Monthly cash machine powerful strategies for selling options in bull and bear markets

If you buy a call “if you are long a call”, you are betting that the stock willmove up in price.. If you sell a call “if you are short a call”, you are betting that the stock willstay ro

Monthly Cash Machine

Powerful Strategies for Selling Options in Bull and

Bear Markets Matthew R Kratter

www.trader.university

Copyright © 2016 by Little Cash Machines LLCAll rights reserved No part of this book may be reproduced in any formwithout written permission from the author (matt@trader.university).Reviewers may quote brief passages in reviews.

Neither Little Cash Machines LLC, nor any of its directors, officers,

shareholders, personnel, representatives, agents, or independent contractors(collectively, the “Operator Parties”) are licensed financial advisers,

registered investment advisers, or registered broker-dealers None of theOperator Parties are providing investment, financial, legal, or tax advice, andnothing in this book or at www.Trader.University (henceforth, “the Site”)should be construed as such by you This book and the Site should be used aseducational tools only and are not replacements for professional investmentadvice The full disclaimer can be found at the end of this book

Table of Contents

Chapter 1: The Power of Monthly Cash Flow

Chapter 2: How to Trap a Stock in a Box

Chapter 3: How to Take Wing with Iron CondorsChapter 4: Selling Spreads for Profits

Chapter 5: Financial Freedom and Monthly Cash FlowKeep Learning With These Trading Books

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Chapter 1: The Power of Monthly Cash Flow

back to top

Once upon a time, there was a man who traded stocks

One day he bought a stock, and it went up

That made him happy

So he sold the stock

But then the stock kept going up

Now he was sad

So he bought another stock

But that stock went down

Now he was sad

“Why did I ever buy that stock?” he wondered

So he bought another stock

But that stock just sat there and did nothing

Now he was tired

“I am tired of having to know when a stock will go up, and when astock will go down,” he said

When you buy a stock, there are 5 different things that can happen:

1 The stock can go up a lot

2 The stock can go up a little

3 The stock can do nothing (“trade sideways”)

4 The stock can go down a little

5 The stock can go down a lot

The best scenario occurs when you are correctly positioned for a large move:

• You buy a stock, and it immediately goes up a lot (#1 above)

• You short a stock, and it immediately goes down a lot (#5 above)

In both cases, you can lock in your profits, having captured the bulk of themove.

But even if you are a professional trader, capturing these large quick movescan be quite difficult

The worst scenario occurs more frequently, especially for amateur traders(and the chronically unlucky):

You buy a stock, and it immediately goes down a lot (#5 above)

Or, you short a stock, and it immediately goes up a lot (#1 above)

The middle scenario is the most common You buy a stock and it moves up alittle, down a little, or just trades sideways (#2, #3, and #4 above)

Being in such a stock can be like watching paint dry

And not only is it boring, but it is also expensive

Time is money If you are stuck in a stock that is not moving, there is a realopportunity cost You could have instead had your money in a stock that wasmoving, or in a CD that was earning interest

We can see that it is often difficult to know whether a given stock will go up

or down And it costs us money if we are in a stock that moves the wrongway—or doesn’t move at all

So what is a trader to do?

I had been trading for many years before I realized that it was possible tomake a lot of money from a stock that was doing pretty much nothing

But how is this possible?

Isn’t a dead stock the complete opposite of a red-hot stock?

And whoever signed up for a stock newsletter about stocks that are about to

do nothing?

Yet, as it turns out, there is a market that is willing to pay you big dollars for

just these kinds of stocks.

