Entries Tagged 'Trading Strategies' ↓

Once you become aware of the many things you can do with options, the world of option trading is suddenly very fascinating indeed! The beauty of options lies in their flexibility. You can do almost anything with them - and for a fraction of the risk involved with buying and selling actual shares, commodities or currencies.

The options market is known as a “derivative” market, because the option price is “derived” from price movements in another market, usually called the “underlying” market. So if you’re looking at stock options, the underlying market is the stock market. But it must be remembered that an options market is a market in itself, with its own supply and demand factors in play.

Here are a few interesting components to options, which give them their flexibility:

Expiry Date:- options expire worthless on an agreed date if they are “out of the money” at that time. This factor, adds to options the element of “time decay”. To the buyer of an option, time decay is a bad thing, but to the seller (writer) of an option, it works in your favour.

Strike Price:- this is the agreed price that the underlying market (say, a stock price) must be above (or below, depending on whether it is a call or put option) at any given time up to expiry date, for it to be “in the money” - i.e. have what is called “intrinsic value”.

Volatility:- this is a component of the option price, theoretically based on the anticipated percentage movement in the underlying market price over a given period of time. So if a stock is expected to move 20% in price over the next 30 days, then the “implied volatilty” in the option price should be around 20%. This “implied volatility” is then compared with the “historical volatility” of the share price movement, to evaluate whether the option is fairly priced. Sometimes you get “volatility spikes” or “skews” which can present trading opportunities. Buyers of options usually look for low volatility, whereas sellers would like to see high implied volatility in the option price.

Buy them or Create Them:- this is the part about options that makes all the difference. Not only can you buy them in the hope of selling for a profit, but you can actually create an option contract out of nothing. This is usually called “writing” or “selling to open” an option contract. The ability to do this opens up a whole world of possibilities. Here are just a few:

Spreads

Option spreads involve the simultaneous buying and selling of an option contract at two different strike prices, with the same expiry dates. If you buy an option closer to the stock’s current market price and sell another one further away from it, you have invested in a debit spread. It is a net debit because the closer the option strike price is to the underlying’s current market price, the more expensive it is. The one further away is cheaper, hence a net debit.

However, if you did it the other way around, you would have an option credit spread. You would receive funds into your trading account. There are many advantages in option credit spreads, including the ability to adjust the position if the underlying price goes against you. The returns are not as good as with debit spreads, but they are much safer. For more, click here.

Credit and debit spreads are known as “vertical spreads” for obvious reasons. However, because you also have the added factor of different “expiry dates” with options, you can use this to create “calendar spreads”. A calendar spread involves buying an option with a strike price closer to the current share price, but with a long expiry date, say, one year out - and then selling (writing) options with a short expiry date such as only one month out and for a strike price further away than the bought position. As the months roll on, you keep selling more options with short expiry times. The idea works on the principle that the sum of the parts is greater than the whole. The total of all your “sold” positions over a year will realize a greater credit, than the debit (cost) of your one bought position. The debit (bought) position is simply a hedge for the sold ones.

There are many more variations of the above, all with interesting nicknames, including ratio backspreads, butterflies, condors, iron condors. Then there are also the “delta neutral” positions such as straddles and stranges … but these will have to wait until a later article.

Did You Know That You Can Make a Good Living Using Option Credit Spreads?

Want to Know the “Nuts and Bolts” of How to Do It?

To Find Out How Easy it Is, Click Here

Want LIVE option trading online classes, using live charts, able to ask questions with other real people attending in real time, all for less than $20 per hour? For more information about Planet Wealth Live Trading Room

Option debit spreads can be a very useful and in some cases, lifesaving tool when trading. The following example shows how that, even when the price of the underlying financial instrument goes against you, you can still make a nice profit on your investment. It just takes a bit longer, but it illustrates the superiority of this strategy over only ‘going long’ on call or put options.

The following example was traded on the Australian market, but the principles can apply to any market in the world.

