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Posts Tagged ‘implied volatility’

How Option Prices are Determined

Monday, April 21st, 2014

Last week was one of the best for the market in about two years.  Our option portfolios at Terry’s Tips made great gains across the board as well.  One portfolio gained 55% for the week, in fact.  It is fun to have a little money tied up in an investment that can deliver those kinds of returns every once in a while.

This week I would like to discuss a little about what goes into an option price – what makes them what they are?

Terry

How Option Prices are Determined

Of course, the market ultimately determines the price of any option as buyers bid and sellers ask at various prices.  Usually, they meet somewhere in the middle and a price is determined.  This buying and selling action is generally not based on some pie-in-the-sky notion of value, but is soundly grounded on some mathematical considerations.

There are 5 components that determine the value of an option:

1. The price of the underlying stock

2. The strike price of the option

3. The time until the option expires

4. The cost of money (interest rates less dividends, if any)

5. The volatility of the underlying stock

The first four components are easy to figure out.  Each can precisely be measured.  If they were the only components necessary, option pricing would be a no-brainer.  Anyone who could add and subtract could figure it out to the penny.

The fifth component – volatility – is the wild card.  It is where all the fun starts.  Options on two different companies could have absolutely identical numbers for all of the first four components and the option for one company could cost double what the same option would cost for the other company.  Volatility is absolutely the most important (and elusive) ingredient of option prices.

Volatility is simply a measure of how much the stock fluctuates.  So shouldn’t it be easy to figure out?   It actually is easy to calculate, if you are content with looking backwards.  The amount of fluctuation in the past is called historical volatility.  It can be precisely measured, but of course it might be a little different each year.

So historical volatility gives market professionals an idea of what the volatility number should be.  However, what the market believes will happen next year or next month is far more important than what happened in the past, so the volatility figure (and the option price) fluctuates all over the place based on the current emotional state of the market.

Legging Into a Short Iron Condor Spread

Monday, March 3rd, 2014

Today I would like share with you the results of an actual trade recommendations I made for my paying subscribers on January 4th of this year and how subsequent price changes have opened up option possibilities that can further improve possibilities for a first investment.

Please don’t get turned off by what this new spread is called.

Terry

Legging Into a Short Iron Condor Spread

In my weekly Saturday Report that I send to paying subscribers, on January 4, 2014 I set up an actual demonstration portfolio in a separate trading account at thinkorswim in which I made long-term bets that three underlying stocks (GOOG, SPY, and GMCR) would be higher than they currently were at some distant point in the future.  The entire portfolio would make exactly 93% with the three spreads I chose if I were right about the stock prices.

Almost two months later, things are looking pretty good for all three spreads, but that is not as important as what we can learn about option possibilities.

If you recall, early this year I was quite bullish on Green Mountain Coffee Roasters (GMCR) which has recently changed their name to Keurig Green Mountain.  The major reason was that three insiders who had never bought shares before had recently made huge purchases (two of a million dollars each).  I Googled these men and learned that they were mid-level executives who were clearly not high rollers.  I figured that if they were committing this kind of money, they must have had some very good reason(s),  Also, for four solid months, not a single director had sold a single share, something that was an unusual pattern for the company.

My feelings about the company were also boosted when a company writing for Seeking Alpha published an article in which they had selected GMCR as the absolute best company from a fundamental standpoint in a database of some 6000 companies.

This is what I wrote in that Saturday Report – “The third spread, on Green Mountain Coffee Roasters (GMCR), is a stronger bullish bet than either of the first two, for two reasons.  The stock is trading about in the middle of the long and short put prices (70 and 80), and the time period is only six months (expiring in June 2014) rather than 11 or 12 months.  I paid $540 for the Jun-14 80 – Jun-14 70 vertical put credit spread.  My maximum loss is $460 per spread if the stock closes below $70, and I will make 115% after commissions in six months if it closes above $80.”

