Monday, June 29, 2009

Some Prerequisites

Before you get started there are a few basic tools that you will need to do the job. If you don't already have these tool you can start to set them up while waiting for my posts to start rolling in.

• Computer with internet access and a spreadsheet program like Excel
• An online brokerage account with Tier 3 trading privileges
• A subscription to Morningstar, or access to other online stock screening tools

I know the Morningstar subscription costs money, but it is the best service that I have found to do the Option Income system, because of its proprietary ranking system and focus on high quality value stocks. However, if you need to keep your costs down while you are starting out and learning the ropes there are several free online websites that screen stocks for fundamental analysis, such as MSN's stock screener, which is located at:

http://moneycentral.msn.com/investor/finder/customstocksdl.asp

Next up... A multi-part post on: "How to identify and track opportunities across a range of stocks?"

Tuesday, June 23, 2009

July's WAM (walking around money) Trade

Disclaimer: The following post is getting the cart before the horse, but is for those of you who are wanting to get started right away trying out this system. I will be breaking down the process in future postings so that you can easily do this on your own with a little research and, of course, application of the Rules.

With the June options expiring last Friday June 19th (stock options expire on the 3rd Friday of the month) we are now in a position to place our next trade for July. Let's suppose you have $6,000 and you are looking to earn a little WAM this month! You are looking for a trade with a high probability of success that will generate a 2% return for the month (24% annual). You don’t necessarily want to purchase stock, but should that occur you want to ensure that you're investing in a company that you would be willing to purchase because the company is fundamentally sound, has great management, and has a strong record of commitment to sharing the company’s profits with its shareholders in the form of dividends.

Okay, that said here is July’s WAM trade:

Order Type: Sell-to-Open
Contracts: 3
Symbol: OSD (July $20 Put)
Price Type: Limit
Limit Price: 0.40
Term: Good Till Cancelled

Your order would read: “Your Good until Cancelled (GTC) Sell-to-Open order for 3 OSD July 20 Puts at a limit price of $0.40.”

What does this mean?

You are going to sell (not buy) three July $20 strike price Put option contracts (the ticker symbol for the option contract is OSD) against your $6,000 cash. The underlying asset (stock) is Realty Income (O). Since you are selling (or writing) the option contract you immediately receive $120 in option premium from the buyer (less commission cost of course). The $120 breaks down to $40 per option contract 3 x $40 = $120 of instant WAM!

The option contract (the deal) that you have just entered into is that you are now contractually obligated to purchase 300 shares of Realty Income (O) stock at $20 per share if the price of the stock is at or below $20 per share on July 17 (July’s option expiration date). Even if the price of 'O' is $18.50 on July 17 you still have to buy it for $20 per share. The stock is automatically assigned to your account.

However, if the price of ‘O’ is above $20 per share on July 17 your option contract will expire worthless (worthless to the buyer that is) not you as the seller nothing happens to you. Your $6000 is still cash in your account along with the $120 premium WAM.

Do the math!

Before we enter into the deal we have to make sure that the odds are in our favor. Our trade entry requirement is a minimum 70% statistical probability of success. Because we are on the selling side of the trade time is on our side! The odds of success will increase with each passing day that draws closer to the option expiration date due to the time decay value of options. More on time decay and how to do the math in future posts.

Here are the numbers:

Stock: O (Realty Income)
Current Price: $22.24 (6/23/09 close)
Days to Expire: 24 (7/17/09)
Volatility %: 36.3
Dividend Yield: 7.68%
Risk free interest rate: 2%
Result: 85% probability of stock finishing above $20 on 7/17/09

Getting In

The trickiest part of selling Options is executing the trade. The 85% success probability is great for 24 days until expiration date, almost too good. This is due to the stock trading so far above $20 (our strike price). With Puts, the higher the stock price the lower the premium (less risk, lower reward). With Realty Income trading above $22 the option premium is only in the 0.20 to 0.30 cent range and we would really like to get 0.40 cents per share for a 2% return. We could make well over a 2% premium by moving up to the $22.50 strike price, but that would lower our success rate below 50% which breaks our rule of at least 70%.

You have to decide whether you're getting in now for a lower return or waiting a few days to see if the price of 'O' drops which will raise the premium. I like to do a little of both, drop our limit order down one notch to 0.35 cents and wait a few days for 'O' to drop. We can afford to wait a few days (3-5) without losing too much to time decay, but past that it is not worth it. The worst case is that 'O' continues to go up and you don’t get in this month.

Remember rule #1: “The purchase should meet ALL of the requirements.”
Rule #2 is: “See rule #1.”


Not getting in is okay and perfectly acceptable! You should only get in when everything is right and all of the planets are aligned. If not, drop it and move on to find another worthy stock where all the planets are aligned.

