Friday, March 14, 2014

Update on Generating $1000 Monthly Income

In yesterday's entry, I spoke about InvestorPlace's Lawrence Meyers' discussion of three stocks on which to sell naked puts to generate $1,100 in monthly income.  My assessment of his recommendations was that they were a bit on the riskier side, and did not address the question of margin requirement.  I offered a safer version in Altria (MO), just as an example.  I did not elaborate, nor give my own version of how to generate a similar income stream.  I shall attempt to do so now.

Admittedly, MO is not a high-flying stock, and perhaps for that reason does not command high option prices.  But it is relatively safe, in that it is a steady stock, not prone to wide fluctuations in price.  Selling OTM puts likely will not trigger assignment.

Clearly, that's not the only possibility.  I like Mr. Meyers' suggestion of Starbucks (SBUX).  As discussed yesterday, its current market price is $74.43, and the Jul14 72.50 strike put goes for 3.10 on the bid.  Let's stay with Mr. Meyers' recommendation to sell 2 naked puts.  MR: $5,444.00.  Income generated: $620.00.  ROI: 11.38%.

My next choice is Yahoo! (YHOO), at $37.23.  It may seem somewhat volatile to some, but here is my rationale.  Since its new CEO, Marissa Mayer, took the helm, the stock has rallied substantially, perhaps because of the expectation of good things to come.  In fact, YHOO rallied above $41, and has recently settled back down to the $37 mark.  In light of the selloff of March 13, 2014, the stock is even further down in price.  This is usually a great place to sell naked puts with the expectation of a bounce.  The Jul14 OTM 36 strike puts are going for 2.51 on the bid.  Let's sell 2 naked puts.  MR:$2,762.00.  Income generated: $502.  ROI: 18.17%.

Next on my list would be Boeing (BA).  With its recent pullback from a high of around $141; its multiyear contracts around the world, Boeing is a stellar company (pardon the pun!) which should continue its high-flying (a'hem) performance.  Currently at $121.71, the Aug14 120 strike price put goes for 7.25 on the bid.  Again, we will sell 2 puts.  MR: $9,627.00.  Income generated: $1,450.  ROI: 15.06%.

Note that all of these stock put options (I kept them down to 3 for the sake of examples) expire either July or August 2014, for an extra margin of safety in terms of time, to allow them to recover from recent selloffs, and simply grow as part of their normal cycle.

The total cash produced by selling 2 naked puts each of SBUX, YHOO, and BA comes to $25.72 or $2,572.00 total, with a total margin requirement (MR) of $9,167.90 (calculated as $46,674 x 35%-$9,740+$2,572).  ROI: 28%.

Instead of generating $1,000 per month, you would be generating $2,572 for about 5 months.  Not as good a return, but probably a safer return when compared to the test case of Mr. Meyers' recommendations for an income of $1,100 on margin requirement of $13,712, for an ROI of 8.02%.

Please note again that the numbers above are based on a hypothetical 35% margin requirement for the underlying stock.  Your brokerage and stock selection may require more or less margin.

CAVEAT: None of this constitutes stock recommendations.  These are merely examples.

CAVEAT:  Another caveat is that I am arbitrarily taking 35% of the underlying stock price in calculating margin requirements.  Note that not all stocks qualify for 35% - some have a 50% requirement, others only a 25% requirement - and some of this depends on the individual brokerage house.  These examples are educational only.

Thursday, March 13, 2014

Generate $1000 Monthly Income! - and a Primer on Put Options

A few days ago, InvestorPlace contributor, Lawrence Meyers, wrote another one of his columns touting the virtues of selling naked puts to create monthly income.  I had taken issue with his suggestions before, and emailed him my opinions, and he was quite gracious and affable.  This time was no different, in the sense that I disagreed with his approach, but unlike the first instance, I refrained from writing to him again: He already knows that I disagree, and that would seem simply annoying.  I decided, therefore, to post it here and explain my position vis-a-vis his.  To read his article of March 10, 2014, please click on 3 Naked Puts for $1000 in Monthly Income.

The strategy of selling naked puts is one of the soundest, least risky of all option strategies.  Without getting too technical, this strategy permits for the underlying stock to rise, stay at the same price, and even fall a little without generating losses, unlike buying calls which require a bullish upward move, or its opposite, buying puts, which requires a bearish downward move by the underlying stock.  Not so with naked puts.

