In my conversations with Insiders about the way I plan to invest in some opportunities
and even in the email I sent everyone last week about how I planned to play a specific
stock, I mentioned three different options strategies that I would use (or might use)
to improve my returns long-term.
After that, I had a flood of requests for additional information and context; specifically,
how these strategies work and when it makes sense to use them.
So, that's gonna be our theme for the week.
If you're interested in adding some additional investment tools to your strategy arsenal,
then you're gonna wanna stick around!
Hey there, my name is Stephen Spicer and it's my goal to help you invest smarter.
And by mastering even these three 'basic' option strategies, you'll be able to do
just that - you'll be equipped to increase your returns without any additional research
BEYOND what you're already doing.
You can take that research (that you should be doing) and actually profit from your existing
thoughts on a particular stock.
You'll see what I mean.
So, in this video, I'm going to dive into using covered call options, and then in the
next two videos I'll explain and explore how and when you might want to use Long-term
Equity AnticiPation Securities and then the benefits of selling cash-secured put options.
So, if you're interested in learning these strategies that could help you invest smarter,
hit subscribe and the notification bell so that you don't miss a thing.
--
When you understand covered call options, you'll be able to take the analysis you
already have, identify the price at which you plan to sell out of it anyway on its way
up (whether because that would mean the stock is now over or even just fairly priced and
so you'd be selling out anyway in order to take advantage of some other better opportunity)
- so with this, you can take that information, that plan, and profit from it today ...regardless
of what the stock actually ends up doing.
By the end of this video, you're going to understand exactly how this beautiful strategy
works and when it might make sense for you to use.
Now, remember, I'm speaking to a lot of people here, so, I understand that many of
you will be at different levels of understanding when it comes to options in general.
So please, if some of this is too basic for you, use the detailed timestamps in the description
to hop around and get to the parts that will help you the most - that's the reason I
spend so much time on those for EVERY video.
So let's get started with the basics.
An option is a contract that allows its owner to control (buy or sell) a separate asset
at a fixed price (called the 'strike price' or 'exercise price') for a specific period
of time.
And they don't just exist in the stock market.
I've used them with my real estate before.
Say, for example, you go to sell a rental house that you own, and the current tenant
reaches out saying they're interested in purchasing your house.
For whatever reason, they can't qualify for financing now, but they'd like the ability
to buy it from you at some point within the next few months.
Well…
I wanna sell it.
But I have no guarantee that it would actually sell over those next few months anyway, but
if I take it off the market, just for the chance that my tenants are able to secure
funding in that time, (if I do that) I'm taking a ton of potential buyers off the table
just in favor of this one POTENTIAL buyer… that doesn't sound like a great deal to
me.
Unless... they pay me for it.
So, to make my waiting worth it and to compensate me for the risk that the tenant is ultimately
unable to purchase anyway…
They pay me $500 for the option to purchase this home for $50,000 at any point within
the next 3 months.
There you have the basics of an option contract.
If they end up getting the money and exercising their option by purchasing the house from
me, great!
It might have been on the market this long or longer anyway, so obviously it was worth
it to me.
And, having the exclusive right to purchase this house was obviously worth it to them,
so it's a win-win.
If they don't get the money (or for whatever reason don't end up buying the house) within
that allotted time period, well, either they pay me another $500 to extend their exclusive
right for another quarter, for example, or I put it back on the market - I may have lost
some opportunities over those three months and the value of the house may have changed
a bit, but that $500 I made (by selling my tenant the option contract) was pure profit.
There are, of course, other considerations, but hopefully you get the general idea.
--
This might happen to you at some point in the future.
You're trying to sell your car.
Somebody approaches you who REALLY wants it but needs a month to pull together enough
money to buy it.
You could just say "sorry, tough luck," or… you could make them pay you for the
option.
You'll take it off the market for a month and (during that time) they'll be the only
ones that can buy your car from you.
Or maybe you're on the other side of the deal.
You're the one who really wants the car, but you just need a little more time to get
the cash.
You approach the seller and offer to pay them $100 for that exclusive option.
So even if you don't see them all the time, hopefully you can understand why option contracts
exist.
But, although they absolutely do exist in other places, nowhere is there quite as vast
a tradable market for them as you'll find in financial markets.
Specifically, we'll be looking at the stock market.
--
A stock option contract is quoted like this…
Clearly, there are many more variables with options than when you're just dealing with
buying or selling shares of a stock.
It's important that you understand what you're looking at here and some of the more
important terms associated with trading options.
The first letters tell you upon what stock this option is based.
The stock is represented here by its ticker symbol - the 1, 2, 3, or 4 letter code assigned
to that particular company.
