Options

In my last post, I mentioned that Berkshire Hathaway was undervalued and a good buy that the current price of $76 per B-share.

It turns out that it’s probably a better buy than anyone expected.

Buffett just announced that he’s spent $10.7 billion buying IBM stock, as well as a few billion dollars on CVS and VISA.

I currently own BRK-B, and I’d like to increase my exposure to it. But I’m strapped for cash.

So how do I make money from being LONG BRK when I’m short on cash?

Time to look at option strategies.

When most investors are bullish on a stock, they buy CALL options on it. They fork over some money (called a premium) and have an option to buy that stock at a specific price (called a strike price) at a future date. If the stock price exceeds your strike price, then you’ve made money.

One problem with this approach is that the recent volatility in the market has increased the premiums on options.

Another problem with this approach is that usually,  investors lose money on options. Most commonly, the options expire worthless because the stock price didn’t hit your strike price. And sometimes investors paid too much premium, so that despite exceeding the strike price, they still end up losing money overall.

Let’s look at an example.

Consider the BRK-B, Jan 2013 $75 CALL option. It’s currently selling for $10.50, which means on each contract (1 contract is 100 shares), you’d pay $1,050.

So, in January 2013, unless BRK-B is trading for more than $85.50, you’ve lost a thousand dollars!

A better way is to use PUT options.

When you buy a PUT option, you’re paying a premium and you have the right to sell a stock to someone at a specific price at a future date. You make money if the stock price declines below the strike price. You would enter this contract if you were bearish on the stock.

However, if you SELL a PUT option, you receive a premium. In return, you must buy the stock if it declines below a certain price. If the stock goes up in value, then you get to pocket the premium. So you would only enter this contract if you were bullish on the stock.

Being bullish on BRK-B, and short of cash, I’ve taken a short PUT position.

As I outlined in my previous post, I think BRK-B is worth $112 and has a floor below $72.

I sold the Jan 2013 $60 PUT for $4.50. This means I collected $450 per contract.

If BRK-B drops below $60 per share, I will be forced to buy the stock.

However, based on the premium I collected up front, my purchase price will be $55.50 or 50% of what I think is the intrinsic value.

Mostly likely, the option will expire worthless and I’ll get to keep the premium.

This also how you can turn around the high premiums to work in your favor.

If I didn’t already own BRK-B, I would go for a higher strike price. Most likely, I would sell the Jan 2013 $80 PUT for $11. This would allow me to collect $1,100 per contract.

Of course, the risk that I would be assigned the stock would also be much higher. But I would be comfortable owning this stock at an effective price of $69 per share ($80 strike price – $11 premium = $69).

Option trading is not without risk.

It’s easy to over-leverage and wipe out your portfolio. I use this strategy with great caution and with a lot of forethought.

You also need the highest level of option trading and a margin account in order to sell puts.

A trade like this one usually has a 20% margin requirement. Which means, I need at least $1,200 in margin. Based on that margin a $450 premium would represent a 37.5% gain in 14 months. Not too shabby.

If you’d like to learn more about option trading, I strongly recommend The Bible of Options Strategies: The Definitive Guide for Practical Trading Strategies. It’s a excellent primer on various option strategies.

Disclosure: If it wasn’t already obvious, I’m long BRK-B. Both the stock and by selling puts.

Friday’s stock market had a distinct sense of deja vu about it. Even though it was down overal, I was reminded of the crazy dotcom days in late 1999 when any tech stock could rally 25-50% in a single day!

One of my friend’s subscribes to a stock newsletter. Periodically he gets an email alert informing him when a stock is about to make a significant jump. He often sends them to me and I usually look at them and then ignore them. Yesterday he sent me an email about a China Clean Energy Inc (CCGY.OB).

By the time I got the email, it had already jumped 30% that day, but I really liked the chart. It had retreated about 15% from the highs of the day and looked like it was ready to make a move back up to the $2 range.

This is what the chart that I follow looks like.

The image is bit hard to understand since they’re aren’t any notations on it. The first chart is the intra-day stock price of CCGY.OB for September 28th 2007 using Candlesticks. It also has the bollinger bands and exponential moving average lines.

