I’m sure we have all traded a call option that declined in value when the stock was on the rise. I know I have done it many times before I started focusing mostly on option selling strategies. We all know that stocks and options are completely different investment vehicles.

What’s hard about the question above is that a stock’s price is just one of 7 factors that effect the price of an option. And usually this question is asked by newbie options traders, but I’ve seen seasoned pros even mess up. That’s because option pricing is tricky and can be downright confusing without some simple guidelines to follow.

This Is NOT Uncommon

At first it may seem like something is going wrong. You thought the stock would rally and so you bought a call. Now the stock is higher (as you predicted) and yet you’re losing money! What’s going on right?

I can assure you that it’s not uncommon to have this happen. In fact this happens each month to thousands of traders. That’s why knowing the ingredients of stock option pricing is so critical to your success.

So let’s get started…

Stock Price And Strike Price Relationship

This is the most important factor when determining the value of a stock option. The strike price is the price that a call buyer may purchase the shares at or before expiration.

When the stock price is above the strike price, a call is considered in the money (ITM). The situation is reversed when the strike price exceeds stock price — a call is then considered out of the money (OTM). An at-the-money option (ATM) is one whose strike price equals (or nearly equals) the stock price.

So the first reason why your call option could be losing money is because the stock price is not above the strike price. If the OTM option you own has no intrinsic value, its price consists entirely of time value and volatility premium.

Time Value Decreases Rapidly

Time value is your worst enemy as an option buyer because it erodes the value of your call option each and every day. Therefore, an option’s value at expiration is only the amount it is in the money (ITM).

Stock traders don’t have to worry about time value because they can own as stock for years (and even decades). But options have a finite life that ends at expiration. So it’s make it or break it for the stock price to rise higher than your strike price before time decay eats away at the value of your option.

Decreased Market Volatility

As I mentioned above, OTM options are made up of mostly time value and volatility premium. Volatility is simply the propensity of the underlying stock to fluctuate in price. The more volatile a stock the higher the chances of it “swinging” towards your strike price.

The higher the overall implied volatility, or Vega, the more value an option receives. Generally speaking, if implied volatility decreases then your call option could lose value even if the stock rallies.

Underlying Stock Dividends

Dividends increase the attractiveness of holding stock rather than buying calls. This is because call buyers are not entitled to the dividends until they actually own the stock. You can’t have your cake and eat it too right! Therefore, larger dividends reduce call prices overall.

Interest Rate Effects

I bet you never thought interest rates effect an option’s price right? Well they do to a certain extend and it’s another Greek – Rho. As interest rates rise (which is ironically what will happen in the near future) this helps call option premiums.

Higher rates increase the underlying stock’s forward price (the stock price plus the risk-free interest rate). If the stock’s forward price increases then the stock gets closer to your strike price, which we know from above helps increase the value of your call option. On the flip side, decreasing interest rates hurt call option owners.

Share A Trading Story

Not one person has ever traded options and NOT had this happen. Share your story via the Facebook Comments below and tell me what you learned from the experience. Did you choose to start buying options ITM or ATM instead of OTM? Or maybe you are not playing volatility?

Rebalancing your portfolio and adjusting it for risk and reward can be a daunting task for some traders. As with most things in trading, sometimes it just simply looks harder. To start there are many schools of thought with regard to rebalancing and allocating a portfolio – none of which are correct since they are all subjective.

What Is Portfolio Rebalancing?

In short, it’s the process of reworking the mix of investments in your account. Depending on how your portfolio performs, it will naturally need to be rebalanced over time.

This is because the better performing investments will take up more room and under performing investments will take up less. When this happens you need to sit down and again take another look at risk and reward.

Simple 4 Step Process

This is a very simple process you can use to get you on the right track. Of course there may be other ways of approaching this, and if you have some other suggestions please add them via the Facebook Comments. If you money is in one account this will be easy. If not then it’ll be a little harder but you still need to do it!

1) What’s your target portfolio mix?

What is your trading plan and investment goals? From this you can determine the appropriate blend of investments that were going to allow you to reach your goals.

2) Compare and contrast your current mix.

