May 2014 Income Report

Starting this month, I will be summarizing my progress in building wealth through playing stock options. I will document each play I have made during the past month, before the expiry date of the options. I will also report on how each play paid off. At the end of the income report, I will list a few takeaways for other investors to utilize in their strategies.

If you have any questions, please ask them below the post.

Plays Made in May

• Bull Spread on CSL
• Short Strangle on AOL
• Out-of-the-Money Call on AMTG
• Long Strangle on FEYE
• Long Straddle on ZU

Income Summary

• Money spent: $3,050
• Revenue gained: $4,380
• Profit: $1,330
• ROI: 44%
• Beat the market (monthly) by: 43%

I recently started playing options for real after having played the stock market (via buying stock) for 5 years with barely any gain. My results from this month make me regret not getting started sooner. Had I started this five years ago instead of throwing money at stocks, I could probably rely on this for a full-time income. Of course, this is all retrospective thinking; I may have gone bankrupt had I started playing something as risky as stock options at the tender age of 25.

My original plan was to start with short options exclusively (selling contracts instead of buying them) so as to generate immediate income instead of having to pour my saved-up cash into calls and puts that might not pay off. But I later decided to try a variety of different options strategies so as to see for myself what strategies work out. I’m glad I did, as I only lost money on one play (though I could have gone completely bankrupt on the AOL short strangle had I not been watching the market). In the future, I’ll be both repeating what works and testing new strategies.

My Plays

Bull Spread | Carlisle Cos Inc | CSL

For this play, I chose a slightly bearish stock. I wanted it to approach 85 but wasn’t sure it actually would. Instead of flat-out buying a call, I ran a bull spread, which allows you to buy a call at a low premium by simultaneously selling a call at a higher strike price. I ended up buying a call at 80 and selling another at 85. In this way, if CSL doesn’t move in the way I predicted, I at least saved money by selling a call option that would never be used.

I closed the position before the call I sold at 85 became valuable. That is, I waited for the stock to approach but not touch 85, bought back the calls I sold at 85, and simultaneously sold off the 80 call, which was then worth $630.

Start:

Cost to buy 1 call at 80: ($520)

Profit on sale of 1 call at 85: $140

Finish:

Cost to buy back 1 call at 85: ($145)

Profit on sale of 1 call at 80: $630

Total Profit: $105

Short Strangle | America Online | AOL

To test my ability to handle the risk associated with naked short options, I wanted to sell some naked puts and calls at the same time. But I didn’t want to bother monitoring two stocks. Instead, I decided to find a stable stock and run a short strangle, which means I would be selling both out-of-the-money puts and out-of-the-money calls on the same stock.

I chose AOL, which was unfortunate. I cannot say it was a mistake simply because technical analysis could not have predicted what happened next. Though at the time I opened the short strangle AOL had been stable for nearly half a year, the following week AOL dropped by $10. This was doubly unfortunate because the short strangle I was running only needed a week to expire (and therefore pay off).

Luckily, I was watching the stock before the bell and quickly put in an order to buy back the sold naked put options (at a loss, of course). Had I not done so, I would have lost nearly all the money in my account should I be assigned to my put options. This play still worked out for me, amazingly enough, because (1) I still made money from the sold calls (which I sold for more than the puts) and (2) I bought back the puts before AOL fell another $5 (at which point, the puts would have been at a ridiculously expensive price).

Start:

Profit on sale of 5 calls at 45: $550

Profit on sale of 5 puts at 40: $350

Net profit of short strangle: $900

Finish:

Cost to buy back 5 puts at 40: ($425)

Total Profit: $475

An Unlikely Out-of-the-Money Call | Apollo Residential Mortgage Inc. | AMTG

I wanted to try my hand at an unlikely bet that would pay off quite well should it succeed. I bought a handful of cheap out-of-the-money calls that had a low percentage of paying off. Though an example of a low-risk, high-reward strategy, such a call strategy rarely pays off. My own example with AMTG supports this. AMTG had a week to climb up $1.50. Had it, I would have made a decent amount of money on this inexpensive bet.

Start:

Cost to buy 7 calls at 17.5: ($35)

Finish:

Total Profit: ($35)

Long Strangle | FireEye Inc. | FEYE

For this play, I wanted a volatile stock. I chose FEYE from a list of volatile stocks. After analyzing the candlestick chart, I decided this stock was right for a long strangle strategy.

In a long strangle, you buy calls and puts, both out-of-the-money. Should the stock move over one of the strike prices for the options, that particular option would become in-the-money and could be sold for a profit. I did exactly this, with the call options paying off.

