by Lee Lowell, Advisory Panelist
Saturday, August 1, 2009: Issue #1056

I’d like to focus today’s segment on the markets that typically see heightened activity during the summer months, due to the fact that it’s their prime growing season.

Specifically, that means the grains and orange juice markets.

As we’ve mentioned before, these products are heavily dependent on the weather for their yield. So if erratic weather patterns affect the crops’ growing cycles, it’s very likely that their prices will rise.

These products aren’t just consumables either. The farmers and food/drink companies that are front-and-center of their production use these markets for income production, too. They do this by using commodity futures and options contracts as hedging mechanisms.

So let’s hit the grains market first…

How To Play The Grain Market Upside With Commodity Futures

A few weeks ago, we keyed in on corn and wheat, stating: “Most of the speculators who play these markets are bullish in nature, so a majority of them are placing bullish bets, either in the form of outright long futures contracts or long call option contracts.

“Right now might be one of the best times to get into the grain markets on the long side because not only are we right smack in the middle of summer, but the prices of corn and wheat have just undergone a five-week massacre to the downside.”

Both commodities markets are still meandering around their lows, which offers another good opportunity to get in on a speculative bullish move. Here’s how to do it…

Take a look at the daily charts below for the corn and wheat December 2009 futures contracts.

If you believe in the seasonality of bullish moves for the grains, and are willing to take a speculative bet, now is a good time to consider a trade.

Your best bet is to hit the futures options contracts that trade on the floor of the Chicago Board Of Trade (CBOT). But make sure you do so in a way that gives you limited risk and unlimited reward possibilities.

For example, that could include entering a call option spread or just buying call options.

For call options, look to play the December 2009 or March 2010 options expirations, which will give enough time for any major weather scares to produce a good upside run.

• Corn: Specifically, consider December 2009 & March 2010 call options with strike price levels from $3.50 and higher.
• Wheat: Use the December 2009 and March 2010 call options that have strike prices between $5.60 and $5.80, or higher.

You can also trade these contracts through the Chicago Mercantile Exchange’s electronic platform, where you can bypass the brokers in the option pits. These contracts are exactly the same as the other, so you can trade them whichever way works best for you.

The Orange Juice Markets – A Hot Spot For Speculators

Having last broken down the orange juice market one month ago, this market has become a hot spot for speculators, as hurricane season got underway.

At the time, the market had carved out a low and we mentioned that it was shaping up for a “potentially lucrative seasonal trade.”

It certainly didn’t disappoint. Over a two-week period, orange juice futures launched higher to the tune of 2700 points. Usually, a move like that will take a good portion of the summer to develop, but with the oversold conditions that existed, it was stronger and quicker than normal.

This served all call option buyers well – especially those who took our advice to buy the January 2010 $85 cent call options. At the time, these options were available to buy for roughly 900 points or lower. And with the 2700-point surge, they tripled in price, fetching prices of over 3000 points.

So what now?

At this point, we wouldn’t advise buying these options anymore. The feverish move has already happened now and OJ prices are beginning to fall back. This is usually a one-time event every year, and unless orange juice drops back down into the low 80-cent area quickly (based on the January 2010 futures), we don’t recommend buying calls at this time. Markets move fast and timing is very crucial.

Let’s take a quick look at our other favorite “weather-prone” commodity – natural gas…

Commodity Futures – Waiting on a Natural Gas Bull

We’ve been bullish on natural gas for a while now, as it slinks along the lows it’s carved out since it reached manic highs last summer (along with many other commodities).

Natural gas will eventually hit a bottom, as it’s an in-demand natural resource that will be around for a long time. We just have to wait patiently for the turnaround, as the market grapples with high underground storage supplies.

Like with the orange juice market, though, we know hurricanes can cause huge upside moves, as the majority of drilling rigs are centered in the Gulf of Mexico. If a few storms go rumbling through that area, it could be the impetus that eventually brings this commodity out of the doldrums. But until then, we’ll bide our time.

One of the ways we’re playing this market in my Instant Money Trader (IMT) service is by selling out-of-the-money naked put option contracts on the natural gas exchange-traded fund – United States Natural Gas (NYSE: UNG).

This ETF tracks the movements of natural gas futures contracts, giving investors a lower cost way to enter this market.

And by selling put options, it allows us to collect the option premium, while having an opportunity to buy natural gas at unbelievably low historical levels. Check out this article for more information on how to sell put options.

That’s all for this time.

Good investing,

Lee Lowell

P.S. If you’d like to find out more about profitable option transactions, take a look at The Instant Money Trader.

by Lee Lowell, Advisory Panelist
Stock and Commodity Analyst, Mt. Vernon Research
Monday, June 29, 2009: Issue #1029

Let’s say you’ve been interested in buying Microsoft stock and you feel $20 is a good price to pick up some shares. It currently trades at $23.50 per share, so you’ll need it to fall in price a bit before getting filled on the trade.

Most stock traders would just put in a “limit buy” order to buy the stock if/when Microsoft falls down to $20 per share. But there’s no guarantee that Microsoft will ever fall to $20 per share, and there’s no one paying this stock trader upfront for his time while they wait to buy Microsoft at $20…

That is unless you’re using a put selling strategy…

As an option trader, you can take the transaction one step further by selling a Microsoft $20 put option contract – you’ll receive the going rate for that option and receive instant income.

I recently showed Investment U readers some of the ins and outs of put options – you can read all about them, but right now I’m going to show you how to profit from a real life example of selling puts options.

