Terry’s Tips White Paper

Stock Option Trading Strategies

Congratulations – You have earned Insider Status at Terry’s Tips. Please print this report and keep it as a reference guide as you make trades.

This report is organized as follows:

1. General Discussion of Option Strategies. . . . . . . . . . . . . . . . . . . . . . 2 Monthly Decay for a One-Year Leap Option. . . . . . . . . . . . . . . 4

How to Pick Stocks. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 Some Generalizations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

2. Getting Started With the 10K Strategy . . . . . . . . . . . . . . . . . . . . . . . 9 How to Measure Market Direction . . . . . . . . . . . . . . . . . . . . . . . 9 Which long-term options (or LEAPS) should you buy?. . . . . . . 10

3. Trading Rules for the 10K Strategy . . . . . . . . . . . . . . . . . . . . . . . . 13 Using the 10K Strategy With QQQ . . . . . . . . . . . . . . . . . . . . . .17 Summary of the 10K Strategy for QQQ . . . . . . . . . . . . . . . . . . 24

4. “Lazy Way” Strategy To Double Your Money in Two Years. . .. . . . 27 21 “Lazy Way” Companies . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31

Tax Implications of “Lazy Way” Companies. . . . . . . . . . . . . . . 34

5. Reach For The Stars Strategy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36

6. Cover Your Butt Strategy. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .39

7. Tax Implications of Options Trading . . . . . . . . . . . . . . . . . . . . . . . . .42

8. Appendix A: Easy Pie Strategy . . . . . . . . . . . . . . . . . . . . . . . . . . . . .45

Recommended Discount Brokers:1. OptionsXpress – low commission rates ($1.50 per contract,

$14.95 minimum), option-friendly (e.g., delta calculation for each position, butterfly spreads, etc.), no minimum deposit, allow option spreads in your IRA account – OptionsXpress. Forbes awards OptionsXpress "Best of the Web" and "Favorite Options Site”.

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2. Thinkorswim – slightly higher commission rates ($10 extra per trade but lower rates for less than 5 contracts). This company has an unlikely name for an on-line options broker, but has superior software, and possibly better executions (they guarantee that all orders are sent to the market with the best bid or asked price), extremely option-friendly, $3500 minimum deposit, and allow option spreads in your IRA account -thinkorswim.

General Discussion of Option Strategies

Admittedly, some of the returns that are projected in Terry’s Tips seem preposterous. How can you make 100% or more a year when the stock doesn’t move? There are three parts to our strategies that explain the possible extraordinary results:

1. Use of leverage . All the strategies employ leverage, but only one (the “Lazy Way”) uses margin. Three of the 4 strategies involve using a LEAP (or other longer-term option) as the long position rather than margin. Leveraging the account with LEAPS rather than margin avoids the risk of a margin call.

Margin calls are particularly nasty because they come at precisely the wrong time – when the stock is at its lowest, you could be forced to sell some stock to cover the margin call. For this reason, I recommend using the one strategy that employs margin, the “Lazy Way” Strategy, for only a small portion of your portfolio, and leaving the majority of the account not margined so you will not have to worry about getting a margin call.

2. Owning (LEAP) positions that have a low rate of decay . As we know, if the price of the stock stays the same, an option is a deteriorating asset. It goes down in value each month by an amount called the decay. You can calculate the average decay rate for a LEAP by taking the time premium of the option price and dividing by the number of months in the LEAP option.

In my report “How I Made 124% on Fannie Mae While the Stock Fell 8.4%,” the 80 call LEAP that I bought at the beginning cost $16.50 ($1650) when the stock was selling at $86.75. Decay can be calculated by finding the

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time premium (the amount of the option price which is above the intrinsic value). In this case, the time premium is $9.75 (the $16.50 price of the LEAP minus $6.75 intrinsic value (the difference between the stock price and the strike price)).

If you divide this number by the 24 months left until expiration, you find the average decay each month is a little over $.40. In other words, if the price of Fannie Mae stays the same, the LEAP you paid $1650 for will go down in value by an average of $40 each month. That is the amount of decay you will need to cover each month by selling options to someone else.

3. Selling options to someone else that have high rates of decay . A distinctive element of option prices is that the decay in the last month of an option is usually three or four times greater than the average decay over the life of a LEAP. In the Fannie Mae example, as soon as I bought the LEAP with two year’s life left to it, I sold January 85 calls for $4.50 and January 90 calls for $2.06. The decay for one month on the January 85 call was $2.75 ($4.50 option price less intrinsic value of $1.75), and the entire $2.06 premium for the January 90 call would be decay.

In other words, the short-term calls I sold yielded me $275 or $206 each compared to the $40 I would lose in the decay of my LEAP (assuming the price of Fannie Mae stayed the same for that month).

This is the essence of my trading strategies. I hold a position that goes down a small amount each month, and sell someone else an option that goes down 3 or 4 times more quickly. If the stock stays the same, or moves only a little, I usually get to keep the entire amount of options I sold.

Actually, the average monthly decay for a LEAP understates the difference between the decay for the LEAP that I own and the short-term call that I sell. In the early months (when a LEAP has a long way to go before expiration), the decay rate is less than the average monthly decay for the entire period. Each successive month, the decay gets larger, until the final month (when it is no longer a LEAP, but now a short-term call) when it skyrockets. Under normal circumstances, I would sell that former LEAP when it has two months to go until expiration, and avoid suffering from the months with the highest decay.

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The following chart shows the monthly decay for a one-year LEAP for DIA (the Dow Jones Industrial tracking stock, better known as Diamonds). With DIA at $80, a one-year LEAP was selling for $8.30 ($830). In the first month, if the stock stayed flat, the decay would be only $42, while in the final month, a whopping $275:

And Now, The Basic Underlying Problem

All of this discussion has been made with the assumption that the price of the stock remains the same. Everyone knows that stock prices do not stay the same. My strategies fail to work in the event that the stock gyrates wildly. If you sell short-term options, and the stock sails up, you have to buy these options back at a loss. (Since your LEAP also goes up in value, some or all of that loss is covered by your long position). However, if the increase in stock price is sufficiently high, you can definitely lose money if you have sold one short-term option for each LEAP you own.

Conversely, when the stock falls a great deal in a single month, you may lose out as well, although to a lesser extent. You are protected from the

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first part of the stock’s fall by your short options, but if the stock keeps falling, your LEAP will decrease in value, causing you to show a loss in the account for the month.

Realizing this, the wise thing would be to select stocks that don’t fluctuate all over the place. One of the reasons I made so much in Fannie Mae in 2001 was that for the entire year, the stock traded in a range from $75 to $87, or only $12. If I had re-invested the money that came in each month in more positions in Fannie Mae, I could have made extraordinary returns – in the 300% range or higher.

It isn’t always easy to pick stocks that won’t fluctuate a lot, even if they historically have not been particularly volatile. Unfortunately, the past is not always a good predictor of the future. Quite often, it is, however. As companies become more mature, they tend to become less volatile. Some companies, like Fannie Mae, seem to be pretty steady year after year, and make good selections for my trading strategies.

How To Pick Stocks

Picking stocks is more an element of art (or luck) than it is a science. As some sage once noted, it is extremely difficult to make predictions, especially when they involve the future.

Selecting good stable stocks is so difficult that my absolute favorite strategy right now is not to pick a stock at all, but to trade in the NASDAQ 100 Tracking Stock (QQQ) and the Dow Jones Industrial Average tracking stock (DIA). DIA is made up of 30 very large and established companies in a variety of industries, each paying a dividend. It tends to be more stable (less volatile than most individual stocks). On the other hand, QQQ is made up of the 100 largest non-financial companies on the NASDAQ.

When you select a stock to use for one of my strategies, pick a company you have confidence in, and would like to own for the long run (or at least two years, depending on what your idea of long run might be). You may use some sort of fundamental or technical analysis to pick stocks, check out what the analysts are recommending, or listen to a hot tip from your Uncle Albert who has a track record for picking the good ones.

I would recommend that you select at least five or six companies in different industries to diversify your portfolio (or QQQ or DIA, which both

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give you lots of diversification). Pick companies in growing industries. Generally, companies with dominant market positions perform better than companies who have only a small part of the market.

When I select companies to invest in, I primarily consult two sources of information. First, is Investors Business Daily (IBD). If you subscribe to this newspaper, you gain access to their web site which has a wealth of mostly technical information. This publication advocates momentum investing, making the assumption that the companies that are currently going up in value can be expected to go up in value even more in the future. Most of the time, they are right. But when they are wrong, and the momentum changes, these stocks tend to fall even faster than they went up.

