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Wednesday, July 16, 2008

Covered calls and Naked Puts

I don't think I can explain this well enough for anyone to trade these options just by reading this post. But these definitely are really powerful tools that I recently got exposed to in Prof. Rao's class that allow you to make the most of some of your stock holdings. I plan to apply them soon with his blessings ... ;-) read guidance!!!
  1. Scenario 1: Stock A is right now at 120. I want to buy it only if it comes to 100. You can actually make some premium for the money you have reserved to buy these shares at 100 by selling a Naked Put and assuming A does not hit 100. Of course if it does, you will need to buy the shares from the guy who buys the Put options from you if he exercises it. But that was exactly what you wanted to do anyway. :-) You now have some additional premium thus lowering your overall purchase price.
  2. Scenario 2: A is right now at 80. I want to sell a lot of A at 100 when it hits 100. Sell Covered calls of A at 100 and you earn a premium for doing that in case A does not hit 100. If it does, you achieve what you wanted to achieve and are able to sell your share at your target price.
Problems: The lots are really big - so you need to be a really big trader to make money here. But if you do have such huge lots, you are supposed to be able to conservatively make 1-2% per quarter which is quite significant since it is a fixed revenue stream.

Another reason why it pays to not hold more than 10-15 stocks in your portfolio.

Warning: Apply at your own risk or at least after doing your research. I haven't yet applied it myself.  :-)

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