Here is a very abbreviated lesson in selling naked puts:
Puts are options which permit the owner of the put to sell the underlying stock at the strike price of the put, but obligate the put seller to buy the underlying stock if put to him.

BUY a put - you own the right to sell the stock.
SELL a put - you obligate yourself to buy the stock.

Why would you want either one of these conditions? Say your grandmother gifted you a stock a few years ago, and it has gone up in price.  Let's say Altria, symbol MO.  At the time she gave you the stock, its price was $15.  Today it is trading at $36.00 or so.  To protect your gains, you could buy a put on MO.  Put (and call) options are designated in strike prices and expiration dates.  Usually, the farthest out in time, the more costly the option; and the deeper in the money the strike price, the costlier it is.

Some definitions are needed here: 
ITM (in the money) put - the put strike price is above the current market price.
OTM (out of the money) put - the put strike price is below the current market price.

Stock: Altria
Symbol: MO
Market price: $36.00.
Put strike: $35 - OTM
Put strike: $39 - ITM

Got it? Take a look at the following options chains for MO:
The yellow highlighted area represents ITM strike prices - any price above the current market price (indicated in the left column of this graphic).  If you compare the strike prices between the white and yellow sections, you will confirm that as the strike price moves more deeply ITM, so does the price/cost of the option. In the above graphic, the 34 strike price is listed as 0.07 x 0.11, while the 36 strike price is listed as 0.50 x 0.54.  These are bid and ask prices, and might require further elucidation, but are not quite germane to this conversation.  Suffice to say that for puts, the deeper in the money (ITM), the costlier the option.  That would be true whether you buy the put or sell the put.  A light bulb should now light up: If you sell the ITM put option, you would also get a higher premium! Yep! More later.

The graphic is as follows:  For the bearish put, the put you buy (also known as the long put), the graphic would look like this:
 Notice the P/L graph on top - as the price of the stock decreases, your profit increases.

Conversely, to sell a put, the graphic looks like this:

Again, the P/L increases as the stock price decreases.

The strategies available with selling puts are many, to wit: generate income, generate immediate usable cash into one's account, hedging stock, and the possibility to buy stock at a discount.

Let's get back to MO.  At its current price of around $37.00, selling a Jun2014 36 strike put brings in 1.94.  Keep in mind that options are sold as contracts, and each contract controls 100 shares of underlying stock, therefore, 1.94 per contract would equal $194.00 in your account immediately.

What are the implications? You have sold someone the right to "put" the stock (MO) to you at a price of $37.00.  This is ITM, as this strike price is higher than the current market price of the stock.  Why would the put owner want to sell you the stock at $37.00?  If MO were under that price at expiration.  It makes sense: If the buyer of the put wanted to protect his own stock at a level of $37.00, and the stock declined to $35.00, he owns the right to sell his stock at $37.00.  After all, he bought that insurance policy guaranteeing him that right.  You, as the seller of that insurance policy, have agreed to have MO "put" to you at $37.00, and for that agreement, you got paid a premium of $194.00.  Just like any insurance company collects premiums year after year, sometimes it has to pay out, and it is obligated to do so because it has sold you that right. Some simple calculation reveals that your break-even cost on MO shares would be $35.06 ($37-1.94).  That is almost $1.00, or about 2.77% less than the current market price.  Oh, by the way, that would be for a mere three months! Annualized, that return would be 11%.  Not too bad.

But, you may ask, what happens if the stock RISES above my sold strike of $37.00? Well, then, you keep the entire $194.00, and move on to the next trade.  In either case, you keep the $194, whether the stock is put to you, or rises above the strike: You keep the $194.00.  

You have several choices when you sell a naked put: You may hold onto it, and watch the stock to see if it rises above the strike; you may elect to have it put to you if you absolutely love it and want to own it, but at a discount; or you may close your position by buying back the put! In the example, you received $194 for selling someone the right to put you the stock.  Suppose you hear some news that makes you change your mind about owning MO? Simply go to the marketplace and buy back to close you naked put.  No muss, no fuss. The cost you will incur is whatever the stock/option prices are at the time you wish to buy back to close.  If the stock has moved up - in your favor - the put option will be cheaper, thus buying it back more cheaply realizes a profit for you.  The opposite may be true - the stock is lower on the market, and thus your option may be costlier (depending on how much time remains to expiration).  Either way, once you buy back to close your position, your obligation is likewise ended.

Let's get back to the object of this entry: Lawrence Meyers' article in InvestorPlace (above). 

