That is unless you’re using a put selling strategy…

As an option trader, you can take the transaction one step further by selling a Microsoft $20 put option contract – you’ll receive the going rate for that option and receive instant income.

I recently showed Investment U readers some of the ins and outs of put options – you can read all about them, but right now I’m going to show you how to profit from a real life example of selling puts options.

Selling Naked Put Options – Strike Prices & Option Chains

When selling naked put options, it can be hard to grasp how the strike prices and contract prices work together until you understand what an option price list – or option chain – looks like.

Take a look at Microsoft’s option chain below:

Chart: http://www.investmentu.com/images/iu062909chart.gif

This is a typical option chain for Microsoft options that expire in January 2010.

• The strike prices are listed in the column in black. Since we’re interested in the $20 strike price, we look at the JAN10 20.00 line.
• Scan over to the “bid” column that shows how much you can receive for selling that $20 put option contract. The bid column shows $1.30 as the price. This translates into $130 you will receive for every $20 put option contract you sell because all prices are in listed in per share costs. And an option contract controls 100 shares of stock.
• For a typical 1,000 share stock trade, you can sell 10 put option contracts and instantly receive $1,300 in your account, no questions asked.

This is money for you to use anyway you see fit. No matter what happens, this money is yours.

In exchange for selling those 10 put option contracts and receiving your instant $1,300, you are obligating yourself to buy 1,000 shares of Microsoft at a price of $20 per share until the expiration day in January 2010.

At this point, you know ahead of time that you will be obligating yourself to buy 1,000 shares of Microsoft at $20 per share, for a total investment of $20,000.

Not only do you get to collect $1300 upfront just for placing the option trade, but you’re also giving yourself a chance to buy a stock that you want to own, at the price you want.

How great is that?

As long as you know this potential future transaction is within your financial means and trading plan, then it is a win-win situation for you.

When Selling Options, What Happens On Options Expiration Day?

So, when selling put options or any options, people often ask what happens when options reach their expiration date?

Only two things can occur at expiration – either the price of the stock is above the chosen strike price or it’s below.

• If the stock finishes above the strike price, then the trade is over and the option expires worthless. The option buyer walks away with nothing while the option seller gets to keep the upfront cash with no further obligations.
• If the stock finishes below the strike price at option expiration, the option buyer will “exercise” his right to the contract and you will be required to fulfill your end of the agreement – which means you end up having to buy a stock you wanted at the price you wanted.

Sounds pretty good to me. And all the while you still get to keep the upfront cash.

So in the case of our Microsoft example above…

• If Microsoft closes below $20 in January 2010, you will be obligated to purchase your 1,000 shares at $20 each. With the $130 received upfront for each option contract, this essentially reduces your cost basis to $18.70 per share once the transaction is complete. Not bad.
• If Microsoft closes above $20 at January 2010 expiration, the trade is over and the option expires worthless. You keep the $1,300 and are free to repeat the process again for another expiration period. This is the key to income generation.

As I mentioned in my article about selling naked put options article that up to 90% of option contracts will expire worthless, leaving you with the upfront cash payment.

After implementing this strategy for a while, you will come to see that most of the trades will expire and you’ll keep padding your account with instant income.

Using a Put Selling Strategy – Six Tips to Selling Options

A few guidelines to keep in mind when selling naked put options:

• Only sell put options on stocks you want to own. Do not use this options trading strategy on high flyers just to receive the upfront income.
• Only sell enough contracts to stay within your comfort zone. If you normally trade in 500-share blocks, then only sell five option contracts.
• If you are uncomfortable at anytime during the trade, or do not wish to own the stock at the strike price you’ve chosen, then you can unwind the trade at any point. All you have to do is buy back the put options you’ve sold.
• The option price will fluctuate during the course of the trade. It may get cheaper or more expensive while you hold it. The bottom line is – you’ll either get to buy the stock at expiration or the option will expire with no value.
• You will need to have an approved “option trading account” with your broker. This needs to be set up before making these transactions.
• You’ll always know ahead of time what your potential total outlay will be if obligated to buy the shares. No surprise endings.

That’s all there is to selling put options. It’s easy, simple and much safer than most investors imagine if you just stick to my six tips above.

Using Put Options With The Instant Money Trader

These are the profitable types of trades we execute in The Instant Money Trader service.

In fact, since launching in November 2008, we’ve had a 100% win streak, meaning all the options have expired worthless, allowing us to bank all the money paid to us upfront from the option buyers.

Although we concentrate on selling put options on high quality stocks within the Dow Industrials and S&P 500 that we’d be more than happy to own, we’ve yet to have to fulfill our obligation and purchase them.