The 2nd chart with red and blue vertical lines denotes the volumne. The 3rd chart is the Relative Strength Index (or RSI) with oversold and overbought indicators.

The 4th chart is the Moving Average Convergence/Divergence indicator orMACD.

The last chart is the Slow Stochastic.

From these charts I felt that there was sufficient momentum in the stock to carry it higher, despite it having already jumped 30%. I was able to buy in at $1.73 around 12 pm EST (which was 9 am for me) and sure enough it continued higher throughout the day.

It closed the day at the highest price of $2.23, for a stunning 28.9% one day gain! Although the stock was up ~60% for the entire day, I was very happy with my 28%. Made me feel like I was reliving the good old dotcom (or dotbomb) days.

Here’s a much better daily chart.

Very rarely do I buy stocks based on tips and without looking at any underlying fundamentals. Usually, the newsletters that I subscribe to, will recommend a stock based on good, solid fundamentals and I will use the charts to determine the market sentiment for that stock and a good entry point. Recently, Freight Car America (RAIL) was recommended, but the chart looked terrible and I didn’t buy it. Sure enough it dropped from it’s recommended price of $48 and is now trading at $38. Here what the chart looks like. I’ll wait until the technicals improve before I jump in on that one.

Sometimes this strategy will backfire because some breaking news will come out that will send the stock shooting the opposite direction than expected, but it doesn’t happen often enough. And unexpected news can make value investors look like fools too!

Most traders use some form of technical analysis. Many investors believe that technical analysis is rubbish and doesn’t work, but they probably feel that way because they don’t understand it. Its basically a representation of the current market sentiment based on price and volume action.

Most traders use some from of it and it can get fairly complex. Studies have shown that currency traders use it a lot (or atleast the successful ones!). I’ve attended several currency traders meetup sessions and they all use some sort of technical analysis to trade in and out of their positions. That and proper money management is the key to succesful trading.

I strongly recommend at least learning the basics and deciding for yourself whether to use it or not. Getting Started In Technical Analysis is a really good book that’s fairly easy to read.

If you’re interested in learning about trading, I strongly, strongly recommend Trading for a Living: Psychology, Trading Tactics, Money Management. By far one of the best introductory books on the subjects. You’ll get more out of it than a $5,000 seminar!

If you like to day (or swing) trade, you’ll also enjoy An American Hedge Fund: How I Made $2 Million as a Stock Operator & Created a Hedge Fund. A fascinating story about Timothy Sykes, a college student who made a million dollars day trading and started his own hedge fund.


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Even though I’m not a fan of private-equity firms (check out How Capitalism Really Works) and especially not Blackstone, I did however put some money into a private-equity ETF, the PowerShares Listed Private Equity Fund(PSP) and I also bought some stock in Sears Holdings(SHLD) today.

[Image for SHLD stock]

SHLD had a great day today, up nearly 6%. Technically, both of them look very strong (well atleast SHLD does!). I’ve had my eye on SHLD last week and I was looking for a good entry point. I was hoping to get it for around $165, but it didn’t quite make it there. Instead it shot up today and I managed to get in at $172.38. It closed at close to the highs of the day at $174.06.

If we see some quick moves in both of them I’ll take my money off the table. Lets see how it works out. My divestment from my Seabridge Gold(SA) options was premature. Its up 25% from my exit point which kind of sucks. Just enforces the idea of letting your winners ride and cutting your losers quickly, instead of the other way around.

As previously mentioned, I entered a synthetic long stock position using options in Seabridge Gold.

As a recap, a synthetic long stock position is buying the calls and selling the puts to offset the cost the of calls. (If you don’t know what calls and puts are, I suggest you read up on option trading. Options Made Easy: Your Guide to Profitable Trading is a good book).

With $60 I was controlling $1650 worth of stocks, or about 100 shares. On Friday, or about a week later, the stock was up just over a dollar, so I sold 2/3s of the call contracts and all of the puts. On the call side, I netted a profit of $0.40 or $40/contract and on the put side I netted an additional $0.35 or $35/contract. I actually closed out all the puts and kept only 1/3rd of the calls.