Selling Naked Put Options – Strike Prices & Option Chains

When selling naked put options, it can be hard to grasp how the strike prices and contract prices work together until you understand what an option price list – or option chain – looks like.

Take a look at Microsoft’s option chain below:

Chart: http://www.investmentu.com/images/iu062909chart.gif

This is a typical option chain for Microsoft options that expire in January 2010.

• The strike prices are listed in the column in black. Since we’re interested in the $20 strike price, we look at the JAN10 20.00 line.
• Scan over to the “bid” column that shows how much you can receive for selling that $20 put option contract. The bid column shows $1.30 as the price. This translates into $130 you will receive for every $20 put option contract you sell because all prices are in listed in per share costs. And an option contract controls 100 shares of stock.
• For a typical 1,000 share stock trade, you can sell 10 put option contracts and instantly receive $1,300 in your account, no questions asked.

This is money for you to use anyway you see fit. No matter what happens, this money is yours.

In exchange for selling those 10 put option contracts and receiving your instant $1,300, you are obligating yourself to buy 1,000 shares of Microsoft at a price of $20 per share until the expiration day in January 2010.

At this point, you know ahead of time that you will be obligating yourself to buy 1,000 shares of Microsoft at $20 per share, for a total investment of $20,000.

Not only do you get to collect $1300 upfront just for placing the option trade, but you’re also giving yourself a chance to buy a stock that you want to own, at the price you want.

How great is that?

As long as you know this potential future transaction is within your financial means and trading plan, then it is a win-win situation for you.

When Selling Options, What Happens On Options Expiration Day?

So, when selling put options or any options, people often ask what happens when options reach their expiration date?

Only two things can occur at expiration – either the price of the stock is above the chosen strike price or it’s below.

• If the stock finishes above the strike price, then the trade is over and the option expires worthless. The option buyer walks away with nothing while the option seller gets to keep the upfront cash with no further obligations.
• If the stock finishes below the strike price at option expiration, the option buyer will “exercise” his right to the contract and you will be required to fulfill your end of the agreement – which means you end up having to buy a stock you wanted at the price you wanted.

Sounds pretty good to me. And all the while you still get to keep the upfront cash.

So in the case of our Microsoft example above…

• If Microsoft closes below $20 in January 2010, you will be obligated to purchase your 1,000 shares at $20 each. With the $130 received upfront for each option contract, this essentially reduces your cost basis to $18.70 per share once the transaction is complete. Not bad.
• If Microsoft closes above $20 at January 2010 expiration, the trade is over and the option expires worthless. You keep the $1,300 and are free to repeat the process again for another expiration period. This is the key to income generation.

As I mentioned in my article about selling naked put options article that up to 90% of option contracts will expire worthless, leaving you with the upfront cash payment.

After implementing this strategy for a while, you will come to see that most of the trades will expire and you’ll keep padding your account with instant income.

Using a Put Selling Strategy – Six Tips to Selling Options

A few guidelines to keep in mind when selling naked put options:

• Only sell put options on stocks you want to own. Do not use this options trading strategy on high flyers just to receive the upfront income.
• Only sell enough contracts to stay within your comfort zone. If you normally trade in 500-share blocks, then only sell five option contracts.
• If you are uncomfortable at anytime during the trade, or do not wish to own the stock at the strike price you’ve chosen, then you can unwind the trade at any point. All you have to do is buy back the put options you’ve sold.
• The option price will fluctuate during the course of the trade. It may get cheaper or more expensive while you hold it. The bottom line is – you’ll either get to buy the stock at expiration or the option will expire with no value.
• You will need to have an approved “option trading account” with your broker. This needs to be set up before making these transactions.
• You’ll always know ahead of time what your potential total outlay will be if obligated to buy the shares. No surprise endings.

That’s all there is to selling put options. It’s easy, simple and much safer than most investors imagine if you just stick to my six tips above.

Using Put Options With The Instant Money Trader

These are the profitable types of trades we execute in The Instant Money Trader service.

In fact, since launching in November 2008, we’ve had a 100% win streak, meaning all the options have expired worthless, allowing us to bank all the money paid to us upfront from the option buyers.

Although we concentrate on selling put options on high quality stocks within the Dow Industrials and S&P 500 that we’d be more than happy to own, we’ve yet to have to fulfill our obligation and purchase them.

This is mostly because we sell the put options that have the high percentage of expiring worthless. It’s fine with us, as we’ll gladly keep accepting all the instant money we get from these transactions.

We’re able to pick quality stocks that are paying good money to us, all the while knowing that we’ll either take possession of these great stocks or repeat the process for the next month.

Good investing,

Lee Lowell

P.S. If you’d like to find out more about profitable put option selling, take a look at The Instant Money Trader.

by Lee Lowell, Advisory Panelist
Stock and Commodity Analyst, Mt. Vernon Research
Friday, June 26, 2009: Issue #1027

Right now, bunches of savvy investors are getting paid cold, hard cash for nothing more than agreeing to buy stocks. Investors are giving them money to buy stock that they were looking to purchase anyway.

Sound crazy? Well it isn’t.

There’s an incredibly profitable, but little-known trading and investment strategy that you will come to love as much as I do because of all the “instant cash” it can generate for you.

In the lucrative world of options trading, this strategy is called “selling a naked put option.”

Sounds sexy, and to some it is, but really it’s an incredibly simple way to buy stock you want to purchase at a specific price – while having someone pay you to do it. It’s easy to do but there are a few things you need to know first…

Here’s how you can use this powerful options strategy to get paid for buying stocks.

