The Secret to Earning an Extra 20% a Year

Series Three: Put OptionsA Safer Alternative to Shorting Stocks

Welcome to the third video in this series, The Secret to Earning an Extra 20% a Year. Im Andrew
Packer, moneynews financial analyst.
In the first two videos of this series, we looked at how options work in general and how call options
work in more detail. If youre still unsure about how options work or have questions about call
options, please check out the first two videos, read the transcripts, available in PDF form, and read the
options guide PDF.
That said, welcome to the bizarro world of put options. Unlike call options, put options require
flipping your perspective. Up really is down! Thats because, unlike call options, a put option will rise
in value as the underlying stock declines in value.
So lets talk declining stocks in general.
In the last video, I talked about how buying a call has some similarities to buying a stockyoure
betting on prices to go up either way.
By buying a put option, youre betting on stocks to go down, so its a lot like shorting a stock.
If youre like most investors, youve already bought stocks before. So I didnt bother to explain that
in the last video on call options. You already know that by buying shares of stock, youre acquiring a
fractional ownership in a company and that you can receive dividends and get capital gains if the stock
prices goes up.
But, most investors have probably have never shorted a stock in their life. Thats okay, and, as an
investor, youll never even need to, as Ill show you in this video.
Shorting a stock is a pretty simple concept if you think through how it works. Rather than
seeing rising prices, say you expect prices to fall. There are a few reasons for that. You may expect a
companys hot new product to be a dud. You may have noted that the companys financials dont seem
to match their earnings per shareand there may be some financial shenanigans involved. Whatever
your reasons, if you expect the share price to be lower than it currently is, then youd want to short
the stock rather than buy shares.
Heres an example:
You borrow 100 shares of, say, Bank of America (BAC) at $8. You then sell those shares to obtain
$800 ($8 x 100). That money stays in your margin account. Then Bank of America falls to $6 over the
next few months. At that point, you decide to close out the position. To do that, you must return the
shares you borrowed. To do that, you would buy to cover, paying $600 ($6 x 100). Then you keep the
difference in this case $200.
Shorting stocks requires a margin account with at least 50% cash, in case the trade goes against
you. (Say you sold Bank of America at $8 and it went to $12, youd need to either sell out your position
at a loss or put more cash up to cover the potential shortfall.)
A 25% gain is nothing to sneeze at for a few months time.
But shorting stock has some problems. Not every stock is available to easily borrow. And if you
short a dividend-paying stock, youre the one who gets to make that payment to the shareholder you
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borrowed from. Most people who lend out a stock to be sold short also charge a fee to do so.
Even if the stock goes all the way down to zero, youll only be able to make a 100% return. But even
a bankrupt company will still trade for a few pennies.
Also, if the stock keeps going up, your risk is essentially unlimited!
Add in the fact that sometimes the government will outright restrict short selling (like they did in
late 2008) and the lack of leverage, and it seems as though shorting stocks isnt all its cracked up to
be. In fact, it can be a bit of a headache.
Fortunately, theres a better way.
By buying put options, an investor can take not only short positions, but leveraged ones as well,
ultra-specific to an individual stock.
Options dont require a margin account (so you can actually make these trades in retirement
accounts and thrive in times of market downturns), and best of all, the most you stand to lose is the
premium you pay for their option.
Frankly, though, one of the best reasons to use options especially on the short side is you get
to skip the onerous government regulation designed to suck all the profit (and fun) out of going short.
During the market panic in 2008, the SEC took the extraordinary step of banning short sales against
hundreds of stocks. Initially focused on financials, it spread beyond. Ironically, this sent a signal to
options buyers to BUY puts like there was no tomorrow.
As big banks like Citigroup and Bank of America saw their share prices fall over 90%, and AIG was
put into government receivership, put buyers were scoring record profits (or at least making some
gains to offset losses on long positions).
Theres no telling when or where it could happen again. But if the government does choose to do
it again, now you know that you can profit by buying puts on the companies they ban from outright
short selling.
Thats why buying put options remain your best bet to profit on the short side and still avoid
potential times when regulators step in and ban short selling.