How does your portfolio mix stack up to the mix that you started with? Look for areas that are either over or under allocated and make some hard decisions on places where you can make a change.

3) Start reallocating and rebalancing.

Determine where your allocations have shifted and start rebalancing. Also, consider out right adding or removing different exposures. Maybe it was a good idea to be in Oil stocks last quarter and now it’s just not favorable. And as always, make sure you aren’t overexposed to one particular industry.

4) Readjust quarterly.

Revisit this each quarter (or however often you like). Pare back the parts of your portfolio that have grown considerably and direct those dollars to the investments that show better opportunity.

Too Much Can Be Hazardous

I’m a fan of reducing clear and obvious risk when rebalancing. But sometimes rebalancing can be hazardous to your portfolio. Transaction costs and taxes can really eat away at the benefits quickly. In addition, the traditional thinking is to sell some of your high performer to buy more of the under performers.

The problem is that you don’t let your winners run right? You cut potentially amazing gains short to buy under performing investments. Again this is a personal preference but always something to consider.

Why Bother Anyway?

Rebalancing is all about controlling your risk. Isn’t everything with trading! It’s making sure that you are not overly exposed to one asset class, industry, sector and/or company. Generally speaking, you don’t want to have all your money in 2 companies for example. That would be stupid.

Markets change. Sectors, industries, companies go in and out of favor. Rebalancing helps you reap the full rewards of diversification and learn to how to manage your risk.

May was very good for our members! I tried to make the theme of the May portfolio “trade what you see, not what you want to see.” I thought it was fitting because I’ve been burned before on the Call side anticipating moves lower in the market. Not this month – we had a very Put heavy portfolio across the board.

As you can see below the calm market really didn’t leave us room to enter an Iron Condor trade this month. I’m of the opinion that sometimes taking a big fat 0% return is much better than trying to force a trade into the market that doesn’t make sense right? That’s when you really lose your capital fast.

Credit Spread Strategy: 3.89%

To re-cap this month’s income, let’s look at what we made in premium vs. our required investments (in margin). Here are the positions we had with corresponding PROFIT/INVESTMENT and RETURN:

SPX 1,175/1,170 PUT SPREAD – $30/$470 = 6.38% Return

RUT 700/690 PUT SPREAD – $25/$975 = 2.57% Return

SPX 1,180/1,175 PUT SPREAD – $35/$970 = 3.61% Return

With regard to TOTAL INCOME and RETURN, the portfolio produced $90 of income after investing just $2,415 in margin. That means we saw a total portfolio return of 3.89% this month based on our model allocation.

Naked Puts/Calls Strategy: 1.51%

To re-cap this month’s income, let’s look at what we made in premium vs. our required investments (in margin). Here are the positions we had with corresponding PROFIT/INVESTMENT and RETURN:

IWM 67 PUT – $15/$670 = 2.24% Return

SPY 115 PUT – $20/$1,153 = 1.73% Return

DIA 105 PUT – $12/$1,051 = 1.14% Return

SPY 112 PUT – $16/$1,120 = 1.43% Return

With regard to TOTAL INCOME and RETURN, the portfolio produced $63 of income after investing just $3,994 in margin. That means we saw a total portfolio return of 1.51% this month based on our model portfolio.

Iron Condors Strategy: 0.00%

To re-cap this month’s income, let’s look at what we made in premium vs. our required investments (in margin). Here are the positions we had with corresponding PROFIT/INVESTMENT and RETURN:

–NO POSITIONS THIS MONTH–

With regard to TOTAL INCOME and RETURN, the portfolio produced $0 of income. That means we saw a total portfolio return of 0.00% this month based on our model portfolio.

Chart patterns play a critical role in usefulness technical analysis. Chart patterns are a result of human nature and trading psychology. If you can learn to recognize patterns early you can also learn to profit from breakouts and reversals.

As you all know I’m a big fan of technical analysis and chart patterns are very powerful for any trader.

Why Are They So Important?

Simply put, chart patterns are just a series of price action that occurs in a stocks trading. These can happen on any time frame really; monthly, weekly, daily and intra-day. The great thing about chart patterns is that they repeat themselves over and over again. Human psychology and investor emotional cycles never fade. The markets change but human emotion does not!