Understanding Put Option Contracts

If someone has a bearish outlook for a particular stock, they can either sell the stock short or purchase a put option contract. My colleague, Karim Rahemtulla, discussed put options at length in “Short Selling Strategies” last week, but there are some terms to be aware of.

• When you purchase a put option contract, you gain the right to sell that particular stock at a particular price within a specified period of time. To do this, you must pay a fixed amount of money upfront, which is called the “option premium” to the option seller.
• The option seller gets to keep this upfront cash regardless of any future outcome of the transaction.
• The amount at which you can sell the stock is determined ahead of time by the “strike price” – the only price you’ll sell the stock at.
• The time period that the option is active for is also determined ahead of time – and it’s referred to as the “expiration date.”

So as a put option buyer, if the stock you choose ends up falling in price below the strike price you have chosen within the time frame, you will have a winning trade.

It sounds simple enough for most investors to make money hand over fist, but it’s not.

• In about 80% to 90% of option buyer’s transactions, the option will expire worthless and the option buyer ends up forfeiting the option premium he paid upfront to the option seller.
• Most option buyers (both calls and puts) do not end up picking the correct strike price and expiration period to give them a profitable trade.

So who really comes out ahead? The option seller of course – he gets to walk away free and clear with the money. So let’s put ourselves on that side of the trade.

The Secret to Selling Options

Sounds like being an option seller is no-brainer? Well, it is – if you do it correctly.

For getting paid upfront, the option seller also has an obligation to fill if certain conditions arise. His obligation is to buy the stock from the option buyer (remember, the option buyer wants the stock to fall in price) if the stock falls to a certain price within the expiration time period.

Here’s where it gets good.

As a put option seller, you also can determine ahead of time where you would feel comfortable buying a stock if it dropped in price, and then collect the cash from the option buyer.

This is how to be a smart put-option seller – only sell put option contracts at strike prices at which you would like to own the stock if called upon to do so.

That’s it.

The secret to selling naked put options is to pick a stock that you would potentially like to own at a cheaper price than where it currently trades, sell the corresponding strike price, collect the money from the option buyer, and then sit back and wait until option expiration to occur.

These are the profitable types of trades we do all the time.

In fact, since launching The Instant Money Trader service in November 2008, we’ve had a 100% win streak, meaning all the options have expired worthless, allowing us to bank all the money paid to us upfront from the option buyers.

And it couldn’t have been easier.

Good investing,

Lee Lowell

P.S. I know this might sound a bit overwhelming, so next week I’ll walk you through an example to see how simple this strategy really is. In the meantime, if you’d like to find out more on the put option selling, take a look at The Instant Money Trader.

by Lee Lowell, Guest Contributor, Investment U
Thursday, November 6, 2008: Issue #882

Did you know that you could get paid to buy stocks at the price you want? That’s right, someone will actually hand you cash today for your promise to buy any stock you want at a cheaper price than where it’s currently trading.

All you have to do is decide which stock you want to buy, at what price you want to buy it, place the trade and collect your money.

Is this for real? Is this a joke? Is this legit?

This is absolutely for real, it’s absolutely not a joke and it is extremely legitimate. When was the last time someone gave you a wad of cash just for buying your favorite stock at rock-bottom prices? I’m guessing probably never, unless you’ve been using this very simple and safe strategy. I personally use it all the time, and many others “in the know” have been using as well.

Being a professional options trader for the last 17 years, I’ve figured out exactly which options strategies are best to use at various times in different market environments. But one strategy can be used at almost any time…

It’s called “put option selling” and it’s a great way to get your hands on instant cash while at the same time giving yourself an opportunity to buy your favorite stock at a price much lower than where it’s currently trading.

Many people have never heard of, let alone used, this option strategy, but in my book there’s no better way to spend your time and effort while you wait for your stock to come down in price. I’m going to show you how you can use it to start collecting some of that cash that’s being handed out.

Being Paid to Wait With Put Option Selling

What do you usually do when there’s a stock you want to buy but it’s too expensive? I’ll bet in most cases, you enter into a limit-buy order for that stock using a price that’s lower than where it’s trading.

That’s how 95% of investors do it, so don’t feel bad.

But what are you doing in the meantime, while you’re waiting for the stock to drop in price? I’ll bet you’re just sitting there twiddling your thumbs and wasting valuable time. Has anyone given you cold, hard cash while you sit there and wait? Nope. Could you be doing something better with your time while you wait? Definitely.

Well, then put option selling might be right for you.

The actual mechanics of put option selling is quite easy:

• When you enter into a put-sell transaction, you’re entering into an obligation to buy the stock you want at the price you want.

• The person on the other side of the transaction, the put option buyer, pays you money today for your obligation to buy that stock sometime in the future at your price.

Put option selling is a bullish option trading strategy while put option buying is a bearish strategy.

When someone thinks a stock is going to fall in price, they can either short the stock or buy a put option contract. If they opt to buy the put option contract, they have to pay for it at the going rate.

That’s where you, the put option seller, comes in. Since you’re bullish, you want to sell that put option and the option buyer will gladly pay you the going rate for it. You keep that money, deposit it into your account and wait for option expiration to come. Easy enough, but let’s go over some specifics.

Options Trade As Easily As Stocks

Options contracts trade in the marketplace just as easily as stocks do. All options have “strike prices.” These are the levels in which you can buy or sell the stock if called upon to do so.

