Option Investor
Educational Article

Safe Investing, How Much is Enough

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By Jim Brown

After the recent Nasdaq crash we have had many emails asking if there was any safe way to use options to maximize returns. First, there is no safe investment. All stock and option investing involves risk. In the current market environment the urge to trade is the biggest challenge facing most investors. If you trade less the odds are in your favor.

Many investors only use a portion of their capital to speculate in options. This is a good idea but the problem is what should you do with the rest of your money. If you are a conservative investor and could be happy with 30% to 50% annual returns then I have a deal for you.

The current volatility has created an opportunity to capitalize on the current high premiums yet do it fairly safely.

I am talking about long term covered calls using leaps. Now before you hit that delete button, hear me out.

Many stocks on good companies are very beaten down right now but their long term prospects are still very good. By buying the stock and writing leaps on it you accomplish several things. First you put that excess capital to work as safely as possible. Second you can lock in substantial returns and third you do not have to worry about your positions on a daily basis. You are freed up from the daily terror of watching your net worth fluctuate with every nasdaq tick. You are also protected from a serious drop in the stock price by the substantial premiums received from the leaps. Most premiums equal 25% to 35% of the stock price.

Look at this example:

JDSU $85.19

JDSU is currently trading at $85 with strong support at $75. The odds of JDSU closing below $85 by January of 2001 are very close to zero. If you wrote the JAN-2000-$90 leap today you would receive $27 in premium. Without using margin if JDSU closed over $90 the third Friday in January your return would be 37.6% for one trade.

Here is the calculation:

$27 premium
$ 5 gain from $85 to $90 strike
$32 profit

$32 profit / $85 stock price = 37.6% return if called out.

If you use margin the return will be much greater but involve more risk. Very minimal risk but still risk.

$32 profit / $42.50 margin required = 75.2% return (margin interest not included in calculation but neither is the interest on the $27 premium received either)

Do you think JDSU will close above $85 in January?

Is a 37.6% return better than what you are getting on idle money now?

Is a 75% return worth the $15 net margin you would have at risk? ($42.50 margin less $27 premium received)

If JDSU did not close over $85 would owning JDSU with a basis of $58 be worthwile for a long term investor?

You have to be comfortable with the concept and the risk but unless we have a real bear market in the near future the risk of stocks going much lower than they are now is very minimal.

Here are some likely candidates for this concept. Most large cap stocks have leaps but even those that don't have options that expire in Nov/Dec and they will produce the same type of returns.

Stock Price Strike Premium Return/Margin Return

JDSU $ 85	$90	$27	37.6%		75%
QCOM $110	$110	$29	26.3%		52%
BRCM $152	$150	$48	31.5%		63%
YHOO $123	$125	$32	26.0%		52%
ARBA $ 69	$ 70	$22	31.8%		64%

You can experiment with these and get a larger return by increasing the strike price but you then increase your chances of not being called out in January. That is also not a bad deal. Using these numbers you could write leaps on your stock every year and after three years if you still had the stock your basis would be zero. ZERO ! Of course the odds of you being called out for a 75% to 100% profit during those three years is very high.

The key to this strategy is quality stocks, with any growth rate above zero. Even a five percent growth rate will get you called out for a nice profit in the first year.

Think about it. How much are you making on your idle money? How much have you made on those marginal stock investments in the last six months?

Good Luck

Jim Brown

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