HEDGING – Lock in Profits and Minimise Losses

You’ve made some gains on your share portfolio but you’re a little worried about the unknown….what if the market suddenly drops again? Learn to hedge your portfolio >>

LEVERAGE – Enter the Market with Minimal Funds

Would you like to profit from rising stock prices without having to buy any shares at all, keeping your capital protected from unexpected price moves? Learn to control shares >>INCOME – Option Trading Strategies for ANY market direction

Stock Options allow you to profit from stock prices that are moving in any direction.  Imagine using just a small amount of money and making a large amount of money in a stock market crash? Learn how to profit from falling share prices >>

PUT YOUR PORTFOLIO TO WORK – squeeze extra income out of shares you own

In the same way you would rent out your investment property for income, you can rent out shares you own to create a regular income. Learn how to execute the covered call stgrategy >>

When you purchase a Put Option over shares you own, you are effectively ensuring your shares against loss because you have the right to sell your shares at an agreed price at any time throughout the life of the Put Options contract.

In much the same way as you would insure your house or car for a specific value, a Put Option has a ‘strike price’ which is the amount you have the right to sell your shares for.

Like a traditional insurance policy, the Protective Put has an expiry date, after which you need to renew your insurance policy. You may also select the time period over which you wish to insure your shares.

An example would be if you purchased some shares for say $ 20 and at the same time, you purchased a 12 month dated Put Option with a $ 20 strike price. You would have the right to sell your shares to the market at any time within the next year for $ 20, regardless of what price the shares were trading at.

When Would You Use a Protective Put?

You would employ a protective put when you own shares in the underlying stock and you have an unrealized profit from capital growth that you wish to protect without having to sell your shares, or you may have just purchased the shares and simply want peace of mind in case the share price were to fall.

Although you would be hedging against a downside move, your overall view on the underlying stock would be Bullish.

How Does a Protective Put Benefit You?

When you use Option Trading Strategies like the protective put, the benefits you receive from being a shareholder (dividends etc) remain the same until such times as you sell your shares.

The real benefit to you is that your potential downside loss is limited throughout the life of the Put Options contract, regardless of how far the share price may fall in value. You have complete control over your shares as YOU choose which price to insure them at as well as when to sell them if the share price fell.

What is Your Risk vs Reward?

PROFIT: Your maximum profit potential is unlimited depending on how high the share price rises.

LOSS: Your maximum loss is limited to the difference between the price you can sell your shares for (strike price) and the cost of your Put Option protection (Strike Price – Option Premium Paid)

If you never used your put protection (exercised your right) and it expired worthless, any gain in capital growth would offset the premium you paid to own the Put Option.

Your break-even point would occur when the share price increased by the amount which you paid for the protective put.

Do You Have to Sell Your Shares?

NO! When you own a Put Option, you are under no obligation to sell your shares, or ‘exercise’ your right. You control when and if you sell and you can do so at any time up until the expiry date of the Put Option.

If the share price rose and your Put Option expired worthless, you would keep your shares and may wish to consider renewing your ‘insurance’

If the share price rallied before option expiry and you decided to sell your shares at a profit, you may also sell your Put Option back to the market and recover some of what you paid for it.

Just like your house or car insurance, if you took out insurance for 12 months and you sold the house or car after just 6 months, the insurance company would refund a portion of what you had paid.

In a nutshell – a derivative is generally a contract rather than an asset. This contract directly relates to the asset, which is usually called the underlying and when you buy a derivative, you buy a promise to convey ownership of the asset, rather than buying the actual asset itself.

Sound confusing?

Liken it to buying a house… generally the legal terms of the contract for sale of a property are much more varied and flexible than the terms of actual property ownership. Well it’s this flexibility that appeals to investors.

Derivatives offer the same sort of leverage as a home mortgage.

When you buy a property you use a smaller amount of money than the full purchase price and in exchange for taking on the obligation of a mortgage, you gain control of the property.

