SUCCESS STOCK MARKET INCOME GENERATING STRATEGIES. Intelligent Cash Flow and Investment Decisions. Written by Mike Coval

Transcription

1 SUCCESS STOCK MARKET INCOME GENERATING STRATEGIES G Intelligent Cash Flow and Investment Decisions Written by Mike Coval

2 S U CCESSSTO C KM AR K E T. CO M Stock Market Income Training Incometrader.com 6338 Presidential Court #204 Fort Myers, FL Phone Fax If your educational course came with live webinar training, you will be given access to your login procedures at your live event. Webinar Website: Webinar Username: Webinar Password: Webinar Time: Your 4 Cash Flow course videos are in DVD format to ensure compatibility with both PC and Mac.

3 Disclaimer Success Resources USA, The Success Stock Market Income Manual, and the Success Stock Market website are information services for investors and traders, and are not a recommendation to buy or sell securities, nor an offer to buy or sell securities. The principals, employees of, as well as those who provide contracted services for Success Resources USA are neither stockbrokers nor investment advisors, and are not acting in any way to influence the purchase of any security. The information provided is obtained from sources deemed reliable, but is not guaranteed as to its accuracy or completeness. It is possible at this, or some subsequent date, the principals, employees of, as well as those who provide contracted services for Success Resources USA may own, buy, or sell securities presented. The principals, employees of, as well as those who provide contracted services for Success Resources USA are not liable for any losses or damages, monetary or otherwise, that result from the content of The Success Stock Market income Manual and the Success Stock Market website. The principals, employees of, as well as those who provide contracted services for Success Resources USA have not promised that you will earn a profit when or if you purchase stocks, bonds, options, currency or futures. It is recommended that anyone trading in the financial markets should do so with caution and consult with a broker before doing so. Past performance of any principals, employees of, as well as those who provide contracted services for Success Resources USA may not be indicative of future performance. Securities presented in The Success Stock Market Income Manual and within the Success Stock Market website should be considered speculative with a high degree of volatility and risk. A

4 Introduction into Trading for Income You have made a wise choice in your next level of education, moving from stocks or even basic long calls and puts to a higher probability of successful trading. Option spreads give the investor a unique opportunity to invest less money, increase the rates of return and even show a profit even when the original trade moves against your current trend. To help learn these skills, we have created The Success Stock Market Income Course to share with you a specialized knowledge which, hopefully, will increase your rates of return while providing some cash flow along with lower risk trades. Course Goals: - Understand how options can be used in your portfolio - Learn how options are priced - Create income on stocks you own - Trade with Vertical Spreads - Achieve positive cash flow with Iron Condors Throughout this class, we will use several tools and websites. First and foremost, we will use the SuccessStockMarket.com website. SuccessStockMarket.com was created to help you search for stocks and their options as well as provide trading/investing opportunities with timely articles on potential set-ups. We will also use live charts and quotes from a brokerage platform. Since we cannot recommend any, we may use a couple of different brokers websites in the class. Please copy the contents of the 4 videos onto your computer to play. The files are saved in an.mp4 format to ensure compatibility with both PC and Mac B

5 Table of Contents Chapter 1 Getting Started... Pg 1 Resources.. Pg 2 Chapter 2 Charting... Pg 4 Indicators. Pg 7 Patterns... Pg 13 Chapter 3 Understanding Options. Pg 19 Setting Up Accounts.. Pg 25 Elements of an Option.. Pg 33 Chapter 4 Buying Calls and Puts... Pg 39 Buying Call Checklist Pg 48 Picking a Strike Price.... Pg 52 Placing an Order Pg 57 Chapter 5 Covered Calls. Pg 59 Covered Calls Checklist... Pg 65 Chapter 6 Debit Spreads Pg 72 Expectations and Scenarios. Pg 73 Debit Spread Checklist..... Pg 77 Chapter 7 Credit Spreads Pg 81 Bull Put Spread Checklist..... Pg 87 Closing the Trade.. Pg 87 Chapter 8 Iron Condors... Pg 89 C

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7 S U C C E S S S S T O C K M A R K E T Chapter 1 Getting Started To be a successful investor, we need to understand the alternatives available to us regardless of the market direction. These include various strategies for both the buyer and the seller. We will go over many of these throughout this training but for now, understand that market dynamics can and will change at any moment which may cause you to alter your original trading plan. You will learn that the more choices you have available to you, the better you can adapt to shifts in the market and last as an investor. In fact, the single most common trait among successful investors is their willingness to adjust or alter their trade IF their stock has changed its trend. This means that you ll have to monitor your positions on a nightly basis if you re trading options and once or twice a week if you re trading stocks. Other types of investments will vary as well, but it s always a good idea to know what is happening in your portfolio. An unexpected surprise that has been left alone for extended periods could be quite costly. Our Stance Our motivation comes from educating investors, of all types, how to trade stocks, options, currency and futures. Combined with a proven track record, you will find that the more education you have within the financial arena, the better you ll sleep at night. For many investors, the days of buy-and-hold for the long-term are gone. Past decades have proven that prices can begin and end at the same price many years later. Our goal is two-fold, first and foremost is to encourage individual investors to become better stewards of their investments by generating monthly income, whether it is within a personal investment account or a self-directed account and secondly, to give a small portion of your trading proceeds to those who are less fortunate. 1

8 To help aid in this teaching process, we will utilize the Success Stock Market website for convenient and easy access to resources. The Success Stock Market Site This website is where we ll do most of our research and find all the educational articles. Automated stock scanners will quickly search the markets for the best or worst stocks. This top-of-the-line resource includes the popular Dividend Search and Weeklys Search. Automated fundamental analysis is run on every stock when you type in a ticker symbol, no need to manually grade a stock. Automated buy and sell signals are added to every chart to help you easily identify buy and sell signals. A market commentary is written twice a week to give you a better understanding of the overall trend and of any major upcoming news announcements. Homework trades are live trades that are followed from start to finish allowing each student the opportunity to see exactly how to trade a real position. 2

9 S U C C E S S S T O C K M A R K E T Covered calls, spreads, LEAPS and stock picks are given each week so that you ll have an opportunity to view what we think are some of the better investments. Some of these will be followed from start to finish meaning we stick with the trade until it is closed out. Others will simply be what we think is the best trade at this current moment in time. Investor psychology plays a large role in determining overall profitability of a student. We cover some of the thought processes that most investors fall into. These are written with a sense of humor and come from actual examples. Education articles are extremely useful and the Success Stock Market website has plenty of them. Need to find out what a technical term is or how it s used just check the Technical Talk, Options Institute, or Traders Analysis portion of the site. Opening or Updating an Account Since you ve already gotten to this point, it s safe to assume that you have committed yourself to the education process and maybe even opened up a brokerage account. Now that you have made the decision to include options with your trading, you will need to make sure you have the correct permissions within your account. When opening an account, it is important to find the correct type of brokerage firm. Since we will be trading both stocks and options within this training, we ll concentrate on these types of firms. A simple Google search for best online brokerage firms will give you a great starting point. A couple of key points to look for are accounts that allow complex options (allows you to enter into spread trades to potentially fix a bad trade), IRA trading, and of course, the lower the commission cost the better. Most of these firms will have free real-time streaming charts and quotes that you will want to access prior to entering into your trade. Once you decide on the brokerage firm you want to use, you ll need to fill out the paperwork and then mail in a hard copy of the signature form. At this point, all that is left is for you to fund the account. Either transfer over some existing securities, wire cash or write a check. If your account is already opened but you have not registered for options trading, you can simply call your broker and let them know you want to trade spreads. Copyright 2013 SuccessStockMarket.com. All rights Reserved. Terms of use apply 3

10 Chapter 2 Charting The appeal of charting and technical analysis has formed a new breed of investor. Gone are the days of investors only investing on a stock s fundamental attributes. Now with the speed, low cost and the availability of the internet, charting has gained in popularity and could soon become the number one factor in many investors decision-making process for buying and selling a stock. For options traders in particular, the skills of technical analysis can fine-tune one s ability to assess entry and exit points for shorter-term time frames. Chart Types As you first log into your brokerage account or onto the Success Stock Market website, you ll want to set up any customizable charts or learn to read the available charts. This will allow you to be able to evaluate how 4

11 S U C C E S S S T O C K M A R K E T a stock has been reacting in the past, what is currently going on and what the chart is potentially forecasting for the stock. Stock market charts are an easy-to-read graphical representation of the past price performance of a stock. Looking at the chart is one of the first steps in analyzing the past success of the company you re looking to invest in. More advanced technical analysis charts, which we will cover later on, are used to identify the stock market trends, changes in trends, price variations, institutional buying or selling and many other critical measures. While there are many different types of stock market charts available, three of them are used 90% of the time. These include the line chart, the bar and the candlestick chart. Line Charts The line chart is the most basic chart and plots the stock's closing price over a selected time frame of choice. The most popularly viewed timeframe for a stock chart is a daily period. The 3-month chart below takes the daily closing price of the stock, puts a dot at the closing price, and then just connects the dots to create a line. This line chart shows that the stock has been as high as $44 during September and as low as $26 per share in June. Bar Charts A more complex type of chart is the bar chart. It expands information of each data point to the open (O), high (H), low (L) and close (C) price in the given period. That is why this type of stock market chart is also called an OHLC chart. A bar is a vertical line for each time frame, showing the price range between the minimum (low) and maximum (high) price for the time period being displayed. On the left side of the Copyright 2013 SuccessStockMarket.com. All rights Reserved. Terms of use apply 5

12 vertical line there is a small horizontal dash, which is showing the stock s opening price. On the right side of the vertical line there is also a small horizontal dash, but this one is representing the stock s closing price. Bar charts can be colored to show whether the price rose during the timeframe (green or black bars) or fell (red bars). The lower left dash represents the opening price of the stock for the day, and the higher right dash represents the closing price for the day. If the bar is colored green or black (your choice), it is because the stock has increased in value at the end of the trading day. If the bar is red at the end of the trading day, it is because the stock s value dropped from the opening price of the trading day. Candlestick Chart Candlestick charts originated as a form of Japanese charting and are similar to bar charts except they have a body and the shadows. The length and position of the candle body determines the open and closing prices of the stock. The shadows represent the stock's high and low values similar to the bar chart. A weekly candlestick represents Monday's open, the weekly high-low price range, and Friday's closing price. 6

13 S U C C E S S S T O C K M A R K E T The body of the candlestick represents the opening and closing price, while the wicks represent the high and low price the stock traded at throughout the trading day. A candle body is colored red when the closing price is lower than the opening price. When the closing price is higher than the opening price, it is usually displayed with a green or hollow body. Other colors and fills are also possible (black and white for example), depending on your charting program - there is unfortunately no standard for use of colors in this area. Moving Averages A moving average is an average of a stock s closing price for a set number of days. For LSB Industries below, we take the closing price each day for 30 days and then average them into one number and plot it on the graph. Then we take the next trading day and add it to the last 29 days and average them into one number and plot it on the graph. The current moving average for LSB Industries is just above $ Anytime the stock is trading above this moving average, the stock is trading in a stronger trend than its average trend. When the stock crosses above the moving average and then closes above it, we give it a green arrow on that day. Copyright 2013 SuccessStockMarket.com. All rights Reserved. Terms of use apply 7

