The Black Book of Retirement Trading Secrets
Before you read this guide, you should know something important.
You should know I required a special contract – unlike most in the investment advisory business – before I agreed to write this service.
I love the advisory business. I've been reading and acting upon advisory recommendations for more than 30 years. But the business involves one ridiculous element... one mandated by its customers.
Investment advisory publishers tend to go broke if they don't urge readers to buy a hot tip each month... or even each week. Most of their customers have the insane belief that great investment opportunities appear with the same regularity as a full moon. Customers riot if there isn't some hot tech stock or big oil strike sent to their mailboxes on the third Tuesday of each month.
Thus, financial publishers urge their analysts to come up with a stock pick each month. Their customers demand it, so they demand it.
If you share this common belief, I'd like you to cancel your subscription to Retirement Trader. It isn't for you. You should also cancel the other financial publications you receive, sell all of your stocks, and stick your money in the bank. You're going to have a hard time making money in the market. You aren't emotionally suited for it.
If you believe the market will give you an incredible opportunity each week, you're probably the type who checks stock quotes every five minutes, won't cut your losses, and always feels the market should be doing something for you. Honestly, I'd rather your financial train wreck happen somewhere else.
Now, if you're like me and know super-safe investment and trading opportunities don't pop up every week... if you know the markets don't adhere to anyone's schedule... if you know success only comes from waiting patiently for what world-class billionaire investor Warren Buffett calls the "fat pitch..." then this service is EXACTLY for you.
You'll know why I insisted on a special contract with my publisher that allows me to do the best possible job for you, instead of coming up with hot stock tips each month...
You see, I used to be part of an elite team of traders at Goldman Sachs. We created sophisticated investment vehicles for clients and other traders at the firm who wanted to hedge risks and take advantage of business opportunities they foresaw. For instance, imagine an airline like Southwest wanted to protect its cash flows no matter how high the price of oil. We would use a variety of trading tools – in this case, commodity futures and options – to provide a tailor made program that allowed the airline to pay a fixed price for fuel for a set number of months.
The special arrangement I negotiated with my publisher allows me to take what I've learned working for the best firms on Wall Street (Goldman Sachs and Yamaichi, Japan's top investment bank at the time)... and show you unusual ways to make large, very safe gains in the stock, bond, and commodity markets... whenever and wherever they arise.
I might tell you about three trades in one day... I might tell you about three in two months. But I can tell you for sure that with 30 years of trading, and two early "retirements" under my belt (I left Wall Street in 1995, went to medical school and residency with fellowships. I became an eye surgeon before retiring again to write my advisories Retirement Millionaire and Retirement Trader), I'd be nuts to agree to something that keeps me on an arbitrary trading schedule just so some people can get their weekly fix.
If I haven't scared you off yet and you're ready to start safely doubling or tripling the gains you normally make in your retirement account, with much less risk, let's get started. But beware, once you read this guide, you'll never look at stocks and options the same way again...
How the Rich Man Sees the Market
I could tell you I manage my money the way professional Wall Street traders do... or tell you that you'll be hearing about complicated hedge-fund strategies. But I believe it's more useful to describe intelligent trading in terms of the anaconda.
Anacondas are the largest snakes in the world. They are also one of the world's most efficient hunters. Anacondas don't zip around and get into long battles with their prey.
They sit in rivers for long periods of time, waiting for the easiest prey possible. Only when they get easy, slam-dunk opportunities – like when an unsuspecting animal stops for a sip of water – do they strike. Then, they slowly wrap themselves around their prey and squeeze it to death.
Said another way, anacondas are nature's "cheap-shot" artists. They aren't interested in fair fights. They only participate if the odds are overwhelmingly stacked on their side. Anacondas grow to enormous sizes because they don't spend much time or energy chasing everything that comes along. They are the natural world's "no risk" operators.
That's how I'd like you to think about trading stocks, bonds, and commodities – like an anaconda might. I want you to act only when the odds are heavily stacked in your favor. I want you to avoid the loser's mentality I described above. Avoid worry, wasted time, and impatience. I want you to be a rich skeptic who racks up extraordinary returns by avoiding risk.
Avoiding risks and becoming a rich skeptic has nothing to do with sticking to bank deposits and Treasury bonds paying 2% a year. It has everything to do with what I call the "Black Book of Retirement Trading Secrets."
The "Black Book" is a collection of six trading tools I assembled over decades of trading, going to the best business schools, and working with the "sharks" at Goldman Sachs. (In case you're wondering, yes, the company does some shady things... but it is also the very best in the world at advanced trading techniques.)
Don't worry about that word "advanced," though. Each technique I'm going to show you is simple to learn and use. Each is focused on "high upside, with low downside" opportunities that retirees and people saving for retirement should always focus on. Put them all together, and you're going to have a safe trading system that rivals that of any highly paid hedge-fund manager.