IBD advocates selling whenever your stock falls 8% to avoid the double-edged sword of momentum investing. I agree with this idea. Some people buy more shares when a stock goes down, (“averaging down”). I don’t believe this is a good idea in most cases – it is close to impossible to pick the exact bottom when a stock is falling. Better to take a small loss and move on to greener pastures.

I use IBD’s rankings and look at their charts, not so much because I believe that technical analysis is the best selection technique, but because so many millions of investors do believe it. This makes technical analysis somewhat of a self-fulfilling prophecy.

I have never picked a stock purely on its chart pattern. Frankly, the chart readers find patterns (usually with hindsight) that I never do. However, I have found it wise to avoid picking stocks that are trading below their 50-day moving average, unless you are betting that the stock is going down (see my Cover Your Butt Strategy).

The second source I use to help pick stocks is Yahoo Finance. I check their Research, Profile, and Upgrade/Downgrades sections before buying any stock. I want to see what the analysts are saying, even though I understand that many of them are essentially being paid to make positive recommendations. I don’t like to select stocks which have had recent analyst downgrades, as this is often a signal that additional downgrades are coming (and lower stock prices).

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When picking stocks, I like the probabilities to be on my side. So I check out both the technical and fundamental information that is available, and pick companies that score well on all measures. (And then stand ready to bail out if the stock falls by 8%. I recognize that picking stocks is mostly a matter of luck, and don’t take it personally when one goes against me.)

One thing I have learned (and unfortunately, learned again many times) is NEVER BUY A STOCK JUST BECAUSE THE PREMIUMS ON THE SHORT-TERM OPTIONS ARE HIGH. Extremely high premiums exist for a reason. The stocks are volatile. Maybe a buy-out is rumored – if it comes true, the stock will soar, or if it proves to be just a rumor, the stock will plummet. In either case, you will do poorly if you are using my strategies and your stocks ratchet all over the place. Stocks with extremely high option premiums can be expected to vacillate widely.

Some Generalizations

I would like to propose some generalizations to help guide you when you make decisions each month as to which options to sell (and buy):

1. The chances are better than 2 to 1 that in the next time period, the stock will move in the same direction it did in the last time period. This phenomenon is part of the theory of cycles, and holds true for almost any set of economic numbers for almost any set of time periods, including the stock market as a whole.

2. If a stock makes a large move (over 10%) in a single month period, the odds are greater than 2 to 1 that it will move in the opposite direction in the next monthly period. While this may seem to contradict the first generalization, I have found that it is generally true. For example, IBM has fallen in price over 10% on 9 different occasions in the last 3 years, and 8 of those times, it increased in value in the subsequent month (an average of 15%, by the way).

3. The market usually goes up . Over a 50-year period, the stock market has, on average, increased a little over 10% a year.

4. Go with the trend. This means that if your stock, or the market in

general, is going in one direction, don’t bet against that direction, regardless of what your personal opinion says should really be

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happening. It is a dangerous, and usually fruitless, strategy to try to pick a bottom (or a top, for that matter).

5. Friday is the best day for the market, and Monday is the worst .* Over a period of 50 years, the market has increased an average of .085% on Fridays and decreased an average of .089% on Mondays. (Monday was the only day of the week to show a decline.) I use this generalization to help decide whether to sell options on expiration Fridays, (which might mean buying back out-of-the money expiring options, incurring commissions), or waiting until Monday to sell.

6. For the past 50 years, the gain in the Dow Jones Industrial Average during the first six calendar days of each month has been greater than the entire gain for the month.* This means that there has been a net loss for all the other days of the month. It probably happens because people who are paid monthly (primarily upper-income workers) plunk down some of their earnings in the market soon after they get paid.

*Stocks for the Long Run, by Jeremy J. Siegel (New York: McGraw Hill, 1998), p. 264-5.

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Getting Started With the 10K Strategy to Make 100% Every Year

The general philosophy of the 10K Strategy is based on the difference in the decay rates of long LEAP position and short-term short position. As long as I can protect myself from the fluctuations in the underlying stock, I will make money holding the slower-decaying LEAPS and selling someone else the faster-decaying short-term options.

Before deciding whether you should be trading in puts or calls, you must make a determination of the general market direction.

How to Measure Market Direction

When the stock (QQQ or DIA) is trading above its 90-day and 200-day moving average, we consider the market to be in a Green Mode.  The 10K Strategy will consist of owning long-term calls and selling next-month calls while maintaining a slightly positive net delta position (5% - 10% of portfolio value).  Based on historical patterns, this strategy will earn a profit 5 out of 6 months (in the sixth month, the stock would drop over 5% and an average loss in the neighborhood of 20% might occur).  The average gain in the winning months would be in the 10% - 20% range. 

When the stock has traded below either (but not both) its 90-day average or its 200-day moving average for 14 business days, consider the market to be in an Amber Mode.  The 10K Strategy will consist of having 50% of its positions in calls and 50% in puts, and maintaining a net delta neutral position.  Any new spreads placed will be in the necessary options (puts or calls) to help bring the ratio toward an equal number of put and call long positions.

An alternative way of investing in the Amber Mode is to use calls exclusively, but to have half of your spreads in in-the-money calls. This alternative is best for smaller accounts that do not have enough invested capital to buy at least 10 spreads at a time to minimize commissions.

When the stock (QQQ or DIA) has traded below both its 90-day and 200-day moving average for 14 days, we consider the market to be in a Red Mode.  The 10K Strategy will consist of owning long-term puts and selling

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next-month puts while maintaining a slightly negative net delta position (5% - 10% of portfolio value).  Based on historical patterns, this strategy will earn a profit 5 out of 6 months. 

Even in a Red Mode, calls may be used instead of puts as long as they are predominantly in-the-money spreads, and higher-strike spreads are taken off when they become 8% away from the stock price (and replaced by in-the-money call spreads).

The market was in a Red Mode from 9/21/00 until 11/6/01 (including the 9/11/01 crash) and from 2/4/02 until 10/17/02.  During this time, the 10K Strategy would have earned an average profit of over 10% a month.  This would have been the most satisfying time to employ the 10K Strategy – just when everyone else was tearing their hair out because the market is tanking, this strategy would be making extraordinary gains.

The amazing statistic concerning this Mode classification system is that (based on the past four years) the chances of a 5% monthly gain in a Red Mode is exactly the same as the chances of a 5% losing month during a Green Mode.  Both cases only occur once out of every six months.  In the other five months, the 10K Strategy will earn a profit.

The most difficult time for the 10K Strategy occurs when the market shifts into and out of the Amber Mode. For this reason, we are slow to shift to a new Mode for fear that the recent market action is not really an indication of general market direction. The 14-day waiting period is designed to reduce the number of times we need to shift to a new Mode.

In this White Paper, I generally discuss the 10K Strategy as if the market were in a Green Mode, (i.e., buying and selling calls instead of puts). Since the market has gone up, on average, about 10% a year for over 50 years, the Green Mode is the most common market direction indicator.

Which long-term options (or LEAPS) should you buy?

Instead of buying the longest term LEAP available, I prefer to buy an option with only 6 or 8 months until expiration.  I intend to sell that option when it has only 2 months of life left, and then purchase another option with 6 or 8 months left (at the strike price closest to the stock price at that time).

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The return on investment when buying the 6-to-8 month option is more than double the return on investment if the longest-term LEAP were purchased.

Using QQQ as an example in early November 2003, here is a comparison between buying the June 2004 call, January 2005 LEAP, and the January 2006 LEAP:

Price of QQQ:  $35.00

Price of QQQ Dec03 call (six weeks remaining): $1.20

                                                Jun04 35 Call       Jan05 35 call          Jan06 35 call  

Call option symbol                         QQQFI                XCWAI                   YWZAI

Price of call option                       $2.90                   $4.20                       $6.00

Expected sale price of option

  With 2 months remaining             $1.20                   $1.20                       $1.20

Net cost of option                           $1.70                   $3.00                       $4.80

# of months option held                      6                         12                            24

Decay per month                              $.28                    $.25                        $.20

Cost to purchase 1-for-1 spread:

Purchase of long-term call                $2.90                   $4.20                       $6.00    

  Less sale of Dec03 call                 $1.20                   $1.20                       $1.20   

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           Net Investment Cost            $1.70                   $3.00                       $4.80  

Return on investment for 6 weeks if stock stays flat:

   Gain on Dec03 35 call                $1.20                   $1.20                       $1.20

   Loss on decay of long call              .28                        .25                           .20

               Net gain for month           $ .92                    $ .95                     $1.00

Return on investment         $.92/1.70=54%     $.95/3.00=32%      $1.00/4.80=21%

Of course, I understand that if you took this reasoning even further, the best bet might be to buy the Jan04 35 call and sell the Dec04 call against it.  This would yield an even higher return on investment.  However, this strategy would involve considerable more trading each month, and give you very little time to recover if the price of the stock moved significantly in either direction.

