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"Only the pros can trade options." The action-hogs on Wall Street just love to perpetuate that myth, because they know options are one of the most powerful, versatile tools (that anyone can use) for making money.
You might also hear that they're "too risky." That's another one of Wall Street's scary bedtime stories.
Those Wall Street myths are precisely why I want to talk to you today, to show you how safe and easy options trading can be for regular investors.
The truth is, you can use options to protect an entire portfolio of stocks from excess risk, or generate modest but market-beating income each month. It's possible to play for big, money-doubling gains, too.
There's an options strategy for every financial goal, in any kind of market.
But one of the coolest things about options is they grant you the Warren Buffett- or Carl Icahn-like ability to control outsized positions in all sorts of companies for as little as a tenth of the share price.
In some trades, like the one I'm going to show you in a moment, you don't even need to own the stock underlying the option. Instead, you "squeeze time for cash" and create a setup for endless profits.
Here's how it works…
"You Have to Be a Buyer Here"
Last week, I showed you an options strategy called the covered call. It's an income play, where you sell the right to buy stock you own at a specified price in the future – you collect the premium for selling the right to buy.
It's a great strategy to consider if you own a relatively inexpensive stock that hasn't moved much in the May to November market doldrums.
A $44 stock like Linear Technology Corp. (Nasdaq: LLTC) is a great example, because it's relatively inexpensive and you likely won't mind parting with 100 of your shares if the stock happens to get called away per terms of the options contract (remember, these kinds of options contracts are always for 100 shares).
Now, this is where some of my students get a little nervous, because you must own the stock to be able to "cover" your call.
Let's say you want to participate in Amazon.com Inc. (Nasdaq: AMZN), the company that put the "A" in "FANG stocks."
There's a tremendous amount of interest in the stock, and it moves year-round, but importantly, not too much. It also costs around $714 a share right now. So if you wanted to write a covered call on it, you'd have to shell out $71,400 for the 100 shares in the contract – that's the price of a nicely loaded 2017 Jaguar F-Type, or a Ford F-450 Super Duty pickup, if you're into trucks!
Depending on your wealth and risk tolerance, that may be manageable. Then again, it may be an entire year's salary.
So let me show you a better way to play these expensive market movers. This is where you get the power, without the premium price…
How to Use the Quick and Easy Calendar Spread
A calendar spread (sometimes called a time spread) strategy is similar in concept to covered call writing.
The critical difference is that you're not required to own the stock first.
A calendar spread is a two-legged options trade where you buy a longer-term option and sell a shorter-term option with the same strike price. When using this strategy, you must choose calls or puts to buy and sell; you cannot buy a call and sell a put, for example, or buy a put and sell a call.
What you're basically doing is using a longer-term expiration option, such as long-term anticipation securities (LEAPS), instead of buying the 100 shares of stock you'd need to write covered calls.
The goal is to profit off the time decay, or theta (Θ), between the two options.
Simply put, theta (Θ), is the change in price of an option with respect to a one-day change in its time until expiration. It measures the amount an option will lose with the passage of one day.
Now, theta (Θ) is higher in the shorter-term options than the longer-term ones. This means, based on time decay alone, with the stock price remaining flat, shorter-term options depreciate in value faster than the longer-term option.
So if a stock is not moving in your favor, and you're holding onto it, theta (Θ) is relentlessly eating away at the value of your option.
And that's where the calendar spread comes to the rescue…
Let's look at this strategy closer using Amazon shares as our example. But first, I know AMZN has been cranking higher, but I only want to use it to emphasize how you can use the calendar spread to (significantly) lower your costs. Let me be clear that I'm not making a trade recommendation on Amazon.
As you can see above, one contract of the AMZN January 2017 $710 calls (AMZN170120C00710000) is quoted between $72.75 and $73.40. You'd typically buy at the higher ask price, so we're looking at the $73.40 price in this scenario, which equals a cost of $7,340 (100 shares per contract x the ask price of $73.40).
That's 10 times less than the $71,400 you'd spend on this trade otherwise. But you could slash that cost even more if you make an end run around having to buy the stock first. That's where a calendar spread comes into play…
With a calendar spread, you are buying a longer-term option (in this case the AMZN January 2017 $710 calls).
You're then going to look for options with expirations between four and six weeks or less, similar to the covered call strategy, to see the selling price of an option with the same strike price.
Remember… calendar spreads and covered call writing should be considered when you anticipate the stock staying pretty flat or moving only slightly higher between the time you open your position and the expiration of the month you sell.
Here's an options listing for an AMZN June 2016 week 3 $710 call (AMZN160617C00710000) for the selling side of the spread:
To sell this, you'd typically use the lower bid price, which is $14.85. And since one contract equals 100 shares, the total amount you'd bring in is $1,485.
Now let's compare the rates of return with the calendar spread and covered calls if AMZN stays under $710…
- Using the covered call strategy… you would have to buy 100 shares of AMZN before executing. This means you'd need to spend $7,600 to own 100 shares. The premium you brought in from the sale of the $710 call you sold against your stock would be $1,485. This is a 2.1% rate of return ($1,485 / $70,600).
- Using the calendar spread strategy… you would not need to buy 100 shares of AMZN before executing. So your cost upfront to enter the trade would be $7,340 instead of $70,600. And the premium you brought in from the sale of that $710 call would still give you $1,485, bringing your rate of return from 2.1% to a whopping 20% ($1,485 / $7,340).
And that's just of the sale of the premium alone for June. If AMZN shares stay under $710 after expiration, you can repeat the process – and generate more income.
With calendar spreads, you have less risk simply because you spend less money, and the cost of a longer-term LEAPS option is much less than buying shares outright. Let me explain…
Since you are spending less to open a position that you wish to sell options against, your risk is also less. Additionally, you're further reducing your risk by selling options against the option you bought, plus you're bringing in money to offset the cost of the longer-term option.
At the end of the day, every time you write or sell a call against either your stock or your longer-term option position, you're reducing your cost basis.
Generating, say, a $1,485 profit every month from selling calls can quickly cover… or should I say recover… the total cost of that longer-term options contract than it can the cost of buying the stock outright.
Beyond saving you thousands of dollars and slashing your risk, there are a few other benefits to consider.
You can actually turn this into a net long call option position if you see the stock taking off or about to break out even higher than you originally anticipated. Now, you may have to buy-to-close the sold option at a bit of a loss… but by keeping the long call, you can be in position to make money (over and above that loss) thanks to the increase in value of the long call position.
There's an advanced trading concept in play here, too…
As an ironclad, unbendable rule, I never recommend selling naked options because it's just too risky. But, if you do, you'll be subject to certain margin requirements in your account – money or securities that you can't use while the naked trade is open. In this case, the shorter-term call option you are selling against the longer-term option is considered an offsetting position and will significantly reduce, or eliminate, your margin responsibility. Once again, I only mention this because it's a fact of these kinds of trades and something you may encounter in your trading, but I strongly caution you against naked selling.
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About the Author
Tom Gentile is one of the world's foremost authorities on stock, futures and options trading.
With more than 25 years' experience trading stocks, futures, and options, Tom's style of trading systems and strategies are designed to help individual investors propel themselves past 99 percent of the trading crowd.