Naked (uncovered ) puts are a useful way to earn some money with low risk if you intend to purchase the stock anyway and don’t need to get in immediately.

You are “naked” when you sell a put (the put guarantees you will buy X shares on contract at the strike price if exercised) without a corresponding short position in the stock.

This scenario is exposed to “risk” because if the stock drops below the strike price and the option is exercised you will be forced to buy the stock. Therefore you would have to lay out capital on a stock that has decreased in price and could be a dog.  If the company has a catastrophe you would be stuck with shares that may never recover. 

But what if you want to buy the stock anyway?  Then being forced to buy at a lower price might not be a “risk” after all.

So here’s the deal:

If you’ve found a stock you want to buy at its current price and have done all of your homework, consider selling a front month naked put at an out of the money strike price.

You will have the premium deposited into your account and you have essentially agreed to purchase the shares at the strike price if the option is exercised.

You already have the desire to buy the shares and wouldn’t mind getting them a little cheaper.

Most major Canadian discount brokers will not let you trade uncovered.  After looking around, TD Waterhouse and ETRADE are your best bets for the discount brokers.

Here is an example:

You like the proposed infrastructure spending that the US has pledged to undertake.  Steel will be a significant component of the spending and commodity prices might be poised for a rebound next year.  So you’re thinking Nucor Corp (NUE), Andrew provided an overview back when they were really booming,  which is currently trading at $39.19 with a 52 week high of around $83 and a low of $25.

The March $37.50 put has a price of $2.50. 

1)You sell 5 puts (Total Potential Purchase of 500 shares x $37.50 = $18750 if exercised) and pay associated commissions (ETRADE will be a max of $19.95 per order plus $1.75 per contract) of $28.74.

2)$1250 is deposited to your account (500 shares x $2.50)

3) Waiting game begins. Do your best not to check Yahoo Finance every 5 minutes.

4a)It is getting close to March 20 and the stock price has stayed steady around $40. The option will not be exercised and you keep your premium. 

4b)The stock drops to $35 and you are required to buy 500 shares at $37.50 on or around March 20.  Keep in mind that you have collected $2.50 per share in premiums and paid $37.50. So unless you spent the $1200 on a gold-plated iPhone, your cost basis is $35.  You have then bought the shares at market price after an 11% drop in the stock price over a month.  If you bought before the drop you are now down 11%.

5a)Repeat the next month until you get exercised and keep the premiums while you wait.

5b)Hold the stock as per your bullish take on steel and infrastructure and you have now bought Nucor for $35 when you were ready to buy at $39.19.

There’s no time like now to find some great stocks you wouldn’t mind buying for below current levels.  Consider naked puts as a way to get into those positions when Mr. Market permits and be paid to wait in the process.

Risks are present, but if you like a stock and are ready to buy at current levels, go naked and sit around for a while instead!

Lately I have been trying to implement the deep-in-the-money calls options strategy that I explain in a recent post through my paper trading account at Investopedia. On April 22nd I outlined our first success with Microsoft calls and a second idea with Corning Inc. With the stock trading at $25.73 I bought 10 of the August $20 calls for a premium of $5.91 per share for a total capital investment of $5910. Sometime last week the premium on the calls hit our target of $6.91 per share and the position was sold for a gain of $1000. Good for 17% in less than two weeks. The move was thanks to a solid earnings report by Corning where both earnings and revenue saw strong double digit growth. In addition, guidance was raised for the upcoming quarter and full year. In the same time-span the stock price increased approximately 5%, again illustrating the leverage of options.

In a comment on the previous post Jeff from Blue Moat illustrated a potential downfall of this strategy. Essentially his point was, the strategy is great when it works but if you pick a bad stock you can end up down 95%. The leverage of options is great when it works for you but when it goes the other way it can translate into serious losses. One way to get around this may be to put in a stop loss order after the calls are purchased. In the same way we limit our gains to $1000 we can limit our losses to $1000 as well. As long as you are smart about your stock picks you should be able to stay on the winning end of the trade the majority of the time. Stay tuned for more potential stock ideas for this strategy.