In late August, I entered an option trade on ANZ bank. It was a debit spread, in this case, a ‘bull call spread’ which is where you BUY a call option (in this case) at a ’strike price’ just above the current market price, but also SELL another call option at a ’strike price’ higher up. In this case, it was an $18.50 / $19.00 spread. On reflection, it was a bad time to buy, but I had it pre-set in my broker account to automatically enter at a certain price and it did so. I was away at the time and not monitoring the market and had forgotten about this. The next day, ANZ came out with some bad news and the share price dropped about $2 (see chart again).
 
Now, if I had only entered the ‘buy’ side of the contract, this would’ve been very bad news. However, with a “spread” you can do interesting things…. I thought to myself, “if the share price has dropped, that means my ‘way-out-of-the-money’ $19 “sold” call option is now going to be very cheap” - cheaper in fact, than my bought position. (the share price was now about $16). Remember, this was a SOLD position, so why not buy it back when it’s practically worthless. Well, I had to wait a few weeks for it to get to the price I was prepared to pay, but last week the US stock market took a big dive and so the Aussie market followed the next day, particularly the banks.
 
The whole position (spread) had originally cost me 24.5 cents. This comprised the BOUGHT option at a cost of $1.48 less the SOLD option for $1.235 = 24.5 cents. Anyway, when the ‘big dive’ took place last week, I was able to “buy-to-close” the original SOLD position for only 12cents.
 
I thought to myself … “my total cost is now 24.5 + 12 cents = 36.5 cents. All I need now, is for the share price to rise a little, so that the original BOUGHT option comes up to about 38cents and I can get out and break even.
 
I was prepared to wait a few weeks for this to happen, because I had noticed that ANZ was in a sideways channel. Well, to cut a long story short, the ‘big dive’ on the US markets was followed by a huge rally the next day, so the Aussie market followed (wagging its tail). The ANZ shares took off, so that my original ‘bought’ $18.50 call option was now worth 65c. I sold for an overall profit of 78%!! 
 
We all like to share our successes. This impressed me with the flexibility of ‘debit spreads’ - how you can turn a setback to your advantage. Options are so flexible! That is why I prefer them over other derivative instruments such as futures or CFDs.

What better way to learn option trading than by watching and listening to someone who makes a full time living out of it, choose his trades in real time, during the last hour of the Australian stock market each day.

Before you join the Planet Wealth Trading Room, you will need at least a basic understanding of the options market, including how to place a trade with your own broker.

This learning experience is invaluable, but you can access this online mentoring program for less than $US20 per hour. There are no fixed fees - you simply pay only for the hours you use.

Want LIVE option trading tutorials, using live charts? LIVE recommendations in real time for less than $20 per hour? For more information about Planet Wealth Live Trading Room

Click Here

Option sellers believe that if it is not, it is pretty darn close. Probably the closest an investor will ever get to the long sought “Holy Grail of Investments” or what is considered to be the ideal investment.

Let’s take a look and see what exactly is regarded as the ideal investment. When asked to define what this is investors have various versions of what they consider to be the ideal investment or the Holy Grail of Investments.

In the ultimate analysis, with few exceptions, most investors feel that an ideal investment should provide the following qualities: safety of capital, consistent high returns, immunity from economic and market fluctuations and finally, liquidity, or availability of funds should the investor find an immediate need to tap his resources.

Safety of capital and high returns seem to be the most desirable of all yet these two are totally opposing qualities in any investment. As the saying goes, the higher the risk, the greater the reward or inversely, the lower the risk the smaller the reward.

That said let’s explore our choices. Until the advent of options there appeared to be nothing that came even close to being called an ideal investment let alone be called the Holy Grail of Investments. We had to face the fact that investments were either low risk low reward or high risk high reward. Some investments were somewhere in the middle ground but few or none were in the Holy Grail category.

Investors may be classified into two groups, passive and active investors. Passive investors prefer entrusting their capital to third parties and doing nothing more than expect returns from their investments either on a regular basis or value appreciation over time. They put their money into a fixed return instrument such as passbook savings accounts, money market funds, treasury bills, certificates of deposits, bonds and included in this lot are dividend paying stocks and mutual funds.

