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Trading a Calendar Spread with LEAPS

Previously, we posted information on doing a covered call using a LEAPS option. Call calendar spreads are similar to a covered call. One part of the call calendar spread is buying a LEAPS call instead of owning the stock. Then, we can sell call options (like a covered call) with less time to expiration (the calendar part). For example, we can buy a call LEAPS with two years of time and sell a call option in the next month. It the strike price of the LEAPS is the same as the call sold, then you have created a call calendar spread. It the strike prices are different, then we have created a diagonalized calendar spread.

My preference is to buy a LEAPS that is in-the-money. This gives you a higher delta so you captured more of the stock price move. A good target is to buy a LEAPS call with a delta of 0.70 or higher. If the stock makes a strong up move, then you gain more profits in the LEAPS call. Also, ITM LEAPS give us more choices in what strike prices to sell the call. In comparison to a covered call with stock, we DO NOT want to e exercised in the LEAPS position. The reason is simply that we do not want to lose the time value of the LEAP call. You can buy an ATM or OTM LEAPS call, but your delta will be lower and it is more difficult to sell a call until the stock price moves up.

When I sell a call, I like to sell the shortest amount of time available because it will decay faster (more profit per day due to time decay) than a call with several months of time. I like to use the existing month and the next month for call sells. I like to sell an OTM call when holding a LEAPS because the call sold is all time value.

The bottomline: Your returns will be leveraged. For example, you may get a 3% return on a covered call but that same return will be 12% if your underlying is a LEAPS instead of stock. Since we are using LEAPS, if the short call strike price is above the stock then it will expire worthless. You can then sell a call against the LEAPS for the next month. If the stock price is greater than the short call, you can back back the short call or roll it up to a higher strike price.

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How to take Advantage of High Implied Volatility

Implied Volatility (IV) gets high when a company has some impending event that can move the stock price.  The impending event sometimes refers to the stock as being a special situation stock.  The impending event causes the option IV to change based on the likely stock price move.  Here are some causes that increase IV:
 

  • There is a pending event such as an earnings report, FDA ruling, etc.
  • A significant news event is pending on another company in the same industry
  • The company’s industry is more volatile due to expected changes
  • The stock has a higher level of volatility so its options are more expensive
  • An aberration occurs as there is no apparent reason for more expensive options.

When a stock is already moving its price, option premium will be high.  IV will simply reflect that volatility and potentially more volatility. Options are also more expensive when a stock is in a confirmed trend.  
 
Time value that is inflated due to spiking IV will collapse when the event causing the spike arrives.  You do not want to be long an option when IV collapse as you can lose money even if the stock price doesn’t fall.  In general, you want to buy low volatility and sell high volatility.

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To use high volatility to your advantage when you are Bullish:

  1. Buy stock as options are expensive;
  2. Write covered calls to collect higher premium;
  3. Sell naked or cash-covered puts for higher premiums;
  4. Write bull put spreads for higher credits.

If you are bearish with high volatility:

  1. Short the stock since puts are expensive;
  2. Sell naked calls;
  3. Write bear call spreads for credit.

How To Use Volatility in Selecting Covered Call Trades

If options were always fairly priced, then we would expect the option price to always imply a level of stock volatility that is more or less in line with historic volatility (HV).  But this not always the case.  For example, two stocks are trading at $20 each with current month calls at $20; one calls ask price is $1.00 while the other is at $2.00.  In comparison, one calls value is twice the others. Why? The difference is in implied volatility of the two stocks.

Implied volatility is the market’s perception of how volatile a stock will likely be in the future.  A covered call trader must understand how implied volatility affects their trading  decisions.  IV Can be the same as historical volatility, lower than historical or higher than historical.  What if an option has an implied volatility of 70% while the stock had a volatility of 25%?  The Black-Scholes calculation would tell us that the option is overpriced.

The key to covered writes: how implied volatility compares to historical volatility.  When option volatility (call IV) is lower than the 10-day/30-day historical volatility, then the call option is under priced.  For call writers, under priced options mean you are not being paid for the stock’s actual volatility.  However, if the calls IV is extremely higher than historical volatility, the market is expecting something to happen.  If after the event the IV collapses then the calls value will collapse.  But…

You should not chase the high IV because those stocks are too risky.  You should compare IV to both the 10-day and 30-day historical volatility.  This will tell you if the the IV is in line with HV.  Generally, you do not want IV to be significantly higher (10-15%) than either 10-day or 30-day historical volatility.

