The Position Makers

so i had the unique pleasure of being contacted recently via gmail through the finance.google.com forums.

the person who contacted me was curious about options and how i use them. i’m not sure if there was a single post that caught his eye or a series–forgot to ask. probably for the best.

i spent the first few minutes of our chat on gchat trying to delve into his current trading/investment habits. what was most clear to me was a lack of a plan–not on paper or in his mind. this is actually pretty normal i think. i don’t think i had a plan for a number of years…in fact, i’ve spent the first ten or so years of my investment adventure experimenting with different techniques. as i mention on the about page, i ended up living off swing/momentum trading for quite a while. since then, i’ve come to realize more and more lately that having a plan is extremely important. without the plan, we can’t know how we want to react and handle a situation that [potentially] requires immediate attention–but in most cases doesn’t!! in my case , i was an utter fool for not having a plan. i think a plan that clearly defined my investment goals, technique, approach, paradigm, whatever-you-want-to-call-it, would have put me in a better state of mind for managing my returns. rather than being only marginally better off, i’d be way better off. what a simple way to make myself feel stupid. lol

this brings me to my first rule of investing and trading: have a plan.

the best way i know of to treat a plan seriously is to consider my business. at least for me, it helps eliminate the gitters and anxiety of the stock market. i certainly can’t control mr. market’s offers or immediate need to sell (or buy), so i simply put a plan in place that helps me to be always profitable.

before going further, it’s important that you understand what an option is and how it works; so, if you’re unfamiliar with options click over to wikipedia’s entry, maybe follow up with a bit more reading from the external references and then get back over here. once you have the basics down, you’ll want to understand my plan a bit more–even if it only helps you to understand your own plan.

now, as we all know, an option contract constitutes the right to buy [in the case of calls] and the right to sell [in the case of puts] 100 shares of an underlying stock. i’m not going to recommend anyone purchasing/selling naked options–option contracts where there’s no underlying stock supporting the contract. in those situations, the investor or trader is taking a bit of risk that the contract will expire worthless and therefore have no obligation to own the underlying stock in order to procure the shares of an exercised option contract. besides not fitting in my plan, it seems like undue risk for lop-sided returns. just mon avis.

because my goal entails developing the largest stream of income while maximizing reinvestment potential, i buy underlying shares in the company. i don’t buy 100 shares at once, unless the stock is pretty cheap ($3-$5…i’m not talking penny-stocks), so i can make sure my entry price is actually at a fair value. maybe it’s just old chart reading habits; at the same time it really just comes down to me not wanting to pay full price. that’s a relative number typically so i just slowly build up a position over a month or even quarter. i also add to existing positions in this way.

covered calls:

again, i’m trying to maximize my reinvestment potential. that means i’m going to want my money to be compounding as often as possible (i like every 30-60 days). Luckily, option contracts are expiring once a month. So, depending on the option contract price and my total share number (100 shares to 1000 shares for example), i sell 1 to 10 contracts.

i choose the price that i feel i need to make the transaction, with general pricing metrics in mind. the nice thing about option contracts is they’re based on some pretty rigid mathematical formulas, namely accounting for underlying stock value and volatility. this means there’s not much fudging of the numbers going on. the market price is actually pretty accurate in my mind for that particular day/week. this doesn’t mean i don’t get to choose the price that i’m willing to sell for. it’s just about proper timing and . (so, yeah, you can definitely time the market…it’s just all a question of what we mean by ‘time it’.)

how do i figure my price out?

simple. i just ask myself a couple of quick questions:

what return would i be willing to sell these stocks for if the option contracts are ultimately exercised?

what is the value for the risk i’m taking to sell this option contract?

depending on the volatility of the market and the long-term growth potential of the company (again in relation to the violent swings mr. market creates), i set a % return. i typically want 20% return on the stock itself and 2-5% for the option contract.

so, if my shares are taken in the 30-60 day period, i’ll make 22+%.

again, i always look at where i think the stock is going to end that period at, so i’m not selling in the money options. i’m selling out of the money but not ridiculously out of the money unless i have to extend my reinvestment horizon out. (i’m a fan of 22% returns). the reason for not tending to avoid really-out-of-the-money options is that they are worthless at that point; i’m certainly not going to give someone the right to purchase my stock. i’m a greedy bastard.

reinvestment is of course an issue. so, what happens if the shares are taken?

i’ve never seen a stock that sky-rocketed up and then didn’t come back down to earth. if someone buys my shares because of irrational exuberance, fine. i’ll just buy it off someone other schmuck after the euphoria passed and the price is back down to normal, pocketing/reinvesting the differnce. (my definition of normal of course).

let’s keep in mind that as we implement our plan, the underlying stock may keep creeping up to the point where the stock 2, 3, 6 months before was ‘way out of the money.’ that’s just great in my mind. that means i’m selling even more out of the money options for an even better return. and if the price tumbles from there, i haven’t lost anything on my original investment. sweet.

another obvious concern is that i didn’t enter the position at the right value and the underlying stock goes down even further. so long as my break-even is out of the money, i don’t see a problem with selling the option contract for that exercise price. so long as i’m confident that it won’t end in the money. again, i can also just say, “shit. i didn’t do my homework correctly. i have to sell a LEAP.”

some of my companies are dividend payers, others aren’t. dividends are great because it’s just gravy for the reinvestment program or for starting new positions.

i think of it like this:

options are the monthly dividend and some of the companies pay me quarterly bonuses for good behavior.

i am in the process of getting ready for a trip to africa, so i may have left a step out or glossed over an important/debatable point. leave your comments and i will definitely discuss when i get back. and just for the record, i won’t even dream to think or imply that i’m the first to do this. that’d just be straight up ignant.

on that note i’m going to end this post with a poem that i’ve had posted at my desk for 4 or so years now–i also have a sign that says, “jesus helps me trick people” so go figure on the crazy stuff i have hanging around my desk!! i originally came across the poem in how i raised myself from failure to success in selling by frank bettger, and I think it’s fairly applicable to this post and especially rule one. (author unknown) it’s over my desk so i’ll read it at least every other day; helps me keep focused on the tasks and goals at hand.

There may be nothing wrong with you/The way you live, the work you do,/But I can very plainly see/Exactly what is wrong with me./It isn’t that I’m indolent/Or dodging duty by intent;/I work as hard as anyone,/And yet I get so little done./The morning goes, the noon is here,/Before I know, the night is near,/And all around me, I regret/Are things I haven’t finished yet./If I could just get organized!/I often times have realized/Not all that matters is the man;/The man must also have a plan./With you, there may be nothing wrong,/But here’s my trouble right along;/I do the things that dont’ amount/To very much, of no account,/That really seem important though/And let a lot of matters go./I nibble this, I nibble that/But never finish what I’m at./I work as hard as anyone, /And yet, I get so little done, I’d do so much you’d be surprised,/If I could just get organized.