Like manna from the sky

Wednesday, 30 January 2019
Melbourne, Australia
By Matt Hibbard

  • As simple or complex as you make it
  • Money seemingly from thin air

Hello and welcome to today’s edition of Port Phillip Insider.

With Bernd away on annual leave, he has kindly handed Port Phillip Insider over to me for the next week or so.

As you read this, I’ll bet Bernd is dropping into a nice wave on his surfboard. Or maybe, just chilling out with his family and enjoying a glass of wine.

For the many fans of Bernd, you can look forward to reading more from him when he gets back on deck late next week.

And don’t worry, you won’t miss out on Sam. He will still send you his best analysis and ideas with his regular gig on Friday.

I hope you enjoyed Murray’s insights into the markets. They certainly dig a lot deeper than most of the stuff out there in the ether. What I find the most interesting is how differently we all approach the market.

That is why I try to read about other traders’ strategies as much as I can. You certainly won’t learn anything new if you sit inside your own little bubble.

Before we get started today, let me introduce myself. I am the editor of Options Trader here at Port Phillip Publishing.

My love for options runs deep. Just be grateful that you are not sitting next to me on your next long distance flight. I’ll probably still be jabbering on about options when the plane reaches its final destination.

What I aim to do with my trading service is to dispel so many of the myths about options trading. And…generate lots of income.

We’ll delve a little deeper into that in a moment. Before that though, two things.

First, a big thank you to Bernd for lending me the keys while he is away. What can I say? I’ll try not to scratch it. And second, you know the drill…here’s a summary of the key markets.

Markets

Overnight the Dow Jones Industrial Average closed up 51.74 points, or 0.21%.

The S&P 500 lost 3.85 points, or 0.15%.

In Europe, the Euro Stoxx 50 index finished up 16.15 points, or 0.51%.

Meanwhile, the FTSE 100 gained 1.29%, and Germany’s DAX gained 8.52 points, or 0.076%.

In Asian markets, Japan’s Nikkei 225 is down 64.15 points, or 0.31%. China’s CSI 300 is up 0.17%.

In Australia, the S&P/ASX 200 is up 0.100 points, or 0.0017%.

On the commodities markets, West Texas Intermediate crude oil is US$53.50 per barrel. Brent crude is US$61.62 per barrel.

Turning to gold, the yellow metal is trading for US$1315.00 (AU$1,827.39) per troy ounce. Silver is US$15.98 (AU$22.21) per troy ounce.

One bitcoin is worth US$3,417.07.

The Aussie dollar is worth 71.95 US cents.

As simple or complex as you make it

If you have looked at options before, my guess is that you will fall into one (or more) of the following three camps.

One. They are too risky.

Two. They are too damn hard.

And three. They are just not worth the time and effort.

If you are in any of these camps, as much as it pains me to say it, you are partially right. The important word, though, is ‘partially’.

Make no mistake, options can be risky if you use the wrong strategy. They are also risky if you don’t fully understand your obligations. That is why you need to understand exactly what your rights and obligations are before you ever place a trade.

The second objection is that options are too hard. Well let me tell you a little secret. Everyone, and I mean everyone, runs out of ‘smarts’ eventually. And options trading is no different.

Think you know a bit about maths or physics? Then try having a conversation with someone who designs propulsion systems for a living.

It is the same with options. Some of the maths used in option pricing models is beyond the realms of any of us. The best-known option-pricing model, Black-Scholes, won Myron Scholes and Robert C. Merton the 1997 Nobel Memorial Prize in Economic Sciences.

I’m not sure about you, but last time I looked, I certainly didn’t have one of those sitting on my mantle piece.

Note: Black and Scholes developed an equation from which Merton further developed into an option-pricing model. While Scholes and Merton received their Nobel Prizes, poor Fischer Black only got an honorary mention, due to his passing two years earlier.

Pricing models do as their name suggests. They are all about trying to work out the true value of an option.

That, of course, is mightily important. But this value might only vary slightly from one model to the other.

What we need to decide as private traders is if we are happy to pay the premium when we buy an option. And also, if we think we are receiving enough premium when we write (sell) an option, for the obligation we are taking on.

Irrespective of what a price model says, it is your belief about the trade’s probability of success that determines whether you should take on a trade.

Another trap is simply trying to understand too many strategies. At the heart of any option strategy are two basic ingredients — a call and/or a put option.

Together, they from dozens of different strategies. Some are so complex that even a computer will need to take time out.

But there are also lots of much simpler strategies that can help generate you a tidy stream of income.

The other common objection is that options trading is not worth the time and effort.

Yes, there is a bit more work in setting up an account. You might have to take a quiz from your broker.

But surely that is a good thing. Your broker already knows how options work. What they want to ensure is that you understand options too.

Once you are up and running, you might be surprised at how quickly you take to it. Dividends are certainly nice a couple of times a year. But why not see if you can more than double that income by employing one simple option strategy?

Money seemingly from thin air

If all of the above is enough to put you off, so be it. However, before hitting the delete button or skipping to another article, I want you to consider just one example.

Note that this is not a hypothetical trade. This is something you or I could go into the market and do right away.

The following screen shot is straight out of CommSec. As you can see in the top right hand side, I took this shot at 1.33pm today, Sydney time.

The stock is Commonwealth Bank Ltd. [ASX:CBA], likely the most widely held stock in Australia. And please note, this trade is for illustrative purposes only — it is not a recommendation.



chart image

Source: CommSec
Click to enlarge

On the top left you can see the last traded price for CBA. That is $70.94 — down 41 cents from yesterday’s close.

If you look down the table, you will see two blue rectangles. I have put these in to highlight two different call options.

The top one — with a $71 strike price — is bid at $1.46, and offered at $1.63. If we wanted to buy it, we would need to pay somewhere around the middle. That is, around $1.54.

By buying that call option, that gives us the right to buy 100 CBA shares for $71, any time before the option expires on Tuesday, 23 April.

However, if we own CBA shares, rather than buying a call option, we can write (sell) a call option instead.

Just a quick note on that. ‘Writing’ is where your initial trade is to sell an option. That is, it is not selling an option that you bought earlier.

Instead of paying out money, by writing an option, we receive it instead.

When we write a call option, and the buyer exercises it, we have to hand over the shares at the option strike price ($71 in this example).

There are other considerations, which I will run through tomorrow. Things like tax, risks to consider, and what you might potentially be giving up.

But for now, I want to highlight how options can generate you money seemingly from thin air.

If we go back to our CBA example, let’s say that we went into the market and bought 100 CBA shares. Again noting this is not a recommendation — it is for illustrative purposes only.

Having bought 100 shares at $70.94, you could then write a $71 call option for $1.54, generating $154 in premium.

If you buy the shares at $70.94, and your $71 call option is exercised, you will pick up a handful of cents on the sale. However, that $154 remains yours to keep.

Go down to the next blue rectangle — the $72 call option — and you could write that for around $1.09. If exercised, that would mean buying shares at $70.94, and selling them at $72 for a profit of just over $100. Plus, you’ll pick up $109 in premium.

As I say, there are other things to consider. We’ll take a closer look at them tomorrow. What I wanted to achieve today, though, is showing you just how much potential options, rightly used and understood, can bring to your trading account.

Until tomorrow,

Matt Hibbard,
Editor, Options Trader