Then there are the other passive investors that prefer to place funds into long term appreciation assets with capital growth as their main goal. Examples of these types of investments would be real estate, precious metals, arts and antiques. All these investment instruments while delivering small returns on a year-on-year basis do offer much safety of capital.

The active investor on the other hand is a more adventurous individual. He seeks high returns for his money, hopefully at reduced risk, by actively being involved in trading the markets, be it real estate, stocks, bonds, commodities, futures, foreign exchange, options or whatever else can be traded and made money on. Although more of a risk taker he nevertheless tries to moderate his risk exposure by restraining his profit objectives or rates of return on his capital.

While passive investors are happy with annual returns of 6 to 10 percent, active investors seek higher rates of over 12 percent and more like in the region of 14 to 18 percent per annum. Is this doable? Yes, it is and many are happy actively trading the markets and achieving these returns using their own trading techniques that somewhat controls risk to an acceptable degree. Now here’s the shocker. Option traders are able to generate annual profits in excess of 20 percent without exposing themselves to any more risk that those achieving 14 percent. Now here is an even greater shocker. Among those that trade options the ones specializing on the selling side generate annual returns in excess of 30 percent with many averaging annual returns in the region of 40 to 50 percent without increasing the risk factor any more than the passive investor!

Foreign currency traders as well as commodities and futures traders sneeze at this claim saying that they can outshine the option seller in annual returns. True. But can they claim to do so at the same risk level as the passive investors? Most probably not.

Selling options (stocks, commodities, futures, etc) has become for many the Holy Grail of Investments. To the experienced option seller this trading strategy offers high, consistent returns, a fair degree of immunity against economic and market fluctuations, liquidity, and finally safety of capital.

This last claim may be open to debate from non-believers in this trading strategy. To be fair let’s qualify the safety claim by saying that the inexperienced option seller is open to potentially heavy losses if he does not know what he is doing. But to the seasoned trader selling options is a safe investment strategy delivering all the qualities of an ideal investment to the point where successful option sellers claim to have found what to them is the closest one can ever get to the Holy Grail of Investments.

Selling options on stocks can be particularly rewarding using a carefully planned trading system combined with disciplined money management and with proper safeguards in place. There are many trading strategies in selling options. Some are simple enough, like the covered call technique, delivering fairly decent returns while others are more complex but more rewarding.  

Did You Know That You Can Make a Good Living Using Option Credit Spreads?

Want to Know the “Nuts and Bolts” of How to Do It?

To Find Out How Easy it Is, Click Here

For further information about Kim Reilly and his Ultimate Trading Solution DVD Home Study Course, CLICK HERE

Kim Reilly is believed by many to be one of Australia’s foremost options super-traders. His most notable trade was in April 2003 when he netted $1.8million profit on AMP put options. This of course, was more the exception than the rule, but people always love to tell us about “the day they caught the big one”. From an option trading perspective though, the positive part is that according to his promoters, he has a very high successful strike rate.

Kim Reilly believes that 90 percent of trading success is about psychology. I wasn’t sure about this when I first heard it, but I have learned from personal experience that in the end, the decision to trade with real money at the right time all comes back to what’s going on inside your head, so there seems to be some truth in this. You can know all the rules, but doing it in a completely relaxed manner, like you’re just playing a game and don’t care, is another matter. When real money is on the table, it can affect your decision making ability.

Kim has been described as a pioneer stock market presenter. This is mainly because many of today’s educators have modelled their information on his course and some even began their own education by attending one of his seminars. Some even say he has set the standard for stock market and options trading education.

Kim Reilly has produced an option trading DVD home study course. The course consists of 20 written modules in Adobe Acrobat format, plus 8 DVD movie presentations by the man himself. It claims to provide the A-Z of basic option trading education, which is about right because it doesn’t focus on the more advanced option strategies such as spreads, strangles, straddles etc. It’s pretty much a “buy the option and sell it for a profit within a week” approach. The course first expounds all the elements of options and then teaches how to identify, using charting techniques, the entry signals for short term trading opportunities.

The strategy is divided into two stages. The first level involves harmonising weekly and daily trends from charts so that short term moves can be recognized. The second level uses a selection of “confirmation” indicators which validate these moves when they’re about to occur. Apply exchange traded options to the mix and you have a recipe for highly leveraged profit potential.

