How to Buy and Hold Stocks

January 5, 2008

317

Several members have been asking about stock strategies and I just had a great conversation with Trading Goddess on the subject so I figure now is as good a time as any to discuss them in detail.

As with any purchase, the key is to scale in and out of positions (this is something we've discussed on many occasions) so you can't get burned by something like yesterday's action. While some may find scaling in dull as it takes a long time to build up a full position, I have a very simple way to make it much more fun and profitable: When you go to buy a stock – DO NOT BUY THE STOCK, SELL THE PUTS.

You must, of course, be buying 100 share blocks but the logic is this. If I think Apple is a good deal at $180 and I'm about to buy it, then I can, instead SELL the $180 puts for $8.95. Since I was going to spend $18,000 anyway for 100 shares, the money is obviously in my account so the margin is a non-issue. Rather than spending the $18,000, I'm collecting $895 and I have the obligation to buy 100 shares of Apple for net $17,005.

The downside to this strategy is that if I did happen to pick a perfect bottom on Apple and it jumps back to $200, rather than the $2,000 I would have made by committing $18,000, I "only" make $895 for doing nothing. I could, of course, make another attempt to buy Apple at $200 by selling the $200 puts for $10 (now $22.58) which means I would have collected $1,895 without ever taking possession of the stock.

If that pesky Apple refuses to go down and next month climbs to $220 and I still really want it. I can sell the $220 puts for $10 and will have collected $2,895 while I wait for the stock to go down so, even if it triggers on me at $220, my net cost is $19,105 when my original intention was to buy the stock for $18,000. That is the downside but you can see how, if you do this as a habit, you will generally make a lot of money and hold less shares of stock.

You can, if you are one of those people who hates to lose. Also buy something like the July $210 calls for $17.95 to stop Apple from getting away from you. Assuming you want the same $18,000 worth of Apple you buy those and sell the $180 puts. Now you have no negative if the stock goes up and if it takes you those same 3 sales to get filled you would still own the stock and some pretty valuable calls as a bonus. If it goes the other way quickly, you still get the stock cheaper than the $18,000 if you would have bought it straight and the July $240s (a drop of $30 in Apple) are $10.60 so the net loss on the calls vs. the money you collected on the puts still leave you better off than if you had just bought the stock for $18,000.

Another bonus to this strategy is that, on a steep drop, you can buy out your putter for less than the drop when the stock moves against you. I thought Google had bottomed at $680 on Thursday and, if I were the kind of person who liked stocks, I may have been tempted to buy some there. 100 shares of Google is a whopping $68,000 at that price but Google opened Friday at $675, paused around $670 on the way down and finished the day at $657 a quick loss of $23 a share or $2,300 had I bought the stock.

If I had, instead, sold the $680 puts on Thursday, my putter would have paid me $16 to promise to buy the stock for $680 so that would be $1,600 in my pocket. As Google dove on Thursday morning the puts went to $17.50 at 10am – when GOOG traded at $677, $22.50 at noon – when GOOG traded at $666 and finished the day at $30 – with Google down $23. At any point during the day I could have bought out my putter for less money than I would have lost had I owned the stock.

On the upside, Google would have had to break $696 before I would have been better off owning the stock. Granted Google can easily jump $30 in a single day but if I follow that strategy 12 times during the year, I will collect $192 aggregate dollars selling puts against my position so unless your 12 month target for Google is around $900, this strategy is something worth considering – You lose less on the way down, you make an extra 28% ($192/$680) on the way up (extra assuming some of your buys actually trigger).

This is a very basic strategy that applies to any stock and, as I said with Apple you COULD buy the Jan '09 $850 for $41 so you wouldn't miss out if Google goes to $1,000 and I will tell you now that if you don't think buying that call is a good deal, then obviously $900 isn't really the target in your heart, which is all the more reason you should use my strategy rather than tying up $68,000 for a year in an uncertain market.

Speaking of tying up, if you follow this strategy over the long haul you can drop your margin requirement to $15,700 per block sold by buying the Jan '09 $500 puts for $30. Now you can collect the same $19,600 by spending $3,000 to cap your margin, leaving you with $50,000 to play with BUTBUTBUT you must keep in mind that you can have the stock put to you at any time and you will need to have the money available. You can, of course, turn around and sell the stock the next day and your ownership of the '09 $500 puts means you can turn around and put the stock that was put to you to your putter for $500 in some catastrophic emergency but this is an article for people who WANT to buy stocks, not about playing options!