For example, IBM is trading at $90 currently. The options exchanges set up strike prices at various levels, like the $80, $90, $100, $120, $150, etc. You will buy or sell these strike prices at the going rate for each. An option like this, with say five months before expiration, could cost roughly $750.

All options have an expiration date that can span from days to years. When someone buys a put option whose strike price is set lower than the current price of the stock, it’s called an “out-of-the-money” put option.

Option contracts represent 100 shares of stock, so for every option you sell, you’re obligating yourself to potentially buy 100 shares of stock.

If someone chooses to buy the “$80 put option” today when IBM is at $90, they are speculating that IBM will fall below $80 per share by option expiration date.

Why would anyone want to sell IBM at $80 when it’s currently trading $90? Why don’t they just sell it now at $90? Good question. Probably because this person already owns IBM shares in their account and wants protection in case of a disaster.

If IBM happens to fall to $60 per share before expiration, the put option buyer can “exercise” the option and sell IBM at $80 even though it’s now trading at $60. This is how professionals “hedge their position.”

But what happens if IBM never falls to $80 by expiration? Well, the option expires worthless and the put buyer ends up losing the full $750. Who gets to keep that money? You, the option seller! It’s been estimated that up to 90% of out-of-the-money options will expire worthless, so in most cases, you’ll get to keep the money free and clear.

How to Buy Stocks for Less With Put Option Selling

Let’s say that you want to own IBM at $80 per share while it’s trading at $90. Instead of putting in that limit-buy order and waiting, you now know that you could sell the $80 put option and collect $750 for every option that you sell.

If IBM happens to end up trading below $80 per share at option expiration, then you’ll be called upon to buy your shares at $80 per share. That’s a good thing because $80 was the price you wanted to acquire it, and $10 cheaper than where it had been trading. Not only that, but someone paid you $750 extra per option just for your time and effort to buy your stock at your price.

Since options trade in 100 multiples, the option is quoted as $7.50. When it’s time to collect the money, you will receive $750 (100 shares x $7.50).

Even better, that $7.50 actually lowers your cost basis if you have to buy the stock. Even though you’re buying IBM at $80 per share, it’s really only costing you $72.50 per share when you factor in the $7.50 you received up front – an extra bonus.

Here’s a sample option chain for IBM options that expire in April 2009. The option chain lists all options activity and the options that trade for a particular stock and can be accessed online or from your broker.

Courtesy www.optionsxpress.com

You can see with IBM currently at $88.22 per share, the April 2009 $80 put option can be sold for $7.50 (splitting the bid/ask prices). So for every option you sell, you will instantly collect $750. If you sold 5 put options, you would receive $3750.

Put Option Selling & Option Expiration Day 2009

Here’s what goes down at option expiration day in April 2009:

1. If IBM is trading above $80 at expiration, then the options will expire worthless and you get to keep the full $750, no questions asked. You can then move on and do another put-sell trade for a future expiration period. Unfortunately, you will not be asked to buy any shares at $80. But at least you were compensated $750 per option for your time.
2. If IBM is trading below $80 at expiration, then congratulations, you will be called upon to buy the shares at $80 a piece. This is good news because $80 was the price you wanted to acquire them. Plus, you still get to keep the $750 paid to you on Day 1. The shares will show up in your account and you’ll be required to pay for the shares in full at that time. If you sold five option contracts, which is the same as 500 shares of stock, you will be required to pay out $40,000 at that time.

Just remember, you’ll only get to buy the shares if the price of the stock is trading below the strike price on expiration day

A few points to consider before implementing a put-selling plan of attack:

1. Only sell put option contracts on stocks that you want to own for the long haul, as you might be required to buy them at expiration. We use this strategy to acquire high-quality, top-notch stocks. Don’t sell put options on risky stocks that you have no intention of buying, or only do it just to receive the put option income.
2. You will need to have an option trading account set up with your broker in order to sell put options.
3. Only sell the amount of put options that correspond to your buy levels. If you eventually want to buy 500 shares, then don’t sell more than five option contracts.
4. You will need to keep a percentage of money in your account on hold at all times while the trade is active. This percentage is called the “margin requirement” and is set by your broker. In most cases, your broker will ask you to keep anywhere from 10% to 50% of the full purchase price of the stock while the trade is active. This is great, as you don’t need to keep the full $40,000 (in the IBM example) on hold at all times. This still allows you to use your funds for other trades

That’s it, put selling, in a nutshell. It’s an alternative way to acquire stocks while getting paid for your time and effort. You get to pick the stock you want and the price at which you’re comfortable owning it.

Just remember, stick with quality stocks that you want to keep for the long haul.

Good investing,

Lee Lowell

Editors Note: Lee’s book Get Rich with Options can be accessed through our Investment U Bookstore.

Today’s Investment U Crib Sheet

Options can be confusing at first, but with familiarity, they become just another tool in your investment toolkit. Here’s a quick review of some of the key put option topics.

• Options Chain – listing of a stock’s option contracts of puts and calls. An options chain is broken down by strike price and expiration date, with each option receiving its own security symbol.
• Strike Price – the price at which a contract can be exercised.
• In the Money – if a put contract is lower than the strike price, the contract is considered in the money. It means that the contract will make money for its owner.
• Out of the Money – if a put contract is higher than the strike price, it is out of the money. The price is too high for the transaction to be profitable – it makes no sense for the owner to exercise the contract.
• Expiration Date – date at which the option is either exercised by, or expires worthless.
• Time Decay – while not discussed much, the value of an option contract is based on several things, one of them being time value of the option. The longer an option has control over a stock, the pricier it is. Time decay is the declining value of an options contract as it approaches its expiration date.

