Video #6: Options 201 Enhanced Securities

VIDEO #6

Video # 6 in our 6-part series, featuring Doug Fabian, How to Super-Charge Your Profits using ETFs.

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VIDEO # 6 TRANSCRIPT:

Hi, this is Doug Fabian. I’m the President of ETFU.com and the editor of Successful ETF Investing and ETF Trader’s Edge. I’m back again to talk to you about our video series, “How to Supercharge Your Profits Using Exchange Traded Funds” in any market environment. This is video number six and it’s “Options 201: Enhanced Strategies.” One of the things I want to do to begin with is just go back and review some basics on options.

Now in my last video, I talked about the purchase of a call option and the purchase of a put option. But there are some considerations for you, and before you get started with options, first of all, you have to have options privileges with your broker. And this means that you have to fill out a document that explains your experience with options and what size trades you’re going to make with options and receive permission from your brokerage company to use options within your account.

Next, you need to start thinking about the buying of put options, the buying of call options, and your trade size. Now, with options—because there is risk and your risk with an options purchase is, you can lose all of your money that you put at risk—you want to think about trade size. And if an option costs $1 and if you’re going to buy 10 contracts, you would be risking approximately $1,000 on that particular trade. Now if you’re comfortable risking more on that trade, then you can, but you have to decide as an individual investor how much money you’re going to put at risk within your portfolio.

And then we come to the subject of trade complexity. And the purchase of a call option and the purchase of a put option are the simplest options strategies that you can implement. This video today is going to be about enhanced options strategies.

So let me talk about, “What is an Enhanced Strategy.” An enhanced strategy is a strategy where you would introduce, into one trade under one underlying security, multiple positions or multiple legs. So you could be purchasing two call options on one underlying security at the same time, or you could be purchasing a put option and selling a call option. So the whole idea with an enhanced strategy is that you’re going to have multiple opportunities to be able to profit. Now let’s talk for a moment about why you would want to implement an enhanced strategy, and there are some specific reasons and these reasons are good reasons.

The first reason is that you can generate income. When you sell an option back to your broker, you’re immediately going to get a deposit into your brokerage account. That deposit, of course, is income. So the first reason for using an enhanced options strategy is income.

Second, if you sell an option and you buy another option where you receive some income and then you also have some money outgoing in your portfolio, you can reduce the cost of your trade by implementing multiple legs to that trade.

Third, enhanced options strategies can give you the opportunity to lower the risk of your overall options view.
And then lastly, you can increase your profit potential with enhanced options strategies.

So obviously there are some real good reasons here to consider using enhanced strategies. So now I want to get into the subject of “What are Enhanced Options Strategies,” what are some of the types of strategies that you can implement. So let’s review.

First of all, you can sell a call option or you can sell a put option. And as I mentioned a moment ago, when you’re selling an option, you’re actually receiving immediate income from your brokerage company.

Second, you can purchase long-term equity anticipation securities. These are LEAPS. These are long-term options, options that can be longer than 12 months. You can have a LEAP where you’re implementing an options strategy that might take one or two years to come to fruition. So obviously that’s a more enhanced strategy. I will say that LEAPS can be more expensive because they’re longer-term in time. But under certain circumstances LEAPS make sense.

And the third strategy—and this is a strategy we’re going to talk a lot about today—is the enhanced strategy of using spreads within your options contract. Now what does that mean? What does it mean to implement a spread? A spread generally means that you’re going to be purchasing call options and put options at the same time but at different strike prices. Now there are different types of spread options. There is the call spread options, and this is the purchase and the sale of a call at different prices. We have the put spread, which is the purchase of a put where you’re also selling a put at the same time. And then the final is the risk reversal strategy where you might buy a call option and sell a put option at the same time. So, this might sound a little bit complicated, but again, one of the things I’m trying to do here is give you an overall education that there are advanced ways to be able to use strategies like this. Advanced options strategies. And the whole idea with options strategies is increasing your returns and lowing your risk.

Now let’s go through an example relative to spreads right now. And this is an actual trade that we implemented for subscribers in ETF Traders’ Edge. And here’s what we recommended that subscribers do. We recommended that, number one, they buy the underlying security USO, which is an ETF that represents oil, buy USO June $9 calls—and at that time they were trading at $1.13 per contract. And then at the same time, we were advising that they sell USO June [$]8 puts, and they were trading at that time at 48 cents per share. And that means that we were going to take in income at the time of the implementation of this strategy. So if we bought 10 contracts on each side of this equation, the buying of the $9 calls would cost $1,130, but the selling of the puts would put $480 into our brokerage account. So the actual cost of this trade was a little over $500. Now here’s what we were expecting to happen. We were expecting that the price of USO, which is oil, was going to rise when we implemented this particular strategy. And it was going to rise over the next two to four weeks. And if it did, we were going to make money on this trade. Now let me talk about the sale of the put option. We sold 10 contracts at [an] $8 strike price, and if USO had traded below $8 or at $8 prior to expiration, we were going to be under the obligation to actually purchase 1,000 shares of USO. But in our minds that was a low risk. And if we were purchasing that, we would be buying oil at a seven year low, and we didn’t think that that was a bad outcome if that would’ve happened. But it just so happened that this particular trade worked out quite positively, and USO traded up to $10.70 per share, and that’s when we made the decision to go ahead and sell the options, close out our positions—and when we did so, we walked away with a 168% gain on the two sides of that particular trade. So spreads can work out to your benefit by lowering the cost of the trade, reducing your risk, giving you potentially other profit opportunities, and in this case things have worked out well because oil went in the direction we expected it to.

So in conclusion, enhanced options strategies are great tools. And I realize that you might feel that you don’t have the tools yourself to implement these enhanced options strategies. But this is one of the reasons why we created the ETF Trader’s Edge service. We have a lot of expertise in our firm in regards to options, and one of the things that we do when we instruct subscribers to purchase an enhanced options strategy, is we explain exactly what you need to do to successfully implement that trade with your broker to get the trade implemented correctly. And if we’ve done our research and the trends go in the direction that we expect them, we expect that we’re going to profit from these trades. And do so at a very low risk. So we are quite excited about our new service, ETF Trader’s Edge. We’re doing basic options strategies, we’re trading underlying ETFs, and then we’re also doing the enhanced options strategies as well. And just as a reminder, here are the reasons why you want to consider enhanced options strategies: Number one, you can generate income. Number two, you can lower the cost of the trade. Number three, you can lower your risk. And number four, you can increase your profit potential. So I hope this helps.

This is Doug Fabian, thanks so much for joining us today and I look forward to doing more videos for you in the future.