Heres how put buying compares to outright shorting:

In the last video, I showed you how to find an options chain on Yahoo Finance. Lets use Google in
todays video, continuing to use Bank of America as an example.
Just a quick note; Im not saying you should be long or short Bank of America right now, Im just
using it as an example. The bank stocks can sell off rather quickly when the market gets fearful, so it
makes for a fine example.
So, on Google Finance, we pull up the ticker for Bank of America, BAC

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Once were on the main page for Bank of America, we would click on the option chain tab on the
left to pull up the options available for BAC.

From there, well find a date we like, say January 2013, a few months out, and that we still think the
price will fall from $8 to $6.
Heres what the January put strike prices look like:

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Currently, we can buy put options for between $0.18 and $0.19 per share. Lets be conservative and
say that we have to shell out the full $0.19. That means for $19 (the $0.19 times 100 shares), we can
control 100 shares of B of A stock at $6.
So what happens? Well, as with buying or selling call options, many things can happen.
Lets fast forward to January. Fear has broken out, and Bank of America stock has sold down to
$5.00 per share, a full dollar below the expected $6.00 when we selected the strike price.
We can do a few things here. First, we can re-sell the option. This is the simplest and best strategy.
The option will have at least $1.00 in intrinsic value, since whoever buys the option from us can
exercise the put and sell 100 shares at $6, then immediately turn around and buy them back from the
open market at $5.00.
So weve gone from $0.19 to $1.00a fivefold increase in the value of the option.
Alternatively, we can exercise the option, and sell 100 shares of BAC at $6.00. We could then turn
around and cover the short position by buying BAC shares back at $5.00 for a tidy profit. It involves a
few more steps than simply reselling the option though.
In either case, the $1.00 difference less the price we paid on the option of $0.19, leads to a $0.81 or
$81 profit per option before expenses.

What if Shares Dont Fall Enough or Even Rise?

Now, what if shares only fall to $6.05? In that case, the option would still expire worthless. Just like
with call options, if youre right in the direction but not the timeframe, you could still lose the entire
value of your option.
If shares continued to rise above their current $8, then the option would also expire worthless as
well. But your total loss would still be just the $19 that you paid for the option contract, and not a
significantly higher and potentially unlimited loss had you simply shorted the stock. Indeed, if you
had shorted the stock, a rise from $8 to $12 would leave you on the hook for $400. Its always better to
lose $19 than $400. You can see why buying puts keeps a lid on the risk.
Thats why I like buying put options to profit from companies that are overvalued by the market and
are highly susceptible to a pullback. If youre wrong, you lose significantly less money. If youre right,
you can make far more than 100% of your money.
But for the most part, if you find a company overvalued, your best bet is to sell shares if you own
any and stay away. History is full of traders who went broke expecting a stock to fall because it was
absurdly valuedonly to find it fall even further.
Over time, markets tend to go up. While they dont go up in a straight line and will often have down
years, history has shown that having a positive attitude to the markets will do far more for your bottom
line than living constantly with the doom and gloom.
That said, the market can and does have big corrections every few years, and smaller retracements
each year. So its also good to be able to hedge your long positions cheaply and effectively with a few
put options.
Say youve got a stock thats gone up 20% so far this yearand it looks like its topping out. It may
soon come back down. You could hedge this position by buying put options. Its a little different from
selling covered calls, which we looked at in the last video.
In this case, youd be paying out money rather than having it come in. Either way, the fact that
80% of options tend to go to zero means that buying puts to hedge a long bet where you own the
underlying isnt as profitable as selling call options.
But the real money in any insurance contract isnt made by the buyer; its made by the seller.
So, the real value to making money with put options, as with call options, is the other part of my
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two-part strategy to make 20% per year. And thats by selling puts.

Put Selling: Getting Paid to Wait to Buy Companies You Want at a Reasonable Price
How many times have you thought to yourself, Gee, Id love to own shares of this great company,
but its too expensive at $60. If they trade to $50, though, Id definitely buy.
So you may call up your broker and put in a limit order, where the trade only happens when shares
drop below $50. That may never happen!
Its also possible that if shares of your favorite company DO trade below $50, its in the middle of a
big market selloff and you cancel the limit order because youre too paralyzed with fear to buy. After
all, as long as its still selling, why buy now if only to see an immediate decline?
This is where selling puts come into playand why its my absolute favorite investment strategy. By
selling puts, youre essentially saying, I WILL buy shares of this company if it falls below $X.
So if I were looking to buy shares of Proctor and Gamble (PG), but found its current price of $68
too high, I might sell some $60 puts. If I get put the stock, then Id be able to buy a company I like, at
a price I like.
And if the shares dont trade down to that level, you get to keep all the option premium that you
obtained from selling the option.
Its that simple. You get paid to wait for lower prices. Why would you ever place a buy limit order
again? If you dont get lower prices, you keep the money. Heck, if you get put you get to keep the
money you made from selling the puts too. I love this strategy so much, its taking over an increasing
amount of my portfolio.
Lets take a look in more detail.
Looking back at the Bank of America December $6 put options, lets say you decide to sell them
instead of buy them.