Owning the 6-to-8 month out option is a good compromise between maximizing potential return on investment and giving you some time to recover if the stock price fluctuates wildly.

I understand that owning a LEAP with two years until expiration is intuitively pleasing (you have ever so many months left to get back the premium you risked).  However, as the above table points out, the return on investment is considerably higher if you bought a shorter-term option instead of the longest-term LEAP possible. 

If you make the assumption that you will sell the option you bought when it has two months of remaining life, the monthly decay you will incur is only negligibly more costly with the 6-to-8 month option, and the original cost is considerably less.

Buying the 6-to-8 month option will enable you to put on many more spreads with the same amount of money, and generate considerably higher profits.

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I understand and support anyone who feels more comfortable owning a LEAP with two or more years to go until expiration.  Maybe they will sleep better knowing that they have more time to recoup their investment.  But they should understand that their return on investment will suffer from having this extra time.

A final reason I prefer to buy shorter-term long-term options is that they are generally more actively traded, and have smaller differences between the bid and asked price.  This allows you to get better prices if the stock price changes considerably, and you have to sell the option you own and replace it with a strike nearer to the current price of the stock.

In this White Paper, I often refer to buying LEAPS when, in reality, I am referring to the longer-term options that provide the underlying security which enables you to collect short-term time premium (decay).

10K Strategy Stock Option Trading Rules

Note that these trading rules vary slightly when trading in regular stocks than they do when trading in QQQ (Nasdaq 100) and the Dow Industrials (DIA) because of the existence of strike prices at every dollar figure for QQQ and DIA (LEAPS have prices at $4 increments). (A special discussion of my QQQ strategy follows these trading rules.)

Rule #1. On expiration Friday each month, sell half the number of options you are allowed (based on the number of LEAPS or other longer-term options you own) in the next month call option with the most time premium. (Remember, time premium is the option price less the intrinsic value). The call option with the most premium is usually the at-the-money strike price, (i.e., the strike price closest to the stock price). For example, if you owned 10 call LEAPS with a strike price of 40, you are allowed to sell 10 calls for the next month. If the stock is selling within a dollar or so of $40, you would sell 5 calls at the 40-strike price for the next expiration date (which occurs in four or five weeks from the current expiration date).

Note: This Rule can be fined-tuned if the stock price is slightly away from the strike price (i.e., there is no at-the-money strike price). If the stock price is less than the strike price, say $38, sell 6 of the 40 strikes (and 4 of the 45

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strikes under Rule #2). If the stock price is more than the strike price, say $42, sell 4 of the 40 strikes and 6 of the 45 strikes).

Rule #1 Postscript. If the strike price of the LEAP you own is 5% or more greater than the price of the stock, sell as many calls as you can at the strike price level. In the above example, you would sell 10 calls (rather than 5) for the next expiration date at the 40-strike price if the stock fell to $38 or less, since that is 5% less than your LEAP with a 40 strike price. (This postscript does not apply if the LEAP strike is less that the stock price).

Rule #2. In conjunction with Rule #1, sell the other half the options you are allowed in the next month call option at the next-higher strike price. In the above example, you would sell 5 calls at the 45-strike price for next month’s expiration.

Rule #3. On expiration Friday, if the stock has risen or fallen by more than 10% since the last monthly expiration date, Rule #1 and Rule #2 should not be followed. Instead, you will sell options for the next month in anticipation of the stock moving in the opposite direction it did the previous month.

This means that if the stock fell by more than 10% last month, you will sell only out-of-the-money calls. In the above example, if the stock falls below $36, you would sell 10 calls at the 40-strike price rather than 5 at the 35 strike and 5 at the 40 strike.

If the stock increased by more than 10% last month, you will sell only in-the-money calls for the next month. In the above example, if the stock is above $44, you would sell calls at the 40 strike. In order to accommodate the possibility that the reversal won't happen next month and instead, the stock will keep rising, at the current expiration only sell 70% of the calls you are allowed, or 7 in the above example.

While I do not have quantitative proof that the entire market will behave in the manner I have described here, my experience has shown me that this is true. For example, over the last three years, IBM has increased or decreased by 10% or more between expiration Fridays a total of 13 times, and 11 of those times, the stock moved in the opposite direction during the next month. It seems to be a phenomenon worth counting on.

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Rule #4. After you have sold options each month, use the proceeds (if any) to buy more call LEAPS at the strike price closest to the current price of the stock, and sell an equal number of next-month calls at the same strike price.

This tactic allows you to enjoy the exceptional returns possible from the wonder of compound interest. In addition, it allows you future protection in the direction that the stock seems to be heading. If the stock has fallen in price, you will be adding new LEAP positions at lower strike prices than you originally owned. This means that if the stock stays at these lower levels, you will still have at-the-money calls to sell (where the premium is always the greatest).

Rule #5. On expiration day, buy back all in-the-money call options expiring on that day. In the event that the stock has moved up so much that the cost of buying back this month’s expiring options is greater than the money you will collect by selling next month’s options according to Rules #1 and #2, or Rule #3 (whichever ones apply), sell enough of the deepest in-the-money LEAPS you own to cover the cash shortfall.

This tactic insures that you will be closing out your positions after prices have gone up. Under Rule #5, you will be adding to your positions after the stock has fallen, or stayed the same. In many respects, you will be enjoying the benefits of dollar-cost-averaging (a strategy of putting a fixed amount of money into the market every month, automatically buying more shares when prices are low and fewer shares when prices are high).

Rule #6. When placing orders to buy or sell stock options, always place limit orders (as opposed to market orders) except when buying back a short call on expiration day when the stock price is within a dollar of the strike price (see Rule #7 when this condition exists).

When selling calls, place limit orders at a price which is one price increment higher than half way between the bid and asked price. For example, if the market is $2.40 bid and $2.80 asked, halfway would be $2.60, and you would place your order to sell at $2.70. This makes you the lowest asked price, and puts you ahead of the other people trying to sell this option.

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When buying calls, place limit orders at a price which is one price increment lower than half way between the bid and asked price. In the above example, you would place your order to buy at $2.50.

When you place limit orders in this fashion, you will enjoy one of the few advantages ordinary investors enjoy over the market makers on the floor of the exchange. Since your order will not usually be executed immediately, it is placed in what is called “the book”. Orders sitting in the book must be executed before a market maker can get that same price for his own account, even if that is the price he is publicly announcing. (Knowing this fact could save you hundreds or thousands of dollars every year if you are an active trader).

Rule #7. When closing out a short call position (i.e., buying back a call you sold earlier), and the stock price is within half a dollar of the strike price of your short call, telephone your discount broker (if necessary) and place a “buy to close at the market close” order.

This order will allow you to capitalize on the well-known tendency for stock prices to close on expiration day extremely close to a strike price. Until the very end of the trading day at expiration, there will be quite a bit of premium in the at-the-money option. You will be forced to pay this premium until the very end of the day.

It is dangerous to wait until the last minute on expiration Friday to place a closing order because there is often an order overload at that time, and telephone lines may be jammed. It is far safer and usually more profitable to place the “buy to close at the market close” order early in the afternoon on expiration Friday.

Rule #8. Buy back expiring (more than $1 out-of-the-money) calls only if you want to sell new options and do not have enough margin available in your investment account. If you have plenty of margin available, you can do nothing, and let these calls expire worthless. This strategy does not work in your IRA, because you do not have margin. In an IRA account, you must buy back all expiring options if you intend to sell new calls for the next month on expiration Friday.

In a margin account, when you do not buy back expiring out-of-the-money calls, and you do sell new calls, you are technically naked short the expiring calls for the weekend. The only way these naked call positions

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could hurt you was if something extraordinary happened (like someone offering to buy your company at a great premium) on Friday after the close (and before the calls formally expire on Saturday). This is a risk that I can live with.

Rule #9. If your company has announced a stock split, suspend all sales of at-the-money calls, and sell only out-of-the-money calls. This will allow you to take advantage of the likelihood that stock prices increase after a stock split announcement (even though nothing of real value has been added to the stock). Enough people seem to believe that a stock split means higher prices in the future that it often becomes a self-fulfilling prophecy.

