Position:

Buy QIUUA September 5 Put for          $0.35

Sell QIUUU September 7.5 Put for      $1.20

Net                                                                    $0.85

Break even for this position is OSIR trades for $6.65 ($7.50 – $0.85) on expiration.  Today OSIR is trading for $11.75.  This would be a decline of $5.10 in the next month, or 43%.  Possible, but not likely.

Maximum Loss would be $1.65/share (+ trading costs) OSIR – $5.00 or less.

Maximum Gain would be $0.85/share (- trading costs) OSIR – $7.50 or higher. 

Assuming $.15/share trading costs the gain would be $0.70 ($0.85- $.15) for a return of 28% ($0.70/$2.50) in one month, or 336% APR.

SRS traded at $19.40 at the close on Friday July 17th.  Both Call options, the one bought (long) and the one sold (written), expired worthless.

We have realized our maximum loss of $3.50 (+ trading costs) or $7.80 (+ trading costs), depending on the strike prices chosen.  Our loss represents a 100% loss of the money at risk.

NOTE:  I am including this trade as a 100% loss, HOWEVER, SRS traded upto $111.22 on March 6th.  The low beteween these dates was $48.00.  IF we had placed a trailing stop order (to be explained in another post) we could have avoided this loss AND this trade would have been a WINNER of probably 75% OR BETTER.  I did not include these instructions in this trade, because I have not explained what a trailing stop is.  I would have had a trailing stop of 20% on the price of SRS (it would have been this large because of the volatility of SRS), which means that we would have exited this position when SRS was trading aroung $88.50-$89.00.

SLV traded for $13.17 at the close on Friday July 17th.  Both Puts, the one sold (written) and the one bought (long), expired worthless.

We realized the maximum gain for this trade of $0.40 (less trading costs), if we assume $0.15/share as trading costs, we have a gain of $0.25/share.  We risked $0.75/share, which makes our return on this trade 33% (0.25/0.75) for four months or approximately 100% APR.

Please note that $0.15/share trading costs assumes that only one option contract was used.  These costs go down (dramatically) if more than one option contract is used which would raise the return of this trade.

We started this trade on January 27th

We had an update here, here,  here and here.

The call that we sold has been exercised, the call the we held long was used to cover the trade.  We had a gain of $1.10 on an initial capital requirement of $4.20, including all trading costs.  This represents a 5 month gain of 26% ($1.10/$4.20) or almost 63% APR.

Sell October 2009 $20 Put on LINE (QGJVD) for     $2.05

Buy October 2009 $17.50 Put on LINE for                 $0.95

Net                         +$1.10 (less trading costs)

Max. Gain               $1.10 (less trading costs)

Max. Loss               $1.40 (+ trading costs)

Linn Energy is trading for $19.66 at the close of trading today June 15, 2009.

If Linn Energy is trading for $20.00 or more on October 17, 2009 both puts will expire worthless, we get to keep the $1.10 (less trading costs) premium.  If Linn Energy is trading for less than $17.50 we will suffer the maximum loss.  In between $17.50 and $20.00 we will have to make a calculation for the gain or loss.  I feel this is a great trade because Linn Energy is paying a +12% dividend and their earnings should be very solid as they have hedged their product for the next three years, at favorable prices.  I do not believe that Linn Energy will decline from here.

We are risking $1.40 (+ trading costs) and the return that I am looking for is about 78% in 4 months or 235% APR.

In order to enter this position the investor will have some beliefs.

          1)  She believes that the underlying security will stay the same or go down.  Depending on the strikes chosen, the underlying security can go up a little and this position will still make money.  That is why this position has the word Bear in the name, it has a bearish bias.

          2)  The investor understands that IF the underlying stock moves counter to the postion, in this case, up, the position can lose 100% of the money invested.  The good thing about a vertical spread, however, is that the options WILL retain some value, up until, expiration.  This means that a 100% loss can be avoided. 