Usually, one quote - one contract - like this represents control over 100 shares of the
underlying stock.
Next you see the date that the option expires.
This is the last day that you could trade this option.
They usually expire on the 3rd Friday of a given month.
The next number you see is what's called the "strike price" for the stock.
It's the price that the stock, if this option is exercised, will change hands, regardless
of the underlying price at the time.
So, in this example, this option gives its owner the right to exchange each share for
$50, whether the underlying stock price is $70, or $30, or whatever.
Then, the quote tells you which kind of option we're dealing with here.
At the most basic level, there are only two different kinds of options: calls and puts.
(Throughout this series we'll explore both of those - in this video, specifically, we'll
be going through a specific call option strategy.)
In brief, a call option gives its owner the right (but not the obligation) to buy stock
at a specified price within a specific period of time.
A put option gives its owner the right (but not obligation) to sell stock at a specified
price within a specific period of time.
And finally, rounding out this quote, you see the "premium" or cost per share of
the option.
You'll recall that option contracts usually represent 100 shares of the underlying stock.
The quoted price you see is PER SHARE.
So usually, to figure out how much you'd need to pay in order to own this contract,
you have to multiply this price by those shares.
So, $1.10 per share times 100 shares equals $110.
To own this contract - this 'right' to a specific stock - you'd have to pay $110
(plus whatever commissions).
--
Using option contracts allows you to pay a relatively small amount of money to control
assets worth much, much more.
It's a form of leverage - using a small tool to control (and potentially profit from)
much larger assets.
Let's explore the power behind this concept briefly.
If you were bullish on a stock (the made up XYZ company, in this example) - expecting
it to go up in the future - and its current price is $45, you could buy 100 shares for
$4,500.
Or… you could essentially control 100 XYZ shares by purchasing that contract we just
looked at.
All you have to do is pay $110 and now you have the right (but not the obligation) to
buy it for $50 per share before March 15th (in this case).
So let's say you do that - you own this contract now.
Let's look at some extreme possible outcomes to fully explore the implications here.
Your risk - your exposure to this stock - is limited.
Meaning, if the stock actually goes down over this period, you're only out that $110 you
paid for the option.
If it drops to less than $43.90, you would have been down more than that $110 anyway.
And just to hit the extremes of this example to prove the point, if the stock price tanked
over that time, or the company goes bankrupt… again, you're out that $110, no more.
If you had actually held the stock, you would have lost MUCH more.
On the other hand, what if the underlying stock goes up?
Well, because the strike price of the option you own is $50, any move above that price
- which for a call option is considered to be "in-the-money" - would justify you
exercising that contract.
If it moved up to $51, for example, you could buy those 100 shares for $50 each, or $5,000
total, and then immediately sell them for the market price of $51 each, or $5,100, if
you wanted to.
Did you make a profit there?
No, you'd still be out $10 - the $5,100 you just made, minus the $5,000 you paid,
left you with $100, but you can't forget the original $110 you paid for the option
to begin with.
So, to be profitable would require the stock to move above $51.10 - the strike price plus
the premium paid.
But then, because you're using leverage here, every move higher would represent a
significant potential return.
For example, if the underlying stock moved up to $55, you could instantly make $500 by
exercising the contract at $50 per share - paying that $5,000 for your 100 shares - and immediately
selling those shares for $5,500.
Factor out the $110 investment you made in this option to begin with - you've realized
a profit of $390.
On a $110 investment… that's not bad!
That's pretty great actually - a more-than-350% return on investment.
And, on an annual basis, it's FAR more than that when you consider that was done over
a month's time (as I record this in February).
Just for fun - and to demonstrate the power of leverage here - let's make it go up another
$10.
On March 15th, the stock price of that underlying stock just hit $65.
You exercise the option and immediately sell those shares.
After subtracting out your initial investment in the contract, you profited $1,390, or more-than-1,250%
return in a single month!
So, you can see the power this leverage could give you: you know exactly how much you have
on the line, if things go wrong, and you have the potential to profit significantly, if
things go as you expect.
Now remember, even that $10 move (from $45 to $55) was a more than 20% jump for the underlying
stock over that month - absolutely possible, but that's not going to happen that often
for you.
More often than not, options expire worthless.
And therein lies a big risk for casual investors...
There's a temptation to see that potential and buy option contracts that represent far
more shares than you were initially even considering with the underlying stock.
For example, you had $5,000 to spend on that aforementioned stock deal.
You decided to use the power and leverage of options to 'play' your thesis instead
of stocks.
You could just spend that $110 to control those 100 shares that you're interested
in…
BUT, think about how much you could control with all of that $5,000!
That could buy you like 45 of those contracts, instead of just one.