Similarly, for a much smaller amount of money you can control much larger value of company stock then you would be able to without using derivatives.

Be warned though, this can work against you depending on whether the trade goes your way and what style of derivative you trade.

Sure, your potential returns would be far far greater than investing directly in the company if your view is correct, however if you got it wrong there are some derivatives that will actually multiply your losses instead.

Futures and Stock Options are two of the most commonly traded derivatives and rapidly growing in popularity are CFD’s.

A stock option contract gives the owner the right (but not the obligation) to buy or sell a particular stock at a fixed price on or before a given date, while the owner of a futures contract HAS A DEFINITE OBLIGATION to buy or sell the asset.

In the latter case, your potential losses can be unlimited whereas when you buy an option, the most you stand to lose is limited to what you pay to own the option. Hence your downside risk can easily be limited.

If your choice of derivatives is CFD’s then your potential losses are magnified sometimes 10 times over due to the margin component because you are actually trading with borrowed money.

For instance, you may start with $5,000 in trading capital but you can take out a $100,000 CFD position.

If the market moved significantly overnight and gapped against your position by say 10% then your total loss overnight would be $ 10,000. So you’ve lost $ 5,000 of your own money and you now owe your broker another $ 5,000!!!!

OUCH!Opportunities when trading the global markets are everywhere, but if you have wiped out your trading account then you won’t see a single penny of profits by sitting on the sidelines in negative territory.Our choice of derivative remains the stock option and several simple option trading strategies are a vital component of our trading toolbox.

In much the same way as you would insure your house or car for a specific value, a Put Option has a ‘strike price’ which is the amount you have the right to sell your shares for.

Like a traditional insurance policy, the Protective Put has an expiry date, after which you need to renew your insurance policy. You may also select the time period over which you wish to insure your shares.

An example would be if you purchased some shares for say $ 20 and at the same time, you purchased a 12 month dated Put Option with a $ 20 strike price. You would have the right to sell your shares to the market at any time within the next year for $ 20, regardless of what price the shares were trading at.

When Would You Use a Protective Put?

You would employ a protective put when you own shares in the underlying stock and you have an unrealized profit from capital growth that you wish to protect without having to sell your shares, or you may have just purchased the shares and simply want peace of mind in case the share price were to fall.

Although you would be hedging against a downside move, your overall view on the underlying stock would be Bullish.

How Does a Protective Put Benefit You?

When you use Option Trading Strategies like the protective put, the benefits you receive from being a shareholder (dividends etc) remain the same until such times as you sell your shares.

The real benefit to you is that your potential downside loss is limited throughout the life of the Put Options contract, regardless of how far the share price may fall in value. You have complete control over your shares as YOU choose which price to insure them at as well as when to sell them if the share price fell.

What is Your Risk vs Reward?

PROFIT: Your maximum profit potential is unlimited depending on how high the share price rises.

LOSS: Your maximum loss is limited to the difference between the price you can sell your shares for (strike price) and the cost of your Put Option protection (Strike Price – Option Premium Paid)

If you never used your put protection (exercised your right) and it expired worthless, any gain in capital growth would offset the premium you paid to own the Put Option.

Your break-even point would occur when the share price increased by the amount which you paid for the protective put.

Do You Have to Sell Your Shares?

NO! When you own a Put Option, you are under no obligation to sell your shares, or ‘exercise’ your right. You control when and if you sell and you can do so at any time up until the expiry date of the Put Option.

If the share price rose and your Put Option expired worthless, you would keep your shares and may wish to consider renewing your ‘insurance’

If the share price rallied before option expiry and you decided to sell your shares at a profit, you may also sell your Put Option back to the market and recover some of what you paid for it.

Just like your house or car insurance, if you took out insurance for 12 months and you sold the house or car after just 6 months, the insurance company would refund a portion of what you had paid.