That market is the options market

You see, there are two types of people in the options market: the insured, andthe insurers

The insured are those who need to buy insurance Maybe you own a largeblock of stock, and want to make sure that for the next year, you will always

be able to sell that stock at 100 or higher

So you use the options market to take out an insurance policy to protect

yourself

Most people think like the insured We are all used to writing big checks toinsurance companies for our cars and homes

What we are not used to is being on the receiving side of those checks

When you are an insurance company (insurer), you get used to people givingyou money

Every once in a while, you might need to pay out a claim

But most of the time, you just smile to yourself on the way to the bank andcash the checks

This book will teach you how to set up your own personal “insurance

company” in the options market

You will learn how to think like an insurer

You will learn how to evaluate a given situation and weigh the risks againstthe rewards

And in the process, you will learn how to turn boring stocks into big monthly(or even weekly) paychecks

This book will teach you everything you need to know in order to

successfully sell options for money, even if you have never traded options

The next couple of chapters may make your head hurt a little at times, butstick with me Once you get the hang of it, you will be able to quickly

evaluate the risk/reward of an options position

Selling options will become second nature to you

In the meantime, get out a pen and paper, and take some notes If you getstuck, I’m always here to answer your questions: email me at

matt@trader.university I always enjoy hearing from my readers

It’s time to make some money the smart and easy way—so let’s get started!

Chapter 2: How to Trap a Stock in a Box

back to top

Many options trading books begin with advanced theory, and a lot of jargonabout credit spreads, gamma, vega, etc

We’ll take an easier route and begin with a practical example

In the process, we will reinvent something called “iron condors” from theground up There’s no better way to understand a trading strategy than tobuild it yourself, brick by brick

So let’s get started

Suppose that you come across a stock (“XYZ”) that has the following

characteristic: it has been stuck in a range between 110 and 120 for the lastsix months

And let us further suppose that there is a real-world reason (as there often is)for this range-bound behavior:

The management team (CEO, COO, etc.) are heavy sellers of XYZ around

120 And they own a lot of stock, so we can reasonably assume that they willcontinue to unload their positions over the next few months

And there is a large institutional investor (a value investing hedge fund) that

is accumulating XYZ around 110

Because of these large players at either end, XYZ has been forced to trade in

a range between 110 and 120

There are a few different ways to profit from a situation like this, especially if

we believe that the sellers will keep selling around 120 (perhaps they stillown many shares, and have been consistent monthly sellers) And if we

believe that the hedge fund buyer will keep buying around 110 (perhaps inthe reported filings, it is still a small position relative to the assets under

management, so we can assume that they will continue to scale it up)

One could simply wait until XYZ traded close to 111 or so, and then buysome shares, knowing that there was reasonably strong support for the stockprovided by the hedge fund at 110.

As XYZ got close to 120, one could sell off these shares for a profit

(preferably in the 118-119 range, so as not to compete with the insider sellingaround 120)

If one wanted to get fancy, one could then sell short some shares around 119,and cover the short when the stock fell back down to 111 or so

And, theoretically, one could play this range again and again, making

multiple round-trips In theory, one could make quite a bit of money

Unfortunately, the real-world does not always respect the theory

For example, what if XYZ decided to just hang out around 115 and do

nothing? Then we would be stuck We could sell the shares that we bought at

111 for a profit, but we would be unable to reload our position until the stockgot back down to 111

In the meantime, we’re back to watching paint dry

So we decide to structure our own special little trade, with the stock justsitting there at 115 (let’s pretend that today is January 21)

We’re reasonably certain that the stock will not trade above 120 for any

significant length of time, because of the aggressive insider sellers at 120 Ifthe stock trades above 120, they will probably accelerate their stock salesuntil the stock is driven back below 120

Because of this, we are comfortable selling (“sell to open” is the order typethat you should use with your broker) 10 XYZ Mar 120 calls at 1.40

Let’s first review some basic options terminology

A “call option” (or just a “call”) is a contract that gives you the right to buy astock at a certain price, over a certain period of time, until the option expires

If you own a call option (“are long a call”), you have the right to buy the

stock, but you don't have to buy the stock

So, for example, let’s look at the XYZ Mar 120 calls that we are interested inselling.

“XYZ” is simply the ticker of the underlying stock, in this case a made-upcompany that we will call “The XYZ Corporation.”

