Get Rich with Options

Four Winning Strategies Straight from the Exchange Floor

Lee Lowell

• Publisher: Wiley
• Year: 2009
• ISBN:
  9780470530856
• Edition: 2
• Topic: Betriebswirtschaft
• Subtopic: Investitionen & Wertpapiere

A detailed guide to successfully trading stock and commodity options

After numerous years as an options market-maker in the trenches of the New York Mercantile Exchange, few analysts know how to make money trading options like author Lee Lowell. Now, in the Second Edition of Get Rich with Options, Lowell returns to show you exactly what works and what doesn't.

Filled with in-depth insight and expert advice, this reliable resource provides you with the knowledge and strategies needed to achieve optimal results within the options market. It quickly covers the basics before moving on to the four options trading strategies that have helped Lowell profit in this arena time and again: buying deep-in-the-money call options, selling naked put options, selling option credit spreads, and selling covered calls.

• Breaks down four of the best options trading strategies currently available
• Explains how to set up a home-based business with the best options trading software, tools, and Web sites
• Contains detailed discussions of how options can be used as a hedging or speculating instrument

With this book as your guide, you'll quickly see options in a whole new light and learn how to become part of a small group of investors who consistently win.

PART ONE

THE OPTION BASICS

CHAPTER 1

IT’S ALL ABOUT THE CALLS AND PUTS

Let’s start at the beginning. There are only two types of options—calls and puts. It’s really very simple, and it doesn’t have to be any more complicated than that. Call and put options are a direct form of investment and should be seen as such. You can achieve everything you want on an investment basis with options, just as you would with any stock, bond, or mutual fund. That fact is very important to remember.

Every position that is built using options is composed of either all calls, all puts, or a combination of the two. One thing that smart option traders know is that you can sell options as easily as you buy them. That is going to be one of the main themes of this book as you will soon see that a majority of my trades entail the selling of options. Don’t fret if you’ve heard that selling options is risky. The way that I do it has limited risk. One of the great aspects about the financial markets is that you can sell something first that you don’t own yet. Instead of the usual “buy low, sell high,” we can reverse it and “sell high, buy low.” In this case, the sale transaction comes first.

What are call and put options? In short, options are another form of investment that can be bought and sold just like a stock, a bond, or a commodity. They are referred to as “derivative” investments because an option’s value is derived from other sources, which we will talk about later on in the book. If you’ve read some of the mainstream literature that is published about options, you will see the examples given from the buyer’s view of the market. I want to let you know that I’m going to teach you to trade from the short side (selling) as well as the long side (buying) of an options contract. Why limit yourself to one strategy?

The main purpose of buying options is to gain leverage on your investment and to cut down on your initial capital outlay. This is a smart way to use your money. Options allow you to take a directional position in an underlying security using a small down payment. The reward is the potential for a big gain. It’s just like buying a house with your 10 percent down payment. You only have to put up a fraction of the price, yet you get to control the whole house. In simple terms, you’re using options as a substitute for the stock or commodity. But you have to know how to choose your options correctly to maximize your potential gains. And since I’ve found that most option buyers do not do this correctly, that’s why I’m here to help.

OPTION BUYERS HAVE RIGHTS; OPTION SELLERS HAVE OBLIGATIONS

How do options work? In short, a buyer of a call option has the expectation that the underlying security is going to move up. And when I say “underlying security,” I’m referring to the stock or commodity in which you are trading options on. A call buyer has the right to control a bullish directional position of long 100 shares of stock (in the case of stock options) for a specified period of time (until option expiration day) at a certain strike price level (the price at which you will buy the stock). The buyer pays a fee to the option seller for this right, which is called the “premium.” In the case of commodity options, the call buyer has the right to control one long futures contract for a specified period of time at a certain strike price level. The buyer has no obligation to exercise the option contract and turn it into a bullish position in the underlying security if it is not profitable to do so. The option buyer has a limited loss potential equal to the price paid for the option, but also has an unlimited upside gain potential.

The put option buyer has the expectation that the underlying security is going to move lower in price. A put buyer has the right to control a bearish directional position of short 100 shares of stock (in the case of stock options) for a specified period of time at a certain strike price level. In the case of commodity options, the put buyer has the right to control one short futures contract position for a specified period of time at a certain strike price level. The put buyer has no obligation to exercise the option contract and turn it into a bearish position in the underlying security if it is not profitable to do so. The put option buyer has a limited loss potential equal to the price paid for the option, but also has an unlimited upside gain potential.

Sometimes it’s difficult to understand the put-buying side of options. Most people understand call option buying because we’re all so used to going long the market. I think people get caught up in the terminology of buying something to sell it. It sounds confusing. When you buy a put option, you’re giving yourself the opportunity to sell something at a certain price for a specified period of time, no matter where the price of the underlying security may be. As I have already mentioned, the financial markets allow you to sell something that you don’t own first. That’s a hard concept to grasp. If you own a stock and are willing to sell it, either you can just sell your shares or you can buy a put option contract, which allows you to pick the price level at which you may want to sell the stock and the expiration date of when to do it.