 

The rules are as follows:

  • If IV is higher than HV – then an event is projected such as news, earnings, etc. Find another stock to write calls on;
  • If IV is lower than HV – then the option is likely under priced so you should Find another call write trade;
  • If IV is in line with HV – then this is a good trade if stock volatility is below 40%.

For conservative covered calls, you want stock volatility below 40%.  Any stock with a volatility above 60% is too risky for a covered call trade.  

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8 Ways to Profit from Covered Call Trades

The covered call trade has always been known as an income strategy as you receive premium for selling calls against your stock.  This is the most popular rationale for implementing this type of tradings.  However, there are many more dimensions that can be coupled with covered call trading to further enhance the potential for profits.  Here is a list of 7 methods to more profits writing covered call trades.

  1. Selling the classic covered call against stock you own.  You make money with the time decay of the short call.  usually you sell the near month or next month out so you can continue to compound your money.
  2. You can use LEAPs as stock replacement to leverage a covered call trade which will increase potential profit returns.  Click here  for a recent article on this topic.
  3.  You can sell out-of-the-money (OTM) calls as your short call.  Here you get the call premium and potential for a capital gain as the OTM call offers some upside profits for the stock price to increase.
  4. You can make more money on a short call when volatility collaspse early in the trade and you close the trade.  We have all been in covered call trades when after a few days the call option loses value and you find yourself in a very profitable trade.  You can close this short call to lock in profits.
  5. You can trade the short call as the stock price changes.  For example, if the stock price decreases, you can close the short option early for a profit.  Then, the call can be written again when the stock prices snaps back to higher levels.  This is similar to channeling stocks by trading the short call against stock price changes.
  6. You can roll up or roll out the short calls to a higher strike price or to a later expiration month.  This allows you to squeeze extra profits out of a stock price rise.
  7. You can add option legs to a short call to create spread positions such as a bull or bear call spread.  This is good to take profits from a rising covered call trade or a falling stock price.
  8. You can add a long protective put to the covered call position as it will increase in value as the stock price decreases.  This is usually utilized as protection against stock declines but can create more income when a stock price declines while you are holding a covered call position.

It is not necessary to use all of these methods when trading covered calls.  It will be advantageous to the income trader to use more than one method to make money income from selling premiums.  In addition, some of these methods can be used to enhance and/or protect your monthly income.

Adding these methods does require more monitoring or your covered call positions.  The advantage is that it adds more potential for profits compared to the classic covered call trade.  It really comes down to how active you want to be in your income trading each month.

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8 Tips to Becoming a Millionaire

We at Get Rich already know the path to wealth is having multiple streams of income that we create each month using covered call trades and monthly income dividend stocks.  This article from Entrepreneur magazine captures the tips we live by each day.

See the full article here

Millionaire. It’s a title that plenty of us would love to have. But, is that actually feasible?

Believe it or not, becoming a millionaire is a goal that can be achieved this year. In my life, I have been a millionaire several times. Most of the time before my 30s, however, I gambled my money away on cars, homes and a lifestyle I had no reason to be living.

Despite the chance that you too will blow millions, the process for you or anyone to become a millionaire has been consistent over the years. If you follow these eight valuable pieces of advice, I can guarantee that eventually you will become a millionaire. Here’s to making this happen this year!

Develop a written financial plan.

One of the main reasons why someone can never become a millionaire is that they haven’t written a financial plan. Developing a financial plan forces you to take action, instead of just talk. It also guides you in making the right decisions in order to achieve all of your dreams and goals.

Financial planner Scott D. Hedgcock said that, “When planning for a more secure future there are two inputs that are indispensable: how much money you have and how much money you spend.

Increase your streams of income.

After studying the very wealthy for five years, author Thomas Corley discovered that 65 percent of self-made millionaires he studied had three streams, 45 percent had four streams and 29 percent had five or more streams. This could include starting a side business, working part time, making investments and renting out everything from your home to your car to household items.

