Options Investing for Beginners – How to beat the house by playing small ball.
04-19-2018, 01:11 PM
This is a thread about investing using options to reduce your risk and increase your returns.
This method is not glamorous – its not something you will brag about at parties or on message boards. But its safe, reliable, and the results can make you location independent after several years of compounding.
Realistically, you can expect 12% to 20+% returns annually. If you get those results, the rule of 72 means you will double your money in 3-6 years!
(The rule of 72 is just a short hand calculation to figure out how long it takes to double your money if you assume a certain interest rate. For example, if you earn 10% a year, compounded it will take you approximately 7.2 years to double your money.)
To use this method successfully, you have to understand why it works and why you should use it.
Why it works.
If you have gambled at a casino, you know that the house has a slight statistical advantage. Yet casinos are full of gamblers who want the thrill of beating the house. The smart money instead tries to change the odds in their favor by counting cards, etc.
This method works by becoming the house. Instead of buying an option on a stock, you sell it. The person buying the stock is gambling that the stock is going much higher. You collect an immediate payment from the gambler called the option premium. If you do this with the right stocks, you can reliably earn 20% a year! And the fact that you have money in your hand immediately reduces your risk.
Here is an actual example of a trade I put on Monday of this week:
Trade No. 1:
Bought UnderArmor (UA) for $14.33.
Sold the $15.00 May 25 call for $.88.
In plain English, I sold the right to buy my UA stock from me for $15. I got paid $0.88 per share to do that. Why did I do that?
Well three things can happen.
First, if UA is above $15 on May 25, roughly 39 days from when sold the option, the option buyer will exercise the option. That means I effectively sell my shares for $15, resulting in a $.67 profit. I also get to keep the $.88 option premium. Together, that’s $1.55 on an investment of $14.33, or 10.8%. But realize that I got that result in less than one-eighth of a year. Annualized, this is a return of more than 86%!
Second, and more likely, my stock will be less than $15 when the option expires. If this happens, then I keep my stock and I keep the option premium. So I earn $.88 on an investment of $14.33, or 6%. But annualized, this a return of 48%! In fact, this is what I hope to happen, because then I can put on the same trade after the option expires.
Third, UA could decline. In fact, as I write this, its declined about 3% from where I bought it at. Lets assume on May 25 it is still down 3%. If this happens, then again I keep my stock and I keep the option premium. So I earn $.88 on an investment of $14.33, or 6%. But annualized, this a return of 48% before the 3 % loss. I think the best way to think about this is to subtract 3% from the 48%, but that is still a return of 45% per year!
Now, is my result typical? Yes and no.
First, if you do this, you should diversify and have a basket of 10-15 stocks. I cherry picked this one because the result was so high.
Second, keep in mind that you are always going to be at risk of the price of the sock going down so you want to pick a company that is solid. Most of the companies I do this with are dividend payers, boring companies. Low beta if you know what that means.
Third, the return in this case is about twice what you would expect for two reasons. One, volatility in the market is high right now, so as the casino-owner you get paid more to sell your option. Second, there is a lot of optimism about this particular company, so gamblers have bid up the price of its call options. In baseball terms, everyone is swinging for the fence. What we want to do is play small ball and try to hit singles (or in this case a double or triple).
Before you pull the trigger on a trade like this, you have to realize a few things. These prices were earlier in the week, and you may not get the same prices. The value of an option decreases as the time run short, so as an option seller (the casino) you can’t expect to get as much.
Also, you are giving up all the upside above the strike price. So set the strike price where you are comfortable selling. If Nike buys UnderArmour for $29, double the current price, I'm only going to get $15. But I'm fine with that because a buyout is unlikely and we are playing for singles and doubles - $.88 per share guaranteed - and not swinging for the fence gambing on a buyout.
I aim for 2-3% above the current price. If I get 2%, and I can do this trade 8 times a year, that is effectively 16% on an annual basis. Anything less than 2% and you increase the chances that the stock is called away from you, and at a less attractive return. And the higher you set the strike price, the less the gamblers will pay you for the option because it makes it harder for their bet to pay off. So you need to balance things a little.
This works best with low volatility stocks. Look at boring companies like AT&T or Hershey;. It works best when you can roll the trade over without having to repurchase the underlying stock. It works best when you collect the option premium, the dividend on the underlying stock, and a gradual capital appreciation in the underlying stock.