14 Anytime LSB Industries is trading below this moving average, the stock is trading in a weaker trend than its average trend. When the stock crosses below the moving average and then closes below it, we give it a red arrow on that day. Trends A trend can be defined as an overall direction. In the stock market, we work with three up, sideways and down. When looking at a stock chart, you should be able to pick out two trends the overall trend and the most current trend. In the first example (below) from IBM, the overall trend of the 6-month chart is sideways. Six months ago, the stock was trading around $ per share. At the end of the six months, the stock is trading at $ Even though the stock had ups and downs, the overall trend is sideways. In this same chart, the most current trend is up, beginning after the stock bounced up off the $ support. So if there are many trends within a trend, how do you decide when a trend starts, stops or changes? The simple answer is that you ll likely never know until after it already happened, but this should not stop us from using them. 8

15 S U C C E S S S T O C K M A R K E T Support and Resistance Levels One way to find the beginning or ending of a trend is to use support and resistance levels. All stocks move higher and lower based on the amount of buying and selling. If the buying remains strong, the stock moves higher. If the selling remains strong, the stock continues to move lower. If however, the buying or selling is not on increased volume, there is an excellent chance that the next time a stock reaches a previous high, investors will lock in their profits and sell the stock causing the previous resistance level to remain in place. Investors are always looking for an edge trying to predict where a stock will move to before it stalls out or changes direction. The most common method is to look for past areas where the stock stopped its current trend and moved sideways or reversed its trend. These areas are called support and resistance levels. The Success Stock Market website automates this process by drawing automatic support and resistance lines on each chart for you. With the chart of HXL above, the Success Stock Market website has automatically drawn a resistance line just below $ It appears that each time the stock neared this level, it stopped moving higher. As an investor, this information is timely to know since you might want to lock in some of your profits or even close the trade early particularly if you re trading options. Using the same chart for HXL, you can also see that every time the stock dropped near $22.50 the stock stopped falling and then started back up again. This stock chart shows a support area of $22.50 and a resistance area of $ Copyright 2013 SuccessStockMarket.com. All rights Reserved. Terms of use apply 9

16 Looking at a Chart Now you know a little bit about the makeup of a price chart, the top portion of a chart. Now we ll move into the secondary section, the indicators. All indicators work off price action, the upper portion of the chart. Some measure past performance and then use a mathematical formula to help forecast future moves, some measure current volatility, some look at averages and others look at In other words, there are almost as many different types of indicators as there are stocks. Since we each interpret what we see from our own perspective, it really does not matter which indicator you use as long as you find it helpful. On the Success Stock Market website, we have tried to keep it easy and have only listed three indicators on our standard charts. You are able to change the indicators and their settings; however these three indicators, the Coval indicator, the MACD s and the volume work extremely well together. Coval Indicator The Coval indicator is an oscillator and combines three separate different indicators into one along with some skewed settings. They work and are read much the same way the MACD s and Stochastics do in that they help to identify overbought and oversold areas. When the Coval indicator is high (the upper side of its graph) and turns to the downside (red arrow), there is a very strong chance that your stock is about to drop. When the Coval indicator is low (lower side of the graph) and turns higher (green arrow), there is a very strong chance that your stock is about to bounce up in price. 10

17 S U C C E S S S T O C K M A R K E T MACD s Moving Average Convergence Divergence. The MACD s are a combination of two different moving averages, a shorter-term moving average, generally 12 days and a longer-term moving average, generally 26 days. These are then plotted and smoothed over a 9-day period. Anytime the MACD s are low and turn higher, the stock is considered to be undervalued and ready to bounce higher. Anytime the MACD s are high and turn lower, the stock is considered to be overvalued and ready to turn and drop in price. To make it easier to identify these buy and sell signals, we have added red and green arrows to these charts. Please note, that a red or green arrow should not be considered a recommendation of a buy or sell, it should only be used to help confirm your decision-making process. Volume Volume lets you know what the institutional buyers are doing and whether or not a stock s move was just some manipulation or if it was a true buying/selling day. Each line above represents the total volume for one trading day. In the chart above, the last trading day, volume seems to be near 350,000 total shares traded. It is the bar furthest to the right and contains both the buying and selling volume. The horizontal line running across the volume bars represents the average 20-day volume level. Anytime the current day s volume is above this level, it indicates increased buying or selling. If it is substantially above this level, 50% or more, then you have some institutional buyers/sellers trading heavy quantities. It is important to look for these institutional buying/selling days as it generally leads to continued buying or selling. Copyright 2013 SuccessStockMarket.com. All rights Reserved. Terms of use apply 11

18 An important note to remember when it comes to buying is that volume spikes are only necessary if you want the stock to change its direction. If a stock is in an uptrend, you do not need to see a volume spike to give you a buy signal. However, if a stock is in a sideways trend and is slowly moving up, approaching a resistance level it will likely need to see a volume spike before it can break through this resistance and resume its uptrend. This would indicate the bullishness of the larger institutions to continue to buy at these higher levels. Putting it all Together The Success Stock Market website has automated as much as possible to help you with your technical analysis, red and green arrows, support and resistance levels and volume averages. When looking at a stock chart, it s best to approach it from the top down. The trend is moving higher, the stock is just getting ready for a break out above resistance. All three indicators, the moving average, Coval indicator and MACD s are all showing green arrows. The stock is even showing a volume spike as it hits resistance. 12

19 S U C C E S S S T O C K M A R K E T Scroll down lower on the website page, and you ll see that the stock even ranks as a Good Stock and trades under its Fair Value and under the Analyst s Average Target Price. All this found from one simple Automated Good Stock search. Pricing Patterns There are many pricing patterns and each has their opposite side, all bullish patterns can be inverted and you now have a bearish pattern. The Success Stock Market website has some excellent archived technical articles under the Technical Talk section. For now though, we will cover a few of the more important ones. Recognizable Trading Consistencies Investors might be considered the ultimate history buffs. They constantly look at the past to help in their decision-making process, for example: what was the last high, the last low, the intraday volatility, the last earnings move Whatever little edge they can find, they will use. A trading pattern is really just a collection of past trading levels drawn together to make it stand out, think of a connect-the-dots drawing and you get the point. Copyright 2013 SuccessStockMarket.com. All rights Reserved. Terms of use apply 13

20 Just Support and Resistance Eventually your eyes will become accustomed to seeing different trading patterns. Until they do, just know that all patterns are just variations of different support and resistance levels. Since the Success Stock Market website draws automated support and resistance lines, you re already ahead. Double Bottoms The double bottom is a bullish pattern to recognize a stock or index hitting a support level and twice bouncing up off of it. The double bottom signifies the stock s unwillingness to break to the downside as investors buy the stock on the pullback. Often, an upside breakout on high volume follows a double bottom. It is best to combine a double bottom with secondary signals as well. Increased volume on the bounces and decreased volume on the drops will also help confirm the possibility of an upside breakout. 14

21 S U C C E S S S T O C K M A R K E T Double Tops A double top pattern is similar to a double bottom but is a bearish pattern. The unwillingness of a stock to break out above resistance on two consecutive occasions displays the stock s bearish tendencies. It is best to combine a double top with secondary signals as well. Increased volume on the drops and decreased volume on the bounces will also help confirm the possibility of a downside breakout. Copyright 2013 SuccessStockMarket.com. All rights Reserved. Terms of use apply 15

22 Head and Shoulders This pattern is bearish if the head is higher than the shoulders and bullish if it is inverted with the head lower than the shoulders. The pattern is similar to a triple top or triple bottom with the middle point (head) trading outside the two end points (shoulders). A breakout move comes when the neckline is broken. The chart below represents a bullish head and shoulders pattern. Ascending Triangle This bullish triangle is formed with lows that are getting higher and higher, although the highs (resistance) maintain a constant price level. The pattern gives a buy signal on the breakout above the upper trend line. 16

23 S U C C E S S S T O C K M A R K E T Descending Triangle This bearish triangle is formed with highs that are getting lower and lower, although the lows (support) maintain a constant price level. The pattern gives a buy signal on the breakout below the lower trend line. Copyright 2013 SuccessStockMarket.com. All rights Reserved. Terms of use apply 17

24 Triangle This pattern can be bullish or bearish and is often called a wedge or a pennant. A breakout occurs when the stock breaks out either above or below its support/resistance lines. This breakout most often comes on increased volume and breaks in the direction of the previous trend. 18

25 S U C C E S S S T O C K M A R K E T Chapter 3 Options Since the early seventies, investors have been jumping on the option trading bandwagon, causing the option trading volume to grow so quickly that it is now supported by nine different option exchanges. If an investor buys an option contract from one of these nine exchanges, they now own a contract that allows them to buy or sell a stock at a set price, anytime they want as long as they do it before the expiration date. Have you ever bought one of the Entertainment coupon books that are sold at the beginning of each year? Perhaps you have and you paid $40.00 for it. Inside the book are hundreds of coupons for you to use at your leisure. Each one of these coupons is an option contract that you entered into when you paid for the book. It allows you to buy something at a set price, anytime you want as long as you do it before it expires. The seller of the stock option contract (the business within the Entertainment book that advertised the coupon) is obligated to sell you the underlying product at the price agreed upon in the option contract and to do so the moment you decide to exercise that option. In the stock trading arena, these types of coupons are known as call options. Copyright 2013 SuccessStockMarket.com. All rights Reserved. Terms of use apply 19

26 Options on stocks which allow you to sell your current shares at an agreed upon price in the future are known as put options. You buy calls on stocks you want to go up in price, and you buy puts on stocks you want to go down in price. If you think about it, you ve probably been trading options for generations and you just didn t know it. Now before you start thinking you ve been an excellent coupon clipper and this now makes you a seasoned and profitable stock options trader, we need to cover a bit more information. Call Options When you buy a call option, your option contract gives you the option of buying a stock in the future at a set price before the contract expires. If this stock begins to rally higher, the call option becomes more and more valuable due to the fact that you are able to still buy the stock at the price that was listed in your option contract. Remember the seller of the option contract will have to sell you the stock at the agreed upon price if you decide to exercise your option contract. Example: Assume XYZ company shares are trading at $30 right now. You buy a call option contract that allows you to buy XYZ shares at $30 any time before the contract expiration in 2 months. 1 month later, XYZ company shares are trading at $40. You still own the right to buy XYZ at $30 through the call option contract. Stock Option Trading is exactly like two persons betting against each other. The person who speculates that the price of a stock is going to go up in price would buy a call option. The person who speculates that the price of a stock will go down in price would sell a call option. You buy call options on stocks if you think they will go up in price If the option seller was correct and the price of the stock drops in price, the seller of the call option contract, known as the writer, wins. This allows the seller to keep the money the option buyer paid when buying the call option. 20

27 S U C C E S S S T O C K M A R K E T If the option buyer was correct and the price of the stock increased in price, the buyer of the call option contract wins. This allows the buyer to exercise their contract and buy the stock at the lower price. The option buyer has more choices including selling the option for a profit and not exercising it, but we ll cover this a bit later. Put Options Once you get the grasp of a call option, it will start to seem straight forward. Put options, however, can take a little longer. If you buy a call option on a stock you want to go up in price, you would then buy a put option on a stock you want to go down in price. You buy put options on stocks if you think they will go down in price Buying a put option on a stock buys you the option to put a stock (selling it) into someone s account, at a set price before the option contract expires. If the stock drops in price, the put option becomes more and more valuable due to the fact that you are still able to sell your stock at the higher agreed upon price to the seller of the put stock options. In the example above, the buyer of the put option wanted the stock to drop in price, the seller (writer) of the put option wanted the stock to go up in price. Had the stock actually gone up in price, the buyer of the put option contract would obviously not exercise the put option's right to sell the stock at the lower price and would just let the put option contract expire worthless. This would allow the seller of the put option contract to keep the money they received for selling the put option. If the stock falls, the buyer of the put option contract would still be able to sell the stock to the seller at the higher price, making a profit. Sellers of put options feel that the stock will go up, while buyers of put options feel that the stock will go down. Keeping the option concept simple, a buyer of a call option can profit when the stock goes up, and the buyer of put options profit when the stock goes down. Conversely, the seller of call options profit when the stock goes down, and the seller of put stock options profit when the stock goes up. I m sure that by now you re confused, so let s move on to the next topic and come back to the huge advantages along with the indepth details when we cover some basic and advanced options. Copyright 2013 SuccessStockMarket.com. All rights Reserved. Terms of use apply 21

