I’ve posted a few things in the past about my trading activities in the financial markets. These activities and my education continue, now more than ever. How about a 35% gain in my portfolio since November, and it has nothing at all to do with the "Santa Clause Rally;" and now, the New Year rally that will probably set a new benchmark and render 9/11’s effect on the financial markets part of the settled past (for now)?
Since I began trading last spring and summer, I grew increasingly frustrated with the two steps forward, three steps back routine, time and again. There was no clear direction in the market. Gains one day are wiped out by losses the next, and vice versa, over and over. Frankly, unless one is prepared to trade full time, one is better off in such markets just buying good mutual funds or trading ETFs and checking them over once a month. And that’s really the rub. Hey, I know people with good trading educations they paid lots of money for who do better than 10% per month, consistently. But it’s a full-time job.
There is almost nothing that bores me more than researching fundamentals and technicals on stocks and their underlying companies. You do all of this work, and then you must stake your money and your time spent on being right; and what’s more, it’s all completely out of your control. You can invest in the best companies with the best rated stocks in the best rated and performing industries and the next day get screwed by something Alan Greenspan said. Yes, of course, it’s the long term, and if you buy and hold a diversified portfolio of good stocks in good industries, you’ll do 10, 11, maybe even 12% per year long term. We’ll, you can do that and more with good mutual funds, without the hassle, without the commissions, and without the tax complications. Hell, buy a house and live in it for 10 years. Chances are you’ll do better, and the gains will be tax exempt.
Options are–of course–to stocks what a mortgage is to paying cash for a rental property. They are leverage. Yep, I can buy an option to purchase a stock at a certain price for a certain length of time and pay only a small premium equating to a small fraction of the actual value of the stock. If the stock goes up, the value of the option increases, which I can then sell and profit almost as though I had owned the stock itself, but only for a tiny fraction of the investment capital required.
But did you know you can sell options too, even if you don’t own the underlying stock? You can sell an option (a call) that gives the buyer a right to buy a certain stock from you at a certain price for a certain length of time. There’s another kind (a put) you can sell that gives someone the right to make you buy a certain stock from them at a certain price for a certain length of time. When you sell these, you get the money up front and it’s yours to keep.
So, suppose you sell someone the right to make you buy [to ‘put’] Google [to you], currently trading at $436, for $430, and the option expires on Feb 17, 2006. Right now, today, the market will pay you $21 per share for that. An option contract is 100 shares, so $2,100 per contract. In your pocket. So long as Google is trading at $430 or above at market close on 2/17, the option will just expire worthless and you’ll keep the $2,100 (or $21,000, if you sold 10 contracts). If the stock is trading below $430, then you’ll be put the stock at the $430 strike price (even if it’s trading lower). So, for one contract, $43,000 will be deducted from your account, but you’ll own a hundred shares of GOOG at a basis of $430. There’s actually a lot you can do at this point. Of course, even if the stock was trading as low as $425, you could sell immediately for $42,500 and you still profit $1,600 overall. In fact, so long at it’s trading above $409 at expiration (430-21), you’re break even or better.
You could also turn around a sell a March covered call (covered, meaning the sale of the call is covered by the shares you now own) at a strike price of, say, $440, collecting about $2,400 on that sale. Then, if the stock closes below $440 on 3/17, the call expires, you keep the $2,400, sell an April call and do it all over again. If it closes above $440, your $43,000 of shares will be sold for $44,000, giving you an additional $1,000 over the $2,400 for selling the call. Essentially, you win, or you win.
These are just some basics. Next, I’ll cover what I’m actually doing, primarily, which are credit spread trades on the SPX (S&P 500 Index). But first, let me relate all this to the title of the post. Remember when I sold the Feb $430 Put on Google and collected $2,100? Guess what happens if Google continues to trade around $436 for the next month. You know, up a few points, down a few points; up, down; up, down between now and expiration on Feb 17. What happens to the value of that option I sold? It depreciates. And the closer you get to Feb 17th, the more rapidly it depreciates. On Feb 16th, so long as that stock is trading above $430, that option is only going to be worth a pittance. Around $100. Therefore, what did I sell when I collected $2,100? I didn’t buy and I didn’t sell any security, and certainly nothing secure. I sold time. When you comprehend the power of that is when you begin to understand how so much money can be made and lost in the markets, and how much there is to learn and master.