This vertical put credit spread involved selling the Jun-14 80 puts for $13.06 and buying the Jun-70 puts for $7.66, collecting $540 for each spread.  I sold 5 of these spreads, collecting a total of $2700.  There would be a maintenance requirement of $5000 for the spreads (not a margin loan which would have interest charged on it, but an amount that I couldn’t use to buy other stocks or options).  Subtracting what I received in cash from the maintenance requirement, my real cost (and maximum loss) would be $2300.  If GMCR closed at any price above $80 on June 21, 2014, both puts would expire worthless and I could keep my $2700 and make 115% after commissions (there would be no commissions to pay if both puts expired worthless).

An interesting side note to the $2700 cash I received in this transaction.  In the same account, I also owned shares of my favorite underlying stock.  I am so bullish on this other company (which is really not a company at all, but an Exchange Traded Product (ETP)) that I owned some on margin, paying 9% on a margin loan.  The cash I received from the credit spread was applied to my margin loan and reduced the total on which I was paying interest.  In other words, I was enjoying a 9% gain on the spread proceeds while I waited out the six months for the options to expire.

In case you hadn’t heard, GMCR announced on February 5th that they had executed a 10-year contract with Coke to sell individual cups on an exclusive basis.  The stock soared some 50%, from $80 to over $120.  In addition, Coke bought 10% of GMCR for $1.25 billion, and gained over $600 million on their purchase in a single day.  Obviously, those insiders knew what they were doing when they made their big investments last November.

Now I am in an interesting position with this spread.  It looks quite certain that I will make the 115% if I just sit and wait another 4 months.  The stock is highly unlikely to fall back below $80 at this point.  I could but back the spread today for $.64, ($320 for the 5 spreads) and be content with a $2380 gain now rather than $2700 in June.

But instead, I decided to wait it out, and add a twist to my investment.  Since the deal with Coke will not reach the market until at least 2015, it seems to me that we are in for a period of waiting until the chances of success for single servings of Coke are better known.  The stock is probably not going to move by a large amount in either direction between now and June.

With that in mind, I sold another vertical credit spread with June options, this time using calls.  I bought Jun-14 160 calls and sold Jun-14 150 calls and collected $1.45 ($725 less $12.50 commissions).  These options will expire worthless if GMCR is at any price below $150 on June 21, 2014, something that I believe is highly likely.  I think it has already taken the big upward move that it will take this year.

If the stock ends up at any price between $80 and $150, I will make money on both spreads that I sold.  Now the total I can gain is $3400 (after commissions) and my net investment has now been reduced to $1600 and my maximum gain is 212% on my money at risk.

This new spread will not have any maintenance requirement because the broker understands that I can’t lose money on both vertical spreads I have sold.  He will look at the two spreads and notice that the difference between the long and short strike prices is 10 for both spreads.  As long as he is setting aside $5000 in a maintenance requirement on the account, he knows that I can lose that maximum amount on only one of the two spreads.

What I have done is to leg into what is called a short iron condor spread (legging in means you buy one side of a spread to start, and then add the other side at a later time – the normal way to execute a spread is to execute both sides at the same time).  You don’t have to know any more about it than know its name at this time, but I invite you to become a Terry’s Tips Insider and learn all about short iron condors as well as many other interesting options strategies.

Another Interesting Options Bet on Google

Monday, February 24th, 2014

Just over two months ago, shortly before Christmas, I suggested that you might consider making a bet that Google (GOOG) would be higher in one year than it was then.   I figured the chances were pretty good that it might move higher because it had done just that in 9 of its 10 years in existence.

I made this bet in my personal account and also in a real account for Insiders at Terry’s Tips to follow, or mirror in their own accounts.  The stock has moved up by about $90 since then and the bet is looking like it might pay off.

Today I would like to discuss either taking a profit early or doing something else with Google if you feel good about the company as I do.

