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Investing with Credit Spreads for Higher Winning Percentages

As with all investments, the name of the game is “risk versus return.”  How much bang for the buck can you achieve for a given level of risk?  For many option-buying strategies, higher risk takes the form of lower winning percentages.  In fact, winning on fewer than half of your trades is quite normal.  The payoff, of
course, comes from the much higher profits you can achieve with these strategies, often in excess of 100%.

With credit spreads, the risk/reward paradigm is reversed.  You can reach winning percentages of 80% or higher using out-of-the-money options.  However,
the return per winning trade will be much lower, most often within the range of 10% to 25%.

A credit spread involves the simultaneous purchase and sale of puts (or calls) that expire at the same time, but have different strike prices.  Puts are used if you are bullish on the underlying stock or index, while calls are used for a bearish outlook.  For out-of-the-money credit spreads, the strike price of the sold (or written) option is closer to the underlying stock’s market price than the purchased option, and therefore carries a higher premium – resulting in a net credit.  The goal of a credit spread is for both options to expire worthless, allowing you to retain this entire net credit.

You may wonder why you would use puts for a bullish position and calls for a bearish position.  This is because you want the spread to finish out of the money, so you can achieve your maximum potential profit on the play.  Logically, then, puts will expire worthless on a bullish move, while calls will expire worthless on a bearish move.

Credit spreads offer two primary advantages over straight put or call purchases.  First, by using out-of-the-money options, you can profit from a wide range of outcomes, including the underlying stock moving somewhat against your expectations.  If you initiate a bearish credit spread with the sold call option 2% out of the money, you will keep the entire premium if the underlying security moves down, stays flat, or goes up 2%.  Only when the sold option slips into the money is your position at risk of losing value.  In addition, losses are generally capped at the difference between the strike prices of the options, minus the net credit collected upon initiation.

The second advantage is that no commission costs are incurred to exit your most successful trades, since the best-case scenario involves both options expiring worthless.  This feature increases your net return on a winning credit spread trade.  Moreover, unlike option purchases, credit spreads actually benefit from time decay, since neither option has any intrinsic value (as long as they stay out of the money), and the sold option will lose time value at a faster pace than the purchased option.

This is just one reason why we prefer to use front-month options for credit spreads.  In addition to providing the greatest exposure to time decay, these shorter-term options allow less time for the underlying equity to move substantially against you.  Such a move has a far more negative impact on a credit-spread position than the benefits of the underlying stock making a move in your favor.

What Option Open Interest Means to the Trader

Option open interest is the number of options contracts open in a specific option series.  Open interest serves as a measure of option liquidity in the underlying option series.  The higher the open interest, the tighter the bid/ask spreads will be so slippage in trades will be lower.  When looking at option series, you want to be sure open interest is at least 5,000 and that the bid/ask spreads are no larger than 20 point apart.

When net buying or selling occurs in the underlying security, the open interest will show this change in the same direction of trader moves.  Increases in call open interest indicate the underlying is advancing up while increases in put open interest indicate more selling pressure.

Here are some rules on how to interpret open interest levels for OTM calls and puts in relation to the stock’s price movement:

  • Growing OI in Calls – confirms strength of stock’s advance
  • Declining OI in Calls – bearish divergence of stock’s advance
  • Flat OI in Calls – slightly bearish as no additional support for stock advance
  • Growing OI in Puts – confirmation of stock’s decline
  • Declining OI in Puts – slightly bullish as no additional support for stock decline
  • Flat OI in Puts – slightly bullish as it is not confirming decline

The growing interest in OTM and ATM options will confirm the stocks continued movement in the same direction.  Basically, this means the traders who have
been right are still buying more options for continuing the same direction.  In comparison, when open interest falls it indicates that traders are leaving the trade so it will likely end the current movement.  Traders are taking their money off the table.

The chart below displays a put/call open interest chart for Salesforce.com (CRM).  Notice how the blue line has been declining from 1.25 down to 0.95.  This indicates the number of puts are declining while the calls are increasing.  The traders are starting to turn more bullish on CRM as its stock price (red line) has increased to $125.

Put/Call open interest chart for CRM - getrichinvestments.com

Click to enlarge

List of Available Weekly Options

 

LIST OF AVAILABLE WEEKLYS OPTIONS (last updated October 26, 2011) – official
Note: CBOE Removed ElPaso Corp. (EP) and added Cree, Inc. (CREE)
Ticker Symbol Name Product Type

