The Weekly Trader

UNDERSTANDING OPTION STRATEGIES

In my bestselling book, Understanding Options, I introduced a variety of option strategies. To help you understand these strategies in more depth, I wrote the following option articles for one of my corporate clients, which is also posted on their website.

Here are four basic options strategies:

PART ONE: BASIC STRATEGIES

  1. Covered Calls
  2. Buying Calls
  3. Collars
  4. Straddles

 

COVERED CALLS

Options strategy: How to sell covered calls
Income potential, while theoretically reducing the risk of simply owning a stock.

If you’re looking for an options strategy that provides the ability to produce income but may be less risky than simply buying stocks, you might want to consider selling covered calls. As long as you’re aware of the potential risks — including transaction costs and tax and wash sale implications — this basic strategy is designed to help generate income from stocks you already own, even within an IRA.

 

Understanding covered calls
As you may know, there are only two types of options: calls and puts.

Calls: The buyer of a call has the right to buy the underlying stock at a set price until the option contract expires.

Puts: The buyer of a put has the right to sell the underlying stock at a set price until the contract expires.

Although many option strategies have exotic-sounding names, every strategy is based on the buying and selling of calls and puts.

When you sell a covered call, also known as writing a call, it means that you already own shares of the underlying stock and you are selling someone the right, but not the obligation, to buy that stock at a set price until the option expires—the price won’t change no matter which way the market goes. If you didn’t own the stock, it would be known as a naked call—a much riskier proposition.

Why would you want to sell the rights to your stock? Because you receive cash, also known as the premium.

For some people, receiving extra income on stocks they already own sounds too good to be true, but like any options strategy, there are risks as well as benefits.

 

How this strategy works
Before you make your first trade, it’s essential that you understand how it works. For example, let’s say in February you already own 100 shares of XYZ, which is currently at $30 a share. You decide to sell (or write) one call, which covers 100 shares of stock. (If you owned 200 shares of XYZ, you could sell two calls.)

 

The strike price
You agreed to sell those 100 shares at an agreed-upon price, known as the strike price. When you look up the options quotes on your screen, you’ll see an assortment of strike prices. The strike price you choose determines how much premium you receive for selling the option. With covered calls, for a given stock, the higher the strike price is from the stock price, the less valuable the premium.

Therefore, a $32 strike price is more valuable than a $35 strike price. Why? Because it is more likely for XYZ to reach $32 than it is for it to reach $35, and therefore more likely that the buyer of the call will make money. Because of that, the premium is higher.

 

The expiration date
In addition to deciding on the most appropriate strike price, you also have a choice of an expiration date, which is the third Saturday of the expiration month. For example, let’s say in February you choose a March expiration date. On the third Friday in March, trading on the option ends and the following day it expires. Either your option is assigned and the stock is sold at the strike price or you keep the stock. Because some people don’t want to tie up their stock for too long, they may choose expiration dates that are only a month or two away. Hint: The further away the expiration date, the more valuable the premium because a longer time span gives the underlying stock more opportunity to reach the option’s strike price.

Note: It takes experience to find strike prices and expiration dates that work for you. As a new options investor, you may want to experiment with one options contract and different strike prices and expiration dates. Eventually you’ll find a combination that works for you.

 

Your first covered call trade
Now that you have a general idea of how this strategy works, let’s look at more specific examples.

Note: Before placing a trade, you must be approved for an options account.

In February, you own 100 shares of XYZ, which is currently at $30 a share.

You sell one covered call with a strike price of $33 and an expiration date of March. The bid price (the premium) for this option is $1.25.

If you were willing to pay the additional commissions and initiated this trade over the phone, you’d say, “I’d like to sell one covered call for XYZ March 33 for a limit price of $1.25 good for the day only.” Hint: It’s suggested you place a limit order, not a market order, so that you can specify the price.

If the call is sold at $1.25, the premium you receive is $125 (100 shares x $1.25) less commission.

Now that you sold your first covered call, you simply monitor the underlying stock until the March expiration date.

Let’s take a look at what could go right, or wrong, with this transaction.

Example one: The underlying stock, XYZ, is above the $33 strike price on the expiration date.

If the underlying stock rises above the strike price at expiration, even by a penny, the stock will most likely be “called away” from you. In options terminology, this means you are assigned an exercise notice. You are obligated to sell the stock at the strike price (at $33 in this example) at expiration. If you sell covered calls, you must expect and plan to have your stock sold. Fortunately, after it’s sold, you can always buy the stock back and sell covered calls on it the following month.

One of the criticisms of selling covered calls is there is limited gain. In other words, if XYZ suddenly zoomed to $37 a share at expiration, the stock would still be sold at $33 (the strike price). You would not participate in the gains past the strike price. If you are looking to make a big score, then selling covered calls may not be an ideal strategy.

Benefit: You keep the premium, stock gains, and dividends, but the stock will be sold at the strike price.

Risk: You lose out on potential gains past the strike price. In addition, your stock is tied up until the expiration date.

Hint: Choose from your existing underlying stocks that are slightly bullish and not too volatile.

Example two: The underlying stock is below the strike price on the expiration date.

If the underlying stock is below $33 a share (the strike price) at expiration, the option has a greater likelihood to expire unexercised and you keep the stock and the premium. You could also sell another covered call for a later month. Although some people hope their stock goes down so they can keep the stock and collect the premium, be careful what you wish for.

For example, if XYZ drops a lot, for example, from $30 to $25 a share, although the $125 premium you receive will reduce the pain, you still lost $500 on the underlying stock.

Benefit: The premium will reduce, but not eliminate, stock losses. 
Risk: You lose money on the underlying stock when it falls.

Advanced note: If you are worried that the underlying stock might fall, you can always initiate a collar, that is, you can buy a protective put on the covered call, allowing you to sell the stock at a set price, no matter how far the markets drop.

Example three: The underlying stock is near the strike price on the expiration date.

Some might say this is the most satisfactory result for a covered call. If the underlying stock is slightly below the strike price at expiration, you keep the premium and the stock. You can then sell a covered call for the following month, bringing in extra income. If, however, the stock rises above the strike price at expiration by even a penny, the option will most likely be called away.

