LET’S TALK OPTIONS

I like options. I normally trade in equities; nevertheless, I like options. I will briefly explain the good and bad of option trading. The bad side of an option is that options expire. The good side is, not nearly, as much money is needed to trade options. December 23rd Microsoft (MSFT) ended the day valued at $36.58. If I purchased 1000 shares of MSFT it would require an output of $36,580.00 plus commission. With most companies, I could purchase MSFT on margin, but that is another topic and one I do not recommend. Let us look at what I could do with an option on MSFT.

The January 35 option last price was $1.96. Options trade in contracts and one contract is normally 100 shares, thus 1000 shares of MSFT would be 10 contracts. If I purchase 10 contracts of MSFT and control 1000 shares, my outlay would be $1960. plus commission and fees. To make this easier to understand I am going to change the price of MSFT to an even number. Let us assume MSFT is trading at $35. Now my investment would be an even $35,000. If during the coming month before MSFT options expire, MSFT goes up in value to $45 we would make $10,000 profit on our trade. If instead of buying the equity, we bought the $35 January call option at $1.96 our investment would have been $1960. If the equity increased to a value of $45 per share, our option would have increased in value at least $10 per share as well. We can purchase the stock at $35 per share by exercising our option, or we can sell the option at the higher value and take the $10 selling price for the option.

Let us now look at the percentages involved in these transactions. If we purchased the equity at $35 per share, our risk is $35,000. However, the risk is not as great because MSFT is not likely to go down in value to $0.00. If we bought the option, our risk would be $1960 and we could lose that amount of money if the equity should go down in value. However, $1960 is the maximum risk of loss.

Here are the percentages:

______ Purchase Price Sale Price__Profit____Percentage

Equity price:..$35............ $45.............. $10 ........28.571%
1000 Shares .$35,000 .......$45,000 .........$10,000 ....28.571%
10 $35 calls ..$1960 .........$10,000 .........$8040 ......410%

The risk with the option trade is if the stock drops enough, your options may be worthless when they expire on the third Friday of January. In reality, I would not expect MSFT to increase $10 in that month although it has happened. I would think a $5 increase would be a reasonable expectation if I have done my research. The point I am trying to show is the percentages involved in the two types of trades. If you trade equities on MSFT and the equity increases in value by $10, you make a profit of $10 per share but if you have traded in call options your investment is a small fraction of what you would have invested in equity trades but the profit would have been equal. Percentage wise, the options trade would have been considerably more valuable.

Please be advised the above scenarios are intended as examples only and should not be construed as actual prices. Their intention is solely to relate possibilities in trading options, and how we can view these types of trades.

AN IMPORTANT STRATEGY

AN IMPORTANT STRATEGY

Today’s blog will be short but important. Strategy is important and an area not to be overlooked is news. Routinely first thing each morning, Monday through Friday, I have all of my televisions in the house preprogrammed to tune into CNBC and find out what they are talking about. The first thing I want to know is what they are expecting the “Futures” to do. Will they open higher or lower? If they are expecting Futures to open at least 3% higher, you can with caution, expect the stocks you are interested in to open higher. This is not a hard and fast rule but simply begins your day with some educated expectancy.

Another strategy I use and have used in the past is listening to what companies CNBC newscasters are talking about. I normally try to start listening to CNBC about one hour before the market opens so I can catch up on any early news about companies I may be interested in. I do not recommend the following strategy, but it worked for me once. CNBC was talking about a cheap stock. I am talking about a $3 or $4 dollar stock. This happened several years ago so there is no way I remember all the details, but I definitely remember the strategy and what happened. A visitor to the program commented the stock was much undervalued and should be worth about $50.00. Immediately the stock began to climb. As it approached the $50 dollar level, I sold the stock. I did not own this stock but I sold abut 1000 shares short. Selling short is selling shares of stock you do not own, you are borrowing the stock from the market. This kind of trading is extremely risky, and I do not recommend it. I had plenty of money in my account and took a chance. Fortunately, the stock did exactly as I expected. It started to tumble and at the end of the day, I bought the stock to cover my short making a tremendous profit. I cannot emphasize enough the risk involved in this type or trading. If the stock had continued to go up, I would have had to buy the shares at the higher price to cover my short sell. I mention it to show the importance of listening to news. Stocks move on news.