List Date

Expire Date

OEX S&P 100 Index (American style) Index, pm-settled, cash

20111027

20111104

XEO S&P 100 Index (European style) Index, pm-settled, cash

20111027

20111104

SPX* S&P 500 Index Index, pm-settled, cash

20111027

20111104

DJX Dow Jones Industrial Average Index, am-settled, cash

20111027

20111104

NDX Nasdaq-100 Index Index, am-settled, cash

20111027

20111104

RUT Russell 2000 Index Index, am-settled, cash

20111027

20111104

EEM iShares MSCI Emerging Markets Index ETF

20111027

20111104

EWZ iShares Brazil Index ETF ETF

20111027

20111104

FAS Direxionshares Daily Financial Bull 3X Shares ETF

20111027

20111104

FAZ Direxionshares Daily Financial Bear 3X Shares ETF

20111027

20111104

FXI Ishares FTSE/Xinhua China Index Fund ETF

20111027

20111104

GLD SPDR Gold Trust ETF

20111027

20111104

GDX Market Vectors Gold Miner ETF ETF

20111027

20111104

IWM iShares Russell 2000 Index Fund ETF

20111027

20111104

QQQ Power Shares QQQ Trust ETF

20111027

20111104

SDS Proshares Ultra Short S&P 500 ETF

20111027

20111104

SPY S&P 500 Depository Receipts ETF

20111027

20111104

SLV iShares Silver Trust ETF

20111027

20111104

SSO Pro Shares Trust Ultra S&P 500 ETF

20111027

20111104

TBT Proshares Ultrashort Barclays 20+ Yr. Treasury ETF

20111027

20111104

TLT iShares Trust Barclays 20+ Yr. Treasury Bond Fd. ETF

20111027

20111104

TZA Direxion Daily Small Cap Bear 3X Shares ETF

20111027

20111104

USO United StatesOil Fund ETF

20111027

20111104

UNG United StatesNatural Gas Fund ETF

20111027

20111104

VXX iPath S&P 500 VIX Short-Term FT ETF

20111027

20111104

XLE Energy Sector SPDR ETF

20111027

20111104

XLF Financial Select Sector SPDR ETF

20111027

20111104

AA Alcoa Incorporated Equity

20111027

20111104

AAPL Apple Corporation Equity

20111027

20111104

ABX Barrick Gold Corp. Equity

20111027

20111104

AIG American International Group Equity

20111027

20111104

AMZN Amazon.com Inc Equity

20111027

20111104

AXP American Express Company Equity

20111027

20111104

BA Boeing Company Equity

20111027

20111104

BAC Bank of America Corp Equity

20111027

20111104

BIDU Baidu Inc. Equity

20111027

20111104

BP British Petroleum Equity

20111027

20111104

C Citigroup Equity

20111027

20111104

CAT Caterpillar Inc. Equity

20111027

20111104

CLF Cliffs Natural Resources Equity

20111027

20111104

CSCO Cisco SystemsInc. Equity

20111027

20111104

CREE Cree Inc. Equity

20111027

20111104

CRM Salesforce.com Inc. Equity

20111027

20111104

CVX Chevron Corp Equity

20111027

20111104

F Ford Motor Company Equity

20111027

20111104

FCX Freeport McMoran Copper CL B Equity

20111027

20111104

FFIV F5 Networks, Inc. Equity

20111027

20111104

FSLR First Solar Inc. Equity

20111027

20111104

GE General Electric Company Equity

20111027

20111104

GM General Motors Company Equity

20111027

20111104

GMCR Green Mountain Coffee Roasters Inc. Equity

20111027

20111104

GOOG Google Inc Equity

20111027

20111104

GS Goldman Sachs Group, Inc. Equity

20111027

20111104

HAL Halliburton Company Equity

20111027

20111104

HD Home Depot Inc. Equity

20111027

20111104

HPQ Hewlett-Packard Company Equity

20111027

20111104

HRBN Harbin Electric Inc. Equity

20111027

20111104

IBM International Business Machines Equity

20111027

20111104

IDCC InterDigital Inc. Equity

20111027

20111104

INTC Intel Corporation Equity

20111027

20111104

ISRG Intuitive Surgical Inc. Equity

20111027

20111104

JNJ Johnson and Johnson Equity

20111027

20111104

JPM J. P. Morgan Chase & Company Equity

20111027

20111104

KO Coca Cola Equity

20111027

20111104

LVS Las Vegas Sands Corp. Equity

20111027

20111104

MA MasterCard Inc. Equity

20111027

20111104

MCD McDonalds Corp. Equity

20111027

20111104

MCP Molycorp, Inc. Equity

20111027

20111104

MGM MGM Resorts International Equity

20111027

20111104

MMM 3M Company Equity

20111027

20111104

MOS Mosaic Company Equity

20111027

20111104

MRVL Marvel Technology Equity

20111027

20111104

MSFT Microsoft Corporation Equity

20111027

20111104

MU Micron Technology Inc. Equity

20111027

20111104

NEM Newmont Mining Corporation Equity

20111027

20111104

NFLX NetFlix Inc. Equity

20111027

20111104

NKE Nike Inc. Equity

20111027

20111104

NVDA Nvidia Corp. Equity

20111027

20111104

ORCL Oracle Corporation Equity

20111027

20111104

PCLN Priceline.com Inc. (new) Equity

20111027

20111104

PCX Patriot Coal Corp. Equity

20111027

20111104

SINA Sina Corporation Equity

20111027

20111104

POT Potash Corp Saskatchewan Equity

20111027

20111104

QCOM Qualcomm Inc. Equity

20111027

20111104

RIMM Research in Motion Limited Equity

20111027

20111104

RMBS Rambus Inc. Equity

20111027

20111104

S Sprint Nextel Corp. Equity

20111027

20111104

SLB Schlumberger Ltd. Equity

20111027

20111104

SLW Silver Wheaton Corp. Equity

