Trading Stock and Options (US)

Trading Stock and Options

Trading stock and options

Trading stock and options is what I actually do with the money I make trading forex. I am often asked about trading stock and options; what I do, how I do it, how much I make and the level of risk involved. I am working on a course on trading stock and options but this article outlines the unique self-developed technique that I use to make around 40% per annum with very little input of time and very low risk. I call my trading technique; The Money Engine.

image of platic pie representing investmentsThe Money Engine trading technique combines a number of elements. Each of these needs to be understood in its own right before the assembled whole can be seen clearly. Many students try to understand the whole technique without being familiar with these components and because of this it takes them far longer and causes them to use a lot more effort to get to the point of understanding. I urge you to halt your search for a full understanding of the whole at this stage. Just concentrate on understanding the elements and worry about seeing the full picture a little way down the line.

The components of the Money Engine are:

  • Stock markets. I use several stock markets for its trading. However, they each share some very particular characteristics and we have many good solid reasons for preferring them. They are commonly used by United States and United Kingdom based investors and the markets are very accessible. That said, I believe that it is possible to build a Money Engine in any open market as long as underlying assets such as stocks, traded options and long term traded options are available.
  • Stocks or shares. It is very easy indeed to find the stocks that we use as part of our strategy. However, there are certain characteristics that they must have including the availability of traded options.
  • Traded options form our third component. I use both call and put options and you will need to ensure that you understand exactly what these are and how they work. For the moment it is enough to know that traded options are instruments that give the right, but not the obligation, to buy or sell stock at a particular price on or before a certain date. As the term implies, I use traded options, that is, options with obligations that can be bought out or sold on at any time before they are exercised (taken up) or expire.
  • Traded LEAP options are the final component. Traded LEAP options will also be fully explained. However, in simple terms they are just traded options with a life of at least 9 months to run before the option inherent in them expires.

image of rising investment graphThe above components are all that is needed to fit together a Money Engine. I coined the term Money Engine because a diagram of the technique reminds me of the diagram used to explain how an engine works. Each “stroke” of the engine, such as the injection of fuel or the igniting of the fuel, sets in train a chain of events that drives forward motion as long as fuel is available. At the risk of taking the analogy too far, like any machine, we need to know how to run our engine. It needs fuel and the components must work together in a finely tuned and timed sequence. The engine needs to be maintained, serviced and lubricated.

However, there are also many significant differences between a real engine and our Money Engine. Some of these differences are advantageous, some are merely differences of note but, thankfully, none are disadvantageous. One of the main differences of note is the ability to start our engine at any of several stages in the cycle of trading.

Stages in the trading cycle

To keep things simple, we will start with a stock that is rising in price to give us a Money Engine sequence as follows:

Stage 1 – Buy a stock that our analysis tells us is “looking as though” it is in a rising trend. (Don’t worry; later we will look at what happens if this assumption is wrong)

Stage 2 – Buy a long term (LEAP) call option that will give us the right, but not the obligation, to buy at least the same number shares again, in the same stock purchased in stage 1, but at a price which is slightly lower than we have actually paid for the stock. Obviously, we will pay a small premium for buying this right.

We are now set-up for the first stroke of our engine sequence to take place. This is the anticipated increase in the share price. Our strategy requires that we now simply wait until the share price stops rising and begins to fall. Once more, at this stage, just concentrate on what happens if the shares performance does conform to our expectations. We will deal with exceptions later.

Stage 3 – When our share price rise has eventually reversed into a fall we have a choice to make. We can either sell both the stock and the long term option that we previously bought and take profit OR we can retain both the stock and the option and sell new call options against both the stock and the long term call options that we own. At this stage, unless we have decided to exit the trade, we will also buy a long term Put option to protect our stock and or protective LEAP call as their price falls.

Stroke 2, now we let the stock price fall and wait until we are happy that it “looks as though” it has stopped falling and has reversed again. In the course we will describe exactly how we decide when this point has been reached. We are now at the bottom of the stock’s price cycle again.