I have no doubt that used properly – and paired with an "anaconda's view" of trading – these strategies will allow you to SAFELY double or even triple the gains you are used to making in the stock, bond, and commodity markets.
Here they are...
Retirement Trader Tool No. 1
Free "Play Money" Stock Options
Most people know stock options are a great way to get rich in America...
Take Stephen Hemsley, CEO of the big insurance firm United Health Group. His 2009 salary came in at around $9 million. But a decade earlier, he received stock options as part of his compensation package. In 2009, he exercised 4.9 million of them for a total gain of $98.6 million.
These huge option payoffs are just business as usual on Wall Street... and most of the time, there's nothing wrong with them. Several of my good friends will never have to work again because they exercised options on thousands of shares of company stock. These options allow people to buy a company's shares for a small amount of money, then eventually sell the shares for much higher prices. They can bring in hundreds of thousands of dollars of extra income for folks.
Most people have to work for years to receive stock options from their employer – or use risky trading strategies to acquire in-the-money options ("in the money" means the option's strike price is below the price of the underlying stock). They have no idea there's a way to receive free stock options any time you want them.
In fact, acquiring free stock options is one of the easiest, safest ways to invest in the stock market. It's a strategy I learned more than 20 years ago while trading derivatives on Wall Street.
I guarantee 99 out of 100 investors have never heard of it before.
Let me give you an example of what I mean... In April 2010, I recommended one of the best "free stock options" trades I've ever seen...
I follow the medical and biotech stock sector closely. Several of the most profitable trades and investments of my life have come from this sector... and I've traded it from just about every angle possible: from private biotech investments... to owning shares of health care powerhouse Johnson & Johnson... to complicated option "insurance" strategies.
One of my favorite companies in this space is $100 billion British drug giant GlaxoSmithKline (NYSE: GSK).
GSK is an innovative Big Pharma company with an exceptional research & development process. It constantly increases shareholder equity... and has a culture of treating investors well in the form of big dividend payments. In April 2010, GSK was yielding around 6%... or around $2.30 per share, per year. GSK was also undervalued relative to its annual earnings, so I expected shares to appreciate in value.
This $2.30 annual dividend payment is important... it's the key to our "free stock option."
You see, I love to own safe stocks that pay big dividends like GSK. But I also like the tremendous leveraging power that stock options provide. That's why I often buy these sorts of stocks... then take the money I receive in dividends and buy call options with them. I fund the speculative portion of my position with the company's dividend.
That's why I consider these sorts of trades to be getting "free stock options."
To give you a better idea of exactly how these kinds of trades can work out, let me show you how the math looks for the GSK trade I just talked about.
In the original trade, I recommended folks buy GSK and buy one call option for every 100 shares of stock they purchased. Remember, when you trade options, one contract represents the right to buy and trade 100 shares of stock.
At the time, GSK was selling for around $39.50 per share. I recommend buying the January 2012 $45 call options for $2.30 or less... about the amount of the annual dividend. (The calls were actually trading for $2 per contract at the time.)
These January 2012 $45 calls would only become profitable if GSK shares climbed to more than $45 per share by January 2012. If GSK climbed to say, $80 per share, that option, which was trading for around $2 per contract at the time, would be worth $35 per contract... a more than 17-fold gain.
For every 100 shares traded on GSK, the math worked out as follows (not factoring in commissions, as everyone's fees are different):
Buy 100 shares of GSK at $39.50 for $3,950.
Buy one GSK January 2012 $45 call option for $200.
Total outlay: $4,150.
This trade could work out in a variety of ways. Here's how...
Scenario No. 1:
If GSK trades for $85 per share by January 2012, we can buy shares at the strike price and immediately sell them for a profit. The profit per share is the difference between the price GSK is trading at in 2012 and the strike price of $45.
If GSK is trading for $85 by January 2012, you'll make $38 per call option ($85 minus the $45 strike price less the $2 cost of the option). You'll also make $45.50 in capital gains on the stock itself. That would be a combined gain of $83.50 (on a $39.50 investment) for every hundred shares... more than 200%.
Here's the math for a 100-share position:
Initial outlay of $4,150.
Option contract is now worth $4,000 ($85 current price minus the $45 strike price).
Stock is now worth $8,500.
Initial outlay of $4,150 is now worth $12,500. A terrific 201% gain in less than two years on a safe, dividend paying stock.
Scenario No. 2:
Let's say GSK shares don't rise to $85 per share by January 2012. Let's say they rise to just $65 per share. Here's how the math works out in this scenario:
Initial outlay of $4,150.