I continued watching FEYE after selling the call options, hoping that the stock would drop so that I could sell the put options as well. No luck.

After performing the calculations, however, I see that this strategy did not pay off. After commissions, I didn’t make any actual money on this play.

Start:

Cost to buy 5 calls at 26.50: ($625)

Cost to buy 5 puts at 26.00: ($550)

Net cost of long strangle: ($1175)

Finish:

Profit from sale of 5 calls: $1200

Total Profit: $25

Long Straddle | Zulily Inc. | ZU

When running the long strangle on FEYE, I was actually torn between the long strangle strategy and the long straddle strategy. The difference between these two strategies is how far apart you place the calls and puts. For FEYE above, I bought both options at values extremely close to the strike price (but still out-of-the-money). But for ZU, I bought in-the-money calls and out-of-the-money puts. Surprisingly, the prices for both of these options were essentially the same.

The end result was much the same as FEYE, but the long straddle strategy paid off with better profit margin. I sold the calls when ZU moved above 32 and let the puts expire worthless. The reason I made more money with this play as compared to the FEYE play was due to the call being originally in-the-money, which allowed the calls to rise in price faster as ZU rose.

Overall, I’m not sure either of the straddle or strangle strategies are especially useful, as it seems like I’m wasting money on the option that expires worthless. Luckily, this play worked out for me, though I did waste $400 on the puts.

Start:

Cost to buy 2 calls at 30: ($490)

Cost to buy 2 puts at 26.00: ($400)

Net cost of long strangle: ($890)

Finish:

Profit from sale of 2 calls: $1650

Total Profit: $760

Key Takeaways

1. Spreads can help you save money. When you buy a call or put that’s unlikely to pay off and ends up not paying off (surprise!), you will be left regretting the move. A spread is a strategy in which you buy a put or call option while simultaneously selling another option in the hope to lower the premium you pay for the options. When you do this, you both lower the money you spend and reduce your strategy’s potential payoff. This is a useful tradeoff for an investor who doesn’t have much money to spend. For this security, if you do the math, you’ll see I only paid $5 for the CSL play (you need to buy the sold call back when you close the position). Entirely worth it in my opinion.

2. If you’re not able to watch the market, don’t sell naked options. Had I not been watching AOL when it began to fall, I would have gone broke. When selling naked options, do so with the determination to keep your eye on the stock. You don’t have to obsessively watch it 24 hours a day, but you should at least watch it as the market opens. Another option is to put in stop or limit orders on the option, though I haven’t personally tried this yet.

3. Out-of-the-money options are cheap for a reason. The probability of them paying off is low, regardless of how much confidence you have in the stock shooting a certain way. You might be better off buying a scratch ticket.

4. Long strangles and straddles, in which you buy both a put and a call, do pay off, but the unused contract (the put or call that expires) will certainly take out a chunk of your profits. I would have made nearly $600 on the FEYE play had I went with a standard call instead of a strangle. Though a strict call might pay off more than a strangle, some volatile stocks won’t show an obvious direction. That is, if you’re choosing the stock as your first step in playing options, you might have little choice but to go with a long straddle or strangle. However, if you’re making the decision as to which strategy you’ll use before you choose the stock to play it on, perhaps you’ll be better off avoiding strangles and straddles.

Summary

Overall, it was a good month in terms of profit. I was imagining I’d be in the red for my first income report, as this is my first real experience writing up and making public how I invest my money. Luckily, I didn’t embarrass myself by losing my investment or going bankrupt (e.g., from AOL’s decline).

But it’s actually not about luck at all. The fact that I had to write up every one of my moves, discussing the technical analysis and how it relates to the strategy, really forced me to think carefully about every move. It’s easy to look at a stock and think “bear spread.” It’s harder to justify that decision with logic and technical analysis. Thus, in a way, writing up my strategies took out the human intuition and emotion from the game, forcing me to rely entirely on the technical analysis and desired goal to develop strategies.

I hope that this month’s income report can inspire others who would like to get into the options game but are afraid of the risk or fear they might not have enough money to start. As I showed in May, an investment of a few grand is enough to produce a decent amount of money. For some people who scoff at an extra monthly grand, imagine doubling or tripling what I did, simply using the exact same moves but putting more money into them (e.g., buying 5 or 10 calls instead of my 2). Assuming others can replicate this month I’ve had, someone with around $10,000 to invest could make a satisfactory monthly income just by buying and selling stock options.