Earlier in the week I put out a Flash Alert suggesting buying large cap China darling BIDU and selling covered calls against your position.
Since offering the idea, I have purchased the stock, then shorted covered calls twice and closed out both positions for a profit.
I promised to show you how this works with a detailed explanation, so here we go. If you're familiar with options strategies and don't need this information, just go back to what you were doing.
Options are considered risky as they are contracts to buy or sell a stock at a fixed price up to a certain date, and they will eventually expire on that date.
However, selling covered calls against a position you own is actually a conservative strategy. It's almost like insurance against a loss. You might give up some of your upside, but you can generate income from your position.
The strategy of selling covered calls works very well with large cap tech stocks that are highly volatile- stocks like BIDU, AAPL, and GOOG are great candidates because the option contracts trade with big premiums- you can sell them for very high prices.
An option is a contract that trades on the CBOE- Chicago Board of Options Exchange. Each contract represents 100 shares of stock, and has a strike price and an expiration date. Options expire the 3rd Friday of every month.
For example, BIDU closed at $127 on Friday. If you want to purchase the right to buy BIDU at $140 between now and the third Friday of September, it will cost you $435 to lock up 100 shares. So, if you were to buy 10 contracts, which represents the right to buy 1,000 shares at $140 up until September 16th when the option expires, it will cost you $4350. Seem like a sucker play with the stock at $127- I agree. You don't want to be the sap who buys that option. You want to be the seller.
If you happened to own 1,000 shares of that stock, you could sell someone the right to buy those shares from you at $140 for $4350.
So, what happens if the stock is less than $140 on September 16th? The option expires, and you keep the $4350- thereby reducing your cost on the 1,000 shares by 4.35 points..
What happens if the stock is over $140?- Well- you lose the stock at $140, but you still keep the $4350- so you have actually sold the shares at $143.50. And, if the stock closes below $140 and the option expires, then you can go ahead and sell the October options and generate more income.
So, let's take it one step further. You own the stock, you sell the call option. This is known as "selling covered calls" as you have the stock underlying the option you sold.
Now, your account is technically "short" the call option. If BIDU goes down, the call option will go down in price as well. Then, if you so choose, rather than wait for it to expire, you can buy the option back at a lower price than where you sold it, and lock in a profit.
I bought BIDU on 8/16 for $136.64. I immediately sold September $140 calls for $7.20- 10 calls, representing 1,000 shares, generated $7,200 in cash. If I lost the stock at $140 in September, I would effectively lose the stock at $147- over 10 points higher- a $10,000 profit on the whole trade.
The stock went down, and I bought back the options I had sold at $6.00 the next day, generating a profit of $1200 overnight.
Then, I sold the September 145 call options at $4.00, now generating $4,000 in income. The stock went down again, and I bought back those calls for $3.50. I've now generated another $500 profit from this portion this week for a total of $1700, and I still own the stock. I bought back the second calls a little early as the stock kept dropping, but if I choose to do so, I can go ahead and sell calls again to generate more income.
So, I still own the stock today at $136.64. Seem high compared to a $127 close? Not when you look at this chart:
One look at this chart and you will understand why I'm not worried. When this stock moves, look how it moves. In April it went from $120 to $155.
In mid June it got hot, and moved from $115 to $165. Seven points is not a big deal with this stock.
I'm not short any covered calls against my position right now. I'm ok with the two profitable trades this past week, and I'm looking for a rebound in the stock next week, at which point I will sell calls again and generate more income.
If you never traded options like this, I know it can be confusing. If you are considering trying this strategy, but have questions, just drop me an email and I'll be happy to help you understand how this works.
Email Larry@emergingchinastocks.com, and I'll help any way I can.
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|Warmest Regards, |