By Lee Lowell, Advisory Panelist
Friday, October 5, 2007: Issue #462

“Wow, you see what the market’s doing today?” “Hey, check out Stock X – it’s flying!” Boy, if I collected a dollar for every time someone said this to me whenever a market/stock makes a big move, I’d probably be kicking back on a beach right now.

If you’re in the investment world like we are, you hear this all the time – and this past Monday was a good example. Talk about getting a fresh start… the stock market shook off its third quarter woes and leapt into the fourth quarter with an impressive peformance. The Dow sprinted past 14,000 and set an all-time high, while the Nasdaq 100 galloped to new six-year highs. As many stocks sucked up Wall Street money and charged ahead, many investors simply looked on and admired the rally, wishing they were a part of it.

But you know what the professionals were doing? They were making money from it. And they were doing so using a very sophisticated, yet easy-when-you-know-how investment technique, called an strangle option, that is invaluable when assets make big moves. And today, I’m going to show you how to do it, too…

Straddle The Fence… Then Jump Down On The Profit Side

In this column we gave you the nuts and bolts of an option trading strategy known as an “options straddle.” It’s the type of play where you buy both a call option and put option at the same time with the same expiration date and the same strike price.

You execute it when you want to take advantage of an explosive move in the underlying shares. And here’s the beauty: It doesn’t matter which direction the stock goes. You’re not making a bet on that – you’re simply betting that the move is going to be big, regardless of which direction. As long as the move is large enough to offset both option premiums that you’ve paid, you’ll have yourself a winner.

We Straddled A (Hypothetical) Win On Google… Now We’re Going To Strangle Some Gains, Too

When I discussed straddles, I used a hypothetical example on Google (Nasdaq: GOOG) options that expire this month. Specifically, we bought the $550 straddle ($550 was our strike price) that cost us a total of $35.80 for both options combined. This equated to a dollar value of $3,580 for one straddle purchase. Working on the theory that Google could see a large move, regardless of direction, we bought both the call and the put.

Right now, that straddle is worth $51. That means we could cash out for a hypothetical gain of $1,520 per straddle and a 42% return on investment in just a few short days. Not too shabby!

But the straddle play has a brother. It’s called the “strangle.” It’s exactly the same as a straddle, except that the strike price levels for the calls and puts are different.

There is one other key difference, too. While it’s best to pick at-the-money options with straddles, when playing strangles, we choose options that are out-of-the-money (OTM). This means the overall cost will be less than the straddle because OTM options are cheaper to buy.

While this sounds great on the surface, be warned… the cheaper cost comes with a caveat: Since the options are OTM, it’s going to take a bigger move in order to see a profit. But if you’re confident of a large move, the strangle can give you a larger return.

So let’s see how it works in reality, again using Google as an example…

At-The-Money For Option Straddles… Out-Of-The-Money For Option Strangles

Take a look at the Google option chain below and we’ll construct a hypothetical strangle options play.

While we played the October options for the straddle, we’re going to go out to November for the strangle. The price of GOOG at the time of this screen capture was $585, so we would pick OTM strikes to form the strangle.

You could pick whichever OTM strikes agree with your wallet, but for the typical strangle, you want to focus on strikes that are roughly equidistant from the current price of the stock. So for this example, we’re going to use the $600 call (GOO-KT) and the $570 put (GOP-WQ), which are both $15 OTM and equidistant from GOOG’s price of $585. The cost to buy both options at their “ask” prices would give us a total cost of $35.20 for the strangle ($19 for the call + $16.20 for the put), or $3,520 in total dollars.

Next step… figuring out your breakeven level…

Crunching The Numbers… Finding Your Breakeven And Profit Levels

You always want to know what your breakeven prices will be if you are going to hold onto this play until option expiration. This lets you know how far GOOG must go before you’re profitable. All you do is add the total strangle price to the call strike and subtract it from the put strike to find your breakeven levels.

So we have $600 + 35.20 = $635.20

… and $570 – $35.20 = $534.80.

Bottom line: Until/unless GOOG gets past either level, you won’t be profitable if you held until expiration. The graphic below shows you how the breakevens look on a chart.

Of course, you don’t need to hold until expiration. You can sell at any time. So if GOOG makes a large move soon after you buy the strangle (just as it did with our hypothetical straddle play), you could easily sell it for a profit.

Take a look at the profit & loss table below to see how the strangle will fare on expiration day at various GOOG share prices.

You can see from the chart and the spreadsheet that if GOOG stays between $570 and $600, you will lose the maximum amount. However, that can be no more than what you paid for the strangle.

But once you move either lower than $570 or higher than $600, you’ll see your losses decrease. And once you get past the breakeven points of $534.80 or $635.20, you’ll move into profitability.

**Please note that the Google example above is just an example of how a strangle works, not an actual recommendation.

Don’t Let An Options Strangle Choke Your Profits

Of course, there are a couple of downsides to buying a strangle – and you need to know about them before you execute this options play.

First of all, remember that you’re buying two different options and paying two premiums. So instead of just buying the call or put and hoping it makes the move you anticipated in one direction, GOOG needs to make a very large move in order for you to profit. In fact, GOOG must make double the move in either direction to offset the total $35.20 premium.

