Perhaps you think it's impossible to score another 1,000% gain off this "tech titan" stock. Think again. An unusual strategy lets you virtually "recreate" gains off the biggest companies you thought had come and gone. CLICK HERE to see how it works.
Trading Options: The Power of Leverage, Call Options & LEAPS
by Karim Rahemtulla, Investment Director, Smart Profits Report
Monday, June 1, 2009: Issue #1008
Editor’s Note: Almost 5 years ago, options expert Karim Rahemtulla wrote to his subscribers on the best times for trading options…
“Right now, the market looks VERY promising, jumping around like a banshee. Interest rates are low, home prices have not collapsed, China is still growing and the geo-political situation around the globe stinks. Why is this promising? For options traders, nothing is better than uncertainty and instability.”
And apart from the statement about housing collapse, his commentary rings true today and the market’s trading patterns are looking similar. It’s why we thought it’d be a good time to take a look at some options trading basics…
Many years ago, when I first started trading options in earnest, I remember pausing to think: Why would anyone buy a call option – as in, ever?
I look back now and wonder how I could trade without them.
Many investors hear the words “trading options” and dismiss anything that has to do with them flat out. Concerned about their risk and, in many instances, truly unsure how to use them, options get a mixed reputation from many investors.
They have difficulty looking past the “scapegoat coat” that the options wear.
In reality, using options can be a way to reduce the risk in your portfolio while opening up explosive, life-altering profits. But you need to understand what you’re doing and why…
Trading Options: Call Option Basics
When trading options in the options market, a call option gives you the right to buy a certain stock at a certain price by a certain time. Think of a call option like a real estate transaction…
- Say you know of a piece of land that you’d like to buy because you are fairly certain it is going to become more valuable. Maybe you even know of some development headed that way…
- It’s too good to miss, but you don’t have all the money you need to take advantage of the opportunity – right now, at least. Or you don’t want to tie up that much capital in one investment. It’s a fairly common investing situation.
- So you decide to take an option on the land instead. You approach the owner and offer him a deposit to “hold” the land for you for six months at an agreed upon price.
Let’s add some numbers to this example…
- The price of the land is $100,000. You put up a deposit of $5,000 to have him hold the land for you at $100,000.
- At the end of six months, the land is worth $115,000. Since you still have the right to buy the land for $100,000 and can now sell it for $115,000, you have just made $15,000 on your $5,000 investment.
- When you put up the $5,000, you entered into an option contract with the seller. It gave you the right to buy the land – or not. In options terminology you bought a call.
Your deal satisfied the three criteria that make up an option contract: It had a price, expiration date and premium (the amount you paid for the right to buy the land.)
Trading Options: Harnessing the Power of Leverage
Putting up $5,000 to control a $115,000 investment is an example of smartly using the power of leverage. That kind of leveraging power is what prompted me to buy my first call option. At the time, I didn’t have enough money to buy the underlying stock that had caught my eye.
In this case the stock was IBM, which I had been following for some time…
- It was trading at $82 per share and based on my analysis, I believed strongly that it was ready to move higher. The problem was that I didn’t have $82,000 on hand to buy a thousand shares.
- I decided to buy a call option rather than pass up this trade altogether. But it wasn’t without risks. If the stock moved lower, or didn’t move at all before the contract ran out, I could lose all of my money.
- In this case I had to spend about $2 per option, or about $2,000 total, to control 1,000 shares of IBM. If I was right, I would make a bunch of money. If I was wrong, I would lose my $2,000. Still, that was a better alternative than having $82,000 at risk.
- As fate would have it, IBM did report a blowout quarter, and the stock took off – to the tune of $15 per share.I pulled the trigger when the shares hit $90 and sold my option for an $8,000 net profit, or 300%, days later.
I pulled out early, but you never can lose when you sell at a profit.
Now, if I’d bought the shares instead of using the call options, I would have profited as well. But I would only have made 9.7% and tied up $82,000 instead of $2,000. That’s why investors love trading options, it gives them the ability to use leverage to their advantage.
In addition, most options move much faster than the underlying stock price. It’s how we hit the triple-digit gainers.
Trading Options With Short Expiration Dates? Try LEAPS
One of the biggest complaints I hear about trading options are their short expiration dates. But there’s a simple answer to this problem though, called LEAPS – also known as Long-Term Equity Anticipation Securities.
LEAPS are one-, two- and three-year options that give you control of the underlying shares through the purchase of PUTS (short) and CALLS (long). In short, they give you much longer timelines to invest in the long-term movement of individual securities.
Two to three years is a long time to take advantage of market movements. And more importantly – they reduce your risk. Why risk 100% when you can take 90% of your money off the table and risk only 10%?
Call options and their older brethren LEAPS help you put time on your side when you use options leverage.
Now, options are volatile. Their prices can change rapidly – both up and down. You have to be right about which direction prices are headed and how fast, or you can get nuked in the short term.
Plus, call options can expire worthless if you are wrong about the move of the underlying stock. Despite the big returns options can deliver, they still carry big risk.
I urge you to do your research and find out if using call options and LEAPS are right for your investment strategies and risk levels. Because if they are, you could find yourself looking at a 300% gain at the end of this year instead of only a market return of 14%.
Good investing,
Karim
Today’s Investment U Crib Sheet
- Options are a great way to use leverage and hedge your bets. And we’ve been talking a lot about hedging recently. David Fessler gave readers, “Four Ways to Protect your Portfolio Against Inflation.”
- And Alexander Green warned readers to hedge their bets in real estate because we may not see the quick rebound everyone expects. You can read more on, “The Housing Market: The Disappointment Of The Decade.”
- Louis Basenese seems to be the only one not hedging, he just gave readers a stock he believes will “Smoke the Markets.”
- LEAP Options: Put Time on Your Side With This Trading Strategy
- In Response To IU’s E-Mailbag…
- LEAPS: How to Add This Option Trading Strategy to Your Investment Arsenal
|
The Company Set to Dominate a $60 Billion-a-Year Market
$60 billion is spent on cancer treatment in the U.S. - each year. And one company is poised to receive the lion's share of it.
The medical director at the Alta Bates Comprehensive Cancer Center says, "...possibly a third of our cancer patient population will soon be undergoing this [company's] treatment."
Another doctor at the University of Texas MD Anderson Cancer Center says he intends to treat over 1,000 patients a year with this technology.
Here's how you can claim your stake in the company before this cash infusion sends shares soaring.
3 Responses to “Trading Options: The Power of Leverage, Call Options & LEAPS”
Comments
**By submitting your comment you agree to adhere to our Comment Policy and Privacy Policy.Check out our selection of daily Investment Research:
 |
 |
Investment U RSS Feed
June 1st, 2009 at 5:30 pm
very well explained ‘call’ & ‘put’,,,i must admit that as a recent invester, some of the terminologies have been a bit bewildering until i joined investment u, and received the articles and crib sheets. however ‘options’ were as mystifying as asking for the answer to a magicians trick, many answers hardly any sense.
thank you for makling sense
Reply
June 1st, 2009 at 7:23 pm
You left out one true fact “most options expire worthless”
Reply
June 8th, 2009 at 4:48 pm
Re: “The price of the land is $100,000. You put up a deposit of $5,000 to have him hold the land for you at $100,000. At the end of six months, the land is worth $115,000. Since you still have the right to buy the land for $100,000 and can now sell it for $115,000, you have just made $15,000 on your $5,000 investment.” It looks like you paid $105,000 total for the land and sold it for $115,000, which would be a $10,000 profit (less any borrowing cost).
Reply