The Easy Way To Turn A Small Price Move Into A Massive Gain

Risk and reward go hand-in-hand. Investors have been so conditioned to believe this axiom that we often accept it as gospel. And for the most part, it’s true.

But I’ll let you in on a little secret…

You don’t need to roll the dice on unproven assets like bitcoin to rake in massive profits. You don’t need to speculate in the futures market, go long on soybeans or short the Japanese Yen. And you don’t need to risk your hard-earned cash on some micro-cap software developer that your neighbor’s cousin told you about.

Let me put you at ease…

There is a proven way to magnify your returns that is far less exotic. You can utilize this tactic with reliable, blue-chip stocks trading right here in your own backyard. I’m talking about widely-held companies such as Amazon and Home Depot with time-tested business models and predictable cash flows.

The secret has nothing to do with which securities you buy – but how you buy them.

I’m talking about 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

“Leverage” is often seen as a dirty word when it comes to investing. But if you can understand the analogy I’m about to share with you, then you’re halfway to understanding how that isn’t always the case. Moreover, you’ll be that much closer to understanding how options, when used responsibly, can be a powerful tool to grow your portfolio.

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. A few 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.

If you can understand this simple analogy, then you’re halfway there.

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 an example. Shares of Company XYZ are currently trading at $140. There is a call option expiring September 15th with a strike price of $145 and a premium of around $3. Remember, each contract controls 100 shares, so the total cost for the option would be $300.

Suppose Company XYZ stays flat or declines between now and the expiration date. In that case, there would be no point in buying a stock from the seller for an above-market price of $145. Therefore, the option would expire worthless.

So even if XYZ stays unchanged, you would lose $300. That’s the tradeoff for a much richer potential payday.

The breakeven point on this contract would be $148. You would gain $3 per share ($148 minus $145) for 100 shares, offsetting the $3 premium. Anything above that level would be profit.

Let’s suppose XYZ shares climb to $155.

At that point, you could exercise the option, buying 100 shares at $145 and then promptly selling them in the market at the going rate of $155, collecting a gain of $10 per share, or $1,000 total. After subtracting the $300 premium, that would leave a net profit of $700.

In percentage terms, that’s a hefty return of 133% ($700/$300).

Alternately, instead of exercising and taking control of the stock, you could simply sell the option for $13 per share (which would be its new price). Either way, the call option made the most out of the stock’s rally.

Had you just bought the stock outright, it would have cost you $14,000 upfront (100 shares * $140). And the gain would have been much smaller, just 11% ($1,500/$14,000).

In other words, the options contract would have turned a routine 11% move in XYZ stock into a much larger 133% gain – multiplying your return twelve times over.

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.

I’ll leave those strategies for other, more qualified experts.

But here’s the point I want to get across to you today. Even though my primary focus of investing is centered around income and value investing, I still think options can have a valuable place in your portfolio.

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