If I had closed out the position entirely I would’ve made about $70/contract or about 116% in roughly 1 week. As it stands, since I’ve liquidataed most of the position, I’m now in each call contract at almost cost and I’ll recognize a total net profit when I exit the calls. Currently the calls are selling for $235.

Last friday was also Triple Witching Day, (the contracts for stock index futures, stock index options and stock options all expire on the same day) and historically the week after that in June has a tendency to ended lower. Thats why I decided to close out most of my position. If the stock market does move lower, I can re-enter the position at a cheaper price. If not, then I’ll still make money on my existing call options.

If the stock drops, so long as I sell the calls before they drop under $10-$15, I won’t lose any money. If the stock moves significantly to the upside, the Delta will move towards parity with the stock and I then get most of the upside.

Currently I’m in a good situation. Lots of upside potential with minimal downside risk!

On another note, BHP Billiton (BHP) and Anglo American (AAUK) are hitting new highs! I love my commodity stocks.

Even though my CFC and WCI option strategies backfired, my JRCC puts did quite well. Enboldened by that success, I decided to try some more option trading.

I’ve been keeping my eye on Seabridge Gold (SA) for a few months now. A few months ago, I sold some naked puts on SA hoping that it wouldn’t drop more than $2 and I would get to keep the premium when the options expired worthless. It worked out exactly as planned and I made a few hundred bucks on the trade.

I’m still bullish on the stock and yesterday it gapped up on very high volume with absolutely no news. The options jumped too, but late in the evening the stock trended back down and filled the gap. The options dropped as well and I bought some November 17.5 calls for 1.95/contract. I also sold an equivalent number of November 15 puts for $1.35/contract bringing my net price to $60 per 100 shares.

If SA continues its rise, I should make some decent money. If it drops a few bucks, I’ll actually lose money, but I’ll probably have lost less than if I had bought the stock outright.

Buying a call and selling a put is called a synthetic stock position (technically, synthetic long stock) because your position mimics the behavior of the underlying stock so its like you’re artificially creating a stock. Its a cheap way to enter a position. Its not risk-free or a low-risk position but a simply a way to leverage your investment (and thus amplify your winnings or losses).

For an out of pocket investment of $60, I’m controlling $1650 worth of stock. The Delta of the November 17.5 call is 0.52, which means for every $1 move in the stock the option should move $0.52 in the same direction. As the price moves closer to the strike price of 17.50 and the time till expiration decrease, the Delta should increase. For the June 17.5 call, its 0.927 so it closely mimics the behavior of the stock.

If the stock moves $1, based on the Delta of 0.5, the option should (theoretically) move up $0.5, which means my $1.95 call option is up 25%. The put option will similarly lose value and I can close out at roughly a 30-45% profit. (Yes, this is a gross simplification. I’m not going to explain further because its 4 am and I haven’t slept for 2 nights – more on that later).

I’ll let you now how this trade works out.

NOTE: Do not blindly copy this trade. If you lose money, I take no responsibility whatsoever. (But if you make money, please send me a cholocate chip cookie!).

In an earlier post on investing on news, I had sold puts on JRCC.

Well JRCC was up sharply in the past few trading sessions. I closed out my position by buying back my naked puts and netted a 38% profit (sold the puts for 1.95 and bought them back for 1.20).

There’s a chance the stock might go higher. But, I bought puts because it was a speculative trade and the idea was to make a quick (or somewhat short-term) buck. It went up, I made money so its time to get out.

Thats the good thing about options. They prevent you from getting married to your positions. That can be a dangerous thing if the market turns against you (speaking of which, I’m really glad I closed out my Countrywide puts after they started going against me. When I closed my puts, the stock was at $37 – now its almost $42).

Now if I could only figure out a way to make 38% returns EVERY 2 weeks!!!!!

I read an email today that mentioned China (who is already the planet’s largest coal consumer) claims it will need an extra 80 million tons by next January. India is also estimated to need an extra 120 million tons, and most other Asian countries are expected to increase demand by 7%.

According to Kevin Kerr, “Coal prices are going much higher than I thought. Keep an eye on those diesel prices too, they are already creeping up. These two markets are going to surge this summer, absolutely.”

Since I like to take advantage of investment opportunities whenever I come across them, I placed an order to sell PUT option contracts on James River Coal Company (JRCC). Its essentially a long position on the companies stock, which has nicely trended up 50% in the past several months.

