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Demystifying Options...

...Introducing the Options Strategies Portfolio


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Many of you originally knew Rick Currin as long_and_leaping.  The long part of the moniker signifies Rick's tendency toward a long term investing philosophy.  The leaping part of the moniker refers to his periodic use of the options called LEAPS.

Top Hulbert Portfolio

We have used option strategies at various times especially in our sister publication currinTechnology's LEAPS portfolio.  And results have been impressive.

In fact for the last 3 years results have been off the charts.  Many investors have had a hard time getting much ahead of where they were at the time of the Lehman event.  The markets as a whole have too.  But the LEAPS Portfolio D of our sister publication currinTechnology has performed amazingly well.  It's the top portfolio of the hundreds tracked by the investment newsletter watchdog The Hulbert Financial Digest since the Lehman event.

 

Outperforming the by S&P and DOW by more than 200% is no easy feat.  But many of you already have by following the portfolio so there is no need to sell you on the idea. Instead we listened to you.

We've listened to your feedback and have decided to introduce a special Options Strategies portfolio here at Rick's Research.

As we are using the same basic strategies we believe we can produce the same or better results as we have in  the chart on the right.  We're excited to roll this out in 2012.

 


About the Option Strategies Portfolio

option strategies

 

The Options Strategies Portfolio is a product addition to the basic premium membership.  As with the basic membership it will include email updates, alerts and member level website portfolio access. The product can be added for a $79 membership but we are making it available to early enrollment members at the introductory price of only $59.


Save 25% - add the Option Strategies Portfolio during early enrollment

Price: $ 59.00 Quantity:
or call us toll free (877) 654-2246


If you order the product during early enrollment you will keep the $59 price for the life of your membership as long as you also maintain the Rick's Research/ currinTechnology membership.  You can order the Options Strategies portfolio above and lock in the $59 annual membership price.  Look for an update soon introducing you to the opening portfolio transactions.

The portfolio will be available right here with your membership though access will be limited to members that have purchaed the additonal product.

 

Our Goal

Our goal with options is providing a vehicle where you can use as little or as much of what we do with options as you please and still outperform the market handily.  In Rick's Research we are focusing on limiting the use of options to this special portfolio.  We'll be using the strategies around our long term investments as well as a few new investments.  As usual the focus investments will be in our main market focus areas:

  • Digital Mobile Multimedia
  • Life Sciences
  • Next Generation Technology

Fear of Options

Options are sometimes viewed as risky and other times viewed as complicated.  There is no question that it depends on how you use them that determines the risk. Options can in fact be one of the most conservative forms of investing when writing covered calls.  On the other hand they can be considered a form of pure speculation when used as simple optimistic prognostication of share appreciation well outside the current share price.  Simple optimistic prognostication might be called gambling in some circles and justifiably so depending on the situation.  There is a certain mystique about options and these fundamentally at odds points of view that needs to be demystified.

Buying a call well out in time and out of the money can certainly be considered risky.  But writing an out of the money call is considered a safe income generation tool that could easily serve you well to be included in your investment toolkit.  The risk of buying a call can be weighed against the risk of owning the underlying shares outright.  Certainly both contain risk but we don't usually equate owning stocks to gambling. 

We wanted to give you a basic primer on a few of the option strategies Rick has used in the past and could use in the future.  We will employ graphs that aid in visualizing the strategies and the reasons for their use. 

 

LEAPS

LEAPS are Long Term Equity Anticipation Securities.  They are options with quite long time to expiration.  They can be either calls or puts. 

There are advantages of using LEAPS including long term tax treatment of capital gains.  

LEAPS also allow stocks to ride through market noise (e.g. market risk, what Bernanke says next week, what Al-Qaeda does next week, what North Korea does next month, the latest storm in the hurricane season, etc.) which can impact all stocks for a short period of time. 

With a long time to expiration, LEAPS allow stock risk (i.e. your specific stock's price performance based more specifically on the company's fortune and performance as opposed to the general economic conditions and market risk) to determine the value of the investment.  In other words LEAPS can ignore the voting machine and give the weighing machine time to work its magic. 

While the long time to expiration gives LEAPS special advantages they are otherwise just long time to expiration options. 

 

The option strategy categories that follow apply to LEAPS and shorter duration options as well.

Buying a Call option

A long call is a bullish stake taken assuming a stock will appreciate.  The buyer acquires the right to purchase 100 shares at the strike price.  The buyer pays the premium to a seller willing to sell shares at a later time.  If the stock fails to appreciate to the strike level at the expiration of the option, it will expire worthless. 