The third essential ingredient to the strategy is money management. Those who promote the Kim Reilly strategy claim you can expect an average of at least 7 out of 10 successful trades, or better. It’s what you do with the other 3 that can make all the difference between success and failure. Recognizing the importance of stop loss limits is vital to becoming a profitable options trader. This is part of the psychology that Kim Reilly is at pains to emphasise. In his own words, it is essential to have an “abundance mentality” first, if it’s abundance you want.

Kim Reilly has developed a trading system that became his own foundation for financial independence. Since then, he has shared his methods to over 50,000 people. I once heard him say at a seminar, that after his million dollar trade, he gave it all away to a good cause and started over again, knowing he had the skill to get it all back again. Wouldn’t it be nice to have that sort of confidence!

For further information about Kim Reilly and his Ultimate Trading Solution DVD Home Study Course, CLICK HERE

Stock Market - “Renting” Shares For Income
By Jules Dawson

When we think of investing, there are two major areas we are familiar with in which to achieve capital growth and ultimate wealth creation.

REAL ESTATE and the STOCK MARKET

Most people feel more safe when Real Estate Investing, even though you can begin Investing in Shares with a lot less money. Besides being able to drive by and look at your investment property a major advantage is the rent you can receive as extra income.

But not too many people realize that you can also rent out your shares as an income strategy!

I’m using the term renting shares because most everyone understands the concept when talking about real estate. You buy a house and rent it out to a tenant who pays you money (rent) for the term of the lease.

Well you can do EXACTLY the same thing with shares you own.

You can rent your shares out to someone at an agreed price (rent) for an agreed time (lease) for extra income.

In this case the agreed rent is called the strike price, the rent received is called the premium, and the term of the lease is the time leading up till the expiry date.

I am of course talking about an income strategy using STOCK OPTIONS

How do Stock options work?

THE COVERED CALL

A Call Option is a contract that relates to a particular stock.

Call Options give the holder the right to buy the underlying shares at any time up until and including the expiry date of the option contract.

There are two parties involved in any option contract:

The Writer (person who sells the option)

The Taker (person who buys the option).

Options Traders are generally Takers. That is they buy Stock Options only to sell them for a profit.

When using the Covered Call strategy we are not trading options, we are selling, or writing them.

If we were to write Call options over a stock we would be covered if we had to sell our shares. Hence the name covered call.

The taker is not obligated to buy the shares, but as the writer, we ARE obligated to sell our shares if the option contract is exercised.

However, regardless of whether the taker decides to exercise their right to buy the stock or not, the premium we are initially paid as rent is ours to keep.

And if we do have to sell our shares to the taker, it means they would have gone up in value, so not only do we get to keep the premium as income, but the sale of our shares converts to cash, earning us capital growth as well.

So let’s look at an example of how this works:

Let’s say we own some XYZ shares that we paid $ 11.00 for and they are currently trading at $ 11.30

We write some Covered Calls with one month until expiry with a strike price of $ 11.50 and the premium received is 50c.

Remember we get to keep the 50c per share regardless of what happens. Money made while you sleep!

As long as the share price stays below $ 11.50 then the option will expire worthless in one month’s time and we would still own the shares to do the covered call strategy again and again.

And if the share price was above $ 11.50 then we would have to sell our shares to the option holder.

BUT we still keep our 50c PLUS the 50c capital growth we have made on our initial purchase of $ 11.00.

So we have sold our shares but have made a profit of $ 1.00 and we can just buy the shares back again if we wish to do so!

Ready to do another Covered Call.

MONEY MADE WHILE YOU SLEEP, without the possibility of your tenant trashing your house or getting behind in the rent.

More on Stock options

Article Source: http://EzineArticles.com/?expert=Jules_Dawson http://EzineArticles.com/?Stock-Market—Renting-Shares-For-Income&id=1193901

Planet Wealth’s flagship product is what they like to call “The Amazing Dimitri Strategy”. It’s all about how to “rent out” shares that you already own, as well as “selling insurance on any market”.

