Keep Your Options Open – Part 2

Know tricks in selecting pomelos? photo by foodie Skip to Malou

Be Selective

The first thing I have to admit upon rising from the ashes of my trading debut is that my funds for trading is small to start with and I just can’t keep adding to it if I am losing money. I’ve got growing children and for sure their needs are many and have to prepare for the future.  It is certainly not acceptable to lose all of it again.(Sounds so serious!:p)  Anyway, that’s what I tasked myself to do and moved forward.

That means, I need to make the most of the capital, and achieve the following:

• Protect my investment
• Income is produced
• Grow the investment

Remember PIG Investing? I’ve been attending seminars on wealth creation and did several businesses and real estate deals before and was able to boil down the lessons from them and my trading failure.  I found a way to fulfil all three by employing ideas that help us to last financially as discussed earlier —  Velocity of Money (aim to reuse / redeploy it), Infinity (aim to fish out your capital quickly and get a return from zero ) and Position Sizing (ensuring we are able to fund series of trades that will meet our goal).   These are best implemented using Options strategies on stocks I hold.

I only trade what fulfils the “5 Reasons to Trade” – most of them by 3 Options strategies:

• Writing Covered Call Option
• Buying Call
• Buying Put

Fresh Durian, yummy but expensive and forbidden in airlines as is! - photo by Hjh Tom

** There are advanced Buying strategies that can achieve “being wrong and still profitable” but they require another leg of transaction.  I’m not including it here to keep within our Position Sizing considerations.  You can read up on other Strategies  in the Options booklets from your exchange or the one  I recommended above.

We will discuss those 3 Options strategies with examples later.  The rest like Spreads, Straddles, Naked Options are “forbidden fruits”.

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Knowing the Risks … Make it Work for you, or Avoid it!

1.  Options are considered risky because at the most basic Buy-only strategies, the value of the Option goes down as you get closer to expiry. This is called “time decay”. 

What to do :

• Make it work for you,  time decay works against  buying strategies, you can do the Sell side of  Opening transaction – this is best when already owning the shares, which  is done with the Covered Call strategy. 

2.  Unlimited loss – While it is true that you have a sure profit, some “naked” Selling strategies carry unlimited loss.  Naked selling means Selling options without the shares like in Writing Calls or Naked Put Selling.

What to do :

• Avoid the strategies where your loss will be unlimited.
• I find that “Buy”strategies are easier and safer to use for Trading because you know how much you risk at the start and it is limited. Important rule is to Follow Position Sizing^TM when buying options.

3.  You can get stuck –remember “liquidity” is your ability to get in and out of the market easily?  You might want to get out to limit your loss or take your profit and no one wants to do the other side of the transaction.  

What to do :  Avoid stocks or Options  series with low volume, observe this over time by checking up on the number of Buyers / Sellers on the series or the Open Interest, check the Active Options list in your Exchange.   Select the stock whose Options market has high volume of transactions.  Exchanges usually have Market Makers (professional traders) that can fill trades, but it is safer to be in the highly liquidstock options series/markets.

4.  Expensive – Some Options strategies have high cost of transactions – Options fees are much higher already than straight buying and selling of shares and these are strategies that will involve simultaneous Buying and Selling or 2 legs of transactions – this will add to the transaction costs and may eat up your profits.

• What to do : Avoid these strategies until you have built up your account.Important rule is to Follow Position Sizing^TMwhen Buying options.

Durian Delights - photo by Hjh Tom

Again, this is like “exotic fruits”.  For sure  there are some that I don’t like or not too excited about.  Something  about the texture, or after-taste. Like the hairy “mabolo” or velvet apple, a cousin of the Japanese persimmon. So since, I don’t like them, I don’t eat them. I can live blissfully without them.  Similarly with Options, you can do your trading business without the riskier strategies. Just do the ones you are comfortable with that offer low-risk. Simple as that.

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3 Low-RiskOptions Strategies

OK we went through a list of criteria and risks and arrived at 3 Low-Risk Options strategies that make the cut. 

• Writing Covered Call Option
• Buy Call
• Buy Put

Writing Covered Call Option

We said earlier, a Taker buys a contract to have “the right to buy”. With this strategy, you are the Writer selling the contract – obligated to sell at the Strike Price —  and receives the premium. You have to own the shares to be able to do this strategy, or purchase the shares and immediately write a Call Option against it — a  buy and write strategy — which is a slight variation but has the same goal of protection.

If the Taker expects the price of the stock to go up, you, the Writer expect the price to go down, just up slightly or not moving much.  If you happen to be wrong in your view, say the stock surged, the worst that can happen is you have to sell your shares at the strike price.  