So if you can learn to recognize these patterns early, you will gain a real competitive advantage in the markets. Just as volume, support and resistance levels, RSI, and Fibonacci Retracements can help your technical analysis trading, chart patterns can help identify trend reversals and continuations.

Print This Out So You Won’t Forget!

Click the print button right now and keep this article by your desk. I promise it will be a huge help in the coming weeks and months. Just having them in your face each and every day will subconsciously help you learn to recognize them in live trading.

1. Pennant

2. Cup And Handle

3. Ascending Triangle

4. Triple Bottom

5. Descending Triangle

6. Inverse Head And Shoulders

7. Bullish Symmetric Triangle

8. Rounding Bottom

9. Flag Continuation

10. Double Top

11. Bearish Symmetric Triangle

12. Falling Wedge

13. Head And Shoulders Top

14. Did I Forget Your Favorite Pattern?

Add your comments below and let me know what patterns you like to trade besides the 13 above. There are many more stock chart patterns out there, but these will just get you started.

Today we are opening the new position as follows:

Trade: Sell RUT June 720 Put AND Buy RUT June 715 Put

Premium: $20 (0.20) Net Credit or better per contract

Underlying Price: $820

Max Return: 4.17%

Break-Even Price: $719.80

Time Until Expiration: 29 Days

Probability of Loss: 7.72%

Trade Explanation: For the Credit Spread portfolio we are entering our 3rd and final position for the June portfolio this week. We are entering a Credit Spread with a NET credit of $20 per contract (remember that for larger portfolios you should be selling multiple contracts).

April expiration is tomorrow and is going to be a very good month once again for our Credit Spreads. All our Put spreads are expiring worthless and profitable once again which is great. And with June expiration and the portfolio front and center, we need to focus on managing risk should things fall apart with the end of QE2.

Something that I have suggested multiple times is that you all start to buy cheap protection on the downside. All we want to do here is get some downside volatility protection should we get another “flash crash” type event in the coming weeks. Maybe these options on the SPY…

I still think that all our positions will be very safe as we are only 29 days away from expiration and time decay has turned the corner and is rapidly increasing.

This week I’m glad that I waited until today to enter this RUT trade. The last two days the RUT has made a move lower over 2% which we can now take advantage of on the Put side.

I have to be honest with you all (as always good or bad) and say that I’m not overly crazy about this trade to end the June portfolio. I have this very deep feeling that the market is just floating on thin ice right now and that a good strong break could come soon. With this thinking you would assume I’d sell Call spreads right? Well, those are getting crap premiums and are way too close on this upside (which is where I’ve been burned in the past).

Either way I feel these are still safely below the market and again take measures NOW to protect from the downside. And as always, feel free to email me with questions for your specific portfolio.

For this trade we are only risking roughly $480 in margin requirement per contract to possibly make $20 in premium collected on this trade by expiration – making an solid gain of 4.17% overall. As always, if you are having trouble getting filled, try legging into the spread (i.e. sell the higher put first and then buy the lower put in separate orders).

As always we will monitor this position for adjustments to minimize our risk exposure. To view the current portfolio and past trading alerts, please login to the protected area of the website.

Beginning traders were probably shocked the first time they experienced a stock price gap. I guess even the most experienced traders still get taken back when there is an unexpected stock price gap in a stock they are trading. Either way I wanted to cover once again why they happen and what you can do (if anything) to trade them.

It Happens When The Market Is Closed

Nearly all stock price gaps happen in pre market trading or during after hours trading. Call them Black Swans if you want since they seemingly come when you least expect it.

Generally speaking gaps are rare for the normal stock. Most mutual funds, ETF’s, and other illiquid assets actually gap more frequently which make the gaps less important.

How The Actual Price Gap Is Created

A price gap is created when a stock closes at say $91.50 (as AAPL did below) for the day which is at 4:00 PM EST and then the next day opens dramatically higher or lower than it’s previous closing price of $91.50.