On April 4th I wrote a post on implementing the deep-in-the-money calls strategy with Microsoft calls. To recap I bought 10 of the July 2008 $24.00 calls for $5.15 on March 26th. Sometime last week the July calls reached our target of $6.15 and the good-till-canceled limit order executed to lock in our $1000 gain. This means that in three weeks we made nearly 20% by carefully implementing the deep-in-the-money calls strategy. The best part of this is that in the same time frame the stock price moved less than 2%. A great example of the leverage of options.

So lets try and repeat this success. Corning Inc. makes the specialty glassware that goes into LCD screens and has a new technology for bendable fibre optic cable for fibre-to-the-home internet connections. They are cheap on a valuation basis, trading at 19x trailing and 13.5x forward earnings. The have been trading fairly flat for the past year but, based on the fundamentals and the company’s performance, could be due for a breakout. The stock is currently trading at $25.73. Looking out to the August 2008 calls will give us four months to get the required move in the stock. The August 2008 $20 calls (GLWHD.X) at a current cost of $5.91 per share fit the bill for this strategy (strike price $20 + option premium $5.91 – stock price $25.73 = $0.18; which is well under our threshold of $1.00). Therefore, we will place a limit order to purchase 10 of the August 2008 $20 calls at a cost of $5.91 per share. Once the order fills we will immediately place a good-till-canceled limit order to sell the calls $1.00 above our purchase price (~$6.91). This will insure that if we get the required move in the stock price our gains will be locked in.

Once again I will keep you posted on the progress.

In keeping with the options theme I decided to write a post on another fairly straight forward, easily applied strategy…covered calls. In this strategy an investors holds a long position in a stock and simultaneously sells call options on the stock to generate extra income from the position. A call option is a contract giving the owner the right (but not the obligation) to buy a specific number of the underlying shares at a specified price within a specified time frame. By selling calls against your shares you are selling the right for someone else to buy those shares at a certain price before a certain date. The price is determined by the strike price of the option and the date is determined by the option’s expiration date (options expire on the 3rd Friday of each month). To obtain this right the purchaser of the calls must pay you a premium, known as the option premium. Confused yet? Let’s take a look at an example to clear things up. Let’s say you own 1000 shares of XYZ stock currently trading at $25 per share. To generate some passive income from these shares you sell 10 May 2008 call options on XYZ at a strike price of $30. Remember each option contract represents 100 shares of the underlying stock so this transaction includes your entire position. The purchaser of the calls pays you the option premium of $1.00 per share (total of $1000). There are three scenarios that can play out from the time of the sale until the 3rd Friday in May:

1) The XYZ shares trade flat (somewhere below the $30 strike price). In this case the options expire worthless, you keep your shares and the premium from the calls. By selling the calls and collecting the premium you have outperformed the stock by 4%. You can repeat the process for the next option cycle, hopefully with the same outcome.

2) The XYZ shares fall in price. The options expire worthless, you keep the shares and the premium. Because you still own the shares you are on the hook for the decline in the stock price, but by collecting the option premium you have supplemented your losses. Once again, rinse and repeat.

3) The XYZ shares rice in price above the $30 strike price. In this situation the options are exercised and you are paid $30 per share for your position. Your upside is capped in this case at $31 per share (the strike plus the premium). If the stock had risen to $35 you would be missing out on $4 per share in upside.

In the covered call strategy you are reducing your downside risk by collecting the option premium each month. And because you have to own the underlying shares you would research the initial purchase just like with any other stock. If the option is exercised and you lose the shares, just take the 5-10% gain, plus any collected premiums, and move on to the next stock. Although the covered call can be implemented in any market condition, it is most often employed when the investor feels the stock will trade in a narrow range over the lifetime of the call contract. This strategy is a fairly simple one that anyone can do to generate extra income from shares they already own.

Stay tuned for a real world example of how to apply this strategy.

In a recent post I wrote about the deep-in-the-money calls option strategy. In the post I used Microsoft (MSFT) as an example of how to implement the strategy. Calculating the ‘premium’ based on the current stock price, the strike price, and the option cost we found that the July 2008 $24.00 calls (MSQGD.X) looked interesting. Using my paper trading account at Investopedia.com I set up an order to purchase 10 of the July $24.00 calls for a price of $5.90 or better. Microsoft’s stock took a bit of a dip on the day I placed my order and I ended up getting the calls for $5.15…even better. Unfortunately Investopedia doesn’t support good-till-canceled limit orders and I don’t have access to streaming option quotes so I’ll have to stay on top of the price action to see if it hits our target. Once the price of the calls reaches $6.15 we will assume that our sell order was executed locking in the $1000 gain. The calls are already at $5.70 meaning we are more than half way to our target. Since my ‘purchase’ the stock has only moved 2.1% while our calls have moved 10.7%…talk about leverage. I’m starting to see why options are so popular.