Option contract is now worth $2,000 ($65 current price minus the $45 strike price).
Stock is now worth $6,500.
Initial outlay of $4,150 is now worth $8,500... a 105% gain on a safe, dividend paying stock.
Scenario No. 3:
Let's say GSK shares rise only slightly to $50 per share by January 2012. Here's how the math works out:
Initial outlay of $4,150.
Option contract is now worth $500 ($50 minus $45).
Stock is now worth $5,000.
Initial outlay of $4,150 is now worth $5,500... a 33% gain in just over 18 months. Not a huge gain, but still a great safe profit.
Please note... this is not a "covered call" trade where you buy a chunk of stock and SELL call options against your shares, pocketing a premium in the process. There's a time and place for covered calls... but in situations where you can buy a cheap call option that is paid for by the company's rich dividend, you want to BUY the calls... and get a lot more "juice" on conservative trades like GSK.
This is especially important when you have a stock you expect to substantially appreciate in value. You want plenty of exposure to that upside... which is what a call PURCHASE provides.
How to Protect Your Capital from Losses
In every trading situation, we have to form a plan in case we are wrong. Most advisories never tell you how to form a plan in case a trade doesn't work out as expected. But in my opinion, that's a huge mistake. Forming a plan for all kinds of situations is vital.
Statistics show even the best traders are right on only 55%-60% of their trades. The key to making plenty of money with these odds is to set yourself up for big profits (like in scenario No. 1 and No. 2) while ALWAYS limiting your downside with protective stops and intelligent bet sizes.
In the case of this trade, I initially placed a 25% "protective stop loss" on the total position ($4,150). This means that if the combined value of our shares and options falls to less than $3,113, we'd sell the position to protect the bulk of our capital.
Here's how the math works out should the broad stock market enter a period of extreme weakness and drag GSK down with it...
A market decline could send GSK shares to less than $35. In this situation, our call option would drastically decline in value... probably from $2 per contract to just 10¢ or 20¢ per contract.
Let's be conservative and not assign any value to them in this situation. If GSK shares sink to less than $31.13 by January 2012, it would trigger the 25% stop loss. Our options would retain some small amount of value. But for simplicity's sake, I'm assigning zero value to them... and stating that our stop loss would be triggered by a decline to $31.13 per share. This would be a loss of $1,038.
As you can see by the various potential scenarios, we are risking $1,038 to make $5,500... $8,500... or even $12,500 on a big, safe stock. This "low-downside/huge-upside" situation is only possible by the addition of an option contract paid for by the company's dividend. A dividend that allows us to accumulate "free stock options."
Why Bother with the Stock?
Experienced option traders might wonder, "If shares have the potential to rise all the way to $85, why not just outright buy the options for $2 and watch them go to $40? Why bother with buying the actual shares?"
After all, making $40 on $2 is a 1,900% return on your investment.
You could do that trade... and you might make a bundle doing it. Buying JUST a call option – and no actual stock – limits your downside to just the premium you pay.
But those options won't be "free." You have to spend your own cash for the options. There's also a higher risk of the trade not working out.
If the stock moves up to just $45 in one year, your options will only be worth about what you paid for them today – $2. And though you've lost nothing with just buying calls, my first strategy of owning the stock and using the dividends to pay for the options has made us 19% during the year ($45 plus the value of the options at $2 each, less the $39.50 we paid for the stock – for a gain of $7.50 on $39.50 invested). Plus, we're still holding the free options that haven't cost us a dime.
Similarly, if the stock stayed at $39.50 for the year, we would make a little money on the original strategy because the options would still be worth about 65¢. The calls-only buyer would have lost 70% of his money ($2 to 65¢). And he'd likely have stopped out of the position, assuming he used a reasonable stop loss of 25% to 50%.
In Retirement Trader, we're aiming for surer, safer gains. While there might be a rare occasion down the road that I'll recommend a straight call option purchase, it's unlikely. Ninety-nine percent of the time, it's more risk than I'm willing to take on.
One of the greatest moments of my financial career was made possible by "stock options that never expire."
Let me take you back to the 1980s...
John, as I'll call him, was a hulking man – six-foot-four and at least 250 pounds. He was so big that when you shook his hand, you prayed he didn't squeeze. John was a big-shot client at Goldman Sachs, and I met him in my Wall Street days when one of the firm's partners introduced us on the trading floor.
Somehow, we got on the subject of health. He told me he was on dialysis. His kidneys and blood cells weren't working right. Then, added with a big grin that a new drug had changed his life. (I was years away from med school then and didn't know a kidney from a gallbladder.)
John explained how his blood had returned to health and he had rediscovered the energy lost years ago. It was like a second chance at life: He was walking with his wife and "regularly doing things" they did when they were 30 years younger.