Maybe you drool over that 350% return (we talked about) be realized for your entire
$5,000 (instead of just on a measly $110) - that would be it growing from $5,000 to
more than $17,000 in just a month... yeah, that's tempting.
But you have to remember that most options expire worthless - which means a 100% loss
on whatever you paid for those contracts.
If you spend all $5,000 on options - that would be irresponsible - you're risking
everything.
If you spend $110 on the option to control $5,000 worth of stock - you're putting 2.2%
of the funds you have allocated for this position at risk - which MAY be a prudent move, for
you.
--
They can be a valuable tool.
But when you see their power, the temptation is absolutely there to use them to speculate,
or worse, to gamble.
And that's extremely dangerous.
That's the reason that Warren Buffett publicly criticizes derivatives as "financial instruments
of mass destruction" (an option contract is a derivative - it's value is derived
from the underlying stock).
Like a bomb, you must use caution when around them!
And please don't take this series of videos as me telling you TO use them.
I'm not.
They have the power to blow up someone's entire portfolio if you're not careful.
But, I'm not naive - I know you're exposed to them, at least conceptually - you hear
about people using them.
So obviously, the temptation to use them yourself will be there.
And I don't want to just discourage it, because...
I use them - heck, Buffett uses them (and we'll talk more about that in a later video).
But, I do want to make sure you're careful and I'd like to help however I can.
If you're planning to get into options anyway and only after you've done a ton of research
and really understand them and all the implications that come with owning them, I'd recommend
starting with one of the three strategies I mentioned earlier, and that's why I'm
going to walk you through each one.
--
Now, there's one more aspect of options trading that you'll need to understand before
the idea of covered calls - the first strategy we're gonna explore - can make sense.
Here it is: when you bought that option contract from earlier for $110, where did it come from?
Someone had to sell it to you.
That could be the market maker, could be your broker, or it could just be another individual
trader interested in taking the other said of that bet.
Remember, most of the time option contracts expire worthless.
Meaning the one who made that purchase lost 100% of their premium.
Which would also mean that the person who sold the contract made $110 on the deal (minus
commissions, of course).
Sounds great, right?!
Being on that side of an option contract like this is called selling or writing a call option.
You are essentially paid that $110 so the buyer has the right to buy 100 shares at $50
per share FROM YOU.
But that means that you now have the OBLIGATION to sell them those shares at $50 should they
choose to exercise their right.
If you don't own any shares of XYZ already, but choose to sell a call option - also called
a short, or naked, or uncovered call - your potential loss, in theory, is unlimited.
If the price of the underlying stock just keeps going up, as long as you own that short
call, you'll keep losing more and more money!
With our example from earlier, if the stock price were to soar to $65 per share, of course
the owner will exercise his or her option to buy those shares at $50.
That means, you HAVE to sell them 100 shares for $5,000 - 100 share that you do not have.
So, to get them, you will HAVE to buy them in the open market for roughly $6,500, for
an immediate loss to you of $1,500.
Well, minus the premium they paid you of $110 - so, an net loss of $1,390.
If the stock price had gone up by $5 more before expiration, you would have lost another
$500, just like that.
And sure, it's unlikely that the stock would double in price over that month, but it's
not impossible.
If that happened, you'd be out almost $4,000… you get the point.
All that risk, just for the chance to make the relatively small profit of $110?
--
For traders who are interested in dipping their toes into the world of options, I'd
recommend selling calls ONLY when you already have the shares on hand to satisfy any potential
execution of your contract.
In other words, you already own 100 shares of XYZ and THEN you sell a single call option
contract.
This is called writing (or selling) covered calls.
--
Let me give you a quick example of when I might use this strategy.
Now, I rarely purchase shares in a stock unless I expect significant upside potential at least
within the next couple of years.
So I'm not using this strategy right out of the gate.
(There are some others I might use right from the beginning, and I'll cover those next
time in the next couple of videos - so, subscribe, cause obviously this stuff is gonna help you
invest smarter!)
So, why wouldn't I use covered calls right from day one?
Well, if I'm expecting high upside potential… writing those calls would cap my potential
gains while still being exposed to the downside that comes with owning actual shares.
With the example from earlier, I buy 100 shares at $45 for $4,500.
Let's say, I immediately turn around and write that call option from earlier.
You pay me $110.
Great!
If they expire worthless (which, as we know, they likely will) I just made over 2% AND
I still own the stock.
Pretty cool, right?
BUT, if my thesis plays out - perhaps quicker than expected - and the stock price jumps
up to $65 per share, for example, if I had just owned the stock, I'd be up more than
40% on that position.
