Why Option Traders Rule Stock Traders

04/22/2011 5:00 am EST

Focus: OPTIONS

Jared Levy

Senior Market/Derivatives Specialist, Financial Markets Education, LLC

By using options instead of buying stocks outright, traders can tap into a powerful investment vehicle that can drastically reduce risk, increase profits, and still provide all the benefits of owning stock.

Over the weekend, I had the pleasure of spending some time with a friend—we will call him “Greg.” Greg is a true “stock investor.” He has been investing for years and has done well for himself through diversification and other methods.

We were talking about his stock portfolio, and he was expressing some of his frustration with the amount of money he had at risk, as well as the fact that his stock portfolio was not performing to his expectations.

It’s not that he owned the wrong stocks, necessarily. He was just using the wrong vehicle and strategy to invest in them.

Uncertain Times

I think that about sums up the current global situation, geopolitically and economically, and in the stock and bond markets. Experts can’t agree at all on which way the stock market is going, nor do they seem to know what the fate of the US housing market or economy will be, for that matter. The market is choppy, trendless, and volatile at times.

With all this confusion, do you think it is a good idea to invest a good portion of your stock portfolio in anything but cash (or maybe precious metals)? Probably not.

But at the same time, you don’t want to park the bulk of your investments in cash, which is going to suffer the effects of low interest rates and inflation.

You must at least keep up with inflation to grow your nest egg or at least keep your current retirement stable, because the way things look right now, Social Security and Medicare will look quite different in ten years.

Augment Your Risk

I was looking at some of Greg’s positions and noticed that he had 500 shares of McDonald’s (MCD), currently trading at about $78. He had bought them at $72, so he was making a good profit of about $3,000. The problem was that almost $40,000 of his stock portfolio was tied up in that investment.

This obviously wasn’t his only position, but many of them had the same dollar amounts tied up and he had little cash to make other investments or in case of emergency.

What if I told you that you could use options to essentially control 500 shares of MCD, but at less than 10% of the cost and still have unlimited profit potential and limited risk? Would you be interested? Greg was.

Call options can provide you with an investment vehicle that can reduce risk drastically and still allow you just about all the benefits of owning stock.

Now, I will say that it will take a bit of education, practice, and some guidelines to know how to do this. So let me explain how to use options without increasing your risk.

NEXT: Profit with Lower Risk Using Call Options

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Call Options Explained

A call option is similar to a coupon to purchase any item, only a call is a coupon to purchase 100 shares of stock. Just like a coupon, a call option has a price at which you can buy the stock and an expiration date.

If you had a coupon to buy a DVD player for $100, which expired in September 2011, you essentially have a September 100 call option on that DVD player.

Obviously, you have to pay for a coupon in one way or another. Follow me on this one:

  • Let’s assume you paid $2 for the Sunday paper and cut out the coupon

  • In that case, the DVD player should be selling for at least $102 for it to even be worth it to you. (If you have the right to buy it for $100, but you paid $2 for the coupon, that is your “breakeven” point, meaning you wouldn’t be paying anything else out of pocket, nor would you be making a profit.)

  • But what if you went into the electronics store and the DVD player was selling for $120?

  • How much value does your coupon have then? ($20, right?)

  • If you paid $2 to get the coupon, theoretically, you just made $18 on a $2 investment

We all know that you can’t just waltz into the electronics store with a coupon that is worth $20 and demand cash…but you can in the equity options market!

A common misconception is that you must buy the stock to make money on your options, but that is simply wrong. Call options can be bought or sold at any time. It’s like being able to sell your coupon for the DVD player back to the store and capture your profits.

Another rule of thumb is that you can only lose what you pay for a call option and you don’t have to have the money to buy the stock.

For many people, that’s reducing their risk already, because they don’t have to have $40,000 tied up in a single stock.

How Else Can They Reduce Risk?

Using MCD as an example, imagine Greg sold the 500 shares of stock at $78, for a profit of $3,000. With the profits he made, he decided to replace the costly stock with coupons (call options), which gave him the right to buy the stock at $75 until September.

In the current market, those calls will cost about $4.20 apiece ($420 per contract), which means he can afford to buy seven contracts.

(Options contracts are sold in blocks of 100, meaning one call option contract gives you the right to buy 100 shares of the underlying stock. This means a call option with a price of $4.20 will actually cost you $420 to buy.)

But since your original investment in the stock was 500 shares, you might only buy five call options. That total investment would cost $2,100 (pocket the other $900 as a guaranteed profit on the trade no matter what happens).

So now, with the five calls, you have control of 500 shares at a cost of $2,100, which is the most you could ever lose, even if MCD dropped to $10 per share!

Essentially you have locked in a $900 guaranteed profit, and if MCD moves higher, you can continue to make an unlimited amount of money. Remember, the calls give you the right to buy MCD at $75 per share, so if MCD were to rise to $85 by September, the calls would be worth at least $10 (or $1,000, because remember, contracts give you access to 100 shares of stock).

And guess what: Since you paid $4.20, you would make 161% on your call options.

Not only is that cool, but you are reducing your risk from $40,000 to $2,100, pocketing $900 in guaranteed gains and still giving yourself unlimited profit potential until that option expires. All the while, you are taking risk off the table in this uncertain market.

No investor could do this just by investing in stocks.

One of Many Techniques

This is just one of the hundreds of different strategies that option traders have at their disposal. You may be taking unnecessary risk in your portfolio, and you may be able to reduce that risk, amplify returns, and/or increase your probability of success by learning the options markets.

Remember that there is usually more than one solution to a problem. Think outside the box and you might find them.

By Jared Levy, editor, WaveStrength Options Weekly

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