So that's how we buy a stock. Now that we own it, what do we do?

As I often tell members and as we saw first hand yesterday, people who buy short-term options are suckers while people who sell short-term options do quite well for themselves. If you are a long-term investor who holds stocks and you DO NOT sell options against those stocks, then you are a dumb-ass! Do you want me to sugar-coat it? That is sugar-coating it! You are as dumb as a guy who has a beach house that he uses two weeks a year and never rents it out – perhaps you are so rich you just don't care about the income on a beach house but, no matter how rich you are, THE FACT THAT YOU ARE BUYING STOCKS AS AN INVESTMENT MEANS YOU SHOULD DAMN WELL CARE ABOUT THE RENTS YOU SHOULD BE COLLECTING!

Le's go back to Google as an example. You will need the 1-year chart to follow this along and I'm going to just make up some rough numbers on old options but let's compare 2 paths. Had you just bought Google for $466 on Jan 1st, 2007 and held it, you would be up $191 for the year – very nice! Let's say you had purchased 300 shares for $139.800 – you would have made $57,300 or 40%, that's about as good as it gets for a stock.

Path 1 – Buy the stock all at once and sell covered calls:

Jan 1 – Lay out $139,800 sell Jan 19th $470s for $15. Options collected $4,500
Jan 19 – Google finishes at $489, you give the caller back his $15 plus $4 more and sell the Feb $490s for $17. Net options collection $3,900
Feb 16tth – Closes at $469 so your caller goes worthless. Sell the March $470s for $17. $9,000 collected.
March 16th – Close at $440, caller worthless. Earnings are on expiration day and your stock is worth $132,000 but the options you've collected ($9,000) have kept you even. There are two schools of thought; You can keep covering and let yourself get called away if earnings are good or you can risk earnings since you now own the stock for far less than you originally intended so you believe in the value of it.
- If you were following our trades at the time you would have been psychotically bullish about Google going into earnings as this was one of our big wins of the year and you probably would not have sold calls but lets, for the sake of simplicity, assume you simply sell $440s for $20 (earnings gives you better premiums). $15,000 collected.
April 20 – Close at $480. You owe your caller $40. You can let him have your stock for $440, which would net you $132,000 for the stock plus the $15,000 you've collected selling calls works out to $490 a share. Let's assume you are in an IRA or have tax reasons not to sell and you pay your caller the $12,000 and now sell the May $480s for $17. You are still in the stock with Net $8,100 collected.
May 18 – Close at $470. Your caller expires worthless and you sell the June $470s for $17. $13,200 collected.
June 15th – Close at $505. You pay your caller $10,500 and sell the July $510s for $15. Net $7,200 collected.
July 20th – Close at $520 (note you would have had a heart attack as Google dropped $40 that day). You pay the caller $3,000, sell the $520s for $17. Net $9,300 collected.
August 17 – Close at $500. Your caller expires worthless and we will continue to assume you don't go crazy and go naked as we did around that day. Sell the September $500s for $20 (earnings again). $15,300 collected.
Sept 21 – Close at $560. Assuming you didn't follow any of our stopping rules and let it go this far, you owe the caller $18,000! The correct strategy here, since you own the stock and your worst case is you will get called away, is to buy him out and sell whatever October contract will give you most of it back. That would have been the $520s, which would have been about even at $60. Net collected still $15,300.
Oct 19th – Close at $644. This is getting ridiculous! You owe your $520 caller $124 per contract or $37,200. The good news is that the price of contracts went up but rolling him to the $540s seems silly. The correct move here is to bite the bullet and put back the $15,300 you collected and sell him whatever contract you can get $22,000 for. That would have been the Nov $580s. Your net collections are now $0.
Nov 16 – Close at $633. After another heart attack, Google drops $100 in two weeks and you are right back where you started the option period. You owe you caller $15,900 and sell the Dec $600s leaving you net $0 on collections again.
Dec 21 – Close at $696. Still annoying – now you owe this caller $28,800 and the proper move is to take $13,000 out of your pocket so you have at least some premium in the next sale. That puts your next caller in the Jan $660s and you are net negative $13,000.