So one thing you might want to consider is to execute an options strangle strategy on a stock that has shown the ability to make big moves. That certainly applies to Google. However, while it could move past either breakeven level and become profitable, keep in mind that it can also trade in unprofitable areas. It’s essential that you keep an eye on the underlying stock’s activity, so you can book profits quickly before you lose them.

Lastly, since the options for a strangle play are OTM, GOOG has to move a little more than it would need to for a straddle. The tradeoff to that larger move is the strangle will always cost less than a straddle. Bottom line: You need to strike a balance between how big you expect the move to be and what you can afford to risk.

Good investing,

Lee Lowell

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by Lee Lowell, Advisory Panelist, Investment U
November 13, 2006: Issue #607

If you’re an investor who’s long on a stock right now, I want to show you how to make money by selling call options while you’re waiting for the stock to move higher.

Selling the “Rights” to Your Shares With Call Options

At this very moment, there’s another investor somewhere who’s willing to pay you cash – today – in return for the opportunity to possibly take your stock from you at a higher price sometime in the future.

That means you can start making passive income right now all due to your having some shares sitting in your account.Here’s how it works

If you own at least 100 shares of stock in your account, you have the opportunity to sell a covered call option against those shares.

What does that mean?

Basically, you can sell one call option (one option contract equals 100 shares) against the shares of the company you already own.

In doing so, you’re giving up the right to own the shares to the person who buys the option from you. So he now has the right to buy the shares from you at a pre-determined price (this is called the strike price) and at a pre-determined date (known as the expiration date). For that right, he must pay you money – yours to keep, free and clear, no matter what happens in the future. That’s your return.

If the stock moves up past the strike price of the option you sold, you will then be obligated to sell your shares of stock to the option buyer at the stated strike price. Is that a bad thing? Not if you do the trade correctly, and have a price in mind that you would be willing to sell the shares anyway.

Let me give you a real-life example of how this covered call trade works

Turning IBM Into An Income Machine

My parents both own 800 shares of IBM that they’ve held for many, many years. Over that time, they’ve obviously experienced the ups and downs, but have still not cashed out of the stock.

But now they’ve finally decided that if they’re going to sell their IBM shares, it’s going to be when the stock is $95 or more. Fair enough. But instead of simply having them enter a sell order limit at $95, I got them to sell some covered calls against their 800 long shares at the $95 strike price instead.

Since each option contract is the equivalent of 100 shares of stock, my parents sold 8 call option contracts each.

Take a look at the IBM chart below:

We sold the first set of call options on March 17, 2006 – selling the January 2007 $95 strike calls for $1.95 each. That brought in an immediate $3,120 (16 x $1.95 x $100 multiplier = $3,120) into my parents’ accounts.

We chose the $95 strike calls because if IBM ever happened to trade above $95 by option expiration in January 2007, my parents would get the stock called away from them at that price. So instead of sitting around, waiting and hoping for IBM to eventually move back up to $95, they got proactive with their portfolio, sold some calls and made easy cash.

Obligation-Free Call Options

Since you’re never obligated to hold onto a call option, we decided to buy back the calls in the middle of July 2006 in order to take a profit on the option side of the trade. Even though IBM was moving down in price (and causing a paper loss on my parents’ long stock), the call options were getting cheaper too, giving us a gain on those.

We bought all the calls back for $0.15 each, which cost us $240 total (16 x $0.15 x $100 multiplier = $240). So in essence, we locked in a real-life gain of $2,880 ($3120 – $240 = $2,880). Sweet!

Since we bought the options back, we were left with no more obligation to sell IBM at $95/share. My parents had their 1,600 shares of IBM just sitting in their account again. And we waited for the next chance to sell a covered call

Using Call Options to Deposit Another $4,800 Into the Account

The next opportunity occurred about three months later, after IBM gapped up to $92 per share on October 18, 2006. Because IBM had rallied back $18 a share, it was a good time for selling more call options.

My parents opted to sell the April 2007 $95 calls this time, and they collected $3 per option, which brought in another $4,800 of fast, easy money. All they have to do now is sit and wait to see if IBM gets to, and then stays above, $95 per share by the April 2007 option expiration.

If that happens, they will sell their shares for $95. If IBM stays below $95 at April expiration, the calls will expire – and my parents will keep their IBM shares and will look to do another trade sometime in the future.

The covered call strategy is a sound and easy way to bring in extra cash every few months. If you have stock sitting idle in your account, and have a pre-determined sell point, don’t just wait for the stock to reach that level, sell call options against your stock at a strike price that coincides with your sell point. Make your stocks work for you, instead of you working for your stocks.

Good trading,

Lee Lowell

Today’s Crib Sheet

• Selling call options is a great way to generate income in your brokerage account. Buying them can also be extremely profitable, especially if you have time on your side.

By Lee Lowell, Advisory Panelist, Mt. Vernon Research
Tuesday, December 27, 2005: Issue #270

If you own at least 100 shares of stock, and you’re not selling call options against it, then you are throwing away free money. How’s that?

Well, there are other traders out there who will give you money today for the right to take your stock away from you if it reaches a much higher price.

Selling covered calls is such a great strategy for padding your bank account that I still can’t believe there are investors who aren’t taking advantage of it. It’s one of the best ways to take in extra cash flow that you never thought you could have.

Here’s how it works…

Selling “Longshots” On Intel With Out-of-the-Money Calls

Let’s say you own 500 shares of Intel Corp (INTC) that you bought in 1997 for $25.50/share. How have you done?

