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Risk In Investing

The Smart Profits Report: Issue #150
Monday, October 11, 2004

Risk In Investing: Don’t Take Insane Risks When You Have Options
By Karim Rahemtulla
Chairman, Mt. Vernon Research

Am I insane? I am sure that all of us - at one time or another - have asked ourselves this question after taking a bath on a “sure” thing. As human beings, we have one major disadvantage compared to other animals: We can think AND we can react illogically at the SAME time.

Consider this: As investors, we are literally at risk at all times. Then consider that we can reduce our risk in investing significantly and still remain fully allocated - but most people don’t. Let me show you how to change that…

Most investors - over 95% - prefer the high-cost, high-risk, low-return investing choice: buying stocks for huge money down.

The market offers the opportunity for the savvy investor to win while minimizing risk. But, in order to take advantage of this opportunity, you have to become a savvy investor first.

Controlling $87,000 Worth of Stock for $10,000

Here are two choices:

  • You can buy 1,000 shares of IBM today for $87,000 ($87 per share) - the choice most people will make.
  • Or, you can buy a two-and-a-half-year option to buy IBM at $90 per share for $10,000 (10 contracts at $10 per contract to control 1,000 shares).

Even if you think you are playing it safe by using a 20% stop loss on the stock trade, you stand to lose less money with the option - even if IBM tanks.

The difference is that you limit your risk in investing with the options. When you buy calls, you can only lose the premium you paid for them - $10 per share. That would be a maximum of $10,000 for your whole 1,000 shares if IBM dropped beyond all reasonable expectations.

With the stock you would lose $17,400 if your stop were hit. And the possibility that it will be hit is good. In the last five years, IBM has fallen 20% or more from its high eight times! It’s headed downward again this year.

And if you only put $10,000 in the options, you’d have $77,000 that you DID NOT invest in IBM…

How about putting it in a money market account paying 2.5% for two years? That would earn you about $5,000 over the same time period. So now your cost is only $5,000 to own IBM for two and a half years at a price of $90.

Enjoying Safer and Higher Returns: $43,000 in Two Years

This is lower risk in investing, but it also sets you up for a much bigger return. If IBM shares were to move to $130 per share in two and a half years, you would make $43,000, about 17% a year - not unheard of. That’s quite a chunk of change.

Now, let’s look at what would happen with the two-and-a-half-year option…

Your strike price (where you have the right to buy the shares) is $90. Add the cost for the option, another $5 (remember, we get $5 back from our money market account) to the share price, for a cost per share of $95. At $130, you would make $35,000 on your net $5,000 investment, or about 600% - now that is what I call a phenomenal chunk of change.

Good Trading,

Karim Rahemtulla

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Today’s Smart Profits Cribsheet

  • This type of low-risk investing is what I try to do regularly with my LEAPS Option Trader. I suggest you seriously consider using this system in your own portfolio or sign up for the service. Either way, you will take some of the insanity out of investing in the current market! To read more about it, just click here.
  • Check out the Smart Profits Glossary for definitions of terms like “contract” or “call options” found in today’s article.

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