Rule #10. Once the actual stock split has occurred, for the next two months, sell half your calls in at-the-money calls, and half at the next lowest strike price (i.e., the highest in-the-money strike price). This tactic will let you take advantage of the phenomenon that stock prices often fall after the stock split actually takes place.

Does the 10K Strategy to Make 100% Every Year Work for All Companies?

It works best if the stock does not fluctuate all over the place. During 2001, when I made over 200% employing this strategy with Fannie Mae, the stock traded in a very tight range (from $75 to $86) all year, and the 10K Strategy was extremely successful.

High volatility stocks, even though the option premiums are much greater, are more difficult to trade successfully with this strategy. (You can find the historical volatility for all companies at the CBOE site).

The biggest problem with using the 10K Strategy to Make 100% Every Year for high-volatility companies is that they often go down as fast as they go up. As long as they are only volatile in an upward direction, you will do just fine. However, this has not usually been the case for most high-volatility companies (at least not for the last few years).

Using the 10K Strategy with QQQ17

(The following discussion of QQQ also applies, with a few exceptions, to DIA.) Instead of betting on a single stock, you can use the same strategy with QQQ, the NASDAQ 100 index tracking stock, traded on the American Stock Exchange. QQQ is virtually certain to be less volatile than the average of its component individual companies. Investing in QQQ removes the fear of a huge sudden drop due to some unfortunate news about a single stock.

There are other advantages of using QQQ option spreads as well. First, there is extremely high liquidity in these options, and this liquidity results in better prices whenever you buy or sell. Hundreds of investors deal in them, and the result is that there is a very small range (spread) between the bid and asked price. You can trade often, and not feel you are getting killed by the spread.

Second, there are far more strike prices. In fact, there is a strike price at every dollar increment. For most stocks, strike prices are $5 apart (for stocks over $30) or $2 ½ apart for stocks under $30. More strike prices means you can be more precise in your monthly trading, and it is easier to sell some premium in an out-of-the-money option. If you have traded option spreads, you know that this is not always possible with most stocks.

A third reason that I currently only trade in QQQ and DIA is that these options receive preferential tax treatment. Sixty percent of your gains are considered to be long-term (even if you held the option for only a single day) taxed at a maximum of 15%. You file these gains with Form 1256. It only applies to QQQ and DIA options, not the stock itself. For a complete report on how options are taxed, see the special report on my website for Insiders.

If you use the 10K Strategy, you will make maximum profits when the stock price on expiration Friday is very close to a strike price where you have sold lots of expiring options. (Your short options expire worthless, or nearly so, while you gain maximum premium income by selling the next month’s option). With many more strike prices for QQQ, you increase the chances of the stock closing exactly at a strike price, and gaining these maximum profits.

When options expired on the third Friday of October, Bristol Myers Squibb (BMY) and QQQ traded at almost the exact same price ($23.85). (At the

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time, I owned BMY LEAPS, and sold short-term calls against them each month). The nearly exact prices between these two stocks provided a rare opportunity to compare options of a typical stock and the QQQ index tracking stock.

Here are the January 2005 call LEAP prices for the two issues:

Stock Symbol LEAP Symbol Strike Bid Price Asked Price

BMY ZBMAD 20 6.10 7.10 BMY ZBMAE 25 4.10 4.90 BMY ZBMAF 30 2.60 3.40 QQQ ZWQAS 20 7.80 8.00 QQQ ZWQAW 23 6.20 6.40 QQQ ZWQAX 24 5.70 5.90 QQQ ZWQAY 25 5.20 5.40 QQQ ZWQAD 30 3.50 3.70

Note that the average spread between the bid and asked price is $.87 for the BMY LEAPS and only $.20 for the QQQ LEAPS. This means that you get fairer prices both when you buy and sell the QQQ options.

Also note that to buy the 25 LEAPS, you would have to pay $.50 more for the QQQ series ($5.40) than you would BMY ($4.90), even though the stock price is essentially the same. Since BMY should be more volatile than QQQ, the BMY option prices would be expected to be more costly, not less costly. The slight extra cost of the QQQ LEAPS should be covered many times over in the better prices you might get when you sell short-term calls 27 times over the next 27 months, however.

Here are the November call prices for BMY and QQQ on October 18, 2002 when both issues are selling for $23.85:

Stock Symbol Call Symbol Strike Price Bid Price Asked

BMY BMYKE 25 .80 .90 QQQ QAVKY 25 .70 .75

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Once again, note that the spread on the BMY series is double the spread on the QQQ series. As we would expect, the premiums on the more volatile BMY ($.80 for the November 25 call) are slightly higher than the QQQ premiums ($.70 for the November 25 call).

You could make an argument that the BMY spread is a better investment than the QQQ spread. After all, the 25 LEAP price is lower, and you will be buying that one, while the November 25 call price is higher, which you will be selling. All I can say is that I own both of these spreads, and I worry far less about my QQQ spread than I do about the BMY. I know that at any time, the FDA may turn down a promising drug application, or a class action suit may be brought against Bristol Myers, and I could lose a ton on my investment.

The Nasdaq 100 is also quite volatile, but 5% changes in a single day are essentially unheard of, and the multiple strike prices for QQQ gives me many more choices when making adjustments to sudden price changes.

A Note About Deltas

When deciding how many calls (and which strike prices) to sell against my LEAPS, I occasionally check out the delta calculations at the CBOE site. Be sure to click on the equity options tab - the default screen is for index options (QQQ is an equity option since it is based on the price of QQQ, which is essentially an index of the NASDAQ 100). A faster way to check deltas is to open an account at a good options discount broker such as thinkorswim or OptionsXpress.

The delta of an option is the amount it will change in price if the price ofthe stock goes up by $1.00.  If an option carries a delta of 70, and thestock goes up by $1, the price of the option will go up by $.70.In-the-money options have high deltas, while out-of-the-money options have low deltas.

If you multiply the delta value of an option by the number of options youhold, you get the equivalent number of shares of stock you own (or areshort, if you have sold that option). If you buy 10 QQQ January 2005 25call LEAPS when the price of the stock is $23.85 and there are 27 months to expiration (which has a delta of 65), you own the equivalent of 650 shares of QQQ.

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When I was a market maker on the Chicago Board Options Exchange, it was imperative to calculate my net delta position at all times.  A market maker is typically both long and short a great many options with different strike prices and expiration months.  It is most desirable to be delta-neutral(meaning that he doesn't really care if the price of the stock goes up ordown).

If you could set up an option spread strategy where your total long deltasequaled the total short deltas, and the decay on your short options wasgreater than the decay on your long options, you would absolutely beguaranteed a profit on your investment, no matter which way the market went!

While it is possible to set up such a position, in reality, there is a catch.Unfortunately, deltas never stay static.  As the price of the stock rises, or as expiration Friday approaches, the delta increases.  A delta-neutral position you put on suddenly becomes either long or short as soon as the price of the underlying stock changes.  In other words, THE DELTA CHANGES IN VALUE EVERY DAY!

A major advantage of trading in QQQ options is that you can more easily make adjustments to maintain delta-neutrality because of multiple strike prices and great liquidity (which results in smaller spreads between the bid and asked prices).

Rather than trying to set up and maintain a delta-neutral position, Irecommend selling 7 at-the-money short-term options for every 10 LEAPS you own (however, if the at-the-money strike is slightly higher than the price of the stock, I recommend selling 8 instead of 7).  With a full month to go before these 7 (or 8) options expire, you are slightly delta-long. As expiration day approaches, the delta for the short positions will get close to 100, and you become more delta-neutral.

I do not try to adjust frequently to maintain delta-neutrality because it is a daily hassle, and, more importantly, you are always adjusting when prices are against you. (In order to maintain delta-neutrality, you need to buy more options after the price of the stock has gone up, or sell more options after the price of the stock has fallen - just the opposite of what you would really prefer to do.)

Let's look at how delta calculation works on the QQQ example with the

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stock selling at $23.85 with a month to expiration for the November 2002 24 calls.  Using the CBOE website to calculate deltas, I calculated that 10QQQ January 2005 24 call LEAPS have a delta of 65, so I have the equivalent of 650 long shares of QQQ, while my 7 short November 24 call options have a delta of 54, giving me the equivalent of 378 short shares.  My net delta position is a long 272 shares of QQQ (650 - 378). 

Being net delta-long 272 shares means I will lose $272 if QQQ falls by $1, or I will gain $272 if QQQ goes up by $1. Since I expect to gain over $600 on the decay differences in one month, I am covered for more than a 2 point drop on the downside (and if QQQ falls by $2.40, or 10%, I will sell more premium as I discussed above).