In fact, he proposes establishing naked put positions on 3 stocks, Dollar Tree (DLTR), Encore Capital Group (ECPG), and Starbucks (SBUX).

At the time the article was written, DLTR was trading at $54.33, and the April 55 puts were yielding 1.70.  ECPG was trading at $48.69, and the April 50 put was yielding 2.10.  SBUX was trade at $73.07, and the April 72.50 put were yielding 1.70.  Mr. Meyers analyzed each of those stocks in terms of earnings and chart patterns and other criteria, and suggested selling 2 naked puts of each stated position, for a grand total of $1,100, a bit better than his $1,000 monthly income come-on. Simple calculations reveal the $1,100.

Here's the problem (there actually are two problems with the above scenario).  True, one of the biggest caveats for selling naked puts is that you must want to own the underlying stock.  What troubles me is that Mr. Meyers is proposing selling ITM puts. For both DLTR and ECPG, the proposed naked puts are ITM.  SBUX is OTM.  My own preference is to not have the stock put to me; I'd much rather just collect premium, and either buy the position to close more cheaply, or let it expire.  In order to generate substantial income, one can go much further out in time and collect a far larger premium even by going deep OTM.  For exam, with DLTR at $54.33 at the time of the article, the Aug14 52.50 put yields 2.00.  There is significant safety in staying OTM and going further out (as of this writing, March 13, 2014, DLTR has declined to $54.21).  What about ECPG? With a 200-point Dow Jones decline today, ECPG declined to $47.11, and the Jun14 45 put is going for 1.55.  SBUX today is trading at $74.43, and Jul14 72.50 put yields 3.10.  All these stocks are now OTM, and selling the same 2 naked puts together would yield $1,330.00 just to extend the time a bit.  With a precipitous fall in the Dow Jones today, it is also likely that there might be a snap back in the next few days, thus increasing the underlying stock prices. Here, your return is higher, while your safety margin is much wider.

Let's consider our friend, Altria.  At the current $36, the Jun14 35 put yields 0.93.

The second problem in Mr. Meyers' analysis is that he does not discuss margin requirement.  Selling put premium is attractive (in fact, it's my favorite strategy), but in order to be approved for that, one needs to post a bond of sorts.  That bond is a formula constructed by each brokerage house, but is fairly commonly assumed to be as follows: 35% of the current underlying stock price - OTM amount + premium.  With our friend, MO, 35% of $36=$1,260-$100+$93=$1,253.  That is the amount of money on hold to be able to sell a naked put on MO for Jun14 and receive $93.  What is your return? $93/$1253=7.42% for 3 months.

'Nuff said.

Wednesday, January 22, 2014

Learn How To "Protect" a stock, AND Simultaneously Generate Income

I love the versatility of options. 

Consider JAZZ Pharmaceuticals (JAZZ).  This stock has had an upward chart since its inception, currently trading at just under $155.00.  Some time ago, I sold a naked put on JAZZ at a $105 strike, expiry in 2016.  I collected a premium of $16.42, or $1,642.00 for each contract (recall that options trade in contracts, each contract controlling 100 shares, ergo, $16.42 x 100=$1,642.00).

Since that trade, the stock has rallied about $40 (or 40 points in the "lingo").  I'm beginning to wonder if it's going to pull back some, and I want to protect my profits from the sale of my put.

Recall that if you sell something, you take money in; while if you buy something, you pay money.  When you sell a put, you take premium money into your account; likewise, if you buy a put (or a call, for that matter), you pay money.  In this case, I sold a put, and received a premium of $1,642.00, as above.  That premium is now down to $868.00.  Since it is less than what I received into my account, it follows, then, that I would have less to pay in order to close this position.  In this case, to buy the put back to close, I would have to pay $868.00, but since I received $1,642.00, my profit would be $774.00, or 47.13% of my original premium.

But wait, there's more ...

As long as JAZZ remains so far above my sold strike price of $105, the likelihood of being "put" the underlying stock are relatively slim.  Therefore, I am inclined to keep my naked put and let it continue to "cook" until expiration.  This exposes me to some risk (that the stock will pull back dramatically, and I will be put the stock, in which case my basis would be $105-16.42=$88.58). 

So here's my dilemma, for lack of a better word: The stock is currently trading at about $155.  If I wish to "protect" that price of $155, I can do a couple of things: Buy a protective put at the $155 strike price, or sell a Bear Call Spread, or buy to close my naked put position.  Let's examine these possibilities (we've already discussed buying back the put to close the position).

