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Stocks and Options: Similarities and Differences

Many investors ask about the fundamentals of options and the difference between types of options. Here I share some background on the fundamentals of option trading. Bonus: An active option trade is shown below for our Covered Call of the Week.

There are both similarities and differences between stocks and options. Some think of options as a stock substitute which is correct in some cases. However, it is important to know the differences as you include both in your investing plan.

Similarities:

  • Stocks and options are both securities. Options are technically derivatives since they relate to another security: shares of stock.
  • Stocks are traded on exchanges and also over-the-counter. Stock options trade only on exchanges regulated by the SEC.
  • Market makers buy and sell stock options as they do stocks.

Differences:

  • Stock represent an equity ownership interest in the company. An option is a contract.
  • Options expire on their respective expiration dates. An option not exercised by its expiration date expires worthless. Stocks never expire except when a company goes out of business.
  • Stocks are represented by stock certificates, although buyers often don’t see the shares because they are held in the broker’s street name. But options are maintained in the form of electronic book entry only, and there are no certificates that represent options.
  • At any time, there is a fixed number of shares of stock outstanding. However, there is no limit to the number of option contracts that can be created on a stock.
  • Holders of stock have the right to vote and receive dividends, but holders of options have neither, since the option is only a contract to buy or sell.

COVERED CALL TRADE OF THE WEEK

KKR & Co. (KKR)

The KKR Oct 25, 2019 covered call with a $27.50 strike price (selling at $0.85) could potentially yield a 3.89% return if KKR stays above $27.50 a share at expiration 26 days from now. The covered call has a 3 Key (Moderate Relative Risk) ranking. On 07/26/19, Argus Research set a $31.00 12-Month price target for KKR, which is currently trading at $3.68 below that target. By using this covered call strategy potential returns may be higher than simply holding the stock if KKR stays below $28.38 through Oct 25, 2019. The covered call strategy offers limited protection if the stock drops in price, but if the stock goes below $26.47 expect losses.

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The Best Method for Call Writing

Most experts in the stock market will generally say, “the writer of an options is foregoing any increase in stock price that exceed the strike price for the premium received when selling calls.  The option writer continues to bear the risk of a sharp decline in the price of the stock. The cash premium will only offset this loss.”  Do you buy into this way of thinking?  This is not correct based on how I trade covered calls.

With my method, you no longer care about the price of the stock that you purchased.  When the stock does go down, we would buy back the option at an inexpensive cost and immediately write a new option.  For example, we received a premium of $3.00 and close it at $0.25 when the stock price drops.  If the stock price went down $5.00, we would write a new call at at a $5 lower strike price.  This may net an addition premium of $3.00 so when you add the premiums minus the buy back of the first option we have $5.75 while the stock only dropped $5.00.  The second premium helped to offset the loss from the strike price.

When the stock does not reach the strike price, let the option expire, keep the premium, and write a new cal at the same strike price.  When the stock price goes above the call strike price, buy back the call option and write a new option at a higher strike price to reflect the gain in the stock. the second premium will help defray the cost of the buyback while you have a gain in the stock price.

For the buyer, options are a wasting asset as time decay erodes value.  The time value portion of a option is always zero at expiration.  Selling the time value repeatedly on the same stock makes option income work for you.

With my trading method, you will not be waiting on the stock price to go up to make money.  You will make money on the wasting time value of options you have sold.  this will change your investing philosophy about the stock market.

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Trading Covered Calls by Legging In

This strategy is a variation of the out-of-the-money (OTM) covered call strategy.  When you are anticipation a market upturn such as a bounce up or your stock is in a prolonged uptrend, this strategy may work for this type of situation.  The legging in strategy is to buy the stock and then wait for the price to increase before selling OTM calls.  The legging in is related to the buy the stock (one leg) before you sell the calls (second leg) at a later date to complete the covered call trade.

This strategy can significantly increase your returns when the stock price moves up rapidly.  Then, you have a decision to make about when to sell the call.  Some traders decide that the stock will continue to rise so they do not sell the call.  Others may decide the stock is out of gas to move higher so they will
sell an OTM call for additional income.

As an example, you may purchase a stock at $52.40.  The current month 52.50 call strike is selling for $1.00.  You can buy the stock at $52.40 and sell the 52.50 call for $1.00 and get an unassigned return of 2.14%.  You don’t want to lock in your covered call trade for a low return so you wait on the stock.  To leg in to this trade, you would buy the stock and wait until its price increases to around $54.00.  At this time, the 52.50 call strike price is $2.50.  The leg in trader
would sell the 52.50 call strike if the stock was out of momentum and poised for a pullback.  This would create an assigned return of 5.01%.  This return is more than double the initial trade with a downside protection to $52.50.