But because I had sold that call option to you, of course, you're going to exercise
it - you're going to buy those shares from me for $5,000, and now, I've only made $610
on the deal and I'm no longer in this stock that I had researched and liked and expected
good things from over the long run.
Not the end of the world.
That was a quick 13% return on my position.
But, like I said, I'm only entering a position if I see a reasonable possibility for 50-100%
upside over the next year.
I know all my positions won't do that - I just need one or two of them to do that each
year for me to hit my personal investment goals.
But if I'm capping ALL of my positions to a 10-15% gain, just so I can make that 2%
return from all their premiums - that may not be a terrible strategy for some, but for
me, I'm shooting myself in the foot - it won't work with my holistic strategy.
And I hope that makes sense.
Obviously, this strategy is at least not as dangerous as any of the others we've talked
about so far.
That's why I'd recommend this one (or perhaps one of the next few we'll cover)
before trying to get any more creative (which I don't recommend anyway).
--
But let me tell now how I personally incorporate this strategy into my trading:
What if, when I entered XYZ at $45, my thesis (that came from my detailed analysis) suggested
a fair value of $90 per share.
If after a while - it doesn't really matter how long - the stock price is approaching
that number - let's say it's at $80 after a year - that's when these can really come
in handy.
Now, as people who have been through my value investing course know, if some fundamentals
have changed and my thesis has weakened, I'd likely be most comfortable just selling my
shares at this point - locking in my 75% gain.
Or, if that fair value price for XYZ was still at $90 (meaning the percentage upside potential
was now WAY less than at first), and I felt pretty confident about some other opportunities
I was finding as having 50-100% upside potential - again, the best move for me would likely
be to just sell those XYZ shares.
But, if the fundamentals (and consequently my thesis) are still strong, if I'm not
really seeing better opportunities out there, and if perhaps that fair value price has been
creeping (or might creep) up a bit - then this strategy is perfect!
Have you ever been in that position, where your trade has gone your way, you feel like
it's starting to peak or maybe the stock is getting close to being overvalued, but
you just really don't want to sell it.
You think she has just a little more to go - you know, you have a price in mind when
you would like to sell it.
That happens.
A lot of people, in this situation, will put stop losses below the current price - just
in case the price starts to fall.
I think that's smart.
But, if you're not going to sell it, because you'd like to see it go up just a little
more before you do.
You might as well profit from that MINDSET.
If XYZ is at $80, maybe you put a stop loss in (to sell your 100 shares and lock in your
gains) at $72, just in case.
But if your research and analysis suggest that it has more upside potential - and you've
told yourself that once it hits (say) $90, that's when you'll sell.
You can profit from that mindset TODAY - while it's still hovering around $80.
Why not write a call option with that $90 strike price?
Write them 30-45 days out, when the 'time decay' is really working for you (that's
the time period where most options lose most of their value at an increasing rate - which
is good for the seller of the option).
By doing that, you could pull in an extra percent or two in profit every month as long
as your stock hovers around that price.
If the stock unexpectedly crashes, well, hopefully the stop loss we talked about earlier will
catch it locking in your 60% gain.
If it spikes up, you might be forced to sell your shares for $90, giving you a 100% gain.
But every month that it just trades sideways - within that $72-90 range - you're making
passive income.
Essentially, you're lowering your cost basis for this overarching 'play' on this particular
position - XYZ, in this case.
For simplicity's sake, let's say you're able to sell a single call option - covered
by your 100 shares - for a post-commission profit of $100 each month.
Now, for your final calculation, once you do exit this position, you're lowering your
cost basis (in other words, the net amount you have invested into each share).
So, you started with $45 invested into each share, right?
Now, each month that these contracts expire worthless, you're pocketing that $100 and
essentially lowering your cost basis by $1 per share.
So, if after 10 months, one of those two scenarios finally plays out - the stock falls or surges
- pushing you out of your underlying shares, your new cost basis (after those 10 months)
for your ROI calculation, would be (in this simplistic example) $35 - $10 less than your
initial $45.
So now, an exit at $72 would represent a gain of 105% on this position.
And an exit at $90 would represent a gain of almost 160%.
Remember, if you hadn't used the options there and had just used that stop loss (and
then discipline on the upside, to sell at $90) you would have only realized a 60-100%
return ...and you still would have waited those 10 months.
But because of this 'simple' strategy, you were able to realize the much greater
return of 105-160% for that overarching position - XYZ.
That was a lot.
I hope not too much.
I hope I got your wheels turning.
If you'd like more strategy videos like this one, please let me know by hitting that
like button and telling me in the comments.
And don't forget to subscribe (at the very least) so that you don't miss the next videos
in this series.
I look forward to getting to know you better and helping however I can.
Take care.
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