Wednesday, May 20, 2009

The Greatest Currency Trades Ever Made

by Andrew Beattie

The foreign exchange (forex) market is the largest market in the world because currency is changing hands whenever goods and services are traded between nations. The sheer size of the transactions going on between nations provides arbitrage opportunities for speculators, because the currency values fluctuate by the minute. Usually these speculators make many trades for small profits, but sometimes a big position is taken up for a huge profit or, when things go wrong, a huge loss. In this article, we'll look at the greatest currency trades ever made.

How the Trades Are Made

First, it is essential to understand how money is made in the forex market. Although some of the techniques are familiar to stock investors, currency trading is a realm of investing in and of itself. A currency trader can make one of four bets on the future value of a currency:

* Shorting a currency means that the trader believes that the currency will go down compared to another currency.
* Going long means that the trader thinks the currency will increase in value compared to another currency.
* The other two bets have to do with the amount of change in either direction - whether the trader thinks it will move a lot or not much at all - and are known by the provocative names of strangle and straddle.

Once you're decided on which bet you want to place, there are many ways to take up the position. For example, if you wanted to short the Canadian dollar (CAD), the simplest way would be to take out a loan in Canadian dollars that you will be able to pay back at a discount as the currency devalues (assuming you're correct).

This is much too small and slow for true forex traders, so they use puts, calls, other options and forwards to build up and leverage their positions. It's the leveraging in particular that makes some trades worth millions, and even billions, of dollars.

No. 3: Andy Krieger Vs. The Kiwi

In 1987, Andy Krieger, a 32-year-old currency trader at Bankers Trust, was carefully watching the currencies that were rallying against the dollar following the Black Monday crash. As investors and companies rushed out of the American dollar and into other currencies that had suffered less damage in the market crash, there were bound to be some currencies that would become fundamentally overvalued, creating a good opportunity for arbitrage. The currency Krieger targeted was the New Zealand dollar, also known as the kiwi.

Using the relatively new techniques afforded by options, Krieger took up a short position against the kiwi worth hundreds of millions. In fact, his sell orders were said to exceed the money supply of New Zealand. The kiwi dropped sharply as the selling pressure combined with the lack of currency in circulation. It yo-yoed between a 3% and 5% loss while Krieger made millions for his employers.

One part of the legend recounts a worried New Zealand government official calling up Krieger's bosses and threatening Bankers Trust to try to get Krieger out of the kiwi. Krieger later left Bankers Trust to go work for George Soros.

No. 2: Stanley Druckenmiller Bets on the Mark - Twice

Stanley Druckenmiller made millions by making two long bets in the same currency while working as a trader for George Soros' Quantum Fund.

Druckenmiller's first bet came when the Berlin Wall fell. The perceived difficulties of reunification between East and West Germany had depressed the German mark to a level that Druckenmiller thought extreme. He initially put a multimillion-dollar bet on a future rally until Soros told him to increase his purchase to 2 billion German marks. Things played out according to plan and the long position came to be worth millions of dollars, helping push the returns of the Quantum Fund over 60%.

Possibly due to the success of his first bet, Druckenmiller also made the German mark an integral part of the greatest currency trade in history. A few years later, while Soros was busy breaking the Bank of England, Druckenmiller was going long in the mark on the assumption that the fallout from his boss's bet would drop the British pound against the mark. Druckenmiller was confident that he and Soros were right and showed this by buying British stocks. He believed that Britain would have to slash lending rates, thus stimulating business, and that the cheaper pound would actually mean more exports compared to European rivals. Following this same thinking, Druckenmiller bought German bonds on the expectation that investors would move to bonds as German stocks showed less growth than the British. It was a very complete trade that added considerably to the profits of Soros' main bet against the pound.

No. 1: George Soros Vs. The British Pound

The British pound shadowed the German mark leading up to the 1990s even though the two countries were very different economically. Germany was the stronger country despite lingering difficulties from reunification, but Britain wanted to keep the value of the pound above 2.7 marks. Attempts to keep to this standard left Britain with high interest rates and equally high inflation, but it demanded a fixed rate of 2.7 marks to a pound as a condition of entering the European Exchange Rate Mechanism (ERM).

Many speculators, George Soros chief among them, wondered how long fixed exchange rates could fight market forces, and they began to take up short positions against the pound. Soros borrowed heavily to bet more on a drop in the pound. Britain raised its interest rates to double digits to try to attract investors. The government was hoping to alleviate the selling pressure by creating more buying pressure.