The “rent out shares” is otherwise known in investor jargon, as “Covered Calls”. The idea is that you own at least 1,000 shares if you’re investing on the Australian Stock Market, or just 100 shares if you choose to own US Stocks.

Most people who own shares tend to rely purely on dividends as their income source from these investments. Andrew Dimitri shows you how you can earn extra income by “selling” call options on your shares. By “selling” we really mean “creating out of nothing” or sometimes called “writing” call options. You create the option contract and sell it to the market and receive an immediate income. Easy, but you have to know what traps to avoid, which is where the Dimitri Strategy comes in.

But the “main event” on the Planet Wealth menu, is how to “sell insurance” on the stock market, for shares that you don’t even own. In investor jargon, this is otherwise known as “option credit spreads”. The “insurance” part is given that name because the primary focus of their material is on writing PUT options, which are really just another form of insurance on stocks.

The principles they outline however, can be used just as effectively for CALL option credit spreads.

There are many advantages to option credit spreads which other forms of share market investing don’t provide. One of the most attractive features is the ability to adjust your position when the trade goes against you. What would otherwise have been a “losing trade” if you had simply purchased call options and the stock price went against you, can simply be “rolled out” for extra income when you have a credit spread strategy in place.

Here’s how Planet Wealth describe their own material:

You’ve heard of buying a property and RENTING it out? Did you know you can do a similar thing with stocks? We’ll show you how we use latest techniques for “RENTING” OUT OUR STOCKS.

• How we easily replaced our income in 90 to 180 days - without really having to work for it
• How we generate extra CASHFLOW per month for less than 5 minutes work (it sounds unbelievable, I know, but we will actually show you how we do it)
• Why we believe getting HIGH returns does not have to mean taking HIGH risks (and why the average person will never understand this without a financial education on risk management)
• How we minimize the risk of investing in stocks (so that we sleep easy at night - even if our stocks go down……we don’t have to worry!)
• The incredibly simple way we make money EVEN when the stock prices go down!

…and even more exciting strategies!

• By SELLING INSURANCE on the stock market, we make considerable monthly profits on stocks we DON’T EVEN OWN!
• We NEVER need to own these stocks if we choose not to - we just keep getting income from them.
• The amazing secret where we don’t even have to pick a stock to trade – we can create income from an entire market at once!
• How we also insure ourselves so we almost never lose any money - we call it the Sleep-At-Night factor.

If you decide to purchase their downloadable ebook, they also provide you a free “Spreadulator” Excel spreadsheet, which allows you to calculate and monitor your trades using their methods.

They also provide one full year of daily put option closing prices, in spreadsheet form, so that you can backtest the strategy and see how you could’ve made an income even in adverse conditions.

Did You Know That You Can Make a Good Living Using Option Credit Spreads?

Want to Know the “Nuts and Bolts” of How to Do It?

To Find Out How Easy it Is, Click Here

The reason I have written this post, is because Option Credit Spreads can sometimes be more suited to shares on the Australian Stock Exchange (ASX), rather than the USA Stock Exchanges, due to the tighter spreads and therefore lower exposure to risk.

Most option spreads on the USA stock exchanges are a minimum $2.50 apart, whereas on the ASX they can be as low as just 25 cents.

This can affect your risk to reward ratio.

For example, a credit spread that is $1.00 apart for 1,000 shares gives a risk of $1,000 less the premium received for the credit spread. But the risk for the same number of shares where the spread is $2.50 gives a risk of $2,500. Moreover, the “bought” (debit) part of the spread would be further “out of the money” than the “sold” (credit) part, which would mean your net credit should be greater, but so also would be your risk. You would need to assess your “Return on Risk” percentage at a $2.50 spread on strike prices vs the same on a spread of only $1.00.

This being the case, there is an easy solution for U.S. citizens who wish to trade on the ASX.

We recommend OptionsXpress as your broker. With them, you can open one account and use it to trade both the USA and Australian stock exchanges. You can also create a direct link from your US Bank Account to your OptionsXpress account, using their ACH facility, so that funding and withdrawing from your account becomes easy.