Benefit: You keep the stock and premium, and can continue to sell calls on the same stock.

Risk: The stock falls, costing you money.

 

Advanced covered call strategies
Some people use the covered call strategy to sell stocks they no longer want. If successful, the stock is called away at the strike price and sold. You also keep the premium for selling the covered calls.

If you want to avoid having the stock assigned and losing your underlying stock position, you can usually buy back the option in a closing purchase transaction, perhaps at a loss, and take back control of your stock.

 

BUYING CALLS

Options strategy: how to buy calls
Buying calls can help to increase the returns, and risks, of your investments.

If you’re looking for a strategy that gives you the potential for larger returns without having to invest a lot of money up front, you may want to consider buying call options. When you buy calls, you profit if the market or an individual stock rises far enough within a certain period of time. If you are right, you can participate in the rise of the stock without actually having to buy it, and only pay a fraction of the cost that would be involved if you purchased actual shares of the stock.

To be profitable, you must be correct both about both the direction and timing of the stock price change. For example, if you believe that a stock will go up within the next month, you could consider buying a call option rather than buying the stock. Like any strategy, the goal is to be profitable while minimizing risk. Buying calls has the potential to help you achieve this goal.

 

Understanding call options
Before you buy your first call, it’s essential that you understand how they work. For example, let’s say XYZ stock is $30 a share in February. If you wanted to buy 100 shares, it would cost you $3,000. Instead, you could buy one call option, which gives the right to buy 100 shares of the stock at a set price, known as the strike price. The cost of the option contract is usually a fraction of investing in the actual stock. So, in this hypothetical example, instead of paying $3,000 to own the stock, you might pay $300.

Say you are trying to decide between buying a call or the stock itself in the above example—100 shares would cost $3,000, and the option contract would cost $300. If the stock price goes from $30 to $35 by the options expiration, the shares of the stock would rise in value from $3,000 to $3,500, and you would make 17%, or $500, for this time period. As the stock price rises, the value of the option at expiration would rise from $300 to $500, a $200 gain, or a 67% return for the period that you held the option. But what if the stock price falls to $28? At expiration the option would expire worthless and you will lose 100% of your investment. Every options contract has a few key criteria that option traders must be aware of:

Strike price. When you buy a call, you have an opinion about the direction of the stock. Let’s say you believe that XYZ will rise from $28 to $32 a share within one month. Options contracts let you choose the best way to take advantage of your forecast by choosing the best strike price. The strike price is the price at which you can buy the underlying stock for call options. For example, the option may have strike prices of $30, $35, and $40. Every investor needs to review the available strike prices, and find one that matches their investment forecast. For instance, if you think the price of the underlying stock will reach $32, you may want to look at a $30 strike price.

Expiration date. When you buy calls, time is not on your side. In fact, as soon as you buy a call, the clock is ticking. All options contracts have an expiration date. The standard expiration date is the Saturday following the third Friday of the month. It is important that you choose the expiration date that is going to let your forecast be realized.

Commissions. As they do with most investments, brokerages charge commissions when you buy or sell options contracts. Those commissions—which aren’t reflected in the examples used in this article—can reduce your returns.

 

Buying your first call option
Now that you have a general idea of how this strategy works, let’s take a look at more specific examples.

Note: Before placing a trade, you must be approved to trade options in your account.

In February, you decide to buy one call option (equal to 100 shares) of XYZ, which is currently at $30 a share.

You choose an XYZ April 30 call option currently trading at $1.50.

If you initiated this trade over the phone, you’d say, “I’d like to buy (or go long) one XYZ April 30 call for a limit price of $1.50 good for the day only.” You may want to consider placing a limit order, not a market order, so that you can specify the price you are willing to pay.

If the call is bought at the limit price of $1.50, you will pay a total of $150 (100 shares x $1.50), plus commission.

Now that you bought your first call, you have to closely monitor the underlying stock until the April expiration date. Since time is not on your side, there are a number of choices you have to make.

 

How a trade may play out
Let’s take a look at what could go right, or wrong, with this transaction.

Example One: The underlying stock, XYZ, rises from $30 to $35 on the expiration date.

You expect and want the underlying stock to rise above the strike price. The higher the stock goes, the more valuable the call option. At any time before the expiration date, you can close your position and take the profits. Many option traders will lock in gains based on their profit forecast, because the price of the stock could fall.

In this example, as XYZ rose to $35, the call option at expiration was worth $5 ($35 – $30). You decide to sell the call to close. You are left with a $350 profit ($5.00 gain – $1.50 premium = $3.50 net gain x 100 shares), less commissions.

Benefit: In this example, the call option had a larger return (by percentage) than the underlying stock, while requiring less capital to make the investment.

Risk: The stock could fall and you lose some if not all of the premium paid.

Caution: Although buying calls may look attractive when compared with buying stock, in real life there are many things to consider before making your investment.

Example Two: The underlying stock, XYZ, drops below $30 at or before expiration.

If the underlying stock falls below your strike price at expiration, the option will be worthless. In fact, as the stock gets closer to the expiration date, the option can deteriorate quickly because of lost time value.

In this example, the underlying stock fell to $28 a share a few weeks later, causing a partial loss. You sold the call for $0.60 as your exit strategy ($150 investment – $60 sales price = $90 loss).

Risk: You could lose all or part of your $150 investment.

Example Three: The underlying stock, XYZ, is near the $30 strike price at or before expiration.

This scenario is similar to Example Two. Because of diminishing time value, the option may expire worthless. Therefore, in this example, you could lose your entire investment of $150. You always have the choice of selling the option before the expiration date and closing the position to minimize losses.

Risk: You could lose all or part of your $150 investment.

 

Exercising call options
In the first example, when the underlying stock rose above the strike price (the option is “in-the-money”), you can sell the call and take the profit. You also have another choice, and that is to exercise the option. In this example, you can convert the single call option into 100 shares of stock by paying the strike price. You might be interested in converting shares into stock if you think the stock will continue to rise, and are comfortable owning the stock in your portfolio.