Paying out interest costs money, however, and the British government realized that it would lose billions trying to artificially prop up the pound. It withdrew from the ERM and the value of the pound plummeted against the mark. Soros made at least $1 billion off this one trade. For the British government's part, the devaluation of the pound actually helped, as it forced the excess interest and inflation out of the economy, making it an ideal environment for businesses.

A Thankless Job
Any discussion around the top currency trades always revolves around George Soros, because many of these traders have a connection to him and his Quantum Fund. After retiring from active management of his funds to focus on philanthropy, Soros made comments about currency trading that were seen as expressing regret that he made his fortune attacking currencies. It was an odd change for Soros who, like many traders, made money by removing pricing inefficiencies from the market. Britain did lose money because of Soros and he did force the country to swallow the bitter pill of withdrawing from the ERM, but many people also see these drawbacks to the trade as necessary steps that helped Britain emerge stronger. If there hadn't been a drop in the pound, Britain's economic problems may have dragged on as politicians kept trying to tweak the ERM.

A country can benefit from a weak currency as much as from a strong one. With a weak currency, the domestic products and assets become cheaper to international buyers and exports increase. In the same way, domestic sales increase as foreign products go up in price due to the higher cost of importing. There were very likely many people in Britain and New Zealand who were pleased when speculators brought down the overvalued currencies. Of course, there were also importers and others who were understandably upset. A currency speculator makes money by forcing a country to face realities it would rather not face. Although it's a dirty job, someone has to do it.

Tuesday, May 19, 2009

Play Foreign Currencies Against The U.S. Dollar - And Win

by Todd Shriber

For decades, if not longer, the U.S. dollar has been known as the world's reserve currency. Foreign investors and central banks have gobbled up greenbacks and debt issued by the U.S. government on the premise that the dollar is the world's dominant currency and American economic strength will bolster returns on dollar-denominated investments.

While the conventional wisdom regarding dollar strength has proved to be true over the years, it is important that investors remember that currencies act just like stocks or other financial instruments. They enjoy runs of success and suffer through periods of doldrums. And while the dollar has been a highly desired currency for the international investing community, it experiences periods of decline.

A fall in the dollar isn't cause for panic, though. Savvy investors can exploit the mighty greenback's decline when it happens and profit from it. Best of all, the avenues to profit from a dollar drop continue to increase.

Where to Turn When the Dollar Tumbles
There are generally a few key warning signs that indicate a decline in the dollar is on the horizon. A consistent pattern of key interest rate cuts by the Federal Reserve, a surge in the national debt and rising commodity prices, especially among gold and oil, can all help investors identify potential peril for the dollar.

And when the dollar falls, that likely means other key currencies are rising, because investors are flocking to perceived quality. For example, a tumble in the dollar combined with rising exports and economic growth in Japan would lead investors to the Japanese yen. On the other hand, if U.S. economic growth is stagnant, but Europe and the U.K. are performing well, the euro and British pound become safe havens for currency investors. (For more insight, read Top 8 Most Tradable Currencies.)

Another avenue to consider is the Swiss franc. While Switzerland is in Europe, the country doesn't participate in the common currency and likely never will. In addition, the Swiss government and central bank take almost painstaking efforts to keep the franc strong relative to competing currencies. As such, in 2009 the franc ranked as the world's fifth most-traded currency behind the U.S. dollar, euro, pound and yen.

Watching the Dollar? Watch Commodities, Too
Because many commodities are denominated in dollars, meaning their quoted price is in dollars, investors should watch certain commodity markets to get a sense of where the dollar is headed. For example, rising oil prices have generally resulted in dollar weakness because the dollar's purchasing power suffers and consumers get less gas for their cars and heating oil for their homes when crude oil prices rise.

To hedge against the dollar's fall when commodities are in a bull market, look toward commodity-based currencies such as the Australian and Canadian dollars. When precious metals, such as gold, are in high demand, the Australian dollar often benefits. Likewise, Canada's dollar rises when demand for crude oil surges. Another more recent play on a commodity currency is the Brazilian real. Formerly an emerging market, in 2009 Brazil stands as the 10th largest economy in the world and is rich with natural resources, particularly oil.

Plenty of Options to Profit From the Dollar Decline
Trading in the foreign currency markets can be daunting as the daily dollar volume in these markets dwarfs that of U.S. equity markets. Investors need to be aware that playing in FX markets is not for the faint of heart and they can lose more than their initial investment. For many, the best choice is to leave this arena to the professionals and seek out other methods for profiting from a fall in the dollar.

Fortunately, there is no shortage of products to help investors do this. One is the U.S. Dollar Index, which tracks the dollar against a basket of foreign currencies. It is updated 24 hours a day, seven days a week and trades on the New York Board of Trade. There is also a plethora of mutual funds that track foreign bonds or short the dollar against the other currencies. These funds give investors the international exposure their portfolios need without the headache of directly tracking wild intraday swings in the currency markets.