Normally I want to watch for stock that is going up. I buy low, and as soon as the stock is bought, enter a high sell order. That is not always possible. A lot depends on the market and the overall picture. A few years ago, Krispy Kreme Doughnuts (KKD) got into financial trouble. The news broke they would file bankruptcy. I was in a motel room away from home. I quickly put all the numbers into my computer and decided to buy a “put.” I have not discussed puts. I will explain puts so you will know what my trade strategy was.

There are two types of options, calls and puts. A call gives you the right but not the obligation to purchase a stock at an agreed on price during the agreed time. A put is just the opposite. A put gives you the right but not the obligation to put the stock to the market at the agreed price during the agreed time. If you are buying calls, you are expecting and hoping the stock will go up. Conversely, with a put you are expecting the stock to go down. In the case of KKD, the bad news would drive the price of their stock down, so I bought several contracts of puts for KKD. Immediately their stock began to fall and as a result, the puts I bought went up in value. True to my nature, I did not own the puts very long. I did not know how long I would be in the motel or how long I would have internet service so I entered a sell order as soon as I owned the puts. I sold my puts before the trading day was over and made a handsome profit. I still like KKD stock but only buy it when it is heavily discounted. I may be a little philosophical but one of the reasons I like the stock is because I like their donuts. Try to figure that out.

FINDING THE RIGHT STOCKS CONTINUED

FINDING THE RIGHT STOCKS CONTINUED

There are a number of things I look for in finding the right stock. Determining stock purchase is an area you may have to experiment with to determine what works for you. I almost never purchase a stock with intentions to hold it long term. If I look for channeling stocks, then 12:00pm is long term. If I plan to write a covered call, then about 30 to 40 days is my long term goal.

Here are some stocks I either own or probably will own at some future date. Some are discounted at this time due to conditions in the market. Each of these stocks pay a dividend. That is one of the first things I look for, in fact I have a portfolio watch with the heading, “Stocks that Pay Dividends.” After finding stocks that pay a dividend I look at their options charts and decide if they are paying good premiums compared to the purchase price of the stock. If you think you may hold the stock for long term, you need to look at their earnings per share and other analysis or performance markers.

I like (MMP,) “MAGELLAN MIDSTREAM PRTNRS.” I bought this stock primarily to capture the dividend. I bought MMP at $41.99 per share online at Zecco so I only paid $4.50 commission. The stock last traded today (December 12, 2007) at $43.70. Unfortunately, it has not run up enough to get a good premium from an “Option,” since the next “Strike” price is $45.00. I have a choice, I can hold for a while and hope it runs up close to $45.00, or I can sell at a profit.

I know Microsoft is a worn out horse so to speak, but at this time because of the price, I like them. The last trade today for MSFT was $34.47, the last $35 strike was 0.30; however, if you roll out to January the price is 0.91. I don’t like to go out into the next month, but the difference is probably worth looking at. It could possibly be better to wait a few days for the market to move a little.

I have owned AT & T several times. While other stocks sold off yesterday and today, AT & T (T) held up nicely. The price may even be to high. I should have bought the stock yesterday when it was almost $2 cheaper. The last trade today was $41.77, and the last option trade today for the $42.50 strike was 0.35.

When you study hese examples, you may notice something you need to look for. Watch for the stock to be discounted. As an example, (T) closed yesterday at $39.48. If you had purchased at that price, you could have sold the $40 strike today for $1.93; and hopefully, you would be called out on Friday, December 21, 2007 at the $40.00 price. Then you will making a profit on the sale of the stock as well as almost $2.00 per share for the option premium.

General Motors (GM) is another discounted stock today. The last close today was $27.36. GM 52 week low was $24.50 so they are just a little over their 1 year low. The $27.50 strike for the Call Option is 0.78. but I believe you could hold out for a few days and maybe get a good premium.

Another thing you need to keep in mind is the amount of commission you must pay. There is a commission when you buy and when you sell. For the Option trade there is an additional charge and it is based on the “contract.” A contract is usually but not always 100 shares. Zecco charges 0.50 per contract, Etrade charges 0.75, and Scottrade charges $1.25.