Important: Although you have the right to exercise, many option traders simply buy and sell the option without exercising. By selling the option, the trader does not have to assume the risk and cost of owning the underlying stock.

 

Options and stocks don’t always move together
Although buying calls is usually a straightforward strategy, there is some nuance. For example, some people are confused when, on occasion, the stock goes up but the option doesn’t follow. “Sometimes a stock could rise in value but an ‘out-of-the-money’ call could drop,” says Joe Harwood, manager of the Options Industry Council (OIC) help desk. The solution is to take the time to learn how options are priced. “Many people think that options are pegged to the stock price, but they are not. Options are a derivative of stocks, but they are not pegged.” This means that prices fluctuate based on the options market and other forces, not purely on the price of the stock.

 

Bottom line
Buying calls can offer an alternative strategy to buying stock, for investors looking to increase the size of returns relative to the amount of money they choose to invest.

 

COLLARS

Put a collar on this market
Here’s a sophisticated options strategy designed to limit losses and protect gains.

The S&P 500® Index has gained 9% so far in 2012. That’s a huge gain over a very short period of time. You may have stocks that have generated strong returns in the rally, and such a big move might raise red flags for a potential correction. If you’re looking to protect gains on current stock positions, or you are moderately bullish on a particular asset but could be concerned about a potential downturn, consider the collar options strategy.

 

Getting to know collars
A collar is a relatively complex options strategy that puts a cap on both gains and losses (see graphic below). There are three components to constructing a collar:

Purchasing or having an existing stock position (e.g., owning shares of XYZ Company)

Selling a call (the seller of a call has an obligation to sell the stock at the strike price until expiration or until he or she closes the short call position)

Buying a put (the buyer of a put has the right to sell the stock at the strike price until the expiration or until he or she closes the long put position)

This strategy can help mitigate downside risk via the purchase of a put, and some or all of the cost for the purchased put may be covered by selling a covered call on a new or existing stock position.

The premium, or cost of the position, that you pay for the collar is similar to paying an insurance premium. The put could expire worthless if the underlying stock stays the same or rises, but may become more valuable if the underlying stock falls. This allows you to protect the value of the investment by limiting losses in the event of a decline. You are also selling a covered call (to cover some or all of the cost of the put), and become obligated to sell the underlying stock if it rises above your call strike at expiration or is assigned.

You might be asking yourself: Why buy protection for a stock you think might go down in value? Why not just sell the stock? One reason is that there might be significant tax consequences or transaction costs. You may prefer to maintain your position in a stock rather than selling it. However, sometimes selling the stock may be the right answer if you no longer are bullish on the stock.

 

Let’s take a closer look at collars
Now that you have a basic idea of how this strategy works, looking at a specific example will help you. Please note that before placing a collar, you must fill out an options agreement and be approved for the appropriate options trading level.

In our example, we will look at a hypothetical scenario for XYZ Company.

  1. In January, assume you decide to buy 100 shares of XYZ Company for $53 a share.
  2. Four months later, with the stock trading at close to $53, you become concerned about a potential stock market decline but do not want to sell the shares, so you decide to construct a collar. To do this, you buy a September 52 put selling at $2.45 per contract. Each options contract typically covers 100 shares, so you pay $245 ($2.45 per contract x 100 shares x 1 contract). This out-of-the-money put acts as an insurance policy, effectively protecting your XYZ shares in case of decline below $52.
  3. At the same time, you sell a call on XYZ at the September 55 strike price that costs $2.30 per contract. Each options contract typically covers 100 shares, so you receive $230 ($2.30 x 100 x 1 contract) in premium for this one contract. The primary purpose of selling this call is to cover some of the cost of buying the put.

You now have a collar on your XYZ shares. The net cost of options needed to create the collar is $15 ($245 – $230). The maximum gain on the position is now $185, which is equal to the call strike price ($55) less the purchase price of the underlying shares ($53), multiplied by 100, less the net cost of the collar ($15). The maximum loss is now $115, which is equal to the purchase price of the underlying shares ($53) less the put strike price ($52), multiplied by 100, plus the net cost of the collar ($15).

Breakeven, or the price at which the underlying asset must settle for the costs of the trade to equal profit, is equal to $53.15. This is calculated as the purchase price of the underlying shares ($53) plus the net cost of the collar per 100 shares ($0.15).

 

Managing the collar trade
Assume that the share price of XYZ rises to $57 on the expiration date. In all likelihood, the holder of the call option that you sold will exercise the call, so you are forced to sell the stock at the $55 strike price. On the other hand, the put would expire worthless because it is out of the money. Although you incurred a net debit of $15 to construct the collar, you made a two-point gain, or $200, on the underlying stock (bought at $53 and sold at the $55 strike price). In this example, the put acts as unused insurance protection.

Now suppose the share price of XYZ falls to $49 on the expiration date. The most obvious impact here is that the value of your stock position falls $400 ($53 to $49 price decline, multiplied by 100 shares you own). However, because XYZ is below $55 at expiration, the call you sold will expire worthless and you will keep the $230 premium received from the covered call. This offsets some of the loss you have experienced on the stock.

Also, while the covered call expires worthless, the put you bought rises in value. In this example the put premium price has risen from $2.45 to $3.00, so you realize a gain of $55 ($300 – $245). As the stock price falls, the put increases in value.

You still have a loss of $115 ($55 put option + $230 call option – $400 loss on the stock). This highlights how the collar provides protection in a down market.

Finally, let’s assume that XYZ rises to $54 on the expiration date. If XYZ moves between the strike price of the covered call ($55) and the strike price of the put ($52) at expiration, no action needs to be taken, as both options will expire worthless. In this event, you lose the $15 difference between the cost of the put and the money you took in for selling the call.

 

STRADDLES

Straddling the market for opportunities
Here’s an options strategy designed to profit when you expect a big move.

Stocks have been broadly advancing at a steady pace since mid-December of last year. But in the event that the rally slows or market volatility returns, what will you do? Well, when you aren’t sure which direction a stock is going to go but you are expecting a big move, you may want to consider an options strategy known as the straddle.