“Mar” is short for “March,” which is the option’s “expiration date.” This isthe month when the options contract expires Expiration usually occurs at theend of the day on the 3rd Friday of the month (let’s say it’s March 18 thisyear) At expiration, the contract goes away forever

“120” is the “strike price”: this is the price at which the owner of the calloption has the right to purchase the stock (or “call it away” from its owner,hence the name “call”)

If you buy a call (“if you are long a call”), you are betting that the stock willmove up in price

If you sell a call (“if you are short a call”), you are betting that the stock willstay roughly where it is, or move down in price

That is why on January 21 (today) we decided to sell ten March call options

on XYZ, with a strike price of 120, when the underlying stock is just sittingthere at 115

Now notice that with options, you can sell something that you don’t alreadyown

We don’t own the March options, but we can sell them anyway, which makes

us “short” the March options

Because we sold something, we were paid some money In this case, we werepaid $1.40 per contract Each call option controls 100 shares of stock, so wewere paid $1.40 times 10 call options times 100 shares of stock per option(1.40 x 10 x 100) equals $1,400 (not counting the commission, which should

be less than $10, if you are using the right options broker)

What happens to these March 120 calls at expiration (on March 18)?

Well, that depends on where the underlying stock XYZ is trading at

expiration If the stock is trading at 120 or below, the options expire

worthless, and we get to keep the $1,400 (again, not counting commissions)

If the stock is trading at 122 at expiration, the 120 call options will be worth

122 minus 120, or 2.00 at expiration 2.00 times 10 call options times 100shares per option equals $2,000 If you are long the call options, they areworth $2,000 at expiration, and you are very happy

But we sold the call options (we are “short” the call options), so they areworth negative $2,000 to us We collected $1,400 when we first sold the calloptions, but now they are worth negative $2,000, so we have essentially lost

$600 ($1,400 minus $2,000)

What if XYZ gets a buyout offer from another company, and XYZ’s stockshoots up to 150 by expiration? Well, then the options are each worth 30 (150minus the strike price of 120 equals 30) 30 times 10 call options times 100shares per option equals negative $30,000, since we are short the call options

We collected $1,400 when we entered the trade, but now they are worth

negative $30,000, so we have lost $28,600

This is obviously a complete disaster!

Always keep in mind that if you sell a call option, and the underlying stockmoves up a lot in price, you can lose a lot of money, and end up having tobuy back the call at a higher price to exit the trade (you can “buy to close”any short option position at any time before expiration, if you so choose) Ifyou are short only a call, it is called a “naked call.” It is a naked call becauseyou are “exposed” to sharp up-moves in the stock

We know that there is heavy insider selling in XYZ at 120, so it seems

unlikely that the stock would receive a buyout offer at 150 in just 2 months

If this were in the cards, the insiders would probably have known about it,and thus not been aggressive sellers of their stock at 120

But, as you know, anything can happen in the markets We need to protectourselves against a nasty move like this when we are short the 120 calls

So, let’s cap our maximum loss by buying 10 XYZ Mar 122 calls at 0.95 (thelatter price is set by the market).

To review, these are call options, whose strike price is 122 and that expire onsame day as our 120 calls, namely the third Friday of March We pay 0.95per options contract, so it costs us 10 contracts times 0.95 per contract times

100 shares per contract, or $950

There is no out-of-pocket cost to us (except a commission of about $10),since we have just received $1,400 by selling the 120 calls

We received $1,400 and paid $950, which gives us a net credit to our account

of $450, or about $430 after commissions

Now let’s see how this has changed our risk profile

If XYZ shoots to 150, our short 120 call position is still worth negative

$30,000 Fortunately, however, our long 122 call position is then worth 28per contract (150 stock price minus the strike price of 122 equals 28) 28 percontract times 10 contracts times 100 shares per contract equals $28,000.Notice that since we are long the 122 call options (we bought the calls, notsold them), this $28,000 is a positive number for us

So we have made $28,000 on our long 122 calls position, and lost $30,000 onour short 120 calls, for a net loss of $2,000 This is certainly much moremanageable than our previous loss of $30,000 when we were short the naked

120 calls

If you do the math, you will see that this combined position can never losemore than $2,000, whether the stock is at 122 or 150 or 1500 The maximumloss starts when the stock is at 122, because at that point the short 120 callsare worth negative $2000, and the long 122 calls are worth zero (122-122equals zero)

