Calculating the Value of an Options Trade

I’ve found that it is sometimes difficult to “see” the value of an options trade. The reason is simple – premiums compound *when* they are taken. That is, a premium earned quickly compounds much faster than the same percentage over the long haul.

So, for instance, I entered a trade to sell a PUT option on MNK with a strike of $18.50 at $0.25 for a close date of June 29 – 3 days away! Now, first of all, my cardinal rule is that I would only sell a PUT with a stock that I don’t mind owning. That’s rule #1 (unfortunately, exercise fees on Ameritrade are $20, so that’s kind of expensive, but we’ll let that go for now).

Now, $0.25 doesn’t seem like a lot, especially since it is only a tiny return (after fees, it winds up being only 0.93%). However, for 3 days, that’s a lot! Now, you might try to do a simple multiplication to find out what that is worth over the year. You might think that, since there are 365 days in a year, 1% for 3 days will yield 120% averaged for the year, but you would be wrong!

The reason for this is that you have forgotten compounding periods. Because you get the premium money *now*, the compounding period is only 3 days. Compounded over a year, this is:

((1 + r)^n – 1)

Where r is your total return for the trade (0.0093), and n is the number of compounding periods (121 in this case). Therefore, the return that I will get is (1.0093^121 – 1) = 2.06 = 206% annualized return!

The method I have been following for finding premiums is this:

  1. Search for the best short-term (within the next weeks or months) out-of-the-money puts.
  2. Screen the list for companies you wouldn’t mind owning. Check the fundamentals, and see if seekingalpha.com likes it.
  3. Use these calculations to find the best option to sell.
  4. Don’t use margin. Make sure you have the cash to cover anything put to you!
  5. Also remember to factor in your “friction” – the amount that your trading platform will charge you. If you are doing small trades, this can be very difficult, and you may wind up having to sacrifice some of these principles just to avoid friction issues.

To find the “r” in the above formula, I am using this formula:

r = (p * c * 100 – f) / (s * c * 100)

where p is the premium, c is the # of contracts, f is your “friction” (cost of using the trading platform), and s is the strike price. To be super-conservative, you might add in the “exercise” price to “f”. Right now, using Ameritrade, f is calculated as

f = 6.95 + c * 0.75

And, if I was including the exercise price, I would add another $20 to f. This makes a huge difference in small trades, but not much difference in large ones.

Investment Report – 2018/06/14

Haven’t updated in a while. I doubt anyone is listening anyway. I’m still holding on KGJI and FTFT. They haven’t done jack squat over the last several months, but the story on them hasn’t changed. One thing to realize is that, if you find a low price now, then that means that you believe that the market is wrong. Why should it suddenly right itself after you buy it? The reason to sell a stock isn’t because it does something, but because the company itself has changed, or the company’s situation, or you learn something about the company that you didn’t know before.

In any case, a friend of mine suggested a strategy that I have been working on implementing.

Think about this – imagine that there is a stock you want, but you wanted to buy it at a lower price. You *could* put in a limit order and wait for the price to drop. But what if someone PAID YOU to put in that limit order? Don’t think this is possible? Well, actually, it is.

If you write a PUT option (that would be “sell to open”), that is precisely what you are doing. Most people write put options with the hope that they won’t be exercised. They believe the stock will go up, and if they wind up having to buy the stock that is considered a fail. However, a better strategy would be to find a company whose stock you WANT, and write a put option for the price you want to pay. You get immediate cash just for writing the option, and then, if the price goes down, you get to buy the stock at the price you asked for! It’s like a limit order that pays you!

The other side works the same, you can write call options for the price you want to sell at. You don’t really lose if the price goes up too high, because you were going to sell anyway. Instead, you get paid to write the sell order.

Anyway, I’m experimenting with this now. I purchased DM at $13.32, and wrote a call option for $15.00 that pays $0.63 per share, which expires on Nov. 15 (5 months). The cost of the shares was $2665 and I got paid $126 for the call option. That is a 4.7% gain in 5 months, if the stock does nothing, for an annualized return of about 11.3%. If the stock actually goes up to $15, then I would earn an additional $320. That is an additional 28%.

To me, this seems like a win/win. The problem I’ve had is that, with the limited amount of cash that I have, the stocks I want to buy are very limited in the options that are available. Micro-cap stocks often don’t qualify for options. Hopefully, when I have a bigger account, I’ll be able to be more flexible with my option strategy.

In fact, I was looking for a company to write put options for, but I haven’t found one which (a) I can afford, and (b) which you can write PUT options for which someone is willing to buy for a reasonable price.

Five month call options are the only things I have found that I can lucratively write.

As for other trades, I found SALM at $3.35, bought 500 shares, and sold at $3.97 and $4.50. I still have 200 shares which I will just hang on to indefinitely.

I bought IRL – probably a bad idea, but it’s a fund whose asset value is below the stock price.

I’m currently looking at GURE, BCRH, and SORL. GURE and BCRH both fit the profile of good, solid companies that have had a bad year. GURE got hit with a bunch of regulatory stuff, but have almost no debt. BCRH is an insurance company that got hit with major claims due to a hurricane, but other than that seem solid. SORL is just an undervalued stock.

Anyway, currently my portfolio is only gaining about 12%/year. Of course, since it is only half-invested, that’s not too bad. On the other hand, having a pile of cash to pick up good deals is part of the strategy, so I can’t readjust my numbers for that. If I am correct, my longer-term numbers should be about 40%/yr. If I’m incorrect, it will be probably still be at 12%/year.

Another strategy I’ve been thinking about is buying dividend-paying stocks and writing covered calls on them. If I can get a stock that pays an 8-10% dividend, and then gain 10% writing covered calls, that would be a nice easy way to earn 15-20% year-over-year.