 

Getting to know straddles
You can buy or sell straddles. In a long straddle, you buy both a call and a put option for the same underlying stock, with the same strike price and expiration date. If the underlying stock moves a lot in either direction before the expiration date, you can make a profit. However, if the stock is flat (trades in a very tight range), you may lose all or part of your initial investment.

Here are a few key concepts to know about straddles:

They offer unlimited profit potential but with limited risk of loss.

The more volatile the stock or index (the larger the expected price swing), the greater the probability the stock will make a strong move.

Higher volatility may also increase the total cost of a long straddle position.

In comparison to other options strategies, the upfront cost of a straddle may be slightly higher because you are buying multiple options and volatility is typically higher.

The concept behind the long straddle is relatively straightforward. If the underlying stock goes up, then the value of the call option increases while the value of the put option decreases. Conversely, if the underlying stock goes down, the put option increases and the call option decreases. While it is possible to lose on both legs (or, more rarely, make money on both legs), the goal is to produce enough profit from the option that increases in value so it covers the cost of buying both options and leaves you with a net gain.

 

What to look for before making a trade
Our focus is the long straddle because it is a strategy designed to profit when volatility is high while limiting potential exposure to losses, but it is worth mentioning the short straddle. This position involves selling a call and put option, with the same strike price and expiration date. This nondirectional strategy would be used when there is the expectation that the market will not move much at all (i.e., there will be low volatility). With the short straddle, you are taking in upfront income (the premium received from selling the options) but are exposed to potentially unlimited losses and higher margin requirements.

 

Let’s dive into straddles
With a basic understanding of how this strategy works, let’s look at specific examples. Please note that before placing a straddle, you must fill out an options agreement and be approved for options trading.

In our example, we will look at a hypothetical scenario for XYZ Company.

In August, you forecast that XYZ, then trading at $40.75 a share, will either rise or fall sharply based on an earnings report that is set to be released in a week. Due to this expectation, you believe that a straddle would be an ideal strategy to profit from the forecasted volatility.

To construct a straddle, you buy 1 XYZ October 40 call for $2.25, paying $225 ($2.25 x 100). We multiply by 100 here because each options contract typically represents 100 shares of the underlying stock. At the same time, you buy 1 XYZ October 40 put for $1.50, paying $150 ($1.50 x 100). Note that in this example, the call and put options are at or near the money. Your total cost, or debit, for this trade is $375 ($225 + $150), plus commissions.

The maximum possible gain is theoretically unlimited because the call option has no ceiling (the underlying stock could rise indefinitely). The maximum risk, or the most you can lose on this trade, is the initial debit paid, which is $375, plus commissions. This would occur if the underlying stock closes at $40 at the expiration date of the options.

Let’s make use of breakeven here. In this example, the cost of the straddle (in terms of the total price for each contract) is $3.75 ($2.25 + $1.50). Breakeven in the event that the stock rises is $43.75 ($40 + $3.75), while breakeven if the stock falls is $36.25 ($40 – $3.75). With this information, you know that XYZ must close above $43.75 or below $36.25 at expiration to be profitable.

 

Managing a winning trade when things go right
Assume XYZ releases a very positive earnings report. As a result, XYZ rises to $46.30 a share before the expiration date. Because XYZ rose above the $43.75 breakeven price, our September 40 call option is profitable and might be worth $6.40. Conversely, our September 40 put option has almost no value; let’s say it is worth $0.05.

Before expiration, you might choose to close both legs of the trade. In the above example, you could simultaneously sell to close the call for $6.40, and sell to close the put for $0.05, for a gain of $645 ($6.40 + $0.05). Your total profit would be $270 (the gain of $645 less your initial investment of $375), minus any commission costs.

Now, consider a scenario where instead of a positive earnings report, XYZ’s quarterly profits plunged and the stock falls to $33 before expiration.

Because XYZ fell below the $36.25 breakeven price, the September 40 put option might be worth $7.25. Conversely, the September 40 call option is worth just $0.15.

Before expiration, you might choose to close both legs of the trade by simultaneously selling to close the put for $725 ($7.25 x 100) as well as the call for $15 ($0.15 x 100). The gain on the trade is $740 ($725 + $15), and the total profit is $365 (the $740 gain less the $375 cost to enter the trade), minus commissions.

 

Managing a losing trade
The risk of the long straddle is that the underlying asset doesn’t move at all. Assume XYZ rises to $41 before the expiration date. Although the underlying stock went up, it did not rise above the $43.75 breakeven price. More than likely, both options will have deteriorated in value. You can either sell to close both the call and put for a loss, or you can wait longer and hope for a sudden turnaround.

Let’s assume that with just a week left until expiration, the XYZ October 40 call is worth $1.35, and the XYZ October 40 put is worth $0.35. Since XYZ didn’t perform as expected, you might decide to cut your losses and close both legs of the option for $170 ([$1.35 + $0.35] x 100). Your loss for this trade would be $205 (the $170 gain, minus the $375 cost of entering into the straddle), plus commissions.

The risk of waiting until expiration is the possibility of losing your entire initial $375 investment. Both options could expire worthless if the stock finishes at $40. This is called pinning: the stock finishes at the stock price.

 

Other considerations
Timing is an important factor in deciding when to close a trade. There are cases when it can be preferential to close a trade early, most notably “time decay.” Time decay is the rate of change in the value of an option as time to expiration decreases and, because of that and other reasons, traders might choose not to hold straddles to expiration. Instead, they might take their profits (or losses) in advance of expiration.

In addition to time decay, there are other factors that can influence options used in the straddle trade. Learn about the factors that influence options used in the straddle trade and keep the straddle in your trading arsenal in case high volatility makes a comeback.