If I buy a $150 strike put expiring in, say, January 2015, it would cost me $25.90, or $2,590.00 per contract (each contract controls 100 shares).  That's rather expensive.  But I can mitigate that cost! How? By selling monthly puts against it.

The next expiry is February 21, 2014.  The JAZZ $150 strike put currently sells for $4.30.  That means that my total outlay would be $2,160.00 ($2,590.00 - $430.00).  The caveat, of course, is that I have to be pretty comfortable that JAZZ would close above $150 by the February expiration, or it might be put to me at $150.  If it is put to me at $150, my basis would be $171.60 (because I paid $2,160.00 to own the protective put).  However, if the stock does decline and is put to me, I am not obligated to retain it - I exercise my $150 put.

If JAZZ remains above $150 by the February 2014 expiration, my premium of $430 will be mine to keep, and I can then sell the March expiration $150 put for more premium.  The idea here is to sell enough monthly premiums to pay off the cost of the protective put ($2,590.00), and hopefully make some income at the end of the line.

Let's look at a different scenario: With JAZZ currently selling at approximately $155 on the market, I could sell a January 2015 $150 put at $25.90 (for the sake of simplicity, I am not going to discuss bid and ask prices.  This is simply for illustration purposes).  Recall that when I sell something, in this case premium, I receive $25.90 or $2,590.00 into my account.  That's a very nice chunk of change, but also carries a risk, that the underlying stock pulls back below the strike of $150 and is thus put to me.  In that event, my cost basis in the stock would be $124.10.  I don't have to keep it - I could sell it back to the marketplace, or sell covered calls.

Let's see what happens if I sell an out-of-the-money $150 strike put expiring in January 2015.  I'm now on the line to be put a stock at $150.  I can mitigate that risk by buying the February 2014 $150 strike put at $430.  In this case, my premium credit would be reduced by the purchase of the put to $2,160.00, but I am also protecting myself against having the stock put to me.  I'm not as fond of this strategy. 

Friday, October 4, 2013

The Backspread

Yahoo! (YHOO) has been rallying over the past few months, and sometimes makes me dizzy. I wonder how much further up it will go.  I currently have two bullish positions at much lower prices, but I'd like to hedge my bets by placing a short position on YHOO.  That may be foolhardy, so a nice technique might be the backspread.

Here is how it works.  The shorthand explanation is that you are shorting the stock, while giving yourself an opportunity to profit if it rallies.  We'll play with call options here.

YHOO is currently trading just about at $35 a share.  The October 2013 expiration is in 2 weeks.  If I believe that YHOO is due for a pullback from this point, I may wish to do a Bear Call Spread, whereby I buy the upper strike and sell the lower strike, as:

Monday, January 21, 2013

The Butterfly

This is a strategy I have not employed heretofore, and here is why: Essentially, a butterfly is a strategy where you buy 1 wing at a lower price, sell 2 wings at a higher price, and buy 1 wing at a higher price still. Here, I will analyze a butterfly on Apple Computer (AAPL), which closed Friday 1/18/13 at $500. It looks like this:

     Buy 1 call option of AAPL at 490
     Sell 2 call options of AAPL at 500
     Buy 1 call option of AAPL at 510

Wednesday, January 16, 2013

Setting up new spread

NFLX. That was an old trade, David. As I recall, I profited even on the roll-out. I generally don't hold my positions very long, so when NFLX got into trouble (in Aug 2011, as I recall), I was out. I'm back in with a new bull put spread, Jan15 90p covered with a Jan15 60p. I put this spread on one leg at a time, first selling the 90p, waited for it NFLX to rise before buying the 60p.

Wednesday, September 26, 2012

Call Option Buying

Call options are arguably the easiest trading strategy there is.

What are options:  Options are contracts to buy or sell stock at a given price by a certain date.

Options come in two varieties: Calls and Puts.

Both calls and puts grant the buyer the right, but not the obligation, to buy or sell stock.

Both calls and puts impose on the seller the obligation to sell stock.

As the chart above shows, one can either buy or sell both calls and puts.  Whether one buys or sells these options grants him or her either a right or an obligation.

Some concepts to understand about options: 
  1. Options are listed in strike prices at specific intervals, depending on the underlying stock price.
  2. Options are said to be wasting assets because they have expiration dates.
  3. Stock prices are listed as for a single share of stock.
  4. Each option controls 100 shares of stock.
  5. The price of an option is comprised of intrinsic and time value.
  6. Options expire typically on the third Saturday of every month.