Stock Markets globally have rallied over the last six months, however here in Australia our increasingly strong economic data and recent interest rate rise have massively increased investor confidence and this has had a follow on effect throughout global economies.

Like many savvy investors out there, if you have taken advantage of those low share prices over the last 6 months then now may just be the time to employ a protective option trading strategies that involve the use of Put Options.

A Put Option is a type of stock option contract that gives you the right to sell a parcel of shares at an agreed price, anytime before the contract expires, so they act extremely effectively as a hedge over your equities within a portfolio.

Why? you ask:

1) Because premiums are relatively cheap right now while implied volatility is low, so insuring your shares won’t cost as much. Any indication of the global economy weakening will affect insurance premiums as volatility increases.

2) Although we look strong fundamentally, what are the chances of stock prices continuing their almost vertical upward price movement? Protecting your portfolio now will give you peace of mind in the event of a market correction.

How to Hedge Your Share Portfolio

Firstly, we use option trading strategies that involve the use of Put Options. A Put Option is a type of stock option contract that gives you the right to sell a parcel of shares at an agreed price anytime before the contract expires, so they effectively act as a hedge over shares you own.

For example – if you were to buy shares for say $ 20 and you buy Put Options with $ 20 as the agreed sell price, you can sleep easy at night knowing that even if the market crashed overnight you could sell your shares tomorrow for the $ 20 you initially paid and not lose any of your hard-earned cash.

This works in almost the same way as your house or car insurance does. If your car was written off in a collision, you know the insurance company would pay for it to be replaced. And in the same way you have the choice of paying your car insurance premium monthly or annually (the choice is yours) you may choose the duration of your put protection too.

Option Trading Strategies

When implementing option trading strategies, we deal with the ASX options market and there are two different types of Put Options we may use.

Stock Options – (ETO’s or Exchange Traded Options) relate to an individual company stock or share. So if you were to buy XYZ shares at $ 20 then you would look to buy an XYZ $ 20 Put Option.

Shares that have ETO’s relating to them are called ‘optionable’ stocks and they are generally the big reliable blue-chip shares. Out of the thousands of stocks listed on the ASX, only a few hundred of them are optionable, which means that you may not be able to buy put options relating directly to some of the smaller cap stocks.

Index Options – relate to an index as a whole. Although the All Ordinaries Index is Australia’s leading indicator and represents the top 500 companies in Oz, the index itself is not optionable.

The S&P/ASX 200 Index, however, reflects the prices of the top 200 companies in Australia and it represents almost 80% of the market as a whole. The ASX 200 is optionable, so this means you can buy Index Put Options and hold a view on the whole market with one transaction.

So if the market falls in value overall, you have effectively hedged your whole equities portfolio and the index suddenly becomes more valuable and you can cash it in to cover any loss you may incur on your individual share price.

Before deciding which type of trader you would like to become, you need to realise that the quality of your lifestyle very much depends on your chosen trading style.

Trading can be a very active lifestyle.  Day trading is basically defined as the buying and selling of a security (stock) or derivative within a single trading day, without holding an open position after market close. As a day trader, you would be spending hours every day in front of a computer screen monitoring small movements in price to take quick profits. This style of trading is generally done online with a very short investment time frame.

Because of the high profits (and losses) that day trading makes possible, it is often regarded as a form of gambling rather than investing. Higher risk-taking would be closer to the truth and this is a major reason why day traders only hold positions for a few seconds or a few minutes – to limit risk.

You see, a typical day trader would trade the more volatile stocks as they offer greater opportunities to play the price movements throughout each trading session. However, with greater volatility, comes higher risk and perhaps higher stress levels. Day trading is not a get-rich-quick scheme; it can be very mentally and psychologically challenging and is by no means meant for everyone.

Short term traders, trend traders or swing traders, may profit occasionally from the daily open to close, however, they generally make their income over a matter of days or weeks and have an abundant lifestyle in both money and time.