In after hours that same day or pre market trading the following morning, something newsworthy happens to create either a buying or selling frenzy. The result is a gap in the stock price when the market re-opens at 9:30 AM EST.

The most common reasons price gaps occur is because of earnings and acquisitions. The bigger the stock price gap, the more important or influential the reasoning behind it. Any major event that dramatically changes the value of a stock today (or it’s future business value) will immediately effect the stock price when the market opens.

Let’s Look At A Real Life Example

Using Netflix, Inc. (NFLX) as our classic example, you can visually see that the trading creates a gap in the daily candlesticks. What happened in this example to create the gap in NFLX stock?

Well, the stock closed on 1/27/10 at $50.97, then reported earnings after the market closed which were much better than the analysts on Wall Street had expected. In after hours trading, NFLX stock traded higher to $63 on the earning excitement.

The next morning when the market opened it created the classic gap in the daily stock price of nearly 26%. This left this huge visual gap on the chart.

Do Price Gaps Help Predict Future Moves?

While the actual gaps themselves are virtually unpredicable – stock price gaps are fairly good at predicitng the future price of a stock following the gap. Of course we would all like to know when a stock is going to gap higher so that we can buy it right? But it’s what happens after the gap that acutally can be very useful for you as a trader.

A price gap up or down in price can actually be a determination of the overall direction the stock will move in the coming months. For the most part volume is the big indicator and confirmation sign during a price gap.

A stock price gap on very high volume like the one below means that strong institutional buying of the stock could send prices higher in the weeks and months to come.

Like I said before, the size of the gap is also very important. Smaller gaps are less important and actually can happen on daily basis for some stocks. But it’s the large and obnaxious gaps that kind of jump off the screen that you should pay attention to when trading.

Gaping Support/Resistance Levels

Personally I like gaps for the technical importance they serve in determining strong areas of support and resistance. With stock prices gaps the whole area of the “gaping window” as it’s called can act as strong support and/or resistance going forward.

In the examples below, you can see that the gaping window successfully acted as S/R levels for these stocks following the initial gap. More experienced traders will look for an entry following a pull back in the stock that is much more favorable.

How Do You Trade Gaps?

I’d like to hear from you as to how you like to trade gaps for earnings? Some people like to play the volatility move or the big gap higher with OTM Calls? Add your insight via Facebook below.

I’m an option seller and I think we get a bad rap. When people first hear about naked option selling and option writing they immediately heard about “unlimited losses” and “unlimited risk”. This ignorance and lack of understanding is frustrating to say the least.

It’s high time we bring this myth to an end! Frankly I’m tired of hearing about it since I think it’s completely crap. It only occurs in theory, because in the real world, things are completely different. So I decided to write this post to help educate and shed light on the topic for beginning option traders.

Enter The “But Kirk” Crowd

Now that I’ve said the things above I’m sure I’m going to get the “but” crowd who are going to take this to its literal end. Here is what they will say, “But Kirk…you are wrong. You can have unlimited losses when selling naked options!” So here’s my disclaimer…

IF you are a complete idiot and do absolutely nothing to manage risk whatsoever, YES you can have the potential for huge losses. This “unlimited losses” feature comes only with Call options and the theory is that the stock could risk to any possible level (seemingly with no restrictions) and if you held on long enough to your short option (which would be STUPID) then you could have huge losses.

This Risk Is Manageable

The so called “unlimited risk” feature then becomes completely manageable risk which you can deal with once you have some simple education.  There are thousands of option sellers who are making a small fortune selling naked options. Over the last 7+ years it’s been my bread and butter strategy. Besides Warren Buffett’s Berkshire Hathaway also sells options for income.

As with anything in life, ignorance and stupidity only lead to unmanageable risk. Being successful selling options will always depend on your trading discipline and employing safeguards to manage risk.

Let’s Look At The Numbers

Selling or writing naked options when done in a disciplined manner coupled with proper protective trading techniques is no riskier than buying options. In fact I’d even argue that option buying is more risky! Not only is it more speculative but the statistics show there are more traders who lose money as option buyers than option sellers. Facts are facts people.