This method is not glamorous – its not something you will brag about at parties or on message boards. But its safe, reliable, and the results can make you location independent after several years of compounding.
Realistically, you can expect 12% to 20+% returns annually. If you get those results, the rule of 72 means you will double your money in 3-6 years!
(The rule of 72 is just a short hand calculation to figure out how long it takes to double your money if you assume a certain interest rate. For example, if you earn 10% a year, compounded it will take you approximately 7.2 years to double your money.)
To use this method successfully, you have to understand why it works and why you should use it.
Why it works.
If you have gambled at a casino, you know that the house has a slight statistical advantage. Yet casinos are full of gamblers who want the thrill of beating the house. The smart money instead tries to change the odds in their favor by counting cards, etc.
This method works by becoming the house. Instead of buying an option on a stock, you sell it. The person buying the stock is gambling that the stock is going much higher. You collect an immediate payment from the gambler called the option premium. If you do this with the right stocks, you can reliably earn 20% a year! And the fact that you have money in your hand immediately reduces your risk.
Here is an actual example of a trade I put on Monday of this week:
Trade No. 1:
Bought UnderArmor (UA) for $14.33.
Sold the $15.00 May 25 call for $.88.
In plain English, I sold the right to buy my UA stock from me for $15. I got paid $0.88 per share to do that. Why did I do that?
Well three things can happen.
First, if UA is above $15 on May 25, roughly 39 days from when sold the option, the option buyer will exercise the option. That means I effectively sell my shares for $15, resulting in a $.67 profit. I also get to keep the $.88 option premium. Together, that’s $1.55 on an investment of $14.33, or 10.8%. But realize that I got that result in less than one-eighth of a year. Annualized, this is a return of more than 86%!
Second, and more likely, my stock will be less than $15 when the option expires. If this happens, then I keep my stock and I keep the option premium. So I earn $.88 on an investment of $14.33, or 6%. But annualized, this a return of 48%! In fact, this is what I hope to happen, because then I can put on the same trade after the option expires.
Third, UA could decline. In fact, as I write this, its declined about 3% from where I bought it at. Lets assume on May 25 it is still down 3%. If this happens, then again I keep my stock and I keep the option premium. So I earn $.88 on an investment of $14.33, or 6%. But annualized, this a return of 48% before the 3 % loss. I think the best way to think about this is to subtract 3% from the 48%, but that is still a return of 45% per year!
Now, is my result typical? Yes and no.
First, if you do this, you should diversify and have a basket of 10-15 stocks. I cherry picked this one because the result was so high.
Second, keep in mind that you are always going to be at risk of the price of the sock going down so you want to pick a company that is solid. Most of the companies I do this with are dividend payers, boring companies. Low beta if you know what that means.
Third, the return in this case is about twice what you would expect for two reasons. One, volatility in the market is high right now, so as the casino-owner you get paid more to sell your option. Second, there is a lot of optimism about this particular company, so gamblers have bid up the price of its call options. In baseball terms, everyone is swinging for the fence. What we want to do is play small ball and try to hit singles (or in this case a double or triple).
Before you pull the trigger on a trade like this, you have to realize a few things. These prices were earlier in the week, and you may not get the same prices. The value of an option decreases as the time run short, so as an option seller (the casino) you can’t expect to get as much.
Also, you are giving up all the upside above the strike price. So set the strike price where you are comfortable selling. If Nike buys UnderArmour for $29, double the current price, I'm only going to get $15. But I'm fine with that because a buyout is unlikely and we are playing for singles and doubles - $.88 per share guaranteed - and not swinging for the fence gambing on a buyout.
I aim for 2-3% above the current price. If I get 2%, and I can do this trade 8 times a year, that is effectively 16% on an annual basis. Anything less than 2% and you increase the chances that the stock is called away from you, and at a less attractive return. And the higher you set the strike price, the less the gamblers will pay you for the option because it makes it harder for their bet to pay off. So you need to balance things a little.
This works best with low volatility stocks. Look at boring companies like AT&T or Hershey;. It works best when you can roll the trade over without having to repurchase the underlying stock. It works best when you collect the option premium, the dividend on the underlying stock, and a gradual capital appreciation in the underlying stock.
