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Educational Article

How To Trade High Risk Internet Stocks Without High Risk

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By Jim Brown

Do you watch the highly volatile Internet stocks run up and down $25, 30 or even $50 a day but are afraid to play them because of the risk? Have you looked at the options on stocks like QCOM, YHOO, CMRC or BVSN and passed because you could not see paying $35 for an out of the money option? I know this happens every day. We at OIN skip over dozens of good plays every day because the options are too expensive. I did not say too high, I said too expensive. The options are high because of the expectations of the option writers that the stocks will continue to make big moves.

For straight call/put buyers these options represent extreme risk. For option writers these options represent windfall profits. Still option writers must be content to collect a $25 on a $200 stock and then watch as it zooms to $300 without gaining another dollar. But what if you could collect $30-50 per share every month with almost no risk? Sure you would miss out on some rockets sometimes but would you be content with 1000% returns a year, every year instead of the CHANCE to maybe do 1500% sometimes? Of course. Who would not want to make 1000% per year almost risk free. This strategy works in all markets, up, down or flat. Does this sound like a fairy tale? I am going to show you how but you must obey my instructions completely with no cheating. A $50,000 account can turn into a $500,000 account in twelve months through the miracle of compounding this 25% monthly return using this strategy. This is the only option strategy I know that can really be compounded every month.

The Covered Straddle

There are many different names for this strategy but the one I like is "Covered Straddle". It is a combination of covered calls and covered puts at the same time. There is almost no risk because you maintain a cover for each of your positions at all times. Before you click that back button because I am talking over your head you really should follow this through. It will be worth your effort.

I am going to show this several different ways and explain how it differs depending on your risk profile. There is a conservative method, aggressive method and an extreme risk method. Each has its own rules within the strategy. First, I will explain the basic strategy and then detail the different risk applications.

The Basic Strategy

Pick a stock that is highly volatile but has a directional trend. Strongly up is better than down but either direction works. I am going to use CommerceOne (CMRC) in my example. It closed today at $187. On the first Sunday after options expiration, you find a stock like CMRC, high volatility but likely to charge off in one direction or the other at a high rate of speed. Second, pick the at the money call and put options. In my examples I am going to use the February $190 options since there are only two weeks left in January options. (Actually you could still make 18% on CMRC with this strategy and January options if you acted Monday morning.)

This is a calculator program that I use to determine the returns on each stock I analyze for this type of play. There is a download link for a free copy at the end of this article. I input the numbers in green and the blue areas are calculated for me, including the numbers of contracts to buy/sell, as well as the total profit.

The object of this strategy is to sell both the Feb-190 calls AND the Feb-190 puts at the same time. Your total cash received would be $54.88, using Fridays closing prices. Now the catch, you can readily see that one of these options will be exercised and the other will expire worthless. Both would not be exercised at the same time. We are going to cover ourselves from any risk of exercise by covering the side of the position that is at risk. If the stock goes up over $190 we go long 100 shares for each option we sold. If the stock moves below $190 we short 100 shares for each option we sold. We stay long OR short for as long as the stock stays on that side of $190. Ideally we want a stock that will pick a direction and stay in that direction all month and we never have to worry about it again. We will be exercised at the end of the month and we keep all the premium received for a +33% return and then we start a new play the next Monday.

It is very important that you realize we are not trying to trade the stock. We only want to use the long or short position to cover based on the direction of the move and then just stay covered. It does not make any difference if the stock goes up or down hundreds of dollars. We only want to collect our 25% to 30% premiums each month and then do it again the next. The object of the play is to be called out or exercised on expiration Friday.

WE DO NOT CARE HOW FAR THE STOCK MOVES IN EITHER DIRECTION WITH THIS BASIC STRATEGY.

Now I will detail the different variations on this strategy. They all work as well with only the amount of risk and the amount of return as the variable.

Conservative Strategy

With the conservative strategy, we will not sell options at the money. We will go out to a strike on either side of the current stock price. Using our CMRC example we will:

Sell Feb-210 Call for $19.38
Sell Feb-180 Put for $25.63
Total cash in = $45.00 or a 27% monthly return

The risk is less because of the free zone between $180 and $210 and yet the base returns are still 27%. This is a no brainer trade since the action lines are clearly set out in advance and easily executable. Remember, we are not trying to trade the stock. We only want to cover as it crosses the strike lines and then stay covered as long as it stays on the outside of the strikes. It makes no difference how far it goes in either direction, we only want the $45 premium and +1000% per year.