That’s not to say a day trader lacks time, in fact, they could easily profit in just a few hours leaving the rest of the day to do what they please, whereas the short term trader has the luxury of placing just a few trades every few weeks, allowing for plenty of relaxing time.

Like most people who begin trading the markets, you more than likely hold a full-time job that funds your current lifestyle and financial commitments. Attempting to day trade may not be the most realistic choice. Learn to walk before you run.  

Most people on the outside perceive the trader as being glued to a computer screen all day in a stressed-out environment, however, those people who trade from home know it can actually provide a consistently rewarding career in a very relaxed atmosphere.  The ability to be your own boss and do what you want with your time easily beats the consistency of a 9-5 job.

This means they are active in all market conditions and don’t sit it out when conditions change or become volatile the way many novice investors do. Which group of traders or investors would you rather belong to?

Your answer to this question depends on your reasons for getting involved in the stock market. Maybe you are happy with your current lifestyle and income and you are simply looking for an area to invest for your future, choosing the traditional way of stock investing and holding on over the long term through the good and the bad times.

However, if you are keen to develop a system of investing and trading that can improve your lifestyle and allow you to profit from the share market with each passing year, regardless of market conditions, then it may pay you to look at the derivatives market, rather than just buying shares with the intention of profiting from capital growth.

Derivatives are financial instruments that have another asset as the underlying base and there are numerous types available to the investor, such as futures, forex, warrants, CFD’s and Options, each with a varying degree of risk.

The benefit of derivatives is that although they provide you with exposure to shares, they deliver leverage that cannot be achieved investing in shares alone.

When you buy shares you are relying on the market to rise, whereas when you trade derivatives, you can make money no matter which direction the market is trending in. And if you think this sound’s too good to be true and only something the institutional trader may do, then think again.

Stock Options are one of the most widely used derivatives with a level of risk that can be easily managed, compared to some other forms of financial instruments that have grown in popularity over the last few years.

Why would someone trade options?

1)    By using options we can safeguard or protect our portfolio

2)    Trading options allows us to profit from falling share prices

3)    Even when the share price is trending sideways there is an options trading strategy designed to help you make money.

4)    Flexibility – instead of holding onto shares for months or years, options offer us the flexibility to make money over the shorter term

5)    When trading options, you don’t need to analyse a great number of shares. We focus only on the most liquid shares and their related stock options leaving us more free time

6)    The leverage of options can provide excellent returns from a minimal outlay. For leverage to work properly for us, we need to understand and manage it effectively.

When trading leveraged financial instruments, when you win, you win exceptionally well, but when you lose, the leverage can work against you and depending upon which derivative you choose the trade with, it could be game over for you much sooner than you think.

7)    When buying options to trade, the most you could ever lose is limited to the amount you pay to own the option

Some derivatives such as CFD’s operate on margin, which means you are actually using borrowed money to trade with. The attraction not only is more money left in your pocket and less in the trade, but the return on investment can be much much higher. What you need to be very aware of, however, is that when a position goes against you, you stand to lose much much more than what you have taken out of your pocket to get into the trade initially.

You stand to lose someone else’s money as well as your own!

Regardless of which instrument you choose to trade, your technique of analysis to help you decide when to get in and when to get out of a position predominantly remains the same. There are several key factors that will help maximise your success in trading options and if you can analyse the direction of a share price or index, there is an options trading strategy that you can use to make a profit.

Almost everyone has at some point, but most people never really stop to think about what it means. It can mean different things to different people, so before you begin searching for the key to financial freedom, it may be a worthwhile exercise to examine what the concept really means to you.

You may not realize it, but Time and Money are inversely related and one can be traded for the other in most situations. If you take a moment to imagine how that applies to both your everyday life and to the way business is conducted, you might see that it’s true. For instance, you could spend your own time cleaning the house or mowing your lawn, or you could trade your time and pay someone else to do those chores for you, effectively freeing up that time for yourself.

With this in mind, you might consider financial freedom to mean reaching the point where you no longer have to trade your time for money in order to provide what you want in life. For most of us, financial freedom means simply not having to go to work every day to pay the bills….in other words, making money work hard for us, not finding a smarter way to make an income stepping off the daily treadmill of going to work every day to pay the bills.

Another important factor in finding financial freedom for yourself is that of your current and future lifestyle. Some people prefer a modest home, car, vacations, and possessions, and will always want to live that way. Starting from the same point, these people will be able to reach a level of financial freedom sooner than those who aspire to more elegant surroundings.

Ultimately, financial freedom is about control. Control over your own time and life, that will let you make the choices you want to make, rather than being forced to accept those offered by circumstance.

For most people, it would take a lifetime. This is why we need to use leverage. In very simple terms….leverage is spending a little to buy a lot, or investing a little to return a lot (also known as using Other People’s Money – OPM).  

When you understand and master the art of leverage and you put other people’s money to work for YOU at the lowest cost, you will rapidly build your net worth.

There are countless financial instruments in business and personal finance that you can use to help you acquire something of a greater value, whether it be in the form of cash or an asset.

Let us talk in terms of property for a moment as most people relate more easily to real estate.

When you buy a house or property, you would commonly use a mortgage which is merely a written promise you make to repay in exchange for a cash loan to finance your purchase. You’d be required to pay the lender a minimal deposit, leaving them with the mortgage and you would receive the cash tobuy more in value for less out of your pocket.

As the new property owner, you would then possess and control the property, leaving the rest of your hard earned dollars available to use for other opportunities.

While your property value grows, so too does your equity and net worth.

Unfortunately, the average person loses sight of the benefits of leverage, and rather than use it to create financial freedom for themselves, they very quickly forget about their mortgage, the scheduled repayments become a habit and the vehicle for building their net worth actually robs them of lifestyle and restricts their cash flow.

What I mean by that is that many owners feel they would be financially better off to pay down their mortgage, often paying more than required, with the intent of owning their own home outright and debt free but they shoot themselves in the foot in the process.

A very close friend of mine has spent each of the last 10 years building a house to sell on completion of construction for a profit, in order to reach the destination he has recently arrived at – personally debt free.

Like many of us, Greg was raised to believe debt is bad and now that he has paid off his home, he feels a sense of relief. This is quite an achievement and I really do congratulate him, however, how does that property support Greg’s financial future and generate a stream of income for him if he intends not to sell and continues to reside in it as the family home?

Sure, he has a well paying job that now allows him to add to his bank account balance, but how many more years would you want to sustain that kind of hard work for?

Consider this…..  

• Every extra dollar you pay toward principal in order to reduce your interest liability to own that home sooner, essentially RAISES your tax liability because you are decreasing your tax deductions.
• You are creating a situation where you will continue to work hard for your money and perhaps have enough left at retirement to fund a mediocre lifestyle at best.

In a similar situation to Greg, if you were to tap into that unused home equity (100% in Greg’s case) or simply pay just the required to your lender, then each dollar you would free up would potentially grow much faster in an asset accumulation investment, be it another property(s) or a protected share portfolio.

And when you understand how to effectively and safely use leverage and OPM, your net worth would not only grow substantially through amassed assets, you’d also be creating an additional income generated monthly by the asset so you could enjoy a better standard of living.

Like most people who begin to invest with good intentions, you may decide to leverage into property alone to create cash flow from rental returns, however you may want to also consider the flexibility of the stock market and shares.

You see, in much the same way you would invest in property for rental returns, you can easily rent out your share portfolio for consistent monthly cash flow using stock options.

Option trading strategies such as the Protected Buy Write follow the same principles and allow you to benefit from cash flow as well as capital growth and one of the major attractions is that you don’t require nearly as much of your own money upfront as you would a deposit on a property.

Self-made millionaires and banks amass a fortune because they not only effectively use strategies such as these, but they understand cash flow and the effects of compound interest when employing OPM.

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