Trading option credit spreads on the ASX then becomes straightforward. Your order goes “direct to market” which means there are no live human beings processing your order. It’s all done over the internet, using their state-of-the-art web interface.

OptionsXpress are also one of the most competitive in the market, having won numerous awards. You can trade 10 contracts for 1,000 shares each, for only $23.50 for each leg of the spread (total cost $47).

To open an OptionXpress account for free and without any obligation to fund the account, Click Here and we’ll arrange for a special invitation to be emailed to you.

Simply write “OptionsXpress” in the email header, leave the body of the email blank and we’ll do the rest.

Let’s take an imaginary scenario, where during August we have taken out a credit put spread, often called a Bear Put Spread, on a stock whose price we expected to rise or at least remain around the current level, by the September expiry date. But during that time, to our surprise, the market takes a dive instead.

We originally took out a bear put spread when the stock was trading at $19.97. Our spread involved the purchase of a $19.50 put option and writing (creating and selling) the same amount of put option contracts at $18.50 strike price.

Let’s say the stock price of XYZ sank to $19.35 two weeks into the trade, and stayed there until the expiry date. We should observe that is a significant drop (from $19.97 down to $19.35) in only 2 weeks, but it does happen, so we need to know how to react when it does. There’s no point making lots of money time and time again if we have to sacrifice it back again.

What do we do?

It’s only when there is no time value that we are at risk of being exercised. All we need to do is calculate our time value and we can easily avoid being exercised.

Now, let’s say time goes on and a few days before expiry, the price of XYZ is still $19.35. What do we do then?

Let’s assume the time value left in the bought option is very small, and we have concluded we need to do something.

The next question is What do we do? We have a couple of choices…

Rolling Out

The easiest, and most common one that we do, is simply to ‘roll out’ our insurance.

In Stock Broker language ‘Roll out’ - means to extend the option expiry date, with the same exercise price, for another month. What our broker will do is buy back our sold option, then re-sell it for the following month, at the same exercise price.

If we think the stock price is good value at $19.50, and we think it will recover to above that price soon (from its current position of $19.35), then we can ‘roll out’ to the following month and keep the same exercise price.

Rolling out is easiest to understand if we look at it like two different acts.

First, we close our current position by buying back our sold puts and selling our bought puts (if they are worth anything). Then let’s assume we decide to re-open a new position in the same stock at the same prices, just for the following month.

This is what we call Rolling Out, and if the stock price is only just below our exercise price, then we would normally do exactly that.

If we do decide to Roll Out, what happens is this:

We buy back our $19.50 put for 17c, which would have expired at the end of Sept, and we sell another $19.50 put, which expires in October, for a higher price (since it has more time value). Let’s say we get 32c for each option.

We also buy put options out to October, again at the same level of $18.50, which will cost around 10c or so

So let’s now look at the trade as a whole.

We originally received 31c in August for our $19.50 puts with $18.50 protection.
The stock dropped below our exercise price

We bought back our “sold” September $19.50 puts for 17c before they expired.

We then re-sold $19.50 October puts for 32c and bought $18.50 puts for protection, for 10c, thus receiving a new premium of 22c which expires in October.

Our total profit is now 36c per option (31c minus 17c plus 22c), except that it’s over an extra month.

Our Total Risk has not changed much it’s still a $1 total risk with a 36c premium. So our Total Risk is now 64c if we include the premium we received, which is 5c less than it was originally.

If the stock closes above $19.50 at the end of October, we have made 36c for an outlay of $1, over a period of 10 weeks (the original 6 weeks plus another month).

Our Return on Risk (ROR) is: 36 divided by 100 which equals 36% over 10 weeks (70 days).
Our Annualized ROR is then 36 times by 365 divided by 70 days, which equals 188%

We can see, for this one trade, which risked only a portion of our overall capital, our ‘per annum’ return is less now, since it is over a longer term 10 weeks instead of 4-6 but it’s still pretty amazing!

In real terms, assuming we had the 20 contracts to start with, we have now made $360 for every contract (instead of the original $310), which is a total of $7,200 profit (instead of the original $6,200), but one month longer than intended.