Aggressive strategy

With this strategy you can easily add $10 to $15 premium but you will be uncovered for some period of time and therefore at risk. The risk is still minimal since you will take in a larger premium in advance. With this strategy you must commit to a direction when you start the trade. If the trade goes against you on the first day you should close it immediately and pick another entry point. Where the conservative strategy can be entered at any time the aggressive strategy is best entered only at strong support levels after a dip. This strategy consists of selling the put $10 in the money at $200, the call $10 out of the money at $200, and going long the stock at $187. Your income on the play with a final close over $200 will look like this:

Sell Feb-200 Call at $22.50
Sell Feb-200 Put at $34.00
Gain on stock from $187 = $13.00
Total income = $69.50 or a 41% monthly return

While this strategy offers substantially more return you must be right about the direction from day one to get the full benefits. If you wait for a bounce off support to implement this strategy you will have a greater chance of success. Even if the stock moves down from $187 the very first day and you have to short it from the beginning you will still have a decent return. Say you shorted at $185 and it never came back then your return would be $69.50 -$15.00 = $54.50 or 32%. Not shabby for a busted play! If the play moves up from the start then your action line should move up also. Should the stock reverse downward at any time you should go short from that point. Once the stock moves above $200 that is your permanent action line until the play is over. Stay long over $200, stay short under $200. You will have the maximum return at that point. Remember, we do not want to trade the stock. We only want to collect the $69.50 premium and 1000% return for the year.

Extreme Risk strategy

This is for the day traders only. This strategy has extreme risk as you may be uncovered at the wrong time and have the stock move against you. Still, with these stocks the possibility of major moves in your favor are very likely. The method starts out like the aggressive strategy above only we don't sell the call at the start. We sell the put as deep in the money as you dare depending on the stock and the trend. You have to be right about the direction (up) to maximize this play. We then go long the stock and ride it up to the strike price we sold the put. Once at that strike, lets use $220 as the example, we then sell the $220 call to take advantage of the increase in premium from the run up.

Using CMRC as an example we would collect the following:

Sell Feb-220 put at $47.88
Sell Feb-220 call at $28.75 (est)
Gain in stock from $187 = $33.00
Total profit = $109.63 or a 65% monthly return

I am sure you can see the obvious risk here. The risk is that the stock never reaches your $220 target and you never get to sell the $220 call for full price. This is a good reason for setting reasonable targets only $10-15 over the stock price. Still if you are reasonably confident of the direction and speed, you have a month to move $20 and most of these Internet stocks can move that much on a good day. When using this extreme risk strategy you must be very careful to switch from long to short quickly under the $220 strike should the trade turn negative. You have a huge cushion of $50-60 but waiting to go short can be costly.

Another source of income in the extreme risk strategy is trading the stock. In both the conservative and aggressive strategies we never want to trade the stock. We just use the stock position as a cover for the open options. In this strategy you can trade it based on strong moves and counter moves. An example would be JDSU or YHOO this week. Both made huge moves and then backtracked. If you had been long YHOO with $420 as an action line and you saw it roll over at $500 I would immediately close my long for a really nice profit and go short. You can capture the large up move and then the large down move. When it reverses, again you go long and you are still covered but you have a double digit trading profit intraday. This is risky on these fast movers but if you know how to read the cycles and determine support and resistance then it is easy money. Looking back it is easy to see how you COULD have done it but actually doing it requires solid experience.

Points to consider:

The best trade is one that starts in one direction once you execute it and then never crosses the action line again. The danger in these strategies is the whipsaw effect. Using the CMRC example you can see that you would have been beat to death if your strike prices had been $200 two weeks ago. With CMRC trading basically flat and on either side of $200 many times, you could have been constantly switching from long to short. While an experienced trader could have made a couple dollars with each swing, we really want to avoid switching the stock position more then once or twice per month. This is the reason we want to pick a stock that is moving in a clear direction. It is much easier to play. Of course Murphy is alive and well and every clear direction may change when you execute your entry. If it changes more than two or three times you can either move your action line one strike in either direction and give up the $5 move or close the play entirely and pick another stock to play. Every day that passes helps the premium decay so even if the stock stays flat your premiums will shrink and provide a profit.

