Malibu Investment


The benefits of options trading by Kevin Lee Blain, JD/MBA

What do you think of when your investment advisor, brokerage, or long time friend brings up the subject of trading or investing in options? Common responses you will hear include " I don't touch them, they are too risky" or "You can lose everything." Many investors simply find options a taboo subject in the investment community. Why? A likely reason given is the lack of understanding of how options can be part of an overall strategy and part of a balanced portfolio. While the big time TV news pundits try to scare the masses regarding options, or may not want you to invest in options, the truth is that options were designed to be a safety net for your portfolio, just in case your position didnt move in the direction you intended it to move.

Options trading can be best described as a "measured risk" trade that has a very favorable risk/reward ratio. Investors can make many times their original investment with the clear risk associated with what we pay for the option.

There are two types of options positions: "CALLS" when we expect higher prices ahead, and "PUTS" when we expect lower prices ahead. Surely one may hear a mind boggling array of options with fancy names such as "spreads", "straddles", "condors" and "butterflies" which many people get when investing ! But the truth of the matter is that these different names are still only different combinations of puts and calls given unique names. Calls give you the right, but not the obligation, to buy the underlying stock at a specific price (strike price) within a specified time frame (by expiration.) "Puts" give the investor the right, but not the obligation to sell the underlying stock at a specific price (strike price) within a specified time frame (by expiration.)

When Malibu investment uses options as a part of its overall portfolio strategy, we like to refer to them as "Turbo Trades." What is best about these "Turbo Trades" is that they carry "measurable risk," in other words; we know ahead of time what the maximum exposure is to any particular trade. The measurable risk is what the investor pays for the cost of the option; also known as "the premium."

For example, if we think McDonalds ($28.50 today? is likely to fall to $25.00 by mid-April, we could purchase the April $25 "Puts" for $1.25. (1 contract controls 100 shares, so 20 contracts controls 2000 shares) If we buy 20 "Put" contracts for $1.25, the maximum risk is $2500. If the McDonalds stock stays above $25.00 between now and the third Friday in April (expiration date) we would then lose the entire $2500. It does not matter how high McDonalds stock price may rise, we as investors are still limited to the measured risk of $1.25 per contract. If however, we are correct and the stock falls to $20 anytime before expiration (the 3rd Friday of the expiration month, here April) the "Put" options would now be worth $5, also called "$5 in the money." As a result, the $2500 would now be worth $10,000 (a 300% return.) If the stock fell to $17.00 before the expiration, the options would then be worth $16,000 (a 540% return.)

The mathematics are actually quite straightforward, $25.00 minus $17.00 equals $8 times the number of contracts held. each contract controls 100 shares so if we purchased 20 contracts, we are "controlling" 200 shares at a fraction of the cost of owning the shares outright, thus, limiting our risk, and opening ourselves up for the potential for large gains. Using leverage in this manner, in this hypothetical trade, we were able to take a "measured risk" knowing the entire time, that the most we could ever lose on this trade was $2500.

Now let us look at an option in the overall market. Often we trade the SPX index options, which is actually the S&P (an index of the 500 largest stocks.) Lets assume we think the stock market as a whole will go up 5% sometime between now (Feb 11) and the third Friday in March. With tthe SPX at 1148 today, we could buy 1175 "Calls" for $8. If we are correct and the S&P Index goes up to 1205 (+5%), we are now 30 points "in the money" (1205-1175) and thus can sell the calls for $30 at any time before expiration (275% return.) If however, we are wrong, and the market does not rally, or even falls greatly, the maximum risk is still only $8 per contract. Thus, if in this case we buy 5 "Call" contracts (controlling 500 shares) our maximum loss would have been $4000.


Below, Mr. Blain is seen with Options King trader Jon (Dr.J) Najarian  from Consulting with Dr.J extensively has helped improved Mr Blains analysis and results while teaching Mr. Blain that volatility has a significant influence on the price of an option. Dr.J has appeared numerous times on cboe TV, bloomberg, and cnbc among others.



Occasionally Mr. Blain is able to attend industry events with fellow investors, traders and publishers. Here Mr. Blain opines with capricious and confident Tobin Smith of Fox's Bulls n Bears saturday morning business block. After exchanging banter and humor, it was time both to head off for Heineken.




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