28 Risks of Trading Options When you purchase a stock option contract, you re buying time. This time allows you the option of exercising or selling your stock option contract at any time, before it expires. The downside to this is that you are paying for time. This time frame can be a risk factor if it runs out prior to your stock moving in the correct direction. Not all stocks go straight up and if it takes 4 months for your stock to increase in value and you only bought 3 months of time, you may end up losing your investment. Because stock options also have more choices, different strike prices, expiration months, calls, puts, spreads they are considered to be more difficult than trading a stock which only allows you to buy or sell. Market Maker Manipulation One last risk in trading stock options is the manipulation that can happen from the market makers. A market maker is the person on the other end of each transaction. Each time you buy, they are the seller, each time you sell, they are the buyer. Since they are the ones who set the prices, they will often times change the rules. It s important to watch the option prices daily to see if any inconsistencies start to emerge. You ll learn to do this as you master the spread trading portion of this training. All new option traders should also receive a booklet called The Characteristic and Risks of Standard Options. Your broker should provide you a copy of this publication when you open up an options 22

29 S U C C E S S S T O C K M A R K E T account. You can also download one from the Options Clearing Corporation, Advantages of Trading Options Sometimes a risk can also be an advantage. An experienced investor will find the various ways to trade an option an advantage, whereas a newer investor might find it more of a risk. Since you are able to buy long and sell short as well as combine different expiration months and strike prices, trading options allows for a lot more choices. Nine Different Exchanges Options currently trade on nine different exchanges and what this means for you is better fills. Since these nine different exchanges are all trying to get your business, you ll benefit from the competition. Copyright 2013 SuccessStockMarket.com. All rights Reserved. Terms of use apply 23

30 Less Expensive Buying a stock can be expensive, especially if it is trading near $100 per share. Buying an option to buy that same stock might only cost you a few dollars. Remember when you buy an option contract you are not buying the stock, you are only buying time, time for you to decide if you want to actually buy the stock. Many Types of Strategies The most basic of options involves buying a call or put option. There are, however, just about as many different types of an option trade as you can think of. Some of the more popular include buying a time spread, selling a time spread, LEAPS, Straddles, Strangles, and Iron Condors. Leverage and Defined Risk We already talked about how little an option can cost compared to the price of the stock, but another great advantage is that this reduced price is the maximum amount you can lose on the trade, if you are an options buyer. If you buy an option for $2.00 per share, the most you can lose is $2.00 per share. Portfolio Insurance Many of the stocks in your portfolio may be optionable and if so, you can buy longer-term put options on them. Perhaps you pay $5.00 per share for a put option that expires in 12 months. This put is on ABC stock that you currently own and which is trading at $100 per share. If your stock drops in price to $85.00 over the next year, you ll still be able to sell it for $100 since you bought a put option to do so. In effect, you bought insurance on a stock in your portfolio. If the stock went up in price to $115 you will lose the $5.00 per share you paid for the put option and make $15 per share on the stock for a total profit of $10 per share. You can also buy call and put options on indices like the Dow Jones 30, NASDAQ and the S&P 500 for a more broad market approach. 24

31 S U C C E S S S T O C K M A R K E T Setting up an Option Account Before you begin to trade options, you ll need to set up an account. It s different from your regular stock account and requires additional paperwork. Although additional paperwork is required, the options trading account will be added to your current brokerage account. It will be two parts of the same account, much like a checking and saving account. They are both separate but under the same account number and owner name. When filling out the paperwork for your options trading account, you will be asked a series of questions. Depending on how you answer these questions, you will be given different levels of options trading. These levels range from level 1 to level 4. There are times when you ll want to make sure you have level 4 so that you can unwind a spread or repair a good trade gone bad. Option Commissions Options, like stocks, have a commission to be paid for each transaction. Since you re the one finding the trades, managing the trades and placing the trades, there is no reason to pay a high amount for each trade commission. If all other brokerage firm comparisons are equal, the one with the lower commission rates might be your better choice. Copyright 2013 SuccessStockMarket.com. All rights Reserved. Terms of use apply 25

32 Option Terms Long & Short These are two terms you will hear on almost every option trade. It does not refer to the length of time but to the ownership instead. If you are long an option call, you own the call. So if you buy an August $25 call on a stock, you are said to be long the August $25 call. If you are short an option call, you have sold it without owning it. I know it may sound strange to be short a call but it is something you will do with every covered call trade, our next option strategy. Exercised This option term refers to the word option in a call or put option. When you go long (buy) a call option, you have purchased a contract that gives you the option to buy the stock. If you call your broker and tell them to exercise the contract, you are telling them to buy the stock at the agreed upon price that is within the contract. 26

33 S U C C E S S S T O C K M A R K E T If you went long (bought) a put option and at some point before the put option expires, you call your broker and tell them to exercise the contract, you are telling them to sell the stock at the agreed upon price that is within the contract. Assigned When you go long a call or put, you have the option of exercising it. If you go short (sell) a call or put option, someone else has the option of exercising their call or put option contract on you. This is called being assigned. Spread The term spread can be used several different ways, depending on what you are looking at. It can be a type of strategy and if so, a spread strategy is one that involves more than one option. An example might be to buy a call option for the current month (also known as front month) and then sell a call option for the same month at a higher strike price. This is called a vertical debit spread or bull call spread. A second way a spread might be used is to announce the dollar amount between the two option contracts. In the above example, we would be long the $35 call and short the $40 call for a $5.00 spread. Lastly, the term spread could simply be used to show the difference between the bid and ask for the option or options. Perhaps you are looking at buying a January $25 call and the price is $2.00 x $2.10, the spread is $0.10. Call Option Example Starting with the Success Stock Market website, pick your overall market direction. In this example you believe the market is bullish so you go to the stock scanner and click on the Good Stock Scan. When the stocks come up, you look for a buy signal; perhaps one that just bounced up off support on strong volume. Copyright 2013 SuccessStockMarket.com. All rights Reserved. Terms of use apply 27

34 The stock you find is trading $100. You are thinking of a longer-term investment and decide to buy a $100 call option that is good for 2 years and you pay $15 for the option. You are now long the call. Over the next 2 years the stock has a series of ups and downs but over time it has increased to $140 per share. You have two choices for the call option you own. You can exercise it to buy the stock at $100. Since you paid $15 for this right your cost basis in the stock will be $115, and with the stock currently at $140 you have a $25 profit. You could also sell the call option. If the stock is at $140 and you have the right to buy the stock at $100, you can sell the call option for difference of $40. We ll cover more on option pricing in a moment. Don t worry about finding a buyer for the call if you decide to sell it, there will always be someone who will buy it. If for some reason you don t do anything with the call option and forget you have it, your broker will automatically exercise the call for you. If you don t have enough money in your account to buy the stock, your broker will exercise the call, buy the stock at $100 and then sell it for you at $140 leaving you with your $25 profit minus commissions. 28

35 S U C C E S S S T O C K M A R K E T Put Option Example You have a couple of choices here, either you look for a down trending stock with bad fundamentals using the Success Stock Market website Bad Stock scan, or you find a stock in your current portfolio that you believe is breaking support and about to head lower. Your stock is currently trading at $100 so to protect your position, you buy a 2 year put option for $15 that allows you to sell your stock for $100 anytime you want within the next 2 years. At first it seemed as if your stock was going to bounce higher but over time your stock falls to $60. You have two choices for the put option you own. You can exercise it to sell the stock at $100. Instead of a $40 loss, your loss is contained to $15 since that is what you paid for the put option contract. You can think of this much like buying insurance on your house. If there is some major damage, you are covered but you re still out the premium you paid for the insurance policy. Copyright 2013 SuccessStockMarket.com. All rights Reserved. Terms of use apply 29

36 Your second choice might be to just sell the put option. If the stock is at $60 and you have the right to sell the stock at $100, you can sell the call option for difference of $40. You might do this vs. exercising the put option if your stock is at a support and appears ready to bounce higher. If you were wrong on buying the put and the stock never broke support and over the next two years it starts to move higher, you are out the $15 you paid for the put option. You can think of this as a cost of doing business, buying an insurance policy just in case it is needed. Hopefully your stock increased enough to more than make up the difference. Elements of an Option Each standard option contract you purchase gives you the right to buy 100 shares of stock. Each standard option contract you sell gives someone else the right to buy 100 shares of stock from you. Occasionally, you will see a nonstandard contract which might be from a split or merger. 30

37 S U C C E S S S T O C K M A R K E T Expiration Dates All options have an expiration date. It used to be fairly simple to explain them but with new and different options being created, it becomes a bit more difficult. We ll cover the 3 most common ones. 1) Monthly these expire at 11:59 am on the Saturday that follows the third Friday of the month. 2) Weekly these expire at the close of the trading day every Friday. 3) Quarterly these expire at the close of day on the last trading day of each quarter. There will always be exceptions to these expiration dates (holidays), so it s best to check with your broker to make sure there have been no changes. You can also find out more on the CBOE website. Strike Price The strike price is the price at which you strike a deal, the price at which you agree to buy or sell the stock. These might trade in $1 increments, $2.50 increments, $5 increments or $10 increments. If you buy a January $25 call your strike is $25. Premium Every time you buy an option, you pay what is known as the premium or if you sell an option, you receive a premium. If you pay $2 for a January $25 call, the premium you paid is $2. In the example above for VECO, the expiration is monthly and for the May $50 call option the premium quoted is $2.25 x $2.40. If you want to buy the May $50 call, it will cost you $2.40 per share and if you want to Copyright 2013 SuccessStockMarket.com. All rights Reserved. Terms of use apply 31

38 sell the May $50 call, you will receive $2.25 per share. This bid/ask spread is $0.15. Option Greeks There are no Greek mythological figures floating around the trading floors but many investors do like to use option Greeks in their analysis. These include Delta, Theta, Gamma, Rho and Vega. The two that we ll be using for this level of training include Delta and Theta. Delta Delta is the rate of change within your option price based on the movement of the stock, ETF or index you re trading. It is said that a call option with a Delta of.89 will see the call option price increase $.89 for every one dollar the stock price moves up. A delta of.49 will see the call option price increase $0.49 for every one dollar the stock price moves up. Theta Theta is often referred to as the amount an option price will decay (drop in value) each day of the week. If you have a 30 day option, it will have to drop in price every day that the stock does not move in price. This amount that it drops is called Theta. We often refer to Theta as an ice cube the closer your option gets towards its expiration date the faster the Theta (ice cube) will melt away. All options expire on expiration day with no Theta value. 32

39 S U C C E S S S T O C K M A R K E T An option with a Theta of $-0.06 will drop $0.06 per day in value for every day the stock does not move. There will be times when the option Theta increases in price or decreases in price, so it is beneficial to watch this number. Some influences to the Theta would come from the stock price increasing or decreasing or changes to the implied volatility. Copyright 2013 SuccessStockMarket.com. All rights Reserved. Terms of use apply 33