Equities, both international and domestic, provide another area for investors to profit from a dollar slide. If the forecast appears grim for U.S. equity markets, certain foreign markets may be poised to benefit. Of course, there are U.S. stocks that can benefit from a fall in the dollar, too. Large multinational firms that count on overseas markets for a fair amount of their profits benefit when the dollar is weak as they convert a British pound or Japanese yen back into a greater amount of U.S. dollars. Names like Procter & Gamble (NYSE:PG), General Electric (NYSE:GE) and PepsiCo (NYSE:PEP) come to mind.

Investors need not suffer at the hands of a weak dollar. The methods to protect one's dollar-based investments are plenty and effective hedging can serve as more than just protection: it can boost a portfolio's bottom line. In addition, the global economy means there are global opportunities to help investors sleep a little easier when the dollar drops.

Good investing, Kingsley.

Monday, May 18, 2009

Trade Of The Day - Natural Gas ETF Shows Continued Strength

by Houghton and Atkeson.

United States Natural Gas Fund (UNG) -- As Sam mentioned on Friday, this trust invests directly in futures contracts on natural gas and is traded on the NYMEX. We see further evidence of UNG's strength.

The price of UNG has been in a steady decline since July 2008 when it was trading at more than $63. Today, it is about $16.

Virtually every market-traded asset has seen appreciation since the March low, including oil, which has rebounded from about $30 per barrel to the mid-$50s. Natural gas typically has a high positive correlation with oil. (see image above)

In the past few days, a lot has changed for UNG. From a technical standpoint, it is beginning to breakout from its 10-month decline on rising volume. We believe UNG has hit its lows and there is a high likelihood the gas ETF will climb above $20.

Join me tomorrow as a bring you another hot trade of the day in this new segment; Trade of the day.
Good investing, Kingsley.

Friday, May 15, 2009

5 Penny Stocks to Buy Now

By Jamie Dlugosch, Editor, InvestorPlace.

A Great Buying Opportunity in Low-Priced Stocks
Last December I wrote about the Top 5 Penny Stocks to Buy Now. At the time, I suggested that readers could enhance returns by speculating on stocks with market caps of less than $500 million. By taking a chance on these beaten-down stocks, investors could reap a huge reward.

And now six months later, we can see how true that statement really was. Four of the five stocks have generated positive returns, with three of the four up more than 50%. Only one stock is down, posting a small loss of just 6%.

Those are fantastic returns and are even more remarkable considering that they have been generated during a time when the market has fluctuated greatly.

The market meltdown has created a great buying opportunity in low-priced stocks. Keep in mind that I'm not talking about non-listed pink sheet garbage. These are real companies with some on the list with market caps of more than $250 million.

Here is an update on my top five penny stocks…

Penny Stock 1 WPT Enterprises Inc. (WPTE)

The company that kicked off the recent craze in Texas hold 'em poker with its franchise World Poker Tour became a low-priced stock due to its inability to sufficiently monetize its brand equity.

While other companies shunned U.S. law with online poker sites that operate illegally in this country, WPT Enterprises Inc. (WPTE) made the decision to stay out of the U.S. online poker market. At the same time, interest in poker appears to have peaked based on attendance at last year's flagship event, The World Series of Poker. In addition, a global recession impacted even so-called recession-proof companies, including those involved in the gaming space.

In December, WPTE traded at 52 cents per share. Since then, the stock is up more than 50% to 79 cents per share. In its recent earnings report, WPTE announced that its season seven was doing well on the FSN Network and that the company inked a deal for season eight on the same channel.

Although the company shuttered its WPT China effort, its continues to grow. The company is engaged in discussions with customers and other parties in order to best leverage the WPT brand. The translation is that the company may be sold. If so, it will be at a higher price than 79 cents per share.

Penny Stock 2 TriQuint Semiconductor (TQNT)

If you believe that the economy will eventually recover to begin a new growth cycle, investing in technology makes sense. While the rest of the market is struggling to move higher in 2009, the technology-heavy Nasdaq is well into positive territory.

Within technology, the semiconductor space is really seeing stocks surge higher in value. That is certainly the case with TriQuint Semiconductor (TQNT). The stock is up more than 65% so far in 2009. Even so, the stock is still down more than 50% from where it traded in early September 2008.

Assuming the next business cycle lasts the typical four years, the recent move in TQNT could be just the beginning. This is a stock that has the potential to triple in value or more. The timing is right, and the valuation is attractive.