His story was so powerful and his passion so strong that I asked him the name of the drug. He said "E-P-O." The tiny company that made it was called "Amgen." Then, he turned to me and said: "Son, I know when things work and when they don't. And this stuff works. In fact, I've bought several thousands of shares, and you'd be wise to do the same."
Back at my desk, I reviewed what I could find about this unknown Amgen and put around $12,000 into the stock.
Many of you will recognize Amgen as the preeminent biotech company in the world today... a $60 billion behemoth that pioneered the use of bioengineering in the development of drugs. But back in 1987, its success was anything but assured.
Amgen was merely one of at least 20 other equally promising biotech startups.
It was a risky play. But everything I learned about it looked great: The science made sense... and I figured any drug that could save or alter a life like it had the John's was probably a good bet.
I made nearly 21 times my money over the next three years... a little more than $250,000.
I never saw John again. I never had the chance to thank him for helping me make so much money. But the experience taught me one of the greatest investment lessons of my life:
When you find a risky opportunity that has the possibility of making you a lot of money, take it... but "take" it small. Throw a little bit of cash that way. Don't throw in the rent money, but if you can afford it, toss in a little play money.
My investment in Amgen represented a small (1% or 2%) portion of my portfolio. At any one time, I had three or four speculations like that going. And I don't say this to brag, but the simple fact was, it was money I could lose and not worry about coming up with my next rent check.
These sorts of opportunities frequently arise in the form of tiny start up companies working on one or two big ideas. They come in the form of "stock options that never expire."
Why do I call shares of tiny companies "stock options that never expire?"
Many people see stock options as a way to buy, for just a few hundred dollars, the chance to make a huge amount of money on a trading or investment idea. They know the chances of the bet working out are not as high as the chances of making money on a stable blue-chip company like Johnson & Johnson or Coca-Cola. This is why a smart stock-option position is just a tiny portion of an overall portfolio... perhaps just half of 1%.
Also... many tiny companies focus on just one or two big products, technologies, or in the case of resource companies, just one piece of prospective exploration property. They give you enormous upside exposure to one particular idea. Tiny companies don't have the broad diversification that Johnson & Johnson does.
J&J sells all kinds of things like Band-Aids, mouthwash, cough syrup, and cholesterol drugs. The drawback with companies this diversified is you're not getting the hundreds of percent upside a tiny company focused on one idea can offer... like Amgen was offering in the late 1980s.
Look, here's where stock in these tiny companies and exchange-traded stock options differ: Stock options have a predetermined shelf life. They expire in a few months or at best a year. Most expire worthless.
Thus, making money on an outright stock-option purchase requires you to be right both on the business... and on the TIMING. Your trading thesis has to be proven right before the options expire in a matter of months. This is difficult for most investors and traders.
On the other hand, tiny stocks don't expire. You can hold a speculative position for as long as you want, provided the company isn't spiraling into bankruptcy. And since the timing doesn't matter... you just wait for spectacular payoffs, just like the anaconda.
For example, consider stun-gun maker Taser International.
Back in 2003, Taser International was just the sort of one-trick pony that could produce huge capital gains. At the time, Taser was the name in stun guns. Police departments were buying stun guns like crazy back then. The guns offered a nonlethal alternative to shooting criminals with lead bullets.
In early 2003, shares of this super-small company were trading for $4.20. When investors got wind of Taser's sales and potential growth, they bid shares to more than $110 per share in a little more than one year... a gain of 2,500%.
This sort of gain turned a modest $2,000 investment into more than $52,000.
I'm not saying we can expect to make 2,500% on every tiny stock we buy in Retirement Trader... I'm simply pointing out that placing a small amount of money into a tiny stock with big potential can result in a huge payoff. All with little risk to your overall wealth.
This "timeless option" strategy provides you with a lot of leverage to one single idea... just the sort of leverage conventional stock options offer... but without an expiration date.
Getting "cash at closing" is perhaps my favorite way to make nearly risk-free profits in the stock market.
And while I encourage everyone I know to use small position sizes (0.5%-2% of an overall portfolio), for the vast majority of their trades, "cash at closing" deals are usually so safe... so profitable... and so high probability... I often recommend committing a major chunk of your investment capital to them.
These deals are rare, but they must be seized with a significant amount of money.
Two incredible "cash at closing" opportunities turned up in late 2008. I alerted readers of my monthly newsletter, Retirement Millionaire, to them. Anyone who took my advice made nearly risk-free profits of 17%-18% in a matter of months. These are truly "safe options."
"Cash at closing" opportunities arise when one company tries to buy another. I'll discuss how they work as I walk you through one of our past trades...
In July 2008, Swiss drugmaker Roche Pharmaceuticals agreed to buy, in an all-cash deal, the U.S. based biotech company Genentech.