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The Right Philosophy for Covered Call Trading

When getting started in covered call trading you have so many options available that it can be overwhelming to determine where to begin.  Before you place any trades, you have have an ideal of what your perspective should be.  This is where you want to keep it simple so you don’t get stuck in option overload.  Here are some suggestions:

  • Keep it simple.  Don’t sell uncovered options because they represent free money because the stock can’t move that far.  This can cause some humongous loses beyond your magnitude of capital.
  • Always keep it safe.  You should know your risk tolerance and don’t venture beyond it.  If it feels risky, then it is too risky for your mental risk avoidance.
  • Keep it sensible.  Don’t trade anything that takes you beyond your sleeping and eating points.  Stay within your comfort zone.
  • Keep it diversified.  You gain some level of safety through buying different stocks in different industries than a large trade of a single stock.
  • Keep it disciplined.  Always stick to your trading plan in all cases.  More often, losses occur and get larger because of a lack of discipline.
  • When you implement a trade, you should have these tow items in your head:
    1. Set an approximate goal – the point where you expect the strategy to produce profits.
    2. Set an exit point to be used if the trade goes against you.

You should keep in mind that selling calls against your stock holdings is safer than just holding stock.  Here, the concept is to continue owning stock but to give yourself some downside protection and to get some income from the option premium.  This approach is not as exciting as buying calls and anticipating a hugh stock rally.  However, our goal is to preserve our capital so we can continue to create a monthly income.

Option Basics – What Vega Means to the Covered Write

Vega measures the sensitivity of the price of an option to changes in volatility. Vega is the estimate of the change in theoretical value of an option for the 1% increase in implied volatility. A higher volatility means higher option prices while a lower volatility means lower option prices. Vega is the measure of changing volatility on option prices. A higher volatility means an expected higher price swings in the stock.

An increase in volatility will increase the price of options on the stock while a decrease in volatility will cause all options on the stock to decrease. The vega of a long call or put option is always positive while the short calls and puts are negative. At-the-money (ATM) options have the highest vega so they are most sensitive to volatility changes. The further an option goes ITM or OTM, the smaller its vega will be. As volatility decreases for ITM and OTM options, vega is unchanged for ATM options. Vega decreases when time elapses similar to call premium decay. This causes vega to be higher for long dated options than short dated options. Of course, LEAPs have a high vega so an increase in volatility will raise the time value of the option.

For example, a stock that is trading at $35 with a high volatility of .75 with a vega of 30%. The stock option will lose $.30 for every 1% decrease in volatility and gain $.30 for every 1% increase in volatility. If volatility decreases by 20 points, then the stock option will decrease by $6.00. This suggests that you do not want to buy any call or put with a high volatility. Vega can cause option prices to change even if the stock price does not change.

Typically, I do not use vega in covered call trades as I tend to only sell options on stocks below 40% volatility and usually in the current option month. However, vega is important if you use LEAPs as a replacement for stock in a covered call trade.

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Close Trade for 76% Return

Monthly income seekers should close the position on KR as the stock has increased from the entry price of $24.12 to the closing price of $25.52.  Investors will lock in a 2.1% return in 10 days for an annualized return of 76%.

 

Sell Put on The Kroger Company (KR)

STRATEGY: Look at the May 2018 24 cash-secured put trade. For each 100 shares of KR stock you want to control, sell one May 2018 24 put option for a $0.70 debit per option or better. That’s potentially a 3.0% return on the cash-secured put trade.

A “Double Bottom” chart pattern formed on The Kroger Co (KR on NYSE). This bullish signal indicates that the price may rise from the close of 24.58 to the range of 25.30 – 25.50. The pattern formed over 18 days which is roughly the period of time in which the target price range may be achieved. The Kroger Co has a current support price of 23.48 and a resistance level of 28.01.

 

Using a Protective Put to Prevent Investment Losses

At Get Rich Investments, we create investing strategies to capture monthly income. This may take the form of covered call trades, cash-secured put trades, CEFs for monthly dividends and other strategies. However, as the market volatility increases such as we have experienced lately, investors get worried about protecting their capital. We do have an answer which is an effective strategy. It is called a protective put trade to protect against losses during a price decline. We like to also combine the protective put with our covered call strategy to have our income and protect our capital at the same time.

Please don’t take my word for it , here is how our friends at Fidelity Investments describe using a protective put.

There are two types of options: calls and puts. The buyer of a call has the right to buy a stock at a set price until the option contract expires. The buyer of a put has the right to sell a stock at a set price until the contract expires.

If you own an underlying stock or other security, a protective put position involves purchasing put options, on a share-for-share basis, on the same stock. This is in contrast to a covered call which involves selling a call on a stock you own. Options traders who are more comfortable with call options can think of purchasing a put to protect a long stock position much like a synthetic long call.