20111027

20111104

SNDK SanDisk Corp. Equity

20111027

20111104

SU Suncor Energy Inc. Equity

20111027

20111104

UTX United Technologies Corp. Equity

20111027

20111104

V Visa, Inc. Equity

20111027

20111104

WFC Wells Fargo & Co. Equity

20111027

20111104

WLT Walter Energy Equity

20111027

20111104

WMB Williams Companies Equity

20111027

20111104

WMT Walmart Equity

20111027

20111104

WYNN Wynn Resorts Ltd. Equity

20111027

20111104

X United States Steel Corp. Equity

20111027

20111104

XOM Exxon Mobil Corp Equity

20111027

20111104

YHOO Yahoo Inc Equity

20111027

20111104

* S&P 500 Index (“SPX”) Weekly options trade on CBOE with PM settlement and are listed under the root ticker symbol, “SPXW”
and are commonly included in SPX (traditional) options chains which are AM settled. Separately, the C2 Options Exchange lists
S&P 500 Index options with PM settlement, under the ticker symbol SPXPM, that expire on the same Friday of the month as
traditional SPX options that trade on CBOE.

Covered Call Trade on Expeditors International of Washington, Inc. (EXPD)

Covered call trade on Expeditors International of Washington, Inc. (EXPD).
Expeditors International of Washington, Inc. (EXPD) , today announced that its Board of Directors has declared a semi-annual cash dividend of $.25 per share, payable on December 15, 2011 to shareholders of record as of December 1, 2011.
STRATEGY:  Look at the December 2011 42.5 covered call.  For each 100 shares of Expeditors International of Washington Inc (EXPD) stock you buy, sell one December 2011 42.5 call option for a 40.85 (43.65 – 2.80) debit or better. That’s potentially a 4.68% assigned return including the dividend.
TECHNICAL:  The technicals for EXPD are bullish with a weak upward trend.  The stock is under accumulation with support at 45.19.  S&P rates this stock 4 STARS (out of five) – buy.
RISK:   For those seeking downside protection with a blanket put, buy the May 2012 42.5 Put for 4.10.  Sell the put when you exit the covered call trade.
S&P RESEARCH:  S&P reiterates buy opinion on shares of Expeditors International (EXPD) . Q3 EPS is $0.50, vs. $0.44, $0.01 ahead of our estimate and Capital IQ consensus.  However,$0.03 of EPS came from higher non operating income.  Gross revenues were disappointing, but net revenue growth improved on better airfreight margins.  We think EXPD did a good job in a difficult operating environment, and believe it remains well positioned for an eventual improvement in shipping demand.  We cut our ’11 and ’12 EPS forecasts to $1.80 and $1.98from $1.89 and $2.28.  We cut our target price to $60 from $65, 30X our ’12 estimate, in the middle of EXPD’s historical range.

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.

Covered Call Write on Caterpillar (CAT)

Caterpillar (CAT) reported blow-out earnings on October 24. CAT jumped 5.7 percent to $92.39 and led the Dow higher after the heavy equipment maker reported a quarterly profit that topped estimates on record revenues. Excluding the impacts of the recent acquisition of Bucyrus International, profit was $1.93 per share, up 58 percent from a year ago. Sales and revenues excluding Bucyrus were $14.581 billion, up 31 percent from the third quarter of 2010. Excluding the impacts of Bucyrus, it was an all-time record quarter for both sales and revenues and profit.

STRATEGY: Look at the December 2011 92.50 covered call. For each 100 shares of Caterpillar (CAT) stock you buy, sell one December 2011 92.50 covered call option for a $88.85 (92.35 – 3.50) debit or better. That’s potentially a 4.11% assigned return in 25 days or a whopping 60% annualized return.

TECHNICALS: The technicals for CAT are bullish with a possible trend reversal. The stock is under accumulation with support at 80.76. S&P rates this stock 4 STARS (out of five) – buy.

RISK: The stock has to drop 3.8% to threaten the breakeven point.

PROTECTIVE PUT: For those wishing to protect your downside, buy the May 2012 90 put for $10.35. Buy one put for each 100 shares of stock you own. Sell the put when you exit the covered call trade.

S&P RESEARCH NOTES: S&P reiterates buy opinion on shares of Caterpillar (CAT) . Q3 adjusted EPS of $1.93, vs. $1.22, beats our forecast by $0.19. Revenue gain of 41% was above our 36% forecast, on higher demand in almost all products and geographies. Record Q3 sales and profit results were particularly impressive to us in light of economic challenges in developed nations. CAT’s current trends also lead us to expect ongoing demand growth in ’12. We lift our ’11 EPS estimate $0.05 to $7.35, and ’12’s by $0.10 to $9.20. In light of growing economic uncertainties, however, we trim our target price by $13 to $129, on our revised historical P/E analysis.

Performance of Caterpillar (CAT) stock

Click to enlarge

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