Lets look at an example:

Lets assume that GE (General Electric) fits the criteria.  GE is trading for $10.78 on March 27, 2009.  I would buy an April 2009 $12 Put, for $1.55, while selling an April 2009 $11 Put, for $0.90 .  Here is the Risk/Reward graph for this position.

The Maximum Loss is $0.65 (+ Trading Costs), and this will occur if GE is above $12 at the expiration, April 18, 2009.

The Maximum Gain is $0.35 ($1 difference in strikes -$0.65 premium paid) (- Trading Costs), and this will occur if GE is below $11 at the expiration, April 18, 2009.

If GE is between $11 and $12 at expiration, April 18, 2009, then the gain/loss will be -$0.65 (the cost of the spread) – the price of GE + $12 (the price that you can sell (put) GE).  Therefore the breakeven point for this position is $11.35 (-$0.65 – $11.35 + $12 = $0) (not including trading costs).

This trade would be entered when GE was trading for $10.78.  This means that if GE stays the same or goes down OR goes up $0.22 (2.0%) this position will still make the maximum gain.  GE has to go up to $11.35, a gain of $0.57(or 5.3%), for this position to start to lose money. 

This position cost us $0.65/share and has an upside potential profit of $0.35/share.  That would be a 54% gain in less than 1 month.  Which is an approximate 650% APR (Annual Percentage Rate).

In order to enter this position the investor will have some beliefs.

          1)  She believes that the underlying security will stay the same or go up.  Depending on the strikes chosen, the underlying security can even go down a little and this position will still make money.  That is why this position has the word Bull in the name, it has a bullish bias.

          2)  The investor understands that IF the underlying stock moves counter to the postion, in this case, down, the position can lose 100% of the money at risk.  The good thing about a vertical spread, however, is that the options WILL retain some value, up until, expiration.  This means that a 100% loss can be avoided.

Lets look at an example:

In a recent Trading Idea I said to buy a July 2009 $12 Put while selling a July 2009 $13 Put on SLV  (IShares Silver ETF).  Here is the Risk/Reward graph for this position. 

The Maximum Loss is $0.60 ($1.00 difference in stikes – $.040 premium), and this will occur if SLV is trading below $12 at expiration, July 18, 2009.

The Maximum Gain is $0.40 (Premium recieved for position), and this will occur if SRS is trading above $13 at expiration, April 18, 2009.

The breakeven is if SLV is trading at $12.60 at expiration, July 18,2009.  The breakeven for this postition can be calculated by taking the strike price for the option sold (the $13 Put) – the premium received ($0.40).  If SLV is trading below $12.60, this position will have a loss.   If SLV is trading above $12.60 this position will have a gain.

Today SLV is trading for $13.68.  This means that SLV can lose 5% ($0.68)between now and July 18th and this position will still have the Maximum Gain.  SLV can lose 7.9% ($1.08) in that time frame and this position will Breakeven (not including trading costs).  SLV has to lose more than 12% in this time frame to incur the Maximum Loss.

Sell SLVSM            July 2009    $13 Put             $1.20

Buy SLVSL            July 2009     $12 Put             $0.80

Net Premium               $0.40 (-Trading Costs)

Maximum Loss            $0.60 ($1 difference in strikes – $0.40 premium received) (+Trading Costs)

Maximum Gain            $0.40 (-Trading Costs)

SLV is trading for        $13.61 at the close on Friday 03/20/09

In order to enter this position the investor will have some beliefs.

          1)  She believes that the underlying security will stay the same or go up.  Depending on the strikes chosen, the underlying security can go down a little and this position will still make money.  That is why this position has the word Bull in the name, it has a bullish bias.

          2)  The investor understands that IF the underlying stock moves counter to the postion, in this case, down, the position can lose 100% of the money invested.  The good thing about a vertical spread, however, is that the options WILL retain some value, up until, expiration.  This means that a 100% loss can be avoided. 

Lets look at an example:

In a previous Trade Idea I suggested a Vertical Spread.  I said to buy a July 2009 $35 Call while selling a July 2009 $55 Call on SRS  (Proshares Ultrashort Real Estate Fund).  Here is the Risk/Reward graph for this position.