When considering weather you can make money on a stock and writing a covered call, you must take into account all of these charges. If you only buy 100 shares and pay $9.95 for the purchase, then another $9.95 plus 0.75 for the contract, you have $20.65 in charges added to the price of the stock. Let us look at (FRE) FEDERAL HOME LN MTG CORP COM. Their last trade today was $30.42. If you purchase 100 shares, it will look like this. 100 X $30.42 = $3042. After adding $9.95 for the purchase you have invested a total of $3051.95. For an example, let us sell 1 contract at the strike price of $35. If we write the December option, the price is only 0.20. We have to pay $9.95 for the commission plus 0.75 for the contract. The option this far has cost us $10.70. In order to write the $35 strike we will have a total investment of $20.65, but only be paid $20.00 for the option. We lose 0.65. If you go out to the January option, the price for the last sale was $1.00. Using the same figures, we have now earned $100 less the charges of $20.65, so our profit is $79.35. The advantage of the covered call is, we still own the stock. If the value goes up over $35 we will then sell our stock for $35.00. This will cost us another $9.95 in commissions, but we have made a profit of $438.10. If the price does not go up over the $35 strike, we keep the stock and write another “Covered Call.”

FRE CHART
Etrade Chart© Figure 1[1]

From the looks of the 3 month chart you can immediately see it is considerably discounted, so it appears poised to go up in value.






[1] Etrade.com

FINDING THE RIGHT STOCK

You can understand the languages used, the methods of trading, and your objectives, but without knowing how to find suitable stocks to meet your purpose, you are still disadvantaged. Most online brokerage firms have good research areas on their system. Personally for research, I like E*trade. (http://www.etrade.com/) To me the disadvantage with E*trade is the price of their commission. Unless you are a power trader, their commission is a little high for a beginner, but in my opinion their research is simply the best. ScotTrade is another good choice. I have not used them, however, their commission is reasonable because they are the home of the $7 dollar trade.

Many beginners will try to start with small investment capital and this limits the number of shares available to purchase. If this is your situation, you may want to consider penny stocks. Penny stocks are not without risk, in fact, they fall into a different category of risk but many find them a good place to start. If you buy 5000 shares of a .25 stock and it moves up .01 to .26 and you sell at .26 you have earned $50 minus the commission. Your investment would have been $1250 plus commission. This is a 4% return on your investment. That does not sound like a good return, but you must remember, stocks usually move continually, thus your investment may only be for a couple of hours. I receive emails all the time from people recommending penny stocks. I can’t say their advice is good or bad, just that they are always in my mailbox. Two sources for these recommendations are http://www.otcstockexchange.com/ and http://www.hototc.com/. A major advantage to trading in penny stocks is you can buy a lot more shares. The stock only has to move a small amount before you can make a profit. If you exercise great care it is sometimes very easy to buy a stock and sell it again in the same day. There is a risk in this. If you make three such trades in three days, you become listed as a “pattern day trader,” and certain restrictions apply.

When you add the commission for both the purchase and the sell to the price of the stock, unless you have a good number of shares, this increases the gross expenditure of your investment and it is more difficult to make profit. If you are in this category with a limited amount of investment to spend, my next choice is Zecco. (http://www.zecco.com/) Zecco trades cost $4.50 per transaction. If you trade Options, you must add another .50 per contract to the price of your purchase and sale. Another plus for Zecco is they give you 10 free trades each month if you maintain at least $2500 in your account. I am a little disappointed with their research capabilities; however, they are a new company and are making improvements as they go. If you email them with a question, they are quick with their response.

I have always used a stock charting service to find my stocks. The only one I have used is TelChart, so I can not speak for any of the others available. TelChart is configurable to your needs. You may find it a little intimidating at first but they offer good tutorials. With TelChart you can establish parameters in your search and find just about any type of stock to fit your interested. You are able to establish price ranges from 0 on up to the highest amount. I usually set up several different price ranges then when I have little uninvested funds, I can find a good reasonable priced stock to place the rest of my money in. You need to keep all of your unused money working for you. One of my main objectives is to find stock that can be optioned. My next objective is that it pays a dividend. Those are just two of my objectives in looking for stock.

