I want you to think about the last stock you purchased.
Now think about why you chose to buy stock in that company.
Did you do your due diligence? Did you know the revenues, profits and expenses? Did you know the company’s five major competitors and main suppliers? You wouldn’t dare buy a stock just by looking at the chart, right?
Unfortunately, most individual investors can’t answer 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 Wall Street. 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, using the SPDR S&P 500 ETF (NYSE: SPY), of how I evaluate each and every investment I make.
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. 17, with the SPY trading for roughly $201 and in an overbought state on a short-term basis, I decided to sell a few vertical call spreads in SPY. 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 209/211 vertical call spread for $0.26, or $26 per spread. The max risk on the trade was $174. At first glance the risk/reward seems off to those new to options. I always get the same question, “Why would you risk $174 to make $26?”
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 209/211 vertical call spread has a very high probability of profit of 85.59%. In fact, I can cater each of my trades to fit a certain probability of profit so that I always know what my risk/reward is at order entry.
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 SPY doesn’t push past $209, the short strike of my spread, I will make a max profit on the trade. That’s a margin of error of 4.0%. I challenge investors to find a stock trade that allows you to be directionally wrong 4.0% 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 14.9% ($26/$174*100).
So, in conclusion, I was selling a type of credit spread, more specifically a bear call spread with probability of success of 85.59%. Basically, if SPY stayed below $209 at January expiration (in 30 days) I would make 14.9%.
I’ve been doing trades like this in my various options portfolio for my Options Advantage service.
I hope a few of you will 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 equity investment arena.
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