The maximum profit of this combined position occurs when the stock is at

120 or below at expiration At that point, the 122 calls will be worthless (wepaid $950 for them), but the 120 calls will also be worthless (we collected

$1,400 when we sold them, and they expired worthless) So again we paid

$950 and were paid $1,400, for a net profit of $450, or $430 after

commissions

When we sold the 120 calls and bought the 122 calls, we were putting on aposition that is called a “vertical spread”—“vertical” because the 2 strikeprices are on top of each other

It is also called a “call spread,” since it is built using call options It is alsoknown as a “bear call spread” (since it makes money if the underlying stockdoes not rally) or “credit call spread,” since our account received net cash (or

a credit) when the position was put on

There is no need to learn all of this fancy terminology upfront, though it maycome in handy if you ever need to talk to your broker over the phone

All you need to know at this point is that we simply constructed a trade thatwould make money if XYZ stayed below 120, and would not lose a ton ofmoney if XYZ went above 120

Now it is time to do something similar to the 110 strike of XYZ

For this leg of the trade, we are going to sell (“sell to open” is the order typethat you should use with your broker) 10 XYZ Mar 110 puts at 1.24 (again,this latter price is set by the options market)

Just as we did with our call options, we must now learn a little terminologyabout put options

A “put option” (or just a “put”) is a contract that gives you the right to sell astock at a certain price, over a certain period of time, until the option expires

If you own a put option (“are long a put”), you have the right to sell the

stock, but you don’t have to

So, for example, let’s look at a XYZ Mar 110 puts

Again, “XYZ” is simply the ticker of the underlying stock, in this case amade-up company that we called “The XYZ Corporation.”

“Mar” is short for “March,” which is the put option’s “expiration date.”

“110” is the “strike price”: this is the price at which the owner of the putoption has the right to sell the stock (or “put it away” on to someone else,hence the name “put”).

If you buy a put (“if you are long a put”), you are betting that the stock willmove down in price

If you sell a put (“if you are short a put”), you are betting that the stock willnot move down in price

We sold the 110 puts, because we believed that the stock XYZ should nottrade below 110 for any significant length of time (over the next 2 months),because of the large institutional buyer who has been accumulating at 110.Because we sold something, we were paid some money In this case, we werepaid $1.24 per contract Each put option controls 100 shares of stock, so wewere paid $1.24 times 10 call options times 100 shares per option (1.24 x 10

x 100) equals $1,240 (again, not counting commissions, which should not bemore than $10 for this trade)

What happens to these March 110 puts at expiration?

Well, that depends on where the underlying stock XYZ is trading at

expiration If the stock is trading at 110 or above, the put options expire

worthless, and we get to keep the $1,240

If the stock is trading at 108 at expiration, the 110 put options will be worth

110 minus 108, or 2.00 at expiration 2.00 times 10 put options times 100shares per option equals $2,000

If you are long the put options and XYZ is at 108 at expiration, the put

options are worth $2,000, and you are very happy

But we sold the put options (we are “short” the put options), so they are

worth negative $2,000 to us We collected $1,240 when we first sold the putoptions, but now they are worth negative $2,000, so we have essentially lost

$760 ($1,240 minus $2,000), not counting our $10 in trading commissions.Now what if XYZ reports corporate accounting irregularities (“Our former

CFO was cooking the books”), and XYZ’s stock immediately plummets to 80and remains there until expiration?

Well, then the put options are each worth 30 (110 strike price minus the stockprice of 80 equals 30) 30 times 10 put options times 100 shares per optionequals negative $30,000, since we are short the put options We collected

$1,240 when we entered the trade, but now they are worth negative $30,000,

so we have lost $28,760

Another complete disaster!

