David’s Journal

I’m excited to start investing soon, but I’m doing a little safe “practice” investing first.  So I’m keeping track on paper (actually, it’s in a text file on my computer) what stock and options trades I’d get into and see how I’d do, as if it were real life.

For this virtual trade, I’m assuming I’d use Scottrade, which charges a $7 per trade commission, plus an additional $1.50 per contract if I’m buying an option.

In this case, I did.

I bought a Dec 08 $35 call option on Mavel Entertainment (MVL).  In lay terms, that means I bought the right to buy 100 shares of Marvel’s stock at $35 per share, by the third Saturday of December 2008.  If that all sounds confusing, don’t worry, just keep reading. :)

That $35 call option cost me $3.90 per contract per share… and each contract includes 100 shares, so the total price was $390.  But don’t forget Scottrade’s fees…  So add another $7 plus $1.50 to that transaction too, for a total of $398.50 out of pocket, invested into this trade.

Now, if Marvel’s stock never hit $35 (it was a couple points below it at the time) by the time my option expired (which is the third Saturday in December this year), the entire option would be worthless and I’d lose my entire $398.50 investment.  This is why people say options are risky.  There’s a time limit on them.

But I’ve been following Marvel for some time now.  Many years, in fact.  I understand their industry, I’ve read their prospectus, and I’m aware of the products they’re selling.  (Don’t forget, Iron Man just came out in theaters recently, and The Incredible Hulk is now playing too.)  I also looked at their chart and noticed a consistent trend, rising in price about $2 per month per share.

So while there’s a chance I could lose my entire option’s value, it was unlikely.  But hey, this is for educational purposes anyway.  I’m starting small.  I know what I’m doing, but if it turns against me, it’s still a small enough loss I can recover and learn from.

So I placed this order (bought the $35 call option) on June 6th.  Today, just one week later, the stock has gone up in value … and so has its $35 call option.

That option that was worth $3.80 a week ago is now worth $5.00.

Remember, that’s per share, times 100 shares.

I spent $380.  I can now sell it for $500.

So, in this virtual practice trade, that’s exactly what I did.  I sold it for $500.  Minus the $7 comission fee, and the $1.50 contract fee.  That leaves me with a $93 profit ($500 - $7 - $1.50 - $398.50).

A $93 profit on a $398.50 investment is a 23.3% ROI — or return on investment.

In just one week.

Buying only one option.

Not bad, eh?

I could wait longer (the option’s good until late December, remember?), but other research I’ve done on Marvel tells me now’s a good time to get out.  It’ll probably still go up for a while, but in my opinion, there’s better stocks to play with next.

Hypothetically, if the stock continues to go up for a while, that option would be worth even more, and I could make an even higher profit.

But $93 in a week is good for someone starting out.  A 23.3% return on my investment is very good.

And remember, that was a 23.3% ROI in just one week.  If I did just one deal like that a month, that’d be around a 280% ROI per year.  If I got really good and did a trade like that every week, that’d be a 1,213.55% ROI per year … but let’s not go crazy here.  :)

Most people would be thrilled to get just 23% in a year, nevermind per month or week … but that’s the power of options.  And a little education. :)

Mainly this exercise is just confirming that I’m off to a good start, that I’m applying my knowledge correctly.  I’m not going to think every deal’s going to be like that — some will be better, some might lose money.  But there’s also ways to automatically limit my losses and control my risk, too.

Unfortunately, if you read my last blog, Scottrade hasn’t authorized me to do simple option trades like this yet.  So that’s something that will have to wait until the future.

In the meantime, I can do what’s called a “covered call.”  That’s not as exciting, but still very cool.

For example, if I wanted, I could go out and buy 100 shares of Marvel today.   Its current ask price is $36.12, so that’s what I’d pay.  100 shares would equal $3,612.00.  Plus the $7 commission fee.  Or $3,619.00 total.

I now would own 100 shares of MVL.  So how’s a covered call apply to this?

Remember how I bought the right to buy 100 shares of MVL at $35 in my example above?  Well, now that I own the stock outright, covered calls allow me to sell the right for someone else to buy 100 shares at a certain price from me.

Next price level up is a $40 call option.  Remember, options expire the third Saturday of every month.  We’re already half way through June, but if I want, I can still sell an option that expires this month.  Since there’s not much time left for the stock to jump to (or above) $40, the call option is pretty cheap… only 20 cents.  But that’s the ask price.  I’m selling the option, so I only get the bid price, which is 15 cents.

Here’s what happens.

I sell the right for someone to buy my 100 shares at $40 each, due to expire next Saturday (technically Friday, since the markets aren’t open on the weekend), for $0.15… times 100 shares, for a total of $15.

That’s the premium, the non-refundable fee to buy the right, to buy the stock at $40 per share from me.

Now, if the stock doesn’t hit that high of a price by next Friday… or if it stays the same or even goes down… that other person isn’t going to exercise (use) that option.  Next Saturday, the option expires, I keep the $15 premium, and I can do WHATEVER I want with my MVL shares now.

If I want (and I would), I could then sell another covered call on those same 100 shares of MVL, this time due to expire on the third Saturday of July.  I can keep doing this as long as I own the stock!

Every month I can create income on stock I own, just by selling a covered call.

But wait…what if the stock did go above $40 by next Friday?  What if someone does exercise (use) the call option on me?

Great!  Let ‘em!  If they exercise the call option I sold them, they pay me $40 per share, and I give them my 100 shares of MVL.  Easy.

I still keep the $15 premium for the option rights.  But now I also get $4,000 ($40 x 100 shares).  By using a covered call, I not only created a tiny passive income from my holdings, but also locked in a specific profit.

So, with covered calls, one of two scenarios can happen:

Scenario 1:
The stock doesn’t hit $40 per share by Friday, and the option expires.  In one week, I made a $15 income on my 100 shares by selling a covered call that was never exercised.  I invested $3,619 to buy the stock (plus $1.50 to sell the call option) and made $15 in income, or a 0.4% ROI in one week (about 21.5% annually).

Scenario 2:
The stock does hit $40 or above by Friday, and the person exercises the call option.  They pay me $4,000 and take my 100 shares.  I still keep the original $15 income as well.  That’s $4,015 minus the $3,620.50 investment ($3,619 to buy the stock plus the $1.50 fee to  sell the option), for a profit of $394.50.  That’s a 10.8% ROI in one week (about 566% ROI annually).

And that’s just using covered calls.

Much better than the return on your savings account, huh? :)

If you want to learn more about this stuff, there’s TONS of books, seminars, audio and video programs, you name it.  Obviously my blog was just a very basic overview of what you can do with options and covered calls.  There’s much more to learn and understand before successfully doing this in real life.  I just wish I knew about this stuff back in high school and college.  Who knows where I’d be today if I did.  But, hey, I’m still young, and excited to start where I’m at. :)

In time, with more practice and education, I will someday be a successful investor too.

Namaste, your friend,
David Michaels

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