Using the earlier example, on Call Option

STO’s current price early June is 14.11. STODW8  14.61 Call option gives the Taker the right to Buy 100 STO shares for 14.61 each, on or before the expiry date of the option in August. Premium paid is 35 cents per share and Taker  buys 5 contracts of 100 shares, paying the Writer $175 (.35 per share x 5 contracts x 100 shares)

The writer may have bought STO at 14.00 before writing the Call Option,  with this strategy, she ensures a profit by selecting the Strike Price of 14.61 and receiving 35 cents per share.

If the writer is correct in her view and the share price went down or moved up but stayed below the Strike Price, she can buy back the contract and close out on her responsibilities to the contract.  She is free to write another contract on the same shares she is holding.

If you happen to be exercised and gave up your shares, you made $480 which is 6.8% of your capital. You can of course buy another lot of shares and re do the transaction. 

If NOT Exercised, you earn $175 on the transaction, you can do this every month so for a year ( 12 months) you would have earned 2100 or 30% of your 7000.  Even if you just make half of this amount, that’s 15%.

Let’s evaluate this :

 I personally like the Covered Call strategy and recommend to beginners because even if you are wrong,  the worst-case is that you have to give up your shares for further profit, you don’t lose money on the transaction choosing a series above the price you  bought your shares. For example, you bought  STO at $14, then only write Covered Call Option at $14.50  otherwise you will lose money.   A nifty conservative strategy is to use  a series that has only Time Value, it lets you Sell  Time  — you can only do this with selling options!  

It’s like one of those fruits you can eat ripe or unripe.  (Unripe fruits usually shaken to pulpy softness with salt or the more exotic accompaniments, fermented shrimp fry! (Malay version “belachan” or Filipino “bagoong alamang”)

Buy Call Option

What it is — This strategy allows the Buyer to have the “right to Buy” and a good strategy to use when expecting prices to go Up.  For this privilege, you pay a premium which is just a fraction of money (compared to owning shares) that will allow you to profit from a move Up in price.

When you are wrong –  say the stock price fell, the worst that can happen is you lose the premium you paid.  It’s important to observe your Position Sizing rule.

Using the earlier example on Call Option

STO’s current price in early June is 14.11.  You bought 5 contracts STODW8  14.61 Call option which gives you  the right to Buy 500 STO shares for 14.61 each, on or before the expiry date of the option in August. Premium paid is 35 cents per share and buying 5 contracts of 100 shares, pays premium of  $175 (.35 per share x 5 contracts x 100 shares)

If the price goes up as you expected, you can choose  2 options

• At expiry Buy  500 shares of STO at 14.61, paying $7,305 for the shares and  keeping in mind the additional .35 per share you paid or $175, for the strategy to be worthwhile, the price has to be higher than 14.96 (the Strike Price plus Premium Paid) as well as the fees you paid
• If you don’t want to exercise and merely profit from the move UP, sell the Option.  The new premium price will be dependent on the current price and how much time is left before expiry

If STO’s price does not go above 14.96 the Taker gets no benefit – Call Option is only profitable ABOVE the Breakeven Price (Strike Price plus the Premium paid). She can sell the Option with profit or loss before it expires –  or let it lapse. 

Use Out-of-the-Money Options that follow Position Sizingand will have 3R profit potential.

Buy Put Option

What it is — This strategy allows the Buyer to have the “right to Sell” and a good strategy to use when expecting prices to go Down.  You do not have to own any shares, when you want to exercise your right to sell, you can buy from the market at a lower price. (You lose money when you exercise your right above the Strike Price). For this privilege, you pay a premium which is just a fraction of money (compared to owning shares) that will allow you to profit from a move Down in price.

When you are wrong — say the stock price went Up, the worst that can happen is you lose the premium you paid.  It’s important to observe your Position Sizing rule.

Using the earlier example on Put Option

STO’s current price is 14.11.You bought 5 contracts of STODK8  14.14 Put option which gives you  the right to Sell 500 STO shares for 14.14 each, on or before the expiry date of the option in August. Premium paid is 50 cents per share and buying 5 contracts of 100 shares, you pay a premium of  $250 (.50 per share x 5 contracts x 100 shares)

If the price goes Down as you expected, you can choose  2 options

• At expiry Sell  500 shares of STO at 14.14, selling 7070 for the shares and  keeping in mind the additional .50 per share you paid or $175. For the strategy to be worthwhile, the price has to be lower than 13.64 which is the Strike Price less Premium Paid.  (We are not considering the fees you paid here but you must do so in real life) 
• If you don’t want to exercise and merely profit from the move Dow, close the transaction by selling the Option.  The new premium price will be dependent on the current price and how much time is left before expiry.

If STO’s price does not go below 14.14, the Taker gets no benefit – Put Option is only profitable BELOW the Breakeven Price (Strike Price less the Premium paid). She can sell the Option with profit or loss before it expires –  or let it lapse.

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There you have it.  Strategies to protect and grow your income.

Keep your options open often.

As you get used to it,  you might acquire the taste —  like hot and sour Asian flavors.

Hot and Sour Splash - photo by Stephanie T Igaya

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