If, two weeks from expiration, QQQ has gone up $2 (a not-too-unlikely event), I learn that the delta on my LEAPS has gone up to 70, while the delta on my November 24 calls has soared to 85. This causes me to be the equivalent of 105 shares long QQQ (700 long deltas, less 7 x 85), or less than half my original delta position. By expiration day, the delta of the November 24 calls will be essentially 100, yielding me a perfectly neutral delta position (700 long and 700 short deltas).

By selling only 7 calls for each 10 LEAPS, I make an extra (non-decay related) profit for the first two dollars of increase in QQQ, and break even on any subsequent increases. Of course, the stock will not always go up. But this extra revenue helps cover the non-decay related losses I incur in those months when the stock price falls.

I am still making my real money from the difference in the decay rates of my long LEAPS and my short-term options.  If I can break even on the influence of the stock price going up or down, I will always win this game.

Since deltas change so quickly, it is probably a waste of time tore-calculate your net position frequently.  I find it easier, and less of ahassle, to sell 70% of the at-the-money short-term calls possible each expiration (these should have the greatest premium). I will continue this policy as long as I feel the long-term trend of the market will be either flat or on the upside.

If the stock price has increased during the previous month (and I have tobuy back expiring calls), I may not have much money left over to buy newat-the-money LEAPS, but I will buy as many as I can.

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If the stock price has decreased during the previous month, (and I don'thave to use up cash to buy back expiring calls), once I sell the new month'scalls, I will have more money to buy new LEAPS, and I buy them at theat-the-money strike price which is now lower than the earlier LEAPS Ibought.

The underlying goal continues to be to sell as much short-term premium as you can while trying to protect yourself from market fluctuations in the price of the stock.

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Summary of 10K Strategy for QQQ (July, 2004) 

(The rules you need to implement the 10K Strategy withoutusing delta or the other Greek measures)

 1)   Determine the underlying market direction based on the 90-day and 200-day moving averages. 

a) When the market is in a Green Mode (QQQ is selling above both its 90-day and 200-day moving average), trade only in call options (see page 9 for a complete discussion of Market Direction Modes).

b) When the market is in an Amber Mode (QQQ is selling above only one of the above moving averages for fourteen business days), put on new spreads so that you are moving toward having half your spreads in calls and half of them in puts. As an alternative, purchase in-the-money calls instead of puts.

c) When the market is in a Red Mode (QQQ is selling below both its 90-day and 200-day moving average), all new positions will be put on in put options. As an alternative, put on all new positions in in-the-money calls.

 

2) Establish your initial positions.

a) Buy “longer-term” options that have 6 – 8 months of remaining life (with the plan to sell them when they are two months from expiring).  These options generate a higher return on investment than purchasing LEAPS, have a smaller bid/asked spread (making roll-overs to other strikes or months less expensive), and provide sufficient time to recover from an adverse short-term market move. (See page 10: “Which Long-Term Options Should You Buy).

b) Put 40% of your funds in a 1-for-1 at-the-money spread, buying options with 6 –8 months of remaining life and selling next-month options at the same strike.  (For example, with QQQ selling between $34.51 and $35.49, put on spreads at the 35 strike).

c) Put 40% of your funds in an identical 1-for-1 spread at the next higher strike price (36 in the above example).

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d) Put the remaining 20% of your funds toward the purchase of longer-term options at the next higher strike price.  Purchase one-half as many options as you did for each of the earlier spreads you put on.  (In the above example, if you put on 10 spreads at the 35 strike, 10 at the 36 strike, you would buy 5 longer-term options at the 37 strike). It is up to you to decide whether you choose to sell short-term options against these final options.  If you are in a Green Mode, (i.e., you are dealing only in calls), and you believe the market will go up by no more than 6%, you would sell short-term calls on a 1-for-1 basis.  Since the next-month calls will probably be selling for less than $.50 (see Trading Rule C below), you may have to sell calls expiring in two months.

If you have less than $5,000 to invest, use the Easy Pie Variation of the 10K   Strategy (see Appendix A).   3)   Make adjustments during expiration week.

a) Buy back all in-the-money options and sell the next-month out at-the-money option.  If the option is about $1 in the money, it can usually be rolled over to the next month at one strike higher for a small credit or debit.

b) If the time premium of an at-the-money option is less than the weekly average time premium of the next-month out option, buy back the soon-to-expire option and sell the next month out option at the same strike as a credit spread.

c) Sell any long-term options that are 8% away from the price of the stock. (This means that if the stock is at $35, you will sell any longer-term options you own at the 32 or less strikes, or at strikes 38 and above).

d) Take any cash you receive from the above sales, and put on as many spreads as you can, maintaining the original ratios of 10 at-the-money spreads, 10 spreads at one strike higher, and 5 spreads at one strike higher (although you may have decided not to sell options against this final position).        

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The important measure here is the strike prices of the short-term options you are selling rather than the strike prices of the longer-term options you own.  Your long positions may be a combination of at-the-money options and in-the-money options at two different strikes (but not three, because it would then be 8% away from the stock, and a candidate for selling).

e) Buy back expiring out-of-the-money options and sell next-month options in their place unless you believe that the market is in for a rise (in which case, let the expiring options go out worthless, and sell new options during the next week once the market has gone up).

f) If you are following the Easy Pie variation, see Appendix C for expiration week adjustments.

  4)  Trading Rules 

a) Longer-term options are sold only when one of the following is true:The strike price is 8% higher or lower than the price of the stock, or

There are only two months until expiration.

b) When the remaining decay (per week) of a soon-to-expire option is less than the average weekly decay of the next-month-out option that you intend to sell, it is time to roll over the short position to the next month.

c) Do not sell an option for less than $.50.  If the next-month option you want to sell is less than $.50, sell the two-month out option instead.

d) A good cash management technique is to trade out of (buy back) soon-to-expire options at the highest strike first (since they are the cheapest), and sell the next-month options. This should provide enough cash to buy back more expensive expiring options, and then selling the new month for those as well. 

e) If you have expiring at-the-money options (and you do not wish to buy them back on expiration Friday), place a “buy to close at the market on the close” order.  This will get you the final price of the day (usually with no more than $.05 time premium).

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f) Do not make mid-month adjustments.  With calendar spreads such as the 10K Strategy employs, such adjustments always come at the wrong time (you sell options when the market is down, and buy when it is high in an effort to balance your net delta).  There is a greater chance that the market will reverse direction after a sudden move than it is to continue moving in that same direction.

g) When placing trades in QQQ, if the bid/asked price is only $.05, (or $.10 for options over $3.00), do not try to do better than buying at the asked and selling at the bid.  (Better prices are usually available through Auto-Trade because large collective orders are placed with market-makers, and 2 ½ cents spreads are often possible instead of the minimum $.05 for public orders). Trying to leg into positions at better prices occasionally results in big losses, and is not worth the risk when bid/asked spreads are so small.

  Note: It is not always possible to follow these rules precisely.  Rather, they should be used as a guide for putting on and taking off positions.

The “Lazy Way” Strategy to Double Your Cash Investment in Two Years

This strategy will double your cash investment (or more) in two years if, at the end of the two-year period, any of the following is true:

1. The stock stays the same

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2. The stock falls by less that 5%3. The stock goes up by any amount.

In most cases, the stock can fall as much as 30%, and you will still make a profit. One nice thing about this strategy is that you can calculate your profits before you make the investment, and the profits are guaranteed mathematically before you invest, as long as one of the three above results are true. The profit will be exactly the same, regardless of which of the three above results take place.

The one shortcoming to this system, and it is a major one, is that it involves the use of margin. Normally, I would not advise people to use margin. It’s a dangerous double-edged sword – wonderful when your stock is going up, but devastating when the stock is falling. However, under my “Lazy Way” Strategy, I think using margin is prudent because you are simultaneously protecting yourself against a 30% or 40% drop in the value of your stock. When you simply buy stock, you do not enjoy any downside protection.

In the great market declines of 2000 and 2001, we saw many technology, tele-communications, and Internet stocks fall by more than 40%. Clearly, the “Lazy Way” system would not have yielded a profit during those times. Anyone who owned these stocks lost money as well. The “Lazy Way” Strategy would have only covered the first 40% or so of the drop. Still, that would have been some consolation.

If an investor had put on a “Lazy Way” position in early 1999, the gains in 1999 would have partly or fully offset the losses of 2000, and many stocks would still have yielded a 100% gain for the period.