So instead of shelling out $19 per contract, youd be receiving $19 cash into your account. If youre
selling options, you need to have at least some margin on hand. If you keep all the cash on hand
necessary to buy shares in case youre put, thats called cash-secured put selling.
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Fast forward to January.

If the shares trade above the strike pricein this case $6.00the option is worthless. You keep all
the premium.
If shares are trading below the strike pricesay Bank of America shares trade at $5.50, you may be
put shares at $6.00.
In that case, youre obligated to buy shares. Thats why its critical that you select companies you
want to own in the first place. If youre looking to expand the stocks in your portfolio, selling puts is as
great way to get paid to wait for a better price.
You cant get paid to wait for your favorite soup to go on sale at the supermarket. You wont get paid
to wait for clothing to go on sale either. Indeed, with most things in life, waiting tends to mean just
sitting around, burning time. But thanks to put selling, it doesnt have to be that way with your stock
investments.
Remember, about 80% of options expire worthless. That means that by selling options, such as
covered calls and covered puts, youre placing the odds on your side. Yes, sometimes youll have
shares of a stock put to you by selling puts, just as youll have shares of a stock called away by selling
covered calls.
Just as with call options, you can employ a few different strategies. You could find a stock you like
and go out a month. Youll make less money doing this than going out, say, 6-9 months. But if market
information about the underlying company changes, that may work in your favor to avoid getting put
shares.
As with call options, I like to go a few months out. That way, Im selling more time premium and
get fatter percentage returns.
In the case of the January $6 Bank of America puts that Ive shown you throughout this video, I
actually sold 10 of those back in June for about $0.60. Based on the strike price of $6.00, selling these
puts would net me a 10% return (60 cents versus 6 dollars at stake). Not bad of a return for a little
under seven months.
I want you to see a few more examples of how this works, but instead of me using my own
examples, I am going to turn the microphone over to Aaron DeHoog, the Financial Publisher of
Newsmax. I mentioned in an earlier video that I taught Aaron this exact strategy, and so I want to
show you how he put it into practice. Aaron?