40 Intrinsic Value Intrinsic value is the number of points an option is in-the-money; intrinsic value tracks the changes in the underlying stock, ETF or index based on a one point basis. We will refer to intrinsic value as the amount of equity an option has. If you paid $3 for a $50 call option and the stock price is currently at $52 per share, the intrinsic value would be $2 per share. Extrinsic Value This is the portion of the option that is not intrinsic value (equity). Using the previous example, if you purchased a $50 call option for $3 and the stock price was $52, your intrinsic value (equity) would be $2 leaving $1 remaining as the extrinsic value of the option. We also refer to this cost as time premium, the amount we paid to own the option before it expires. All option premiums have only two parts, intrinsic and extrinsic or equity and time value. With the VECO example on the next page, the stock is at $50.77 but the May $50 call is trading for $2.10. Since the intrinsic value (equity) of the May $50 call has to be $0.77, the remaining amount is the extrinsic value or time value of the option. In this case $ $0.77 = $1.33. This is the amount you ll need the stock to move higher just to break even on the trade, providing you held it to expiration. 34

41 S U C C E S S S T O C K M A R K E T Option Volume Options like stock do have volume. The only difference is that with options, it tells us the total number of option contracts that have been bought or sold for each and every strike price for the trading day. In the example of VECO below, the May $50 calls have traded 328 contracts today. This includes both contracts that have been bought or sold. Open Interest If option volume is the total number of contracts that have been bought or sold for the current day, open interest would then be the total number of contracts that have been bought or sold and not closed out. An example would be if you and only you bought 10 contracts of a call option, the daily volume would be 10. The next morning the daily volume would reset itself to 0 but the open interest would now say 10. If someone else bought 5 contracts of the same month and strike price, then the daily volume for that option would say 5 and the next day the open interest would say 15. Not until you close your positions will the open interest drop. Historical Volatility Any time the word historical is used, it is meant to give us a sense of past performance. This can be used in helping to predict the price one is willing to pay for an option. If we know how volatile a stock has been in the past, we can project what we are willing to pay in the future. In the option market, historical volatility really refers to a stock s past closing price movements over a set period of time. Six months to one year are the most common time frames used. A $100 stock with a historical volatility of 25% means the stock could trade between $125 and $75. Implied Volatility This comes directly from the current price of an option and is what changes the extrinsic or time value of an option. An easy way to think of this is the volatility or expected move in the stock in order for the option to become profitable. Although this was a simplified explanation, it s not necessary to understand all of the mathematical calculations that go into implied volatility. Copyright 2013 SuccessStockMarket.com. All rights Reserved. Terms of use apply 35

42 Since it is possible for the option market maker to change the option price at any time for any reason, thereby changing the implied volatility, trying to figure out the correct pricing for implied volatility is a futile procedure. This does not mean that implied volatility is useless, quite the contrary, it can still be used to let you know if you are overpaying for something. A stock with a historical volatility Rule of Thumb: If the IV is 20% or more than the HV, the options is over valued of 41% and an implied volatility of 45% are quite similar. If however, the stock has a historical volatility of 20% and the current implied volatility of the option you are looking at is 45%, then you know that the option is being overpriced compared to its historical levels. In this case, selling an option since it is overpriced may be the best approach. Some factors that may alter an option s implied volatility are stocks coming up on earnings, FDA announcements, lawsuits, sector news, dividends and any unusual buying activity. In, At and Out-of-the-Money When the stock price is higher than your call option s strike price, the option is in-the-money. If the stock is at $35 and you have a $30 call 36

43 S U C C E S S S T O C K M A R K E T option, your call option is in-themoney by $5. For put options, it is the complete reverse. If the stock is at $35 and you have a $40 put option, your option is inthe-money by $5. Keep in mind when you buy call options you benefit when the stock goes up, and when you buy put options you benefit when the stock goes down. Regardless of if you re buying a call or put option, if the stock price is at $35 and you purchase a $35 call or a $35 put option it is referred to as an at-themoney option since the stock and option strike price are equal. Typically buying an at-the-money call or put option tends to be the highest overpriced option, so be careful. When purchasing a call option, if the strike price is higher than the current price of the stock it is called an out-of-the-money option. If the stock is at $35 per In-the-money: The option has intrinsic value At-the-money: The strike price is equal to the stock price Out-of-the-money: The option has no intrinsic value share and you purchase the $40 call option, you now have the right to buy the stock for $5 more than it s worth. These out-of-the-money options often expire worthless, and you lose the entire cost of the option. If an out-of-the-money call is higher than the current stock price, an outof-the-money put is lower than the current stock price. If a stock is trading at $35 per share and you buy a January $30 put, your put option is out-of-the-money. Out-of-the-money call and put options have a certain lure to new investors, mostly because they re cheap. They are cheap for a reason; institutional money is not buying them, so in order to attract new investors they are priced attractively. In the example below for VECO, the stock is trading at $50.77 with the May $50 call trading at $1.95 x $2.10. The May $60 call is trading at a mere $0.05 x $0.15. Obviously the buy price of $0.15 for the May $60 call is much cheaper than the buy price for the May $50 call, so why then doesn t everyone buy the May $60 calls instead of the May $50 calls? Copyright 2013 SuccessStockMarket.com. All rights Reserved. Terms of use apply 37

44 It all comes down to money and in this case keeping it. If you pay $0.15 for the May $60 call, you are paying $0.15 to buy VECO at $60 leaving you a breakeven price of $ If you pay $2.10 for the May $50 call, you are paying $2.10 to buy VECO at $50 leaving you a breakeven price of $ With the stock currently trading at $50.77 and only 3 weeks of time left before the option expires, there is a much better chance that the stock will make it to $52.10 than to $ Suppose the stock rallies to $55. The May $50 call will be worth $5 and the May $60 call will expire worthless. 38

45 S U C C E S S S T O C K M A R K E T Chapter 4 Buying Calls & Puts You ve got the background covered on what an option is and how it works; it s now time to cover usable strategies for cash flow. Buying a call option can be a short-term trade or even a longer-term investment as with a LEAPS option. We are going to devote this chapter to more of a position trade, approximately 3 to 8 weeks. Risks The risk of loss is limited to the premium paid for the option. It is possible to lose 100% of your investment. Advantages A positive move in the underlying stock can produce a large leveraged move in the option premium. Copyright 2013 SuccessStockMarket.com. All rights Reserved. Terms of use apply 39

46 Reasons for Movement There are several reasons for a stock to move and anyone of them can cause a drastic change in the stock s price. Listed above in no particular order are: Earnings Just prior to earnings being released, many stocks will see some increased buying as investors try and jump into a position ahead of the release to benefit from any potential positive announcement. After earnings are out, there is still likely to be some continued buying if the earnings were positive or better than expected. It s always a good idea to visit past earnings announcements to get an idea of how the stock behaved prior to and after an announcement. Mergers When a company is a potential takeover target, investors try and benefit from the increased buy offers from its suitors. For example, Company A has a lot of free cash in its portfolio, has no debt and continues to increase its market share. Company B likes Company A and sees a strategic fit from buying the entire company. Company B makes an offer to buy Company A at $50 per share even though company A s stock is only trading at $40 per share. Company C becomes aware of this potential buyout or merger and makes an offer to buy Company A for $55 per share. These types of potential buyouts or mergers can be very lucrative, but it is best to study this pattern prior to trading any of them as there are some downsides as well. If both Company B and company C withdraw their offers or they are both refused, Company A s stock could drop right back down to $40 per share. 40

47 S U C C E S S S T O C K M A R K E T Stock Splits There are a great deal of investors who prefer to trade stock split announcements more than just about any other type of trade. The reason for this is really quite simple. If you re going to look for a stock that has a chance of moving, why not just have someone give you the list of the best potential candidates and then actually give you the dates they are expected to move on. This is exactly what you get with stock splits. Since a stock split is a form of a dividend, when a company announces their split they are actually giving you a stock dividend. To do this, they need to vote on it and then record it in the company files. This information is all public and accessible to all investors. Many financial websites will list these dates for you, so all you have to then do is find the stock you re interested in and match it up to a historical stock split pattern and you are ready to go. A typical split might be a 2:1, read as a 2 for 1, or a 3:2. If the stock has a 2:1 split, it means that for every 1 share you have at the current price, you will soon have 2 at half the price. So if you have 300 shares of a $100 stock, after the split you will have 600 shares of a $50 stock. Your total dollar amount will still be the same, but you now have double the amount of shares to work with. Copyright 2013 SuccessStockMarket.com. All rights Reserved. Terms of use apply 41

48 It s important to note here that when your stock splits, your options also split, but your orders to buy or sell do not. Stock Split Trade #1 Prior to the announcement, a potential stock split company might see some increased buying as investors try and jump in ahead of the news. Investors will use previous split announcements, shareholder meetings and company filings to help predict this event. Stock Split Trade #2 On the actual announcement, the news generally sends the stock higher, not so much because of the split announcement but because most stock split announcements come alongside of an earnings release. This move up does not last long, perhaps only a few days since many investors who jumped into the trade #1 will be taking their profits. Stock Split Trade #3 After the news has played out and the initial profit-taking has passed, investors will look at the up trending stock, now on a pullback and at a support and view it as a nice technical entry. 42

49 S U C C E S S S T O C K M A R K E T Stock Split Trade #4 Remember it is news that causes a stock to have magnified moves, so with the upcoming split only 3 or 4 days away, investors will often start buying again. They do this to take advantage of the split knowing that many stocks have a bump up in price just before the actual split. Stock Split Trade #5 This trade comes after the actual split, usually a couple of weeks. After the news is all played out and the short-term traders have all closed out, investors will look for a longer-term buy and hold trade. Remember, the stock was an up trending stock with positive news and strong earnings prior to the announcement. Unless the management team is changed out or economic devastation hits the company, the stock should continue to trend higher. Stocks splits can be an exciting and rewarding way of trading but Trade #5 can be a great setup like any type of options trade, for LEAPS and diagonal spreads they too can unexpectedly move in the opposite direction. You ll also find stock splits to be more plentiful during times of economic expansion. A few terms you should understand when dealing with stock splits include: -Announcement date, the date the company announced the split -Split Date, the day the stock splits, happens after the close -Ex Date, the day after the split Stock Buy-Backs To reduce the number of company shares out on the market for the public to buy (known as the float), a company might decide to buy back some of these shares. This supply/demand scenario will make the remaining shares more valuable causing the stock price to increase. Add to this the buying that is going on while the company buys these shares, and it adds up to increased share prices. Institutional Buying Institutions are the large players in the markets and include hedge funds, pension funds, insurance companies, banks When these large portfolio managers decide to buy, they do so in much larger quantities than the regular retail trader. There are thousands of institutional investors but only a small number of stocks are available to them. Copyright 2013 SuccessStockMarket.com. All rights Reserved. Terms of use apply 43

50 An institutional investor wanting to buy 1 million shares of a stock might not be able to buy shares of smaller companies and instead will have to stick with the more highly liquid stocks. United Stationers, USTR, below is trading in a nice up trend and trades below both its Fair Value and the Analyst s Target Price. However, since the average daily volume is less than 93,000, most institutions will not trade it. Suppose you were one of 20 different institutional money managers who each owned 1 million shares of the stock. The stock has some bad news and you wanted to quickly sell the stock. How could the stock handle the selling volume of up to 20 million shares, all at once, when the average daily volume is less than 93,000? By the time you finally exited the stock, the price might be less than 1/2 of where you got into it. This is one of the reasons you will see us, at Success, stick to stocks with higher volume. To use institutional buying or selling within your trading strategies, find a stock that has some unusual buying or selling for the day. For a bullish signal, look for a stock where the buying for the day is more than 150% of the 20 day average. If USTR has an average 20 day volume of 92,510, an institutional volume spike would be above 138,765. There are times when an institutional buying spike can carry more weight. 44