Well, if you didn’t sell during the tech bubble in 2000, then you are breaking even as of today, with INTC trading for about $26/share. Bummer. All that time and you still haven’t made any money on it. You probably could’ve used that money to invest in something else, or at least buy yourself a nice gift after all that time. Who knew? Nobody knows how an investment will turn out over time.

What could you have done in the meantime? Sold covered call options against your shares. There are two great things about this strategy:

• It allows you to passively accumulate income over time by having someone else pay you money. You become the option seller. For every 100 shares of INTC you own, you can sell one option contract. In this case, you can sell five option contracts.
• It reduces your cost basis of the stock by the amount of the option you sold. If you sell enough covered calls over time, your cost basis could be zero! Let’s look at an example.

Below is an option chain for INTC with an April 2006 expiration date. The last price for INTC was $25.97 (upper right corner).

What we want to do is concentrate on selling out-of-the-money (OTM) call options. An OTM call option has a strike price that’s higher than the current price of the stock. In this example, we will focus on the $30 strike calls.

We see from the “Bid” column that the $30 calls are bidding at $.25. This means that for every $30 call we sell, we will take in $25 ($.25 x $100 multiplier). Since we own 500 shares, we can sell five option contracts and net a take-home pay of $125.

This strategy is great if we really like the stock and want to keep it in our portfolio. The only way we give up the stock is if it moves a good deal higher. Instead of waiting to see if INTC will ever go up in price, we are taking a proactive trading strategy and making some extra cash on the side.

What happens when we sell the $30 strike calls? It means that if INTC trades above $30 by April 2006 expiration, and stays above $30, we will be forced to sell our INTC shares to someone for $30/share. It’s called getting “assigned on our short options.” But is that a bad thing?

Well, considering that INTC hasn’t been above $30 in almost two years, and you don’t really want to give up your shares, I don’t think it’s a bad bet. Plus, the trade is only good until April 2006. If INTC doesn’t get above $30/share by April 2006 expiration, then the trade is over and we get to keep the $125 free and clear… and we also keep our long INTC stock. We can also repeat the trade for a different expiration month.

If you happen to get assigned on your call options and are forced to sell the stock, then so be it. You still came out ahead. Not only did you make $125 from the options, but you also have a gain on the stock from your original purchase price of $25.50. That’s a $2,250 gain.

Using The Force When Selling Covered Calls

Selling OTM covered calls forces you to take some profits along the way (assuming you are selling calls with strike prices above your initial stock buy price). Also, since we are selling the calls for $.25, it reduces our cost basis to $25.25. Do that enough times over the years and your cost basis could be zero!

Some investors will worry about causing a capital gains tax event if they are assigned and forced to sell their shares. That’s true. But in my opinion, it’s better to take a profit somewhere along the way.

Would you rather hold your stock just to avoid the IRS? Look at all the stocks that have imploded since the 2000 meltdown. I’m sure there are many folks kicking themselves for not selling at some point, either through a regular stock sale or by an option assignment.

In the case of our INTC example, if we had been selling covered calls all along, taking in $125 once every three months or so, we could have netted a nice sum while the stock lingered for seven years. It’s sort of like a consolation prize while you’re waiting. Everyone else who didn’t sell covered calls has nothing to show for it.

This strategy is a way to gain sideline income while you wait for an eventual sell price (you do have a sell point, don’t you?) Why not sell potentially worthless options, repeat the process many times during the year, lower your cost basis and enjoy the income?

Good trading,

Lee

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By Lee Lowell, Advisory Panelist, Mt. Vernon Research
Thursday, December 15, 2005: Issue #267

Much of my own option trading occurs from the short side. I’m not referring to a bearish directional outlook, but rather a trading strategy that involves the selling of options instead of buying them. This involves either selling “naked” options, or initiating option credit spreads.

You see, you don’t always have to be an options buyer, and you don’t have to own something first before you can sell it. The great thing about the financial markets is that you can sell first and buy second, instead of the long-standing philosophy of buy first, sell later.

The reason I like to sell options is because I believe that you gain more margin for error if you are incorrect in your market assessment. But you have to know how to sell them correctly. You can’t just sell any old option and think you’ll have a profitable trade. You have to take into consideration the following:

• The general direction of the market or stock you’re trading
• The strike price
• Time to expiration
• Volatility of the options

Many people trade options under the assumption that because they think they know where the stock is headed, they can buy cheap out-of-the-money (OTM) options with little time to expiration. This is the downfall of most option traders. How many of us are actually that good at predicting where and when a stock is going to move? I know I’m not, but many investors still trade options that way. You’re giving yourself such a small window to be correct in your assessment since there’s not much time left before the option expires.

Let’s look at why the short side can be more profitable than the long… and how to set up a put credit spread for a 75% chance of winning.

Three Out of Four Chances to Win With A Credit Spread

When you buy an OTM call or put, you only have one way to be profitable, and that’s if the stock moves far enough higher or lower to pass your break-even point in the time allotted. When you sell an out-of-the-money call or put, or an OTM credit spread, you actually have three ways to become profitable.

For example, if you sell an OTM put option or put credit spread, you will be profitable if the stock moves higher, stays flat, or moves slightly lower, but not lower than your break-even. If you sell an OTM call option or call credit spread, you will be profitable if the stock moves lower, stays flat, or moves slightly higher, but not higher than your break-even. The only way to lose is if the stock moves well past your break-even price.