How does this work in practice:  Firstly, I will not calculate commissions for the sake of this article.  Commissions vary widely from broker to broker, but some excellent brokers have very reasonable commission costs.

Above I stated that call options grants the buyer (owner) the right to buy stock at a certain price before a certain date.  Suppose you buy a Microsoft (symbol MSFT) $33 call option with an expiration date of December 2012.  What this means is that you want to own the right (but not the obligation) to purchase MSFT by the latest December 2012 at a limit price of $33.  For that right, you must pay a price, and as of closing prices September 25, 2012, the December 2012 $33 call was going for $0.34.  You have just purchased the right to buy MSFT for $33, and your breakeven cost would be $33.34, to account for the cost of the call option.  Why would you want to buy this call option?  Because you think that MSFT is going higher.  At today's close, MSFT traded at $30.78.  If it rises by December expiration to $35, and your breakeven is $33.34, you're ahead of the game by $1.66, or $166.00, because you can exercise your call option and buy it at $33.00, which is cheaper than going out on the open market to purchase the stock.  Moreover, if you buy 100 shares of MSFT at the current price ($30.78), you would have to spend $3078.00 ($30.78 x 100) - (remember, stock prices are listed in single-share prices) but buying an out-of-the-money (OTM) call option only costs you $34.00 ($0.34 x 100).  A dramatic difference.

Since I introduced the term "out-of-the-money" above, let's explain this term.  All options (puts and calls) have strike prices.  For calls, if the strike price is lower than current market price, the option is said to be in-the-money; if exactly at the current market price, the option is said to be at-the-money; and if above current market price, it is said to be out-of-the-money.  The reverse is true for puts, where if the strike price is under the current market price, it is said to be out-of-the-money; if exactly at current market price, the option is said to be at-the-money, and if above current market price, the option is said to be in-the-money.  Let's put this in a table, as above.  Let's stay with MSFT, closing today at $30.78.

  • ITM - $30.00
  • ATM - $30.78
  • OTM - $33.00

  • ITM - $33.00
  • ATM - $30.78
  • OTM - $30.00

Strike prices are usually listed in 2.5, 5 and $10, and above, so you will not see a strike price of $30.78.  The ATM figure above is for illustration only.

Intrinsic and Time Value.  Each option consists of Time Value.  But not so with Intrinsic Value.  In the case of MSFT, if the current market price is $30.78, a $33 call option is said to be "out of the money" because its entire cost consists of time value only.  Time value is the portion of the option that is the so-called wasting part.  You may ask, what is time value? Time value refers to the portion of the option that covers the time chance of the stock moving that high.  For example, in weather, you may hear forecasts of a "15 percent chance of a hurricane occurring in December."  That would be equivalent to a "time" chance.  The more time you give an option to "cook," so to speak, the more you should pay for it.

You no doubt have heard that approximately 80 percent of all options expire worthless.  This refers specifically to the time value of an option.  It is this portion that erodes with time.

To repeat, if MSFT rises to $35.00 by the December 2012 expiration, it would be more profitable to purchase MSFT at your agreed-upon price of $33.00 than to go to the open marketplace and purchase it at $35.00.  You paid $0.34 for the privilege of buying it at $33.00, so your total out-of-pocket in this case would be $33.34 - still lower than the market price of $35.00.  In fact, what you have done by purchasing that call option is that you have effectively "locked up" a purchase price of $33.00 per share, no matter how high MSFT rises by the expiration date.

Limited risk:  We have been talking about how to profit if the price of MSFT rises to $33.00 by expiration.  But what happens if it declines?  If MSFT declines from its current price, or simply does not rise enough to cover your breakeven of $33.34, you would lose the entire cost of your option of $0.34, or $34.00 ($0.34 x 100 shares).  But that is the most you can lose.  That's one of the benefits of options - that they limit your risk.  That is precisely what the "futures" markets do - they try to lock up prices in the future and not run the risk of having them increase inordinately.

The title of this article is, Why I don't buy call options.  With the above explanation, you might think that limiting my risk to "only" $34.00 seems like a wonderful idea.  It might be, but consider that if I buy a call option, I need the underlying stock to do two things: move up, and move up in a timely manner.  When you hear the axiom that 80 percent of all options expire worthless, that is what they are referring to: the chances of a stock moving to a target price in a given period of time frequently does not occur, and many (80 percent) call options expire.