Remember my Amgen story from Retirement Trader Tool No. 2? Well, back in 2008, two companies reigned as the undisputed champions of the biotechnology sector: Amgen and Genentech.
Roche, a huge drug seller that needed to grow its drug portfolio, was buying smaller companies left and right for several years. It recently paid $125 million in cash to buy a private gene-therapy company, Mirus, that I held shares in since its founding in 1997.
Roche owned a majority of Genentech (54%) in 2008 and simply wanted the entire company for itself. It had a boatload of cash and was willing to pay up for an elite biotechnology company. It offered $89 per share.
Genentech's board deemed the bid too low. Company shares were trading in the $90s at the time. Many thought Genentech owners should only agree to sell if the price was around $100-$105 per share.
While Genentech owners and managers were trying to figure out what to do, the Wall Street credit crisis struck. Like just about every asset in 2008, Genentech shares declined. Shares sunk into the low $70s in just months... over 18% less than the all-cash offer. This was an absurd discount to an ALL-CASH offer that was on the table from a super-strong buyer. There was no way the Genetech board would walk from an all-cash deal that paid a premium to market cap. And the financing was rock-solid; Roche was offering all cash.
So in October, I urged readers to buy Genentech. I was sure the deal would go through (more on this in a minute). Shares were trading for around $81.50.
My readers made a safe 17% profit in around five months as the deal closed for $95 in March 2009. It was the stock market equivalent of buying a car for $8,150, knowing a guy across the street with a suitcase full of cash would pay $9,535 for that same car.
The Wall Street term for "cash at closing" trades is "merger arbitrage." Companies try to buy each other all the time. When Company A tries to buy Company B for, say, $50, the price of B almost immediately rises up to around $50. Sometimes it even goes to more than that.
How close it gets to $50 depends on many things, including:
Are there any national security issues? The government won't allow certain U.S companies with valuable technology (especially defense technology) or vital infrastructure assets to be acquired by a foreign company.
Are the shareholders on both sides likely to approve the deal? Different shareholders have different perceptions of value and different goals. If you've ever tried to get more than five people to agree on where to eat for lunch, you know this sort of thing takes time. This is largely the realm of huge institutional investors, pension, insurance, mutual, and hedge fund managers.
All of these factors come together to create enough uncertainty that when one company puts an offer on the table to buy another company, the market refuses to "price in" the completion of the deal.
Often, the market is willing to pay 5%-10% less than the buyout offer a company has received. The amount mostly depends on the factors outlined above. The difference in the buyout offer price and the current market price for a stock is called the "spread." In the case of our Genentech trade, the spread was 17%.
Cash at closing deals take advantage of the uncertainty surrounding the merger going through. If you do the proper homework and take only the best opportunities, you can buy shares in the company being acquired below the offered price, hang on through the merger, and turn a quick profit. The risk, of course, is the deal could fall apart.
If the company being acquired enjoys a big price rise after the potential deal is announced, it can just as easily suffer a big fall if the deal falls through.
In my years of trading merger arbitrage, I've developed two secrets that will ensure we only go for the best opportunities, like the Genentech trade:
Secret No. 1: Learn to love all-cash deals. They are simple.
If the deal is announced as an all-cash deal, the financing is pretty secure. Sometimes the company already has the cash in its pocket. That makes the deal even sweeter. If a big company has $10 billion in cash, and needs just $5 billion to complete the deal, it's a good situation. In these cases, we'll consider taking a large position, up to 5% of a portfolio.
Secret No. 2: You only want to trade in securities that you would buy even if the deal fails. Remember: As great as the deal looks... as easy as the numbers work out... as accommodating as a government can be... crazy things like hurricanes, earthquakes, wars, and credit crunches happen.
To account for this risk and ensure maximum safely, you should only get involved in cash at closing deals if you'd be happy to own shares of the company under buyout consideration. To put this idea in real estate terms, only invest in a rental property you'd be happy to live in.
With the Genentech example, in the unlikely scenario that the deal fell through, we would have owned one of the world's best biotech companies at a reasonable price. I believe biotechnology is a great investment opportunity over the next three to five years. Since Genentech is a leader, it was a win-win deal.
Retirement Trader Tool No. 4
Safe Money Options: How to make
a safe 50% in four months
That tool is selling put options. Before we talk about selling puts, let's clarify terms quickly.
As we mention in the How to Unlock Your Brokerage Account for Instant Cash, buying a put option is a contract that gives you the right but not the obligation to SELL a block of stock at a predetermined price, at a predetermined point in the future.
Imagine the other side of this trade... The seller of a put option has the obligation to BUY a block of stock at a predetermined price, at a predetermined point in the future. In exchange for taking on that risk, the seller of the put gets paid a premium.