Based on a CME study of expiring and exercised options covering a period of three years (1997, 1998 and 1999), an average of 76.5% of all options held to expiration at the Chicago Mercantile Exchange expired worthless.

This bias in favor of put sellers can be attributed to the strong bullish bias of the stock indexes during this period, despite some sharp but short-lived market declines. Data for 2001-2009, still shows that annual CBOE trends remain the same as the major study done back in the late 90′s.

Careless Traders Are Dangerous

I like coaching traders who are worried (probably because they are similar to me). Worried about risk first and profit second. These are the type of traders that will be very successful. They have a trading plan together and work that plan each day.

It’s the traders who are completely careless that give the rest of us a bad name. Admittedly, you do face the potential threat that the underlying stock may move continuously against your strike price. So if you just sit back and watch this all happen without doing anything then you may have no limit to the loses. Here’s the lesson: monitor your positions on a regular basis.

Techniques I Use To Manage ‘Unlimited Risk’

Okay I’ve talked about how you can manage risk when option selling, now it’s time to tell you how I choose to do it with my own account. I’m a very cautious and conservative trader as many of you know and thus have developed various protective trading techniques to offset the so called ‘unlimited risk’ factor. In my opinion, these simple things make unlimited losses a negligible risk in my portfolio.

Here are the strategy particulars…

1. Choose The Right Securities First

The most important consideration when selling options is what you decide to trade. Please for the love of god don’t do this on low volume, cheap stocks with no public interest. High volatility stocks like these are very risky for option sellers because they can gap higher/lower overnight and wipe out your profits.

Sure the premiums are attractive but don’t be lured into a false sense of security. I tend to play ETFs (Exchange Traded Funds) or Indexes instead of stocks. These seldom have dramatic one day moves and are less vulnerable to price gaps. This is because they are a basket of stocks and reduce non-systematic risk.

2. Buy Protection Whenever Possible

If you have a good profit, use some of the money to buy cheap protection. More often than not I prefer taking my naked positions and legging into a credit spread. This will completely and 100% eliminate the risk of unlimited losses should the market become more volatile.

Whatever you do, don’t get complacent enough to think that an early profit in the expiration cycle will stay that way. Markets can reverse and volatility can increase faster than you can stay liquid.

3. Don’t Sell Too Far Out

As an option seller we want to use time decay (Theta) to our advantage right? So don’t choose to sell FAR OTM options 4+ months out. These options have little time decay and you are also giving the market much more time to move against your position.

Instead focus on selling options with 2-3 months until expiration or shorter. This forces the market or security to make a strong directional move against you in a short period of time. If not you keep the premium and move onto the next trade.

4. Use A “Stop-Loss” System

I am not a big fan of setting hard stop losses with option selling. Mainly because you can set a stop loss and if the first day after you enter the trade volatility increase you could get closed out at a loss. There was still plenty of time left until expiration but now you are stuck with a loss.

Exiting depends on a whole lot of things that really have nothing to do with the price of the option; time until expiration, delta, theta, volatility, weekends, earnings, etc. But you should have something in place to mitigate risk based on your own risk tolerance. Experience will help in this area.

I’m sure you can think of more techniques and feel free to add them via Facebook Comments below. These 3 are just the ones I use and honestly are extremely simple and effective. At this point I think I have officially dispelled this stupid myth!

The Odds Are Stacked In Our Favor

Option sellers take maximum advantage of the option time decay. They understand that OTM options lose value quickly to the point of being worthless on expiration day. With this strategy we don’t need to correctly predict the market direction or market timing to generate income. An option buyer not only has to be right about the direction (which is hard enough) but also has to be right about the timing of the market move (impossible!). This puts the odds of trading success safely in your court.

Even with the odds stacked in your favor, you still take on risk with any trade right? I mean if there wasn’t some sort of risk then everyone would do it and get rich. Be smart and educate yourself before trading.

Here we are. Back talking about trading discipline – only this time I’m going to show you why I failed in my own trading this past month. More specifically I left not 1 but 2 multi-hundred return trades on the table exiting two trades early and am very disappointed.

Call it what you will, but what I’m most upset about is that I have specific systems in place to prevent this from happening and I ignored them (hopefully for the last time).

