The Tycoon Report

2 Powerful Ways to Profit With Options

Wednesday, August 26, 2009 | Teeka Tiwari

Over the last few weeks, I've been sharing an investor education series with you. Given that it's "Options Week" here at The Tycoon Report, I'm going to digress a little and share with you some of the ways that I use options in my own trading.

Embracing Options Starts With Understanding Them

Being raised in the business in the 1980s, we were taught that options were the living embodiment of Lucifer himself. It was several years before I fully realized how myopic a view this was to hold.

The bottom line was that most people in the business at that time still didn't fully understand how to use options appropriately. There was an enormous amount of misinformation and just plain bone-headed thinking going on at that time.

Even today, options are still widely misunderstood and misused. Typically, the biggest mistake people make with options is that they buy too many of them. This mistake is then usually compounded by buying options that are out-of-the-money with too little time until expiration.

If you're new to options, an out-of-the-money call option is one whose strike, or exercise, price is above the market price; an out-of-the-money put has a strike price that's below the current market value of the underlying stock. And unlike stocks and Exchange-Traded Funds, options come with an expiration date, which means you have a finite amount of time for the trade to work in your favor.

However, when it comes to protecting your portfolio during tumultuous times and helping you to maximize the use of your capital, options can be a perfect fit.

There are numerous well-constructed and highly profitable options strategies available to the savvy investor. Today, I am going cover two primary strategies that I use in my own trading.

Strategy No. 1: Portfolio Protection During Major Market Events

One of the big risks of individual stock ownership is the sensitivity that stocks have to event-driven news, with earnings being of primary consideration. Earnings surprises can cause dramatic one-day moves in stock prices that can either enrich or devastate one's position.

Earnings season takes place four times a year -- typically the bulk of reports are concentrated in January, April, July and October, although other reports do trickle in throughout the year. Other special events like new product releases, legislation or other industry-related events can happen at any time, so it's important to know the companies you're invested in so that you can be prepared for news that might move their stocks.

The big risk with a bad earnings-news announcement is that your stock holding can easily "gap" through your stop-loss point. These gap-downs can sometimes be massive.

Now matter how much research one does, earnings misses can strike any company at any time.

Some companies are more sensitive to earnings misses than others. Companies such as Apple (AAPL), Google (GOOG) and Research In Motion (RIMM) come to mind.

How do we protect our positions against this type of volatility?

A Pre-Earnings Put Option Play

A very easy strategy to use is to buy puts on your position the day before earnings are due. (A put gives you the right to sell your shares at your option's strike price, if you choose to "exercise" that right.)

In these situations, what I'm looking to do is protect myself from a one-day volatility event. So, what I typically do is buy the nearest-month put option that's 3 to 5 points out-of-the money. For a more-expensive stock, I may go 10 points out-of-the-money.

For example, with RIMM trading at $75, the $70 and $65 puts (and anything lower) would be out-of-the-money. With an earnings announcement date of late September, I would look toward the puts that expire in October.

By buying 3 to 5 points out-of-the-money, I am not going to be completely hedged against a big downside move, but that's not the point of this strategy. I enact the strategy to cushion the blow of a dramatic move lower.

I call this strategy "gap insurance," and I apply it to stocks that have a history of high volatility or a position that has large, embedded profits that I want to protect.

If, on the earnings day, the stock does gap down and hit my stop, my put options ensure that my overall losses (or lost profits) do not get out-of-hand. If the stock surprises to the upside, then I exit my puts and just chalk up the cost of the puts as an insurance premium for my position.

If the earnings news is a non-event and the stock stays flat, then I exit the puts with my loss usually being contained to the bid/ask spread on the options. (The "bid" is where buyers want to purchase, and the "ask" is the lowest price where sellers are willing to sell.)

This strategy has served me very well in the past and relieves much of the stress one can feel when carrying a large position going into an earnings announcement.

I also use this strategy right before any pending major news event such as a big lawsuit announcement or a Federal Open Market Committee meeting where the outcome of the meeting has not been clearly telegraphed to the market beforehand. 

Strategy No. 2: Minimizing Margin Interest

The other way that I use options is when I want to take a longer-term position in a stock but don't want to pay margin interest for one or two years. In this case, I will use LEAPS (Long-term Equity Anticipation Securities).

LEAPS are longer-term options on stocks that just like regular options, except that their expiration dates are one to two years into the future.

Let's take IBM Corp. (IBM), for example. You can buy 100 shares of IBM at $120. This would normally cost $12,000 but if you use 50% margin, then you only have to put up $6,000.

However, you will have to pay margin interest on the $6,000 that the brokerage firm loaned you to buy those 100 shares.

If you plan to hold the stock for a long time, that margin interest can begin to add up.

Increase Your Leverage by 'LEAPS' and Bounds

An alternative strategy would be to buy a LEAP call (a call gives you the right to buy shares at the strike price) with a strike of $60. The IBM calls that expire in January 2011 at the $60 strike are currently trading at $59.20 (bid price) x $60.20 (ask price). This represents just a small premium over the current value of IBM.

The advantage of this strategy is that you get the same 50% leverage through the option that buying the stock gives you, but without having to pay any margin interest. If you wanted to apply more leverage to the position, you would do so by changing the strike price.

I'll give you an example:

One could purchase the IBM January (2011) 80 Calls, which are trading at $40.80 x $41.60. In this scenario, we are paying $1.60 in time premium (you are buying on the "ask" at $41.60 because that's the lowest price a seller is offering) versus just 20 cents when we buy the $60 call (at $60.20).

The advantage, though, is that we get to control $12,000 worth of stock by only putting up $4,160 ($41.60 per share x 100 shares represented in one option contract) instead of putting up $6,000.

We have effectively doubled our leverage from having to put up 50% to only 25%.

Again, we're applying additional leverage without having to pay margin interest. The premium of $1.60 that we're paying above the option's intrinsic value represents interest of a sort but its only 4% amortized over the life of the option.

As great as the above options strategy is, it only works if you are correct in your assumption that the stock is going to keep going up. Remember, leverage cuts both ways, so be sure to employ stop-loss points and position-size discipline.





Teeka Tiwari
Chief Investment Officer
ETF Master Trader