It's a must-own penny stock for those looking for such risk exposure.

Penny Stock 3 ION Geophysical Corp. (IO)

Oil prices are on the rise again. As a result, it's highly profitable for oil companies to increase exploration activities. Serving that market is ION Geophysical Corp. (IO).

Thus far, IO is the one stock that has failed to yield any gains in 2009. Shares are down approximately 6%. This includes being down more than 10% on Wednesday of this week due to a less-than-stellar earnings and future guidance report.

The market appears to be missing the mark. IO is a lagging indicator on the economy. When oil prices are falling, lower prices will adversely impact IO results for months after. It should be no surprise then that the company is struggling with oil prices dropping hard over the last 10 months.

That said, oil has been trending higher this year. Such a state should bode well for IO, and the company did say that they are seeing more land-based exploration activity as of late.

It may be late in coming, but I expect IO to do very well in the last half of this year as oil prices continue to rise.

Penny Stock 4 U.S. Home Systems Inc. (USHS)

Another lagging stock on this list has been U.S. Home Systems Inc. (USHS). The stock is very thinly traded and down nearly 10% this year. The credit crisis has negatively impacted USHS as many of its sales are done on credit through its relationship with Home Depot (HD).

This week, the company announced that sales decreased during the first quarter as loan approvals fell to 79%. USHS lost 13 per share in the period.

Fortunately, it would appear that the economy is turning. When it does, look for USHS to move higher. The company's relationship with Home Depot has been challenging as that partner has struggled, but ultimately a recovery will take hold, and with such a strong partner like Home Depot, the future looks bright for USHS.

Penny Stock 5 Osteotech (OSTE)

The baby boomers are aging, and yet they want to remain active. That bodes well for Osteotech (OSTE), a maker of biologic products for orthopedic and spinal surgeons.

Shares of OSTE are up 70% since December, and according to analysts who follow OSTE, the stock has much more upside as profits are expected to come in 2010. Last quarter, OSTE lost 10 cents per share, and even though analysts expected a smaller loss, OSTE's share price held up well given future expectations.

But the past is the past, and demographics being as they are, profits should be forthcoming in coming years. OSTE has the potential to reach double-digit figures in a very short period of time. OSTE represented the high risk, high reward opportunity perfect for those interested in penny stocks.

Good investing, Kingsley.

Tuesday, May 12, 2009

Get Paid to Trade Options!

by Bryan Perry

Let's face it: It's not our parents' economy, and the ways they made their money isn't likely to work in this environment.

The good news is that it isn't our parents' market, either. Gone are the days of simply buying and selling stocks … that is, if you had enough capital left over from the extraordinary fees that brokers charged simply for the privilege of working with them.

With the arrival of more trading exchanges, armies of brokers competing for your business and the explosion of the derivatives markets (i.e., commodities, options, single-stock futures) during the past few decades, it's exciting to wonder what new ways of making money our children and grandchildren will be using.

In the meantime, we've got plenty of strategies to tap into, to turbo-charge our portfolios today.


When the markets are non-directional (i.e., up one day, down the next, with no clear pattern or predominant bullish or bearish bias), some folks cash out their holdings and wait for an "all-clear" signal when the market starts trending higher on a more-regular basis. Others leave their money in the same securities they liked before the craziness started and hope that things don't get too much worse before they get better.

You may trade options for a variety of reasons -- the potential profits you can make on a relatively modest investment, the rush that comes with cashing in a winning trade, or the ability to keep some skin in the game while you wait for a better opportunity to tend to your long-side portfolio.

We all know that you can make money -- oftentimes pretty quickly -- by trading options, whether stocks or the market itself are going up or down.

But using options as a speculative tool is only one way to pad your portfolio with "extra" profits. There are other strategies out there -- using both options and something called "hybrid options" to help investors to use their existing stocks to generate income.


Making a million bucks with stock trading has gotten increasingly difficult during the past year, but options traders are finding it easier than ever to practically print money for themselves, thanks to the influx of new options and innovative strategies.

You might not automatically consider options when it comes to building your retirement wealth or for generating income, but think again. Options are one of the fastest-growing investing strategies -- and with good reason.

There are multitudes of ways to profit from options but some are more attractive to income investors than others, namely covered call writing, put selling and newer hybrid options securities like Stock Return Income Debt Securities (STRIDES).


There's an options income strategy for every level of investor, and one of the easiest to implement and understand is covered call writing. Simply put, covered call writing means selling calls against stocks that you already own.

Covered call writing is a bet that a stock you already own will continue moving up or will trade sideways for a bit. (That's when it's trading within a range and not making any significant jumps or drops.)

