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
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