In the "advanced" cash at closing trade, we find a stock we're willing to own and ask for a little money "up front" in exchange for being prepared to purchase the stock if the owner of the put decides to exercise the option.
For instance, let's say you think stock ABC is worth $22 per share. The business is making plenty of money, has a lot of valuable assets, and zero debt. Let's also say the current market price is $20. You'd be happy to buy ABC at that level.
But what if you could buy it for $18 per share... a 10% discount to the current market price and an 18% discount to what you think shares are actually worth?
I'd jump at the chance.
This is exactly the opportunity selling puts gives you... the chance to buy a stock you already want to own at a 10%-20% discount to current prices. Best of all, you get paid to enter into these contracts.
The market is a big place... with millions of traders and investors with different opinions, needs, and goals. This is why the options market exists.
Many of these investors and traders need to spend a little bit of money to "insure" their portfolios by BUYING put options... just like you'd spend money to insure a car or a house. These contracts give the buyer of the put option contract the right to sell his stock to the seller of the put option contract.
In our example, ABC stock is trading for $20 per share. An owner of ABC might BUY a put option that gives him the right to sell his shares for $18 in six months. Even if ABC fell down to $5 per share, owning that put option contract allows the ABC owner to sell his shares for $18.
Now, here's where profitable put SELLING comes in...
Again, we'd love to buy ABC at $18 per share. The market price is $20. We think it's actually worth $22.
We could enter the market and sell a put contract that leaves us on the hook to buy ABC shares for $18 in six months. We receive $1 per share for agreeing to the obligation. Since one option contract controls 100 shares of stock, we receive $100 for every contract we sell. This amount of money that we collect for selling the option is called the "premium."
By selling the contract to buy ABC, we collect $1 per share... and agree to buy 100 shares of ABC in six months for $18 per share. Should ABC trade down to $18 or less, we'd be obligated to buy $1,800 worth of stock. But remember, we received $100 ($1 per each of the 100 shares in one option) for entering into this contract... so our actual cost for the position is really $1,700. Since we think ABC is worth $22 per share, this is a great discount.
But what if the market catches on to our thesis that ABC is worth $22 during the life of the option contract we sold... and sends ABC to $22 per share?
The same thing that happens when your house doesn't catch fire... the same thing that happens when you don't get into a car accident. The insurance company keeps the money. In option trading, the seller of the put option simply pockets the premium and starts looking for the next opportunity. End of story.
Now that we have an understanding of how put options work, let's go back to our advanced cash at closing opportunities...
Around the same time I was urging Retirement Millionaire readers to make a safe 17% on the Genentech deal, an old colleague of mine, Dr. George Huang was urging people to sell put options on Genentech. It was one of the greatest trades I've ever seen.
George is a medical and biotech stock expert. He's also a brilliant options trader. In his biotech stock and option trading advisory, the S&A FDA Report (no longer published), George told his readers to sell puts on Genentech that would obligate them to buy shares for $80. The contracts were selling for around $8 per share. Each one sold sent $800 straight into the pocket of traders.
Remember, there was an offer for the company at $89 per share that was very likely to go through. George's readers were agreeing to buy Genentech shares for just $80... and receiving $8 per share for entering the contract. This put their actual cost basis at $72 per share if they had to buy the stock... which they were happy to do in case the deal did not go through.
As you already know, the deal went through... each contract sold for $800 was pure profit for George's readers. (I loved the trade at the time, but we don't deal with selling put options in my monthly Retirement Millionaire newsletter.)
By the way, when you sell a put option, most brokerages require a deposit – called a "margin requirement" – equal to about 20% of the purchase obligation. In other words, one contract will put you on the hook for 100 shares of Genentech at $80... for a total obligation of $8,000. George's readers had to front about $1,600 (20% of $8,000). So... this $800 of profit was earned off a capital base of $1,600... a 50% return in under five months!
As you can see, learning this unique option tool is a fantastic way to juice returns on a conservative position. You're agreeing for a nice premium (often $300 to $800 per contract) to buy a stock you want to buy for less than what it's worth. It's "heads I win, tails I win more." The critical thing to remember here is to cut risk to the bone by only entering into put contracts on stocks we know are undervalued and that we want to own in the first place.
Sometimes, a put position doesn't work out exactly as we hoped to and we're left holding shares of stock. I occasionally describe this as the "worst case." But since we only trade stocks we'd want to own anyway, there's no real risk here. We're buying stocks we like, at prices lower than we could otherwise get. And we can now use our new stock position to take in even more money… by selling covered calls.