The calls you sell (also known as "writing") are considered "covered" because you already own the underlying stock. This means if you are "called" to produce the stock, you are covered because you already have the shares.

However, if you are new to investing or simply don't hold many stocks long in your portfolio, you can benefit from the action that covered call writing can bring by buying into an Exchange-Traded Fund (ETF) like the S&P Covered Call Fund (BEP).

The best part is that you don't have to do any of the call writing yourself, but you can profit from the legwork being done for you!

This basket fund invests in stocks that the S&P 500 Index (SPX) holds and the professionals who run the fund write call options on the S&P 500 Index. Funds like this one are as liquid as common stocks, and you can buy them as you would any other security through your online trading platform or your broker.

The downside with funds like BEP is that someone else is deciding what calls to write, and finding out the particular transactions can be difficult.


The converse of the covered call is the naked put-write, which simply means you sell puts on stocks that you don't currently own but might like to. With this strategy, you get income up front for selling, or writing, the put.

Don't be intimidated by this strategy. If you can buy an option, then you can sell an option.

The caveat, however, is that you might end up owning the stock, which is why it's imperative that you only establish put-writes on fundamentally solid stocks that you would be happy owning -- even at reduced prices. Investors like writing puts because it helps them to buy stocks at a discount or to get paid while they wait.


While the two strategies I mentioned above are easy to understand and execute, there are a host of new options income strategies that require just a little bit more work -- but have shown that the profits are worth it.

Earlier this year, I began using Callable Stock Return Income Debt Securities, or STRIDES, to generate income with my options trading experience.

STRIDES use a short-term bond coupon that paired with an option strategy. They are Merrill Lynch (MER) products that serve as hybrid-types securities. They are structured like bonds that mature in a fairly short time frame (one to two years), which allows you to get fairly quick profits while still enjoying long-term taxation.

Even better, each pays a dividend yield. The amount varies, but the STRIDES' name will tell you exactly how much.

For example, a name might read the Apple (AAPL) 12% STRIDES.

I like these kinds of products because they pay 9%-12% in a world where one-year CDs are only paying 2%.

The downside here is that these types of positions are often less liquid than traditional options because, in most cases, you must go through a broker to get them. They do have ticker symbols, but the more important identifier is the nine-character Committee on Uniform Securities Identification Procedures (CUSIP) number to identify the security.

The American Bankers Association owns the CUSIP system and it's operated by Standard & Poor's to identify stocks of all registered U.S. and Canadian companies, as well as U.S. government and municipal bonds. Your broker will know how obtain these for you.


Just consider that at one point the stock market was a new idea. In time, investors will come to understand that options can make millions and you don't have to be one of the laggards. Bottom line: Start trading options today help secure your tomorrow.

Should You Have More Than One Forex Dealer?

By John Jagerson.

I was recently involved in an interesting conversation about forex dealers and there was discussion and debate as to whether certain companies were financially sound. I think that is certainly a great question to ask, because when financial institutions run into trouble, as many are now, the account holders are the last group to recoup their money, if they ever do.

When it comes to your forex trading account, there are some great solutions to deal with this potential uncertainty.

Don't miss reading: 10 Rules for Surviving This Bear Market

Dealer Diversification

I am sure all of us have either been affected directly, or through someone we know, by a dealer or broker's solvency problem. Any of us that have been in the forex business for more than a few years can remember Refco, the largest futures dealer in the market, going out of business in a period of just a few weeks.

To deal with these potential risks and to optimize their own performance, I think traders should consider dealer diversification.

Risk Mitigation

Just like diversifying across asset classes and strategies, having more than one account is a great way to minimize your exposure to the risk of a dealer problem. A collapse or closure by a regulator agency can happen quickly, leaving all your money exposed or in the hands of someone you don't even really know.

Let your dealer know they don't have all the money you could deposit to keep them on their toes and

Strategy Optimization

Some of us are long-term traders, others are carry traders, and a lot of us are short-term traders. Each dealer competes on their relative advantages, and I haven't seen a one-size-fits-all solution.

A dealer that pays great rollover rates may have wider spreads. They may be great for long-term traders, but terrible for short-term traders and scalpers. Pick the dealer that fits your strategy. Most of us probably use a blend of strategies and should pick a dealer for that part of our account that offers the best advantages.

Product Breadth

No dealer is created equal. Some may offer very tight spreads but don't have the breadth of crosses you may want for other strategies. One important differentiator right now is options. If you want to trade options but don't want to abandon the dealer you have currently, what can you do? Work with both of them.

If you have ever been torn between two attractive dealers but felt like it may be difficult to manage your accounts, I think you may be surprised how useful a good spreadsheet can be. Use all the tools that you have available and you may be shocked about how much the variety keeps your trading creativity flowing.

