Selling Options

Hello Everyone,

Thank you for all for all of the great response from my last post about options. As promised today I am going to explain to you how selling options works.

The first thing you need to know in order to understand selling options is the concept of premium. Remember in my last post when I explained that when you buy an option you have to pay for the right to buy or sell the underlying security at a future date at that specific price. That amount you pay is called premium. Selling options is also known as "writing options" or "premium harvesting".

I think that the best analogy to use to explain how selling options works is insurance. Today I am going to explain selling put options... When you buy car insurance you pay a monthly premium, and if you ever get in a car accident the insurance company pays you a lump sum to cover your costs. When you sell put options you are acting as the insurance company. Someone in the market place, we will call him Bob, believes that the market is going lower and wants to BUY a put to "insure" against the possible losses. You, as the seller, believe that the market is not going to go down, and therefore are willing to act as the "insurance" against the market going down. You are going to sell Bob a put option (his insurance against stock losses).

Let's put some numbers to this... today Google stock (GOOG) is at 679. Bob can only stand a 5% loss in one week, therefore he wants to buy a put option 5% below the current stock price with a strike of 645 (679*.95= 645). This way if Google drops more than 5% in one week the put option will pay off, protecting him against the losses. You on the other hand do not believe that Google stock will drop more than 5% in one week and are therefore willing to assume the risk on the other side of Bob's trade (act as the insurance company). You sell him the 645 one week put option on Google stock and you collect $70 in premium. As long as Google stock does not drop below 645 in one week you get to keep your $70. If the stock does drop below 645 then you must pay out the value of the put to Bob at the end of the week, which in theory could be any amount depending on how much the stock drops. Therefore in this trade I just explained you have an unlimited loss potential. However because the probably of Google stock dropping more than 5% in one week is so low, you are will to take on this risk to make your premium. This is known as high-prop trading.

One key difference between buying a put and selling a put is that when you buy an option you have the "right" or the "option" to exercise your put. When you sell an option you are obligated to deliver your pay out. Therefore in this example you could make $70 per contract in an instant as long as you think that Google stock will not drop more than 5% in one week.

I will let you think about this a little before I move on to more complex option trades, and explain to you how you can mitigate the unlimited loss potential described above.

Good bye for now,

Breana

Planet Money

Hello Everyone,

I wanted to make you aware of an amazing radio show/ podcast about finance. NPR's Planet Money has easy to understand, unique and timely shows about finance. I would highly recommend it to all. Here is the link to their website. I usually listen to it on my NPR app on my iPad.

http://www.npr.org/blogs/money/

Breana

What are Options?

Hello Everyone,

Today I would like to talk to you about options. Options are a financial instrument that are very misunderstood. This is understandable because they are very complicated and work very differently than other financial instruments. That being said, options are my new favorite way to invest and I believe are the future of investing as the technology gets better and costs to trade come down.

Options are derivative securities meaning that the price of an option is derived from the price of an underlying asset. For today's purposes we will talk about options on SPY which is the exchange traded fund (ETF) indexed to the S&P 500.

By definition an option gives you the right to buy or sell an asset at a specific price in the future. There are two types of options- puts and calls. A call option would be bought if you believe that the underlying assets will increase in value. Here's an example...

Today SPY is at 140.93. I believe that the S&P 500 is going to rise. Therefore I am gong to buy a call option on SPY with a strike of 141. Say that one week from now SPY rises to 145. I can choose to exercise the option and buy the SPY at a price of 141 and immediately sell it in the market at 145, resulting in a profit of $4 per share.

Another characteristic of options is leverage. One call option represents 100 shares of the underlying assets. Therefore in this example you have made $400 on one call option! However you did have to pay for that call. What you paid to buy the call is called premium. Today it would cost about $100 in premium to buy a one week call option at 141. Therefore you would have netted about $300, or a 300% return. Where as if you had purchased 100 SPY shares at 141 and sold at 145 you would have had to invest $14,100 instead of $100! That is the power of leverage. When you buy an option the most you can lose is the premium you paid for the option. In this example $100.