 

$30 Strike Call with a $1.5 premium

Stock Price at Expiration

Profit/Loss

$50.00

$18.50

$40.00

$8.50

$35.00

$3.50

$30.00

-$1.50

$25.00

-$1.50

$15.00

-$1.50

Table 1

 

 

Figure 1

 

While the risk of a call is that it will expire worthless, no more than the premium is at stake.

An investor can participate in a stock for much less than it takes to purchase stock outright which has the effect of limiting capital exposure.  As in the graph above the loss is always limited to the premium paid for the option.  The potential gain is unlimited.

 

Practical Example

An investor has $7500 to invest and wants to add to his position in Google trading at $450.  The investor is only able to afford 16 shares of this stock.  He considers a LEAPS option.  To control 100 shares of Google at (share price $450) he may opt to purchase Google through a LEAPS call for substantially less capital to control 100 shares.  The cost of a Google $450 strike LEAPS option for controlling 100 shares at $450 is $75 or $7500.

The LEAPS investor needs Google to exceed $525 by mid January 2011 to have made profit on expiration day.  However as long as the stock is at least $450 he can acquire shares at $450 in January 2011.

Of course the option itself has value and can be sold prior to or even on the expiration date. 

The chart below compares what the investor is able to achieve by adding 16 shares or adding the option.

 

 

Figure 2:  Share price versus profit/loss at expiration

 

The maximum exposure with the option is the option premium.

Compared to buying the 16 shares, the option investor in this example assumes plenty of risk but looks for much greater reward.  Obviously if Google were to be $800 at expiration the option investor will be very pleased to say the least.

Risking the $7500 premium is substantial enough.  On the other hand it controls 100 shares that would cost $45,000 to buy outright.  An investor that seeks to put $7500 to work in Google may consider purchasing the LEAPS versus only purchasing an additional 16 shares ($7500/$450) of the stock. 

As this is the realistic choice of an investor with 100 shares and looking to add to the position lets graph the same stock price at expiration using the realistic goal of the investor to add to his 100 share position with his available capital.

 

 

Figure 3

As the graph in Figure 3 shows the investor is greeted with a much less ominous risk reward profile when viewed in terms of the total capital and bullish investment objective.  By using the LEAPS the investor gets more upside leverage and keeps a similar loss profile on the total investment.  Above $525 the LEAPS investment begins to substantially outperform the 116 shares.

Reason for using the call option: Very Bullish on share appreciation, adding leverage to a stock position with a bullish outlook, expanding investment opportunities with available risk capital.



Save 25% - add the Option Strategies Portfolio during early enrollment

Price: $ 59.00 Quantity:
or call us toll free (877) 654-2246


The Put Option

A put is an option that will rise in price if the stock falls.  Although we rarely would use puts alone, we will at times use puts in support of a paired transaction or as a protection to a portfolio share position for a known binary event (e.g. FDA approval, announced date of legal decision). 

Shorting stocks can be quite risky while a buying a put is best viewed for our purposes as simple insurance.  A short seller of stock assumes the risk of a rising stock and being squeezed (forced into buying a quickly rising stock at a big loss) when the stock rises.  Shorts are vulnerable to high losses because of this. 

A put buyer only risks the premium of the put which is appropriate for our purposes as we are in general remaining optimistic long term on the underlying stock and simply buying some insurance.

An example of a put is shown below.  An investor buys a $30 strike protective put paying a premium of $1.5.  At expiration the profit or loss is as follows:

 

$30 Strike Put with a $1.5 premium

Stock Price at Expiration

Profit/Loss

$40.00

-$1.50

$35.00

-$1.50

$30.00

-$1.50

$25.00

$3.50

$20.00

$8.50

Table 2

 

 

Figure 5

 

Puts are often used to protect a portfolio position in a stock from a steep decline.  The gain in value of the put offsets (or even exceeds) the losses in the share position.  Like a call a put also can be sold prior to expiration date.

 

Reason for using the put option: Protection against share decline. 

 

 

Writing a Covered Call

Writing a covered call involves taking a premium on the underlying shares you own by agreeing to sell shares at the strike price of the call.  The writer of the call receives a premium for entering into the agreement.

Writing covered calls is a conservative option strategy that essentially leaves only the risk of not participating in the additional upside beyond the strike price if shares are called away at the strike price.  When viewed as income generated by the shares, the premium received acts as limited protection (or like a generated dividend) for owning the underlying shares. 

