Welcome back to my weekly column with the International Business Times brought to you by Optiontradingpedia.com.
It has been an exciting year so far and those who sold off their positions in the intermediate correction in July have so far gained nothing but regret. Indeed, markets all over the world are in an early recovery phase right now with economic data recovering all over the world and the recovery pattern confirmed by the Dow Theory. It would certainly be paranoid to still think that we are merely in an intermediate bull trap within a primary bear trend.
I am not surprised a lot of people still think that way. They are those who jumped in towards the end of 2007 and are habitually late for the party. But what if you hate to miss out on this recovery while having your reserves as to its sustainability? Truly it is hard to start throwing all your money into the market at this early phase when you are still not totally convinced. So how can options trading help you?
The solution can be found in Call Options.
Call options are contracts that allow you to buy the underlying stock at a fixed price no matter what price it is in the future only for a small price. When you buy call options, you benefit from the same rise in the underlying stock as if you bought the stock itself but paying only a small fraction of the price. This allows you to participate in the same stock market recovery risking only a small fraction of the money that you would normally do!
The best financial instrument to buy in order to ride an economic recovery without any secondary risk or idiosyncratic risk is through an ETF called the SPY. The SPY is an Exchange Traded Fund that tracks the S&P500 index. Buying long term call options on the SPY is the most direct way of benefiting from the economic and stock market recovery. The drawback is that you are not going to receive any dividends out of doing this, so it is purely for capital gains.
Now, which call options shall we buy?
The question to ask ourselves is, how long will it take for the stock market to be higher than it is today? 3 months? Nope, 3 months is too short. How about June 2010? Would the SPY be higher than it is today by the third Friday of June 2010? Well, if you think that way, you could simply buy the SPY June 2010 $107 at the money call options, last quoted at $8.10.
The June 2010 $107 call options allows you to buy the SPY at $107 no matter what price it is by the time they expire in June 2010. That's right, if the SPY rallies to $140 by June 2010, you would still be able to buy the SPY at $107 and make the difference of $33 as profit exactly as if you bought the SPY in the first place for $107! Wait, how about the $8.10 that you paid for the call options? That's right, that's your expense for owning the call options, so your net profit would be $33 - $8.10 = $24.90 instead of the full $33. Well, paying just $8.10 to make $24.90 sure makes a lot more sense than paying $107 to make $33, right? The point is this, if the SPY should drop back into a bear trend like you might have feared, the most you lose is the $8.10 that you spent buying the call options and not the entire $107 that you would have spent buying the SPY stocks itself! See how much less risky that becomes?
The only caveat buying call options as the low risk investment outlined above is this: You only buy as much call options as you would otherwise have bought the stocks itself.
For instance, if you have $11,000, instead of buying 100 shares of SPY at $107 with the entire amount, you could instead buy 1 contract of the above mentioned call options for only $810. 1 contract of call options represents 100 shares of the underlying stock. See what a big difference in commitment?
A comprehensive knowledge in call options is still recommended before you try something like that. Please read my full tutorial on http://www.optiontradingpedia.com/call_options.htm> Call Options at Optiontradingpedia.com.
Disclaimer : Neither I nor Masters 'O' Equity or Optiontradingpedia.com and any of the staff, own any shares in above mentioned options trading position. The above article uses closing prices on 9 Oct 2009. Actual prices on Monday opening may differ. This article is for education purpose only and should not be taken as individual investment recommendation. Options trading is not suitable for everyone and advise should be sought from your local financial adviser.