In my previous post, How To Make Money Going Naked, I described selling put options. Selling put options is a very safe and conservative way to make money and potentially own a stock or fund at a specific price versus the market price.

The price of the particular exchanged traded fund I wanted to own was around $28 per share last month. However, I was willing to purchase the fund at $25 per share, so I sold a put option set to expire in January 2011 and received a premium. (As a reminder, one option contract controls 100 shares.) Therefore, the net premium I received was the dollar amount of the option x 100, for each share. The net premium was $1.38, or $138 per contract. Three contracts mean I would receive $414 cash.

For every contract (option), I had $2,500 set aside in my money market funds to purchase the appropriate number of shares in the event the option exercises in the future. If I had one contract exercised, I would pay $2,500 and receive 100 shares of XYZ. If I had three contracts, I would pay $7,500 and receive 300 shares, and so on.

Rather than wait to see if I would purchase the shares six months from now or if the contracts would expire worthless in January, meaning I would keep the premium and not own the fund, I decided to close my position. By closing my position, I simply bought the option back.

Buying the option cost a net amount of $65, but I sold the option originally for $138, which resulted in a $73 net profit per contract. Taking $73 and dividing the amount by the money set aside ($2,500), I earned 2.92% on my money in one month. Further calculating the return, 2.92% x 12 (months), my return on investment, or money sitting in a money market fund, was 35.04% annualized!

Although the return is annualized and by stopping after only one month and potentially sitting on the money for a while, the investment beats many long term CD rates.

One last note on the option strategy; selling naked puts can be done in an IRA.

Supeman can leap tall building in a single bound. Therefore, let’s look at building wealth using a conservative strategy to leap tall financial buildings too.

Are options risky? I hear people talk about the risk in options all of the time. Even the disclaimers from companies such as Scottrade, Schwab, etc. provide handout material on the risks associated with options.

However, people are risky.

Let’s say there is a company that I want to own. XYZ’s stock is trading at $50 today with a target of $60 in twelve months.

If I buy 100 shares it will cost me $5,000. If I have a stop loss of 15%, I could lose $750. If the price goes up to $60 per share I would gain $1,000.

$1,000 / $5,000 = 20% gain with a 15% stop loss as protection.

However, I like options.

In all likelihood, I won’t own a stock for three years. I’m not a buy and hold person, because too many things go on. See my post Buy and Hold is a thing of the past.

So let’s say I want to control the stock without owning it. I’ll buy a LEAPS option. (Long-Term Equity Anticipation Securities). These options are good for up to three years. I could gain, or lose, on the stock without owning it for a long period of time. The thing about options in the U.S. is I can buy/sell at anytime and do not have to wait until expiration to do so.

Let’s say today’s price on a January 2012, $50 option is $8.10. One contract controls 100 shares. It would cost me $810.

Options use Delta as a way to gauge its performance, price, etc. If the Delta is .5, in simple terms, that means the price of the option moves $.50 for every $1.00 the underlying shares move. If the stock goes to $60, that’s an increase of $10. The option price moves $5.

My profit would be $500 on an investment of $810. The gain is 62% and my risk is $810 if the option expires worthless.

Here is one more thing to consider.

If I took the difference between owning the stock and buying the option, I would have $4,190 sitting in the bank. At 3% interest (although it might have to be in a 5 year CD right), I would make approximately $125 per year. Take $810 – $125 and now my cost is really $685.

Also, I can close out my option and lose less if the stock goes bad. However, my loss is much less than if I purchased the stock outright. If the stock drops to $40, my loss on ownership would be $1,000 for my investment, but the option should only lose around $500 which reduced my loss by 50%.

Although the gain is not as large in dollar amounts as owning the shares, neither is my cash outlay. And if this option is considered expensive, by looking at the implied volatility, I may just sell the option instead and get paid versus paying money. See my post How To Make Money Without Spending Money.

Options are really pretty easy to understand, but there are things you must learn about them. I keep doing homework (homework is not just for kids in school). Maybe someday I’ll be able to LEAP tall buildings in a single bound just as Superman does; and, as Mark Whistler stated in his book Volatility Illuminated – Superman wears his underpants on the outside which is something else not every one does either.

I was asked if I understood beta when dealing with stocks. My answer was pretty simple.

To begin, I really do not care about the complex calculations in determining the beta value, I’m more interested in what beta means. Understanding beta is easy and important.

What makes beta something worth noting is beta has to do with profits and losses. When looking stocks, beta gives an idea about how the particular equity moves in relation to the overall market.

If beta is greater than 1.0, the stock will move either positive or negative at a larger rate. If beta is 1.0, the stock will move proportionally. And, if beta is less than 1.0, the stock will move at slower rate.

To put beta in perspective, if beta on a stock is 1.16 and the stock market moves 3%, the stock should move 3.48% (3 x 1.16), or 16% more. If beta is 2.0 on a stock is 2.0 and the market moves 3%, the stock should move 6%, and so on.

Beta gives a bit of information about the volatility, or risk, of a stock and can be used with other factors in determining whether or not to purchase the equity.

One last note on beta; the previous examples have to do with stocks. Beta on options is different. (More on that later.)

I remember reading an article once basically stating the buy and hold strategy is a thing of the past.  That may very well be true…especially today.  Look what happened to GM and the shareholders after years and decades of ownership.

I remember that I had written about “Investing In Speculation” a couple of years ago, so I dug out my notes and this is what I found:

Here’s a question to consider.

Do you really invest in a company when you buy the stock on the stock exchange? No. You invest in the speculation of the stock’s price (excluding dividend investments). Yes you have invested your money, but the company you purchased had original investors for start up, etc.

When the early owners needed more money for growth and expansion, they issued stock such as an “IPO”, or initial public offering. Unless you or me purchased stock here, we simply bought out someone else that had already invested in the company.  But, probably the additional investors were the investment banks such as JP Morgan, not you or me. The investment banks simply sold the shares they bought to us as an IPO to the public.

For example, Investment Bank ABC purchased stock in Company XYZ. Then the stock brokers sold the shares to Joe Blow as either an IPO or later when the demand for the company pushed the value of the stock higher. If we didn’t get in here, we simply are buying out other shareholders.

The original owners made money when they sold shares to the investment houses or went public. The original owners may have kept control of the company and/or got a bigger salary for running a larger company.

What new buyers of the stock got is a small dividend depending on profits. But that’s okay, the dividend is what was wanted in addition to price appreciation (which is speculation because the principle amount of money invested is not guaranteed.  The value can go down big time!).

The difference between investing and speculating has to do with protecting the principal amount of money.  The short version is, investing maintains the amount of money spent; whereas, speculation doesn’t have guarantees and the value can decline or potentially lose great amounts of money if not all.

If the company doesn’t perform well, and the demand goes down, so does the share value and the invested amount of money. The company still continues, excluding bankruptcy and closing the doors.

So technically people do own part of the company, but unless it is a huge amount, most shareholders cannot control operations, salaries, board positions, etc.  In simple terms, people buy out other shareholders and invested in speculation.

So why would you or I want to buy and hold a company knowing you have no control over it or the price of the stock?

Income. We can generate income from selling options, which is similar to renting the stock.

Dividend income. If we use the cash that is produced from selling options and dividends, we have the opportunity to buy more shares or reinvest, or build cash.

This can give “growth” to our accounts even if the stock price goes down simply because the costs have been reduced by building cash and/or acquiring more shares; thus allowing the potential to sell more options and receive more dividends and grow the account.

Finally, if the shares are never sold, such as a buy and hold, without income from the sources just mentioned, is there really a gain?  Sure, on paper, but not in the checking account.