But what happens if the price of XYZ is not above $19.50 by the end of October?

If it is only just below, we can simply do it all again, making a few more cents on each stock.

Eventually, we would be hoping the price of XYZ will be above $19.50, and our sold put will expire safe. Then we can go shopping!

If the stock drops considerably, even to below our bought protective puts, instead of just ‘rolling out’ we also have the option of ‘rolling out and down’.

But that’s the subject of another posting . . . . .

The above methods work just as well in the situation where we have a Bull CALL option credit spread in place (which we take out if we expect the stock price to fall or remain about the same in a short timeframe).

In the meantime, if you would like to know more about this fascinating option trading strategy, visit the Planet Wealth website and listen to the audio files by clicking at left of screen.

If you’re convinced there is a good safe living from the stock market to be made using this strategy, they have an excellent downloadable book on the subject, plus many bonuses, including historical option prices, recommended brokers and their online contact details - pretty much everything you need to get a great head start trading Option Credit Spreads

Click Here to Go Directly to

“The Secrets to Renting Stocks and Selling Insurance on Any Market”

So many people own popular stocks but fail to realize the potential earning capacity, beyond dividends, of the stocks they already own. Writing covered calls is a way to make additional income from some shares. If you combine this with the leverage of margin lending, you can see very impressive returns.

What is a “Covered Call”?

A “Covered Call” is a call option that you write (i.e. sell) to the sharmarket, on shares you already own. It is a promise to the market, that you will sell your shares for a given price by an agreed date, but only if someone who has purchase your promise, chooses to exercise it.

The call option is called “covered” because the promise is secured by shares you own. The alternative to this, is to sell “naked” which happens when you make this promise over shares you don’t own and would therefore have to buy in order to fulfil your promise.

What is “Margin Lending”?

Margin lending is a type of loan easily obtained from lenders who are prepared to finance the purchase of additional shares, using your existing shares as collateral. There are varying margin lending rates applicable to shares according to their perceived risk. The popular “blue-chip” shares usually have a lending rate up to 70 percent.

How We Use Them Together

Let’s take an imaginary example. You have $20,000 to invest and you want to buy XYZ shares, currently trading at $15 per share. The margin lender will loan you another 70 percent, but you choose to only use 60 percent, so you have a buffer in case the share price drops. This means your $20,000 becomes 40 percent (100 minus 60) of the total shares purchased. Your $20k can now buy $50k XYZ shares, which at $15 per share equals 3,334 shares.

If the stock price moves up one dollar, your gain on
3,334 shares will be $3,334. If you had only purchased $20k of these shares, your gain would’ve only been $1,334. Your margin loan has made you an extra $2,000 less interest on the loan.

Now, let’s combine margin lending with writing covered calls.

You have used margin lending to purchase an extra 2,000 shares and now you write $17.50 call options with an expiry date one month away, on these 3,300 shares. You receive a premium of say, 50c per share, which is a further income of $1,650.

If the share price spikes up to $18 before the options expire, your gain is limited to $2.50 per share, but you have added another 50 cents from the sold call options, so your total gain is now $3 per share, or $9,900 on a $20,000 outlay. Not bad!

If the stock price only moves up one dollar, you’ve made an extra 50 cents from your covered calls, plus your shares have gained one dollar each in value.

If the stock price drops to $13 by option expiry date, your sold call options will expire worthless, which means you won’t be exercised. Your 50 cents per share will offset the loss on your share price and you now turn around and write another covered call contract at $15 strike price, for next month’s expiry date, bringing in further income, again offsetting the loss in share price until the stock price rises again.

This is why writing covered calls is like renting out your stocks. Landlords borrow money and rent out their real estate. Sharelords rent out shares. If you stack the odds in your favour and generally pick shares whose price will rise, this is always the best scenario and will provide you a comfortable return on your investment.

Why rely on dividend income alone from your shares? For some excellent information about writing covered calls, visit Planet Wealth!

Options are commonly known as “derivatives” because the Options market is a market which is “derived” from another market. The most commonly known options are derivatives of the share market, but you can also have options on commodity futures such as gold, silver, sugar, wheat or pork bellies, or on other financial instruments such as currencies. The market is based purely on supply and demand, which means the prices rise and fall according to market sentiment.

