Chapter 02 - Generate 20%+ Cash Return Each Year Without Selling Your Stocks Flashcards
Time is Money
Most people are aware that there is time value to money. When you deposit money in a bank, you earn interest on your deposit. With regards to stocks, most people think that unless the stock pays dividends, the only way to make money is by selling the stock and cashing out. Not true. You can sell COVERED CALL OPTIONS.
Example of selling covered call options.
Say you own 1000 shares of MSFT, currently worth $70,000. MSFT $70/sh. June 2001 option quotes shows that on May 7, 2001, June calls on MSFT $75 = $2/S. If you sell a call on 1000 shares of MSFT June $75 strike, you get $2000 premium.
Possible actions at expiration date
1) MSFT NEVER REACHES STRIKE PRICE $75 - Option expires. You get to keep the $2000 and the stock.
2) MSFT DROPS BELOW $65 - You can buy the option back at a much lower price (around $0.30) for a total cost of $300 and pocket the $1700 difference. Remember that small price changes in a stock result in much faster movement on the option.
3) MSFT CLIMBS ABOVE $75 - two choices here
a) sell MSFT - let it be called. You keep the $2000 + $75000 for selling the stock
b) keep MSFT - buy the option back at a slightly higher price and sell a new call option at a higher strike, say $80.
Case History: Juniper Networks
On 10/16/2000, an investor bought 200 shares of JNPR at $243/sh. Total cost $48,600. Wanted to make 50%, so selling price ~ $360/sh. While waiting for price to approach this target, can sell a covered call.
Investor sells Jan 2001 $260 strike price call for $29.75/sh, giving him proceeds of $29.75 x 200 = $5,950.
Even though we could have gotten a higher premium by picking a lower strike price (eg $250 or $255), $260 was picked because the objective was to have the option expire before the stock reaches the strike price since we don’t want to sell for < 50% profit.
Rule of Thumb
Sell covered calls with a target price 10-20% higher than the present market price. Locate the price resistance closest to that and pick the strike price one level ABOVE that resistance.
ALERT: Stock price FALLS SHARPLY. Sell covered calls immediately?
No. Wait until it reaches 20% above its 20-day closing low to do that.
ALERT: Pick strike prices carefully.
By picking a strike price close to strong resistance, we can avoid having the stock called away or having to buy back the call.
ALERT: When selling calls during an earnings month…
be conservative in picking strikes, especially if you feel there could be a catalyst that will move the stock against your position and risk the stock being called.
ALERT: Using analysts as contrarian indicators is a highly effective technique.
For example, On June 8, 2001, Solomon Smith Barney raised their rating on the semiconductor sector. As a result, LSI moved to $22.5 which is a resistance level. Since the analyst upgrade occurred near resistance, this was interpreted as a contrarian indicator and thus sold 54 contracts (5400 shares) July covered calls $25 strike for $1.05/sh. Total premium $5670.
ALERT: ALWAYS keep an eye on the 1) ___ _______ and use 2) _______ ______ ______ and 3) ________ ____ to your advantage.
1) big picture
2) general market trends
3) upcoming news
Notice that Dr Elias sold calls of LSI on a bounce, anticipating a drop will occur during earnings warning season. He also planned to close the position before the Federal Reserve Meeting in case a surprise 1/2 point cut occurs.
ALERT: Do not get greedy and always buy back any call you already sold when it is _____ of the premium you obtained.
25% or 1/4th of the premium you received.
ALERT: Always be on the lookout for news on stocks in a similar industry to the one you are selling calls on.
To raise maximum cash on your stocks, you need to use news whether it is related to the stock, industry or the general market to lock your profit. The idea here is to repeat this process several times and not have to wait for the option to expire.