The primary benefit of a protective put strategy is it helps protect against losses during a price decline in the underlying asset, while still allowing for capital appreciation if the stock increases in value. Of course, there is a cost to any protection: in the case of a protective put, it is the price of the option. Essentially, if the stock goes up, you have unlimited profit potential (less the cost of the put options), and if the stock goes down, the put goes up in value to offset losses on the stock.

Let’s highlight how the protective put works. Assume you purchased 100 shares of XYZ Company at $50 per share six months ago. The cost of this trade was $5,000 ($50 share price multiplied by 100 shares).

The stock is now trading at $65 per share, and you think it might go to $70. However, you are concerned about the global economy and how any broad market weakness might impact the stock.

A protective put allows you to maintain ownership of the stock so that it can potentially reach your $70 price target, while protecting you in case the market weakens and the stock price decreases as a result.

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When the stock is trading at $65, suppose you decide to purchase the 62 XYZ Company October put option contract (i.e. the underlying asset is XYZ Company stock, the exercise price is $62, and the expiration month is October) at $3 per contract (this is the option price, also known as the premium) for a total cost of $300 ($3 per contract multiplied by 100 shares that the option contract controls).

If XYZ continues to go up in value, your underlying stock position increases commensurately and the put option is out of the money (meaning it is declining in value as the stock rises). For instance, if at the expiration of the put contract the stock reaches your $70 price target, you might then choose to sell the stock for a pretax profit of $1,700 ($2,000 profit on the underlying stock less the $300 cost of the option) and the option would expire worthless.

Alternatively, if your fears about the economy were realized and the stock was adversely impacted as a result, your capital gains would be protected against a decline by the put. Here’s how.

Assume the stock declined from $65 to $55 just prior to expiration of the option. Without the protective put, if you sold the stock at $55, your pretax profit would be just $500 ($5,500 less $5,000). If you purchased the 62 XYZ October put, and then sold the stock by exercising the option, your pretax profit would be $900. You would sell the stock at the exercise price of $62. Thus, the profit with the purchased put is $900, which is equal to the $500 profit on the underlying stock, plus the $700 in-the-money put profit, less the $300 cost of the option. That compares with a profit of $500 without it.

As you can see in this example, although the profits are reduced when the stock goes up in value, the protective put limits the risk to the unrealized gains during a decline.

We continue to identify winning option trades to generate income and to exit early as the stock bullish patterns moves prices higher.

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Option Basics: Risk and Diversification

The winners in option trading are those who manage the risk within their portfolio.  You must always monitor and protect your capital as if you lose your capital you will be out of the game.  Proper risk management starts with trading diversification and discipline to stick with your trading plan.

There are generally two types of portfolio risk: systematic and unsystematic.

Systematic Risk, also called non-diversifiable risk, is risk that cannot be eliminated.  It arises from factors which cause the whole market to move up or down, and can not be eliminated by diversification because it affects all securities. Examples of systematic risk are political or sociological changes that affect all securities.  Some of the most common forms of systematic risk are changes in interest rates or inflation.

Unsystematic Risk, also called diversifiable risk can be reduced or eliminated by diversifying your portfolio.  Unsystematic risk is risk that is unique to a certain industry, firm, or company.  Examples of unsystematic risk include: a company’s financial structure, weather and natural disasters, labor strife and a shortage of raw materials.  Since unsystematic risk affects a single company or industry, it can be mitigated by investing in many companies across a broad range of industries.

Option positions should be diversified.  A major advantage of option purchases is ‘truncated risk’, whereby your loss is limited to your initial investment yet your profit is virtually unlimited.  Option sells have a limited profit but should be diversified across several investments.  Diversification will allow you to use truncated risk to its maximum advantage.  While some of your positions will inevitably be  unprofitable, each profitable trade can offset several unprofitable trades. Option positions should be established among many underlying stocks and indexes in unrelated industries. This gives you diversification, which can help mitigate sector weakness.

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In order to trade options, your broker must first approve your account for option trading. There are various levels of option trading and each level has financial requirements that differ from broker to broker:

Level 1: Covered call writing
Level 2: Call and put purchases and covered put writing
Level 3: Spreads (requires margin)
Level 4: Uncovered call and put writing (requires margin)
Level 5: Index option writing (requires margin)

Be sure to ask your broker about their requirements for the level of options you plan to trade. Lastly, before you trade options, regulations require that you read Characteristics and Risks of Standardized Options prepared by the Options Clearing Corporation (OCC) and available from your broker.

Characteristics and Risks of Standardized Options prepared by the Options Clearing Corporation (OCC) and available from your broker.

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