Lesson 2

How to turn a 107% profit into a 160.86% profit with one simple strategy

Okay everyone, I have the solution to your problem. I know that you have it, because everyone has this problem. People pay big money for the kind of advice that I'm about to give you, but I'm feeling generous today.

First the scenario, then the solution ...

SCENARIO:

• You have a stock, you pay $40.00.
• You think the stock will trade to $70.00.
• After you buy the stock, you watch it trade up to $48 really quick.
• You say, "okay, wait a minute, I know I wanted to hold it to $70, but I also think the stock will pull back first.
• "I'm up 20% ... I don't want to lose that gain."
• "I want to sell it here and try to buy it back again on a pullback."

This is understandable.

It hurts to watch your stock trade from $40 to $48, and back down to $43.00.

You will have gone from a 20% gain, to a 7.5% gain, and at that point you may even find yourself thinking, "Shoot! I'd better salvage what little profit I have left here, before it turns into a loss."

You sell it and the stock then trades much higher.

We've all been there.

So you try to trade in and out of it.

Now the only way to do this perfectly, is to sell right at the top of the channel or trading band or whatever you want to call it, and buy it back at the absolute bottom of the trading band. So IF, and only IF, you execute it perfectly, you may have sold the stock at $48 and bought it back at the bottom of the channel, at say $43.

It's easy to look at a chart, in hindsight, and see how you "should/could have" traded it for several small profits.

Now what happens in reality, is you either:

a) Sell at $47 (not $48) and buy it back at $45.40 (not $43), and that's if you are lucky.

Then it either moves up, or moves to $41.00, and you might kick yourself because you re-purchased it too early.

Sound familiar?

b) Sell at $48, and the stock keeps going to $70 (LIKE YOU KNEW IT WOULD) and you just couldn't bring yourself to buy it back at a higher price than where you just sold it.

Ah Foowey!!!

c) You try trading it, and maybe your timing is successful a few times, but in 3-4 months, the stock is at $70 and you realize that although you made some nice trades, you still would have been better off if you'd just held the darn thing.

d) You don't sell it at all because you want to be disciplined, but then you see the stock trade up and down between $42 and $48 five times before it moves up (or worse, down) and you were not rewarded for exercising your discipline.

More like slapped in the face.

You say, "I won't make that mistake again," and you know the rest of that story (you try trading it the next time and ... well, see a and b above). Okay, there are obviously scenarios e-f-g-h and so on, but you get the point.

THE SOLUTION:

There are two different types of trades where you can have this problem. One is if you are trading the stock, and one is if you are trading the call options. Get ready for this ...

If you are new to this concept, and if you can grasp it, I'm about to change the economics of your life!

Now I'll invite you into a process that is making the subscribers of The Trend Rider richer and richer ...

First – the solution to the more common scenario, the one I just described which is when you are trading stock: "Selling/writing covered calls."

Second – the solution to the more sophisticated scenario, if you are trading call options: turning a long call option position into a certain type of "calendar spread" called the "diagonal call spread". (Don't be intimidated by the name because this is much simpler than it sounds.)

Option traders who understand covered calls already can scroll down, you're going to love this ...

STOCK HOLDERS – A simple strategy that you have most likely heard of: selling covered calls, aka covered call writing.

This one is easy.

If you are too intimidated to at least try to learn about it, then you are really missing out on the extra profits and reduced downside. But there are a few different ways to sell covered calls. You can sell calls that are out-of-the-money, in-the-money, or at-the-money.

If you buy a stock at $40, and the stock trades to $48, and you simply think that it's going to pull back a few points before making its next run, then you should sell calls that are either at-the-money, or in-the-money by a little bit.

For example: If your stock ran from $40 to $48, since today is January 26, 2006, you should sell the February 47.5 calls which are 50 cents in-the-money. They are "in-the-money" because the stock which is at $48.00 is trading above the strike price of $47.50.

Let's say that you are paid $2.00 for selling the Feb 47.5 calls. That means someone is paying you $2.00/share for the right to buy your stock at $47.50 between now and Feb 17th. So if you own 1,000 shares of stock, then someone is paying you $2,000.00 for the right to buy your stock at $47.50.

There are three scenarios here:

1) Stock trades higher, 2) Stock trades sideways, and 3) Stock trades lower

1) Stock trades higher – If this happens you are likely going to get "called away" (you will have to sell your stock) at $47.50. Another way of saying this is "you get assigned the call option that you sold for $2.00. This is a good thing.

Remember, you were paid $2.00 for the call you sold, which means this is the equivalent of selling the stock at $49.50. (So forget about the price the stock is actually trading at. It doesn't matter at this point. Once you are assigned, you have to sell your stock at the agreed upon price of $47.50. So your net sale price is $47.50 $2.00 received for selling that call = $49.50.)