A strong move in either direction will deflate the other option premium quickly. If the premium on either side drops to a very low number like $2-$3 I recommend closing that position. I can hear you now, "but it will expire worthless". Yes it might but it might also jump in price instantly if we have a market event. Do you think Lucent put sellers are wishing they bought their "worthless" January puts back for $1 yesterday? Once you close one side of the trade it makes the long/short decision much simpler. Now instead of switching from long to short you only need to close the open stock position if it crosses your action line and wait until expiration Friday. You really have no risk on the closed side and the premium is decaying quickly on the open side.

I strongly advise only opening positions on strong support points. It simply makes the future decisions much easier and fewer. If the stock bounces off support and starts moving up again then you may never have to open a short position.

Remember, we do not want to trade the stock. We are only interested in collecting the premiums. Trading the stock creates risk. We are not interested in how much the stock gains or loses, just as long as it does either quickly and stays there.

Margin requirements for this type of strategy vary with different brokers. The most common scenario would require 50% of the stock price for going long the stock. Zero margin is required for writing the calls on the long stock position. The put side will require a minimum of 20% to a maximum of 40% of the stock price. As you switch sides on the stock position the requirements change but your worst case is 90% of the underlying. Remember also you are taking in 25% or better in cash at the start of the play. Some of this premium must be maintained as part of the margin requirements but this is not a problem since you did not have it to start with. This is free money and you will earn money market interest for the entire month.

Different brokers require different account sizes to write options. Writing naked puts requires a $20,000 or greater account at Etrade which is a reasonable amount but they will not let you write naked calls regardless of your account size. Ask your broker what his requirements are for writing options.

If you do not have, the capability to write uncovered call options, then you have two choices. Wait for a bounce off support and simply go long the stock and write a covered call which does not require any margin or naked writing capability. If you wait for a support point to start the play then you will normally be ok. For example, buying CMRC at $187 on Monday and writing the Feb-185 call for $28.75 will still net you a 30% return assuming a 50% margin requirement on the stock. If the stock drops below $180 close the play. A close at anything above $180 on expiration Friday is a nice profit.

If you do not have the capability to write uncovered call options then consider switching sides. Sell just the put instead. Naked put selling is much easier to have approved than naked calls. With only a $20K account at some brokers you can write naked puts. Sounds dangerous but you can make it risk free. Using the CMRC example at $187, sell the Feb $180 put for $25.63. The margin requirements are between 20% and 40% of the underlying stock price. ($37-$74) You protect yourself from being put to by shorting the stock under $180. If the stock closes above $180, you keep all the premium. If it closes below $180 and you correctly shorted the stock, you keep all the premium. Assuming you had to short the stock and use a full 50% margin to cover your position, you would still make a 27% return for the month.

Compounding

I know that half of our readers are thinking 25% a month? Why should I limit myself to such a small return. Think compounding! Covered straddles and naked puts are the only option strategy I know that can guarantee (almost) a 25% return or better every month regardless of your account size. If you have a lot of money it is much harder to consistently make big returns with straight calls or puts. You will have losing positions on average 40% of the time. More money means larger positions, slower reaction times, bad fills and larger losses using straight calls/puts. This strategy will work constantly because you are not trading the options. You are only trading the stock which is much more liquid and has smaller bid/ask spreads. I prepared this table to show you how effective compounding can be. I use the stating balances of $10,000, $25,000, $50,000 and $100,000 and an easily attainable 25% per month return. I simply cannot imagine anyone not being happy with the December closing balance and a +1433% return for the year. Will everybody get this? No, many will try to cheat or get impatient and act on impulse. Only those who apply common sense trading rules and stick to the plan will achieve these numbers. Those that try to go for a home run every time are doomed to eventual failure. What if you were conservative and only managed 20% monthly returns? That would still be an 892% return for the year.

Conclusion

Everybody may not be able to use all the strategies that I have outlined here due to account limitations but most should be able to use at least the naked put side of the play. Just remember that even a safe 20% return every month is worth the time and effort in the long run. If you have a small account balance simply pick a cheaper stock or write fewer contracts until your account builds up. Through compounding even a $10,000 account today can be worth over $1 million twenty-four months from now at 25% per month.

Stick to the plan!

Jim Brown
Editor

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