When you use a charting service such at TelChart, consistency is easy to spot. The price of a stock is almost never standing still. It is either going up, down, or moving sideways. By studying the chart for a stock, you can determine what it has done over the past few months and while this is definitely not a guarantee it will continue in this pattern, it does give you an idea of some predictability. The website for TelChart is: http://www.worden.com/ and at this time they are offering a discount. Their advertisement states the price will be different December 10, 2007. Another advantage of using a charting service is you can move backward and forward in time to study what the stock you are interested in has done over a long period. While studying your chart pay particular attention to the trend of the trades. Is the stock trending upward in price or down? If it is trending upward or downward, at what point does it usually reverse its course? Let me caution you again, just because it has traded in a certain fashion does not guarantee it will continue in the same pattern.

Let my inject something here I should have said in the very first blog. You should never invest money you need. I have heard three rules from several different sources and I will use them here. Never invest money you cannot afford to throw away. Always know your selling point before you purchase a stock. Moreover, you should never get greedy and try to hold out for higher prices. When the stock reaches your selling point, sell, even if it is still trending upward. When discussing these rules with people I teach in a one on one class I emphasize this last rule and make it rule number four, “never get greedy.” I am retired; however, I have a part time job. This job gets me out of the house for a little while and the extra income is not in the budget. Since one of my pleasures is stock trading, part of this money is usually invested. This is how my wife and I divide this income. We pay tithes to our church first, and then divide the rest in half. I give her half to use as she wishes, and I put my half in the stock market. We could throw this money out the window, not that we would be that foolish, just that it shows the caution that should be emphasized in your investing. Never use grocery, or rent money and hope you will be able to get rich in the stock market.

I hope you enjoy today’s writing, and as always, comments are certainly welcome. Just click on the comment link at the bottom of the page. If you have a topic you would like to have me comment on, just ask and I will try to answer.

Kermit

COVERED CALLS

COVERED CALLS

In yesterday’s writing I discussed terms you need to be familiar with and one was “Covered Calls.” Today I will give you a simple explanation of a “Covered Call.”

I first learned of the covered call in my early trading days of 1998. I tried a few trades and found them to work, at least they worked for me. My strategy was to find good stocks, which were optionable and buy the stock of the dip, then wait for it to run up so I could write the call. Since I am primarily writing this for beginners I should not assume you know what I mean by, “buying on the dip.” Stock charts will show you stocks are almost never constant in their price. They are usually going up or down and sometimes sideways but they almost never remain constant. To buy on the dip is to make your purchase when the price “dips” down a little. In latter 1998 and early 1999 I was buying stocks like CPQ, SLM, BLS, to nama just a few. At that time CPQ was the symbol for Compaq, SLM was SallieMae, and BLS was Bell South. I normally bought at least 100 shares of a stock and tried to buy 1000. The reason I bought in these multiples was because hoping to write a covered call.

CONTRACTS
A contract is an agreement to purchase a block of options and covering a number of stocks for that company or equity. With a few exceptions, a contract is 100 shares of stock for 1 contract. If you are buying equities, you can buy in different multiples, even as few as 1 share. It would be a little foolish to buy only one share though because you have to pay a commission to the brokerage firm, then average this commission into the cost of your equity. With the brokerage firms I use, the commission is the same price if you buy one share, one hundred shares, or one thousand shares. The definition of an option is the right but not the obligation to buy the underlying equity at a given price within a given timeframe.

