Investing Strategies

The Smart Profits Report: Issue #408
Friday, March 30, 2007

Investing Strategies: Enjoy The Pleasure Of Option Investing Without The Pain Of Speculating
By Karim Rahemtulla
Investment Director, Mt. Vernon Research

I’ve got one simple question for you: Are you an investor or a speculator?

From talking to subscribers and attendees at the many investment conferences I speak at, I can usually tell which side of the fence a person falls on. There are a few major differences between these investing strategies:

The Speculator: Risk means little to this guy. His aggressive approach means he makes a ton of money… but can also lose a lot of money. Trading is a thrill for him and he loves the adrenaline rush. Don’t be fooled, however. He’s usually very knowledgeable and his success is based on a strong system - and his success clearly separates him from regular investors.

The Investor: Most people fit into this category. The investor makes a lot of money, too. But he’s more aware of the risks involved and takes time to understand the various investment strategies and why they work. The pure investor is more patient and isn’t necessarily looking to crush home runs in a short period of time. He allows more time for his trades to work in his favor. He’s well-diversified and follows the rules.

But when it comes to investing strategies in options - one of the fastest-growing areas in the financial world - the rules change a little. This area can provide an exhilarating, yet painful experience. Here’s how to maintain the thrills, but reduce the spills…

Lift Your Leverage… And Look To The Long-Term

Part of the allure that comes from options investing strategies comes from the fact that you can boost your leverage. However, the more leverage you employ, the lower your chance of huge returns.

One dilemma you face is trying to figure out which strike price and which expiration date to choose. And this is where your decision boils down to whether you’re an investor or a speculator.

If you’re speculating heavily, you might as well choose an out-of-the-money option that costs you very little money. While this kind of option does promise some pretty healthy gains, it holds more risk and a higher chance of you coming out on the losing end, so it’s often not worth risking too much money.

However, the bottom line with options is that you’re essentially speculating in some way or other. You’re expecting some kind of catalyst to occur that will allow you to rake in the riches. And those catalysts can be short-term or long-term in nature.

But outside of an iron-clad, hot tip from your brother-in-law’s third cousin, once removed, most retail investors prefer to steer clear of the short-term rollercoaster ride and focus on the intermediate to longer-term outlook.

So if you’re willing to tie up your money for longer in hopes of reaping a reward, how do you tackle this? Here’s my advice for the longer-term speculator…

How To Enjoy The Pleasure Without The Pain

If anyone asks you why you’re investing strategy focuses on the long-term picture, your response should be simple: It gives you that precious commodity: Time. Time for something to happen.

And in this case, you’re looking to buy longer-dated call or put options (depending on your directional bias) - and buy those that are deep-in-the-money.

The reason is simple: Deep-in-the-money options allow you to pay the least amount of premium to participate. In other words, you want the highest Delta (a gauge that tells you how much the option will move in relation to the underlying stock) at the best price possible. This way, you get a similar move in the option from the movement in the underlying shares.

Here’s an example of what I mean…

Investing Strategies: Going For Gold

Let’s say you like gold and think it’s going higher. To take advantage, you can buy one of the sector’s top companies, Newmont Mining, today for $43 in anticipation of that move.

The Short-Term Investing Strategy: If you expect the move to occur in the next two or three months, you want to buy a cheap option that is out-of-the-money - let’s say a $45 call option. This way, an underlying move in Newmont will have a nice percentage gain on the option. And if you lose, you lose little.

The Long-Term Outlook: On the other hand, if you believe gold is in a long-term bull market and have set your sights on $1,000 per ounce in a couple of years, you have two choices: Either buy Newmont shares, or buy LEAPS options on Newmont.

If you want to control 1,000 shares outright, it will cost you $43,000 for the trade.

But if you want to control 1,000 shares via deep-in-the money LEAPS instead - let’s say the Newmont $30 calls - you will pay about $15 per contract. That’s an investment of $15,000 for two years - much better than coughing up $43,000. Your premium on this option would be about $2 ($43 minus $30 minus = $13 (your intrinsic value), plus $2 in premium for time and risk).

If Newmont moves to $50, you will make $50 minus $30 (your strike) minus $15 (your cost) - or about $5 in profit. If you owned the shares, you would make $7 - but remember, you invested almost three times as much.

But let’s say gold prices don’t rise as much as you think. In two years time, Newmont shares have gone nowhere, and remain stubbornly around $43. You would now only lose $2 - the premium paid, since the strike price was $30, your intrinsic value did not change - it is still $13.

There is one more important investing strategy component involved here…

If you bought 2-year LEAP options on Newmont with a $45 strike price, you would pay about $6.50. In this case, you’d need Newmont to close above $51.50 before you make a dime. And if Newmont stayed at $43, you would lose 100% of your investment.

(Please note, the above trade is an example only, not an actual recommendation).

Investment Vs. Speculation: Know The Difference

While the degree of speculation varies, all investments, aside from CDs and T-bills, are essentially speculations, separated by semantics and degrees of risk.

And with options offering many prices and expiration dates, knowing how to differentiate between an investment and a speculation will determine which option you should use and which investing strategy to employ.

With options, however, you can speculate using leverage as a powerful tool that gives you the chance to ramp up your investing strategy’s returns.

Great trading,

Karim Rahemtulla

Today’s Smart Profits Cribsheet

Investors and speculators alike could be facing increasingly sluggish stock market returns. In its latest report on the health of the U.S. economy, the Commerce Department said on Thursday that GDP growth rose at a mere 2.5% annual rate during the final three months of 2006. For 2007, economists now project full-year economic growth to hit 2.7% - which would be the slowest in four years, and well below the economy’s average growth rate of 3.25%.

However, it doesn’t mean you have to sit on the sidelines and wait for profits. In fact, our own options and commodities expert Lee Lowell believes this represents a great chance for you to use the decline to buy quality stocks at deeply discounted prices - and get paid for it while you wait. It’s one of the most powerful investment strategies to use when you think a stock will fall and want to own it at a lower price. For more information, click this link.

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