On the flip side, sellers of calls and puts have different views and obligations. The seller of a call option has a neutral to bearish view of the underlying security and has an obligation to fulfill the terms of the contract if the option buyer decides to exercise the option contract. The seller of a put option has a neutral to bullish view of the underlying security and has an obligation to fulfill the terms of the contract if the option buyer decides to exercise the option contract. In short, the option seller is at the mercy of the option buyer with regard to exercising the option contract. The option seller has a limited gain potential equal to the price paid for the option by the buyer, but also has an unlimited downside loss potential.

PROBABILITY IS THE KEY

Why would anyone want to sell options if the loss potential is unlimited? That’s a great question and one that’s asked just about every time I discuss options trading. The reason that option selling is such a useful strategy if used correctly is because of the probabilities involved. Option trading is all based on probability and statistics. Many investors or option buyers tend to see options as a lottery type of trade where they know it will cost them only a few dollars to play. If the stock or commodity makes the big move, then they’re headed for Easy Street. But how often does that happen? As often as you win the lottery—which is practically never.

Those are low-probability trades and most of them are the “close-to-expiration, far out-of-the-money (OTM)” options. But people are still drawn to the gambler mentality, which of course is fun from time to time; but if you continually lose, you won’t last in the game very long. As smart option sellers, we want to be the ones who take the other side of those low-probability losers and turn them into high-probability winners for us. To reiterate, selling options can be profitable because of the high probability of success if used correctly. Three out of the four strategies I will show you in the book are of the selling type, and I will give many examples later on down the road.

Buying OTM options is the speculation game pure and simple (don’t worry, I’ll tell you more about what OTM means very soon). We all like to speculate because the payoff can be great, especially with options where leverage plays a big part. Where else can you plunk down $100 to control a few hundred shares of stock for a limited time? This is the options market. You get to control something very large for a small amount of money. Unfortunately, this is where I believe the option market advertising went off track. A majority of people only see options as a lottery type of investment and continue to focus on buying the low-probability trades.

You need to remember that options are not an investment unto themselves. An option’s value is derived from other sources; hence, options are considered derivative investments. The most important of these other sources is the prediction of the direction you think the underlying security is going to move in the time allotted before option expiration. For one reason or another, many investors believe they can predict where a stock or commodity is headed in a very short time frame. They are lured into playing that hunch by buying the cheap options that have little chance of success. So once again, we’re going to focus on how we can take advantage of those probabilities and turn those opportunities into our gains.

Even though I like to focus on selling options to take advantage of the buyer’s low probability of profit, I also know how to buy options correctly as a form of investment. There’s a certain way to buy options correctly as a substitute for a stock or commodity, and when I’m interested in purchasing options, there’s only one way I do it. That way is to buy deep-in-the-money (DITM) options, which I’ll explain later.

AN OPTION EXAMPLE

Let’s walk through an example of what to do when you have a stock idea and you want to give options a try. We’re bullish on Intel stock (INTC) and we want to use options to leverage our money. That’s a great idea. But we have to decide what strike price and expiration month to pick. INTC is trading for $21 and we opt to buy a five-month option with a $25 strike price (as of February 2006). This option trades for a premium of $.40 per option contract (see option chain in Figure 1.1). Option prices have a $100 multiplier so our fictional call costs $40 ($.40 × $100). Since each option contract is the equivalent of 100 shares of stock, this means that we get to control 100 shares of INTC for the next five months at a cost to us of only $40. In order to find our cost-basis or breakeven price, we add our cost (option premium) to the strike price: $.40 + $25 = $25.40. If the option is held to expiration, we won’t make money on the position unless INTC rises above $25.40. If you plan to trade out of the position before expiration, then you may see a profit, depending on how fast and how far INTC moves higher during the course of the trade. But I want to focus on the trade as most investors would—keeping the option until expiration.

Figure 1.1 is a screenshot of a typical option chain from one of my options brokers, optionsXpress (www.optionsXpress.com). The strike prices are listed down the “Strike” column and the bid/ask market for the call options is in the middle of the graphic. Our five-month option would take us to the July 2006 options, where the $25 call can be bought for $.40.

Figure 1.1 INTC Option Chain, July 2006 Expiration

Source: optionsXpress.

The advantage of buying options instead of the stock is the leverage you get. You only have to spend a little money up front to control the 100 shares. Instead of paying $2,100 to buy 100 shares...

Table of contents

• Title Page
• Copyright Page
• Dedication
• PREFACE TO THE SECOND EDITION
• Acknowledgements
• PART ONE - THE OPTION BASICS
• PART TWO - THE STRATEGIES
• PART THREE - GETTING READY TO TRADE
• CONCLUSION
• INDEX