The Maximum Loss is $7.80 (+ Trading Costs), and this will occur if SRS is below $35 at the expiration, July 18, 2009.

The Maximum Gain is $12.20 ($20-$7.80) (- Trading Costs), and this will occur if SRS is above $55 at the expiration, July 18, 2009.

If SRS is between $35 and $55 at expiration, July 18, 2009, then the gain/loss will be -$7.80 (the cost of the spread) – $35 (the price that you can buy (call) SRS) + the price of SRS.  Therefore the breakeven point for this position is $42.80 (-$7.80 – $35 + $42.80 = $0) (not including trading costs).

This trade was entered when SRS was trading for $59.44.  This means that if SRS stays the same or goes up OR goes down $4.44 (7.5%) this position will still make the maximum gain.  SRS has to drop to $42.80, a loss of $16.64 (or 28%), for this position to start to lose money.  The 52 week low for this ETF is $48.00.

This position cost us $7.80/share and has an upside potential profit of $12.20/share.  That would be a 256% gain in approximately 6 months.  Which is an approximate 500% APR (Annual Percentage Rate).

One other note on this example:  This position is called a Bull Call Spread, that means that I was “bullish” on SRS.  However, SRS is an “Ultrashort” ETF, which means that it moves up when some index, in this case the real estate fund, goes down.  In essence, this position was a “bearish” position.  I hope I have not confused the situation.

Spreads have many names, but do not let that scare you.  As I said before, half of understanding anything is learning the “language”.  I will attempt to explain them in plain English.

The first Spread that I will explain is the Vertical Spread.

The Vertical Spread consist of buying a Call (or Put) and selling a Call (or Put) with the SAME expiration month, but with DIFFERENT strike prices.  That’s it.  Not very difficult.  This position will have a LIMITED loss potential, as well as, a LIMITED gain potential.  In other words, when you enter the trade you will KNOW the maximum gain and the maximum loss that can occur. 

Sometimes, you will hear of a Credit Spread or a Debit Spread.  A Credit Spread means that you will receive a positive inflow into your account (a credit) when you open the trade.  A Debit Spread means that you will pay (a debit) when you open the trade.

There are essentially four different Vertical Spreads that one can enter, they are:

          1)  The Bull Call Spread

          2)  The Bear Call Spread

          3)  The Bear Put Spread

          4)  The Bull Put Spread

next up - a discussion of the Bull Call Spread

Lets say we alreday own 100 shares of the QQQQ’s (Powershares Nasdaq 100 Index fund).  Today, the fund is worth approximatel $28.50/share.  Thinking over the last year, with most indices down 50% (or more) we want to make sure that we do not lose more than 15% from our current holdings (The smaller the loss that you want to protest against, the more expensive the “insurance”).  For this strategy, I would find the longest duration option that fits my criteria.  The reason I want the longest duration is because I do NOT want to have to repeat this trade very often.  The more trades that one makes, the more one pays in trading costs, and since this is insurance, I want to find the cheapest.  Also, as discussed earlier, the time value of an option decreases more rapidly as the expiration date approaches.  If I am purchasing time value, I do not want it to go to waste.  Here is a list of the January 2011 near the money puts for QQQQ.

If I purchase the OZCMZ (January 2011 $26 strike) Put option for $4.09, I will be “protected” if the stock falls below $26 before January 2011 (almost 2 years).  This “insurance” will have cost me $409 (+ trading costs).  You might be thinking that this sounds expensive.  Lets think what we would have paid for insurance if we owned Citibank at $27.00 at the end of April 2008 (Citibank is now $2.50) or Enron or Lehman Brothers (both bankrupt) or etc.  this strategy works especially well in a falling market.  Here is the risk/reward graph for this position.

Final note:  As the expiration gets closer on this position and options are added at more dates, we should be able to sell this option and purchase another longer duration option, to keep the “protection” in place.

