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Proof that Option Income Writing is a Winner

With a covered call and protective put strategy, you have a win – win- win –win situation.  Here is what happens when the underlying stock changes:

  • Stock price increases –      you win by keeping the premium and either rolling up your call to a higher strike price or letting the stock get assigned;
  • Stock price is unchanged – you win by keeping the premium and possibly the stock to write more calls against it in coming expiration months;
  • Stock price slightly declines – Your amount of premium received will cover a slight decrease in the stock price so you win and keep the stock for more call writes for income;
  • Stock price declines aggressively – the protective put will gain value as stock prices decline closer or through the put strike price while you keep the premium and stock for more writes.

If you use the covered call with a protective put, you can create a great wining trade.  This is better for writing calls against a stock several months as this will offset the cost of buying a put for protection.  The protective put should be at least six months ahead of the current call expiration month when initially purchased.   This allows the investor to spread the put cost over the six month period to increase the profitability of the trade.  For example, if the protective put cost $300 to buy, the cost will average $50 per month on average.  However, if you exit the covered call position before the put expires, you can sell the put to recoup some of its cost.

In the case of a significant price decline, the put will become more profitable as it will increase in value.  The call writer can buy back the sold call
for pennies and sell a new call at a lower strike price to get more premium income.  After a few months of this, the trade should be profitable.

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How To Use a Protective Put with a Covered Call

One of the basic mistakes that new covered call traders make is that they trade for the highest premium available to maximize their monthly income without looking at the amount of risk they are taking on with this type of trade.  When option premiums are high there is a reason for the increase in option pricing because of some uncertainty or increased risks.  The advanced covered call trader knows this and uses a protective put to manage their risk of loss on a high volatility trade.

The classic strategy is protect a position is to buy a put which is referred to as a “protective put.”  With a put buy you have the right (but no obligation) to sell a stock at the strike price of the put.  The protective put allows the stock owner to keep the stock but limits the amount of downsize to a lower stock price at the put’s strike price.  The stock owner no longer has price risk once the stock price falls below the put strike price as they can sell the stock at the put strike price before the option expires.
Stock investors refer to a put as price insurance as the cost of buying a put is similar to paying an insurance premium and the ownership of the put is
the insurance policy.  The management of stock price insurance is an additional cost to the trade.  For covered call investors, they must determine if it is worthwhile to buy the put as it will affect their monthly income plan.  The amount of buying a put depends on the amount of time before expiration, the strike price and the implied volatility of the put.  As you know, as volatility increases then option prices will tend to increase as well.

The table below shows an example trade with Under Armour (UA).  The stock is trading at $67.74 per share.  This example displays buying a put for protection at three strike prices: ITM, ATM & OTM.  As shown, the more in-the-money (ITM) the put then the more protection in stock price and less risk exposure in dollar terms.  The risk exposure is calculated by subtracting the put strike price from the net debit (share price + put cost).

The bottom two rows in the table show selling an ATM October call of 67.5 on UA.  You will receive $5.80 in premium for every call sold.  If you subtract this call premium from the risk exposure shown in the top portion of the table, you get the total risk exposure of the covered call with protective put trade.

Again – the more ITM the trade, the less risk exposure.  This example assumes the protective put strike price comes into play.  Of course, you would not usually use this strategy in a bull market as it is more effective during bear markets with increased levels of uncertainty.  You can also play what-if by using different
expiration months for the protective put.

How to use a protective put with a covered call

Click to enlarge

 

How To Recover From A Covered Call Trade

To remind you, this trade involves holding at least 100 shares of a company’s stock, then selling call options against them (one options contract for every 100 shares you own).  If the underlying stock declines, you’ll begin to see the option’s premium erode, too. But depending on the timeframe of the trade, you may see a greater loss in your stock position in real dollar terms than you will in your option position.  The objective of covered call writing is to produce monthly investment income and to protect your capital.

To calculate your exact current position in the trade versus when you placed it, you must:

  • Get the quote for the stock.
  • Get the quote for the option.
  • Subtract the current option price from the current stock price.
  • Compare that number to your net cost of the trade when you executed it.

