Do you understand what the goal is here with the HAL trade? I think ADP is also a great stock for this. You see, what we like to do is trade where the odds are in our favor. Where is that? Obviously where time works for us. And that is simply by selling options, right?
Sounds easy. Ah! But as we know, not everything is as easy as it sounds.
RVBD is a classic example of where these things go wrong. SIGM too.
SIGM for example falls from $73 to $21 in a month. Looking then at the numbers it appears that SIGM is an extremely undervalued stock. So, we buy the thing at $22, sell the $20 calls and even the $22.50 calls for nice premiums. But then what happens? Nothing. It doesn't go anywhere for days. But if it's so undervalued, why no correction? Something was up. And sure enough, word gets out that SIGM is losing major biz to BRCM and it falls to the high teens in one day.
Ah! Short $22.50 calls sounded so good and so sure, but then the bottom fell out. RVBD basically the same story.
So, how do you take advantage of such a great way of trading (selling calls) but limit your risk AND still be able to actively trade?
Well, it's actuall pretty easy and it does allow you to sleep at night. It's what I did with MRVL and never really thought it completely through in terms of trading it as an active trading plan.
You first have to look at these trades compltelely different. Our goal is to set up a trade whereby we are able to have an asset as collateral to use to sell calls against. That's our entire purpose here. Selling naked calls is extremely dangerous for obvious reasons. You're short a $50 call and the stock jumps to $80 you're screwed. But if you own a call option long or even the stock underneath, then you have no problems. Then it just becomes an issue of math. I'll explain later.
So, let's take first our HAL trade. We buy it at $47 let's say, then buy a Jan 09 $55 put for $9.80, then the stock can do whatever it wants to. If it goes to $10, no problem. We lose $37 a share on the stock, but we gain on the put. How much? Well, $55 strike - $10 = $45 value. We paid $9.80, so we make (45 - 9.80 = $35.20). So, we lose $37 on the stock but make $35.20 on the put making our max loss potential $1.80. Another way of looking at this is to just take the put strike of $55, subtract the cost of $9.80 giving you $45.20 and then subtracting that from your basis in the stock of $47. So, $47 - $45.20 = $1.80 as your total max loss risk.
That means you enter the trade upside down $1.80. Now if HAL trades north of the PUT strike of $55 by Jan 09, once you get $1.80 over that $55, it's all profit! If you bought GOOG for example at $200, then bought a long term put options say $20 in the money, once you get over that risk amount, most likely around $10, you're just swiming in money with no risk.
Nice!
So, here's now how we play this. We do this one of two ways and both are gonna cost you to do it. It's why most don't trade this way because most don't have enough money. But you can easily do 20% a year and most likely nearly double your money if you're on top of this trade monthly.
As I said, you're risk going into it is $1.80. That means we need to make first that $1.80 back and the way is to sell calls. Based on that HAL chart it appears it's ripe for a pullback. I think low $40s. Sell then the May $45 calls which are in the money. I said to do it at about $3. Now they're $2.65. The power of time decay.
Most likley these will be 0 by May op-ex. That's $3 in your bank account offsetting the $1.80. Now it's all profit even if HAL goes to ZERO. The goal now will be to do this for June. And then July etc. $3 a month is actually pretty easy rolling this back and forth as the stock trades in its ranges. $50k gets you 1000 shares and 10 puts. (with a little margin) That's $3k a month. Sometimes more when it appears the stock will fall even more.
Actually, some months you'll get double whammies because you'll short the calls, net out $1 or $2 on the decay of the fall, then cover and ride it up again just long the puts and stock, then re-sell the same calls again and get the same $2 or more. It happens.
With this way of trading, you can care less about what the market does or what GOOG did yesterday or what some high flyer did becuase you're focus is on the intricacies of your one stock.
If you want to milk it even more, you trade the stock, too. For example, you bought it at $47, right. You see it's clearly going down on day and then you sell the stock at say $46.40, and then re-buy a few minutes later for $46.10. What just happened? Sure you lost on the original buy of $47 when you sold at $46.40. But you re-bought it at $46.10. That just took out $.30 out of your basis. So, you actually MADE money on the totality of the trade.
Another way to do this is to buy a straddle. But the Jan 2010 max put (furthest in the money) and call. I think that would be the $20 call and $70 put. 10 would cost you I think about $48k. Why so deep in the money? Because it gets your spread a tight as possible. The deeper in the money the less time value each has. That trade would make your risk $2. That means you have to sell calls netting you more than $2 to make it risk free and then start generating income.
But I prefer the stock because you can trade it better. Just a preference.
Look up ADP's options and you can see for yourself how this works.
The market can go down 50% and you probably will do better becuase you make most of your money on the downside or flat. Look at that S&P chart above and you can see the setup and it ain't looking good.
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