Monday, June 22, 2009

The July WAM (walking around money) Trade

With the June options expiring last Friday (June 19th) we are now in a position to place Let's suppose you have $6,000 and you are looking to earn a little WAM this month! You are looking for a 2% return during one month (24% annual) for a high probability of success

Friday, June 19, 2009

Advantage #1 - It’s a System

First of all the fact that this is a system is an advantage. A good business system has requirements, rules, is clearly documented and repeatable. The same reasons that make McDonald’s or Subway a good franchise is that they can replicate the exact same quality of product and its business systems in every location. I believe my system can be repeated by others, but it has not yet been tested and verified repeatable. One of the objectives of this blog is to create a forum to allow others to test the system and determine if it is repeatable.

Unfortunately the terms “Stock Market” and “System” are oxy-morons, they just don’t go well together. At least in terms of pure mechanical trading systems, as far as I know there has never been a mechanical system that has continued to work. Oh by the way, don’t be fooled by those that claim their mechanical systems beat the stock market. They might for awhile but eventually the market has a way figuring them out and changing enough to make them null and void. So that is the irony of good stock market systems they are a combination of rules and procedures that eliminate emotion and yet are flexible enough and necessitate a certain amount of human analysis and judgment that is taught from mentor to an apprentice (i.e.: see Graham and Buffett).

System Requirements

The system shall…
1 …generate positive returns every year (no years with a loss)
2 …generate monthly income in order to utilize the power of compounding
3 …consistently produce 20 to 36% annual returns (reinvested doubles every 2 to 4 years)
4 …not take more than a few hours per month to execute (once learned)
5 …not require constant monitoring or supervision (can take a week Caribbean cruise, no internet)
6 …allow you to know how much you will make going into the trade
7 …put time decay value on your side
8 …have a 70% to 90%+ statistical success rate for each trade using mathematical probability models (minimizes risk)
9 …trade only the very best most fundamentally sound companies as the underlying asset
10 …minimize exposure to market risk by staying in cash the majority of the time
11 …be repeatable by anyone who understands how stock options work

Next up advantage #2:

Tuesday, June 16, 2009

Introduction

The key concept of the Option Income system is vastly different then most investing premises. Traditional investing seeks a positive capital gain the old “buy low and sell high” or “buy and hold” and wait for your portfolio to hopefully increase in value. Whereas the Option Income system seeks to generate positive income every month! This system uses and treats cash and stock like hard assets, in fact we treat them very much like real estate rental property! We use cash or stock as the underlying asset (real estate) and rent out the use of your asset each month to generate income (rent).

You wouldn’t sell your rental house at the first inkling that the property dropped in value would you? No! Why? Because it generates positive monthly income! Well guess what if your stock market investment is generating 2-3% income monthly (that’s 24-36% annually) you don’t have to sell your stock when the price is down. How does this compare to the traditional advice given by so called Wall Street pros or your stock broker? They would have you sell it! Dump the losers and let the winners run. The typical stock market philosophy is that it is okay to sell for a loss. Sure that’s easy for them to say it’s your money and they still get their commission! Whether you are a short-term trader trying to time the market; or a long term investor trying to gut out the 5 to 20 year wait for your portfolio to become profitable again after that last huge market down swing. Knowing when to buy and when to sell for capital gains is a tough physiological game to win at and most don’t. It’s a fact that even 80% of the professional mutual fund managers do not beat the S&P 500 market average.

Next post advantages of the Option Income system...

Introduction

The key concept of the Option Income system is vastly different then most investing premises. Traditional investing seeks a positive capital gain, the old “buy low and sell high” or “buy and hold” and wait for your portfolio to hopefully increase in value. Whereas the Option Income system seeks to generate positive income every month! This system uses and treats cash and stock like hard assets, in fact we treat them very much like real estate rental property! We use cash or stock as the underlying asset (real estate) and rent out the use of your asset each month to generate income (rent).

You wouldn’t sell your rental house at the first inkling that the property dropped in value would you? No! Why? Because it generates positive monthly income! Well if your stock market investment is generating 2-3% income monthly (that’s 24-36% annually) you don’t have to sell your stock when the price is down. How does this compare to the traditional advice given by so called Wall Street pros or your stock broker? They would have you sell it! Dump the losers and let the winners run. The typical stock market philosophy is that it is okay to sell for a loss. Sure that’s easy for them to say, it’s your money and they still get their commission! Whether you are a short-term trader trying to time the market or a long term investor trying to gut out the 5 to 20 year wait for your portfolio to become profitable again after that last huge market down swing, knowing when to buy and when to sell for capital gains is a tough psychological game to win at and most don’t. It’s a fact that even 80% of the professional mutual fund managers do not beat the S&P 500 market average.

Next post the advantages of the Option Income system: