Replacing Your Stock With Options

| November 9, 2011 | 0 Comments

There are two things that make me sick to my stomach.  Amusement rides that go round and round at lightning speed.  And the stock market bouncing up and down like a super ball in a small room.

If you feel the same way, you’re in luck… I have your Dramamine!

I’m talking about options.  You see, there are ways options can tame the wildest of stock risks… and help you lock in profits on your stock positions.

Now, you may have heard that options are high-risk investments, only suitable for experienced traders.  Not true!

Don’t be too quick to let your fears keep you from getting ahead.

Using options, especially the “stock replacement strategy,” can be a rock in a sea of financial uncertainty.

Here’s the deal…

The stock replacement strategy is designed to help you make more money and take less risk.  How does it work?  You use a call option in place of your regular stock.  It allows you to take gains off the table and still participate if the stock moves higher.  Best of all, you can limit your downside risk.

I’ll tell you how to do it in a minute.

First, let’s review some call option basics.

A “call” option (contract) contains 100 shares of the stock it’s associated with.  So each option you buy allows you, the “buyer”, to control 100 shares at a price you choose, also called the “strike price”.

Like most option contracts, they have a limited lifespan.  In the options world, we refer to this as “expiration”.  Expiration occurs on the third Friday of every month.

Lastly, as the “buyer” of a call option, you have the choice to buy your stock at the strike price any time between now and the expiration date.

Now that’s out of the way… let’s take a look at the stock replacement strategy.

Let’s say you purchased 100 shares of McDonald’s at the beginning of the year.  At the time, McDonald’s was trading at $72 per share.  So you paid $7,200 for the shares.

Today, McDonald’s is up to $93.  You think, “Awesome, it’s only November and I have a 23% profit!”  You’re now faced with a dilemma… sell and take profits or wait and risk watching your profits evaporate.

Let me make something very clear…

There’s never anything wrong with taking profits.

However, there’s nothing wrong with making more money if McDonald’s keeps climbing either.  In other words, wouldn’t you like your cake and be able to eat it too?

Here’s where the stock replacement strategy comes in…

Sell your 100 shares of McDonald’s at $93 and put the $9,300 back in your pocket.  Pleasantly, this includes a nice $2,100 profit.  Now, go spend $380 and purchase one December $90 strike call option on McDonald’s.

Do you see what you just did?

You simply replaced your $93 stock with one call option on the same stock.  And look, it only cost you $3.80 per share.  Now you own the option to buy McDonald’s again at anytime between now and the third Friday in December for $90 a share.

Here’s how you profit…

Don’t forget, you paid $3.80 for your call option.  So your true buy price for McDonald’s stock, if you exercise your option, is $93.80 ($90.00 plus $3.80) per share (or $9,380 for 100 shares).  This means as long as McDonald’s is trading above $93.80, you’re making money on your call option.

And the best is yet to come…

Remember, you sold your 100 shares for $9,300 and replaced them at a cost of just $380.  The remaining $8,920 is safely in your pocket. Most importantly, between now and December, if McDonald’s went out of business, all you can lose is $380.

In other words, your risk of loss is capped at $380 no matter what happens to McDonald’s.

There you have it.  This simple options strategy can be used for almost any stocks in your portfolio.

No doubt about it, “stock replacement” can give you an edge over wildly volatile markets like we have today.  And that edge can make all the difference in your trades.  Without this edge, you’re gambling… not investing.

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Category: Options Trading

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