October 4, 2013
By: Bobby Casey, Managing Director
About a month ago we sent the article, “Get Rich, Stay Rich: 3 Secrets on How”. It was provoked by a recent conversation with one of my buddies.
In short I told him what I found to be the 3 secrets to wealth:
- Chase value, not money
- Leverage time
- Leverage money
During that conversation, ‘Mike’ and I went on to discuss various investment and income producing strategies. I shared with him what I have found to be one of my favorite ways to generate income and leverage my investment portfolio for greater returns.
Options trading is one of the greatest secrets in creating income and wealth I’ve ever seen. I know what you are thinking:
- My brother-in-law lost his shirt trading options
- Options are very risky
- Options are only for professional traders
Let me be clear: your brother-in-law lost his shirt trading options because….well let’s be honest… he’s stupid. After all, he’s your brother-in-law. In our upcoming newsletter, GWP Insiders, we will be providing an options trading tutorial and will also periodically analyze actual trades that I am making. (If you are interested in GWP Insiders, click here to get on our early notification list.)
Options trading has its risks, as does all trading. But I wouldn’t disqualify yourself from participating because you aren’t a professional trader, either. What makes a professional a professional is their knowledge and understanding of how to take calculated risks when trading. They educate themselves on the company and its trends. They analyze the trade and assess the risk.
The professional distinguishes between a senseless risk, and a calculated or educated one. Successful trading is all about managing risk. The smartest traders in the world focus almost solely on risk minimization, not profit maximization.
Let’s take a look at an example of an options trade I made last week:
- Purchased 2000 shares of XYZ for $30/share
- Sold 20 January 28 put options for $1.20/share
- Sold 20 January 34 call options for $1.80/share
What does this mean?
For the first part of the trade, I bought 2000 shares of XYZ for $30 per share. Based on my research the company is undervalued at this price. I am happy to own 2000 or more shares of XYZ at this price.
I then sold 20 put options (i.e. 20 contracts @ 100 shares per contract = 2000 shares) at a strike price of $28 expiring in January for $1.20 per share. This netted me $2400 in option premium. These put options mean that if XYZ closes at or below $28 per share at expiration in January then I must buy those 2000 shares for $28 per share.
If XYZ trades between $0-28 per share in January I must pay $28 per share. My maximum loss is $28 per share. My maximum gain is $1.20 per share.
This may not sound like a good trade unless you understand the fundamentals of the company. This company has never in its history traded for less than 60% of its net assets. Currently 60% of net assets equals just a bit under $28 per share.
Based strictly on the put option trade, my net entry price would be $28 – $1.20, or $26.80 – 10.7% below the current price level. This gives me a significant margin of error.
In addition, I sold 20 call option contracts for $1.80 with January expiration at a $34 strike price. This means that if XYZ closes for more than $34 per share at expiration, I must sell my 2000 shares of XYZ for $34 per share.
I paid $30 per share, which means I have collected an immediate 6% ($1.80/30) for giving someone else the right to buy my shares if they trade above $34 in January.
When you add this to the $1.20 I collected in premium for the put options, this is a total premium collected of $3 per share, or an immediate 10%.
Here’s how this can play out:
XYZ trades between $28 and $34 per share at option expiration.
I have already collected $3 per share in premiums ($1.20 for the puts and $1.80 for the calls), or $300 for every contract sold (1 contract equals 100 shares). If the stock trades between $28 and $34 at expiration both the put and calls options expire worthless and I keep 100% of the premium. In the case of my trade, I keep $3 per share x 100 shares x 20 contracts – $6000.
XYZ trades below $28 per share at option expiration
The call options sold for $1.80 would expire worthless and I would be obligated to buy the shares at $28 per share. Keep in mind I already collected $1.20 in premium for the put options and $1.80 for the call options so my cost basis is actually $25 per share.
As long as XYZ is above $25 per share I am still profitable on this trade. I can then sell call options on these shares to collect more premiums and more income.
XYZ trades above $34 per share at option expiration
If this happens, my shares will automatically be ‘called’ away at $34 per share. Remember I have already collected $3 in premiums ($1.20 + $1.80). In addition I would get the extra $4 in share price appreciation ($34 – $30 purchase price), for a total gain of $7 per share.
To summarize, the lowest XYZ has traded in the past 3 years is $27 per share. The lowest it has EVER traded was 60% of net assets, which based on today’s balance sheet equals approximately $28 per share.
Based on this analysis, our theoretical downside is $27 per share (I say theoretical because clearly the stock can go lower, it is just very unlikely).
At $27 per share, we would lose a maximum of $3 per share on the 2000 shares owned. On the related option trade, if XYZ goes to $27 per share, we still earn $2 since our cost basis after the option trades is $25. So at $27, we lose $3 on our 2000 shares and make $2 on our next 2000 shares. We end up with 4000 shares of XYZ with a loss of $1 per share, or a 3.3% loss. Not bad for maximum downside.
The upside though is tremendous. We can earn either $3 or $7 per share. That equates to 10% or 23.3% return. Keep in mind this is only for a 4 month holding period.
Please keep in mind I have simplified some details due to the nature of this article. For sake of brevity, I have left out some things to simplify the explanation and calculations. I realize that many of you finance and math wizards can read this and note that there are details exempted that could be relevant.
Until next time, live well.