Using the “Lazy Way” Strategy may results in you getting a margin call. If, during the 2-year period, the stock falls 20% or so below your original purchase price, your broker may ask you to put more money in the account (or sell something). You want to avoid margin calls at all costs. If you get one, you may be forced to liquidate some positions at absolutely the worst time – when the stock is at its lowest.

You will not get a margin call if you have other securities in your account that the broker can look to for collateral. Because margin calls are so nasty, I believe that you should only invest a small portion of your money in this strategy. The rest of your invested money can be in the conventional

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(non-margined) manner. That way, margin calls on the “Lazy Way” investment will never occur.

The risk of a margin call is not nearly as bad as not being able to get margin at all. If your stock falls below $5, many brokers will not loan you anything at all on your stock. (Some brokers will make margin loans as long as the stock is above $4.) For this reason, it is better to stay away from those stocks selling below $10.

A final caveat here – many mutual funds will not own securities selling below $10, and will unload them when the price falls below that number. This lends further argument to choosing the higher-priced securities, assuming your analysis of their future prospects is favorable.

In summary, if you plan to use the “Lazy Way” Strategy, do it with only a small portion of your money, and choose the higher-priced stocks whenever possible. Margin is dangerous, even if you have partially hedged yourself on the downside by selling LEAPS against your stock.

The possibility of a margin call is why I believe that the 10K Strategy to Make 100% Every Year is a better alternative, although it does require considerably more work. This strategy uses call LEAPS as the leveraged long position instead of a margin loan.

The “Lazy Way” Strategy involves buying the stock of your choice on the open market, and then selling a call LEAP with the longest possible time available, at a strike price just below the price of the stock. For the companies for which the “Lazy Way” Strategy works, this LEAP can be sold for at least 30% of the cost of the stock. (That is where you get the 30% or so downside protection).

Your broker loans you 50% of the cost of the stock, and then deducts the proceeds from your sale of the call LEAP. The net result is that you put up a very small amount of your own money to put on the position. (In some rare instances, you don’t have to put up a single cent, although you will pay out deductible interest over the period).

The tables below list 21 companies whose call LEAP prices are sufficiently high to net you at least a 100% return on your cash investment in two

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years. For each company, I have shown the results that will occur if you purchased 1000 shares of the company stock.

For the first stock below, Sample Company (ABCD), 1000 shares at a recent $12.77 per share would cost $12,780, including the $10 commission that a typical discount broker would charge for a limit order. The broker will lend you 50% of this with a margin loan of $6,380. Then you would sell 10 ABCD Jan06 12.50 calls (YAIAV) for $4000 ($400 each). (The LEAP price I use for these calculations is the bid price on the day I created the table – you can usually sell these LEAPS at a slightly better price).

The proceeds of the LEAP sale, after commissions, are $3,985. This amount is deducted from the amount that you have to put up for this position, resulting in an initial investment of $2,405.

Over the term of holding these positions (26 months), interest will accrue on the $6,380 margin loan. Once again, I have used a typical discount broker’s margin interest rate (4% at this time).

If we add the initial cash investment of $2,405 and the margin interest of $468, the resulting adjusted investment is $2,837. On the third Friday in January 2006, when the LEAP expires, if the price of the stock is at least $12.50, your stock will be called away, and you will receive exactly $12,500 for your shares. After you pay the broker back the $6,380 margin loan, you will be left with $6,120 in your account.

If you subtract your adjusted investment of $2,837 from the $6,120, you will arrive at your profit of $3,283 for the period, or 113% on your investment for 26 months. Pro-rated for the 2-year period, this works out to 123% for two years.

The margin interest of $468 over the 26-month period can be deducted as business interest on your tax return. Since this money is paid out over two years, the net present value of your initial investment is actually less than the adjusted investment figures that we have used here. (I will discuss the total tax implications later.)

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1. Name of Stock

Sample

Calpine

Corp

Rambus

Inc

Human Genom

eMedare

x PMCSierra

CeleraGenomic

s

Stock Symbol ABCD CPN RMBS HGSI MEDX PMC

S CRAPrice of Stock $12.77 $5.36 $31.91 $12.77 $8.78 $20.09 $14.35

Cost of 1000 shares, w/ $10 commission

$12,770 $5,360 $31,910 $12,770 $8,780 $20,090 $14,350

Margin Loan From Broker

$6,380 $2,680 $15,950 $6,380 $4385 $10,045 $7,170

LEAP to Sell YAIAV YLNAA WWOAF YAIAV YUIAU YMLAD YAWAV

Months to Expiration 22 22 22 22 22 22 22

Strike Price Of LEAP $12.50 $5.00 $30.00 $12.50 $7.50 $20 $12.50

Selling Price Of LEAP $4.00 $2.20 $12.20 $4.00 $3.70 $6.15 $5.05

LEAP Proceeds After Commission

$3,985 $2,185 $12,185 $3,985 $3,685 $6,135 $5,035

Initial Investment $2,405 $ 495 $3,775 $2,405 $ 710 $3,910 $2,145

Margin Interest Over Period

$ 468 $ 197 $1,170 $489 $ 322 $ 737 $ 526

Adjusted Investment

$2,873 $ 692 $4,945 $2,894 $1,032 $4,647 $2,671

Profit if Ending Price Above Strike

$3,247 $1,628 $9,105 $3,226 $2,083 $5,308 $2,659

Profit as % ofAdjusted Investment

113% 235% 184% 111% 202% 114% 100%

Two YearProfit % 123% 256% 201% 121% 220% 124% 109%

Percent Stock Can Fall Before Loss

28% 37% 34% 28% 38% 28% 32%

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Results

2. Name of Stock

Sandisk PMCSierra

LSILogic

BroadcomCorp

EmulexCorp

Network Appl

AdvMicroDevice

Stock Symbol SNDK PMCS LSI BRCM ELX NTAP AMD

Price of Stock $27.96 $20.08 $10.15 $40.63 $25.03 $21.61 $15.03

Cost of 1000 shares, w/ $10 commission

$27,960 $20,080 $10,150 $40,370 $24,030 $21,610 $14,880

Margin Loan From Broker $13,975 $10,035 $5,070 $20,185 $12,010 $10,800 $7,435

LEAP to Sell YSDAE YMLAD WDVAB WGJAH YKFAX YHFAD WVVAS

Months to Expiration 22 22 22 22 22 22 22

Strike Price Of LEAP $25.00 $20.00 $10.00 $40.00 $22.50 $20 $15.00

Selling Price Of LEAP $9.50 $6.15 $3.00 $11.35 $7.45 $7.00 $5.55

LEAP Proceeds After Commission

$9,485 $6,135 $2,985 $11,335 $7,435 $6,985 $5,535

Initial Investment $4,500 $3,910 $2,095 $8,850 $4,585 $3,825 $1,910

Margin Interest Over Period $1,025 $ 736 $ 372 $1,480 $ 881 $ 792 $ 545

Adjusted Investment $5,525 $4,646 $2,467 $10,330 $5,466 $4,617 $2,455

Profit if Ending Price Above Strike Price

$5,500 $5,319 $2,463 $9,485 $5,024 $4,583 $5,110

Profit as % of Adjusted Investment

100% 114% 100% 92% 92% 99% 208%

Two Year Profit % 109% 124% 109% 100% 100% 108% 227%

Percent Stock Can Fall Before Loss Results

31% 28% 27% 25% 27% 29% 33%

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3. Name of Stock

SiriusSatellite

XMSatellite

CypressSemi

ESSTech

OSIPharm

RFMicro Siebel

Systms

Stock Symbol SIRI XMSR CY ESST OSIP RFMD SEBL

Price of Stock $2.96 $25.31 $14.34 $15.83 $33.10 $9.40 $13.08

Cost of 1000 shares, w/ $10 commission

$2,960 $25,310 $14,340 $15,830 $33,100 $9,400 $13,080

Margin Loan From Broker $1,475 $12,650 $7,165 $7,910 $16,550 $4,700 $6,540

LEAP to Sell YFWAZ YLXAE YAWAV WEYAC YIJAF YTZAU YDSAV

Months to Expiration 22 22 22 22 22 22 22

Strike Price Of LEAP $2.50 $25.00 $12.50 $15 $30 $7.50 $12.50

Selling Price Of LEAP $1.50 $7.70 $4.95 $4.85 $11.90 $3.75 $3.95

LEAP Proceeds After Commission $1,485 $7,685 $4,935 $4,835 $11,885 $3,735 $3,935

Initial Investment $ 0 $4,975 $2,240 $3,085 $4,665 $ 965 $2,605

Margin Interest Over Period $ 108 $ 928 $ 525 $ 580 $1,214 $ 345 $ 480

Adjusted Investment $ 108 $5,903 $2,765 $3,665 $5,879 $1,310 $3,085

Profit if Ending Price Above Strike

$ 917 $6,447 $2,570 $3,425 $7,571 $1,490 $2,875

Profit as % of Adjusted Investment

849% 109% 93% 93% 129% 114% 93%

Two YearProfit % 926% 119% 101% 101% 141% 124% 101%

Percent Stock Can Fall Before Loss Results

46% 27% 31% 28% 32% 36% 27%

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Tax Implications of the “Lazy Way” Strategy

LEAPS all expire in the month of January. This is a convenient time, because any taxes that accrue will not have to be paid until April of the following year.