The Covered Call Strategy involves writing (selling) a call against stock that is already owned.  If you write a Call without owning the stock it is called a “naked” call.  The Covered Call Strategy can be a procedure that makes any stock a “dividend” stock.  This strategy is perfect for a buy and hold investor.  This strategy makes a few assumptions:

     1)  The investor likes the stock and wants to own it.

     2)  The stock is not too volatile, meaning the price of the stock does not vary much, or stays within a channel.

     3)  The investor is willing to accept the full risk of a downward move in the stock.

There are two types of positions that can be employed when using the Covered Call Strategy.  The first, which is the one I will discuss here in detail, is selling near the money options that expire in the next month or two, and the second is selling extended duration options that are deep in the money.  If people want examples of strategy #2 please leave a comment.  In strategy #1, we sell options that expire in a month or two in order to capture the time value of the option.  The time value of an option accelerates to $0 as the option approaches expiration. 

For this discussion, lets look at Archer Daniels Midland (ADM).  Here is a chart of the last three months (I am using the last three months, because before that three months everything fell dramatically, and I am using current examples)

3 month Chart of ADM March 13, 2009

As you can see ADM has basically stayed between $24 and $30, so lets say we buy 100 shares today at $27.76 (full cost would be $2,776.00 + trading costs).  Here is a list of the near the money Call options expiring in April.

We could write (sell) the ADMDF $30 strike option for $0.95 (I would try a limit order at $1.00).  This $0.95 represents time value as there is NO intrinsic value in this option because it is Out of  the Money (OTM).  The ADMDE option priced at $3.50 has $2.76 of intrinsic value ($27.76 – $25.00) and $0.74 of time value ($3.50 – $2.76).  At this point we want ADM to continue to appreciate, slowly.  Remember, the investor wants to own this stock (would own it without writing calls).  Here is the risk/return graph for this position.

At this point, there are two possible outcomes:

     1)  ADM stays below $30, then the option expires worthless and we can sell the next option.  The return for the month is $0.45 ($0.95 less trading costs, I will assume $0.50, and this includes the trading costs on the stock, which is only paid in the first month) option premium received for a return of 1.6% for the month ($0.70 if we do not include the trading costs of the stock, for a 2.52% return for the month).  This as a simple Annual Percent Return (APR) of 19.45% (or 30.26%) not including compounding.

     2)  ADM is above $30, then the option will be exercised.  We sell ADM for $30 (this is the strike price of the option that we sold).  The return for the month is $2.44 ($30 Strike price – $27.76 Purchase price + $0.95 Option premium received – $0.75 trading costs) or 8.79% for the month (105.48% APR).  If this happens we can decide to repurchase ADM or look for another opportunity.

These outcomes do not include any dividends received for owning the stock through an ex-dividend date, if this were the case the dividend would need to be included as a gain in the calculation.

The worst case for this strategy is for the stock to decline drastically.  If this happens, the investor will need to decide whether to sell options that could produce a realized loss, sell the stock for a loss or hold the stock and hope for a positive return.

Next the Married Put…

     1) Long stock

     2) Short stock

     3) Long Call

     4) Short Call (Write a Call)

     5) Long Put

     6) Short Put (Write a Put)

If you are Long or Short Stock, or Short a Call or Short a Put you have an unlimited loss potential (or down to $0 on the price of the stock).  If you are Long a Call or Long a Put you have a limited loss.  If you are Long or Short Stock or Long a Call or Long a Put you have an unlimited gain potential. 

Next we will start to combine these positions, to see the true power of options and ways to use them effectively.

Limit – If you place a “limit” order, you are telling the market what price you will either buy or sell at.  In my opinion, this is how every order should be placed.  I have learned the hard way that the market, or market makers, will place their interests above yours if they have the opportunity.

Fill-or-Kill – This is a limit order that you do not want to remain open for any length of time.  Either the market fills your entire order at your price, or it is cancelled.

Market on Open – This means you will have a “market” order for the opening price.

Market on Close – This means you will have a “market” order at the closing price.

Day Orders – This is a time limit that is on your “limit” order.  If the order does not get processed today, it will be cancelled.

