I want you to think about the last stock you purchased.
Now think about why you chose to buy stock in that company.
Certainly, you did your due diligence. You know the revenues, profits and expenses, and of course its five major competitors and main suppliers. You wouldn’t dare buy a stock just by looking at the chart.
Unfortunately, most individual investors can’t answer any of those questions. Yet, investors will invest their life savings in a company they know very little about. But who really knows the answers to those questions? Experts, of course. There are facets of a company that analysts will spew out that you never knew existed.
But frankly, who cares.
Knowing everything you can about a company and making money are two different things. And confusing the two is where most investors, individual and professional alike, are led astray.
It’s all fugazi. Those of you who have seen “The Wolf of Wall Street” know what I’m talking about. Sadly enough, the majority of investors are sold a story and nothing more. In many ways it’s what Wall Street was built on. Believe me, I worked on the floor, I’ve heard the fine-tuned pitches based on nothing but an attention-grabbing story.
And that is exactly why I use options.
I’m not going to allow a story to define how I invest my hard-earned money. I make investment choices based on a “no nonsense” approach of evaluating hard statistics: maximum risk and reward, probability of profit, and expected return.. Before I make any investment decision I know the exact percentage of each statistic mentioned above. Again, no stories or the soft data we are accustomed to seeing from the financial community…just hard statistics.
Let me take you through an example of how I evaluate each and every investment I make using one of my recent trades in Apple (Nasdaq: AAPL).
The first question I always ask myself when looking at a potential option trade is, “What is the most I can make or lose on this trade?” Fortunately, in the world of options the numbers can easily be calculated so that you can make a logical decision based on your risk/reward tolerance.
On Dec. 27 with Apple trading for roughly $560 and in an overbought state I decided to sell a few vertical call spreads in Apple. A vertical call spread is an options strategy for those who are bearish or neutral on a stock. In fact, the stock can actually move slightly higher and you will still make a max profit.
I sold the 600/605 vertical call spread for $0.42, or $42 per spread. The max risk on the trade was $458. At first glance the risk/reward seems off to those new to options. I always get the same question, “Why would you risk $458 to make $42?”
This is where the second question comes into play, “What are the chances that this will be a profitable trade?”
The answer is simple: the trade has a very high probability of profit of over 90%. In fact, I can cater each of my trades to fit a certain probability of profit so I always have an overwhelming edge. Basically, by selling options rather than buying options like most investors I can create an enormous margin of error.
In this case, as long as Apple doesn’t push past the short strike of my spread or $600 I will make a max profit on the trade. That’s a margin of error of 6.6%. I challenge investors to find a stock trade that allows you to be directionally wrong 6.6% and still make a profit. Again, this is why I use options. I compare selling options to being the house in a casino, but with significantly better odds. And as we all know the house always wins over the long term.
Finally, I would ask, “What is the expected return for this trade, taking into consideration the max risk/reward and probability?” The expected return would be 9.1% ($42/$458*100).
I’ve been doing trades like this in my Apple portfolio for my Options Advantage service. So far, so good. Since May 19, 2012 I’ve made over 40% in the Apple portfolio using this same strategy while the stock has moved lower. A buy-and-hold strategy would have failed miserably in comparison.
I hope a few of you will decide to take the plunge and at least investigate the true power of options. Yes, they can be risky, but if used properly they are one of the most conservative and lucrative investment tools available. That is a combination that is impossible to come by in today’s investment arena.
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