It is impossible to determine in advance what the taxes will be on your “Lazy Way” investment. It will depend on what the price of the stock is at the end of the LEAP expiration, and what you decide to do with your stock at that time. Let’s look at the possibilities:

1. The stock falls by 20%a. The gain of the LEAP you sold will be 100% profit, and taxed as

a short-term capital gain (long-term capital gains are not allowed for short sales, even if you hold them for over a year).

b. If you sell the stock, you will have a long-term capital loss to help offset the short-term capital gain on the LEAP sales.

2. The stock stays the samea. Choice #1 – You buy back the LEAP for the small amount of

original intrinsic value (in the ABCD example on page 29, if the stock stayed the same, it would be $12.77 at the end of the LEAP period, so the value of the expiring call at the $12.50 strike price would be $.27). You would have a short-term capital gain on the difference between what you sold the LEAP for ($4.00) and what you bought it back for ($.27). The total taxable gain for 10 LEAPS would be $3,730. There would be no tax due on the stock whether you sold it or not, because the price is the same as when you bought it.

b. Choice #2 – You do nothing, and let the option get exercised. You lose your stock. The tax implications are exactly the same as Choice #1.

3. The stock goes up by 20%a. Choice #1 – You buy back the LEAP and avoid losing your

stock. There will be a small short-term capital gain on the LEAP – in the above example, the stock would be selling at $15.32, and you would have to pay $2.82 for the expiring LEAP compared to the $4.00 you originally sold it for (a profit of

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$1.18, or $1,180 on 10 LEAPS). If you don’t sell your stock, you have a 20% gain on paper, but no tax to pay.

b. Choice #2 – You do nothing. The holder of the LEAP you sold will exercise his option, and take your stock. The stock you bought for $12.77 will be sold for $12.50, netting you a $220 long-term loss, while the entire proceeds of your original LEAP sale ($4,000) will be a short-term capital gain. Clearly tax considerations would dictate that you buy back the expiring call rather than doing nothing.

4. The stock goes up by 50%a. Choice #1 – You buy back the expiring option at a loss and

keep your stock. In the above example, the stock would be $19.16, and the 12.50 call LEAP you sold would cost you $6.66 to buy back vs. the $4.00 you originally sold it for (short-term capital loss = $2,660). From a taxation viewpoint, this is the best of all possible worlds. You have a tax loss, while making a large (paper) gain on your stock.

b. Choice #2 – You do nothing. The tax implications are identical to Choice #2 above, when the stock went up by 20%.

Of course, you understand that this brief discussion of tax implications is being made by someone who is not a tax adviser, qualified or not, of any sort. You should consult a real tax advisor before relying on anything I have said.

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The Reach For The Stars Strategy

This is an options strategy designed to maximize your gains if there is a stock out there that you strongly believe is going to go up dramatically sometime in the next two years. If you are right, you will earn 400% or so more than you would have made if you had just bought stock in that company.

This is the only strategy at Terry’s Tips where significant profits will come only if the stock goes up a lot. All the other strategies work very well if the stock stays the same, goes up, or moves only slightly down.

I recommend that only a small portion of your portfolio be devoted to the Reach For the Stars Strategy. This is your risky bet – your lottery ticket. There’s only a small chance that the average person (or professional fund manager) can pick a stock that will double in the next two years. If you can do it, you deserve a big payoff.

Just in case you are wrong, and the stock doesn’t fly, this strategy is set up to get your money back so that you don’t lose anything. If the stock falls a lot, quickly, you will lose money, just like you would have if you owned the stock. However, if it falls slowly, or just a little, you should be able to get your initial investment back with no loss whatsoever.

Implementing the Reach For The Stars Strategy

1. Buy the longest term call LEAP possible at the strike price nearest the current stock price.

2. Calculate the monthly decay the LEAP will experience over the time period if the stock stays at the same price.

3. Each month, sell only enough out-of-the-money calls to bring in sufficient premium to cover the monthly decay calculated above.

Let’s use an example. Many analysts have predicted a resurgence of the tech market, and have speculated that they expect Veritas Software (VRTS) to double in a year or so. A year ago, Veritas was selling at 4 times what it is as I write this ($16.80), and is still a good company in many people’s estimation. It probably won’t double in value, but it might. If it

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doesn’t, this strategy may allow you to break even. If the stock does fly, you could make 400% or 500% on your investment.

With VRTS selling at $16.80, you could buy the January 2005 call LEAP at the 15 strike price. The January 2005 15 call (XQPAC) could be bought for $8.10. Let’s say you bought 10 of the 2005 15 calls, for a total cost of $8100. Since this call is slightly in-the-money, the intrinsic value of the LEAP is $1.80 (16.80 – 15.00), the time premium (decay) is $6.30 ($8.10 – 1.80), and the average monthly decay is $6300/26 = $242 per month over the 26 remaining months. So we need to sell at least $242 in time premium each month for the entire 26 months to get our money back in case the stock does not go up.

Remember, with this strategy, we are not trying to make money from selling the short-term calls. We are betting on the stock going up strongly. We are only selling the minimum out-of-the-money calls to get our investment back just in case we’re wrong about VRTS.

A check of the market for out-of-the-money calls for VRTS reveals these bid prices:

Dec 17.50 call - $1.30 (5 weeks to expiration)Jan 17.50 call - $1.95 (9 weeks to expiration)

To decide which of these calls to sell, use:

Trading Rule #11: When selling out-of-the-money calls, if the premium for a two-month out call is more than twice as great as the premium for the one-month out call, sell the two-month out call. This gains you more money per month than the one-month call, and you get your money now so it can be put to use on some other investment.

In order to get our $242 per month back, we would sell 2 Dec 17.50 calls, collecting $250 after commissions. That would leave us 8 calls uncovered, so we would enjoy an $800 gain for every dollar the stock goes up.

Since the Jan 17.50 is less than double the Dec 17.50 call, we would not sell it. Better to wait (if the stock stays the same) and collect $1.30 or more in a month.

In the event that we have to shell out money to buy back calls that we sold earlier, the full amount of this cost must be added to the remaining decay to

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determine how much must be received in premiums each month. In the VRTS example, if the stock increased in value to $20.00 by the June expiration, and we had sold 2 Dec 17.50 calls, we would have to pay $2.50 each, or $530 including commissions to buy back these calls. The total decay we need to cover each month is now $263 ($6300 original decay plus $530, less the $250 we received divided by 25 remaining months).

If you do have to buy back calls you sold, you do it with a smile on your face – you have made good money on the increase in the value of the stock, many times greater than the small amount you lost by buying those calls back.

If VRTS did manage to double in value over two years (to $33.60), and you got back all the premium you paid for the LEAPS in the first place, you would have an investment that cost you $1800 (the original intrinsic value), and the new value of your LEAPS would be $18.60, or $18,600 for the 10 LEAPS, a profit of over 10 times your cost. Your average investment over the twenty-six month period would have been about $5000, since you got back some of the original investment each month. This means that your profit of $16,800 on an average investment of $5000 yielded you a 336% profit.

If you had bought $8100 worth of stock instead of the LEAPS, you would have bought 482 shares, and made a profit of $8,100, or 100% on your investment.

Note: I wrote the above narrative in November, 2002. One year later, VRTS had indeed more than doubled in value, and a profit of over 400% could have been made with this strategy (the LEAP still had a full year before it expired).

In summary, the Reach For the Stars Strategy is appropriate for a very small part of your portfolio. It is your mad money. It’s speculative. It can spice up your life with the hopes of an extraordinary pay-off, and with luck, if you are wrong, you may get your money back as well.

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The Cover Your Butt Strategy

When you buy a stock, you do so in hopes that the price will go up over time. If it does, you are happy. If it doesn’t, oh well, we’ve all been there.

Unfortunately, all stocks don’t go up all the time. Some stocks not only don’t go up, they don’t stay the same, either. They actually go down! Ouch! In a perfect world, it would be against the law to buy such stocks. But so far, we haven’t figured out how to create that perfect world.

