• Email This Article
• Print This Article
• Digg This
• Delicious
• Subscribe

David Bickings, Optionetics.com
April 10, 2002

Most of us hold mutual funds or individual stocks and have dreams of becoming really secure financially, or even wealthy.  Some will, most won’t.  The reasons lie in the makeup of the differences between leveraged and non-leveraged investments.

Stock mutual funds are simply large portfolios of stocks that are bought with money pooled from thousands of investors by investment companies.  My biggest gripe with mutual funds is that they are often over-diversified and run by seemingly capable managers who rarely beat their respective indexes.  These guys and gals are often holders of MBA degrees and impressive designations and often don’t do any better than the little guy who diligently researches stocks and manages his/her portfolio with a level head.  Many mutual fund investors don’t build real wealth because they try to trade funds.  One of the worst things you can do is to sell your current fund and buy the biggest winner from last year.  Research has shown that this is a losing proposition.  In order to build real wealth in mutual funds, I believe, you should own only two or three funds and dollar cost average into them every month or quarter.  They will have bad quarters and bad years.  Buy them when they have a bad year and you’ll get them on sale.  In the years when they recover, you’ll have outsized gains from your diligent buying when shares were cheap.  If you buy funds from a big, well-known company like Putnam, Fidelity, Vanguard or T. Rowe Price, you’ll do well long-term.

Want a great way to build wealth in mutual funds and keep expenses and taxes low?  Buy index shares like The Nasdaq-100 tracking stock (QQQ), S&P Depositary Receipts (SPY) ,also known as SPYders, or DIAmonds, the Dow Jones Industrial Average Tracking stock (DIA).  All of these funds trade like stocks and can be bought or sold at any time during the day—unlike funds which can only be bought or sold at day’s end! Remember, most managers don’t beat the S&P 500 each year, so why not just buy the S&P?  Dollar cost average into SPY over a 20- or 30-year period and don’t sell!  The disadvantages of investing like this are many—if you call them disadvantages. First, it’s boring in that there’s no decision making going on.  You just buy SPY or DIA each month with your investment dollars and sit tight.   Secondly, there is very little chance to build wealth quickly as the historical average of the market is about 10 to 11%. Ask yourself if building wealth slowly is so bad.

Now we get to the best investment vehicle, in my opinion—options.  Why?  Simple:  

Limited Dollar Risk and Limited Dollar Exposure

As an options trader, you control the movement in a stock for just a fraction of the cost of buying the stock.  Secondly, you can never lose more than the cost of your trade when you buy options.  As a result, you can keep the bulk of your investment dollars in the safer investments like bonds, cash, or large, stable stocks.  In cash, your funds are immune to the wild volatility of the equity market. For the aggressive investor like myself, you can put a large percentage of your capital in options trades and aim for big returns each year.  Done successfully, you can become wealthy in a relatively shorter time than with the other investments we talked about.  At any given time, 30 to 40% of my portfolio is in options trades.  The rest is in cash, a few well-researched stocks, and index shares.

Leverage

You can achieve percentage gains from your successful options investments that dramatically exceed the gains achieved by stock or mutual fund investors.  As an example, here are three of my open trades, all in LEAPS, made on January 16 of this year, because I had no idea where the market was going this year and felt more comfortable giving myself more time to be right.  On January 16, 2002 I bought January, 2003 $50 LEAPS in Merck (MRK) the drug maker.  The stock was trading at $58.00 at the time of the trade and my options cost me $10.65.  As of 3/31/02, the stock suffered a loss and closed down to $57.58, a 0.7% drop.  The calls were down to $9.70, a loss of 8.92%--a painful lesson that the leverage that works in your favor will also beat you senseless when a trade goes bad.  My percentage loss was 12 times the loss of those holding MRK.  I have confidence and 8 months left so I’m holding tight.

The other two trades are doing very well.  I also bought Exxon-Mobil (XOM) Jan ’03 $35 calls when XOM was at $38.40 for $5.60.  The stock on 3/31 closed at 43.83 for a 14.14% gain.  My calls were worth $9.35, a gain of 69.96% -- over 4.8 times the percentage gain I’d have had if I simply bought the stock!  Did somebody say leverage?  Finally, bullish on the oil sector, I also bought Jan ’03 $40 calls on British Petroleum (BP) for $7.25 with the stock trading at $44.18.  On 3/31, the stock closed at 53.10, a gain of 21.09%.  My calls were worth $13.70 for a gain of 88.97%, a percentage gain of over 4.4 times that of the stock.  Note that I always buy in-the-money [ITM] options as I like the security of the intrinsic value and research has shown that when you buy ITM calls, you have a better than 50% chance that they will stay that way.  The little bit of gain I give up over an at-the-money [ATM] call and the added cost are well worth the lack of stress and the sound sleep at night.  I haven’t had a dose of Maalox since October!

Profit in Bull and Bear Markets Alike

This is an advantage that none of the traditional mutual fund families can make, and it is at the heart of why experienced options traders have profited in the volatile recent markets. By buying put options, you can achieve leveraged profits with limited dollar risk when a stock declines in price. Of course, leveraged gains can be achieved on bull moves by buying call options, but bull market profits comprise only half of the total options profit picture.  There are also a multitude of combination strategies like spreads and butterflies that will allow you to make money, even in sideways markets.  Dollar for dollar, options offer the most bang for the buck, but keep the inherent risk in mind and remember the old Wall Street mantra: Bulls make money.  Bears make money.  Pigs get slaughtered.  Don’t let greed overcome you and turn winning trades into losers or make you poor faster than it made you rich!  Good luck and great trading!


David D. Bickings
Staff Writer & Trading Strategist
dbickings@optionetics.com
Optionetics.com ~ Your Options Education Site

• Email This Article
• Print This Article
• Digg This
• Delicious
• Subscribe

Recent Articles by David Bickings, Optionetics.com

• April 30, 2002
  Survival Rules for Trading
• April 24, 2002
  Know Your Options
• April 19, 2002
  Alternatives to the Stock Market
• April 10, 2002
  Why Trade Options?
• April 5, 2002
  Developing Your Personal Investment Plan