In my case I tried to purchase an equity close to but below the strike price of the option I was going to sell. I covered strike prices in yesterday’s blog. JAVAD, the symbol for Sun Microsystems is a stock I have traded since 1998. I like the company and have followed it extensively. (I am not recommending this stock, I am just using it as an example.) JAVAD today is trading at $19.84. My next step would be to decide from the brokers chart, which strike price I would sell. As you can see, this is just a little below a strike price of $20.00. If I bought the equity at $19.84 and sold the $20.00 strike price I would receive a premium of about .64 per share, which is also shown on the brokerage chart. This is found by first typing the symbol of the underlying equity then pressing “Quote,” on the brokers website. From the chart that comes up you would choose, (Option Chain.) The option chain is divided into two sections. The left side will be the call options and the right side will include the put options. This was also discussed yesterday. On this chart you will find the following information on both sides: SYMBOL, OPEN INTEREST, VOLUME, NET CHANGE, LAST (This is the last trade price), BID (This is the current bid for the option), ASK (This is the sellers asking price, or what they are willing to sell for). This option would expire in 24 days from today’s date. Now let us assume I own 1000 shares of JAVAD. If I wrote a covered call for 1000 shares of my JAVAD stock I would receive a check into my account for $640.00. In essence, I would be renting out my stock for the next 24 days and they would have an option to buy JAVAD at $20.00. After the expiration date, if my stock remains below $20 I will probably keep my stock and I can write another covered call, sell my stock, or just hold on to it. The choice is mine.

I hope this information was helpful. Comments are welcome. Kermit

UNDERSTANDING THE LANGUAGE

LETS TALK STOCKS is still under construction; however, we are making progress.
When I first started trying to learn how to trade in the stock market I was lost because of my lack of knowledge. I turn to the financial pages of the Wall Street Journal and immediately I was LOST. What I needed was an explanation of many of the terms being used. That is where I will start with this blog.

Some of this may seem too simple; however, there may be those reading this blog who need to start at the very beginning. There are different markets you need to know about. There is the NYSE, or New York Stock Exchange, and there is NASDAQ. In addition to these two there are the American Stock Exchange and Over the Counter Stock Exchange. Most of the penny stocks I will mention in later issues will trade as Over the Counter and sometimes will be referred to as “Pink Sheet.”

You will see the words Equities, Options, Calls, Puts, Premiums, and one of my favorite, “Covered Calls” throughout this blog. An Equity is the underlying stock or the company you are researching to possibly buy. Some equities offer options. An easy way to explain an option is compare it to real estate. Let us say you are looking at a piece of property to buy but you don’t want to make that purchase today. You may ask the owner if he will give you an “option” on his property. You will then agree on a price for the property and set a time limit for you to make your purchase. Next you must negotiate the earnest money he requires to hold this property for you at the agreed price and time frame. Now let us look at this as a stock option. You have found a company (equity) you think you would like to own. In this case the market has already determined prices and time frames. You are convinced the equity will increase in value so you want to have the right to purchase the equity at today’s price. You first type in the symbol for the equity on your brokerage account web site and check today’s price. Let’s assume a price of $20.00 so you will understand what I am talking about. You are convinced it will go up to $25.00 within the next 30 days. Next you click with your cursor on “Options Chain.” The next chart that comes up will be a chart telling you different “strike” prices. Example would be $20.00, $22.50, $25.00, $27,50 etc. You believe it will go to $25.00 and you want to be able to purchase it within the next few days for $20.00. You buy the “Call” option of $20.00 and maybe pay $1.50 per share for the right to purchase the equity at $20.00.

There is a difference between a “call” and a “put.” If you own the call, you can call the stock away from the owner any time between the time you purchased the call option and the end of the option period. Options expire on the third Friday of each month, but you can buy options that extend into other months. A put option, on the other hand, can put the stock to the market maker at today’s price or the “strike price.” In this case, you are buying a put because you expect the equity to go down in value. There are two different ways to make money with options. First you can exercise your option and purchase the stock at the agreed upon price or put the stock to someone else if you actually own the equity. The other is you can actually trade or sell the option you own. If the equity goes up a little, the option will go up some as well. Percentage wise, the option will usually increase more than the equity. Option trades are called “Contracts.” A contract is usually the right to control 100 shares of stock. There are times when the number of shares involved in a contract will be different. The important thing is to be sure you know how many shares of stock a contract is actually involving. If you hover your cursor over the option symbol, you may discover this information. I know this is true on the E*trade website. As I use new terminologies, I will try to explain them within the blog.