Here’s an article I wrote for Bankrate on the pros and cons of currency trading:

If you’ve been thinking of ways to trade the falling euro (EUR), or any other currency, you might consider the foreign exchange market. Forex, which is open 24 hours a day and five days a week, is the world’s most traded financial market and also the most liquid. This means you can quickly get into and out of a trade.You also have a choice between trading in the currency futures market, which is a physical exchange, or the forex “spot” market, where you trade over the counter with a broker. Many beginners trade in the spot market because you need so little upfront money. So if you’re certain that betting on a certain currency is a sure thing, see what’s involved.

The basics

Currencies are always traded in pairs. In other words, you buy one currency and sell the other. For example, you could sell the euro against the dollar (EUR/USD). In this case, you short the euro (you believe the euro will go down) but long the dollar (you believe the dollar will go up). Conversely, you could buy, or go long, the euro and short the dollar. Because there are 28 major pairs with eight major currencies, you have many choices.

If you’re a beginner, stick with the major currencies you know. “It’s recommended you start off with a liquid pair, like the euro or dollar,” says Tim Bourquin, co-founder of TraderInterviews.com and co-founder of Traders Expo and Forex Trading Expo. “Don’t start trading the Indian rupee versus the Iraq dinar, which has no liquidity and little information.”

Currencies move up and down by percentage in points, or pip, which is one-hundredth of 1 percentage point. When trading a dollar-based currency, one pip equals $10. Don’t get fooled by the small increments. Because of leverage, you can theoretically make or lose $3,000 or more in a day, depending on the size of your account.

The benefits

One of the benefits of trading currencies is the high leverage. Unlike in the stock market, where you can buy securities on margin with 2-to-1 leverage, in the currency market, you’re allowed 50-to-1 leverage. Therefore, for every $1 you invest, you control $50 worth of currency. That’s good, right?

“The high leverage can work for you or against you,” says Michael Archer, author of “Getting Started in Currency Trading: Winning in Today’s Hottest Marketplace.”

Archer says it’s not unusual for new traders to plunk down $500 (and control $25,000 in currencies), and then lose it all. Why? Because they don’t understand how leverage works. “Just because you have 50-to-1 leverage doesn’t mean you have to use it,” Archer cautions. Although it is possible to lose more than your initial investment, most online brokers close your position before that happens, Archer says.

What are the other benefits of trading currencies? John Jagerson, co-author of “All About Forex Trading,” says that currency trading “can be an extremely low-cost, efficient way for talented, short-term investors to make profits. It’s a fast market with super-tight spreads with no commissions.” In fact, most forex brokers don’t charge commissions, but they make profits off of the spreads between currencies.

The risks

One of the risks of forex is that it’s not transparent. “Currency traders are literally trading against the pros, who have control over where and when the order gets filled,” says Jagerson. “Nine times out of 10 it won’t matter, but there is a conflict of interest.”

The solution, Jagerson says, is to stick with big-name U.S. brokers, which are under stricter regulatory control. The ones you should avoid, he says, are brokers who operate in relatively unregulated territories such as Russia or Cyprus. “These brokers might pop up and then disappear with all of your money,” he warns.

Bourquin agrees. “If you stick with the big-spot forex traders like GFT, Forex.com and FXCM, they have enough volume so they don’t need to mess with the client’s pricing to make money.” In addition, Bourquin says, the National Futures Association, or NFA, started cracking down on rogue brokers, which forced a few to leave the country.

Another problem, Jagerson says, is that people don’t appreciate the risks of currency trading. “I tell aspiring traders to paper trade as long as possible in adverse market conditions,” he says. Paper trading enables novices to mimic the trading process without actually laying out any cash.

The most common reason for failure, Jagerson says, is people trade too large and too inconsistently. “Their analysis is often good, but their money management is so bad it sabotages them.”

Often, the biggest problem is with the trader. “Many people who enter the currency market have crazy expectations, such as making 5 percent to 10 percent a month or more,” says Jagerson. “I don’t know where they get those ideas.”

Trading currencies is more complex than many people realize. “Some firms have entire departments with professionals that have been trading currencies for 30 years,” says Bourquin. “It’s not just earnings or how many widgets XYZ is selling. Currencies involve complicated issues about interest rates and debt in Europe and Greece. People need to study that.”

Getting started

Before you start trading currencies, experts suggest you get an education, although with some caveats. “You have to be careful where you get your education,” says Bourquin. “The Internet is filled with get-rich programs. There’s no reason to pay $10,000 for a forex training program when most brokers offer the basics on their websites for free.”

Trading currencies is similar to trading stocks in one way: money management. “My suggestion is to start small and go slow,” says Archer. “Take six months to a year before you put real money on the line. Find a fairly simple trading technique, and develop trading rules that work for you.”

And learn to sit on your hands instead of constantly trading, he adds. “Wait for the right opportunity.”

MIAMI (MarketWatch) — Of all the mistakes I’ve made in the stock market, these three stood out.

1. Assuming you’re right

Of course everyone wants to be right. But the blind belief that you’re right about a stock can cost you money. I’ve been reading the best-selling book “The Big Short,” which profiles a handful of traders who were short subprime mortgages through credit-default swaps.

In 2007, certain bond traders concluded the mortgage market was on the verge of collapse. Before they placed their bets, two of these traders purposely searched for anyone with an opposing view. That’s right: They wanted to hear conflicting views before placing their trades. They were surprised that no one else in the industry seemed to detect the looming disaster. When the traders realized the counterargument was weak, they invested millions on short positions, betting against most of the large Wall Street bond firms.

I’ve always said that you should talk to short sellers if you want to hear the truth. Surrounding yourself with cheerleaders may feel good, but it won’t help you to detect potential land mines. No matter what your business, take the time to listen to other opinions.

Another strategy: Some traders enter a new trade assuming they are wrong. They enter the market as a pessimist, and let the facts guide them to the truth.

2. Not doing your research

To paraphrase Peter Lynch, people will spend two weeks researching a $500 refrigerator, but spend thousands on a stock without a second thought. Years ago, I invested $20,000 in a small cell-phone company based on a tip from an acquaintance. Within three months, I lost nearly $15,000. At the very least, I could have glanced at a chart or done basic fundamental analysis. For $300, I could have flown to the company’s headquarters. As it turned out, I blindly bought the pump-and-dump stock and paid the price.

