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
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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