By Aussie Rob
You own a house…You insure it, right? You own a car… You insure it too, right? You also own stocks…You insure them too, right? If not, why not?
G'day, Aussie Rob here… Today, I'm going to teach you a really important factor in trading options: how to insure your stocks. If you've never traded options before, or thought you weren't ready to learn how to trade them, you should keep reading. Why? Well, what I'm about to teach 'ya' will change your attitude toward options forever.
Option traders buy 'calls' if they think a stock is going to go up, and they buy 'puts' if they think the stock is going to go down. That's the speculative side of trading options. The other side of trading options is for risk management and that simply involves buying puts to protect your stock portfolio. I say simply because it is simple and there are no excuses why you shouldn't do it.
Think about it for a minute. You buy stock because you think it is going to go up and you'll make a profit. Why not also buy some puts to protect the downside? Should the stock not go up, the losses in your stock can be offset by the profits of your puts.
Here's a basic example of how it can work. Say you buy a stock trading at $20 (there are still some stocks trading at $20 these days, aren't there?) and you simultaneously buy a $20 put for around $1. The $20 put enables you to 'put' your stock to someone for $20. As you can see, $1 is pretty cheap insurance. Now let's compare Joe Public, the average Mom and Pop trader, with a professional trader. Joe buys a stock for $15, and it goes up to $20. YAHOOOO, he made a $5 profit. Joe then buys another stock for $20, but this time, it doesn't go his way. It goes down to $15. BUMMER, he lost $5 (see figure 1). In the long run, the average Mom and Pop trader ends up breaking even, although most have lost money, especially over the last few years! Now let's take a look at the professional trader (see figure 2). What's the difference? The professional trader buys a put to protect his investment. He is always prepared to give up a little of his profit potential to hedge his position.
Bottom Line: Professional traders can lose three out of four trades and still be profitable!
I strongly believe that if you really want to become a professional stock trader, then you need to open your mind and start learning how to trade options. Education is the key to success. You like this concept? I'm sure you do!
Everyone likes the idea of being able to sleep at night knowing their portfolio is protected. And now for the really exciting part…. How would you like to get your stock insurance for free? Yes, free, nadda, zip, zilch.
Excellent, so do I. This is how it works… If you own stock and the stock is optionable, then you can sell calls against your stock. This is known as a covered call. It's 'covered' because you own the underlying stock. If you didn't own the stock, then you'd be selling a 'naked call'.
Your broker should be able to tell you if your stock is optionable. By selling a covered call, you are selling the right to buy your stock from you at a certain price by a certain time. Let's take a look at an example and then it'll start making sense as to why you would do this.
Let's assume it's the beginning of March and you own 1,000 shares and the stock is trading at $8.55. You could sell, say, a March $10 call for say $0.40. Now, what does that mean? It means you have sold someone the right to buy your stock from you for $10 prior to March's option expiration and they have paid you $0.40 for that right.
Now, let's take a look at the maths: Cash Out: $8,550 ($8.55 x 1,000) Cash In: $400 ($0.40 x 1,000) That equates to 4.6%. Some may feel that's not such a big deal, but think about it. That is an extra 4.6% for doing what? Nadda, Zip, Nutting. And if you had bought your stock on margin, it'd equate to 9.2%!
OK, then what happens? There are two possibilities:
1. If the stock closes above $10 on the option expiration date, you would be obligated to sell your stock for $10. Shucks, you may just make an extra $1.45 per share. This is called being 'called out'.
Now let's take a look at the new math: Cash Out: $8,550. Cash In: $1,850 ($400 for selling the call and $1,450 for stock going from $8.55 to $10). That's a 21.6% return or a whopping 43.2% if you bought your stock on margin. (All figures exclude the cost of commission as it varies from broker to broker.)
2. If the stock closes below $10 upon the option expiration, you would keep the $400 paid for the calls and you would keep the stock. Then you could do it again next month. Month after month after month, just keep milking that rental income out of your stock. Treat covered calls like real estate. It's your stock rental portfolio, not your property rental portfolio. Nice monthly rental income, eh!
So there ya go folks. You can use covered calls to pay for your stock insurance (puts) and they can be used to create regular monthly income. That's 'found money' you can make month after month after month.\ Until next time…Cut your losers quick and let your winners run!”
Aussie Rob has just released a brand new Covered Call training DVD called Aussie Rob's Share Renting DVD that teaches step-by-step how to write Covered Calls. Go to www.lifestyletrader.com.au/products to find out more.
