Options Trading Strategy to Minimize Risk, Maximize Return

Okay, let’s start with what I think are the facts…

  • The stock market’s recent volatility is not an isolated event. There’s more in store.
  • Europe is a key driving force behind some of this volatility, and once Brexit and American trade agreements are finalized, the market will hit a turning point.

So with that said, you might be thinking, “Why not just wait until the end of the year to invest or hope for the euro to bottom?”

If it were only that easy, I’d have retired to a tropical paradise many years ago!

What I can say is that if Europe gets its house in order, it will present an explosive opportunity to make money. Until then, though, how do we translate the market’s intraday price swings into even greater profit swings for us? I’ll show you…

To Kill a Mocking Market

The market can be a humbling force for any investor, financial analyst or writer. It often runs in the opposite direction than we predict, mocking our best judgment in the process.

Even I’m not immune to making losing calls from time to time.

So whether the market rallies sooner than expected or falls harder than expected, it’s important to have flexible strategies in place.

Here’s a way to stay profitable or protected either way…

Low-Dollar Risk… High-Dollar Return With LEAPS

The way we accomplish that is by using the old fail-safe investment strategy: Long-Term Equity Anticipation Securities (LEAPS).

Right off the bat, LEAPS options reduce the amount of money that you’d ordinarily have at risk with a straight stock purchase by up to 90%.

So we’re risking only 10% of our capital, with the maximum loss being 10% of what we’d pay to own the shares outright.

That’s a far cry from a 25% stop loss… or worse.

Second, there’s a way of using LEAPS options to reduce risk even further – and potentially enhance returns too.

It’s called a “spread play.”

In a spread, your gains are limited to the difference between two price points (i.e., the price of the options). In return for this limited risk, the gains are also limited. Let me use an example to illustrate…

A Step-by-Step LEAPS Spread Trade

Here’s the step-by-step process for a LEAPS spread trade…

  • Let’s say you have a stock at $20 that you think is headed to $30 by the end of 2012.
  • You look at the $20 LEAPS call options, which are for $4 per contract – 20% of the underlying share price. Stock market volatility has made them more expensive than usual. So how can you reduce that cost?
  • The answer is to combine an options purchase and a sale so that you offset the purchase price.
  • You buy the $20 call for $4 ($4,000) and sell the $30 call for $2 ($2,000).
  • Your net cost is now $2 per contract – 10% of the underlying share price. Remember, there are 100 shares in an options contract, so your actual net cost is $2,000.
  • The profit potential is $8 – calculated by subtracting the net cost ($2) from the difference between the strike prices ($10). That’s a 4-to-1 return.
  • On a 10-contract trade (equivalent to controlling 1,000 shares), that’s an $8,000 profit on $2,000 at risk.

Compare that with what the stock trade would cost. You’d pay $20,000 to make $10,000 – just $2,000 more in profit for $18,000 more in risk.

And what do you give up by slashing your risk? Well, you cap your gain.

If the stock moves higher than $30, you get no more on your options trade since you sold the right to buy the shares at $30 to someone else for that $2 premium you received.

And while the shareholder would have unlimited upside, holding shares in a volatile market can be risky business.

Much riskier than it needs to be when you consider LEAPS spreads…

Good investing,

Karim

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Source: Wealthy Retirement