Daily Gains Letter

Reap the Gains Without the Big Risk

By for Daily Gains Letter | Dec 31, 2012

DL_George_6The fiscal cliff has dominated the news, but we also have the eurozone risk, national debt, job creation, weak revenue and earnings growth, and China.

Given all of the uncertainties, there is ample risk in stocks, and you need a good investment strategy.

Now, you can buy into new positions and assume the risk, but a much safer investment strategy alternative is to play either upside via call options. In this way, you can take advantage of any upward move in the equities market but, at the same time, manage the maximum risk you have via this option investment strategy.

Let’s say you feel the economic renewal will continue to drive auto sales, but you also are a bit worried about a possible economic downfall if Europe and China tank.

You are looking at Ford Motor Company (NYSE/F), and you feel the stock may be heading higher. The risk is that the stock could move downward. A viable investment strategy is to play Ford via call options, instead of buying the stock outright. This will not only add leverage to your trade, but it will also limit the loss to the premium paid, which is a good investment strategy.


Chart courtesy of www.StockCharts.com

Let’s take a look at Ford, and assume you want an option investment strategy that equates to 1,000 shares of Ford. You feel Ford could rally to $15.00 by September 2013.

Assuming this, you buy 10 call contracts of Ford, equal to 1,000 shares of the underlying stock. For every board lot of Ford, for example, one call option may be written.

Here’s the mechanics: Looking at the September 20, 2013 expiry, the Ford in-the-money $10.00 call is priced at $2.13 per share, or $213.00 for a contract, which is the premium paid.

The cost per contract of $213.00 equates to $2,130 per 10 contracts. This is the maximum risk of exposure. If Ford fails to break $9.00 by the September 20, 2013 expiry, the premium you paid is lost in this investment strategy. The upside breakeven is $12.13, which is pretty good, given there’s a good chance that Ford could likely trade above $12.13 by the expiry.

Now, say Ford jumps to $15.00 by the expiry; you would make $2.87 per share, or $2,870 for the 10 contracts, for a leveraged return of around 153% in less than a year.

The maximum risk is $2,130, but you can more than double your money if Ford hits $15.00, which is a good risk-to-reward investment strategy.

You can use the Ford example with many stocks that may interest you as a lower-risk, alternative investment strategy to buying the stock.

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