If the order is executed tomorrow (the order was placed after hours) I get a net credit of $195/contract. By september, if the stock trades above $8.05, I’ll have made a profit. My maximum profit is $195/contract and it occurs at stock prices over $10.00. If the stock drops below $8.05 I will either have to buy it or sell my option before expiration date at a loss. But I’m bullish on the stock so the loss would be smaller than actually buying the stock outright.

If the stock stays at the same $9.50 price, I’ll still make $145/contract at expiry. Both my upside and my downside are limited, but I think there’s a great chance I’ll make more money selling the puts with a lower risk than by buying the stock outright. Plus for each contract instead of putting up nearly $1000, I’m collecting $195 instead. It does use up my margin limits, but it does mean I don’t need to pay interest on the amount, since I’m not borrowing any money.

Of course you manage the risk here by not betting the farm. If the stock moves against me and my option moves against me 50% (ie, I’m down $100/contract) I’ll close out my position. Since this total draw-down is only 0.33% of my portforlio, it doesn’t give me ulcers. And while the total profit is only 0.66% of my total portfolio and isn’t exactly an earth-shattering return, its a 2-1 risk-reward scenario that I’m comfortable with.

If the stock goes BK overnight and I lose the max $805 per contract, it still only 2.66% of my portfolio, which is a bearable loss. Remember, risk management will determine whether you succeed or fail in the long term.

The stock market suffered the biggest loss today since the terrorist attacks on September 11th 2001.

They were allegedly caused by profit taking in China caused by the governments comments on cracking down on the rampant stock speculation taking place and by Greenspan’s comments on the US facing a mild recession later this year. Even Oil and Gold were down today. So was every other sector!

The only green mark in portfolio was URPIX which was up 7% today, but I didn’t own enough to offset my losses. Still, the losses are to be expected and a 30% cushion still isn’t bad. Hopefully WCI will drop even further and I can actually profit from my remaining puts (which are currently underwater)

I did use the drop in GDX (gold mining ETF) to sell some March puts. If they expire worthless, then I’ll have made some money and if they don’t I’ll own some GDX shares for less than what I sold them during the last options expiration period.

Wonder how long and severe this correction will last?

BHP Biliton (BHP) just announced a $10 Billion Dollar stock buyback over the next 18 months!!! Thats on top of the $3 Billion previously announced. About 4 months ago I bought BBL. BHP also trades as BBL and BBL trades at a slight discount to BHP, making it cheaper to own blocks of 100. Since BBL closely follows BHP it doesn’t matter which one you buy. I’m up 8.5% since then and I think there’s still a long way to go.

Most of my holdings are oil & gas or commodity companies. I’ve also been selling naked puts sporadically on companies like STP and CRDN which have done pretty well. Well enough to offset my losses on WCI. Since I started shorting WCI in October its up about 30%.

Has anyone had luck consistently buying options instead of selling them???

Previously, I had talked about selling naked puts on a small mining stock. With one week to go the options are now worth only 5cents a share or about $25. I had sold them and pocketed $175. So it looks like they’ll expire worthless and I’ll get to keep my $175.

Its not a lot of money, but I’m still learning so it never hurts to make money while you learn!

I purchased a stock today. Its a low priced stock but I think it has the potential to do well in the long run. However I’m not sure it’ll do well in the short term. I bought it at $2.70 and sold a December $2.5 call for 40 cents. If the stock is over $2.50 in about 5 weeks, the stock will get “called” and I’ll have to part with it. In return I’ll get $2.50 per share plus I get to keep the 40 cents I got upfront. That equates to a 5.8% (after commissions) return in about 5 weeks. Annualized thats a 60% return!

But probably what will happen is the stock will trend down to about $2.50 where there is a lot of support(meaning its bounced off this price before) and the option will probably expire worthless. Meaning, if I’m lucky I’ll get to keep the stock and also the 40 cent premium.

Of course, if I’m unlucky the stock will tank and I’ll lose money. However, I don’t lose money unless the stock trades below $2.30 cents, which is a 14.8% below what I bought it at and below its support line. But there’s no risk-free reward in real life.