Stay tuned for more updates on our strategy experiment as well as other potential candidates that may fit the bill for deep-in-the-money calls.

Any good investor knows of the numerous options strategies available to them, but few have a strong understanding of how they should be used. There are so many that it is tough to get a good grasp of them all. Options can be very powerful investment vehicles because they provide leverage compared to owning individual stocks. I’ll be the first to admit that my options knowledge is limited. But the goal of this site is for us to broaden our investment knowledge and hopefully educate you in the process. The more weapons you have in the arsenal the better positioned you will be to profit in any market environment. So today I wanted to talk about an options strategy that I do understand. Deep-in-the-money (DITM) calls.

I first read about this strategy in a column by Lenny Dykstra on TheStreet.com…as in three time All Star Lenny Dykstra of the 1986 MLB World Champion NY Mets and 93 National Champion Phillies. A call is said to be in-the-money when the strike price is below the current share price of the underlying stock. If the strike price is above the current share price the call is said to be out-of-the-money. The idea with deep-in-the-money calls is to look for companies with solid fundamentals that have been overly punished for one reason or another. If the decline is overdone or unjustified one can get in-front of the eventual correction by buying the calls at a discount and cashing in as the stock bounces back. Because the calls are leveraged to stock price, any moves in the underlying stock will be captured by the price of the calls. The options are purchased 4 to 6 months out, leaving plenty of time for the required move to materialize. In Dykstra’s strategy he calculates a premium to screen potential purchases. To get the premium for an option you take the strike price for the option, add the price of the call (its premium), and subtract the stock’s present value. A stock with a premium of $1.00 or less is considered to be a good buy. Say for example you found a call option with a strike price of $24 for a stock that was currently trading at $27.50. This means that you would be willing to pay up to $4.50 for that specific call option ($24 + $4.50 – $27.50 = $1.00). Once you find a stock that meets these requirements a good-till-canceled (GTC) limit order is placed for 10 options at the target price. Options can be very volatile so to be successful in this strategy you need to stay on top of your open positions and lock in profits when you have them. Once the order has filled you can place another good-till-canceled limit order at $1.00 above the purchase price ($5.50 in the above example). If the stock moves and the call price goes up by $1.00, a profit of $1000 is locked in by the automatic limit order. In our fictitious example above you only need to put down $4500 to purchase the 10 calls, but because each call represents 100 shares you are actually controlling 1000 shares of the underlying stock. The capital required to purchase 1000 shares of the common stock would have been $27,500. This is called leverage. By putting down $4500 and locking in the $1000 profit you are leveraging the underlying stock for a 22% gain.

Let’s look at a real world example. Microsoft Corp. (MSFT), along with many of the other big cap tech stocks, has been on a slide since the beginning of the year. It was a $37 dollar stock as recently as November, but has gotten punished along with the rest of the market. It has recovered slightly (closed March 25th at $29.14) but is still at a significant discount, trading at 16.58x trailing earnings and 13.88x forward earnings. The company’s past two quarterly earnings announcements have been stellar and there is no reason to believe that trend won’t continue through 2008. The July 2008 $24.00 calls (MSQGD.X) are currently priced at $5.90, which gives us a premium of $0.76 ($24 + $5.90 – $29.14 = $0.76). Going out to July gives us 4 full months to get the required bounce in the share price. To utilize this strategy we would place a good-till-cancelled limit order for 10 of the July $24 calls at $5.90 (requiring a capital investment of $5,900). Once the order fills we will immediately place another good-till-cancelled limit order to sell the calls at $6.90. If we get a move in MSFT that boosts the call price to $6.90, the order will automatically execute to lock in our $1000 gain (good for 17%).

I’ll keep you posted on how this pick works out as well as any other opportunities that I stumble across.