Stage 4 – We either take profit on or Sell a short term put option against the long term put that we bought at step 3. We can also consider buying back the call options that we sold at step 3 (for less than we paid for them of course).

Stroke 3 sees the share price rise again. This time as well as seeing the value of our shares and long term call option rise we see the value of the put that we may have sold at step 4 falling ready for us to let it expire or to buy it back cheaply when the share price completes its rise. To begin to simplify things and to summarise:

Look at the diagram below. The blue curve represents a rising and falling share price. The text boxes summarise the trades that need to be executed at the bottom and the top of the price cycle. Note how the actions are already beginning to look cyclical with the actions at the bottom of the price cycle having been repeated. Just beyond the next “top” the top of the cycle trades would also be due for repetition and, like an engine, we have stokes or phases. Each of these phases can produce profit for us

Image of Money engine stock and options technique

 

 

 

 

 

 

 

 

Already you will notice that we have created three selling opportunities whether or not we sell the stock itself or the long term options that we bought to protect it. We will return to this cycle many times. Hopefully, you are already beginning to see what we are trying to achieve.

My aims

Our first aim is to own shares that are protected against falling prices by owning protective put options. However, we also want to protect the value of our protective put options by owning protective call options which will increase in value if the price of the underlying stock rises and therefore the value of the protective put falls. Achieving this means that our assets (shares and LEAP options) are potentially very safe.

Our second aim is to create an income against all of the shares, protective puts and protective calls that we own and to maximise this income with maximised safety.

Understanding the Money Engine

To understand the Money Engine, an understanding of call and put options is essential. For the uninitiated, the best way I have found of describing options is to start with the familiar. Most people will be aware of options in terms of the new house market. Frequently, prospective purchasers of new houses can pay around £200 to take an “option” on a particular property. This gives the buyer the right but not the obligation to buy the property at a previously agreed price on or before a particular date. This “right” exactly mirrors what a call option is. If we buy a call option we are buying the right but not the obligation to buy a particular number of shares in a specific stock at a particular price on or before a certain date. Similarly, like the house builder, if we sell a call option we are selling the right to the market to make us sell a number of shares in a particular stock on or before a certain date.

Obviously, taking on an obligation to sell shares can be a very dangerous undertaking indeed, particularly if we don’t already own the shares. Therefore, we need to defray or offset this risk. We do this by ensuring that we either own the shares or have the right to buy the shares at a lower price than we are obliged to sell them at. That right, the right but not the obligation to buy stock is called a put option. Like a call option, we can buy the right to buy shares in a particular stock on or before a certain date or we can sell the right to the market to oblige us to buy a particular number of shares at a given price on or before a certain date if the market wants to make us do so.

Once more, taking on an obligation to buy shares at a fixed price can be a very dangerous undertaking. We therefore need a way of defraying or offsetting this risk too. This is done by matching the obligation to buy with a right to sell the shares at a higher price.

The three paragraphs above take us to the heart of the Money Engine strategy. If, probably having read the paragraphs several times, you have already managed to grasp the concept behind the Money Engine you have done very well. If you have not grasped it yet, then don’t be concerned at this stage. Most people probably won’t have “got it” just yet. It won’t get any more complicated and we will be going over the concept several more times as well as looking at many examples.

My course will give you an opportunity to practice using the strategy without risk until your understanding is complete.

Understanding these “mechanics” is central to the Money Engine strategy. However, once we have fully understood the mechanics we need to refine our understanding of the process by tackling such matters as:

  • Which stock markets and shares are the best to select for the Money Engine strategy, why are they best and how can they be identified?

At the time of writing we are aware of just 11 stocks; from the many thousands traded around the globe that perfectly match our requirements. Until recently there were just 7 such stocks so the trend seems to be in the direction of more stocks coming into play for use with our strategy. All of the stocks that we use are those of “large cap” businesses with shares and options traded in very high volume.