Terry

Another Interesting Options Bet on Google

In my January 4, 2014 Saturday Report sent to Terry’s Tips Insiders, I set up a new demonstration actual portfolio that made long-term bets on three underlying stocks that I believe would be higher well out in the future than they were then.  This is what I said about one of them – “The most interesting one, on Google, will make just over 100% on the money at risk if Google is trading at $1120 or higher on January 17, 2015, a full year and two weeks from now.  It was trading at $1118 when we placed the spread, buying Jan-15 1100 puts and selling Jan-15 1120 puts for a credit of $10.06.  The stock fell to $1105 after we bought the spreads, so you may be able to get a better price if you do this on your own next week.

GOOG has gained in 9 of the 10 years of its existence, only falling in the market-meltdown of 2007.  If you were to make 100% in 9 years and loss 100% in the tenth year, your average gain for the ten-year period would be 80%.  That’s what you would have made over the past 10 years.  If the next 10 years shows the same pattern, you would beat Las Vegas odds by quite a bit, surely better odds than plunking your money down on red or black at the roulette table.

I have told many friends about this bet on Google, and most of them said they would not do it, even if they had faith in the company.  The fear of losing 100% of their investment seemed to be greater than the joy of possibly making an average of 80% a year.  I told them that the trick would be to make the bet every year with the same amount, and not to double down if you won in the first year.  But that did not seem to sway their thinking.  I find their attitude most interesting.  I am looking forward to 10 years of fun with the spread.  It is a shame that it will take so long for the wheel to stop spinning, however.

It is now almost two months later and Google’s latest earnings announcement has suggested that the company has continued to be able to monetize its Internet traffic better than anyone else, especially the social media companies who are drawing most of the market’s attention.  GOOG (at $1204) is trading almost $100 higher than it was when I wrote that report and sold that vertical put credit spread.

In the demonstration portfolio account, I had sold 5 of those vertical put spreads, collecting $10.06 ($5030 for 5 spreads) and there was a $10,000 maintenance requirement charged (no interest like a margin loan, just a claim on cash that can’t be used to buy other stocks or options).  My net investment (and maximum loss would be the maintenance requirement less the amount I received in cash, or $4970).

With the stock trading so much higher, I could now buy the spread back for $7.20 and pick up a gain of $1430.  It is tempting to take a 28% profit after only two months, but I like the idea of hanging on for another 10 months and making the full 100% that is possible.  Now I am in the comfortable position of knowing I can make that 100% even if the stock falls by $84 over that time.

Rather than taking the gain at this time, I am more tempted to buy more of these spreads.  If I could sell them for $7.20 my net investment would be $12.80 and I could make 39% on my money as long as GOOG doesn’t fall by more than $84 in 10 months.  This kind of return is astronomical compared to most investments out there, especially when your stock can fall by so much and you still make that high percentage gain.

Even better, since I continue to like the company, I am planning to sell another vertical put credit spread for the Jan-15 option series.  Today, I will buy Jan-15 1110 puts and sell Jan-15 1140 puts, expecting to receive about $11 ($1100) per spread.  My maximum loss and net investment will be $1900 and if GOOG manages to close above $1140 ($64 below its current level) on January 21, 2015, I will make 57% on my investment after commissions.

I like my odds here, just as I did when I made the earlier investment on Google.  I believe that many investors should put a small amount of their portfolio in an option investment like this, just so they can enjoy an extraordinary percentage gain on some of their money.  And it is sort of fun to own such an investment, especially when it seems to be going your way, or if not exactly going your way, at least not too much in the other direction.

An Interesting Calendar Spread Play

Wednesday, February 5th, 2014

Today after the close, one of my favorite stocks, Green Mountain Coffee Roasters (GMRC) , announces earnings.  I am taking quite a chance telling you about another option spread investment that I made this week because if the stock tanks after today’s announcement, I won’t be looking so good.The idea I am suggesting can be used for any stock you might have an opinion about, and it could easily double your money in about six weeks if you are approximately right about where the stock might be at that time.

Terry

An Interesting Calendar Spread Play

As you probably know, I love calendar spreads.  These spreads involve buying a longer-out option and selling a shorter-length option at the same strike price.  You only have to come up with the difference between the two option prices when you place the order.

