Part 2: trading Covered Calls with LEAPs

OK, so let’s pretend that you have a general understanding of the “Covered Call”. Let’s mention just a couple items that you have to keep in mind before you start on this.

1- You must always be working in what is called “board lots” this means multiples of 100 shares. So, if you have 1 share of IBM stock that your grandpa gave you, you need 99 at least more to trade options on it. 1 contract means 100 shares worth of stock.

2- Make sure that you like the company that you trade Covered calls on. You might have this stock for a while, so if you hate the company, or what they do, don’t buy them. They are plenty of other companies. For example, I eat Kosher, so even Campfire Bacon company is making some great moves, I still don’t want my futures set on a company that I don’t ideologically support.

3- Principle 3: if you don’t understand what this company does, or how they make money, this is generally not one I want to be involved. I like to be able to know how my success is working. In these covered calls, I am owning a portion of a business (although there are other ways to do this as well, but that’s beyond this example). I have to feel confident how their success is coming.

4- You will also notice that options are not always available for all companies. These are usually only traded on larger companies, actively traded, significantly of interest to the public. For me, this is more often US companies, or a Canadian company that trades on a US exchange. This is hardly ever a ‘flash in the pan’ new penny stock.

Which brings me to my second possibility. What if you are dealing with a company that you want to trade options on, but the cost is high.

Case in point: Google (trade symbol GOOG) trades on the Nasdaq) and as of today is trading at 484.78 (business close: June 7). Personally I like this company, I think it could trade a lot higher (the trend however is going the exact wrong direction), but I will pretend for this, that it isn’t. However, 100 shares would cost me almost $50,000. That’s a substantial cost for 1 contract. But, let’s say I really wanted this. The trend is going the right way (remember, this is just an example, the trend is actually dropping a lot). Other indications are also looking positive, so I want to trade this company.



Also, although this chart comes from the program I use, almost every on-line trading program uses these types of charts. They may look different, but if you can get used to looking at them you will gain a lot of understanding.

There is a cheap way to get into this holding without the full cost investment. This is called a LEAP (Long term Equity Position). So, rather then buying the stock I actually buy an option far into the future, and then sell calls on this month over month.

To make this work, you need to understand the principle behind options. Every Option has two parts that make up it’s cost. The first is a built in value. For example, if you have a stock like GOOG and you want to buy the option for $450 (the stock is already trading higher then that, so the difference is it’s built in value). You would have to pay at least the difference between the “strike price” and the price the stock is trading for. (484.78- 450.00= $34.78) remember this is a per share price so in an option of 100 shares (single contract this is still $3478.00).

The other part of an option that makes it’s value is the “time value”. How long does it take before it expires. When an options expires, the time value reaches 0. It drops everyday until that expiration date. You can sure see this in the last few days before the option expires. However, if you have a very long term option (a year or two) there is so much time available that the time value is not really significant. It is mostly the embedded value that makes the difference.

So, let’s go back to our GOOG example. I can buy a Call for GOOG that expires in January 2012 (deep in the money) , a $350 strike point for $167.90. The reason you buy a deep in the money, is you want wiggle room. You don’t want a sudden drop in price that suddenly makes this not work for you. Back to our example, 167.90 for 1 contract is $16,790. It still costly, but not nearly as costly as owning the stock (almost $50,000).

So, now that you have the call, you can sell an option of the stock. In this case, you likely don’t want to really sell the stock. You actually want the ability for the system to create you money. So, I wouldn’t pick an option that is as likely. So, rather then sell a Call at 490.00. I would more likely sell an option at 500.00 or maybe 520.00. So, a June option for 500.00 would make 4.80 per contract (remember this is times 100 $480.00) for 8 days. If you don’t sell the stock (which we don’t really want to do), you turn around and sell an option for July, and August.

What happens if the stock does reach the strike price you set? Well, then you use your “option” to buy the stock cheap (LEAP) which should have also gone up in value to get your stock and then sell to the person who called you out of position. A bit of a pain, but certainly possible.

Your desire is to use this as a system to continue to make you money

What if you get tired of this stock. Maybe Google gets upstaged by some new company, or for some reason you just don’t want this trade anymore. All you have to do is sell of the option for whatever value is left. You chose to be deep in the money so as long as the stock is still trading higher then your option there will always be embedded value.

If you want to hear an audio on this, then listen to the “covered calls with LEAPs” pod cast. This is episode 99.
http://www.podbean.com/podcast-detail?pid=17574

Like I said before some good education…and the price is right (free). God’s continued grace to you and yours. -Brad

Line by line what I do for monthly income

I have been getting requests from friends to show the how of what I have been doing. My business is based on running an investment company. My company (entitle Financial Wisdom Inc.) has a trading account that buys and sells stock and options. There are about a million ways to do this, but I will show you line by line a real example that I am running.
The first tool I will explain is called a “covered call” I own some stock. Some I purchased simply to sell covered calls, some are leftover from my former employers (BMO and BNS). For this example I am using Crocs Inc.



