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Derivatives

The Smart Profits Report: Issue #185
Thursday, February 17, 2005

Derivatives: Take the Big Guys’ Money With Their Own Weapons
By Karim Rahemtulla
Investment Director, Mt. Vernon Research

Someone’s making money - why not you?

Derivatives such as options were once thought to be “exotic” trades. They were obscure, hard to use and best left to professional traders and high-powered institutions.

Guess what? Not much has changed. Traders and professional money managers still use them more than regular investors do. But change is coming.

I have often pondered why an options/futures market has existed for as long as it has. These markets have been around for 40-odd years and still I doubt that more than 1% of the investment public dares to use options as an investment tool.

I am sure this sits well with the pros, since it means they still have unfettered access to this money machine.

Derivatives Survival

But if few are using derivatives like options, why is there a market at all? Think about it… How can a derivatives market survive for as long as it has unless someone is making money?

The answer, of course, is that someone is making money. Any business, except one subsidized by the government, is bound to fail unless it makes people money. The only problem here is, it hasn’t been the average investor who has cleaned up.

That’s changing, and if I have anything to do with it, it will change even faster.

We need to be the “people” profiting from this market. The only way to do so is to understand how this market works, how to use it, and then take full advantage of that knowledge.

Here’s one way we can do that…

Three Ways to Use Options to Your Advantage

What you must get over is that options are NOT a weird investment vehicle to be feared, but a tool that the market has provided to use as a proxy to buying and selling stocks.

The first step is to actually learn one strategy that makes sense to you. Just one.

It could be “put” selling, covered call writing, LEAPS trading, spreads, straddles, or a host of other trading strategies. It doesn’t matter a great deal where you start as far as the learning process goes.

With options, you can choose a strategy to accomplish any number of trading/investing goals.

A few examples:

  • If you want to own shares of company but it is too expensive right now, you can sell a put. By selling a put you collect money for nothing - except the obligation to buy the stock YOU ALREADY WANTED for the PRICE YOU WANTED TO PAY FOR IT.
  • Do you now own too many shares of a single company’s stock? Nothing is more dangerous than being overweight in a single company. Instead of being so exposed, buy some three-year LEAP options as a proxy for the shares. It may cost you 10% or 15% of your capital. The other 90% can sit in the Treasury bill earning money to cover 60% of the cost of the LEAPS. Of course if the shares move up, you will make a ton of money either way, but with fewer dollars at risk if you use LEAPS.
  • Can’t decide which way a stock is going to go? Do a straddle trade where you go long and short at the same time. So then when your big announcement comes and the stock soars… or dives… you can still win while controlling your risk.

Derivatives such as options are NOT dangerous, investors are. We need to conquer that fear of doing something stupid with options. The only way to do so is to become educated investors, investors who operate with confidence, smarts and a strategy.

Good Trading,

Karim Rahemtulla

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Today’s Smart Profits Cribsheet

  • In today’s report, I talk about put selling. For more info on this, check out Smart Profits #278, Selling Naked Puts - Get Paid Now To Buy Your Favorite Stocks Later… At A Bargain.
  • Also check out our Smart Profits Glossary for more detailed information on some of the terms used above like “derivatives” or “exotic trades.”

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