The same concept is true for a put option, only when you buy a put option you are betting that the market will go down. Using a similar example as above, today the SPY is at 140.93. You buy a put option at 141. In one week SPY drops to 137. You now have the right to borrow 100 SPY shares at 137 and sell them at 141, making $4 per share. Don't forget that you had to pay for that put option. Today it would have cost you $120 to buy the put. So, you made $400 you paid $120 and you netted $280. The most you could have lost in this trade is the $120 you paid in premium to buy the put option.

I am going to leave you to ponder the concept of buying options. I will explain selling options soon. Then we can move on to more complicated option trades such as spreads, butterflies and iron condors.

As always, I welcome all questions!

Cheers,

Breana

How to Invest in the Market

Hello, Jaye here again. Today I would like to discuss how to invest in the market. If you have been following the savings advice outlined in this blog, you now have a pot of money to invest. So what do you do now?

First things first- have a heart to heart with yourself about your investor type. Be honest. Are you really an aggressive investor, or does the thought of seeing losses in your account make your stomach turn? Stocks and mutual funds do not go straight up, and you can expect short-term losses from any investment. If you are a conservative investor, do not buy the hot tech IPO that just hit the market. Do not buy on your cousin's stock tip, or "play" penny stocks. Pick investment vehicles with a proven investment record, and look at bull market performance (2003-2006, 2009-2010) and bear market performance (2000-2002, 2007-2008). Do the gains justify the losses? Make investment choices based on a long-term view, not just the stock with the highest return last year.

The next consideration for investors is research time, interest, and know-how. Do you enjoy knowing how things work and digging into the company balance sheets or looking at technical charts? Are you really going to spend 5 hours a week researching your stocks? If yes, then open an investment account with low trading costs and a large investment universe and trade away. If you are a hands-off investor with better things to do in your day than track the market, consider using a balanced mutual fund whose manager will change the asset mix based on market conditions. One of my favorites is Permanent Portfolio (PRPFX). There are a lot of them out there, so do your homework before choosing one, and be sure to re-evaluate every so often.

Finally, be systematic with your investing. Put new money in on a regular basis to dollar-cost average into the market. Reinvesting dividends also allows you to catch the market at regular intervals.

Happy investing!

Jaye Weiland, CFP®

Disclaimer- I own shares of  PRPFX

Systematic Saving

Hello Everyone!

Today I would like to discuss the best way to ensure that you will get rich. Unfortunately I do not have a get rich quick scheme, but I do have a guaranteed method in systematic savings. There is an important saying "pay yourself first". You should think about your savings in three buckets. The first bucket is short-term savings, or funds that you may need in less than one year. The second bucket is medium-term savings, or funds you may need in one to five years. The final bucket is long-term savings, or funds you will need in more than five years. Here are some examples of each:

             1. Short-term: You should think of this as your emergency fund for unexpected purchases. Some examples would include car repairs, medical bills, and home repairs. Depending on your situation a good rule of thumb is to have between 3 and 6 months of your income in your short-term savings account. So if you make $50,000 per year you should have around $15,000 in your short-term bucket.

             2. Medium-term: This bucket will contain funds for events you expect to occur in the near future such as a vacation, a new car, a wedding, or a down payment for a house.

             3. Long-term: This bucket will contain funds for items such as your children's education and retirement.

Fortunately because you are young the best thing you have on your side is time (see blogs on compounding interest), and if you can systematically save into accounts that you have designated for each of these buckets you will be guaranteed to acquire wealth. You may wonder how much you should be saving. A good rule of thumb is 10-15% of your income per month. Therefore if you make $50,000 per year, you are making about $4,100 (gross) per month and you should be saving between $400 and $600 each month.

Determining which bucket you should put your savings into is the next factor to consider. As a general rule, the first place you should save you money is into a 401(k) if you have one, up to the match. If you are not saving in your 401(k) up to the match you are throwing away money. Then next most important place to save is in your short-term emergency bucket. After you have accumulated your desired 3-6 months of income in your short-term bucket you can start saving in either your medium-term and long-term buckets. Just remember that it is very dangerous to put off saving for retirement because you are young. I would recommend that after you have your emergency fund accumulated try to save into both the medium-term and long-term buckets.