Whether we are talking about shares, commodities or currencies, these upward or downward trends can be tracked on charts. It is a true saying that “a picture paints a thousand words” and in the same way, charts can give us a visual representation of the movements in price, in a way that no amount of tabulated data can. Charts are our best friend if we want to learn option trading because they help us to decide when to buy or sell, or what strategy to employ.

What is an Option?

Before we can learn option trading, we first need to understand what an Option is. An option is a contract between two parties to exchange an asset for an agreed price, by an agreed time. If you buy an option, you are outlaying a much smaller sum than you would for the full purchase price of the asset the option covers. You may have heard of someone having an option to buy land. In this case, you would pay a few thousand dollars to give you the right to purchase something worth many thousands of dollars for an agreed amount, within a given time frame. So you have paid for a right, but not an obligation. You can exercise that right if you wish, or you can let it lapse, or expire. The same principle applies to options on shares. When you buy a CALL option, it gives you the right to “call” on the owner of the shares, to sell them to you at the agreed “strike price” by an agreed date.

Let’s look at an example.  If you purchased a $30 October ABC Bank (ficticious name) call option, you now have the right (but not the obligation) to purchase ABC Bank shares for $30 up until the contract expiry date in October. Now, imagine that before the option expiry date, the daily market value of ABC Bank shares rose to $32. This would effectively mean that you now have the right to purchase something for $30 and then immediately turn around and sell it on the open market for $32. If you had purchased contracts for 1,000 shares, you have an immediate profit of $2,000 at the time the option expires. It shouldn’t be difficult to see then, that the higher the share’s market value goes before the expiry date, the more valuable your call option will become. As long as the market price is above the option strike price, the call option contract is said to be “in the money”.

To learn option trading, it is critical you understand this simple concept.

On the other hand, you might think the price of a share is going to fall. You may want to ensure that you can still sell your shares for at least what you paid for them, or slightly below. So you take out a form of insurance called a “put” option. A put option gives you the right, but not the obligation, to sell (or put) your shares to someone else, for an agreed amount, by a given date. Let’s take our ABC Bank example above and imagine that you owned 1,000 shares that you purchased for $30 but before our October expiry date, the share price plummeted to only $26. Normally, you would have lost a cool $4,000 (1,000 shares x $4 loss in share value), but if you had also purchased $30 October put options, you have the right to sell (put) the shares for $30 to the market. For a small cost, you have avoided a $4,000 capital loss - so you would feel like you’ve taken out “share insurance” which is what a put option really is. So again, it becomes evident that as the price of a share drops, so a put option becomes more valuable. As long as the market price is below the option strike price, the put option contract is said to be “in the money”.

Why Options?

Options have often been perceived as high risk and indeed, can be so, because their price can rise or fall rapidly as the “underlying” share price moves. If we  want to learn option trading it is imperative we avoid the traps. If we learn how we can harness and tame this power, our perception of options as a trading vehicle can change dramatically.

Options, if used wisely, can actually be far less risky than simply trading shares alone. Why? Because options contain the elements of time (to expiry) and price (movements), as well as the ability to either buy them or create them out of nothing, to sell them. When these three elements are understood and effectively combined, they provide a wonderful flexibility that allows us to protect our trading positions, while at the same time, providing opportunity for the same profit that would ordinarily have come from ten times the investment capital needed to produce a return from investing in the underlying shares. This is called “leverage” - less dollars to produce the same profit. If you can invest a much smaller amount to produce a better profit, this leaves your other capital free for other option investments, bringing even more profit.

You can implement some great option trading strategies with surprisingly little capital and excellent returns. Learn option trading the safe way! It’s not rocket science. Just buying a simple call or put option with the hope of selling it for a profit can be your express route to financial ruin. With a little more education, you would be surprised how much better you can do, with much less stress and with the same trading capital.

One of the safest ways to learn option trading, is by understanding Option Credit Spreads. They are a beautiful, low risk, low maintenance, flexible strategy. For more on this CLICK HERE.