The Tycoon Report

How to Use Options to Get Paid Right Now..

THE BOYS ARE BACK IN TOWN!

Happy Belated Labor Day folks!

This is usually the time of year when we put on our seatbelts, because some of the big traders who had been on summer vacation are getting back into the driver’s seat and taking control of the market.

Be sure to keep your eye on the ball.

Now, each year the classic question is: what are you doing for Labor Day weekend? In New York, the answer is usually either the Hamptons on Long Island, or up to Connecticut somewhere, or it might be Cape Cod. But the common denominator is a long drive with bumper to bumper traffic.

I was in New York with some trader buddies of mine. As a matter of fact, I visited the Hamptons on Long Island. I did the usual mingling and poking around to see what the heaviest hitters are thinking about doing with the managed money. I saw the same regular faces that I'm used to seeing, but something was very different this year. We flew about 70 miles an hour on the Long Island Expressway! I couldn't believe it! We were used to doing more in the neighborhood of 7 miles an hour, and here we were doing 70! Motorcycles were flying by at over 100 mph!

We stopped to get some gas, and Regular was $3.40 a gallon. We were riding in a 2004 Mercedes CLK which is a coupe, and it cost us almost $50 to fill up the tank! Boy, do I feel sorry for all of those folks who drive Hummers! No, actually, that's a fib. We were easing our pain by cracking on the driver of the Hummer H2 who was filling up his own vehicle, when I almost used my phone to snap a picture of his face, but that would have been going overboard.

When we got there, we saw the usual Wall Street crowd, but the beach crowds were practically non-existent. The life of the party was the group of commodity traders who were having a grand old time (I can't imagine why.)

Then I thought of my cousin who didn't visit my parents over the weekend, because they were 150 miles away. I thought of the friends who skipped visiting my fiance' because they would have to drive about five hours from Clearwater FL. to Miami.

So I think about the ride that we’re in for in the stock market for the remainder of the year.

What does it all mean?

Gas prices are soaring, causing a noticeable cutback on traffic and therefore spending. In the wake of the devastating disaster that Katrina brought to our country, she actually had less of an impact on the market than one might have supposed. Even after she wreaked unqualified havoc in the South, the market was up last week on heavy volume!

Oil prices hardly spiked up, and they even sold off! The earnings season, which was positive, has ended, so what catalysts are left to move markets? My cousin Adam asked me this weekend what this all meant. I had to confess, I was confused. The good news is that if you use options to hedge your position, it's okay to be confused.

So I offered him two strategies which offer two solutions.

Solution #1: I told him, "if you own stocks that you like and aren't sure what to do with when they spike higher, sell covered calls when you get that spike in price. Selling a third party the right to buy your stock at the current price in the form of a contract that expires in a couple of months is a great way to collect income."

It had been a while since he sold covered calls so I helped him brush up by giving him a quick course on how to do this effectively. Since the market has been somewhat manic-depressive lately, it's offering big opportunities in the form of covered call writing. The majority of stocks that spike higher lately have only come back to their average prices.

Solution #2: Since he told me that he owns a major stock position that he thinks might trade lower, but didn't want to sell it because of a big a tax consequence, I said you can use what's called an "Equity Collar."

Immediately I thought about the Tycoon Report readers. I have kept it pretty simple each week, because I want to talk about ideas that most readers have heard of. I apologize for not writing about this strategy sooner.

An Equity Collar is the simultaneous purchase of a put option, and writing of a call option. Both are done out of the money and both usually have the same expiration date.

Sometimes this was done when a company executive who we managed money for wanted to hedge against a market downturn and had a reason for not selling stock such as not wanting to send the wrong kind of signal to management or other shareholders.

I gave my cousin a brief example of how this is done.

We'll call his stock position XYZ. I said to him: "XYZ stock is trading at $45 and you want to hedge against a drop in price, correct? Since you think it still has a chance to trade higher, you don't want to simply buy the protective puts which trade at $3.20 That is a huge amount of money that you would lose if the stock trades higher."

I said: "Let's check out the April $40 puts and the April $50 calls." They were trading at $3.20 and $5.20 respectively.

"If you sell the April $50 calls, you will take in $5.20 per share as a premium. If you buy the April Puts, you will spend $3.20 per share. If you do both at the same time, you will take in an extra $2.00 per share altogether.

The Result:

If the stock trades lower like you think it will, you are essentially "short" the call at $5.20, which will trade lower as the stock price trades lower. It will also trade lower as you get closer to expiration in April. This will benefit you, because you can purchase the call that you sold, and the difference between $5.20 (where you sold it) and the price that you pay when you purchase it becomes a profit."

"The put that you bought should begin to trade higher, and once the stock breaks $40, the put should increase significantly in value."

"The two changes in price of the two options should help to significantly offset the paper loss of the stock position."

He completely grasped the idea. Thank the Lord, because his breath was killing me (sorry Adam!)

He asked "What if I'm wrong, and the stock trades up? Do I lose?"

So I told him: "If the stock trades higher, you don't necessarily lose, but you are obligated to sell the stock at $50.00, since you sold (or wrote) the call option. You'll still keep the extra $2.00 (which in his case is a short term gain,) and you'll have a $5.00 increase in the stock price, so I don't think you'll be upset."

He said he could accept that and, if that was his biggest problem, he'd consider himself lucky.

The third scenario, of course, was the stock trading between $40 and $50.

In that case, both options would expire worthless and Adam would make $2.00 extra on his stock position. The difference between the $5.20 that he took in when he sold (or wrote) the call option, and the $3.20 that he spent on his protective put.

I hope that my weekend conversations and experience translate into a nice healthy blood pressure and profits in your accounts. Your health should come before money, and you shouldn't stress too hard about the stock market.