Selling a covered call will bring in more income against our capital (our stock). This is a great way to take a losing position and turn it into a winner. And we'll also receive the dividend the stock is paying. Since we're selling options against stocks we'd be willing to own anyway, we can sleep well at night while collecting extra income.
This "put selling" strategy is something longtime Stansberry Research subscribers may recognize. It was also the cornerstone for my publisher's Put Strategy Report, which was published from October 2008 to June 2010.
During the 2008 Wall Street crisis, Porter Stansberry and I spent hours analyzing numerous stock ideas for use in his then-new advisory. Due to the market's incredible volatility, option premiums skyrocketed... and selling those premiums was a terrific opportunity.
In the initial months, I was the option guru he turned to for ideas on which strikes and expiration months to use in his portfolio picks. We worked diligently to use puts as a way to purchase cheap stocks even cheaper.
For example, in October 2008, we started discussing businesses that traded below book value. One interesting company to pop up during our screening was the company Annaly Capital Management (NLY). It uniquely held liquid assets 100% backed by the U.S. government. As a so-called "virtual back," the company could sell all its assets and pay off its debt and have money left over to pay shareholders over and above the value of the stock.
In Annaly's case, we had a stock worth $13. With volatility high – and premiums fat and rich – we decided to sell puts at a strike price of $10 for $1.50. This meant our cost in the stock would be $8.50 if we were in fact "put the stock" (when the owner of the put forces us to abide by our obligation to buy the stock at $10).
This was an obvious deal... to buy an asset for $8.50 at a 35% discount from its liquid book value of $13. Porter wrote back then: "As far as I can tell, this trade carries literally no risk at all."
In this case we put up $2 (the 20% margin required on the NLY exercise price of $10) to earn $1.50. When the options expired worthless in January, we had locked in a 75% return on a trade we held for just three months. It was a safe low-risk trade but with super-high returns. In Put Strategy Report, we did many more trades with that same risk-to-reward profile.
I believe we can provide even more tools for investors interested in using options to make money. The principles we used in 2009 remain the same though. We'll hunt down valuable companies trading below what we think they're worth... then apply option strategies to increase our gains, while reducing our risks.
Retirement Trader Tool No. 5
The Theta Windows
With Tool No. 5, we're sticking with the strategy of selling safe options (Tool No. 4).
Only with this tool, we're adding a little-known secret in the options world… something I've nicknamed "The Theta Windows."
Option traders use all kinds of Greek letters to label different aspects of options trading. In any given conversation between option traders, you're likely to hear words like "Beta" and "Delta."
But don't worry… I'm not going to ask you to memorize any of that stuff. I just need you to know the closer an option gets to its expiration date, the faster the "time value" of that option erodes.
Think of it this way – selling an option today obliges you to act at some point in the future. Between today and that future date, lots of "stuff" could happen to hurt the value of the stock you're going to trade.
The price you receive for selling the option needs to compensate you for taking that risk. And the longer the time between today and when you might have to buy, the more "stuff" could happen. So the longer you hold the option, the more you should be paid. The closer the stock is the expiration, the less you get paid.
That's time value. And the closer an option gets to its expiration date, the faster the time value of an option "decays."
In options-speak, this time decay is called "theta." And when an option has less than 10 trading days of life left, the time value decays at a rapid pace… much faster than the rate at which it will decline if it has two months left of life. We've nicknamed this 10-day window the "Theta Window."
I'll use an example with put options to show you how it works…
Let's say that with just one week to go before option expiration (options expire on the third Friday of every month), Starbucks (SBUX) shares are trading for $54. Let's also say the Starbucks $53 put is selling for $0.30.
Remember when you sell a put, you accept the obligation to buy the underlying security (SBUX) at a specific price by a specific time. In this example, selling the Starbucks $53 put gives us $30 in premium up front (recall each option contract controls 100 shares). Our only obligation is to buy the stock for $53 by the end of the week if the stock sinks that low.
In this example, we figure $54 represents a good value on Starbucks. That makes buying shares at $53 (nearly 2% lower) a good opportunity. Remember… the odds are slim that Starbucks will drop a full $1. If it doesn't, we'll keep the $30 free and clear.
If you assume we had to pony up $1,060 in margin requirement (like we explained in Tool No. 4), we turned a quick 2.8% profit in just seven days (the $30 on the $1,060). This speedy return is because we're selling puts with just a week or two of lifespan… we're selling puts as the "theta" window rapidly closes.
Now the beauty of it is this… you could do this trade once a month, risking the same $1,060 in margin requirement each time. After 12 months, you've banked $360 in option premiums – a 33% return on your margin amount.
Alternately, if Starbucks shares slump $1 over those five days, we would have to buy 100 shares for a total outlay of $5,270 ($53 a share times 100 shares, minus the $30 premium). This is just fine with us, too. After all, if Starbucks is a good buy to us at $54, buying it at $52.70 is even better.