 

Example:

Assume an investor owning 200 shares of GRHT stock (trading at $30) can write a covered call option with a strike of $50 at a premium of $2.25.  The investor writes 1 covered call which commits the investor to sell 100 shares of GRHT at $50.  The investor receives $225 for the premium (100 shares per contract X the $2.25 premium).  If the shares do not reach $50 the investor simply keeps the shares and the already pocketed premium.  If the shares do get called away at $50, the 100 shares are sold at $50 and added to the $225 premium already obtained.

 

If Shares Price exceeds the strike at expiration

Assuming the stock goes to $55 at expiration, the investor receives the appreciation up to $50 and has the 100 shares called away.  The total gain on the underlying shares of the call is the appreciation to $50 ($20 x 100 shares or $2000) and the already pocketed premium ($225) for a total of $2225.  The gain on the 100 shares not involved in the option transaction is $2500. 

In the example the investor would have been better off simply letting the $200 shares appreciate for a gain of $5000.  By using shares in the covered write (covered call) the investor made $4775.

The goal of the covered write is to not have the shares called away, though the investor should be satisfied if they are.

 

Shares rise but below strike

 

Let's look at what happens when the shares appreciate but only reach $49.  The total gain on the underlying shares is the appreciation to $49 ($19 x100 shares or $1900) and the already pocketed premium ($225) for a total of $2125.  The gain on the 100 shares not involved in the option transaction is $1900.   

In this example the investor profits from both the immediate pocketing of the premium and the appreciation of the stock and still has the shares for continued appreciation.  The investor who held the appreciation of 200 shares made $3800.  The investor who utilized the covered write made $4025.

 

Shares stay the same price

 

If the shares do not move and stay at $30, the covered write shares make $225 and the other 100 shares make no gain.  In this case the covered write shares made a 7.5% return over the time of the option, while the shares simply held made nothing.

This is a valid (if not typical) scenario for a long term investor who believes his shares are not likely to move much over a given time period.  Seeking to make a profit over the period he writes a covered call higher than the level he expects to see at expiration.

 

Shares fall

 

Finally if the shares fall to $27 (a 10% drop), the shares of the covered write will lose $75 (-$3 x 100 shares + the $255 premium already pocketed).  The shares simply held would lose $300.

 

In this example the covered write offered limited protection for a decline in the share price and is one reason the covered write is considered a conservative strategy.

 

Let's look at a share price at expiration graph for the covered write transaction.

 

 

Figure 6

 

The clear thing to see in Figure 6 is that the option writer always has a positive gain (the pocketed premium) compared to the simply holding the shares.  However if the shares go beyond the strike of $50 the investor would wish he had held the shares. 

 

In general the writer does not want to have shares called away but is satisfied if the gain "surpirses".

 

A practical approach:  Ringing the register

 

Many investors look to take some profits when they have a good gain.  Certainly an increase to $50 from $30 is a good gain in the time frame of most options.  If the investor expects to take profits on half the position on a move to $50 anyway, why not make a profit for the decision already made? 

 

In other words, if the investor expects to take profits on 100 shares and let the other 100 shares run he could probably use a covered write for a dividend even if the stock does not get to $50 in the specified time.  This is especially so as it frees the premium to immediately be used as capital for another investment.

Thinking Strategically

We view the strategy in several ways.  First we would implement the strategy if we were simply satisfied with being called away at the strike price.  Such a strategy can be used with LEAPS for example where we would be happy with a 60% gain over the next 15 months.  The large premium associated with LEAPS can present good premiums depending on option volatility.  We might view participating in the 60% gain in the stock as a good result and the premium as an additional source of cash for the portfolio, more shares in the stock, or even as funds for a further out in time or strike LEAPS purchase.

 

A nearer term strategy simply involves taking the premium if we believe the stock price may be somewhat stagnant in the near term.  While remaining bullish long term we would view the writing of an out of the money call as mildly bullish over the near term.

 

An example of a couple of strategies in writing a covered call follows.

 

*  An investor owns 400 shares in a stock he expects will appreciate substantially over the long term.  However he is convinced the stock is unlikely to experience significant appreciation in the next few months.  He turns to writing a covered call on 300 shares to experience the upside potential of the stock up to the strike price while pocketing a premium.  Once the expiration date hits he repeats the process for another round of "dividends".

