Leverage Investments

The Smart Profits Report: Issue #382
Tuesday, January 2, 2007

Leverage Investments: How To Use Options Delta To Vanquish Volatility
By Karim Rahemtulla
Investment Director, Mt. Vernon Research

There’s more than one way to skin a cat on Wall Street. But it’s remarkable just how many investors choose to tread down a very narrow path, faithfully sticking to just one, standard mode of investing: Buying stocks.

That’s why at investment conferences and seminars, I often talk at length about the power of leverage investments. But based on the number of questions from audience members that follow, it’s clear that many are either unaware of this concept completely, or don’t understand how to incorporate it into their investment strategy.

Slowly but surely, however, this is changing, as investors figure out that options don’t have to be confusing, but instead are a really easy and powerful way to control shares of your favorite investments - and more importantly, something that can produce excellent returns.

Simply put, options offer this leverage investment. After all, if you can control 1,000 shares of a stock for a stock for a dollar a share, why pay $50 a share? The problem is trying to figure out which strategy is right for you.

You Use Leverage In Life… So Why Not Leverage Investments?

Here’s the thing: You probably use leverage every day of your life. Whether it’s a mortgage payment, car payment, or simply buying goods with credit, you’re controlling or owning an expensive item for a relatively small amount of money.

The same applies to the investment world - and with options in particular. This is actually unfortunate in a way, because many investors use options in the same way as they use their credit cards: Recklessly. They choose the cheap route of trying to play short-term options. After all, the “lottery effect” is quite a strong lure outside the market, so why not in the market, as well?

But I’ve often said that investors who trade short-term options without a clear system or strategy are heading for trouble. I mean, if you can accurately, and consistently predict the short term movement of a stock, then what the heck are you doing reading this column?

I’d estimate that more than 90% - maybe even 99% - of investors cannot predict the closing price of a stock at its options expiration when that expiration is less than two or three months away.

But as the investment time horizon increases, the probability of being right increases, as well. There is more time for a company to post better earnings, acquire a new partner, develop a new drug, make a blockbuster announcement, etc. So you have to choose: Are you a short-term better, or a longer-term investor?

Well, whether you’re bullish or bearish, your goal is to make money. That’s why, instead of buying the shares outright, you want to increase your leverage investments by using an option. Let’s see how this works…

Vanquish Volatility And Accelerate Your Profits With The High-Delta Trade

In the October, I recommended a play on a healthcare giant to subscribers of our Xcelerated Profits Report service (for more information on this, check out our Cribsheet below). And while it would be unfair to subscribers for me to reveal the pick here, I can break down the mechanics of the play for you here - just like we do with each pick in every issue - so that you can see the best way to invest and “accelerate your profits.”

The company I found had super earnings, a great growth profile, and was in the midst of a ton of insider buying. Even better… the company’s shares had sold off because earnings had missed by a mere penny in the previous quarter.

But what many investors failed to notice was that the CEO had explained the reason for the miss and said that the problem had been resolved and earnings growth was back on track. He put his money where his mouth was, too, ponying up over a million dollars to buy shares on the open market.

So we had two choices:

Buy the underlying shares at the market price - about $39 each.

Look for leverage investments. This is where our real moneymaking opportunity comes into play - and it does so in the form of the high-delta options trade.

Simply put, delta is a measure of change. In options speak, delta refers to the rate of change of the option, based on the rate of change of the underlying stock. In other words, if a stock moves $1, delta figures out how much the underlying option will move.

There are several different factors that affect the delta:

Time
Strike price
Underlying volatility

The most important factors are time and strike price. Volatility is what we can conquer with the high-delta trade. Here’s how it’s done…

How To Invest 70% Less And Earn A 72% “High-Delta Profit” Potential

Take a look at our two choices again from above:

Option #1 sees us spending $39,000 to buy 1,000 shares of the company. My target on the shares was $51. So on the share trade, we stand to make $12 - or about 30%.

Option #2 - the high-delta trade - is to buy an out-of-the-money (OTM) call option. In this case, a $40 one-year LEAPS option would cost about $5. That $5 is pure premium with no intrinsic value. On this option, we stand to make a net of $6 on the $5 we have invested - or 120%. But we can only make money if the stock closes above $45 at expiration. Any close below that number and we would lose money.

I chose neither option. Instead, I decided to take the high-delta route.

As I scanned the various delta figures on the options, I saw that the January $30 option was sporting a Delta of 87. This means that the option should move up 87 cents for every $1 move in share price. The down move would be the same ($0.87 down for each $1 down).

The cost of the option was $11.60. This means our actual risk was $2.60 in premium. We calculate this by taking the strike price ($30), adding the premium ($11.60), and subtracting the stock price at the time of the recommendation.

With a $50 price target, my profit potential is 72%:

$50 minus $30 minus $11.60 = $8.40.

$8.40 divided by $11.60 = 72%.

The amount of money I have to invest is $11.60 as opposed to $39, or about 70% less capital at risk. Also, as long as the shares are above $41.60, I am making money.

Ring In The New Year With Some High Delta Options

So as we enter 2007, resolve to add high-delta options trades to your investing repertoire - for both calls and puts. It allows you to make the most of any move in the underlying shares, with much lower capital at risk than owning the shares outright. After all, with an almost dollar-for-dollar move, what’s the point of buying the shares and taking unlimited risk?

In the example above, we accomplished our goal of finding a way to participate in an accelerated profit play without having to put in a lot of money up front - an enticing scenario for any investor.

Good Investing,

Karim Rahemtulla

Today’s Smart Profits Cribsheet

Having spent six years as a market maker on the trading floor of the New York Mercantile Exchange, my good friend and colleague Lee Lowell is a master of the high-delta options play. He’s expanded on the concept here, as well as deep-in-the-money options. So for more details on how to accelerate your profits through this powerful, cost-effective technique, visit Smart Profits #262, Options Leverage: How to Use Delta to Maximize Leverage.

On December 21, we released the January 2007 Xcelerated Profits Report issue. Besides the regular 8-page issue, where we recommended a flourishing company in the lucrative water sector, and a 2007 chart-based outlook that showed readers how to profit from the key stock indexes, most influential commodities markets, and the U.S. dollar, we extended the issue to include an additional 7 pages of online content, with a comprehensive review of our portfolio. In addition to the winners we already banked in 2006 (including 84%, 66%, 63% and 55%), we’ve got plenty more to come in 2007, as all our open positions are currently in the money. If you’d like more details on how to use powerful investment techniques to “accelerate your profits” in 2007, simply go to Mt. Vernon Research.

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