By Malcolm Berko

January 1, 2014 5 min read

Dear Mr. Berko: Four months ago, I was allowed to buy in as a new member of a large, successful investment club. I'm being mentored by an older member, and next month we're assigned to recommend several growth stocks — "suitable for option writing" — with which we could make 15 to 18 percent returns. Explain options to me. Recommend several "suitable" stocks. Recommend several books to teach me about options. — PJ, Columbus, Ohio

Dear PJ: OK. As you command!

Assume you just paid $100,000 in a duplex producing $10,000 in rent and advertised to sell for $112,000. D. "Peewee" Trump Jr. reads your ad and says: "I may buy your duplex for $112,000 but need 12 months to think it over. If I pay you a $5,000 cash premium, will you write me a contract (an option) allowing me 12 months to think it over?" If you do, then three things can happen: 1) A year passes, and Peewee doesn't buy the duplex. The contract expires, but you've received an income of $15,000 — $10,000 from rent plus Peewee's $5,000 premium. That's a 15 percent return, so you advertise it for sale again and sell another option. 2) At year's end, Peewee buys the duplex for $112,000. Now you've received cash flow of $27,000 — $10,000 from rent, $5,000 from the option premium plus $12,000 from your stock profit. That's a 27 percent return. Then you buy another duplex! 3) You repurchase the $5,000 option from Peewee within the 12 months. The purchase price may be higher than $5,000, lower than $5,000 or the same.

It works the same way with stocks. Suppose you believe that Ambarella (AMBA-$32), a niche semiconductor (systems on a chip) manufacturer with zero debt, will increase earnings by 50 percent this year and should trade in the low $40s within 12 months. You buy 100 shares for $2,800. Now suppose someone's willing to pay you a $500 premium (cash) if you sell him an option to buy 100 AMBA shares from you at $35 during the coming 12 months. Would you do it? Well, you must ask yourself: 1) How much can I make? And the answer is: If the option is exercised at $35, you'll have a $700 gain on AMBA stock plus the $500 premium, which totals $1,200. That's a 42.8 percent return in 12 months. However, if AMBA rises to $48 in those 12 months, you're still obligated to sell it at $35. 2) How much can I lose? If AMBA goes kaput, which is highly unlikely, the maximum you can lose is ($2,800 minus the $500 premium) $2,300. 3) How long will it take to make this money? A maximum of 12 months but sooner if AMBA rises to $35 more quickly. 4) What happens to the dividend? AMBA doesn't pay a dividend, but if it did, the dividends would be yours until the option is exercised. 5) What if I change my mind four months later and decide to cancel my obligation to sell AMBA? And the answer is: You can repurchase the option anytime at the market price, which can be higher than, lower than or the same as the $500 premium you received.

Other suitable stocks that provide 12-month option premiums in the 18 to 22 percent range, plus attractive capital gains, are Zillow (Z-$81), which is making a resurgence in the housing market with record numbers of visitors and agents to its site. Revenues should be up 50 percent this year. Google's (GOOG-$1,107) Motorola purchase now looks like a brilliant move. Along with its growing line of gadgetry, GOOG should continue to grow earnings by 30 percent. And Chart Industries (GTLS-$92) should grow earnings by 60 percent from its designing and manufacturing equipment for the production, storage and end use of hydrocarbons. These picks should impress the club members.

I can't recommend books that teach beginners how to swim. Beginners need to jump in, get wet, feel their buoyancy, swallow some water, sink a little bit and keep stroking or learn to float. And by the same token, I can't recommend any books that teach beginners about the option market. However, there are hosts of titles — such as "Options Trading 101," "Options for the Beginner and Beyond" and "Trading Options For Dummies" — that will suffice.

Please address your financial questions to Malcolm Berko, P.O. Box 8303, Largo, FL 33775, or email him at [email protected] To find out more about Malcolm Berko and read features by other Creators Syndicate writers and cartoonists, visit the Creators Syndicate website at www.creators.com.

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