Either way, it's a win-win deal. We're either pocketing free money or picking up good value stock at a better price.
In Retirement Trader, I'll watch diligently for opportunities like these for you. If market volatility increases and option values spike up, this fattens the premium values. If a volatility spike happens near expiration week, we'll search for undervalued investments with high-priced options. We'll search for that "win-win" opportunity.
Retirement Trader Tool No. 6
You hear it all the time... folks getting into real estate deals because real estate offers so much "leverage"... Or marketers pitching currency-trading services that will make you fabulously wealthy because of the "leverage."
Leverage works both ways. That same friend who was getting rich in real estate because of the leverage is now broke because of the leverage. That same currency trader who was making a killing in Swiss francs and Australian dollars blew his account up because of leverage.
Most people don't know how to take on safe leverage.
One of the secrets of using stock option leverage is to combine it with value investing.
This is where long-term stock options come into play. These are known as Long-term Equity AnticiPation Securities (LEAPS). Sounds complicated, but LEAPS are simply stock option contracts that expire in one to three years. They have a much longer shelf life than typical stock options that are traded in one to six month timeframes.
Let's say you're bullish on Bank of America (BAC)... Here's a hypothetical LEAPS trade on the stock would work out (using May 2010 prices). In May 2010, Bank of America (BAC) LEAPS with a $7.50 strike price traded for $9.60. The LEAPS are essentially long-dated call options that expire in January 2012.
If we felt the bank and the business was undervalued but we were unsure about the recession, legal issues of lawsuits from government, etc... we could buy the LEAP and hold it for nearly two years with much less risk. This gave us the right, but not the obligation, to buy the stock at $7.50 before January 2012.
With the stock paying only a tiny dividend, we gave up little by holding the option instead. Add our strike ($7.50) and the premium ($9.60), and we paid $17.10 – only about 70¢ more than the stock traded for ($16.40).
Thus, we've cut our risk of owning the stock outright by 41%. The maximum we could lose was our premium of $9.60 versus the $16.40 we'd pay to own the stock. However we keep almost 100% of the upside potential (less the 70¢ we pay for two years of time).
If the stock goes to $30 by 2012 (BAC trading in the $50s just three years 2007) we would make $22.50 ($30 minus $7.50) off our $9.60 LEAP investment. This is 134% return versus the 83% on owning the stock outright. This is a 51% greater absolute return with a 41% reduction in absolute risk.
By the way, we could have cut our costs by selling a call option for about 80¢ stuck at $30 to further lower our costs, although it only slightly increases our payoff.
Using long-term leverage is actually one of the secrets of Warren Buffett – arguably the greatest investor to ever live. The Warren Buffett most people hear about is a just a folksy good ole boy who drinks Cherry coke and buys stock in basic businesses that generate lots of cash. But the truth is, he's the ultimate anaconda. He sits patiently, waiting for only the most obvious opportunities to strike.
Amid the 2008 Wall Street crisis, Buffett paid money to Goldman Sachs and General Electric in exchange for a package of securities. Among them were millions of long-dated options that give him the right to buy more shares within five years. These options are called warrants and are worth billions. Warrants are like LEAPS except they expire even further out in time... sometimes five or even seven years out.
Companies issue warrants to entice investors to buy their shares. I think of them as the frosting on the cake. But due to the impatience of many investors, the warrants are often sold long before they expire. In many cases, few buyers are willing to hold the securities four to five years... so they become extraordinarily cheap.
However, by looking at the value of the option in the warrant relative to the stock's value, we occasionally uncover great value opportunities. Using models of price and probabilities, these securities can sometimes be purchased for half the risk of the stock, but with all the upside of the company's future business value.
For example, I recently found a well-known global business that has a cheap warrant available on the stock. But in just a few days, the value of the warrant increased almost 15% as the market discovered its true value.
How often you can expect to trade
with the Retirement Trader
I'll tell you about my favorite trades in each issue of Retirement Trader... I'll also send out monthly position updates between issues. And should the markets get particularly volatile, I'll be in contact with you even more often.
But as I mentioned at the beginning of this report, I can't promise you a clockwork like system of trading the markets. The market is a stubborn beast that doesn't stay on anybody's schedule. We're waiting for the best opportunities... like I said: If three of them crop up in a month, I'll recommend them. If nothing is worth our capital, we won't force a trade...
I can promise you that armed with our "Toolbox," we'll be ready for ANYTHING the market throws at us... whether it's an extraordinary "cash at closing" deal like Genentech... a covered call bonanza like we saw in late 2008 and early 2009... or a "stock options that never expire" situation like Amgen.
I look forward to making the most of your subscription to Retirement Trader.