So that’s three out of four scenarios, or a 75% chance of having a successful trade when selling options. When buying options, you really only have a one-in-four chance of winning, or 25%. I like the odds better when selling options – you can be incorrect in your market assessment to a degree, and still have a profitable trade.

Let’s take a real-life scenario and see how I would set up an option trade:

Here’s a six-month daily chart of March 2006 Sugar. We can easily see that sugar has been in an uptrend for quite some time, so why try to rock the boat and trade any other way? Let’s stick with the trend and look for a bullish trade.

Instead of buying call options and trying to predict what level sugar might go up to, we’re going to look at selling OTM put credit spreads instead. Selling put credit spreads is a bullish strategy that lets us take advantage of our directional bias, but also gives us room for error if sugar retraces to the downside somewhat.

How The Option Credit Spread Works

Ideally, we’d like to wait for sugar to pull back a little to one of our trendlines before initiating the trade, but I will show you the strategy so you understand how it works.

Since we believe sugar won’t retrace much lower than the $1,270 level, we’ll use that as our support area, and the place in which to pick the strike prices for the put spread. We’d like to sell the $1,250/$1,200 put spread (not a recommendation – educational purposes only!). Let’s check the option prices below.

We can sell the March 2006 $1,250/$1,200 put spread for 9 points. Here’s how it breaks down:

What we’re doing is selling the $1,250 put (for a credit of 21 points) and buying the $1,200 put (which costs us 12 points) as a single trade for a net credit of 9 points. If you look in the “Last” column, you’ll see the prices for each strike. Just take the difference between the two and you get your net price.

In the sugar market, each point is worth $11.50, so our initial credit is $103.50 (9 x $11.50) for each spread we sell.  Since we are bullish, we don’t want sugar to go lower than our break-even price of $1,241.

In order to figure the break-even, you take the upper strike in this case and subtract the net credit ($1,250 – 9 = $1,241). As long as sugar stays above $1,241, we will retain the net credit and have a profitable trade. Sugar can go higher, stay flat, or go lower, but not lower than $1,241 for us to win. Since sugar is currently at $1,381, we have much room for error and three out of four chances to win.

Based on our technical analysis, I think it’s easier to predict what level the market WON’T get to, rather than the level it MIGHT go to.

Good Trading,

Lee Lowell

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About a year and a half into my days as an options market maker on the floor of the New York Mercantile Exchange (NYMEX), I discovered the strategy of selling short-term, out-of-the-money options (OTM).

For anyone who’s not familiar with the term “out of the money,” these are put options with strike prices that are lower than the price of the underlying futures contract. Call options that are out of the money have strike prices that are higher than the price of the underlying futures contract.

Selling these options is a great way to generate some income by taking advantage of options that expire worthless – while someone else is taking on the risk. Let me explain…

How to Pocket Cash From Traders Losing Their Bets

From 1991 to 1998, the years I spent on the floor, crude oil energy futures stayed mostly in the range of $15-$25 per barrel. I noticed that many people would pay good money for options that were well above and well below the current price of the nearest futures contract.

If oil was at $20 per barrel, people would buy options on the $15 puts and/or the $30 calls, hoping the price of oil would get to one of those two levels by the time the options expired. What I noticed was that these options were expiring worthless most of the time, because of the large distance that the futures contract had to move for the option to become profitable, plus the fact that the options had such a short life span.

So, I decided to start selling these options, which allowed me to pocket the money from the buyers. All I had to do was wait for expiration to see these options expire worthless.

Over time, I realized that due to the increasing potential of unrest in the Middle East, and the effect that OPEC had on the price of oil, I knew that there could possibly be more violent movements to the upside than to the downside. At that time, I started restricting my out of the money option selling tactics to just the put options.

People were still paying high premiums for these, and I was willing to sell them. What I didn’t realize at the time was that not only was I taking in monthly premium income, but I was also setting myself up to possibly buy crude oil at unheard-of cheap prices.

In the early ’90s, I was selling put options with strike prices from $15 all the way down to $9. If I was ever assigned on my short put options (meaning that the buyer executes his right to sell crude oil futures to me), I would be buying crude oil at very cheap levels – not such a bad thing to do with a worldwide commodity in such high demand. Turns out, I was never assigned on any of my short options, and that was mostly due to the short life span and large distance of being out of the money.

A Reliable Income Strategy

Over the years, I became the market maker that most of the brokers would come to when their clients needed to buy some out of the money put options. Other traders would shy away from these selling tactics, claiming the “unlimited loss potential” of short options. They said I was crossing over to the “Dark Side.”

But for me, the strategy was sound:

• I was taking in good premium,
• I could possibly buy crude oil at unbelievably low levels,
• And I had risk-management plans in place.

The NYMEX futures contracts would trade electronically during the night after the open-outcry session closed, so if I had to protect myself, I could buy or sell futures contracts if need be.

After I left the NYMEX, I started a trading business from my own home office. I began trading stock options with the same methodology. I would sell put options below the market (out of the money) on stocks that I really wanted to own. This would allow me to collect the premium upfront, and potentially allow me to buy them at a great price.

When you are looking to buy a favorite stock at a cheaper level, selling put options is a viable strategy to potentially set a limit price while earning income in the meantime. The way I was using it on the NYMEX was mostly to collect the steady monthly premium income, but when applying it to the stock market, you are potentially setting yourself up to buy a great stock at a great price.

Good Trading,

Lee Lowell

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