Good till cancelled orders – This is a limit order that will remain open UNTIL you cancel it or it gets filled.  Many brokers put a 60 day limit on these orders.

Stop Loss Orders – This is a protective order.  If you purchase a stock for $10, and you have placed a limit on your losses of 10% for any position, you can place a “stop loss” order for the position at $9.  If the stock price reaches $9, you will automatically sell you position.  IF the stock GAPS down below $9, you may get a much lower price than $9.  There are other, better, ways to limit your losses.

Lets use the same INTC March $12 Put (symbol NQOM).  If you buy the Put (Long the Put) your risk/reward at expiration looks like this:

$12 March 2009 INTEL Put

$12 March 2009 Intel Put - Short

At first I wasn’t sure if I would want one, my friends have convinced me that I need one.  I was able to borrow one for a night and after using it I can see how I would never be without it.  It is very easy to download books and it has plenty of storage.  It is very light and easy to operate.

I wish that it had two things.

    1.  A memory card slot – I think this would make transfering your own documents onto and off of the Kindle much better and secure.

    2. I would like to have the screen able to light up (dimly, or adjustable) – I would like to read in bed without disturbing my wife.  I am considering buying the clip on light, but for the cost of the device this should have been included.  A clip on light is just not elegant.

 I also wish that I could try the new Sony reader so that I could compare them.

If you find this post helpful and are planning to buy a Kindle 2, please click this link.  It helps me cover the cost of my time and materials, and does not cost you any more than normal.  Thank you in advance.

Kindle 2: Amazon’s New Wireless Reading Device (Latest Generation)

Some other reviews of the Kindle 2:

http://www.wired.com/reviews/product/kindle2

http://www.businessweek.com/magazine/content/09_10/b4122000174059.htm?chan=top+news_top+news+index+-+temp_dialogue+with+readers

http://www.msnbc.msn.com/id/29354846/

http://www.foxnews.com/story/0,2933,503365,00.html

There are many more articles, but I found these to answer most questions.

Lets look at Intel Corporation (INTC) as an example.  On February 23, 2009 INTC closed at $12.07Bid/$12.10Ask.  The following is a list of near the money Call options that expire in March 2009.

Put Options - Intel February 23, 2009

If you purchased one March $12 Put (symbol NQOM) for $0.75 (plus transaction costs) today, you would have until the March 20th (the third friday of March) Expiration date to EXERCISE the option.  If you exercise the option, you would give your broker 100 shares of Intel (INTC) and your broker would pay you $12/share (plus transaction costs).

Why would you do this?

Perhaps you think INTC is going to announce something that will make the stock FALL between now and when the option expires.  If you think the stock is going to fall, then you can do a few things.  The first would be to SHORT the stock (see earlier posts) or you could purchase a PUT. (There are other things as well that I will discuss later)

If INTC makes an announcement and the stock falls to $10.00/share, you will have a gain of $2.00/share less what you paid for the option ($0.75), for a total gain of $1.25/share (less transaction costs).  If INTC stays above $12.00 you will not exercise the option and it will expire worthless, for a maximum loss of $0.75.  If INTC falls to $11.25, you will break even (not including transaction costs).  If you had shorted the stock, and it rises to $13.00, you would have lost $1.00, and it could go higher.

Lets look at the risk/reward graph, at the expiration date.

$12 March 2009 INTEL Put

If INTC stock is below $11.25 (less transaction costs) the options will produce a gain.  If INTC stock is above $12, the options will expire worthless, and the maximum loss of $0.75 will be realized.  In between $11.25 and $12.00 the options will incur some gain.

If we compare the graph for being SHORT (selling) a stock vs. buying a Put, one can see that we have limited the downside, while maintaining an unlimited upside potential (Not necessarily unlimited as the price of a stock can only go down to $0), by buying a Put.

CONS:  The put option has a time limit.  If we purchased the $12 put (symbol NQOM) for $0.75 and the stock were to stay above to $12.00 the put will expire worthless and we will lose $0.75 at expiration.

Do not be disappointed yet, remember, I am trying to explain the basics before I explain more complex combinations.

To be continued—