When the short options expire, if the stock is very close to the strike price of your spread, you can expect to sell the spread for a great deal more than you paid for it.The further away from the strike price the stock is when the short options expire, the less valuable the original spread will be.

The trick is guessing where the stock might end up when the short options expire. This takes a little luck since no one really knows what any stock is likely to do in the short run.  But if it’s a stock you have followed closely, you might have an idea of where it is headed.

I happen to like GMCR.  I like knowing that insiders have bought millions of dollars worth of stock in the past few months and 30% of the stock has been sold short (a short squeeze could push the stock way up).  So I am guessing that the stock will be closer to $85 in six weeks compared to $80 where it closed yesterday (as I write this Wednesday morning it has moved up to about $81.50).

I bought a calendar spread on GMCR at the 85 strike, buying Apr-14 calls and selling Mar-14 calls.  I paid $.85 ($85) per spread for 10 spreads, shelling out $850 plus $25 in commissions.  Here is the risk profile graph for March 22 when the short options expire:

GMCR calendar risk profile graph feb 2014

GMCR calendar risk profile graph feb 2014

The graph shows that the stock can fall by as much as $5 and I will make a gain, or it can go up by more than $10 and I should expect a gain.  This seems to be a pretty large break-even range to me.  If I am lucky enough to see the stock end up near my $85 target, it is possible to triple my money in six weeks.

One nice thing about calendar spreads is that you can’t lose all of your investment.   No matter where the stock goes, the value of the April options will always be greater than the price of the March options at the same strike price.  When you are only risking $85 per spread, you can be quite wrong about where the stock ends up and still expect to make a gain.

 

A Post-Earnings Play on Starbucks

Monday, January 27th, 2014

I am a coffee lover, and not only am I adding to my Green Mountain Coffee Roasters (GMRC) spreads discussed last week, I am adding two new spreads this week in Starbucks (SBUX).  By betting on both these coffee companies, I end up not caring whether everyone is drinking coffee at home or at their favorite Starbucks café, just as long as they continue to enjoy the java.And as I sip away at my 4+ cup daily coffee allotment, I can feel I am helping my investments just a tiny little bit.  I will feel so righteous.  The coffee can only taste better.

Terry

A Post-Earnings Play on Starbucks

SBUX announced earnings last week, and they were pretty much in line with expectations.  The stock moved a little higher and then fell back a bit along with everything else on Friday.

The company is doing quite well.  Total sales rose almost 12%, same-store sales rose 5%, earnings were up 25%, and they were opening new stores at the rate of nearly 5 per day (417 for the quarter).

While all those numbers are impressive, the market seems a little concerned over the valuation.  It is selling at 28 times earnings (23 times forward earnings).  The stock has fallen nearly 10% from its high reached just after the last earnings announcement.

The stock has displayed a pattern of being fairly flat between announcement dates.  With that in mind, it might be a good idea to buy some calendar spreads, some at a strike price just above its current stock price ($74.39) and some at a lower strike.

I will be buying SBUX 10 Apr-14 – Mar-14 75 call calendar spreads (natural price $.60, or $625 including commissions) and 5 Apr-14 – Mar-14 72.5 put calendar spreads (natural price $.53, or $278 including commissions) for a total investment of $903.

Here is what the risk profile graph looks like for when the March options expire on the 21st:

SBUX risk profile graph

SBUX risk profile graph

If the stock stays flat, these spreads could just about double the investment in the 52 days I will have to wait.  My break-even range extends about $3 in either direction.  Any change less than $3 in either direction should result in a profit.

Since the stock has fallen so far from its high even though it seems to be doing very well, I don’t expect that any further weakness will be substantial.  On the other hand, the valuation continues to be relatively high so I don’t see it moving dramatically higher either.  It looks to me like a quiet period is the most likely scenario, and that is the ideal thing for a strategy of calendar spreads.

I will report back on the success of these spreads after the March expiration.  I like my chances here.