Today those Jan $660s are out of the money but still worth $17.15 so you owe your caller $5,145. Assuming you wanted to get your money back and go back to even, you could sell the Feb $620s for $60.15. Now we've held the stock for a year so we qualify for capital gains and, if we get called away for $620 we will net $186,000, just $11,100 less that what we would have made had we never sold calls and played the moves very poorly.

I'm sure any of our experienced members feel actual pain at some of the moves I described above – this is a VERY basic, hands-off strategy that can penalize you when a stock moves up but this is a good example of how, even with a stock that jumps $220 in less than 90 days, there is very little downside to this strategy.

Path 2 – Putting my lessons (still basic) to good use:

My goal is to own 300 shares of Google for the year and I will buy them in 100 share blocks whenever they are cheap. I think Google could fly up at some point so I spend (in Jan, with Google at $466) $60 for 3 Jan '08 $550s ($18,000).

Jan 1 – Sell 1 set of $460 puts for $15, collect $1,500. Net negative $16,500 (I bought the calls).
Jan 19 – Google finishes at $489. I sell the Feb $490 puts for $17. Net negative $14,800.
Feb 16 – Closes at $469. I take possession of 100 shares at $490. Sell the Mar $470 puts for $1,700 – net negative $13,100 on my options side (I'm ignoring the stock as I'm a long-term investor scaling in). I also sell 1 $470 call against my 100 shares for $1,700. Net negative $11,400.
March 16th – Close at $440. I take possession of another 100 shares at $470. Sell the April $440 puts for $1,700 and sell 2 $440 calls for $3,400. Net negative $3,400. Again we are going to totally misplay this and just robotically follow a very basic strategy.
April 20 – Close at $480. Rather than try to keep my stock here, I will let myself get called away as I have my '09s (remember them) appreciating for me to the upside so there's no need to plow more cash in and they are almost fully paid for at this point. I took possession of 100 shares at $490 and 100 shares at $470 ($96,000) and I had to sell them for $88,000 so I am net negative $11,400. I sell 1 May $480 put for $17 – Net negative $9,700.
May 18 – Close at $470. I take possession of 100 shares at $470. I sell June $470 calls for $1,700 and sell June $470 puts for $1,700. Net negative $6,300.
June 15th – Close at $505. I am called away at $470 (even) and have no stock again. I sell the July $500 puts for $1,700. Net negative $4,600.
July 20th – Close at $520. Still no stock. I sell the Aug $520 puts for $1,700. Net negative $2,900.
Aug 17 – Close at $500. Yay I guess… I take possession of 100 shares at $500. Sell Sept $500 calls for $1,700 and sell Sept $500 puts for $1,700. Net positive $500.
Sept 21 – Close at $560. Lost my shares at $500 (even). Sell $560 puts for $1,700. Net positive $2,200.
Oct 19th – Close at $644. I can't believe I lost my shares at $500! Sell $640 puts for $1,700. Net positive $3,900.
Nov 16 – Close at $633. Take possession of 100 shares at $640. Sell $630 puts for Dec $1,700 and Dec $630 calls for $2,000, Net positive $7,600.
- It is important to note here that the Jan $550 calls topped out on Nov 6th at $200 per contract (Net positive $60,000). It stayed up there for 3 days and dropped about $20 a day the following week. Not taking that money off the table at some point would have made you the dumbass of the year but let's assume you didn't…
Dec 21 – Close at $696. Lose 100 shares at $630 (net negative $1,000). Sell $690 puts for $1,700 – net positive $8,300.

As of today it looks like you'll be owning 100 shares of Google at $690 for a $33 loss per share (down $3,300) but you have $8,300 from all your call and put selling and you have 3 Jan $550 contracts that, despite you being a dumbass, are still worth $107 each for a net gain of $40,400 vs. the $57,300 you would have had if you tied up $139,800 for the year.

There was only one single month during the year in which you had more than 100 shares of Google and that month was the only time that more than $69,000 in margin were required so your average return on capital committed (averaging a mere $80,000 a month) was 50%. If you made just 10% on the $60,000 you didn't use, that's a nice bonus too and don't forget the merits of being diversified!

Again this is really basic and our members know about 20 ways that those returns could have been improved dramatically. Hopefully, even the dumbasses out there can get the idea that this is a system well worth learning more about. Options are a good and useful tool to manage a virtual portfolio and ENHANCE your returns while MINIMIZING your risk. This is an example using one of the most volatile stocks in the market in a very volatile year – during a dull year or a downtrending year, these strategies will literally save your virtual portfolio.