out five market movements. In other words you will win if the market goes down a little (it will not hit your put’s strike price), stays flat, goes up a little or goes up a lot. You will only loose if the market falls sharply.
Less risk:
When most uneducated investors think about options their first reaction tends to be “that sounds risky”. In actual fact options are a lot less risky than trading stocks, futures, CFDs etc. The key reasons why options are less risky are:
* Inbuilt safety factor – options have an inbuilt level of safety because you can sell out-of-the-money options that are very unlikely to be exercised.
* Most expire worthless – we know 75% to 80% of options expire worthless.
* Insulation from market movements – Option prices do not move one for one with the underlying price. In other words if the price of the underlying goes up one point your out-of-the-money option price will only change by a fraction of this, say 0.25 points. This means that if the market moves against you your option price, and thus losses, will not increase anywhere near as much.
* Less likelihood of being stopped out – by selling out-of-the-money options only on extreme market movements will stop you out.
Time is on your side:
Those that buy options need the price to move beyond the option strike price (plus the option premium) before expiry if they are to make money. From the moment they buy an option time is working against them…it is a race that the price can move enough before their time runs out. For the option seller it is exactly the opposite. From the moment they sell their option they have been paid and the option’s time is working for them. Every day the option’s worth becomes a little less to the option buyer and a little more to the option seller. The option seller does not have the pressure that time will run out…the option buyer always wants more time, while the option seller happily watches time run out.
I hope you’ll agree that option selling is a powerful method of generating low pressured, consistent and extraordinary returns. Novices steer clear of options. Those that are uneducated buy options outright. Experts sell options. Writing options is not for everyone…in fact it is only for experts. Don’t be put off by that…become an expert…anyone can. Then you can receive the rewards that are just waiting for you.

How Do You Sell Options To Generate Amazing Returns?