The leg in trade more than doubles the unassigned return because the option premium more than doubled (from $1.00 to $2.50) as the stock price increased.  The return percentage doubled while both trades were at the same strike price (52.50).  This could be even better if the trader moves their call strike price
to 55 to let a stock continue to run up to a higher price.

So what is the trade off for the additional return?  Legging-in is a little speculative because it leaves the investor without a premium for a short time
while waiting for the stock price to increase.  Additionally, the trader does not have the downside protection while owning only the stock without selling the
call.  Lastly, the investor could be wrong and the stock never increases in price.

The bottomline is that the trader must have a solid reason for why the stock will increase in price in the short-term.  the moment this rationale is proven wrong, the trader must make a decision on how to proceed with the stock they own.

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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.

Get new trades for cash-secured puts and CC trades.

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Close This Trade for 450% Gain

2/1/2018 – MOD closed at $24.30 per share today. Buy to close the MOD 22.5 PUTs at $0.20 per contract.  This is a gain of $0.80 per option in 3 trading days. This is a 3.7% gain or 450% annualized return.

1/29/2018 – Get Rich Subscribers Release (NEW Trade)

As income investors, we seek to create consistent monthly income by selling options to collect monthly premiums. This has been successful for our investors for years. Option selling offers another method to diversify investing strategies beyond traditional dividend investing. We have combined technical stock events with our strategy to identify high returns option selling opportunities. This income trade will generate a return of more than 93% annualized.

Stock: Modine Manufacturing Company (MOD) develops, manufactures, and markets engineered heat transfer systems and heat transfer components for use in on- and off-highway original equipment manufacturer vehicular applications.

The RSI is above 50. The MACD is positive and above its signal line. The configuration is positive. Moreover, the stock is trading above both its 20 and 50 day MA (respectively at 21.53 and 21.73).

Chart: We have detected a “Symmetrical Continuation Triangle (Bullish)” chart pattern formed on Modine Manufacturing Co (MOD on NYSE). This bullish signal indicates that the price may rise from the close of 23.25 to the range of 26.70 – 27.50. The pattern formed over 43 days which is roughly the period of time in which the target price range may be achieved. Modine Manufacturing Co has a current support price of 21.15. No resistance level has been found.

Strategy: We have an opportunity to sell options for income with MOD as the stock should trade higher in the coming weeks. I recommend to place your trade and exit when you have locked in profits due to the stock price moving higher. Our goal here is to make income short term so we can exit and compound capital into another trade.

For medium risk option trade, look to sell a February 2018 22.5 PUT for about $1.00. This creates a return of 4.6% to expiration (18 days) or greater than 93% annualized.

For a conservative trade, you can setup a covered call trade. You can purchase 100 shares of MOD and sell a February 22.5 CALL option for about $1.75 for an assigned return of 4.6% in 18 days.

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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Why Sell Covered Calls?

Sellers of covered calls seek two objectives: additional income from their stock portfolio and protection from a market decline in the price of their stocks.  The call premium helps the option writer to achieve these goals.  With the covered call strategy, you can use stocks you already own or you can purchase new shares to sell covered calls on.  In either case, you will not be overly concerned about the the price movement of your stocks over a period of time.  However, you will only write covered calls on stocks you already own.
 
We can apply this call writing strategy to dividend paying stocks.  You will be getting two sources of income: the dividends and the premium you received from selling the calls.  In addition, there is potential for a third source of income if the stock were to increase in price.  If we were to allow the stock to be called away, we would receive the strike price in addition to the premium and dividends.  This is an outstanding scenario where you can potentially receive three sources of income from one investment!

However, the call writer does not have to remain obligated to deliver the stock.  The writer can terminate the obligation if it has not been exercised by purchasing to close an identical option at current premium price.  Also, if the option is exercised, you do not have to deliver the original stock as you can purchase new shares to fulfill your delivery obligation.

When you write a covered call, you still own the stock and can receive all dividends paid before the options expire.  When you sell options, you begin with an immediate profit rather than an uncertain potential gain.  The most you can make is the premium received and the price of the strike minus your cost of the purchase of stock.

There are always opportunities for investors to use options are part of their total investing plan.  With careful stock selection and monitoring of your position, selling options can:

    • Boost annual income by 15 percent or more;
    • Be used for tax benefits and low costs;
    • Offer a variety of choices such as the underlying stock, strike prices and time periods.

The best rule: never buy options, only sell them!  Buying options is speculation while selling options is investing.

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