We have all become aware of the extreme levels of stock market volatility in the last few years. For small investors, this volatility can create a high degree of anxiety when one's retirement fund or life savings are at the mercy of the markets!
Fortunately, there are tools for small investors [and large investors] to achieve peace of mind while “in the market,” outsized returns from low-risk existing stock positions, and significant speculative gains, if one is so inclined. These tools are called options.
If you don't know how to effectively use options, now is the time to learn!
In this short article I am going to demonstrate an options trading strategy that uses a combination of shares of stock, call options, and put options to realize large annual gains with a strategy that actually carries less risk than the traditional method of buying and holding stocks. It is only one of many possible easy and conservative options trading strategies that could be part of a larger options trading system.
Since BP has been in the news quite a lot lately [not for good reasons, obviously] I will use this stock as my example. Let's talk about our assumptions up front. First, we want to make money with little risk. Second, we don't mind either owning BP stock at this level for a few months, or selling BP stock right away for a large return. Third, we know that selling options is far more profitable than buying options. Lastly, in this example I will use 1000 shares to make the numbers easy, I will assume that you know what call and put options do [if you don't, you really need to learn ... seriously], and I will assume you know how to buy and sell shares of stock, etc.
Alright, so here we go with this conservative options trading strategy designed to make us over 100% return per year!
What we are going to do is very simple; by the numbers it looks like this [all data is taken from Yahoo Finance this morning, 14 July 2010]:
buy 1000 shares of BP stock @ $36.89/share
sell 10 call option contracts for August 2010 at a strike price of $37.50 for $2.74.
sell 10 put option contracts for August 2010 at a [conservative] strike price of $32 for $1.35
That's it! I know what you are thinking, “hey, that's great, but what the heck does it all mean?” Once again, it is actually quite simple, but you will be surprised at how the numbers add up in your favor!
So, we all know that stocks can do three things with varying degrees of speed: go up, go down, and stay the same. The first important thing to note is that this strategy can win in all three of these circumstances. The second thing to note is that we are only looking forward in 30 day increments [to options expiration], as long as we own this stock, BP.
Scenario 1: stock goes up.
Let's say our stock, BP, goes up to $40 and we let it get called away. Getting called away is great because you make your money and don't own the shares anymore, which means you don't have any risk anymore, either.
Our return per share is as follows:
premium collected: $1.35 for the put and $2.74 for the call = $4.09, plus
the appreciation of our shares = $37.50 – 36.89 = $.61
total gains = $4.70
Our one month return on this transaction is then $4.70 [gains] / $36.89 [purchase price of stock] = 12.74%! This monthly return equates to an annual return of 153%. This is our best case scenario, and is not at all uncommon, especially if one chooses to invest in stocks that are in an uptrend. By the way, this is a one month income of $4,700!
Scenario 2: stock stays flat.
Let's say that BP doesn't do anything much during this month and finishes at options expiration [the last Friday of August in this example] at $37. What is our return then?
Our return per share is as follows:
Our premium collected is the same as the above example = $4.09.
The stock only goes up 11 cents, and
Importantly, we still own the shares and can do this again next month without making another purchase [that is why some people consider this to be the “best case scenario”]!
Our one month return is now $4.20 / $36.89 = 11.38%! This equates to an annual return of 136%, not too shabby either! We still own the shares, and can do this again next month and make another $4,200 on these 1000 shares of BP.
Scenario 3: BP goes down to $34.
Let's say that BP finishes August expiration at $34, a slight decline from our $36.89 purchase price. Not to worry, we have still made money! Here it is:
Our return per share is as follows:
Our premium collected remains the same as above = $4.09,
Let's assume we keep the shares and account for our loss this month [we don't have to do either], so this is a “loss” of $2.89.
Total gains on the stock are then $4.09 - $2.89 = $1.20 profit.
Our one month return is now lower at 3.25%, but this is still a monthly income of $1,200 and a yearly return of 39%! Not bad either!
For reasons of brevity, I can only demonstrate these three scenarios. Other outcomes are possible, but none are bad if you don't mind owning more shares of BP at lower and lower prices [this strategy should be used with stocks we don't mind owning; if we don't want to own more we would not sell the put and stick only with the stock purchase and the call option sale, it's that simple] and doing this again next month!
As you can see, this is certainly a powerful options trading strategy! The irony is that it is both conservative and profitable. Many people, when they think of options, think of high risk speculation. While this certainly occurs, it was not the reason that options were created in the first place, and it is not the principle way in which they are used.
The best way to use options is with options trading strategies like the one outlined here that are designed to increase your portfolio's safety, while simultaneously increasing your returns! Not a bad combination!
My goal in this short article has been to give you some free information to increase your investing success. I sincerely hope I have done that and, again, if you don't know about options or did not fully understand what I have written here, make sure you learn! They are the best tool available for achieving financial independence in any stock market environment!
Learn about options and get your own options trading system, you will thank me!