An Earnings Play on Green Mountain Coffee Roasters

Wednesday, January 22nd, 2014

Today I would like to tell you about an actual trade I made today in my personal account  as well as two Terry’s Tips portfolios.  The underlying is Green Mountain Coffee Roasters (GMCR) which is located in my home state of Vermont and is one of my favorite companies.This trade will make a nice gain if the stock stays flat or moves higher by any amount between now and 17 days from now, just after earnings are announced.

If the company disappoints in any way and the stock falls, I will have plenty of time to recover by selling new calls against my long positions over the next five months.

I believe this spread has an excellent chance of making a nice gain and there seems to be almost no chance that I will lose money on it even though it might take a little time to at least break even.

An Earnings Play on Green Mountain Coffee Roasters

GMCR announces earnings after the close on February 5, 2013.  The weekly options that expire a couple of days later, on February 7 are trading at extremely high valuations (implied volatility (IV) is 65).  I would like to sell some of that premium.

I am bullish on this company.  Two insider directors recently bought over a million dollars each of the stock (and they aren’t billionaires).  The company is buying back shares every quarter, so they must believe it is a good purchase.

One company wrote a Seeking Alpha article in which they picked GMCR as the absolute best company out of their database of over 7000 companies. Only a handful of other companies have met this criterion in the past, and on average, their stock has outperformed the S&P 500 by a factor of three. Check it out – Green Mountain Coffee Roasters: The Fundamental King.

I bought a diagonal call spread, buying GMCR Jun-14 70 calls and selling Feb1-14 80 calls.  The spread cost me $9.80 at a time when the stock was trading at just below $80.  If the stock moves higher, no matter how high it goes, this spread will be worth at least $10 plus the value of the time premium for the 70 call with about 5 months of remaining value, no matter how much IV might fall for the June options. The higher the stock might soar, the less I would make, but I expect I should make at least 20% on my money (if the stock moves a lot higher) in 17 days.

This is what the risk profile graph looked like at the end of the day today.  (In this portfolio, one of the 10 we conduct for Terry’s Tips subscribers to  follow), I bought 6 spreads which just under $6000.  Commissions were $15.  It shows the expected loss or gain on the investment on February 7th when the short calls expire:

gmcr risk profile graph jan 2014

gmcr risk profile graph jan 2014

If it stays flat I should make about 40% (the graph shows more, but IV for the June calls will most likely fall).  If it falls more than $5, I will be looking at a paper loss, but will still own 70 calls with 5 months of remaining life.  I should be able to sell weekly calls against these June 70 calls and recoup any paper losses that might come my way if the company disappoints on announcement day.

I believe this is a very safe bet that is highly unlikely to result in a loss, although I may have some money tied up for a while if the stock does tank after announcing.   But as usual, I hope that no one will take the risk with money that they can’t afford to lose.

 

 

 

 

A “Conservative” Options Strategy for 2014

Monday, December 16th, 2013

Every day, I get a Google alert for the words “options trading” so that I can keep up with what others, particularly those with blogs, are saying about options trading.  I always wondered why my blogs have never appeared on the list I get each day.  Maybe it’s because I don’t use the exact words “option trading” like some of the blogs do.

Here is an example of how one company loaded up their first paragraph with these key words (I have changed a few words so Google doesn’t think I am just copying it) – “Some experts will try to explain the right way to trade options by a number of steps.  For example, you may see ‘Trading Options in 6 Steps’ or ’12 Easy Steps for Trading Options.’  This overly simplistic approach can often send the novice option trading investor down the wrong path and not teach the investor a solid methodology for options trading. (my emphasis)”  The key words “options trading” appeared 5 times in 3 sentences.  Now that they are in my blog I will see if my blog gets picked up by Google.

Today I would like to share my thoughts on what 2014 might have in store for us, and offer an options strategy designed to capitalize on the year unfolding as I expect.