Again, always keep in mind that if you sell a put option, and the underlyingstock moves down a lot in price, you can lose a lot of money, and end uphaving to buy back the put at a higher price to exit the trade (you can “buy toclose” any short option position at any time before expiration, if you so

choose)

If you are short a put option, it is called a “naked put”—again “naked”

because you are “exposed” to sharp down-moves in the stock

We know that there is heavy (probably “smart money”) institutional buying

in XYZ at 110, so it seems unlikely that the stock could report accountingproblems and plummet to just 80 in 2 months If this were obvious, the hedgefund would not have been scooping up stock at 110

Again, as you know, anything can happen in the markets We need to protectourselves against a nasty move like this when we are short the 110 puts

So, let’s cap our maximum loss by buying 10 XYZ Mar 108 puts at 0.77 (thelatter price is, as always, set by the options market)

To review, these are put options, whose strike price is 108 and that expire onsame day as our 110 puts, namely the third Friday of March We pay 0.77 peroptions contract, so it costs us 10 contracts times 0.77 per contract times 100shares per contract, or $770

There is no out-of-pocket cost to us (apart from another $10 commission),since we have just received $1,240 by selling the 110 puts

We received $1,240 and paid $770, which gives us a net credit to our account

of $470, or $450 after commissions

Now let’s see how this has changed our risk profile

If XYZ plummets to 80, our short 110 put position is still worth negative

$30,000 Fortunately, our long 108 put position is now worth 28 per contract(108 strike price minus the stock price of 80 equals 28) 28 per contract times

10 contracts times 100 shares per contract equals $28,000 Notice that since

we are long the 108 put options (we bought the puts, not sold them), this

$28,000 is a positive number for us

So we have made $28,000 on our long 108 puts position, and lost $30,000 onour short 110 puts, for a net loss of $2,000 (plus an additional $20 from

trading commissions) This is certainly much more manageable than ourprevious loss of $30,000 when we were short the naked 110 puts

If you do the math, you will see that this position can never lose more than

$2,000, whether the stock is at 108 or 80 or zero The maximum loss startswhen the stock is at 108, because at that point the short 110 puts are worthnegative $2000, and the long 108 puts are worth zero (108-108 equals zero).The maximum profit of this combined put position occurs when the stock is

at 110 or above at expiration At that point, the 108 puts will be worthless(we paid $770 for them), but the 110 puts will also be worthless (we collected

$1,240 when we sold them, and they expired worthless) So again we paid

$770 and were paid $1,240, for a net profit of $470, or $450 after

commissions

When we sold the 110 puts and bought the 108 puts, we were putting on

another “vertical spread”—“vertical” because the 2 strike prices are on top ofeach other

It is also called a “put spread,” since it is built using put options It is alsoknown as a “bull put spread” (since it makes money if the underlying stockdoes not fall) or “credit put spread,” since our account received net cash (or acredit) when the position was put on

Again, there is no need to learn all of this fancy terminology upfront.

All you need to know at this point is that we simply constructed a trade thatwould make money if XYZ stayed above 110, and would not lose a ton ofmoney if XYZ went below 110

Now let’s take a big step back and look at the overall structure that we havecreated:

1 We sold a 120/122 call spread on XYZ, that will make us $430 aftercommissions, if XYZ is at or below 120 at expiration

2 Then we sold a 108/110 put spread on XYZ, that will make us $450after commissions, if XYZ is at or above 110 at expiration

Taken together, these two positions are—guess what?

An Iron Condor!

In options parlance, we bought 10 XYZ Mar 108/110/120/122 iron condors

In everyday speech, we placed a trade that will make us $880 ($430 plus

$450) if XYZ closes between 110 and 120 at expiration

Our maximum loss will be $1,120 ($880 premium collected minus $2,000lost), if XYZ is at or below 108, or at or above 122 at expiration

So we are risking $1,120 to make $880 That’s a 78% return on capital at risk

—in just 2 months!

If you can do this successfully 6 times a year (i.e every 2 months), you willbring in an extra $5,280 in income every year

At the beginning of this book, we discussed how difficult it is to know where

a stock is going to go

Here, all we needed to know was where a stock was not going to go

If we think that a stock is about to move up sharply, of course we should buythe stock

If we think that a stock is about to move down sharply, of course we shouldshort the stock (or at the very least, not own the stock!).

But if we don’t have a strong opinion about a sharp move coming, we areusually best off doing an iron condor instead, and collecting the $5,280.Let someone else pay for the insurance

We’ll just sit here and collect the checks, like an insurance company does

In the next chapter, we’ll talk more about how and when to trade iron

condors