I hope this is helpful. Please feel free to ask any questions. There is a new feature to my blog, you can sign-up for email notifications on the right column so that you will be notified when I have new postings.

Cheers,

Bre

Follow By Email!!!

Hello Everyone!

I have exciting news that you can now follow my blog via email. By using this feature you will receive email notifications when new content is posted. You can sign-up for this cool new feature on the right hand-side toolbar.

Cheers,

Breana

Do You Want a Roth or Traditional IRA?

Hello. This is Jaye again, and today we are going to talk about the choice between a traditional and a Roth IRA. We all like options: Vanilla or chocolate? Regular or decaf? In the individual retirement account space, the choice is between a traditional IRA and a Roth IRA. Both can be powerful tools in saving for retirement, but key differences make each one optimal for different investors.

Contributions: While both traditional IRAs and Roth IRAs offer tax-advantaged solution for retirement savings, they work as an essential inverse of each other. With a traditional IRA, you typically do not pay any income tax on your contribution, and your account grows tax-deferred (IRAs). With a Roth IRA, you pay the income tax now, and your account grows tax-free (Roth IRA). So do you want to pay tax now or later?

Income limitations: Anyone can contribute to a traditional IRA, but if you are eligible for a company retirement plan there are income limits to deducting your contribution. If you are eligible for a company retirement plan and your income is above these limits, your contribution will be subject to income tax. Your account will still grow tax-deferred, and you will not be subject to any income tax on withdrawals of the original contribution amount. With a Roth IRA, you are not allowed to contribute at all if your income is higher than the phaseout limits, although you are still eligible for a Roth conversion.

Withdrawals: In a traditional IRA, you owe income tax when you withdraw funds in retirement (although some exceptions apply to non-deductable contributions). The idea is that a retiree’s income tax bracket is less in retirement, and therefore your tax liability will be less when you withdraw your retirement funds. One important note is that you are required to pull out minimum withdrawals (RMD) each year after age 70½. Since you pay taxes on withdrawals from a traditional IRA, after age 70½ you can expect that you will have a portion of your account taxed each year. A Roth IRA withdrawal, in comparison, is not taxed as long as it is a qualified withdrawal.This is because you already paid taxes on your funds before contributing them to your account. So again, do you want to pay taxes now or later?

Early Withdrawals: The general rule for IRAs is that you pay a penalty and tax on any withdrawals taken before age 59½. However, like all tax rules there are exceptions, including education and first-time home purchase. With a Roth IRA, you are also eligible to withdraw your taxed contributions at any time. This added flexibility can be a huge benefit for anyone who finds their emergency fund depleted and needs access to other monies.

So which is right for you? Generally, the rule of which IRA to use depends on your current and expected future tax bracket. If you expect your tax bracket to be higher in retirement, you contribute to a Roth IRA, and if you expect your tax bracket to be lower, you contribute to a traditional IRA. This reasoning leads one to conclude that savers in the beginning of their careers, when earnings are typically lower, should use a Roth IRA and savers at the peak of their careers, when earnings are typically at their highest, should utilize a traditional IRA. However, uncertainty about future tax rates has complicated that rule of thumb. If you believe that tax rates will not remain at the current historic lows, a Roth IRA may be appropriate even if you do not expect your earnings to increase.

Like everything else in finance, the best answer may be to diversify. You are eligible to place a total of $5,000 a year ($6,000 if 50 or over) of earned income into either IRA, or you can split that contribution in any way between the two. This means that you can hedge against future tax rates by placing $2,500 in a Roth IRA and $2,500 in a traditional IRA. As your expectations about the future change, so can your contribution percentages. Each year you are able to decide into which IRA you should contribute, or how much into both. The most important thing is to take advantage of the government’s offer to let your long-term retirement savings grow tax-advantaged, and to contribute every year.

 Best regards,

Jaye