Tuesday, December 5, 2006
It’s the options market’s dirty little secret...
Most people lose money trading options. They use options to speculate... to take on more risk than they can handle.
But there’s a simple options strategy I’ll tell you about today that gives you the leverage of options... and involves no more risk than owning your average stock. Here’s how it works:
Use options as a substitute for owning the underlying stock.
For example, let’s say you want to take a position in Home Depot (HD), which closed Monday at $39.20 per share. You could pony up $3,920 and buy 100 shares of the stock... or you could stroll on over to the options market and establish the same position for no money down.
Let me explain...
One Home Depot January 40 call option (HDAH) – which gives the option holder the right to buy 100 shares of Home Depot at $40 by January 19 – trades for $110.
One Home Depot January 40 put option (HDMH) – which obligates the option seller to buy 100 shares of Home Depot at $40 by January 19 - trades for $170.
Now, if you buy the January 40 call option and also sell the January 40 put option, then you have both the right and the obligation to buy the stock at $40. Put another way, no matter what happens to Home Depot between now and January 19, you’re buying the stock at $40.
At first glance, this seems like a raw deal, since the stock is trading at $39.20. Keep in mind, though, that you paid $110 for the call but you received $170 for selling the put. So you pocketed $60 on the option position. When you take that into account, you’re actually buying the shares at $39.40.
Here’s how it all breaks down...
Buy the HD Jan. 40 call option = -$110
Sell the HD Jan. 40 put option = +$170
Net Credit +$60
Buy HD at 40 on Jan. 19 -$4,000
Net cost of the stock -$3,940
Buy 100 shares of HD = -$3,920
The option position will behave exactly like the stock position. If Home Depot goes up $5, you’ll make $500 on the stock and you’ll make $500 on the option position. If HD drops $5, then both the stock and option positions lose $500.
The biggest difference, of course, is that instead of putting up $3,920 right away to buy the stock, you can control the same position with options and receive a $60 net credit.
And the $3,920 that would have otherwise been spent on the stock can sit in your money market fund and earn interest until you have to buy the stock on January 19.
And that’s how you buy Home Depot with no money down.
Be sure to check with your broker and comply with whatever rules and margin requirements the firm places on option accounts. It’s worth the trouble.
Once you get the hang of “no money down” stock ownership, you’ll join the select few who use options to make money instead of losing it.
Best regards and good trading,
Food and agriculture businesses booming… Syngenta, Agrium, Terra Industries, and Bunge all at new highs.
Dividends are in style… iShares Dow Jones Dividend Index ETF hits a new high. Major holdings include Altria, Kinder Morgan, Merck, and Bank of America.
Big Oil plays the same old song… new highs for ExxonMobil and Chevron.