Why Am I Telling You All This?

I’ve always tried to make this blog and website as open as possible – everything black and white. More often I’m showing and teaching you how to trade profitably via my own examples rather than explaining why I lost money (though I have been very open about these as well).

It’s the trades that I f****d up that I feel are the biggest lessons for me going forward. And I guess I’m hoping you can learn to avoid these pitfalls as well.

My SLV (Silver) Trade And How I Messed Up

You’ll really want to watch this video and see where and how I messed up in my exits for SLV. I literally left 200%+ returns on the table not once but TWICE. As always, you can subscribe to all my trading videos in HD on YouTube.

The Difference Between Goal Setting And Discipline

Lots of traders have goals. They want to do XYZ in profits or increase their account to some value by the end of the year. I have goals as well and goal setting is very important. But you need to understand that no amount of goals setting can lead to success without strict discipline to a trading plan.

Discipline is the foundation and bedrock of successful traders. And this goes for a whole list of things that relate to trading and wealth – time management, risk management, strategy selection, trading psychology, etc. Hard work and discipline go a long way and eventually will separate you from a million other people out there trading.

Honestly I think that I have great discipline when it comes to 90% of the things I do and am not ashamed to say that. I’m very confident it my abilities and potential to continue making money trading options and stocks. And I’m not perfect nor will I ever be; but I’m improving each day.

Know What You Don’t Know First

Nobody has all the answers. Sure you can attend those guru seminars but I promise you are going to come away completely empty handed in the end. Maybe not empty handed as you might get suckered into buying and overpriced program or DVD set – believe me we have all been there!

Successful traders know what they don’t know…

When you know where your weaknesses are and face up to them you become far wiser than thinking that you know a lot when you really don’t. Again, the video above is a public testament to my own weakness of exiting a trade way early and losing out on potential profits.

What I’m trying to show you all is that it’s okay to have a losing trade! A professional trader knows what he doesn’t know and focuses on improving things the next time around. Direct your focus and attitude on the main thing that IS happening not what you think SHOULD happen in the market.

I love reading trading books and learning from some of the great investors and traders. My personal preference is to learn from the “Old Guys” like Livermore, Buffett, Lynch and Graham. These guys laid the foundation for modern investing. They didn’t trade on technicals and always offer great insight.

Here are 19 great quotes. Add your favorite quote via the Facebook Comments!

“The first rule is not to lose. The second rule is not to forget the first rule.”

“If past history was all there was to the game, the richest people would be librarians.”

“Risk comes from not knowing what you’re doing.”

“Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.”

“Buy on fear, sell on greed.”

“Amateurs want to be right. Professionals want to make money.”

“If you want to have a better performance than the crowd, you must do things differently from the crowd.”

“The four most dangerous words in investing are ‘This time it’s different’.”

“If you are not willing to own a stock for 10 years, do not even think about owning it for 10 minutes.”

“Wall Street is the only place that people ride to in a Rolls Royce to get advice from those who take the subway.”

“I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years.”

“In the business world, the rearview mirror is always clearer than the windshield.”

“Stock market bubbles don’t grow out of thin air. They have a solid basis in reality, but reality as distorted by a misconception.”

“The financial markets generally are unpredictable. So that one has to have different scenarios. The idea that you can actually predict what’s going to happen contradicts my way of looking at the market.”

“Go for a business that any idiot can run – because sooner or later, any idiot probably is going to run it.”

“In this business if you’re good, you’re right six times out of ten. You’re never going to be right nine times out of ten.”

“Wall Street people learn nothing and forget everything.”

“Time is your friend; impulse is your enemy.”

“What seems too high and risky to the majority generally goes higher and what seems low and cheap generally goes lower.”

Beta is a great trading and portfolio tool when used correctly – yes some people don’t use it correctly I’m afraid. Beta is another one of those crazy greeks that determines the association of a stock or a portfolio to overall markets.

This is something that I haven’t covered in detail before and I apologize for that. I go over this with nearly all of my coaching students but I kept getting questions via email and it seemed that most people really don’t understand how Beta works and how to correctly use it.

–> Hence this awesome video I put together on YouTube.