The net cost of the trade is the breakeven when you enter a trade.  You can use this number as your threshold to take action if the stock price decreases to this point.  Some covered call investors use the breakeven to unwind a trade.  If the new net number is below your stop-loss threshold – let’s say 20% – then you have the following options:

  • Either: Stick with the position and hope that the share price recovers, so you can sell another option at expiration.
  • Or: Reverse the trade by buying back the current option and selling the stock.
  • Or: You can also buy back the option and sell another one at a lower strike price to mitigate some of the loss. However, if the new strike price you choose is below your cost, then you’re going to take a loss there, too.
  • Or: Buy a protective put on the stock used in the covered call trade.  The put will increase in value if the stock price falls so it will hedge losses from your stock ownership.  Of course you can buy a put as protection for all covered call trades especially when you plan to continueously sell calls each month on the same stock.  If you use a protective put, then select a month with a longer timeframe than the call sold against the stock.

But there’s one way to pretty much avoid this situation entirely… Sell deep-in-the-money calls against your position.  While this does reduce the overall return available, the upside is that it also reduces your net cost significantly and thus provides a nice cushion against risk.

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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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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Put Your Money to Work

To start on the road to financial dependence, you must save some money. Most people start with an emergency fund, retirement account such as a 401K and maybe buy some real estate for rental income. Then, smart investors start creating additional streams of income. At Get Rich Investments, we like to buy world-class dividend stocks, CEFs paying money distributions and sell options for premium income. In today’s investing environment, you can no longer keep your money in near zero savings account or certificates of deposits.

“The only reason to save money is to invest it,” writes Grant Cardone, who went from broke and in debt at 21 to self-made millionaire by 30. “Put your saved money into secured, sacred (untouchable) accounts. Never use these accounts for anything, not even an emergency.”

While always subject to a degree of risk, investing is one of the most effective ways to earn more money. As Ramit Sethi writes in his bestseller, “I Will Teach You to Be Rich,” “on average, millionaires invest 20% of their household income each year. Their wealth isn’t measured by the amount they make each year, but by how they’ve saved and invested over time.”

Why would an investor sell put options instead of just buying the stock? You already know my response to this question – to create monthly income. There are several reasons investors should include put writing as a portion of their investment portfolio. Here is my list:

First and foremost is to create income. In this case, we are looking to collect the cash premium from selling the put option and not necessarily purchase the stock. This concepts is very important to better understand. My initial objective is capturing the premium but I realize in some cases the stock will be put to me. This is why I only sell puts on a select list of stocks I am willing to own if put to me. I like to focus on world class stocks that have stable earnings, strong balance sheets, pay growing dividends and trade within a low beta range in the market. This is part of my success using this strategy as I can collect dividends and sell covered calls for more income if the stock is put to me.

This is how I put my money to work. Join me in creating multiple streams of incomes to live the life you desire.

September 2012 Monthly Income Plan Update

As we approach the end of the September option expiration cycle, the Get Rich Monthly Income Plan had a great month for investors.

In January, we kicked off the perpetual covered call strategy. For those who are new to this concept, let me share the rationale of this income investment. This strategy was created to produce monthly income with stock dividends and covered call premium. In addition, there is a protective, blanket put, to ensure the volatility in the market does not affect your return of capital.

We will be adding one new perpetual covered call each month to keep fresh ideas on the table. We will follow the progress of the perpetual covered calls each month the year. I will email premium members with trading directions when an action is required. Here are some of the results for 2012:

Perpetual Covered Call Returns:

Stock 1 – Oil Company has an YTD total return of 153% including dividends and special dividends.

Stock 2 – Drug Store Company with an YTD total return of 68.1% including dividends.

Stock 3 – Technology Company with an YTD total return of 27.3% including dividends.

Year to date, the SPY (S&P 500) is up 16.1% and the Powershares S&P 500 Buy-Write (PBP) is up 8.16%.

We also provide a list of stocks for monthly covered calls. Here we change the list each month based on investing in the right stock for monthly income. For the September option cycle, this was a great month for our Monthly covered call trades.