Terry

A “Conservative” Options Strategy for 2014

What’s in store for 2014?  Most companies seem to be doing pretty well, although the market’s P/E of 17 is a little higher than the historical average.  Warren Buffett recently said that he felt it was fairly valued.  Thirteen analysts surveyed by Forbes projected an average 2014 gain of just over 5% while two expected a loss of about 2%, as we discussed a couple of weeks ago. With interest rates so dreadfully low, there are not many places to put your money except in the stock market. CD’s are yielding less than 1%.  Bonds are scary to buy because when interest rates inevitably rise, bond prices will collapse.  The Fed’s QE program is surely propping up the market, and some tapering will likely to take place in 2014.  This week’s market drop was attributed to fears that tapering will come sooner than later.

When all these factors are considered, the best prognosis for 2014 seems to be that there will not be a huge move in the market in either direction.  If economic indicators such as employment numbers, corporate profits and consumer spending improve, the market might be pushed higher except that tapering will then become more likely, and that possibility will push the market lower.  The two might offset one another.

This kind of a market is ideal for a strategy of multiple calendar spreads, of course, the kind that we advocate at Terry’s Tips.  One portfolio I will set up for next year will use a Jan-16 at-the-money straddle as the long side (buying both a put and a call at the 180 strike price).  Against those positions we will sell out-of-the-money monthly puts and calls which have a month of remaining life. The straddle will cost about $36 and in one year, will fall to about $24 if the stock doesn’t move very much (if it does move a lot in either direction, the straddle will gain in value and may be worth more than $24 in one year).  Since the average monthly decay of the straddle is about $1 per month,  that is how much monthly premium needs to be collected to break even on theta.  I would like to provide for a greater move on the downside just in case that tapering fears prevail (I do not expect that euphoria will propel the market unusually higher, but tapering fears might push it down quite a bit at some point).  By selling puts which are further out of the money, we would enjoy more downside protection.

Here is the risk profile graph for my proposed portfolio with 3 straddles (portfolio value $10,000), selling out-of-the-money January-14 puts and calls. Over most of the curve there is a gain approaching 4% for the first month (a five-week period ending January 19, 2014).   Probably a 3% gain would be a better expectation for a typical month.  A gain over these 5 weeks should come about if SPY falls by $8 or less or moves higher by $5 or less.  This seems like a fairly generous range.

Spy Straddle Risk Profile For 2014

Spy Straddle Risk Profile For 2014

For those of you who are not familiar with these risk profile graphs (generated by thinkorswim’s free software), the P/L Day column shows the gain or loss expected if the stock were to close on January 19, 2014 at the price listed in the Stk Price column, or you can estimate the gain or loss by looking at the graph line over the various possible stock prices.  I personally feel comfortable owning SPY positions which will make money each month over such a broad range of possible stock prices, and there is the possibility of changing that break-even range with mid-month adjustments should the market move more than moderately in either direction.

The word “conservative” is usually not used as an adjective in front of “options strategy,” but I believe this is a fair use of the word for this actual portfolio I will carry out at Terry’s Tips for my paying subscribers to follow if they wish (or have trades automatically executed for them in their accounts through the Auto-Trade program at thinkorswim).

There aren’t many ways that you can expect to make 3% a month in today’s market environment.  This options strategy might be an exception.

A Look at the Downsides of Option Investing

Tuesday, December 10th, 2013

Most of the time we talk about how wonderful it is to be trading options.  In the interests of fair play, today I will point out the downsides of options as an investment alternative.

Terry

A Look at the Downsides of Option Investing

1. Taxes.  Except in very rare circumstances, all gains are taxed as short-term capital gains.  This is essentially the same as ordinary income.  The rates are as high as your individual personal income tax rates. Because of this tax situation, we encourage subscribers to carry out option strategies in an IRA or other tax-deferred account, but this is not possible for everyone.  (Maybe you have some capital loss carry-forwards that you can use to offset the short-term capital gains made in your option trading).

2. Commissions.  Compared to stock investing, commission rates for options, particularly for the Weekly options that we trade in many of our portfolios, are horrendously high.  It is not uncommon for commissions for a year to exceed 30% of the amount you have invested.  Because of this huge cost, all of our published results include all commissions.  Be wary of any newsletter that does not include commissions in their results – they are misleading you big time.