Thanks Andrew.
Now to those listening, I know this gets a bit confusing and you might not be able to capture
everything at first . . . but keep in mind, there are a few more videos coming your way that get
into the details.
Selling put options is my favorite strategy for options.
As Andrew mentioned, it is a great way to get paid while you wait for a great stock to drop in
value. And if it doesnt drop, you get paid a lot of money.
Let me show you a couple examples of what I have done.
Funny you used Bank of America as an example, Andrew, because that is what I am going to
use first.
In June, on our monthly Brain Trust Alliance call, one of our members - Bill Spetrino convinced me that Bank of America was in a good position to rally over the next few months. I
thought the price was bit high at the time he recommended it. It was trading for about $7.50.
I thought the stock may drop down to $7, but wasnt sure. Who knows, the stock could rally
back up to $10.
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So instead of placing a buy limit at $7, which would automatically trigger a buy if the stock ever
hit that price, I sold a put option.
So on June 11 I sold 5 put options on Bank of America with a strike price of $7. The expiration
date was Dec of 2012.
By the way, I should mention, I did just 5 put options because this was my first trade. I am
only using my play money money I can afford to lose - to do this for now. But as I gain more
experience, it will likely become a larger part of my overall investment strategy.
Now, what do I exactly mean by saying sold 5 put options of bank of America with a strike price
of $7?
It means that I have the obligation to buy 500 shares (remember, each contract represents 100
sharesI sold 5 put option contract, hence 500 shares of the stock) Bank of America stock at $7.
I am doing this because I am bullish on the stock. I think the stock will be above $7. So I dont
mind selling the put for $7 if the stock is trading above that price. Its all profit above that.
In return, I actually get paid to sell these put options. Somebody was willing to pay be $.89 per
option, or $89 per contract.
Since I sold 5 put contracts, the math works out to be $89 x 5 = $445. So $445 was immediately
deposited into my account.
Now I just had to wait.
Two months later, Bank of America was trading around $8. I decided to check on the put options
to see what they were currently trading at. When I looked them up, I saw they were trading at $.23
an option.
Remember, I sold these options at $.89 each. Now they were trading at $.23.
Essentially, my unrealized profit was $.66 per option. Which is huge.
So, I had two choices.
To either wait until December for them to expire worthless, or, I could buy them back at the
$.23 now. I decided to take my profit. After all, Dec. was a while to wait for a mere $23 extra per
contract.
So my total profit ended up being $330.
Not bad for a first trade
Lets take a look at another example.
In June, after reading Sean Hymans newsletter, the Ultimate Wealth Report, I was convinced
that the stock Encana, ticker ECA had room to go up. But the stock was volatile. It is a company
that mines natural gasand natural gas was hitting all-time lows. I was a bit nervous at buying it.
Upon looking at the stock chart, I noticed that the lowest the stock had ever been was $15. It was
currently trading around $18. It could reach all-time lows, but Sean had painted a pretty strong
argument for the stock to rally up above $20.
I decided to test out selling put options on it.
I took a look at the options chain. I decided to check out Jan 2013. As Andrew mentioned, the
longer you go out, the more money you can make. Plus, I figure natural gas prices could rally in
the fall as demand increases from possible winter storms.
I focused on the $15 strike price. That seemed to be the bottom range for the stock. Every time it
hit that price range in the last 3 years the stock bounced back up.
The Jan. put options with a strike price of $15 were trading at $1.05.
Now, I want to discuss this a bit more.
What this means is that in January, I am obligated to buy the stock for $15 if the buyer of the
option exercises the contract, which he or she will only do if it trades below $15. But, I am getting
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paid $1.05 right now to sell this contract. So my all-in sell price would really be $15 - $1.05.
So, as long as the stock stays above $14.95 I will be fine.
And keep in mind, time is in my favor. All that has to happen is nothing.
So, as I said, I sold 10 of these put options and my account was immediately credited $1,050.
And then I waited.
Encana rallied.
In just 5 weeks, the options I sold were trading at $.35.
Again, I had a choice. I could wait until January for them to expire worthless and keep all the
money, or, I could buy that back at $.35 each.
I decided to buy them back.
A few reasons. The main reason was that at the time I was getting some signals the overall
market might pull back some.
So I sold them at the $.35 price.
My profit was $.70 an option. Since I sold and bought back 10 option contracts, my profit was
$700.
Not back for a five week trade and only putting $1,050 at risk.
I have one more example.
After reading David Skaricas September issue of the Gold Stock Adviser newsletter, I was
convinced that gold would rally in the fourth quarter of this year.
He had a chart in there that was undeniable.
Over the last 20 years, gold on average has risen on average about 1%.
In addition, I have been wanting to add to my gold position. Just not at $1,600.
So I decided to sell GLD December put options with a strike price of $155. It was trading just
slightly above that.
These were real pricey at $5.75, and I didnt want to over leverage myself, so I only sold 1 put
option. My account was immediately credited $575.
Now, again, think about this.
Under this agreement, I am obligated to buy 100 shares of GLD at $155 each. That a lot of
money, so I had to be cautious with this move. I dont want to get burned.
Thus far, the trade is working out. The options are now selling at $3.53 each.
I want to hang on to these for a bit longer to collect some more income.
To summarize, its been a fun way to collect some extra money, and I hope these examples help
explain how you can leverage the strategy of selling put options.
Im going to turn the microphone back over to Andrew
Conclusion: Put Options in Review
Thanks, Aaron. This is a great place to wrap things up, so that you can take the time to think about how
you can implement a put selling strategy next time youre looking to buy stocks instead.
In this video, Ive shown you how put options are a better alternative for shorting a stock than it is to
actually borrow shares of a company and sell them short.
More importantly, I showed you the most useful investment tool that I know of todayhow to sell puts
to generate income and buy companies you like at better prices than the market is currently offering.
In the next video, Ill show you the combined pieces of my strategy and how they play togetherselling
puts and selling covered calls. Until next time, stay safe and stay solvent!
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