Do you walk into a car dealership and pay list price? Hopefully not. Don’t expect guidance from the salespeople, who will gladly sell you a car for the highest price. When you’ve done your research, tips, hype or emotion won’t sway you.

Another lesson: Be wary of sources with ulterior motives. In “The Big Short,” the traders assumed that many bond salesmen were lying about subprime mortgages. To find out the truth, the traders spent hours reading mind-numbing contracts. They were surprised that few salespeople even knew what was in the contracts. The so-called experts were as clueless as the public.

3. Following the crowd

I’ve always been fascinated by crowd behavior. In 2006, when people were day-trading houses, few recognized they were on the edge of a cliff. The crowd was in a buying frenzy, and the stock market climbed along with housing.

If you look around and see everyone making the same trade as you, be cautious. Often the crowd is right, but only for a while. When people are making a lot of money, it’s easy to miss the warning signs.

Recently, the “crowd” has been in an ornery mood. Many experts are making wild doom-and-gloom predictions based on opinion and conjecture.

Before you sell all your stocks and hide in a cave, read what author and billionaire Ken Fisher told me for my book, “All About Market Indicators”: “When people approach me with predictions, I ask, ‘Has this happened a lot in history? What do you base that on?’ And if it never happened before in history, they are making a very strong statement. And if it has never happened before, you’d better have some powerful evidence to make me believe this event will happen. People tell me things all the time that are so improbable because they have happened so rarely in history. People who bet on the black swan will get their neck chipped.”

To avoid losing money, follow the three lessons above: Do your own research (and find evidence to support or disprove your view), don’t follow the crowd and listen to people with opposing views.

Michael Sincere ( www.michaelsincere.com ) is the author of “Understanding Options,” “Understanding Stocks” and “Start Day Trading Now.”

Here’s an article I wrote about selling covered calls (below): http://bit.ly/QKytLz

Uncover Covered Calls

We shed some light on 3 features of this basic options strategy: selling stock, collecting dividends, and limiting taxes.

Words By Michael Sincere

What draws investors to a covered call options strategy? Giving someone the right to buy your stock at the strike price in exchange for a few more greenbacks, baby. Covered calls are potential income earners on stocks you already own. Of course, there is no free lunch; your stock could be called away at any time during the life of the option. Selling or “writing” covered calls has many potential uses besides just being a way to potentially generate income that many investors don’t fully realize. Let’s take a look.

1. Exit a long position.

What may be one of the most underutilized ways to sell your stocks is by using a covered call strategy. If you already plan to sell, you might as well consider taking advantage of the potential to receive some additional income for your efforts.

Here’s how it works: Let’s say that XYZ stock is trading at $23 a share, and you want to sell your 100 shares at $25 per share. Sure, you could probably sell your XYZ shares right now for $23 per share in your brokerage account, but you could also sell (write) a covered call with your target price (strike price) of $25 a share.

If you sell the call, you’ll receive cash (premium), which is immediately deposited into your account (less any commissions and contract fees). The cash is yours to keep no matter what happens to the underlying shares. If XYZ rises above $25 or higher before the option expires, you’ll likely be assigned on your short option and your shares of XYZ will be called away from you at the strike price. In fact, that move fits right into your plan. You received premium for selling the call, and you also made an additional 2-points (from $23 to $25) on the stock. As desired, the stock was sold at your target price (i.e. called away from you) at $25. If the stock goes higher than $25, you made what you wanted, but not a penny more. After all, you agreed to sell XYZ at the $25 strike price. You pocketed your premium, and made another 2 points when your stock was sold. But you won’t participate in any stock appreciation above the strike price. Also, keep in mind the transaction costs (commissions, contract fees and option assignment fees) will reduce your gains.

ON THE OTHER HAND—In our example, although you would like to sell XYZ at $25, it’s possible that the stock price could fall from $23 to $20 or even lower. In this case, you still get to keep the premium you received and you will still own the stock on the expiration date, however, instead of the 2 points you had hoped to attain, you’re now looking at a potential loss, (depending on what price you originally bought XYZ at). In other words, there is some downside protection with this strategy, but it is limited to the cash you received when you sold the option.

HINT—Many options traders spend a lot of time analyzing the underlying stock in an effort to avoid unwanted surprises. They use that research to try to improve the odds that they choose stocks that won’t suffer a serious, unexpected price decline. Keep in mind no matter how much research you do, surprises are always possible.

HINT—Any time your covered call option is “at-or in-the-money,” your stock could be called away from you. And the deeper your option is “inthe- money” during the lifetime of the option, the higher probability that your stock will be called away from you, and sold at the strike price.

KEEP IN MIND—If your option is in-the-money by even one penny when expiration arrives, your stock would very likely be called away.

VOCAB QUIZ

COVERED CALL
A strategy in which a call option is written against an equivalent amount of long stock. A “call” gives the owner the right to buy the underlying security at a specified price (strike price) for a certain, fixed period of time (until expiration). Selling a covered call is also known as “writing” a covered call. While a position remains open, the writer is subject to fulfilling the obligations of that option contract.

IN-THE-MONEY
Describes an option with intrinsic value. A call option is in-the-money if the stock price is above the strike price. A put option is in-the-money if the stock price is below the strike price.

BUY-WRITE
A covered call position in which stock is purchased and an equivalent number of calls written at the same time.

Source: Options Industry Council


READING GREEK

DELTA
is a measure of an option’s sensitivity to changes in the price of the underlying asset.

GAMMA
is a measure of delta’s sensitivity to changes in the price of the underlying asset.

VEGA
is a measure of an option’s sensitivity to changes in the vola- tility of the underlying asset.

THETA
is a measure of an option’s sensitivity to time decay.

Read more about greeks.

2. Sell covered calls for premium, potentially continue to collect dividends and capital gains.

Selling covered calls can sometimes feel like you’ve made a triple play. After you sold a covered call on XYZ, you collect your premium and you can still continue to receive dividends and capital gains on the underlying stock unless the stock is called away. That’s the good news.