No one is happy when his/her stock goes down, unless, of course, he or she had earlier bought some insurance. The Cover Your Butt Strategy is a form of insurance. It costs you money if the stock you buy goes up, as you hoped it would when you bought it. But if your stock stays about the same, or goes down, you can actually make a nice profit on your insurance purchase.

The Cover Your Butt Strategy is designed to be used in conjunction with the three other strategies in Terry’s Tips (all of which do best if the stock continues in the market direction it has been going). In the event that you believe the stock is headed south, you could put on this strategy not as insurance, but as a profit-making device in the event that the stock does, indeed, go down.

For those times when you get skittish, and fear a big market drop is in the cards, the Cover Your Butt Strategy is the insurance policy for you. It will only cost you money if the stock goes up dramatically. (In that case, you should have made so much money on your other investments that you can afford a small insurance expense).

The greatest thing about the Cover Your Butt Strategy is that if nothing happens (i.e., your stock stays about the same), you will make a nice profit on the insurance investment. This is a far better deal than you get from most forms of insurance.

Putting the Cover Your Butt Strategy To Work

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Each month, you will have cash coming into your account from selling short-term calls if you are following any of my strategies except the “Lazy Way” Strategy, (which involves making two trades and waiting two years). For the other two strategies, if you are concerned about your stock falling, you:

1. Use the money that you take in from selling calls to buy as many LEAP puts (not calls) as you can at one strike price lower than the current stock price. Buy put LEAPS that expire in one year rather than two years.

2. Each month, follow the same Trading Rules as the 10K Strategy, only you’ll be selling puts rather than calls. This involves selling half the number of puts you are allowed for the next month (selecting the strike price that yields the greatest time premium). Wait until the 6th day of the next month, and sell the other half of the puts at the strike that has the largest time premium at that time.

3. If expiring puts are in-the-money, buy them back at expiration, and sell the next lower strike price puts for the next month’s expiration. Use Trading Rules #1 and #2, except you will be selling puts for the next month rather than calls.

This is the only strategy where we use puts rather than calls (unless the market is in an Amber or Red Mode. Think of puts as just the opposite of calls. Puts increase in value as the stock falls, while calls increase in value only if the stock rises. When you sell an out-of-the-money put, you are selling at a strike price that is lower than the stock price. When you sell an out-of-the-money call, you are selling at a price that is higher than the stock price.

Let’s use an example. You originally bought a call LEAP with a strike price of $40 while the stock was selling at $42 (which is how you would start if you were using the 10K Strategy). The stock falls to $38 by the next month’s expiration, and you are fearful that it might fall further.

Since the stock price is below your strike price, according to Trading Rule #1 Postscript, you would sell ¾ of the calls for the next month that you are allowed at the 40 strike price. You would then buy as many of the one-

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year-out 35 put LEAPS as you can, and sell half as many 35 puts for the next month according to Trading Rule #1.

Remember to count the revenue you will receive from selling those puts when you calculate how many put LEAPS you can afford to buy. Of course, if you are really concerned about the downside, you might put additional money in, and buy as many put LEAPS as you have call LEAPS, dramatically increasing your downside protection.

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Tax Implications of Options Trading

The following report was sent to me by a CPA (and corroborated by another). I am not a tax advisor, so any further questions should be addressed to your own advisor.

BUYING A CALL

IF CALL EXERCISED – The premium paid for the option is added to the price of the stock and is part of the basis. The holding period of the stock begins at the date of exercise.

IF CALL EXPIRES WORTHLESS – The option is considered as having been sold for a price of zero on expiration day. Hence, if the option has been held for less than a year, the price paid for the option is the basis and the net result is a short-term capital loss in the amount of the premium paid. If the option has been held for over a year a long-term capital loss results.

IF CALL IS SOLD PRIOR TO EXPIRATION – The difference between the purchase price and selling price of the option is a capital gain or loss, depending on the holding period.

SELLING A CALL

IF CALL EXERCISED – The premium received for the option is added to the price received on the sale of the stock. This adjusted selling price of the stock is compared to the taxpayer’s basis for the purpose of computing the net capital gain or loss on the stock. Thus, where the stock has been held for longer than a year, the premium previously received on the call increases the long-term capital gain.

IF CALL EXPIRES WORTHLESS – The option is considered as having been purchased for a price of zero on expiration day. It is always a short-term capital gain equal to the premium received for the option. The gain is recognized at the time of expiration.

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IF CALL IS PURCHASED BACK PRIOR TO EXPIRATION – The difference between the purchase price and selling price of the call option is a capital gain or loss. It is always a short-term capital gain or loss.

BUYING A PUT

IF PUT EXERCISED – The premium paid for the option is subtracted from the selling price you receive when you, as the holder of the put, exercise the put option and sell the stock. Thus the adjusted selling price of the stock is compared to the taxpayer’s basis for purpose of computing the net capital gain or loss. It is a long or short term capital gain or loss depending on the length of time the stock has been held. However, if a taxpayer owns a stock and subsequently purchases a put to sell such stock, the time that the put is held is not considered part of the holding period for the purpose of determining long or short term.

IF PUT EXPIRES WORTHLESS – The option is considered as

having been sold for a price of zero on expiration day. Hence, if the option has been held for less than a year, the price paid for the option is the basis and the net result is a short-term capital loss in the amount of the premium paid. If the option has been held for over a year, a long-term capital loss results.

IF PUT IS SOLD PRIOR TO EXPIRATION – The difference between the purchase price and selling price of the option is a capital gain or loss, depending on the holding period.

SELLING A PUT

IF PUT EXERCISED – The premium received on the put option is subtracted from the price paid for the stock. Thus the adjusted basis of the stock is the price you have to pay for the stock (the strike price) less the premium you previously received when you sold the put. The holding period of the stock begins at the date of exercise. (Thus, even though the taxpayer received the premium in cash at the time the put was sold, the effect of this is that it is not taxable until the stock is actually sold.)

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IF PUT EXPIRES WORTHLESS – The option is considered as having been purchased for a price of zero on expiration day. It is always a short-term capital gain equal to the premium received for the option. The gain is recognized at the time of expiration.

IF PUT IS PURCHASED BACK PRIOR TO EXPIRATION – The difference between the purchase price and selling price of the option is a capital gain or loss. It is always a short-term capital gain or loss.

IMPORTANT NOTE: The outline above does not apply to such securities as regulated futures contracts or as options on index stocks, such as QQQ and DIA. These are referred to as Section 1256 Assets and receive special treatment. Generally, this means that (1) all gains and losses are 40% short-term capital gain (or loss) and 60% long-term capital gain (or loss), irrespective of the holding period, and (2) such securities are marked to market as of the last day of the taxable year. Simply stated, the mark to market rule means that for income tax purposes all open positions on this security are considered as having been closed on the last day of the taxable year at the year-end closing price, and immediately reopened on the first day of the New Year at the same price.

Section 1256 transactions are reported on Form 6781.

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Appendix A: Easy Pie Strategy

Several Terry's Tips Insiders have asked for a less complicated options strategy. The following trading rules are appropriate if the market is in a Green Mode (stock trading above both it’s 90-day and 200-day moving averages). 

1. Purchase at-the-money call options, choosing the options which expire six or eight months out.

2. Sell the next month at-the-money call option.  For every 10 long-term calls you own, sell 7 short-term options if the strike is slightly in the money, or sell 8 short-term options if the strike is out-of-the-money.  For example, if you were selling next-month 35 options when the stock price was $35.20, you would sell 7 for every 10 long-term calls you owned, while if the stock were $34.80, you would sell 8 next-month calls.

3. Do nothing else until expiration.

4. At expiration, buy back any in-the-money expiring calls and let out-of-the -money calls expire worthless.  If the stock is within $.25 of the strike price of an expiring option, place a “buy at the market close to close” order to buy back the calls.

5. At expiration, if the stock price is within 8% of the strike price of your long-term calls, go to # 2 above.  Take any cash you generate from these new sales, and put on new positions as if you were starting at #1.

6. At expiration, If the stock price is more than 8% above or below the strike price of the first long-term calls you bought, close them out (sell them) and start over at #1 above.

Most months, the Easy Pie Strategy will make a profit.  Only when the market falls by 5% or more should there be a significant loss (and that only happens about twice a year when the market is in a Green Mode). 

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The Easy Pie Strategy usually involves making only a couple of trades at or near expiration day each month.  There is no need to worry about delta values or the other Greeks.  It is a good way to get your option feet wet without taking a bath.  

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