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Friday, February 20, 2015

A Lesson In The Value of Covered Call Options

I am going to give you a real time example of how stock options, done right, can make you a significant alternative income. For those of us who invest in the stock market, we call this generating cash on underlying investments that you wish to own, do not wish to sell, but that you wish to continue to earn from.

When I have talked about stock options in the past, I always stress that I do not buy stock options. I sell stock options. Why do I do this? It is simply a matter of this being my strategy. I buy stocks because I believe they are worth more than the price that they are currently trading for.

Pretty simple right?

Therefore I do not wish to sell the stock of a company that I feel is going to continue to make inroads, continue to advance, and continue to provide a great income opportunity over time. You sell your losers. You do not sell your winners. But when you have winners, you make the most out of them. You get every penny out of them that you can. You do not worry about what the rest of the markets are doing, or what the rest of the markets are thinking. You do your homework, you decide a valuation, and you proceed from there. And you keep in mind that everyone invested in a company has a different idea about what the company is doing, what it is going to do, and so this helps to create a vast market of individual investors willing to do all sorts of things depending on where they want to be with the stock.

You will not always be right, but that's okay. That is part of the game.

I said you have to do your homework, and repeat this here because if the idea is that if you do not wish to sell your stock, but want to continue to generate income on your stock, you need to have a good idea where you think the share price is realistically going to go.

I won't get into the math of that. You'll have to figure that out on your own. But there are tons of websites that can provide you valuable information on how to valuate a stock.

I currently own 1,300 shares of Cypress Semiconductor, and that's already great because it is a stock that pays you while you wait. My quarterly dividends on this stock are $143. Even if the stock does nothing at all, I'll earn $572 in a year just because I happen to own it. My cost basis per share is $12.83, and as of the close of today's trading, ($14.95) I am already up $2.12 per share, or have an on paper profit of $2,756.

I have no intention of selling my shares. I think the stock is worth about $17 per share.

But herein lies a part of the fun of this. I do believe I own a $17 stock. I do not believe that my $17 stock is going to trade at $17 within the next 30 days. I made this decision in January. In fact, in January I did not believe the stock would trade much above even $15 within the next 30 days, and moreover, I did not believe that the stock would close trading at $15 or higher 30 days from January.

It did go past $15 briefly. But as I suspected, it did not stick, and the stock took a significant down turn after pushing past $15. The stock broke resistance and people took profits. It's that simple.

Why is this important?

I want to make a monthly income on a stock that is now showing a profit. I want the best of all worlds. I want my $17 stock. I want my dividends. I want to keep on owning it. And I want the other investors in the market who believe the stock is going to go higher sooner to want to buy the right to buy my shares at $15.

I am looking for those individuals who believe in the same valuation I do, but believe that it will reach that valuation before I think it will.

This creates a market of buyers in the options world willing to pay a premium to have the right to buy shares at $15 that they are convinced are worth significantly more. If they can buy an option to buy shares at $15 and the stock goes to $17, they reduce their gain by the amount of the premium they paid for the option, but still win since selling the shares they obtain at $17 still reaps them a good reward.

Remember, the options allow them to buy the shares at $15. In their world, they are up $2 per share minus the premium.

Guys like me love this, and take this to the bank.

The options buyer  says "I can buy the stock, or I can buy the right to buy it at a price that I think is valued less than what I think it is worth. If I buy the stock I lose more than if I buy the right to buy it. If the stock does not do what I think it will do, I am only out what I paid for the right. Not the total loss of buying the stock outright and losing the overall value of my investment."

This is where guys like me come in and make money.

I am more than willing to sell you the right to buy my shares that I have $12.83 invested in that are worth $17 for $15 before they will actually be worth $17. Why? Because I am convinced that my $17 stock will not be worth $17 in the time period you think it will be. You are willing to pay me to buy my shares for less than they are worth thinking they will meet the valuation before I think they will. Even if I am wrong, and the stock does something unpredictable, I still get my premium and sell my shares for more than I paid for them.

Enter charts and technical analysis which is way more than I will get into here, but do your research and you can learn where technical analysis can help to make short term decisions on where a stock is heading based on market sentiment...

And that word I used earlier in this text. Resistance. It is important to know what that is, and how you can decide where to set your strike prices in short term options selling.


...to be continued

READ PART TWO




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