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, Advisory Panelist
Tuesday, October 4, 2005: Issue #247

Before becoming an options market-maker on the NYMEX, I never anticipated the initial pain that my legs would feel after having stood in the same spot for five and a half hours a day. That’s what pit traders do. They stand in the pit all day long, giving bids and offers to brokers in hopes of doing a trade with them.

As part of my series of articles on the life of a market maker, this piece will focus on the actual mechanics of what happens when an option order hits the pit, how to read fair value sheets and how the market maker plays a role in the action. Remember, everything that I explain in this article relates to my experiences as it happened on the NYMEX.

The First & Fastest Market Maker To Check The “Sheets”

The opening bell would ring at the NYMEX at 9:45 a.m. EST and close at 3:10 p.m. EST (pre-9/11). Within those five and a half hours, it was every market maker’s job to be the first – and the fastest – to give a specific broker a bid and ask quote that they needed for their customer.

Let’s say, for example, the upstairs Merrill Lynch desk (customer) needed a bid/ask market for the October 2005 Crude Oil $66 call option. The Merrill Lynch broker in the pit would randomly shout out to no one in particular, “How’s the Oct. $66 call?” That’s the market maker’s cue to check the corresponding futures market price and then check their “sheets” to see what a fair bid/ask market would be to yell back to the broker (and yes, everyone really is yelling at each other).

The reason for checking the corresponding crude oil futures market price is that if the market maker actually does an option trade with the option broker, the market maker will then immediately place an offsetting delta-hedge trade in the futures market to eliminate any immediate directional risk. Market makers are not there to pick a direction; they are there to capture a non-directional edge on the trade. I’ll explain that in a bit.

So, before actually giving the option broker his bid/ask market, you would see the 20-some market makers in the pit all waving to their “point man” in the futures pit for a quote on the futures market. The point man would hand-signal back to the options market maker approximately where the futures prices are trading (the options pit and the futures pit are two separate pits that sit side by side). Once the option market maker has a decent idea of the futures price level, he can then give the broker an accurate quote after checking his “sheets.”

How to Read “Fair Value” Sheets… And Keep Brokers On Your Side

The graphic below is a very simplified version of what an option market maker’s “fair value sheets” would look like. The one below contains the “fair value” and “delta” calculations for various futures and option prices for crude oil options as of October 3, 2005, with a fictional expiration date of October 21, 2005.

Here’s how it works: Along the left-hand side are prices for the front-month crude oil futures market in 5-cent increments. In this example, we’re only seeing prices for the futures at $65.45, $65.50, and $65.55. A typical trader’s sheet would contain many dollars worth of prices, so you would literally see market makers coming into the pit with thick booklets of trading sheets, sometimes for more than one commodity. You should see what the floor of the exchange looks like at the end of the day. Actually, you wouldn’t be able to see the floor because every inch ends up covered with obsolete trading sheets.

The “P/C” column indicates whether you are looking at a put or call, and the “VOL” column represents the volatility level you are using to help price the options. The top row of the sheets shows the strike prices that are available to trade in that particular commodity. Here we see strike prices for crude oil options ranging from $62 to $67. The last pieces of the puzzle are the “Fair” and “Delta” Columns. These represent the fair market value for each put or call at the corresponding futures price along the left-hand side, and the delta column lets the trader know how many futures contracts are needed to offset any option trade to balance out the directional risk.

The broker was asking for a market on the $66 calls and we find out that the futures are trading at $65.50 at that moment in time. We check our sheets on the left-hand side for the “calls” at the 65.50 mark with a volatility of 38%, and then we move along the top until we intersect with the 66 strike of the “Fair” column. We see that the fair market value of the $66 calls at a corresponding futures price of $65.50 comes out to be $1.828.

Any attentive market maker in the options pit would now yell back to the broker, “$1.80 bid at $1.85.” This means that the market makers are willing to buy that option at a price of $1.80, or sell it at $1.85. At this point, we don’t know if the broker is a buyer or seller, so we always have to give both sides of the market (we don’t care if we buy it or sell it).

Now, if the broker decides to buy the option from us at our price of $1.85, we have to tell him how many option contracts we want to sell. To make it simple, the delta sheets are based on a trade of 100 contracts. If we are lucky enough to sell 100 contracts to the broker, we look at our sheets again and see that the delta is .46. In order to offset our initial directional risk, we would hand signal back to our point man to buy us 46 futures contracts. Since we are selling call options to the broker, our initial delta is short 46 potential futures contracts, therefore we need to buy 46 futures contracts to keep our delta at zero.

The Paycheck’s in the “Edge”

Delta tells us a few different things:

• It tells us how much an option price will move for a corresponding $1 move in the underlying security; and
• How many shares or contracts of the underlying security must be bought or sold to offset any directional risk from an options position.

As I mentioned earlier, the option market maker is looking for an edge, not a directional trade. If that $66 call is valued at approximately $1.83, and we get to sell it at $1.85, then that’s what we call getting an edge. Our best-case scenario is that someone wants to sell that option now, and we would be able to buy it back for $1.80. That’s how market makers try to make their money. They continuously try to buy for less than what their sheets are telling them, and to sell it for more than what their sheets are telling them.

Unfortunately, it’s not as easy as that, but that’s the main thrust of the market maker’s job. The whole process of getting the futures quote, checking the sheets, doing the trade, and doing the hedge all happen in a matter of seconds. It sounds like a long process, but it’s not. The faster you are, the more trades you do. Speed is key!

So, do that everyday for five and a half hours without sitting down and/or not taking a break for lunch, and you, too, might be saying, “Man, my legs are tired.”

Good trading,

Lee

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