That is better than what you were considering (which was selling the stock at $48.00 in an effort to buy it back cheaper).

Here you still feel like a winner.

2) Stock trades sideways – Remember, you should sell calls that are either "at-the-money" or slightly "in-the-money" because getting called away (or "assigned) is a good thing. If you get called away and therefore have to sell the stock at $47.50 while the stock is trading at $48.00 in the open market, you have received that $49.50 ($47.50 $2.00).

Awesome!

The stock is flat (at $48) but you're out at $49.50.

If you choose to do so, you now have the freedom to either sit in cash and wait to see if the stock comes down some more for a cheaper re-purchase, or buy the stock back at $48.00 and wait, or you can just re-establish the same position all over again! (Buy the stock back at $48.00 and then write/sell another call option and take in another premium.)

Remember though, and this is key:

One main reason that this is the absolute right strategy, is that as time passes, the option's value erodes.

The value depreciates as you get closer to the expiration date.

So if you don't want to get called away, if you find yourself still holding your stock at $48, and the option will expire in a few days, the call that you sold at $2.00 will now only be trading at 50 cents (since it's 50 cents in the money).

You can always buy the call option back at the cheaper price (buy it back at 50 cents).

In other words, the stock was at $48 when you sold the covered call at $2.00.

The stock sat at $48, but the call traded down to 50 cents.

At that point, you buy the call back, and you have profited an extra $1.50.

3) Stock trades lower – If this happens, and you were correct in thinking that the stock would pull back, then depending on how much the stock has pulled back, and in what amount of time, you can either let the call expire worthless, or you can just close the call option out by re-purchasing it.

If the stock trades lower, you can probably re-purchase it at 15 cents or something.

NOW I'LL SHOW YOU HOW THE TREND RIDER SUBSCRIBERS TURNED A 107% PROFIT INTO A 160.86% PROFIT ON ONE TRADE.

OPTION HOLDERS – YOU WANT TO PAY CLOSE ATTENTION HERE ...

It is important that you understand that option trades are executed in one of the following four ways:

1) Buy to open
2) Sell to open
3) Buy to close
4) Sell to close

Just as you can sell a stock first and close out the position by buying it back at some point in the future (commonly known as "shorting" stock"), you can do the same thing with options.

Selling a put or a call option is also known as writing a put or a call. The seller (writer) of an option receives a premium (cash) in return for the contract (promise), just as the seller of a stock receives cash for the stock.

With options, however, you have to always specify, when you enter the trade, whether it will be the opening transaction or the closing transaction.

In other words, an option trader might decide to:

Buy an option "to open" on one day, and then sell that option "to close" on a future date.

Or ...

Sell an option "to open" on one day, and then buy that option "to close" on a future date.

You don't necessarily have to close out an option position. Owners of an option can let the option expire worthless, or can use the option to force a stock transaction.

To ensure that there is no confusion on what you're about to read, be sure to pay attention to the year that the trades were made, and the years that each of the options expired in...

On October 12th, 2005, when Suncor Energy (Symbol:SU) was trading at $51.50, I e-mailed a Trade Alert to our members saying they should buy the 2007 January 45 call options (to open) at $15.20, and that I thought the stock would trade to $85.00 which would cause the 2007 January 45 call option to trade much higher.

In about 2 months, January 23rd 2006, Suncor Energy hit $75.20 and the option that our subscribers owned hit $31.50. I sent out a Trade Alert telling subscribers to sell covered calls ON THEIR CALL OPTION!

This is commonly known as a "calendar spread". Our members sold the 2006 February 75 call options (to open) and in return, they received $3.70. That reduced their cost basis from $15.20 to $11.50. So how did the 107% turn into 160.86%? I could have just recommended the sale of the long 2007 January 45 call option at $31.50. That would have locked in a 107% three month gain. But at the time of this writing (Wed. Jan 25) the option is trading at $30.

Since The Trend Rider members took in $3.70, they are up 160.86%.

Now what happened here exactly? Do I think that the stock won't trade to $85? I'll explain ...

I DO think the stock will trade to $85.00. But like all stocks eventually are, this one was due for a pullback. Instead of selling out of the long 2007 Jan 45 call at $31.50 ("to close",) and attempting to repurchase it at a cheaper price, I sold a covered call (creating the "calendar spread"). If I sold out of the original 2007 January 45 call and took that 107% profit and tried to buy it back today, I would only be buying it back $1.50 cheaper.

But remember: We sold short that 2006 February 75 call to open, and received that $3.70? This would be the same as if I had sold the original call option (to close) at $31.50, and bought it back at $27.80.

So why is this such a great strategy?

What if I was wrong? What if the stock traded higher? Well if the stock traded higher, I might be called away at $75.00. I'll explain the mechanics in a moment but stick to the basics here:

If I get called away at $75.00, then my total profit will be 160.86%. That is because we made 30 points on our 11.50.

