In our trading system, we earn money three ways: like an INSURANCE COMPANY, and like a TAXI DRIVER, and like a RETAIL STORE.
Regardless of which stocks we use, or whether we invest in Puts or Calls, the same methods apply.
1. Time Decay
Insurance companies sells policies, collect premiums, and then wait for monthly and annual policies to expire. They profit by the erosion of time. The insurance giants collect millions of dollars from customers and hold them as surety against future claims. You can’t go back and make a claim on a loss unless you’ve first paid in. And so every year that premium income exceeds claims, the company declares a profit.
In the same way, we collect option premium and hold it until it expires. At that point, it is booked as profit.
Sellers of premium take on the risk that others avoid. Healthcare and life insurance companies keep adjusting prices so they can assure themselves a profit. In a similar way, every month, the exchange computers calculate the risk of a downturn in the stock market and issue a nominal value to stock options. The system therefore is rigged to favor sellers of options over buyers, as the cost of premium is borne by option buyers.
When we sell Puts and Calls, we expect their value to go down, hopefully to zero. As we are first sellers of positions, we wait until the value of an option drops or expires, and the difference is our profit. By selecting and selling options far from the current price, we have a high probability of their expiring worthless.
It is up to the trader to decide the best way to sell premium around a particular stock. If the price is going up, we sell Puts. If the price is going down, we sell Calls. Sometimes we can sell both at the same time, increasing returns. Even if the price of the stock does not move at all, sellers of options will make money as an option slowly expires.
Time = money!
2. Price Movement
The taxi moves out from the curb, carrying me to Honolulu International Airport. The driver turns on the meter and the money starts to pile up. “That will be $27.75,” he says to me on our arrival. I give him $30 and a “mahalo” and he looks for his next customer. Movement means money to the driver, and time is not really a factor in the taxi business. Unless you don’t have a customer, of course.
As traders, we can make money when stocks move, regardless of time. Stock prices, making our positions more or less profitable.
Long Puts and Calls
If we buy Puts or Calls, then we want them to increase in value. The trick is buy then as the prices start to move, and have a target in mind. When you hit the target, then sell the option and keep the profit safe.
When the taxi got to the airport, he shut off the meter and collected $30. Deal done.
Credit Spreads
As prices move away from our credit spreads, they quickly generate profit, which we realize by buying them back at a lower price.
EXAMPLE: When the price of GOOGL is at $551, we sell October 530/520 Put spread for a credit of $1.25. In three days, the price of GOOGL jumps to $578, reducing the price of our spread to $0.78. Even there has been almost no reduction in time value, we have a profit of $0.47.
Of course, if the price moves toward our credit spreads, instead of away, we will see a paper loss. So we put on credit spreads whenever we see the stock starting to move away, not when it is heading towards our chosen strikes.
By selling deep ITM spreads, we can also capiitalize on moderate price movement with low risk. We prefer this strategy to buying long puts or calls as we obtain significantly higher deltas and avoid some time decay.
Movement = money!
3. Maximum Turnover
Retail stores make profit by moving their merchandise. In the dark hours, they restock the shelves, making it easy for customers to select and buy. The same small space in the shelf can sell thousands of dollars. Their secret is turnover, using the same space to sell over and over and over again.
As option traders, we divide our account into $5,000 nests–think of them as spaces on the store shelf. We generate more profits by selling puts and calls frequently, and then replenishing as fast as we can. The difference between what we sold an option for, and the buy back price is our profit. I can use the same $5,000 investment (margin money) a dozen times in a year, and earn perhaps 10% each time. We can do it at least twelve times a year using monthly options, and every week using weeklies. That’s turnover, and it’s a secret to more profits.
Turnover = money!
So that’s the three ways we make money: like an insurance company, a text driver, a retail store. What do they all have in common? They collect more than than spend money.
Tiger says: ““Why join the navy if you can be a pirate?” Actually it was Steve Jobs, God rest his soul. But he is rich and famous because he did the opposite of others do.
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Tiger teaches options trading Honolulu Options Traders, located in Waikiki. meetup.com/honolulu-optins-traders and facebook.com/honloluluoptionstraders
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Copyright © 2014 Graeme Sharrock and Honolulu Options Traders | All rights reserved worldwide. | P.O. Box 75343, Honolulu, HI 96836
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