This is mostly because we sell the put options that have the high percentage of expiring worthless. It’s fine with us, as we’ll gladly keep accepting all the instant money we get from these transactions.

We’re able to pick quality stocks that are paying good money to us, all the while knowing that we’ll either take possession of these great stocks or repeat the process for the next month.

Good investing,

Lee Lowell

Source: Using a Put Selling Strategy: A Step-By-Step Lesson On Selling Options

As you can see from the chart above, the S&P 500 has broken the accelerated downtrend it’s been in since September.

Now, it’s true that this chart is only current as of Monday’s close. I’m writing you these words early Tuesday morning before hopping on a plane.

Perhaps while I’m up in the air at 35,000 feet, Treasury Secretary Paulson will say or do something alarmingly idiotic and help stocks return to form.

But if not, just imagine! The very idea that stocks don’t always go down and down… who’d have thunk it?

Whisper it Quietly

Okay, that was a wee bit of sarcasm (in case you hadn’t noticed).

If I felt like really pushing my luck though – being out of pocket for Tuesday’s market action and all – I could point out that the upmove from 750 to just under 910 on the S&P is a greater than 20% advance… and thus technically constitutes a new bull market.

Not that it’s time to go around shouting new bull market! That would be insane, and worse still not very helpful in terms of making money. Plus, with the volatility levels we’ve seen, 20% just doesn’t carry the same heft that it used to.

Wholly artificial and backward-looking labels aside, it’s eye-opening to note the backdrop against which stocks chose to rise these past few days. Just consider what the beleaguered bulls had to deal with:

• We got word of the ugliest jobs report since 1974 – 533,000 jobs lost – with gloomier-than-thou pundits falling all over themselves to point out why the report was actually even worse than it seemed.
• Treasury bond yields effectively hit zero as panicked investors parked their last slugs of cash with Uncle Sam. On Friday the U.S. Treasury three-month T-bill yield fell to 0.01 percent.
• Credit spreads on investment-grade bonds versus treasuries – a measure of what it costs for companies to borrow money – widened to super-panic levels last week, as the below FT chart shows.

In spite of that awful trifecta, stocks managed to put in a rather impressive reversal Friday… then powered higher again on Monday with news of the Obama infrastructure plan.

If Mr. Market has been fighting off a fever, we may have just seen that fever finally break.

When Yes Means No and No Means Yes (Maybe)

Does this mean that stocks have bottomed? Or, at the very least, that it’s time to again take a harder look at long-side opportunities, from both a trading and investing perspective?

To be honest, I’d rather prefer you didn’t believe that. Well, okay, maybe not you. But as for the investing public at large – we’re better off without their agreement at this point.

I should probably explain…

In order for stocks to bottom, we need to see maximum pessimism. It needs to be thoroughly common knowledge just how bad things are, with everyone and their brother fully aware that things are “only going to get worse.”

This reality is precisely what makes it so hard to buy near the actual bottom. By the time the market gets there, positive sentiment is all but washed out. At the bottom, the true believers have all been converted to cynics.

This ironic sliver of market reality creates a paradox. If you were to go around taking a survey of investors asking, “Is this the bottom?”, the results of the survey would have inverse value.

The more investors who responded to your ad hoc survey with a firm “NO” – or better yet with a “what are you, crazy?” – the greater the odds would be of a bottom having been reached.

Hardly anyone trusts the first ascent from the pit. Everyone is half-waiting for the whole thing to break again. Coincidentally, that’s why professional traders and investors tend to get the best prices… they’re the ones who can steel themselves against queasiness and uncertainty when the odds tell them to act.

Bottoms Aren’t the Point

At this point I have to share a confession with you.

In spite of what the thrust of today’s piece might imply, I don’t really care whether the market has bottomed or not. And you probably shouldn’t either. Here’s why.

If you are a trader, you act based on odds and probabilities (or at least you should). Solid trades, like solid poker hands, are all about getting a handle on odds and reward to risk.

If the reward to risk is right – if the probability and the setup is right – then you take the trade. If not, then you don’t. Trading gains are accumulated over time in this fashion – with large wins overpowering small losses – just as pro poker players accumulate their winnings over an extended series of hands.

If you are an investor, you act based on valuations and long-term assessments of what companies are worth. Like Warren Buffett, you may not “time” things, but you do “price” things. A skilled investor has the habit of looking at a stock quote and seeing the actual value of the business behind it.

For sharp investors the question is less “How much are the shares really worth” and more “How much is the business really worth?” How good a shape is the business in? What kind of cash flows does it have? What kind of long-term potential does it hold? If I could get the financing and the go-ahead to buy this company outright and run it myself, would I want to do it?