admin — Sat, 28 Nov 2009 11:31:32 +0000

In this article we will look at how to effectively implement this strategy to increase your wealth. But before we do it’s important to recognize that this strategy offers you the benefit of cash returns and easy access to your capital. Why are these things so important?
Cash returns:
Let’s look at cash returns first. The best way is probably to use a comparison to another investment alternative such as property. Too many investments don’t offer you good cash returns (only good capital returns), but your ability to generate cash is essential to achieving the freedom you need to pursue attractive wealth creation opportunities. In the UK at the moment the average rental property will generate approximately 5% return. Let’s say you need $50,000 to live each year and you have managed to accumulate $100,000 in savings.
If you decide to buy a $200,000 property and you invest your $100,000 and borrow the balance at 5% you would generate a positive $5,000 net cash return every year (assuming no other property related costs such as management fees, repairs, etc). In essence you’d have to by 10 properties to generate the $50,000 annual cash you’d need to survive. That could take a long time and in the mean time you’re spending your productive hours working for someone else to earn a paycheck to live off…and missing loads of opportunities. I love property as an investment and own numerous rental properties but it is not a great method of generating cash flow…well not without a great deal of work!
Selling options on the other hand can pay you a cash flow in the terms of a premium every month or two. It’s a regular cash flow that you can use to help you quit your job and spend your time building your own wealth rather than your employers. Using effective options strategies that generate between 30% and 50% returns per year would earn you $30,000 to $50,000 per year off your $100,000 savings in a regular monthly income. This would give you incredible freedom and independence to spend your productive hours working for you not an employer. This is the importance of cash flow.
Access to capital:
The second key thing to remember is that options allow you quick access to your cash. Property in contrast takes many months and large costs to realize your cash investment. Your option investments require you to place initial margin with your broker to cover the risk of potential losses, but since your options expire every month or two you receive your initial margin cash back each time. Also it is really easy to buy or sell your options back at anytime at a very small cost (commission) to gain immediate access to your cash if you need it. This is often one of the main benefits cited by Wall Street to investing in stocks.
So now that you know two crucial reasons why options are vital to your wealth creation arsenal it is time to examine option selling strategies…
Option selling:
I like to use an example as a way of illustrating the strategy of selling options as a means to generate brilliant returns. I’ll assume you are familiar with selling calls and puts and that you know your returns are limited to the option premium you receive and that your losses are theoretically unlimited. Though I will elaborate on what this really means as we work through the example.
On the 28th March 2008 gold was trading at $932 an ounce. The June 1 $700 put was bid $0.90 which means that each option is trading at $90 (i.e. 100*$0.90). Now at this stage it helps to actually have a view on the instrument you are trading. In the case of gold I have been extremely bullish for a long time due to a number of factors including the high U.S. inflation rate, collapsing U.S. dollar, poor current account, falling interest rates, huge government and private sector debt etc which all indicates that investors will move their money to a “safe” investment…gold! Now the point here is that I don’t know when gold will rally nor do I know that it will rally really at all…what I’m confident on is that it won’t fall very far. This means I can sell put options confident that fundamentals mean that the price of gold should not fall from current levels…and even if it does it’s not going to fall to $700 an ounce by 1st June.
Each gold option is worth $93,320 (i.e. $932*100) so selling one option and earning $90 in two months might not sound like much but we need to look at it from a few different angles. A $90 return over two months on $93,320 is an annual 0.6% return which quite frankly is rubbish, but this is not the way to really look at this investment. The notional (face value) of the option really doesn’t matter. Why? Well because that is not what you are paying for the option. You are not really buying $93,320 worth of gold (or even $70,000 worth at the strike price), but rather a way out-of-the-money put which requires you to only pay a small initial margin.
The initial margin on one gold $700 option is about $900 which means that over a two month period I would be able to generate a $90 return on a $900 investment. Viewed this way my return would be 60% per year (i.e. 10% every 2 months)! Now that’s an amazing return…so does this mean I should rush out and sell 100 puts and generate a $9,000 cash flow over the next two months? Well not unless you were worth millions I wouldn’t recommend it. Why? Because the unforeseen can happen. Selling 100 $700 put options means that for every dollar the price of gold falls below $700 you would lose $10,000 (i.e. 100 options * $100). So if the price fell to $650 you would lose $500,000. Ouch. So what do you do?
You strike a balance. You never expose yourself beyond what your can afford to lose in an individual trade and you manage your risks via stops. Taking the $100,000 cash worth example what would happen if you sold 5 options. Well you could earn $450 in two months (i.e.5*$90) equating to $2,700 per year in income. Your initial margin to the broker would be $4,500 (i.e. 5*$90) still giving you a 60% annual return. Your risk is now $500 per dollar below $700, which is a fully manageable exposure on your $100,000 capital given the extremely unlikely possibility of gold falling that far.
The second way of managing your exposure is through stops and the KISS method is always the best method. Easy to understand and easy to implement. The two best methods I know of are:
1. to stop out when your option doubles in value against you (or triples for the more adventurous). This method is simple and effective for the more risk adverse investor. I’ve found that it’s not always the best when you are selling way out of the money options as you can be stopped out but still never really be at risk of your options being exercised, thus forcing you to take losses unnecessarily. But it is the safest route.
2. to stop out when the price of the underlying reaches your strike price. In our example your stop would be at $700. The problem with this method is that your losses would be much higher than the first method but obviously the likelihood of your stop being breached are much lower.
The strategy I usually use is to find many of these attractive deals and never expose myself too much to one trade (a lesson I’ve learned the hard way!), which will ensure you will sleep peacefully at night…just as I do! So if you take the above scenario how many trades should you place at any one time? Well you need to find a balance between putting your capital to work (i.e. your $100,00) which is used it as initial margin on trades and saving enough of it such that you can meet margin calls if positions go against you in the short term, so you are not forced to close positions or make margin calls. Again applying the KISS method is easiest and the simplest way is to put no more than 50% of your capital as margin at any one point in time. Any more than this could lead to unnecessary stress of margin calls if positions go wrong and means your positions are too large.
Taking our gold example and replicating it to other trades we could place $50,000 as initial margin which would generate a $30,000 annual return ($90*$50,000/$900*6) or a 30% annual return. I now enjoy a fantastic regular income on my cash capital through options investments and non-stressfully earn a comfortable 30% to 50% annual return on my cash capital.
The final word on gold…
Was I right about the price direction of gold? Yes and no. The price of gold (at the time of writing) has actually fallen to $882 (it has been as low as $850) so my expectation that gold would rally from $932 proved slightly wrong (or at least premature!), but was i really wrong? Well the price of my options have fallen over the past month and a half from the $0.90 I sold them to be worth virtually nothing. So even though the price of gold has actually fallen I’ve made money…wrong and still right! Options are truly an effective wealth tool.