Throughout the Money Engine seminar we introduce a lot of tools and techniques to assist you in narrowing the choice from 11 down to 1 stock. However, you will find that there is no real wrong choice as long as the choice is confined to the 11 stocks that we currently use or those that come to meet our parameters in the future. All of the stocks that we use are those of successful, household name companies. Most people will have previously heard of most of them.

Some of our 11 stocks represent a better choice than others at any point in time. However, as we are likely to stick with our choice for some considerable period, the chances are that the performance of our strategy in relation to each of these stocks will average out to similar level over time. In addition, perhaps surprisingly, we are usually only looking to trade just one stock rather than a basket of them at any time. We therefore only have to find one stock and this should be quite straightforward.

Stocks which trade around the lower to middle range of the average price per share work better in our strategy. Our anticipated return is actually higher if the Money Engine Strategy is applied to such stocks. This is excellent news as it increases the return on our capital. It also means that we can use the strategy to its maximum effect with even a modest sum invested.

Are the options that we need to use always available?

In practice we don’t have any problems finding options to buy or buyers to sell options to at prices that are attractive to us.

Image showing stock options available example

The left side of the screen shot above shows call options that we could sell for one of our 11 stocks; Cisco Systems Ltd. (ticker symbol CSCO). The stock, when the time this screen shot was taken in early April 2010, was priced at $25.83 per share. We could purchase shares at this price and sell the right for the market to make us sell them on or before the third Friday of May 2010, about 7 weeks from the screen shot date, for $26 per share and we would be paid to be paid $0.75 per share (the bid price) for taking on this obligation. We would be paid the $0.75 per share now, less commission, immediately on making the trade.

If the share price stayed below $26 the option would be unlikely to be taken up and we would keep the $0.75 per share giving us a return of 2.9% (21.5% annualised). If the shares were taken away from us at $26 we would still keep our $0.75 per share and our return would be a total of $0.75 plus $0.17 ($26.00 – $25.83 the price paid for the stock) = $0.92 or 3.56% (26.4% annualised) before commissions.

The column headed c_openI shows the “open interest” in this option as being 11,066. This tells us that options to buy 1,106,600 Cisco shares off traders for $26 each had already been traded when the screen shot was taken. Even more options had been traded to take the shares away at the prices of $27 and $28 per share. There is no shortage of option trades available!

On the right side of the screen shot illustration we have “put” options showing how much would have to be paid (the ask price) to make the market sell us Cisco shares at various prices at a time of our choice up to the third Friday in May. Once more the “open interest” already being traded in these options is huge.

How do we recognise when the phases of our engine strokes are over and the share price has changed direction?

Image of Magnifying glass illustrating price direction analysisAs a principle, we wait for stock prices to actually change direction before taking action rather than trying to find the exact high or low point of their cycle. However, we have lots of tools and techniques to assist us in predicting that a directional change is coming, has arrived and has been confirmed. These techniques include technical and trend analysis. As important as these techniques are, they are intended to only slightly improve our performance. You will not need to become an absolute expert in order to use them to make a difference to your trading outcomes.

I do not recommend any particular techniques of technical or trend analysis. However, my programme does include a review of some of the most popular techniques. The review will include candlestick patterns, trend analysis, moving averages, the MACD, Money flow, Bollinger Bands and Stochastics. We will demonstrate a combination of techniques that we use to make very rapid decisions with.

Which call and put options should be used for protection and which for income generation?

The answer to this question partly depends on what the option involved is intended to do. Different answers will arise depending on whether we are buying or selling the option, on whether it is being used as protective “insurance” or for income generation.

The answer will also depend on to the degree to which we are happy to have any option that we have sold taken up by the market. As an absolute rule we will NEVER sell an option or take on an obligation that we would not be in profit on in the event that the option is taken up. However, we will be happier to have some options taken up rather than others. We will therefore demonstrate how we select options to sell depending on our view of the likelihood of having the option taken up by the market. A couple of very simple rules and an easy calculation ensure that we will never get caught having to fulfil an obligation that we would make us lose money.

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About The Author

Jeff Fitzpatrick

Probably the UK's most successful home Forex trader