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.