51 S U C C E S S S T O C K M A R K E T Institutional Buying #1 If the buying spike is followed by a second heavy day of buying, it indicates the willingness of the institutions to continue to buy meaning that they may be bullish longer-term and continue to buy during any pullbacks. Remember, it may take an institution up to a month before they are able to acquire all their positions in a particular stock and since there may be multiple institutions all buying off the same news, it could be an extended rally. For the stock RBCN below, you can see the large volume spike towards the end of February, causing the stock to gap open. Look how the volume remained strong and above the 20 day average line for much of the next 4 weeks as the institutions kept adding to their positions. Institutional Buying #2 One of our favorite institutional trades comes from a trend reversal gap. This is where a stock is trending, has some news and gaps open the next morning in the opposite direction. This will work best on a Good Stock or Almost Good Stock if the stock was trending lower but not in a strong down trend. In the stock below of 51job Inc. JOBS, the stock s overall trend was up but for the past month had been moving to the downside. Then some Copyright 2013 SuccessStockMarket.com. All rights Reserved. Terms of use apply 45

52 positive news was released, and institutions jumped into a buying frenzy at the opening bell. Additional benefits for this particular trade are that the stock is listed as a Good Stock on the Success Stock Market website and the reversal happened at a previous support area. Institutional Buying #3 Using the example for Semtech, SMTC, below: When a stock breaks through resistance on heavy buying, the resistance is now new support paving the way for higher highs. This 46

53 S U C C E S S S T O C K M A R K E T happened with SMTC in early April as the stock closed above its $25 resistance on heavy buying. If a stock does have an institutional buying or selling spike and is not able to close above or below its support or resistance, then the institutional trading for that day can be discounted. In SMTC above, the stock was trending sideways and in early March the company had some negative news causing the stock to drop to the $22.50 support on extremely heavy selling volume. Although it looked negative, the stock failed to actually close under its support level. Without a trend change, broken support or resistance, the heavy volume should not be considered significant enough for you to react. Technical Analysis The last major topic for us to cover on what makes a stock move is through technical analysis. Investors buy and sell based on the projection of a potential profit. To find a projection for the stock we will look backwards for a pattern. If you re bullish, you might start with the Success Trading Tools Good Stock search and then look for a pattern that has a more likely chance of bringing in a profit. This might include a stock that is undervalued using the DCF and Analyst s Target Price as well as a technical pattern of a support bounce off a higher low. All investors will look for something different when it comes to a recognizable, tradable pattern, but if you can focus on a few of the more common patterns combined with the trend, volume and a couple of indicators you ll soon be able to quickly scan for some ideal opportunities. It should be noted that technical analysis, combined with fundamentals and news make the best trading candidates. Copyright 2013 SuccessStockMarket.com. All rights Reserved. Terms of use apply 47

54 Buying a Call The most common strategy for a new investor to learn in the world of option trading is buying a call or put. If this is where you want to trade, there are certain steps for you to follow and know prior to your investment. Pick a Bullish or Bearish Trend It s always best to trade with the trend so to start off, take a look at the S&P 500 and the NASDAQ 9-month charts and look for a trend that you re comfortable with. If you naturally look at shorter-term trends, then you should look for a shorter-term trade. If you look at longer-term trends, you should look at a longer-term trade. Don t look for a 6-month trend and then try and place a 3-week trade off of it. The ideal scenario would be to find both a long-term trend and a new shorter-term trend, both moving in the same direction and then trade in that direction. Always trade in the direction of the trend 48

55 S U C C E S S S T O C K M A R K E T Find a Stock to Trade After some time, you ll have your own favorite way of finding a stock to trade. You might start with the Success Stock Market stock scanner, or take a stock pick from the LEAPS or Covered call section of the site or even trade from a stock that you have in your watch list, portfolio or saw on T.V. Whatever method you use, you ll want to pick one that trades in the same direction of the overall market trend. Check the Chart You re going to spend some time reading and analyzing the chart so the better you are at technical analysis, the easier this strategy will be for you. The analysis you ll want to perform for a bullish trade should include: 1) Trend, overall and current and should be more bullish than neutral. 2) Current price location, is it bouncing up off support or breaking through resistance? 3) Volume, is it increasing as it bounces or breaks through resistance? 4) Green arrows, are the MACD s, Coval Indicator and Moving Average, more bullish than neutral? Below is a chart of HIG. The overall trend is sideways and the most recent trend is up. This came after the stock just bounced up off the $26 support. This is a higher low than the previous support at $25 from the previous month. Copyright 2013 SuccessStockMarket.com. All rights Reserved. Terms of use apply 49

56 The volume is not increasing, so we should not expect to see anything different than the normal trading pattern. A high volume buying spike from a positive news story would have been nice but for this example, we will work with the current pick. We have 2 new green arrows on the Moving Average and the MACD, and the Coval indicator is just about to give a green arrow. Everything looks as though the stock is ready for another move up. But how high will it go, and how long should it take for the stock to get there is the question. Pick the Expiration Month This is a fairly straightforward example and can be used with most types of option trades. Start with a 6, 9 or 12-month chart. Take a look at each time the stock bounced up off a support level and then track how long it took to reach resistance before pulling back. Add to this amount 1 extra month for a margin of safety (this is what you ll use to adjust the trade if necessary), and you ve calculated the amount of time you ll want to buy for your trade. If your time frame came out to 9 weeks and the stock has 50

57 S U C C E S S S T O C K M A R K E T an option cycle that only goes 4 weeks, 8 weeks and then 16 weeks, you ll need to buy the extra time. In the example below on HIG, the stock has bounced up off a support four times over the past 6 months. Each time the stock bounced, it took 3 to 4 weeks before the stock hit a short-term resistance and pulled back. If we average this up to 4 weeks and then add 1 extra month for safety, we know we ll need about 8 weeks of time for this trade.. Copyright 2013 SuccessStockMarket.com. All rights Reserved. Terms of use apply 51

58 The current month is May and these have about 4 weeks to go before they expire. The next month is June which would add another 4 weeks to our time line. If you were to purchase the June calls, you would have enough time for the stock to make its average move of 4 weeks plus the 1 extra month of time necessary in case you need to alter or attempt to repair the trade. If we needed to have 9 weeks of time for our trade, you would then have to bypass June and go out to the next available month which is September. Even though you do not initially need that much time, it is best to have more than you need and sell it back to the market maker when you close the trade. Pick a Strike Price Similar to picking an expiration month, we are going to look at the average point move this particular stock makes each time it bounces up off a support level. The first bounce was 5 points. The second bounce was 2 points. The third bounce was 5 points. The fourth bounce was 4 points Average these out, and you have four bounces for a total of 16 points. 16 points divided by 4 equals 4. In other words, the average bounce this stock has performed, over the past 6 months was 4 points. And it took on average 4 weeks each time the stock bounced 4 points. You should not be so trusting as to believe that there is a 100% guarantee that this stock will bounce 4 points over the next 4 weeks, but we do have an excellent starting point for our trade. We are building several safety nets into this strategy, which will give us added cushion to further manage the trade if necessary. 52

59 S U C C E S S S T O C K M A R K E T If the last support that the stock bounced up off of was $27 and the expected bounce is $4, based on the calculated 6-month average, the projected target price for the stock is $31. -Support $27 -Expected bounce $4 -Target price $31 If $31 is our target price and we are working with the June options, you can start working backwards off the June HIG call option chain to find your strike price. The mathematical calculation you will use here is the strike price + ask price should be less than target price. Copyright 2013 SuccessStockMarket.com. All rights Reserved. Terms of use apply 53

60 If you know that your breakeven price for an option is your cost, you know that you have to add the purchase price of an option to the strike price to get your breakeven price. In other words, if you pay $1 (option premium) to buy a stock for $15 (strike price), you are really paying $16 for the stock. June $40 call + $0.08 for the ask price = $40.08 June $35 call + $0.05 for the ask price = $35.05 June $34 call + $0.08 for the ask price = $34.08 June $33 call + $0.06 for the ask price = $33.06 June $32 call + $0.10 for the ask price = $32.10 June $31 call + $0.17 for the ask price = $31.17 No Profits with the above strike prices June $30 call + $0.31 for the ask price = $30.31 June $29 call + $0.55 for the ask price = $29.55 June $28 call + $0.91 for the ask price = $28.91 June $27 call + $1.41 for the ask price = $28.41 June $26 call + $2.05 for the ask price = $28.05 June $25 call + $2.82 for the ask price = $27.82 Some profits with the above strike prices Strike Price Target Price Breakeven % Return June $30 call $31 $ % June $29 call $31 $ % June $28 call $31 $ % June $27 call $31 $ % June $26 call $31 $ % June $25 call $31 $ % The % Return column is calculated by the mathematical formula of profit divided by investment. The profit is the total dollar profit (target price minus breakeven price) and the investment is the ask option premium. Using our first example of the June $30 call, your purchase price is $0.31. If the stock makes it to $31 you ll be able to sell the June $30 call for $1.00 leaving you a $0.69 profit on your $0.31 investment for a 222% return. Buying the June $29 call option gives you a 263% return. As you continue to move down the list of strike prices you see a diminishing 54

61 S U C C E S S S T O C K M A R K E T rate of return. So in the case of HIG, buying the June $29 call option for $0.55 appears to be the best strike price and month. It may seem to be a staggering amount of work trying to pick the correct strike price, but it gets much easier after a few examples. Pick the stock s average move in time and add an extra month for the expiration month you will purchase. Then find the stock s average point move, add it to the current support or broken resistance level for your expected target price. Now to find a profitable option, just make sure that the option strike price plus the option ask price total up to less than your target price. Plan your Exit(s) There is always more than one exit for every trade and thinking that HIG will hit $31 in 4 weeks or less is not what this training is for. Based on historical averages, you have been able to extrapolate a projected target. This target may or may not be hit, so you will want to have 3 exits in mind an upside target, a sideways target and a downside target. Believe it or not, the worst thing HIG could do at this point is move sideways. Upside Exit Once you buy the June $29 call for $0.55, you will want to immediately place a GTC to sell to close the call at a limit of $2. The reason for this is that stocks will often have intraday spikes in them and if HIG suddenly spikes up to $31 you will want your sell order in and waiting. Copyright 2013 SuccessStockMarket.com. All rights Reserved. Terms of use apply 55

62 You will also want to monitor the stock on a nightly basis. It is possible for the stock to have some positive news and begin to build up on the institutional buying. If you see the buying pressure start to build as the stock approaches your target of $31, you can always adjust your sell order to a higher price target. Sideways Exit When buying time, the hardest type of trade to monitor is one that moves sideways. Every day that passes, the Theta erodes a bit of the option premium. If your analysis had the stock moving up in price over the next few weeks and nothing is happening, you have a couple choices. Choice 1) You can close the trade and sell the June $29 call for the current price and thus lock in only a small loss. Choice 2) You can use the June $29 call as the long leg of a spread. This will allow you to sell time against the current position. This was the primary reason for buying the extra month of time in Step 4, picking an expiration month. You ll learn more about this strategy in the section on trading spreads. Downside Exit News or an unexpected downturn in the market can happen at any time. If this happens, you might see your stock reverse and start heading lower. The first thing to know here is that panicking is an emotional trait and is not helpful in the financial markets. If your stock is falling, you have a couple of choices here as well. 56

63 S U C C E S S S T O C K M A R K E T Choice 1) You can place an automated stop loss below the support level of $27. If the stock does not bounce higher and instead breaks support, you can sell to close the June $29 call closing the position with a slight loss. This is the most common method when dealing with a reversal, but it is not your only option. Choice 2) If this stock does break the support level at $27 and does so with increased volume, then there is a good chance the stock will continue to sell off. If this is the case, rolling into a bear call spread, selling a lower call, perhaps the May $25 call will put you into a neutral position. The goal here is to minimize any losses. Once the stock stops dropping and begins to bounce, you can then buy to close the May $25 call and let the June $29 call increase in value until you break even. At this point, you will want to close the trade. When you go into repair mode like this, you are no longer trying to make a profit; you are only trying to get back out of the trade as close to breakeven as possible. You ll learn more about this strategy in the section on trading spreads. Place Your Order As excited as you may be, you want to treat each investment as a potential loss. What this means is that if you did lose your investment, from this particular trade, how would it alter your trading? Copyright 2013 SuccessStockMarket.com. All rights Reserved. Terms of use apply 57

64 If it would cause you to close your account and stop trading altogether, then you have too much invested in this one trade. Position sizing is important if you want to continue to invest. Monitor your Position Each night after the market is closed is generally the best time to monitor your positions. Look for changes in patterns, volume spikes and news. Follow your exit(s) strategies if needed. 58

65 S U C C E S S S T O C K M A R K E T Chapter 5 Covered Calls One of the many benefits of learning to use options is how they can quickly add fun and profit to an out-of-date portfolio. Learning to sell calls against stocks you already own can be the edge you ve been looking for. The term writing covered calls can be broken down into 3 parts: Writing To write up an options contract to sell Covered You own what you are trying to sell Calls The type of option you ll use will be a call option Putting it all together, write up an option contract to sell something you own with a call option. Goals The number one goal for most call writers is to create some cash flow from stocks currently in their portfolio. If this is your goal, you ll want to pay attention to the technical analysis portion as it will help you time your entries and minimize the chances of being called away from your stock. Copyright 2013 SuccessStockMarket.com. All rights Reserved. Terms of use apply 59

66 Creating Cash Flow This can come from one of two ways either you look for the profits from selling the calls on the stock you own, or you specifically buy a stock with the intention of writing calls against it and the possibility of being assigned from time to time. Both methods can be a lucrative strategy but in the second scenario it s best to stay away from stocks with high premiums, as these are likely to be volatile stocks. Since your capital outlay for covered calls can be large, you re going to Stay away from volatile stocks want to do everything you can to make sure you do not lose large amounts of money on a volatile stock that takes a quick reversal. Protect Downside Moves Like with all other strategies, our method at Success is to teach our students to manage their investments and that through evaluation and planning, most trades can be adjusted if necessary. The typical thought for a covered call is to buy a stock and then sell a call at a price higher than the purchase price. So if you bought a stock at $24, you might then sell the $25 call. Most investors learn this one way to write a covered call, perhaps from a friend or a book and then never learned to really find the better stocks or how to manage them, ultimately ending up with discouraging or heartbreaking results. 60

67 S U C C E S S S T O C K M A R K E T One of the better uses of a covered call is really not even meant to be used for cash flow. It is used specifically to manage and help to reduce losses. Suppose you purchase a stock at $24 and are waiting for the stock to bounce up before you sell the $25 call (this is called legging in). After a couple of weeks of no action, the stock begins to drop in value. You might have some reason for not wanting to sell the stock including no change in trend, taxes, you like its long-term potential or the stock is a company stock. To offset the losses, you sell an in-the-money call option, perhaps the $20 call. For every dollar you lose on the stock, you ll make one back from the decrease of intrinsic value from the option. When the stock hits the next support and stops dropping, you ll want to consider buying to close the $20 call. In the below example, you can see that RBCN took a fall from $29 to $26. Now with the stock at $25.50 and still looking weak, selling the $22.50 calls for $3.30 or more would place you into a fairly neutral position. Every point that the stock drops, so does the intrinsic value of the option you sold. If the stock falls to the $23 support, the stock will have lost another $2.50 in value and the $22.50 call which you sold for $3.30 or better will also have dropped allowing you to buy it back at a reduced price. Copyright 2013 SuccessStockMarket.com. All rights Reserved. Terms of use apply 61

68 When the stock drops down to its support, you can decide if you want to sell another call for a covered call or wait for it to bounce slightly before selling the next call. Either way, your cost value in the stock has been reduced allowing you to get back to breakeven sooner. Stock Option Current Stock Price Current Price $3.00 Drops to Support at $23.00 Projected Price $1.00 Stock Loss $2.50 Option Profit $2.30 Risks and Advantages Assigned? When selling a call on a stock, there is always the possibility of being assigned (called out) on your position. If you do not want this to happen, the only safe way is to not sell a call. There are ways to minimize this risk, which will be covered when we outline when and how to sell the correct call option. Lose Potential Profits? When selling a call on a stock you own, you will want to consider some technical analysis and any upcoming announcements that could alter the stock s movement. If the stock has a sudden bout of positive news, it 62

69 S U C C E S S S T O C K M A R K E T could cause the stock to have a significant upside move up and above the strike price you sold. To avoid this, most covered call writers sell shorter time frames, thus giving them more opportunities to capitalize on upside moves. Stuck in a Down Trending Stock? As mentioned earlier, most option traders really never take the time or spend the money to learn their skill. In taking the easy route, they actually spend more money in terms of losses than they would have paid had they purchased a reputable course. When these new traders learn a basic covered call, they see it as a 3-step process. 1) Buy the stock 2) Sell the option 3) Wait for expiration to see what happens As we progress through this chapter, you will see that there are 6 and possibly 8 steps to a proper covered call. It is in Step 3 mentioned above where most new investors will pay their dues. Step 1: They find a stock they like Step 2: They sell a call option at the next higher strike price Step 3: They watch their stock turn south and fall on some unexpected bad news. On expiration day, the stock is down $10 from where they had bought the stock and their account is down $4,000 to $5,000 in their first month of trading. Copyright 2013 SuccessStockMarket.com. All rights Reserved. Terms of use apply 63

70 Now instead of selling the stock here, they decide to hang onto it until it bounces higher. Over the next 6 months, the stock drifts sideways with a few bounces but ultimately continues lower. Now the account is down $10,000, and the investor has convinced themselves that this is too difficult and not something they should have done. They do not realize it was really a lack of prior knowledge and education about other alternatives available to them. Potential Monthly Cash Flow The reason most investors look at covered calls is its simple transition from their current stock holdings. Since owning a stock is the second most common financial investment for U.S investors with a brokerage account, it s an easy way for them to see how selling a one-month call on their stock can bring in some extra cash flow. This can then be repeated throughout the year if the options sold are never exercised. Downside Protection If a stock in your portfolio is seeing some selling pressure, you have the opportunity to sell an in-the-money-call option to capture some declining intrinsic value to offset the loss in the stock s share price. Portfolio Growth Instead of taking out the profits from the sale of the options, you can use them to purchase more stocks to grow your portfolio. When you re ready for your first covered call trade, you ll want to go through the checklist below. It is best to have gone through the entire list ahead of time, including understanding when and where you might close or alter the trade if necessary. 64

71 S U C C E S S S T O C K M A R K E T Find or Increase Portfolio Potentials New investors in the covered call world will likely need to increase some of their holdings in order to write covered calls. Since each option contract sold is for 100 shares, you might need to add to some of your current positions to round the numbers up. Someone with 178 shares of a stock could purchase 22 more shares and then be able to sell 2 contracts versus just 1. Since mutual funds are not optionable, you might also consider selling some funds and transferring the proceeds into a diversified ETF. Since many ETF s are optionable, you now have more stocks to potentially sell calls against. Identify the Correct Timing You may or may not want to sell the stock in your portfolio. If not, then you will want to make sure you do your best to time your entry. Although no trade is guaranteed to work out perfectly, you can increase your chance of success with some common technical analysis. There are also additional ways to decrease the chance of being called out such as buying back to close the sold call if the stock rallies above the strike price sold. Copyright 2013 SuccessStockMarket.com. All rights Reserved. Terms of use apply 65

72 Using the technical analysis you ve learned up to this point, you can see that DIOD above has 3 red arrows and is breaking through the $32 support on increased volume. There is an excellent chance the stock will pull back to the next support at $30 or even $28. Check the Option Quotes It s generally best to look at the first month. You do not want to be obligated for too long. Giving yourself more monthly opportunities is always a better prospect. The stock is still in an overall uptrend, so you might not be thinking of selling your positions but you would like to capture some additional cash as the stock pulls back. If you sold the May $30 calls, you could bring in an additional $1.20 in revenue. This would help to offset the downside move the stock is experiencing. You could also sell the May $35 calls, but there is no market for these. You could sell the $25 calls, but these are bringing in only $4.80 and since the stock currently has $5.60 worth of intrinsic value compared to the May $25 calls, it is not a good balance. 66

73 S U C C E S S S T O C K M A R K E T Selling the May $30 calls will allow you to collect $0.60 in time value. As the stock drops to the $30 support, you will be able to profit from the decreased Theta as well as the decrease in intrinsic value. The May $25 call has no time value, so it has no Theta and the May $35 calls have no market. Picking which strike price for you to sell here was an easy choice. Copyright 2013 SuccessStockMarket.com. All rights Reserved. Terms of use apply 67

74 Sell the Call When selling the call option, it is placed as a single option trade with a Sell to Open transaction type. Since you do not currently own the May $30 call, you are opening up a new position, hence the Sell to Open. It s also a good idea to make the trade both a limit order and a day order. The limit order should be used so that you do not get any surprises. Placing a market order could get your order filled at any price, perhaps only $0.50 or $0.60. A day order will also help eliminate confusion. At the end of the trading day, if your order was not filled it goes away. You can then decide if you want to renew it or alter it. What you don t want to happen is to find out that you have been filled a week or two later and now the stock has stopped dropping and is bouncing up again. Monitor your Trade After selling the call on a stock you own, you will want to watch it nightly. There is no need to monitor it during the trading day as stocks can have swings in either direction only to close up or down a few cents. It really is the end of day closing price we are interested in, so we can see if a stock closed up, down, below support, above resistance and on what type of volume. 68

75 S U C C E S S S T O C K M A R K E T If you feel there is no change in the direction of the stock, then there is no need to do anything. If however, the stock has stopped dropping around the support ($30 for DIOD) and appears ready to bounce, then you will want to place an order to buy to close the call you sold; doing so will close out the obligation to sell the stock. Since the stock will have dropped from the time you sold the call and some Theta will have depreciated, you should be able to buy the call back at less than you sold it for. In following your rules for an exit order, you can use a GTC to help with the fill. Once the call has been bought back thereby closing the trade, you ll be free to do whatever you want with the stock. Perhaps wait for it to bounce back up, hit another resistance level just as the MACD and Coval indicators are rolling to the downside and then sell another call on your stock. Close or Adjust if Necessary If at any time the stock rallies on increased volume or appears that it will close above the strike price you sold ($30 for DIOD), you will want to close the position early. It may cost you more to buy it back, but the stock will also be increasing in price so it could be more of a neutral trade-off. Covered Calls for Income Up to this point, we have been focusing on covered calls from stocks you already have in your portfolio. There is a second method of writing covered calls that deals with more of a cash flow strategy. It should be noted that this strategy is a bit more risky than some spreads that you ll learn about in the next chapter. However, it also has some advantages, the most important being that you own the stock and can continue to sell calls against it until you are profitable. Depending on your trading style, this can also be a risk in that you have a lot of money invested in a single trade. Copyright 2013 SuccessStockMarket.com. All rights Reserved. Terms of use apply 69

76 Search for Covered Call Candidates The largest risk in a covered call trade is the amount of money you have invested in the trade. To help enhance your chance of success, you might want to start your search using the Success Stock Market Good Stock search. Picking a stock with strong fundamentals will help minimize the possibility of a negative news story and increase the possibility of a positive news story. Making sure the stock also trades at or under its Fair Value and Analyst s Average Target Price should also help in case the market has any pullbacks. A second way to search for some excellent possibilities is to use the Covered Call section of the Success Stock Market website. In this section, we do the work for you and search out what we believe are some of the best candidates at that moment. Every Wednesday and Sunday, we ll list out 2 or 3 candidates and do a write-up on one of them, what price to buy at, what option to sell, what 70

77 S U C C E S S S T O C K M A R K E T the news on the stock is, the fundamentals and our reasoning for picking this stock, and strike price. The covered call candidates listed are not in any particular order and are not meant to be recommendations, just an excellent starting point for you to do your own research. Sell the Call Unlike covered calls on stock you own, in this example, you actually want to be called out to maximize your return. To do this, you might want to leg into the trade doing only one leg at a time. Using this method, you will give the stock a chance to increase in price, allowing the option price to increase as well. Monitor your Trade On a nightly basis, you will want to look for any signs of a potential reversal or bad news or even an upcoming earnings announcement. Close out or Adjust if Necessary If for any reason you think the trade might not work out, don t be afraid to close it out. You might have a slight gain but even if it is a slight loss, it s better than a larger one. Based on how much you think the stock might fall, perhaps there are support levels every $1 or $2. You might just decide to close the call you sold and start selling in-the-money calls until the stock stops its pullback. If writing covered calls for income is a strategy you like, you might also consider using deep in-the-money LEAPS in place of the stock. Copyright 2013 SuccessStockMarket.com. All rights Reserved. Terms of use apply 71

78 Chapter 6 Debit Spreads The term spread refers to the difference between two separate option contracts that are combined to make one trade. In regards to a debit spread, it means there will be a cash outlay (costing you money) for the spread. The two most common debit spreads are a bull call spread and a bear put spread. We ll focus on bull call spreads since bear put spreads are seldom used. A bull call spread, also known as buying a call spread or long a call spread, is placed with the purchase of one long call and the sale of one short call at a higher strike price. An example would be to buy a $25 call and then sell the $30 call against it. The $25 call would be more expensive than the $30 call, so it would end up as a debit spread. These are often used in place of a covered call trade. If the call purchased and the call sold are both from the same month, the trade is called a vertical call spread. If the call sold is a different month than the one purchased, then it is known as a diagonal call spread. 72

79 S U C C E S S S T O C K M A R K E T Expectations As with any trade, your goal is for a profit. For this to happen, you will need to have the stock close above its breakeven price or better yet close above the strike price sold. If you buy a June $25 call for $3.50 on XYZ stock and then sell the June $30 call for $0.75, you have a net debit on the trade of $2.75. Ideal Scenario If XYZ stock closes above $30, an options market maker will want to buy XYZ stock from you for $30. Since you don t own the stock, you ll be able to exercise your $25 call, buy the stock for $25 and then sell it for $30 leaving you a $5 profit from the stock side of the transaction. To make this $5 profit, you spent $2.75 per share for the option spread leaving you a $2.25 per share profit on your $2.75 per share investment. Stock Profit Option Cost = Total Spread Trade Profit You will want to contact your broker prior to entering into any spread to see what their rules are for any type of automatic exercising or closing of a spread on expiration day. This is also a level 3 options trade; however, if you ever need to reverse the trade, you might need to be in a naked position which is level 4. Secondary Scenario If the stock does not close above the short call price, then having it close above breakeven will also work. If XYZ stock closes under $30 but above $27.75, you still manage to show a profit. Since your total cost to enter into the trade was $2.75 per share and you own the June $25 call, your breakeven is $ If the stock closes at $29, the June $30 call will expire worthless but since your June $25 call is in-the-money, it will be automatically exercised (closed out) leaving you a $4.00 profit on the June $25 call. Since the entire trade cost you $2.75 per share, you still end up with a $1.25 per share profit. Copyright 2013 SuccessStockMarket.com. All rights Reserved. Terms of use apply 73

80 Stock Trending Higher These trades usually work best if you think there is a good chance for the stock to move higher, although any move above $30 is not necessary since you sold the $30 call. It will, however, allow you to sleep better knowing the stock is trending above $30. There is also the possibility of having the $30 call exercised early leaving you your max profit prior to expiration day. There may be many reasons for you to choose a bull call spread over a traditional long call, but ultimately it all comes down to your own personal preference. Less Expensive Than a Covered Call Buying into a covered call trade involves coming up with enough money to purchase the stock. $100 shares of a $90 stock will cost $9,000. $100 shares of a $3.50 call option will cost $350 You can diversify your portfolio quite a bit more if you are only spending a fraction of the cost of a stock. 74

81 S U C C E S S S T O C K M A R K E T Time Value An in-the-money call option generally has less time value than an at-themoney or out-of-the-money call option. So when you buy an in-themoney call option, the time value you pay is much less than the time value you receive when you sell an at-the-money or slightly out-of-the-money call option. You can benefit from this lopsided premium. Option Premium Intrinsic Value = Time Value In the example for RBCN, you can see the stock is trading at $25.22 and the June $20 calls can be purchased for $5.60. If you purchase this option, you will pay $5.22 in intrinsic value and $0.38 for time value. $ $0.38 = $5.60. If you sell the June $25 call, you receive $1.65; $0.22 of this option premium is intrinsic value leaving $1.43 of time value. Copyright 2013 SuccessStockMarket.com. All rights Reserved. Terms of use apply 75

82 Both the June calls have the same amount of time until expiration; however, if you purchase the in-themoney call and sell the at-themoney call, you can benefit from receiving the time value difference. At-the-money calls carry the most time value In this case, it is $1.43 (for the $25 call) - $0.38 (for the $20 call) for a total potential profit of $1.05. All you need for this trade to work out and for you to keep the $1.05 per share of profit is for the stock to close above $25 on expiration day. Call Option Strategy Does Not Work for This Trade When purchasing a call option, you need for the stock to increase in value faster than the Theta decreases. In fact, for a long call to work, you generally need to see a significant move in the price of the stock. If the stock moves higher but does not overcome the amount you paid for the time value portion of the option, you can still lose money. If your analysis is telling you a stock has a good chance of moving higher, but purchasing a call option will not work according to your strike price analysis, you might consider buying a bull call spread to take advantage of time value decaying in your favor. Using a bull call spread with overpriced at-the-money options is favorable to buying an overpriced option. Investing Limited Funds Options can be expensive; in the example on RBCN, the June $25 call was trading at $5.60 but if you sold the June $30 calls for $1.65, then your total cost to enter into a trade is only $3.95 per share. Using a call spread helps to reduce your cost basis. Limiting Your Losses If you purchased the June $25 calls on RBCN for $5.60 vs. buying the call spread for $3.95 per share, you have more to lose if the stock decides to drop in value. The less money you have in the trade, the less you stand to lose. Potential Breakout A major benefit to using a call spread is that you still have the option of rolling it back into a long call by buying to close the short call. 76

83 S U C C E S S S T O C K M A R K E T You may have picked a bull call spread for many reasons, but you can still take advantage of a large upside breakout and increase your original potential profit. If the stock breaks above resistance on high volume, you can place an order to buy to close the short call (call you sold) leaving you with a call option on a new up trending stock. The call will cost more to buy back, but the call you own will have also increased in value to offset this. Bull Call Spread Checklist Before placing your first debit spread, it s best to go through your checklist and have an answer for all 6 steps prior to entering into the trade. This includes an action plan as to what you would do to alter the trade if it does not move higher or starts to drop in value. Find a Stock to Trade Since your goal is to own the stock, it s best to look for a Good Stock from the Success Stock Market stock scanner. The LEAPS section of the website will also have some excellent candidates for you. You may also want to check the Discount Cash Flow Calculator; buying a stock under its Fair Value is always a bonus. Copyright 2013 SuccessStockMarket.com. All rights Reserved. Terms of use apply 77

84 Check the Chart The analysis you ll want to perform for a bullish trade should include: 1) Trend, overall and current and should be more bullish than neutral. 2) Current price location, is it bouncing up off support or breaking through resistance? 3) Volume, is it increasing as it bounces up off support or breaks through resistance? 4) Green arrows, are the MACD, Coval indicator and Moving Average, more bullish than neutral? If the stock does not have to break any resistance lines in order to close with a profit, it will make for a much smoother trade. Suppose you have a stock for a debit spread and you are thinking of buying the $25 call and selling the $30 calls for a net debit of $4. If the stock is currently trading at $27.50 and has a resistance level at $28.50, it will have to break this and move above resistance for the trade to work out successfully. Pick Expiration Date and Strike Price A typical debit spread is done in the current month where both the long call and short call have the same expiration month. You can also change this so that the long call expiration month is 2, 3 or more months out while the short call is for the current month. This is called a diagonal spread. In the example for RBCN above, a diagonal spread would involve buying the Sept $20 call for $6.00 and then selling the June $25 call for $1.65 leaving you with a net debit of $4.35. When placing diagonal spreads, it is beneficial (but not necessary) for the net debit to be less than the spread amount. The reason for this is that if RBCN closes above $25 on the June expiration, you will be assigned allowing you to close the trade with a $0.65 per share profit. 78

85 S U C C E S S S T O C K M A R K E T If however, your timing is off just a bit and RBCN does not close above $25, then the $25 call you sold will expire worthless leaving you with a Sept $20 call in your portfolio. You can then choose to sell the call or sell another call against it for another debit spread. Place the Order Copyright 2013 SuccessStockMarket.com. All rights Reserved. Terms of use apply 79

86 When placing your order, make sure it is listed as a debit and that it is only a day order. Also, make sure you are buying the longer- term call and selling the shorter-term call. Monitor the Trade On a nightly basis, you will want to look for any signs of a potential reversal or bad news or even an upcoming earnings announcement. Close out or Adjust if Necessary If for any reason you think the trade might not work out, don t be afraid to close it out. You might have a slight gain; but even if it is a slight loss, it better than a larger one. Based on how much you think your debit spread might fall, you might just decide to close the call you sold and start selling in-the-money calls until the stock stops its pullback. Once the stock stops falling, you can then once again begin selling outof-money or at-the-money calls. The key to having a successful debit spread is your willingness to manage the trade. Don t panic if your original trade analysis does not work out, just outline your next steps and work your plan. 80

87 S U C C E S S S T O C K M A R K E T Chapter 7 Credit Spreads Unlike a debit spread where you pay out cash for a spread, a credit spread begins every trade by paying you, hence the term credit spread. You may also hear the terms selling a put spread or a short put spread or selling time since what you are really after is the time value difference between the option sold and the option bought. The two most common credit spreads are a bull put spread and a bear call spread. Bull put spreads are meant for bullish to neutral stocks and bear call spreads are meant for bearish to neutral stocks. A bull put spread is placed by buying a put and selling a put at a higher strike price. An example would be to buy a $25 put and then sell the $30 put against it. The $25 put would be less expensive than the $30 put, so it would end up as a credit spread. These are often used in place of a purchasing a single call option. A bear call spread is placed by buying a call and selling a call at a lower strike price. An example would be to buy a $25 call and then sell the $20 call against it. The $25 call would be less expensive than the $20 call, so it would end up as a credit spread. These are often used in place of a purchasing a single put option. Credit Spread Expectations For this chapter, we will cover the bull put spread. A bear call spread will have the opposite requirements from everything listed. When selling a bull put spread, you are buying a put at a lower strike price and selling a put at a higher strike price. Since the Bull put spread: Buy lower put, lower strike price will be further sell higher put away from the stock s trading price, it will have a lower time value premium than the put that you sell. Copyright 2013 SuccessStockMarket.com. All rights Reserved. Terms of use apply 81