Good investing, Kingsley.

Taking the Pain Out of Real Estate Investing With REITs

by John Jagerson

Investing in real estate has been a strategy that falls in and out of favor depending on what the general economy is doing.

In 2008-2009, real estate investors took a hard hit with prices dropping significantly, but now that the economy seems to be flattening, real estate bargain hunters are beginning to reemerge.

This article will discuss how a savvy investor can include some exposure to the real estate market within their portfolio without all the headaches.

Real estate investors are drawn to the market because of the perceived potential for large returns. However, what many investors don't understand is that the unusually large returns in a strong economy are due to the use of leverage through loans.

Because of the high cost of real estate, excessive leverage is one of the only ways most individual investors can participate in the market, but it comes with significant and often unanticipated risks.

Excessive leverage in a fairly illiquid asset like real estate can become an account killer quickly. This is the situation so many investors find themselves in now. Leverage has left them upside down on their losses and, in many cases, has wiped out years of profits.

The stock market offers opportunities to invest in real estate, including the possibility of large profits without the usual problems. This can be done through Real Estate Investment Trusts (REITs) that are publicly listed as a stock and available to almost any investor.

A REIT invests in real estate and then sells shares of ownership in the trust on the public market. When you buy a share of a REIT, you are buying partial interest in a real estate investment. This allows you to buy real estate without having to use leverage.

Many REITs are specialized in a specific kind of real estate like Plum Creak Timber (PCL) that invests in land used for lumber production.

Through REITs you can own a share of stores, commercial properties, residential neighborhoods or other income properties that would otherwise be inaccessible to most individual investors.

If investing in a single REIT or real estate strategy doesn't offer the level of diversification you desire, then you may want to consider REIT exchange-traded funds (ETFs). (Learn more about investing in ETFs.)

These ETFs pool investments in many REITs so that diversification can be improved. The iShares FTSE NAREIT Industrial/Office index (FIO) (commercial property) and the iShares FTSE NAREIT Residential index (REZ) (residential property) are good examples of these kinds of ETFs.

An ETF or REIT adds the advantages of liquidity, low entry prices and transparency to the possibilities of profits.

REITs are usually (but not always) negatively correlated with stocks, which helps to smooth your portfolio's growth over the long term. While REITs can experience share price growth, most profits come from dividends that can reach 10% or more. This makes them an interesting addition to tax-sheltered accounts held over the long term.

When compared to the management requirements, financing hurdles, liability and liquidity issues of a real estate investment, REITs present an attractive alternative.

Good investing, Kingsley.

Monday, May 11, 2009

4 Ways to Generate Instant Options Profits

By Chris Rowe

There are two fundamental reasons why we trade options: leverage and protection. (See also the Top 7 Reasons to Trade Options.) We want the big gains that options trading can provide, and we also use options trading strategies to preserve those hard-earned portfolio profits.

Even though we're all searching for those double- and triple-digit wins that options trading can provide (i.e., leverage), in a wild market like this where our profits can practically evaporate within the space of a few days or even a few hours, I want to focus a profit-protecting topic that many of you may already be familiar with: selling covered calls.

I know that talking about conservative strategies might cause some of you to turn away. But for those of you still with me, I can change your life even if you are very familiar with the strategy, because I can guarantee that you are probably under-utilizing this powerful trading tool.

Think about this for a second: If you can generate 2.5% on your investment by selling a covered call each month, that's a 30% annual return. And that's only when you calculate the income you'd get from selling covered calls -- assuming you don't make any money on the underlying stock position. But you have to consider that you might profit from your stock position, too!

To understand why you should make covered calls a regular part of your investment diet, ask yourself one question …

Why Do Gaming Establishments Make so Much Money?

That answer is simple, and it applies to your portfolio, too. It's because there are millions of people who are OK with taking bets, even when they know that the odds are against them.

Sure -- every now and again, the casino loses and the gambler wins. But does "the house" ever really lose? I mean, is the gaming establishment ever really gambling at all?

Nope -- the guests are doing all of the gambling. The casino is simply running a business. The house knows that, every now and again, it will have to pay up. But the amount that it pays out once in a while is dwarfed by the amount that it collects from most of the other guests. Everyone knows that!

But when you are the buyer of (i.e., "buying to open") short-term, out-of-the-money options, you might not realize that you are the same guy as the gambling casino guest.

When you are the person who is selling (aka, writing, or ""selling to open") covered calls, you are the dealer!

You are the one who is accepting payment after payment after payment from the guy who wants to see his $2 call option trade up to $10.