ON THE OTHER HAND—The option buyer (the person who agreed to buy your option) is not dumb. He or she may also want that dividend, so as the ex-dividend date approaches, the chances that your stock will be called away from you increase.

HINT—The option buyer (or holder) has the right to take that stock away from you anytime that the option is in-the-money. You still keep the premium and any capital gains up to the strike price, but you could lose out on the dividend if the stock leaves your account prior to the ex-dividend date.

HINT—Not surprisingly, some option buyers will exercise the call option prior to the ex-dividend date to capture the dividend for themselves. And if the option is deep in-the-money, there’s a higher probability the stock will be called away from you before you get to collect the dividend. Anytime you sell a call option on a stock you own, you must be prepared for the possibility that the stock will be called away. When you sell a covered call, you receive premium, but you also give up control of your stock.

KEEP IN MIND—Only options that are in-the-money would likely be exercised to collect the dividend.

3. Potential tax advantages in selling covered calls.

There may be tax advantages to selling covered calls in an IRA or other retirement account where premiums, capital gains, and dividends may be tax-deferred. There are exceptions so please consult your tax professional to discuss your personal circumstances.

Now, if the stock is held in a taxable brokerage account, there are some tax considerations. For example: Let’s say in November you have potential profits on XYZ stock, but for tax purposes, you don’t want to sell. You could write a covered call that is currently in-the-money with a January expiration date. Special rules apply to calls that are written “deep in the money” so please consult your tax professional to discuss your personal circumstances and the special rules.

If all goes as planned, the stock will be sold at the strike price in January, in a new tax year. Remember, you’re always accepting the risk, no matter how small, that your option will be assigned sooner than you planned. You could even be assigned on that in-the-money call the day after you sold it. The result could be that you sell the stock and take a profit in the very year you wanted to avoid. One way to reduce that probability but still aim for tax deferral is to write an out-of-the-money covered call.

FOR EXAMPLE—Let’s say in November you have potential profits on XYZ stock, but for tax purposes, you don’t want to sell. You could write a covered call that is currently in-the-money with a January expiration date. If all goes as planned, the stock will be sold at the strike price in January, in a new tax year. Remember, you’re always accepting the risk, no matter how small, that your option will be assigned sooner than you planned. One way to reduce that probability but still aim for tax deferment is to write an out-of-the-money covered call.

ON THE OTHER HAND—If the stock falls rather than appreciates, you will likely still be holding the stock, and the call option will expire worthless. In this example, you could always consider selling the stock, or sell another covered call. Nevertheless, a risk of hoping to get assigned on a covered call is that the underlying stock may fall and never reach your strike price, a scenario you must always anticipate.

HINT—Given a choice between paying taxes on a profitable stock trade and paying no taxes on an unprofitable stock trade, most people would rather pay the taxes. But that is a choice only you can make.

HINT—If you believe that the benefits of selling covered calls outweigh the risks, you might look for stocks that you consider good candidates for covered call writing. A buy-write allows you to simultaneously buy the underlying stock, and sell (write) a covered call.

KEEP IN MIND—You will likely pay two commissions, one for the buy on the stock and one for the write of the call. The key to avoiding the misuse of basic options strategies such as covered calls is education, research, and practice. Remember, any options strategy can only be right for you if it is true to your investment goals and risk tolerance.

FIGURE 1: Sample trade shows purchase of 1,000 shares of stock and sale of 10 calls. This example does not include transaction costs. Investors must consider the effects of transaction costs before placing options trades. Probability analysis results are theoretical in nature, not guaranteed, and do not reflect any degree of certainty of an event occurring. For illustrative purposes only. Past performance does not guarantee future results.

FIGURE 1: Sample trade shows purchase of 1,000 shares of stock and sale of 10 calls. This example does not include transaction costs. Investors must consider the effects of transaction costs before placing options trades. Probability analysis results are theoretical in nature, not guaranteed, and do not reflect any degree of certainty of an event occurring. For illustrative purposes only. Past performance does not guarantee future results.

Here’s an article I wrote about the differences between fundamental and technical analysis (below): http://bit.ly/NeZTam

Trading: Art Meets Science

Fundamental or technical analysis? You don’t have to choose. A combination can help with potential entries and exits.

Words By Michael Sincere

Which is better, fundamental or technical analysis? For traders and investors, this debate may rival the classics: Hatfields & McCoys or cats vs. dogs. There can be subtle or profound differences, depending on who you ask.

Fundamental trading is a little more “art.” That is, subjective (See Figure 1). Past company earnings are fact. Yet, where company profit might be headed is anyone’s “educated” guess. Or, take share-price valuation. It’s based on math, but also requires that traders check their gut before jumping.

FIGURE 1: A quote detail on TD Ameritrade’s Trade Architect platform provides news, earnings, analyst estimates for upcoming quarterly results, and more. For illustrative purposes only. Past performance does not guarantee future results. Data: Penson Worldwide, Inc.

FIGURE 1: A quote detail on TD Ameritrade’s Trade Architect platform provides news, earnings, analyst estimates for upcoming quarterly results, and more. For illustrative purposes only. Past performance does not guarantee future results. Data: Penson Worldwide, Inc.

Technical trading (the “science” for our purposes) hinges less on why a market is performing the way it is and more on what a chart shows at a particular time. Like any science, this method isn’t fool proof either.

Below, two active home-based traders invite us for a peak over their shoulder. One considers herself a fundamentalist who leans on chart readings for support. The other is a technician who generates trading ideas by skimming the fundamentals. Study their research methods, analysis, and chart tricks, but keep in mind, their level of expertise or particular approach may not be the best fit for your goals and risk tolerance, or it may contradict your own preferred style. Still, you’ll get an idea of how a fundamentalist works versus how a technician works. In reality, you’ll likely find that both mix a little art and science.

Meet Toni Turner

FUNDAMENTALIST USING TECHNICAL CONFIRMATION

Why take this approach? “You wouldn’t walk onto a golf course with only half your clubs. To get my own reading of what a stock is worth, I combine both,” said Toni.