88 Ideal Scenario If you have a bull put spread on XYZ stock selling a June $25 put and buying the June $20 put for a $1.30 credit, you ll want the stock to close above the strike price you sold. If your XYZ closes above the $25 put on expiration, the buyer (options market maker) of the June $25 put will not exercise their option. It will expire worthless as will the option you own, the June $20 put. Your profit per share is the $1.30. Your investment on this spread is the potential maximum loss of $3.70. If the stock goes bankrupt and falls to zero per share, someone will exercise their $25 put option and assign you the stock at $25. You will then exercise your put option and assign it 82

89 S U C C E S S S T O C K M A R K E T to the options market maker at $20 per share leaving you a $5 per share loss on the stock. Since you already received a $1.30 credit when you opened the trade, your maximum loss is $3.70 per share. Secondary Scenario If the stock does not close above the short put price, then having it close above breakeven will also work. If XYZ stock closes under $25 but above $23.70, you still manage to show a profit. Since your total credit to enter into the trade was $1.30 per share and you sold the June $25 put, your breakeven is $ If on expiration Friday, the stock looks like it will close at $24, the June $25 put will be exercised leaving you to buy the stock at $25. If you don t want this to happen, you can place an order to buy to close the June $25 put you sold. If the stock is at $24, the premium to buy the put option will be close to $1 per share. This closes your obligation in the spread. Since the stock is above $20, the put you purchased will expire worthless. Your profit will now be $0.30 per share. You started the credit spread with a $1.30 gain and then closed it out with a buy to close of the June $25 put for $1.00 leaving you $0.30 per share. Even though the stock dropped slightly, you still made a profit. Assignment Many investors fear what they do not understand. Assignment simply means that someone else exercised their option and assigned you the position you sold in your option contract. If this happens to you, don t panic! Copyright 2013 SuccessStockMarket.com. All rights Reserved. Terms of use apply 83

90 In the above XYZ bull put spread example, you sold a June $25/$20 put spread for a $1.30 per share credit. If the buyer of the June $25 put decides to exercise their contract, you will be assigned meaning you will need to buy XYZ stock at $25 per share. If you sold 5 contracts of the spread, then you will need to buy 500 shares of XYZ stock at $25 per share. When this happens, your knight in shining white armor (aka your broker) will soon appear to help you out. You ll be contacted by your brokerage company telling you that you have been assigned 500 shares of XYZ stock at $25 per share, and you need to come up with the funds to buy it. If you can t come up with the funds, you simply tell your broker to sell the stock at the current price. As an example, let s say you end up selling the stock at $23.50 and you bought it at $25. You ll lose $1.50 per share on the stock side of the transaction but since you started the trade with a $1.30 credit, your total loss on the trade is only $0.20 per share or $100. Investing Note: When options are assigned, it happens overnight. If you believe you might be assigned and the market is still open, you can always place an order to buy to close the short side of the spread. These trades usually work best if you think there is a good chance for the stock to move higher, although any move that keeps the stock above your breakeven price will also work. If the stock has had a significant move higher and you can buy to close the short side of the spread early and for a profit, then it is always a good idea to do so. In fact, some firms will waive the commission cost of closing a trade if the option premium is $0.05 or less. Why Choose a Credit Spread? The most popular reason is that you start off in the trade with a profit. The credit you receive is the maximum profit. It is now up to someone else to try and work this away from you. 84

91 S U C C E S S S T O C K M A R K E T The Stock Does Not Have to Move In the example for VECO above, the stock is trading at $ The June $50 puts can be sold for $2.05 and the June $47 puts can be bought for $1.20 giving an $0.85 credit on a $2.15 investment. Remember, the investment part is the maximum loss (spread amount) minus the option credit. Copyright 2013 SuccessStockMarket.com. All rights Reserved. Terms of use apply 85

92 With an $0.85 credit and a short put at $50, the breakeven for this trade is $ The stock is currently trading at $51.92 per share. If this stock closes higher on expiration day, both put options will expire for a full $0.85 per share profit. If the stock moves sideways and closes at the $51.92, you still end up with the full $0.85 per share profit. In fact, as long as the stock closes above $50, you receive the full profit amount. If the stock drops and on expiration day closes under $50, you might still make a profit on the trade since your breakeven is $ It is at this point that you start to lose some money. Moving Higher but Not Sure If your chart analysis tells you the stock has an excellent chance of increasing in value, a long call or bull call spread may be a better choice. If you are not sure the stock is going to move higher but think there is a better chance it will increase versus decrease, then a bull put spread might make a better choice since it can easily be unwound leaving you with a long put in your account. Limit Your Losses As with any spread, your cost basis is less than if you were to purchase the stock or often times even a long call or put option. The less you have invested, the less you stand to lose if the trade goes against you. 86

93 S U C C E S S S T O C K M A R K E T Checklist Your checklist for putting on this trade follows the same format as the covered call and debit spreads checklist. Where it differs is on closing or altering the trade. Close or Alter the Trade if Necessary If at any time it looks like the stock will turn lower and head under the strike price sold, you have a few choices - leave it alone, close it or unwind it. All stocks ebb and flow and trying to time their moves exactly is a losing battle. All you can hope for is that your analysis on the technicals, news and fundamentals are close enough to allow for a profit. In the example below for Trina Solar, TSL, the stock is just beginning to break down through the $25.50 support while showing 3 red arrows. If you had started this trade a few weeks ago with a $27/$25 bull put spread for a $0.75 credit, you might be thinking that you wish you had picked a different stock. Regardless of the past, you now have to work on the present. If you do not go into repair mode, you are likely to be assigned the stock at $27. Copyright 2013 SuccessStockMarket.com. All rights Reserved. Terms of use apply 87

94 To protect your position, you decide to place an order to buy to close the $27 put you sold while keeping the $25 put. As the stock continues to fall, the $25 put will increase in value. Once your $25 put increases enough so that you breakeven or if the stock stops falling, sell to close the $25 put. Remember, this is a Good Stock with great fundamentals in an overall uptrend. It s just experiencing a pullback. Once the stock pulls back enough, investors will start buying again. This is no place for a long put. 88

95 S U C C E S S S T O C K M A R K E T Chapter 8 Iron Condors Now that we have learned credit spreads, both a bull put spread and a bear call spread let s put the two together. An iron condor spread is simply a bull put spread and a bear call spread placed at the same time for the same expiration date. Instead of collecting credit from one spread, you can collect credit from both spreads simultaneously to increase your profit potential. Iron Condor Expectations When placing an iron condor spread, you are entering four different strikes. For a bull put spread, you are buying a put at An iron condor is simply a combination of two short vertical spreads, one bullish and one bearish a lower strike and selling a put at a higher strike. For a bear call spread, you are buying a call at a higher strike and selling a call at a lower strike. The two short strike prices are closest to the current stock price, while the two long strikes make the outer legs. The net credit of the two spreads combined makes up the maximum profit, as long as price action stays within a range determined by the short strikes you choose. As seen with short vertical spreads, the long strikes give insurance for the shorts and reduce the cost basis of the position. Copyright 2013 SuccessStockMarket.com. All rights Reserved. Terms of use apply 89

96 Ideal Scenario The goal of an iron condor spread is for the stock to stay between the short strikes by the close of expiration day with all four options expiring worthless. Let s say you have a bull put spread on XYZ stock selling a Nov $85 put and buying the Nov $80 put for a $0.90 credit; you will want the stock to close above the strike price you sold. You also have a bear call spread on the same XYZ stock selling a Nov $105 call and buying a Nov $110 call for a $0.65 credit. If your XYZ stock closes above the $85 put on expiration and below the $105 call on expiration, the buyer of the Nov $85 put and the buyer of the Nov $105 call will not exercise their options. They will expire worthless as will the two options you own, the Nov $80 put and Nov $110 call. Your net profit per share is the $ $0.65 = $1.55. Since the iron condor strategy only requires one margin, your investment on this spread is the potential maximum loss of $5 (spread difference between the short strike and long strike) - $1.55 (net credit) = $3.45. Why Choose an Iron Condor Spread? Because it is a credit spread, you start the trade with a premium in your account. The net credit you receive is the maximum profit. It is now up to you to keep it. In addition, many investors are attracted to the iron condor strategy because the margin required for the two vertical spreads combined is the same required for one vertical spread. It would be impossible for the stock to close at two different prices on expiration. So essentially, it is like entering two spreads for the price of one which then increases the trade s overall potential rate of return. 90

97 S U C C E S S S T O C K M A R K E T Checklist Your checklist for placing the iron condor spread strategy follows the same format as the checklists for credit spreads discussed in the previous chapter. Find a Stock to Trade This is a strategy that is most suited for a neutral or sideways-trending environment, so many investors like to utilize ETFs, Exchange-Traded Funds due to the lower volatility and fewer unexpected news surprises such as you might find with a stock s quarterly earnings. Common ETFs often used are the DIA, SPY, QQQ, and IWM which are widely-traded, highly liquid stocks with tight bid/ask spreads often in the pennies. Check the Chart The analysis you ll want to perform for a neutral trade should include: 1) Trend, overall and current and should be more neutral. 2) Current price location, is it staying between major support and resistance levels? When you re ready to sell the short legs of your iron condor spread, you will want to make sure that the strike price you sell for the bull put spread is below a support level and the strike price you sell for the bear call spread is above a resistance level. You can go to the Success Stock Market website and use the Automated Support and Resistance Lines on the charts to help Copyright 2013 SuccessStockMarket.com. All rights Reserved. Terms of use apply 91

98 determine your strikes. These Automated Support and Resistance Lines allow you to see where buyers and sellers tend to take control. You can then choose strikes outside of these levels for an extra margin of safety which will give room for price to fluctuate within the range of the short strikes. Legging In The term legging in means stepping into a strategy one leg or one spread at a time. This is a way to combine the strategy with technical analysis in order to maximize your profit potential even further. You tend to collect the highest premium for a bull put spread when a stock is at support getting ready to bounce and the highest premium for a bear call spread when a stock is at resistance getting ready to pull back. The better your technical analysis skills, the better you can identify the appropriate times to enter. In looking at the Automatic Support and Resistance Lines in the example above for BIDU, you might determine that a significant support level is around $105 and a significant resistance level is around $124. You can see that the Oct $100/$95 bull put spread is giving a credit of $0.52 and the Oct $125/130 bear call spread is giving a credit of $

99 S U C C E S S S T O C K M A R K E T Based on your technical analysis, you could choose to enter both spreads at the same time for a net credit of $0.92 or you could choose to leg in by entering the bull put spread side of the iron condor spread first (or vice versa). Then once the stock makes its average upside move up, you could then enter the bear call spread side which by then would be giving a higher premium as it nears its resistance area. Depending on what you see on the chart, there are many ways you can approach an iron condor spread strategy. Close or Alter the Trade if Necessary It is always preferable to close out of your position with the majority of your profit prior to expiration, so you can free up your capital for another trade. You can choose to exit out of both spreads at the same time, exit one and let the other expire worthless, or even leg out of one spread at a time. If the stock closes outside of the range beyond the strikes of one side, you will have the maximum loss. It is a good idea to have a plan prepared in advance of what your action steps will be before it reaches this point. Copyright 2013 SuccessStockMarket.com. All rights Reserved. Terms of use apply 93