Speaking of commissions, if you become a Terry’s Tips subscriber, you may be eligible to pay only $1.25 for a single option trade at thinkorswim.  This low rate applies to all your option trading at thinkorswim, not merely those trades made mirroring our portfolios (or Auto-Trading).

3. Wide Fluctuations in Portfolio Value.   Options are leveraged instruments.  Portfolio values typically experience wide swings in value in both directions.

Many people do not have the stomach for such volatility, just as some people are more concerned with the commissions they pay than they are with the bottom line results (both groups of people probably should not be trading options).

4. Uncertainty of Gains. In carrying out our option strategies, we depend on risk profile graphs which show the expected gains or losses at the next options expiration at the various possible prices for the underlying.  We publish these graphs for each portfolio every week for subscribers and consult them hourly during the week.

Oftentimes, when the options expire, the expected gains do not materialize.  The reason is usually because option prices (implied volatilities, VIX, -  for those of you who are more familiar with how options work) fall.   (The risk profile graph software assumes that implied volatilities will remain unchanged.).   Of course, there are many weeks when VIX rises and we do better than the risk profile graph had projected.   But the bottom line is that there are times when the stock does exactly as you had hoped (usually, we like it best when it doesn’t do much of anything) and you still don’t make the gains you originally expected.

With all these negatives, is option investing worth the bother?  We think it is.  Where else is the chance of 50% or 100% annual gains a realistic possibility?  We believe that at least a small portion of many people’s investment portfolio should be in something that at least has the possibility of making extraordinary returns.

With CD’s and bonds yielding ridiculously low returns (and the stock market not really showing any gains for quite a while – adjusted for inflation, the market is 12% lower than it was in March,  2000,), the options alternative has become more attractive for many investors, in spite of all the problems we have outlined above.

How to Use Options to Invest in Nike

Tuesday, September 24th, 2013

Today I would like to share an options strategy that we are carrying out in an actual portfolio at Terry’s Tips. It is based on the underlying stock Nike (NKE), and is set up to show how an options portfolio can make far greater gains than you could expect if you bought shares of the stock instead.The options portfolio should make a double-digit gain in the next four weeks even if the stock falls by $3 or so. If you like Nike, you will have to like this options portfolio even more.

Read to the bottom of this letter to learn how you can become a Terry’s Tips Insider for absolutely no cost.

Terry 

How to Use Options to Invest in Nike: Please spend a few minutes studying this risk profile graph carefully. It shows the expected return you would make on an investment of about $4000 in NKE call options in the next 25 days:

NKE Risk Profile Graph

NKE Risk Profile Graph

If the stock ends up at about where it is right now ($69) when the October call options expire on Friday, October 19, 2013, the graph shows that you could expect to make almost $1000 on your $4000 investment. That is almost 25% and the stock doesn’t have to go up one nickel.

People who buy shares of NKE instead of setting up a simple options portfolio like this one will not make any gains at all while we make over 20% in a single month. Of course, stockholders get to keep the 1.5% dividend that the company pays (regardless of which way the stock price might move). We have to give up that reward in exchange for the possibility of making over 20% in the next month, and presumably, in every subsequent month as well.

Admittedly, this sounds a little too good to be true. But the graph does not lie. Those are the numbers.

The graph shows that if the stock manages to move higher by about $3 over the next 25 days, less money would come our way. Only about 13% (after commissions) on our $4000 investment. But that is still a whole lot better than the stockholders would gain. They would pick up about 4.3% (a $3 gain on a $69 stock), less than half of what we expect.

The biggest advantage to our options portfolio actually comes about in the event that the stock falls moderately over the next month. If it should fall about $3 to the $66 area, the graph shows that we would make a profit of about 11% on our investment. Of course, if that happens, the owners of the stock would all lose money while we are re-investing some nice gains, or taking a little vacation in Provence, or whatever we want to do with those winnings.

It’s particularly pleasing to rack up a nice gain for the month when the stock we picked actually fell in value. We call it the “options kicker” and we really get a kick out of it.