Some of you are traders, some of you are investors, and some of you (like yours truly) have a consuming passion for both.

Either way, if you’re really focused on your process – on using all the tools you have available to make money – then picking “the” bottom doesn’t matter so much.

Why Talk About This Stuff At All Then?

Okay, some of you may be wondering now, if calling the bottom isn’t all that meaningful for the trading and investing process, why talk about bottoms then?

The reason to talk about this kind of thing is because there is real value (in your editor’s humble opinion) in analyzing the tone and tenor of market action.

It’s useful to get a handle on how the market is acting, just as it’s useful for a doctor to have means of checking the symptoms and vital signs in a patient.

The key differential comes down to purpose – it depends on what you do with the information you collect, and what your mindset is in collecting it in the first place.

Following market action with the goal of saying “I called such and such a move,” or to win an argument or bolster a pre-existing opinion, is one thing.

Dissecting market action with a cool, dispassionate eye – looking to inform the choices you make with a better sense of odds and probabilities – is quite another.

A Possible Inflection Point

What we’ve seen in the past few days, I believe, is a possible inflection point… a point in the cycle at which the news got about as bad as it could get, with credit spreads on investment-grade debt about as wide as they could be… and yet stocks shot up anyway.

I think, too, that we just might be in the midst of a psychological inflection point here.

After an extended nightmare of government dolts who screwed up at every turn, and banks that blew up every time a Wall Street CEO turned around, we are finally starting to get a handle on what tomorrow might look like.

Source: Source: The Perverse Logic of Market Bottoms

This from Investor’s Daily Edge:

Reacting to market moves guarantees you will be on the losing end of the equation. Jumping in and out of investments as the market swings up and down is the absolute worst way to invest. It amounts to market timing with a broken clock.

Sometime around the late eighties, a real brain found a way to quantify what we in the investment business had been recommending for many years, a balanced portfolio. He called it asset allocation.

What asset allocation did for investors is to prove, once and for all, that investing over many asset classes, and leaving it alone, will make more money than putting all your eggs in one basket, or trying to time the market.

Essentially, a balanced portfolio, or asset allocation, means you don’t have all your money in one asset class. You spread it around over stocks, bonds, gold, cash, etc.

How much you put in each category is directly related to your age or your ability to assume risk, which goes down as you age.

In my experience, investors usually ignore this advice. The urge to get rich quickly is too great. But, the fact remains; you will make more money if you spread your risk around.

The market’s insanity over the past year was driving many investors to gold and cash, or money markets. People who would never have considered gold were pouring money into it. All they were doing was shifting the risk from equities to another investment class. And now that gold has fallen over 20 percent in the last four months, they have jumped off that ship too.  This is not a solution. This is another problem waiting to happen.

This type of activity is called, “detaching from fundamentals.” Everyone has forgotten everything we know about the markets and has just started following the noise of the herd in front of them.

In the ongoing destruction of the capital markets, no haven is safe. Gold… down. Blue chips… down. Utilities… down. Consumer staples… down. Cash? Well, maybe for a little while, but we all know the dollar is doomed.

As the markets recover, and they will, the same investors will run back into stocks long after they have been fully priced. Essentially, people are throwing money at the back of the money train. Too late!

As I pound the desk every week pushing you to look at bonds, it is with the assumption that you are using a balanced approach. That is, you have the appropriate percentage of stocks to bonds for your age.

The formula is very simple, the discipline and patience to make it work is not. Subtract your age from 100. The remainder is what you should have in stock; the balance should be in bonds, or other low risk investments. As you get older, the percentage in bonds should increase, a lot.

Here’s the problem. The get-rich-quick urge kicks in for just about everyone and no one is able to see beyond the end of his or her nose. The best advice available is thrown out the window and time horizons are about six days.

The reverse is also true. You can never have all your money in bonds. As the market churns out the timid it may seem plausible to think, “I will never invest in stocks again.”…

I will never recommend a portfolio invested entirely in bonds.

From an inflation standpoint, it is not recommended, but that’s another article.

Go back over your accounts for the past few years. I guarantee if you work a reasonable return for an appropriate percentage of bonds into the problem, you would have made more money in a balanced approach than in the get rich quick method.

If nothing else, bonds will give you a steady return on a portion of your portfolio when the markets are flat or down, which is most of the time. This investing thing is as much about finesse as information. Patience plays a big part in it as well.

While the markets spin their wheels, take a step back and evaluate what and how you have been doing things for the past few years. From here, it can only get better.

Keep your powder dry.

Source: A Balanced Approach