Here's why:

The difference between the two calls = $30.00 (2007 January 45 call & February 75 call). $75 sale price – $45 purchase price = $30 net sale price.

Plus ...

We sold the call for $3.70, reducing our cost basis of $15.20 down to $11.50. A $30.00 net sale price on the $11.50 purchase price = 160.86% return.

HOW DID HE DO THAT?

The Mechanics:

Again, this is called a calendar spread. You sell a call, that is covered by another call.This is the same as selling a covered call on a stock, so if you've got that down, you're 85% of the way there. Since The Trend Rider members already owned the 2007 Jan 45 call, they have the right to buy the stock at $45.

That is why you are covered. You have the right to buy the stock at $45. "That's a lot of cash to put up! What if I don't want to buy the stock at $45?" Easy. You don't have to. This is a riskless transaction.

Therefore, why should you have to buy the stock at $45? Since you are being called away, it means that you have someone out there telling you that he wants to buy your stock at $75.00! Almost every single brokerage firm will allow a calendar spread.

Almost every firm will NOT require that you put up the cash to buy the stock (in this example) at $45. Certainly any of the majors will allow it. Call to be sure that you can do this at your firm. If your broker sounds confused, demand to speak to a R.O.P. (Registered Options Principal), or an options specialist. It can be embarrassing for your broker to admit that he doesn't know what you're talking about. Not that brokers tend to have big egos or anything ...

Deeper Into the Mechanics:

If you are called away from your (2006) February $75 call option, the actual transaction is being handled by the same guys who will be handling your 2007 January 45 call option: The O.C.C (Options Clearing Corporation). It isn't really your broker who is handling the trade.

The OCC contacts your broker, tells him/her that you are being called away from Suncor Energy at $75.00, and you are required to deliver the stock at $75.00. If you want to call someone else away from Suncor Energy at $45.00, you tell your broker, and your broker tells the OCC.

That is why the transaction happens simultaneously. Do NOT be intimidated by this type of trade. I just turned 107% into 160.86% with one e-mail to members of The Trend Rider.

Here are the basics:

– We bought the 2007 Jan 45 call at $15.20. – The stock traded from $51.50 to $75.20. – The option therefore traded from $15.20 to $31.50. – We then sold the February 75 call and took in an extra $3.70 premium. – This reduced our cost basis (and therefore reduced our risk) from $15.20 to $11.50.

(Note: the OCC automatically calls your stock away if it is 5 cents in-the-money.)

4 Scenarios: On February 17th, 2006 (expiration day)...

1) Stock is over $75.05: We get called away and make 160.86% total.

2) Stock is at $75-$75.05: We may get called away and make 160.86% or we may not get called away, and we will be up 160.86% and still hold our 2007 Jan 45 call.

3) Stock is under $75: We keep our 2007 Jan $45 call, and we ride the stock (we still believe) higher!

4) We simply BUY BACK our short February 75 call option. This is what I will almost ALWAYS recommend. Whether the stock is up, down or sideways, this makes sense. If the stock moved higher, then the call option that we sold short will likely trade up, but by a lesser amount than the call option that we are long. In other words, if the stock trades up five points from $75.20 to $80.20, then the long 2007 January 45 call would probably trade from about $31.50 to about $36.20 (up $4.70.) At the same time, the short call might trade from $3.70 to $6.50 (up $2.80.) So your net gain, in this hypothetical example, would be $1.90 ($4.70 gain on long option $2.80 LOSS on short option = $1.90.)

Quick note:

I know that some of The Trend Rider members may be intimidated, or they may be with a firm that doesn't allow this strategy. So what I am doing is I am addressing that group as well. I recommended to that group that they sell the call at $31.50, and I will be sending them an alert when I think that it's time for them to buy it back. Jim Cramer would say "BOO-YA!" Your broker might say "What the?" I say, sign up with The Trend Rider and start making ridiculous money with the rest of us. To tell the truth, I really didn't think we'd be doing THIS well.

---

After I sent out that trade recommendation I got lots of cool e-mails.

Here’s an example of one:

"BTW, you have great advice and are doing a great job."

"I am learning a lot while I am earning returns that I did not think were possible."

"Your subscription cost was the best tuition that I have ever paid (well I am still getting a lot of mileage out of the college tuition that I paid so that may be a stretch)."

You can't make this stuff up!

I hope that you have learned something.

Okay everyone. D'bdee D'bdee D'bdee That's all folks!

"Profit from the Trend"

Chris Rowe
Chief Investment Officer,
The Trend Rider

P.S. – Keep an eye on your inbox, and within a couple days you’ll get the next installment, where I’ll let you in on six of the most helpful and proven trading tips you’ll ever read.

A video intro to Lesson 2