On the other hand, what if you thought because IBM had been going down in price – you thought that IBM was going to continue to drop, and you bought a put option, for \$1.65? The price of IBM continued to go up, and up, and up, so what would happen to your put option?

Your put option would go farther and farther out of the money, as the stock price continued to increase in price. The market makers are going to value your options much lower, because now it is so much farther away from the price that you actually bought it at.

The fact that it would have any value at all, before the expiration of that option, would be extremely low. Because it has moved so far away from the actual price that you purchased the option it.

If you purchased it at \$1.65, the chances are, if it moved \$8 away from you, and it increased in price – well, if you purchased your put option at \$100, because IBM was trading at \$98. Now, if the stock price is up around 120, your option is only going to be worth 10 cents.

Instead of making \$150-\$160 on your contract, you’ve actually lost 150 dollars on your contract. Not only that, but the closer you get to expiration, the longer it takes for IBM stock to move toward the strike price of your option, the less value it’s going to have.

Remember, our illustration of the person who purchased an option, with 90 days to purchase your house for a million dollars, and gave you a \$500 premium. The person who sold that contract to you now realizes that maybe you purchased that option 90 days before the expiration. Now it’s only 30 days before the expiration. There is less probability that the stock is actually going to be trading anywhere near \$100 again, because now it’s \$124.

Remember, there are only two rules in option contracts. They will fluctuate in price, and it will expire. The closer you get to the expiration, the less value that contract actually has. The probabilities of that stock actually moving in your favor have declined significantly.

If you understand those two rules, that option contracts expire and decline in value the closer they get to expiration, and the fact that they fluctuate in price, those are the only two things that you really need to know, in order to profit from this system. What we hope to do and what our strategy is all about, is…

Let me just say this first. Is that let’s say you purchase this option for 95 cents, out here. Your probability of that actually ever being worth anything is less than 2%. But what happens to someone, if they sold you that contract?

Remember, I told you that even though you don’t own IBM, you can sell contracts on IBM and collect the premiums, just like if you were the owner of the house. The person who sold that contract to the person who bought it, has a 98% probability that option will expire completely worthless.

What does that mean? That means that the 10 cents that you collected for that option, as the seller of that option – there’s a 98% chance that you’re going to be able to keep all of it, and it will not be at a higher price. As the seller of the option, you don’t want it to go to a higher price. You want it to go lower, because you’re selling it. It should be at a lower price.

There’s a 98% chance that it will be at a lower price, and it will expire absolutely worthless. Then you get to keep the premium that you received – a 100% of the premium that you received for writing that option.

Our goal in the entire strategy that I’ve built, is all around collecting the premiums, and writing the premiums, and selling these options, to other people, who are speculating on the fact that the price is going to go up, or the price is going to go down. Our job is to create a strategy in which we collect the premiums from these options, in a way that does not get us into trouble.

Because – let me give you a warning. If you were simply to write these options, if you were simply to sell these options, with absolutely no protection, and if IBM decided to get taken over by some much larger corporation… Let’s say that Microsoft decided to buy IBM, and they were willing to offer them \$220 a share.

If you sold an option at \$135 a share, for 25 cents, and Microsoft came in and decided to buy IBM for \$225 a share, well, all of a sudden, your 25 cents turns into \$100. You will get killed on that trade, because 25 cents will turn into – your \$25 premium, all of a sudden, is worth \$10,000. You will have to pay out. You will have lost \$10,000, because the owner of that contract, the person who purchased that for \$25, will say, “Hey, I’m going to purchase IBM stock for \$135. You have to deliver 100 shares to me now, at \$135.”

You have to go into the market to purchase IBM stock, at \$225 or \$235. You’re going to be paying \$100 more than you sold that contract at.

We never sell what they call “naked options.” Options that do not have any protection on them. What we do, is we create strategies, mostly through spreads, that allow us not only to collect the premium, but to protect ourselves in case of a takeover or something like that.

Actually, most of our strategies do not focus around individual stocks. Almost all of our strategies are on indexes that can’t be taken over, because we do not want that price risk.

Let’s say we want to do something on IWM. IWM is the ETF for the Russell 2000 Index. Nobody’s going to take over the Russell 2000 Index. There are 2,000 stocks in that index. One or two of those stocks might get a takeover bed, which may slightly affect the price of the index, but not dramatically.

Be Sociable, Share!
This entry was posted in Options Trading Basics and tagged , , , , , . Bookmark the permalink.

This site uses Akismet to reduce spam. Learn how your comment data is processed.