Basic Option Strategies
for Income
Enhancing Profits for Building
Wealth
Walnut Creek – October 28,
2009
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Tonight’s Topics
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Market Stance, Dow, S&P, Nasdaq
Basic Income Strategies
• Covered Calls
• Naked Puts
Assumptions
You know what an option is and the basics
of how they work
 Time Value
 Intrinsic Value
 ITM, ATM, OTM
Basic Points
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If you buy a stock you must be right about
direction to profit but time does not work
against you.
If you buy an option you not only have to be
right about the direction of movement but it’s
also a race against the clock
If you sell an option you can be wrong about
direction and profit - the clock is your friend
Critical Concept
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Time value is like an ice cube on a
hot day, it melts away
Option Selling strategies put time
decay in your favor!!!
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Time Value
Time Decay of an option
Time
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General Rules for Selling
Strategies
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Buying options – Buy more time than you need
Selling options – Sell front month – don’t want
buyer to have time to be right
Buy back the short options when most of the
premium has eroded
Example: lets say you sold an option for 1.00
and the premium has decayed to .20 with two
weeks till expiration – Buy it back!!!!!
Don’t be greedy!!!!!!!!!!!!
Covered Call – Most Basic
Strategy
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Neutral to bullish strategy
Must be long the stock (own at least 100
shares)
Sell a call to bring in premium
Selling time premium brings in monthly income
and reduce basis cost of the stock
May sell month after month for income until
called out
Covered Call - Risks
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Limits potential gain - when stock is extremely
bullish move it may be best to leave uncovered
to prevent being called out
A good time to sell is at resistance when the
stock is showing signs of consolidation
If the stock changes direction (becomes
bearish) it may be best to buy back the call and
sell the stock
General Rule for Covered Calls
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Look for at least 3-8% monthly ROI
when looking at covered calls
Two ways to enter a covered call
• Buy-Write: Buy the stock and then
•
immediately sell a call (never in the reverse
order) – Naked calls have unlimited risk!!!
Legging In: Sell calls against stocks you
already own – Stock in a sideways pattern or
heading back down to a moving average
Calculating Covered Call
Returns
Absolute Return if called out
ROI = (Call premium + Potential gain in stock) /
initial price of the stock
Example.
Buy stock for 25
Sell 26 call for .65
Break even price (expiration) = 25-.65 = 24.35
Potential gain in stock price (26-5=1)
ROI = (.65 +1) / 25 = 6.6%
Calculating Covered Call
Returns
Return if Stock price remains unchanged
ROI = Call premium / initial price of the stock
Example.
Buy stock for 25
Sell 26 call for .65
ROI = Premium Received / Price of Stock
ROI = .65 / 25 = 2.6%
Advantage of covered call
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Increase probability of making profit –
can make a profit even if the stock price
drops a little
Bring in monthly income (like extra
dividend payments)
Conservative strategy
General rules for covered calls
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If extremely bullish leave stock
uncovered or sell OTM
If stock is in sideways trend sell ATM
(best to sell at resistance when
beginning to roll over)
If stock is bearish and you still want to
hold the stock sell ATM
Long Stock – Risk Profile
Profit
Purchase Price
Breakeven line
Loss
Stock Price
Covered Call – Risk Profile
Maximum Profit
Break Even Price
Naked Puts
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Same risk profile as covered calls
Bullish strategy
Do this only on stocks you’d like to own but
not at the current price – Good way to buy
stocks at a discount
Do this strategy on fundamentally strong
stocks
Potentially large risk (if stock price goes to 0)
Don’t use this strategy on expensive stocks
Naked Puts – Margin
Requirement
Margin Required = 100% of option
premium + 20% of underlying stock –
any amount the option is OTM
Check with your broker as it may vary
Naked Put – Margin Example
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Stock Price is 25
Sell the 24 put for .65
Margin = .65 +.2 X 25 -1 = 4.65 (per share) or
46.50 per contract
Note: Retirement accounts are cash secured and
therefore the cash required is the entire price
of the stock – the premium received
Possible Future Topics
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Vertical Credit Spreads
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Iron Condors
Butterflies
Diagonal Spreads
Calendar Spreads
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• Bull Put Spreads
• Bear Call Spreads
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Final Thought for Tonight
“Where attention goes, energy flows
and results show”
T. Harv Eker – Secrets of the Millionaire Mind