Feel at Home Being 'the House'

Once you have sold a covered call against stock that you hold long in your trading account and received your payment, either you will keep the premium and your stock position, or you will keep your premium, and you will be "called" to sell your stock at the option's strike price. Big deal! Just be sure to sell covered calls only if you are willing to sell your stock at the strike (or "exercise") price.

Ideally, you want to sell calls with a strike price that's slightly higher than the stock's current price. It's also OK to sell calls with a strike price that's at-the-money (i.e., the same as the stock's current price) or slightly in-the-money (i.e., slightly lower than the stock's price). The idea is to profit from the decaying time value of the option that you have sold.

Ideally, you also want to sell calls that will expire in 30-45 days, because that is when time value will decay most rapidly.

Like the Song Says, 'We're in the Money'

How can you make your money work (or work harder) for you while it's in your trading account? Here's a quick look at how easy it can be to make money with minimal effort.

Let's say you buy 1,000 shares of "Bob's Car Wash" (BOBC) at $50 per share.

The stock now trades to $58 per share.

You say to yourself, "I would be willing to sell my stock at $60. Let's see what the BOBC June 60 Call options are trading at," because you know that someone is willing to pay something for the right to buy your shares of BOBC at $60.

You find out that you can "sell to open" the BOBC June 60 Calls for $2.

Again, the stock is trading at $58, and so far you are up $8,000 on your stock position.

Remember these two keys:

* Each option contract represents 100 shares; 10 option contracts represent 1,000 shares. So, if you own 1,000 shares of BOBC, and you want to sell someone the right to buy your 1,000 shares of BOBC, then you would sell 10 call options (to open, to establish your short position in these call options), because 10 option contracts represents 1,000 shares.

* Some people get confused about selling first, and buying second. Traditionally, people are trained to understand only buying something first and selling it second. But when you write an option contract (or sell that option contract), then you are essentially "short" the option contract. You can first sell an option contract at $10 (to open), and THEN buy the option (to "cover" your short position) three weeks later at $6 (to close) for a 4-point profit ($10 - $6 = $4, or 4 points).

Generate Instant Income With Covered Calls

So, to review, BOBC has traded from $50 to $58 per share.

You sell 10 June 60 Call options ("sell to open"), and you receive an extra $2. (That's $2 per share. Remember, because there are 100 shares of the underlying stock represented in each option contract, multiply that number by 100. In this case, you would collect $200 for each contract that you sell to open.)

That part of the transaction is now done. Assuming you hold 1,000 shares of BOBC, you now have an extra $2,000 in the bank, no matter what happens to the stock. (That's $2 per share, times 100 shares in a contract = $200, times 10 contracts to cover your 1,000 shares, for a grand total premium collection of $2,000.)

Now, take a look at the difference.

How Will This Trade Work Out?

1. BOBC trades to $60.

Your stock position in BOBC is called away (sold) at $60 per share and, instead of $10,000, you net a profit of $12,000. (You paid $50,000 to buy the stock and sell it at $60,000. That's a profit of $10,000 on the stock plus $2,000 on the option that you sold.)

Special note: Your stock will not necessarily be sold at $60 just because it trades above $60. Your stock may or may not be called away at any time before expiration. If, at 4 p.m. on expiration Friday, the stock is 25 cents in-the-money or more (which means BOBC would be trading at $60.25 or higher), then the call that you wrote will automatically be exercised, and your stock will automatically be "called" away (sold) from you.

Here is a quick picture of what this would look like (see picture above).

2. BOBC trades down.

You don't feel so bad because you picked up that extra $2,000 from writing the covered call. If you didn't "sell to open" that call option, BOBC would have still traded lower, but your account would be worth $2,000 less than it is worth right now! Whatever dollar amount the stock trades down by, the decline in value is reduced by $2,000.

If, after you take in that $2 premium, your stock trades from $58 down to $55, then instead of losing $3,000 in value, your 1,000 shares of BOBC would lose $1,000 in value since you will have been paid $2,000 for the call option that you sold. So if the stock trades down 3 points, you really only lose 1 point in value, because while the stock lost 3 points, you made 2 points by selling the call option.

At least you take in an extra $2,000, and you will be free of any future obligation once the option contract expires. (Or else you can just close out the call option position by buying the same call back (i.e., "buy to close") at its current lower price (see below).

Now, here's a fun twist: You actually have two choices if your stock trades lower.

a) You can do nothing and maintain both the "long" stock position, as well as the "short" call option position, until the option contract expires.

b) You can simply buy the option contract (that you previously sold at $2) at a cheaper price. Imagine selling a gold watch for $2,000 and then buying it back from the person that you sold it to for $300. Not bad. That's a $1,700 profit.