When I first started trading I did very well for a short period, then I made a very big mistake. I told you in my introduction I would also give you the mistakes. Here is my first one. Most of the books I read about option trading said a “contract” was control of one hundred shares. One of those books went one step further and said a contract was always control of one hundred shares. I should have known better than trust the word “always,” but I was new to trading. On a Sunday night after I went to bed the phone rang. The party on the other end gave me some stock advice. We both had been to the same seminars. He told me about a stock that was “HOT”. His father had made about $75,000 the previous week buying the equity and writing a covered call on the stock. He advised me to be sure and write my covered call on the correct symbol: since there were two different symbols in the column.

Next morning early, I began my research. I searched E*TRADE, CBOE, (Chicago Board of Options and Exchange) and other locations but could not find why there were two symbols. The information was just not available at that time. This is not the case now. On E*TRADE you can move your cursor over the symbol and get a lot of information including how many shares per contract and how many days to expire day. It certainly would have been helpful in 1999. Instinct made me uncomfortable with the trades and the information available, however I bought 100 shares at about $27.00 per share. After the purchase, I wrote a covered call on the $30.00 strike price. The price paid for the option seemed high, but I made the trade anyway, immediately purchased a lot of shares of the equity, and again sold the covered call. I thought, “This is too easy.” My thoughts were right but I had made the commitment and on expire day discovered the reason the situation was too good to be true.

I can not emphasize enough to do your research. This was an early time in online trading when we all had to learn from our mistakes. That one was a costly mistake. Before it was over, I lost approximately $100,000. E*trade issued a margin call, while I was out of town with no way to go to my bank and borrow money to cover my shortage. The only thing I could do was start purchasing back options I had sold on all of my equities in my portfolio and then selling off stock. Almost all of the options had increased in value so I had to pay more to get them back to sell the equities. By that time in my young career, I had several blue chip stocks and I sure hated to dispose of them. Nevertheless, we learn from our mistakes.

Back to why I lost money on the previous mentioned covered call. I told you there were two symbols for the option I was going to sell. The symbol for the equity was USWB. I think the name of the company was US Web. They probably were the larger company. US Web bought the smaller company with stock, forming a merger of the two companies. The smaller company stock was trading at a higher price when it merged with US Web. Due to the merger, US Web had to pay the smaller company’s stock holders 150 shares of stock per contract. I had to pay an extra 50 shares for each 100 shares I purchased just before the merger. Therefore, the caution here is research, research, and research some more before you make your trades. Even after research, be prepared for loses.

From the above writing, you may assume I like covered calls. I do. To me, covered calls are the easiest way to earn money. One of the things I like about covered calls is there is a good possibility of keeping the equity yet having negotiable cash you can transfer to your local bank and buy groceries, pay bills or maybe just take a vacation. Look at the odds. If the stock, or equity, goes up you will probably sell the equity; however if you made the trade properly you will earn money on the sell. If the equity remains at the same level, you will probably keep the equity and have the money paid to you for the option as cash. In addition, of course, if the stock goes down, you keep your stock. In two out of three situations, you are likely to keep your equity.

In the middle 1990's I began to seriously study the stock market. I had always wanted to do serious market trading but was not sure how to start. I began by buying all kinds of how to books on the subject. I was sure there had to be a better way than just buying a stock and holding on to it forever and hopeing someday it would be worth more than I paid for the original investment. My searches soon found me reading books on "day tradeing", and I knew I had found my nitch.

In 1997 I had to retire from my job in law enforcement due to a health problem. I owned at that time two businesses in addition to my regular employment. One of those businesses was an "Office Coffee Service." I began to seriously work this business and soon it grew to a profitable point and was worth more to my competitors than it was to me. The company was debt free, so I sold the business in September 1998. I had already opened an online stock market account with Etrade and had put a small amount of money in the account. In October 1998 when I received my second installment check for my Coffee Service business I put $20,000 into my account and began serious tradeing. By January 1999 I had over $300,000 worth of stock in my portfolio. I was off to the races.

During the next year I learned many valuable lessons, some of which you need to be aware of if you are going to become a serious market trader. That is what this blog will be about. In it I will also mention from time to time equities I have an interest in. Don't let the word "interest" deceive you, it may not necessairily mean I own the equity, but may indicate I have begun serious study of the equity for future possible acquisition either in the equity itself or an option. Further, the option interest may be either a "call option," or a "put option." Keep watching as I progress with my blog.