Let’s watch Toni trade.

5:30 A.M. ET I begin my research by checking the stock index futures, the Asian and European markets, or choosing a sector or industry group that, as I see it, has a chance of advancing (or declining) in the current market environment. Once I focus on a sector or industry, I create a watch list of five or six equities.

TONI’S RESEARCH APPROACH

Once logged in to tdameritade.com, I open Research & Ideas > Stocks. I’ll check the overview page on each stock, and check the earnings per share, the price/earnings (P/E) ratio, and the annual dividend and yield. For position trades, I tend to like value stocks with dividends. If a company has an extremely high P/E ratio, then I will probably avoid that stock no matter what the technicals tell me. Why? Because if the market takes a sudden downturn, over-priced stocks with poor fundamentals are potentially “shorting targets” of hedge funds. I check out how my target company compares to the same industry group and I see what analysts are saying.

Within ten to fifteen minutes, I can usually learn a tremendous amount about my target stocks using both technical and fundamental analysis. If my stock has good fundamentals, it probably has big institutional support. And if it has crummy fundamentals, it could be one of the first stocks to potentially fall in a downturn.

8:00 A.M. Using technical analysis, I go through the daily charts of each of my target stocks. When I find a setup on the daily chart that I like, I’ll flip that daily chart to a weekly chart because the buy-and-sell signals on a weekly or monthly chart are stronger than on a daily chart.

If my weekly chart confirms it is indeed a buy signal, then I go into my TD Ameritrade account and read fundamental research. I am interested in earnings growth over the last four quarters, and also projected earnings growth. For me, the most important piece of information on the fundamental side is earnings. It only takes a few seconds to check this.

9:00 A.M. Now that I have an overview of the fundamentals, I look at setups using moving averages (MA), such as the 10-day, 21-day, 50-day, and 200-day. I like my target stock either in an uptrend or forming a base, and consolidating in a neat, orderly pattern. I’m looking for a stock that could break out of this pattern. If the stock on a daily candlestick chart (See Figure 2) has long shadows on the top or bottom of its body, that indicates intraday volatility, and I might remove that stock from my buy list. I’m not interested in a stock that has high intraday volatility if I’m swing trading. In that case, I prefer ordering patterns.

Even if fundamentals are good but my stock is trading below its major moving averages, and indicators such as Relative Strength Index (RSI) [See The Chartist in the June issue for more on RSI] are pointing down, I’m not going into it. I use technicals for entries, and fundamentals to confirm them.

9:30 A.M. The only opening-bell trades I make are taking profits in positions that gap up from the night before, or if I need to make an emergency exit.

FIGURE 2: The “candlestick” for each trading day marks the high, low, open, and close. From there, moving averages and volatility can be tracked. For illustrative purposes only. Past performance does not guarantee future results. Data: Penson Worldwide, Inc.

FIGURE 2: The “candlestick” for each trading day marks the high, low, open, and close. From there, moving averages and volatility can be tracked. For illustrative purposes only. Past performance does not guarantee future results. Data: Penson Worldwide, Inc.

11:00 A.M. During the day, I’ll look at economic reports due to come out the next day. I might also take some profits off the table on intraday trades.

1:30 P.M. I’ll continue scanning daily, and 5-minute, charts for strong stocks in an uptrend (or downtrend for down days) that have pulled back from their session highs. I’ll focus on the stocks that are closing in on their highs (which is reversed, if shorting).

1:45 P.M. I might add a little money to open positions depending on the mood of the market. I’m still looking for potential profit-taking opportunities.

3:15 P.M. Before the 4:00 p.m. EST market close, I want to cash in on profits before other traders exit and drive prices down.

Meet Deron Wagner

TECHNICIAN WITH A FUNDAMENTAL SCREENER

Deron primarily sticks to technical analysis, focusing on RSI (See Figure 3). He uses fundamental analysis to find stock candidates.

“For my own trading, technical analysis tells me everything I need to know about deciding my bias on the direction a stock is going: up, down, or sideways. My number one indicator is price. Volume is second,” said Deron.

9:00 P.M. ET The night before a given trading day, I filter through 300 to 500 charts that meet my trading criteria. I like stocks that are consolidating after making highs for at least several weeks, which form bullish chart patterns. The stocks that I think will be the strongest will probably be the ones with strong earnings. Other than earnings, I don’t really care about P/E ratios or other fundamental data, because I think it doesn’t determine the price action of a stock in the near term, and I’m primarily a short-term trader.

7:30 A.M. In the morning, I check out the U.S. futures market and study the Asian and European markets for breaking news.

8:00 A.M. I look for potential gaps in the stock positions on my watch list, or any stocks I’m already in. Then I look at economic data, and check for analyst upgrades or downgrades. Finally, I create a game plan, which helps me to know exactly what I will buy or sell using my target prices. By 9:15 a.m., all of my information is collected and I’m ready to start the trading day.

9:30 A.M. I am managing positions—that is, buying and selling stocks. Meanwhile, I am filtering through the stocks on my watch list (a very short list) to make sure I don’t miss any entries. On the long side, I look for stocks showing relative strength to the broad market.

11:30 A.M. I go over any stock positions to see how they traded during the morning session. I determine if I need to adjust any stops or change position size.

2:15 P.M. Because, as I see it, this is often a reversal period, I keep an eye out for potential sharp reversals.

3:30 P.M. Near the end of the closing day, I check to see where the stocks I own close. If I don’t have many positions, I scan my nightly watch list to see how the stocks performed during the day.

4:00 P.M. At the market close, I log my trades into a spreadsheet and analyze profitable, or unprofitable, positions.

Deron, in fact, finds a little art and science within technical trading. “In my opinion, technical analysis is probably 70% science and 30% art. The art is learning how to translate what you see into deciding whether to buy or sell. The science part of technical analysis is really the personal trading rules, which; for me, are already in place,” he said.

The bottom line: Both approaches offer strengths and weaknesses. Combining fundamentals with a solid charting skill set may become a more popular way for traders to call it as they see it.

http://bit.ly/NeZTam