My son (Noah)
and I were looking at stock and saw that this company had a nice positive trend. Basically while so many companies have stock prices going down or sideways (nowhere), this one was actually going up, and going up at a pretty good rate. There is a lot more analysis I did with my son, but this will show you what interested us. The price was also very attractive (about $10.00 a share). So, I bought 1000 shares (or $10,000 worth of the stock). To be honest, my entry price was $10.25. The stock is doing fine, but to be honest, I have no loyalty to the stock. I can keep the stock and sell it as it has an up day, but I am using a covered call plan.
If you sell an option, those options expire on the 3rd Saturday of the month. Yes, I know the markets are closed on Saturday, but that’s just the way it works. US options can be traded (called) at any point in time in the month until expiration. So, today is June 7. The June calls will end on June 19. Since I own this stock, I can sell a contract which says. “Hey, if this stock reaches a certain I price I will sell it to you at that price.” For this contract, people pay money. In my case, I have said I would sell my stock if the price (called the strike point) reaches $11.00 on or before June 19. Remember, I don’t care about holding this stock. If it sells, it sells. There isn’t a lot of time left until expiration, so I only got a price of ($.15) which is a fancy way of saying I got $.15 per share of stock or (.15 X 1000) in this case $150. Had I chose a longer expiration date (3rd week in July) I would have gotten $550.
Whatever happens, I got that money up front, and if I still have the stock on June 20th, I will sell another option for July, and August, and September until someone buys my stock.
I told my wife, it’s a lot like renting a house. I bought a house for $10,000 (you can only imagine what kind of house you could buy for that), buy as a slum rent lord, I am making $150 a month on my apartment. The bonus is not bad tenant. No backed up toilets in the middle of the night. No excuses for rent checks being late.
So, what can happen?
Best case would be: the stock goes to $11.00 If it goes past $11.00 then I will dump my stock at exactly $11.00. Now if the stock price goes to a million per share (no fear of that), then I will say…”bummer I guess I lost that opportunity”, but if the stock hits $11.01 on or before market close on June 18, then I will likely be called out of position. They will buy my stock. I will have made .75 per share ($750.00) plus the $150 up front money. Total $900. I made the money with a $10,000 investment, so my yield is actually 9%. That sounds pretty good, but you need to understand, that would be 9% in a 30 day time line. If, I could keep this up, my yield would be 9% times 12 months or 108% for the year. So my $10,000 would make $10,800 (and I would still have the $10,000. By the way, this it totally utopian. This is not likely to happen under any circumstances, but I am laying out the best case scenario.
Possibility 2: I think Croc (trade symbol CROX on the NASDQ exchange) will hit $11.00 maybe not by June 18, but sometime. If, we reach June 19 and we are still under $11.00, then I will make sure I have the same deal set up for July, and August etc. until my stock is sold. I collect my slum lord rent checks.
Possibility 3: Bought the stock at $10.25 what if the stock goes down. Can I still sell options on it? Yup. It helps to curb even a small amount of loss month over month.
Possibility 4: Crox appears to be a flash in the pan (maybe they are lying about the money they are making). Maybe no one really buys those cheap comfy sandals. Maybe everyone finds out about this at once by a CNN expose. The stock collapses and 0. In this case, I have lost my stake $10,000. I still get to keep the monthly premium until the stock has no value. By the way, I also don’t think this is likely.
There are many variations of how we do this, but I wanted to put this one out. If you can follow this, you can also understand some more advance plans that I will explain later.

U.S. inflation expected to decline further: BMO

This article taken from the Financial Post. It sounds good (limited inflation for US economy, but if you read the details as to the why, you see all is not as roseyas one might suspect. Enjoy, Brad

By John Shmuel May 31, 2010 – 10:35 am

Inflation in the U.S. remains weak and is expected to decline further despite a surprisingly solid American economic recovery, according to BMO Capital Markets analyst Sal Guatieri.

Core consumer prices have risen 0.9% year-over-year from 2009. Much of that has been bolstered by a 38.3% hike in gasoline prices during that period. Without gasoline, consumer prices have increased a mere 0.5%.

Mr. Guatieri notes that inflation will likely continue to decline further because of several stress factors on the economy. That includes a high unemployment rate which is keeping consumer spending in check.

“The unemployment rate is about four-to-five percentage points above its steady-inflation level. The current high rate discourages workers from demanding wage increases, while draining pricing power from retailers,” he writes in his report titled Deflation Déjà Vu. A high vacancy rate meanwhile will also drag down inflation.

“Rents should continue to soften in the wake of a near record-high 10.6% rental vacancy rate and record-high mortgage delinquencies and foreclosure inventories,” Mr. Guatieri notes.

The disinflation, as Mr. Guatieri refers to it, contrasts with gains made in Canada, where the inflation rate rose in April and retail prices surged.

Canada’s April inflation rate was 1.8%, compared with 1.4% in March, according to Statistics Canada. The April increase caused the country’s core rate to edge up to 1.9%.

Despite continuing decreases in inflation in the U.S., Mr. Guatieri highlights a number of factors will prevent deflation from taking root.

Some services, such as medical care and education, are not considered to be in excess supply and will keep balance out deflationary elements such as rental prices. Mr. Guatieri also highlights that expectations remain near the preferred 2% inflation rate. He also points to a rise in commodity prices due to global demand and an expected GDP growth number of 3% as reasons that will alleviate the downward pressure on deflation.

“All in, these factors will likely prevent CPI inflation from slipping below 1% and core inflation from breaching 0.5% this year, and could lift inflation slightly in 2011,” he writes in his report.


John Shmuel