Systematic & Unsystematic Risk

There are two major types of risk when you invest in the market – systematic and unsystematic risk. I’m sure your probably thinking, “What the hell are you talking about Kirk! Risk is risk right?” Well not exactly and I’ll explain…

Systematic Risk – This is the level of risk that an individual security possesses based on how its correlated with the overall market. These are risk factors that affect the entire market, such as foreign market changes, taxes, global security threats, etc. Exposure to this type of risk is known as Beta.

Non-Systematic Risk – This other level of risk is due to factors completely specific to an industry or a company. Factors that effect a stock’s unsystematic risk could be things like supply shortages, product category, commodity prices, consumer demographic trends, etc.

For example, Apple and Exxon have are both subject to terror threats that effect the entire global markets just like every other company. God forbid something happened tomorrow, every stock would be negatively effected and this type of risk is frankly unavoidable.

However, Apple and Exxon are in completely different industries and a change in oil prices for example will have different effects on each company independently.

The Beta Benchmark?

The most commonly used benchmark in the United States is the S&P 500 index when measuring Beta.

Since Beta is calculated by using regression analysis, the S&P 500 is considered the “Market Portfolio” and is given the number “1”. A positive beta means that the price of the stock will move along the market in lock-step. A negative beta on the other hand implies that prices of the stock will move in the opposite direction.

High/Positive Beta

• Beta of “1” shows that the stock is as volatile as the market and will more or less tend to follow the market higher and lower. If the market climbs by 5%, than the price of your stock should also climb by 5%.
• Beta greater than “1” makes a stock is riskier than the market and more volatile.
• Beta less than “1” makes a stock less riskier than the market and thus less volatile.

Low/Negative Beta

• Stocks with negative beta are theoretically bound to move in the opposite direction of the overall market. Beta of “-1” means that if the market climbs by 5%, the price of the stock will fall by 5% and vice versa.

Keep in mind that Beta is the tendency of the stock as it relates to the overall market (usually using the last 5 years of data). So this isn’t a sure thing when trading – what is right? It just gives you a general idea of what kind of risk you are taking on when building a new portfolio.

I’ve told people for years and years that Warren Buffett’s portfolio and Berkshire Hathaway company publicly discloses that they are naked put option sellers. More specifically they sell index put options, the exact same strategy we use here at Option Alpha.

Why Is This So Shocking?

Honestly I always get a weird response when I tell people this. Why is it so shocking to think that one of the best investors of all time my use the same strategy that I prefer. Well, I guess I’m using his strategy and not the other way around right? I’ll give credit where credit is due.

But the truth is that he’s done it if years and will continue to do so…you need to start doing this right now too.

Do What Billionaires Do!

I’ve always believe that if I want to become a better trader, I have to invest like millionaires and billionaires. What better way to do that then to read the public filings of their companies! Sure it may take some time to get through but I set aside time each month to read these public filings.

Don’t you think that if the richest man in the world is selling index put options, you should be doing the exact same thing? I do.

Read The Proof Yourself…

To prove that Warren Buffett and Berkshire Hathaway use the same option strategy, we have provided direct quotes from the 2010 annual report per the SEC filings. I urge you to check me on these and see what they say for yourself! Download the 181 Page 10-K filing here.

Page 19

Our risks of losses under equity index put option contracts are based on declines in equity prices of stocks comprising certain major stock indexes worldwide. Although the contracts currently in-force do not begin to expire until 2018, we could be subject to significant future settlement payments at expiration if equity index prices are below the strike prices specified in the contracts.

Page 44

In 2010 and 2009, gains on equity index put option contracts were $172 million and $2.7 billion, respectively. Under many of the contracts, no settlements will occur until the contract expiration dates, many years from now.

Page 79

The equity index put option contracts are European style options written on four major equity indexes. Future payments, if any, under these contracts will be required if the underlying index value is below the strike price at the contract expiration dates which occur between June 2018 and January 2026. We received the premiums on these contracts in full at the contract inception dates and therefore we have no counterparty credit risk.

As of December 31st 2010, Warren held the following portfolio of 25 stocks…