We made monthly returns of:

7.83% on GME,

6.91% on LAD,

3.8% on COH, and

3.4% on PSX,

We have added the covered put trades as an additional way to sell premium and to enter stock positions. I frequently sell puts to enter a new stock position because (1) I get the stock at a lower price than it is trading at the market. (2) I get to produce income from the premium I receive when selling the puts. If the stock is above the put strike price at expiration, I keep the premium and have the opportunity to sell more outs or just purchase the stock cheaper because I have the put premium to cover partial costs. I have used this technique for several months on the same stock before I get the stock put to me. This creates enough income to really lower the total cost of the stock. Then, when the stock is put to me, I sell calls (covered) to earn more income until the stock is called away. Then – rinse and repeat.

For investors wanting to create monthly income, the Get Rich Monthly Income Plan is right for you. Click here to learn more.

August 2012 Monthly Income Plan Update

As we approach the end of the August option expiration cycle, the Get Rich Monthly Income Plan had a great month for investors.

In January, we kicked off the perpetual covered call strategy. For those who are new to this concept, let me share the rationale of this income investment. This strategy was created to produce monthly income with stock dividends and covered call premium.  In addition, there is a protective, blanket put, to ensure the volatility in the market does not affect your return of capital.  We will follow the progress of the perpetual covered calls each month throughout 2012 and I will email premium members with trading directions when an action is required.  Here are some of the results for 2012:

Perpetual Covered Call Returns:

Stock 1 – Oil Company has a YTD total return of 96.1% including dividends and special dividends.

Stock 2 – Drug Store Company with a YTD total return of 36.4% including dividends.

Stock 3 – Technology Company with a YTD total return of 25% including dividends.

We also provide a list of stocks for monthly covered calls.  Here we change the list each month based on investing in the right stock for monthly income.  For the August option cycle, this was a great month for our Monthly covered call trades.  We made monthly returns of 7.55% on UA, 4.33% on LVS, 4.0% on HP, 3.73% on VIAB and 3.58% on CERN.

We have added the covered put trades as an additional way to sell premium and to enter stock positions.  I frequently sell puts to enter a new stock position because (1) I get the stock at a lower price than it is trading at the market. (2) I get to produce income from the premium I receive when selling the puts.  If the stock is above the put strike price at expiration, I keep the premium and have the opportunity to sell more outs or just purchase the stock cheaper because I have the put premium to cover partial costs.  I have used this technique for several months on the same stock before I get the stock put to me.  This creates enough income to really lower the total cost of the stock.  Then, when the stock is put to me, I sell calls (covered) to earn more income until the stock is called away.  Then – rinse and repeat.

For August options, the covered put trades were great this month as all recommendations were winners.  Returns ranged from 2.2% to 3.93% in one month.

For investors wanting to create monthly income, the Get Rich Monthly Income Plan is right for you.  Click here to learn more.

Covered Call Trade Recommendation on Kohl’s Corp (KSS)

This is a covered call trade for monthly income on Kohl’s Corp (KSS) using stock and call option with optional protective put.

Covered Call Strategy: Look at the November 2011 50 covered call.  For each 100 shares of Kohl’s (KSS) stock you buy, sell one November 2011 50 covered call option for a $47.37 (50.17 – 2.80) debit or better.  This is potentially a 5.5% assigned return.

Blanket Put:  If you are looking for a blanket put for protection, look to buy the Apr 2012 50 Put for $5.90.  You will sell the Blanket Put when the covered call position is closed.
Stock Trend: The technicals for KSS are bullish with a possible trend reversal.  The stock is under accumulation with support at 47.72.  S&P rates this stock 4 STARS (out of five) – buy.

S&P research notes:

S&P sees September Retail Sales modestly better than expected.  Our sales weighted index of 13 retailers reported a September comp gain of 6.8% vs. our 5.4% estimate.  We see a cautious consumer with retailers offering both newness and value in their merchandise assortments successfully converting store traffic into sales. We think apparel remains a more promotional business than accessories, with exclusive brands a key comp driver for moderate-price retailers like KSS, which benefited from last month’s Jennifer Lopezand Marc Anthony launches. The company posted a 4% comp gain in September vs. our 1.5% estimate and August’s 2% decline.

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