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.

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