So what does this portfolio consist of, and why can we expect to make money if the stock stays flat or moves moderately either up or down? It all comes about from the decay rate of the options that we own and the options that we have sold to someone else.

This portfolio owns call options with strike prices of 62.5 and 65, and most of these calls are LEAPS expiring in January, 2015. All options fall in value every day (assuming that the stock stays flat), but the rate of decay is much lower for longer-term options like the ones we own. Every day, our call LEAPS fall in value by about $1 each (in the options world, this is called theta). Since we own 7 LEAPS, we lose about $7 a day in decay.

Using these LEAPS as collateral, we have sold October, 2013 calls at the 70 and 72.5 strikes to someone else. These calls decay at the rate of $4 a day, and the 7 we have sold short collectively go down in value by $28 every day. Since our long positions are decaying by $7 a day and the ones we sold to someone else are falling by $28, the portfolio is gaining $21 every day that the stock is flat. This number will grow larger as the October 19th expiration is approached. In the last few days, those options will fall by $15 or so (each) while our LEAPS will continue to fall by only about $1 each.

When the October expiration day comes around, we will buy back the expiring short calls if they are in the money (i.e., the strike price is lower than the stock price) and we will sell November calls in their place. If our short calls are out of the money (i.e., the strike price is higher than the current stock price), they will expire worthless and we will be able to keep 100% of what we sold those calls for. At that point we will sell new calls expiring in November.

This is a simplistic explanation of the strategy. It gets a little more complicated when you have to decide which strike prices to sell calls at each month. Since we are bullish on NKE, we usually sell calls that are mostly at out-of-the-money strike prices so that we will gain both from the increase in the stock price and the decay of the calls that we have sold. The above risk profile graph is typical of what we normally have in place because a bigger gain will come our way if the stock gains $3 compared to what we would make if it fell by $3.

You can use this same strategy on just about any stock. It doesn’t have to be Nike. We also have a portfolio that uses the same strategy with one of my favorite companies, Costco. While the strategy may look a little confusing to someone who is not familiar with stock options, it is actually quite simple. I invite you to become a Terry’s Tips Insider and watch how this strategy (and others) are carried out over time.

Once you learn how to do it, you won’t need us any longer. My goal is for every person who subscribes to my service to learn enough in a few months to be able to quit and do it on their own. But first you need to come on board. It only costs a total of $79.95, or you can get it free if you open an account with our link at thinkorswim.

A Useful Way to Think About Delta

Monday, September 9th, 2013

This week we will start a discussion about the “Greeks” – the measures designed to predict how option prices will change when underlying stock prices change or time elapses. It is important to have a basic understanding of some of these measures before embarking on trading options.

I hope you enjoy this short discussion.

Terry 

A Useful Way to Think About Delta: The first “Greek” that most people learn about when they get involved in options is Delta. This important measure tells us how much the price of the option will change if the underlying stock or ETF changes by $1.00.

If you own a call option that carries a delta of 50, that means that if the stock goes up by $1.00, your option will increase in value by $.50 (if the stock falls by $1.00, your option will fall by a little less than $.50).

The useful way to think about delta is to consider it the probability of that option finishing up (on expiration day) in the money. If you own a call option at a strike price of 60 and the underlying stock is selling at $60, you have an at-the-money option, and the delta will likely be about 50. In other words, the market is saying that your option has a 50-50 chance of expiring in the money (i.e., the stock is above $60 so your option would have some intrinsic value).

If your option were at the 55 strike, it would have a much higher delta value because the likelihood of its finishing up in the money (i.e., higher than $55) would be much higher. The stock could fall by $4.90 or go up by any amount and it would end up being in the money, so the delta value would be quite high, maybe 70 or 75. The market would be saying that there is a 70% or 75% chance of the stock ending up above $55 at expiration.

On the other hand, if your call option were at the 65 strike while the stock was selling at $60, it would carry a much lower delta because there would be a much lower likelihood of the stock going up $5 so that your option would expire in the money.

Of course, the amount of remaining life also has an effect on the delta value of an option. We will talk about that phenomenon next week.

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