As the stock trades lower, the call option that you sold also trades lower. This means that if the stock trades lower, you can always buy the call option (that you've sold) at a cheaper price than what you received for it when you sold it. This is a profit on the option trade that will reduce the loss incurred on your stock position. Once you buy back the call that you shorted, your position is closed (i.e., "covered") and you are no longer at risk for assignment, or having your stock called away.

For example, if BOBC trades from $58 down to $55, then the call option that you sold at $2 (to open) might trade down to 30 cents. You can now buy the call option at 30 cents (to close). That's a difference of $1.70. Since you originally sold (or shorted) that call option at $2, that $1.70 difference is a profit.

Said differently, if BOBC traded from $58 to $55, the stock position lost $3 in value. But since the call option that you sold at $2 (to open) is now at 30 cents, you have a profit of $1.70. So the net result is that, instead of your position losing $3 in value, it really only lost $1.30 in value.

In other words:

Stock lost $3
Option gained $1.70
Total loss is $1.30

Or -- as I said originally -- you can let the option expire worthless and realize the entire $2 gain on the call. In this case, if the stock traded from $58 to $55, then your entire position would have lost $1 in value instead of $3.

Stock lost $3
Option gained $2
Total loss is $1

After the option expires, you are free of your obligation. If you wish to do so, you can sell another call option and start the process over again.

3. BOBC doesn't trade up or down, but sideways.


As time passes, the call option that you sold (to open) is losing its time value. Since you are "short" the call option, this is a good thing for you. Basically, as time goes by with the stock trading flat, you are making money as the call option loses value due to time decay.

If the stock pretty much trades flat until the option expires, even though that stock did absolutely nothing, you pocketed an extra $2,000! Even though the stock never got to $60 per share, you still made $10,000, as you had originally hoped for. (You made $8,000 on the stock plus $2,000 on the call option that you sold.)

Meanwhile, there is someone out there who was in the same position as you, but since they didn't sell covered calls, they are sitting on a $58 stock, wondering whether or not it will trade to their target price of $60, so that they can make the $10,000 that you just made with zero movement in the stock.

The call option expires worthless, you now have two choices:

a) You could either sell BOBC at $58 and skip down the street thinking about how cool you are for making $10,000 on a stock that only traded up 8 points.

b) Or you could sell another call (to open) that expires the following month or two out. Maybe you can sell the July 60 Call (to open), or the August 60 Call (to open) and collect even more "extra" premium.

4. BOBC trades somewhere between $58 and $59.99.

Again, GREAT! I can't wait to brag!

Let's say, for example, the option expires worthless, and BOBC is trading at $59 at the time. This means that you made $2,000 by selling the call option (i.e., you had sold that casino guest the right to buy your BOBC at $60) and you are also up 9 points on the stock. You are now up $11,000, and the stock never even hit your price target of $60!

The Moral of the Story

When you are long the option contract (said differently: when you are the owner/buyer of the option contract), time decay is your worst enemy because, as time passes, your option loses value.

When you are "short" the covered option contract (said differently: when you are the writer/seller of the covered option contract), time decay is your best friend because, as time passes, the option that you sold (to open) to someone else, loses value.

You can either buy the option back (to close) cheaper, which will result in a profitable option trade (offsetting your stock's loss of value), or you can let the option expire … which will also result in a profitable trade.

If this covered call lesson has helped you learn something new, then you are probably eager to get out there and write some covered calls on stock that you own, and start grabbing all of that extra money that you have been leaving on the table each month.

But, before you do, first consider this last possible outcome …

A Long Shot on a Short Call

What would happen, and how do you think you would feel, if you wrote a covered call on BOBC, which obligates you to sell BOBC at $60 per share, but two weeks later BOBC traded up to $90 per share? Hmm.

Before you read any further, think about that for a minute.

Do you know what would have to happen in that case?

Well, here it is:

You would have to sell BOBC to someone at $60, even though it is selling at $90 in the open market. Now, that might drive you crazy, even though your original plan was to sell at $60 anyway.

Ask yourself, how much heartbreak would it cause you, if you sold someone the promise that they could buy your stock at $60, only to see it trade up to $90 two weeks later?

Answer: You should feel like a loser much as the casino feels like one when someone puts $2 in a slot machine and wins $30.

Sure, this isn't an ideal situation. But remember, the reason why a casino is happy to give up a profit every once in a while is because it makes so much more in the long run.

I hope that I have given you a clearer picture of why options can be used as a way to gamble, but also as a conservative way to reduce risk.

Good investing, Kingsley.