*  An investor owns 400 shares of a stock and decides to write a covered call on 300 of the shares to receive a premium.  The investor takes the premium and purchases an out of the money LEAPS.

*  An investor owns 400 shares of a stock and decides he'd like also purchase a bullish call.  However the investor does not like the feast or famine nature of simply buying calls.  The investor chooses a strike price he would be comfortable taking a profit on 200 of the shares.  He then writes 2 calls collecting a premium.  He then uses the premiums collected to purchase the calls he has in mind.  Far from being a feast or famine approach this is more like a free lunch approach if he already intends to hold the 400 shares.  The risk of owning the 400 shares is there whether he buys a call or not.  However the upside of the calls purchased was obtained in a costless manner by using the proceeds of writing 2 calls to purchase different calls.   

 

Reason to write a covered call:  Ringing the register with a pre-paid premium, extracting dividends from a stock position, a conservative approach to adding extra premium income when satisfied with the strike price call away possibility, raising capital with shares to make another investment, "costless" purchase of leverage.

 

Writing an Uncovered Put

 

Writing an uncovered put is taking a premium on the stock with the agreement that you will purchase 100 shares of the underlying stock at the strike price.  This strategy can be used in place of a limit buy order to purchase shares below the current market price. 

 

If at expiration the stock closes above the strike price you keep the premium already received.  If the stock falls below the strike price you agree to purchase shares at the strike price (which is in effect like placing a buy order at that price).  Either way you keep the premium.

 

Put writers do carry the risk of being required to purchase shares at a price higher than the market price of the stock if the stock actually falls below the strike price at expiration.  While not optimal, compared to owning the stock from the higher price and seeing it fall to the strike price it can result in significantly lower loss than owning the stock outright.  Similarly, compared to placing a limit buy order (that may never actually be filled) it is an opportunity to make money on stocks you do not yet even own shares in.  

 

Given the underlying risk we view the strategy as only to be employed if we are willing and able to assume the long position (buy the stock at the lower strike) as opposed to actually hoping the strike price is not hit. 

Combining Strategies

One of the best thing about options is the ability to combine strategies (as in the "costless" example above) to limit risk while enjoying the full upside potential in stocks. 

In general there is an implicit tax or limit on the gains due to using a hedge like a put but that limit can be used to limit downside risk.

Similarly bullish call options can be used as leverage (without margin) to maximize returns on a stock we are very high on for the long term.  This leverage can be obtained without explicit ownership and available for less than the cost of owning equivalent controlling interest in the stock.

LEAPS offer unique strategies in combination as their long time to expiration allows writers of options to exit near term positions barely impacting the time value of the LEAPS position. 

 

Keeping it Simple

This is by no means an exhaustive treatment on the use of options.  However these simple basics cover most of what you would be likely to see us engage in.  The basics can be combined to form strategies specific to the investment outlook and mitigate risk as well.  By using options strategically Rick was able to  produce the chart shown at the top of the page.  More importantly perhaps the out-performance was achieved with substantially less risk than any of the top performers tracked by Hulbert over the same period.  That's the goal and we believe we know how to approach repeating it consistently.

We hoped to demonstrate that used strategically options can provide income, protection, and leverage.  The use of simple calls is perhaps the riskiest part of options that leads investors to shun them or fail in options.   It can also bring the biggest return unsurprisingly. 

We believe you will find our use of options somewhat more of an upside leverage play and a strategic use of capital in most cases.  At times we will use what we call a costless option whereby we write an option and use the proceeds to purchase a different option.  The net effect of such a transaction is no change in your cash position.  Such a use of options can provide additional leverage without exposing more capital and without adding "more" risk exposure by simply buying more shares.

We hope that this short treatment of a rather complex topic aids in demystifying options for those that might be mystified by them.   Certainly options can be used in a dangerous or riverboat gambling fashion.  We have tried to pare that back from the legacy once employed by Fred at the old Hager letter but still have managed to have the #1 portfolio over the past 3 years.

Whether you are looking to substantially spice up your performance or learn how to mitigate risk in some of your portfolio we think the product could really deliver on both fronts. 

Save 25% - add the Option Strategies Portfolio during early enrollment

Price: $ 59.00 Quantity:
or call us toll free (877) 654-2246

 

We are not investment advisors and make no claims about the suitability of options, their inherent risks or lack thereof for you as an investor.  Of course we necessarily make the same disclaimer about stocks as well.  For more information on options see the CBOE website and or consult with your investment advisor. Past performance is no guarantee of future performance.  

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