Afraid Of Leverage? Don’t Be. Here’s Why…
Risk and reward tend to go hand-in-hand. So anything that involves the potential to increase your returns more than 10-fold must be extraordinarily risky and volatile. Like scoping out a nano-tech software developer in Eastern Europe or speculating on a South American foreign currency futures contract.
That’s not necessarily the case, however. Let me put you at ease.
There is a proven way to magnify your returns that is far less exotic. You can even utilize this tactic with reliable, blue-chip stocks trading right in your own backyard. The secret has nothing to do with which securities you buy – but how you buy them.
I’m talking about stock options. If you’ve never dealt with options before, don’t worry. I know what you’re probably thinking. But first, I want to start with a simple example.
The Power Of Leverage
Imagine there’s a guy (we’ll call him Steve) who is about to become a first-time homeowner. Steve has just signed the papers and picked up the keys to a $300,000 home. It’s a nice neighborhood, where real estate values have generally appreciated over time. Five years later, the house appraises for $330,000.
Steve decides to sell, pocketing a tidy gain of $30,000 (let’s not worry about realtor commissions). Compared to the value of the home, that’s a return of 10% ($30,000/$300,000).
But here’s the thing… Steve didn’t pay the entire mortgage upfront. He only made a 20% down payment, handing the lender $60,000.
So relative to his $60,000 investment, the $30,000 profit actually represents a gain of 50%. His outlay was five times smaller, so the return was five times larger.
That’s the power of leverage: using a modest amount of money to control a larger amount.
“Leverage” is often seen as a dirty word when it comes to investing. But if you can understand this analogy, then you’re halfway to understanding how that isn’t always the case. And how options can be a powerful tool to grow your portfolio.
As we all know, stocks are constantly pinging around every minute of every trading day. By harnessing the power of options, you can take full advantage of those price swings. Just like Steve did in our example, options will allow you to fully participate in stock movements, while only putting up a small fraction of the underlying asset value – thus magnifying your returns.
It’s like putting up a small ante to win a huge pot.
Is that risky? Not necessarily. While any investment involves the potential loss of capital, options aren’t inherently risky. In fact, they can be used to minimize losses. They can also generate predictable income while safeguarding against market volatility.
Let’s take call options for example. In the following example, I’m going to show you how a simple price move can be amplified into a much bigger gain using the power of leverage.
Here’s How It Works…
Let’s look at a hypothetical example using a household name, Wal-Mart (NYSE: WMT). As I’m writing this, shares of the retail giant are currently trading at $122. There is a call option expiring on September 18 with a strike price of $130 and a premium of $5.00. Remember, each contract controls 100 shares, so the total cost to buy the option would be $500.
Suppose Wal-Mart shares stay flat or decline between now and the expiration date. In that case, there would be no point in buying a stock from the seller for $130 when you could buy it for less on the open market. Therefore, the option would expire worthless.
So even if WMT stays unchanged, you would lose $500. That’s the tradeoff for a much richer potential payday.
The breakeven point on this contract would be $135. You would gain $5 per share ($135 minus $130) for 100 shares, offsetting the $5 premium. Anything above that level would be profit.
Let’s suppose WMT shares climb to $138.
At that point, you could exercise the option, buying 100 shares at $130 and then promptly selling them in the market at $138, collecting a gain of $800. After subtracting the $500 premium, that would leave a net profit of $300.
In percentage terms, that’s a hefty return of 60% ($300/$500). Alternately, instead of exercising and taking control of the stock, you could simply sell the option for $8 per share (which would be its new price). Either way, the call option made the most out of WMT’s rally.
Had you just bought the stock outright, it would have cost you $12,200 upfront (100 shares x $122). And the gain would have been much smaller, just 15% ($138 – $122 = $16, $16 / $122 = 13%).
In other words, the options contract would have turned a routine 15% move in WMT stock into a much larger 60% gain – multiplying your return by four times.
Action To Take
Keep in mind, this is a rather straightforward example. And it’s purely for illustrative purposes and is not meant to be taken as a trade recommendation.
The point is, some options trades are meant to profit from an expected downward move in a stock. Others are designed to generate income if the stock moves sideways. There are even complicated strategies involving two or more options contracts working in tandem.
One of my favorite options strategies, by the way, is where you get paid upfront…
It’s one of the easiest ways to safely enhance your income – and it can work in just about any market environment. In fact, my colleague Jim Fink has perfected a system over the course of his 30-year trading career that delivers regular payouts of up to $2,950 every week.