Lombardi: Stock Market Commentary & Forecasts, Financial & Economic Analysis Since 1986

Here’s a Low-risk Strategy Given the Big Risk

Wednesday, November 7th, 2012
By for Profit Confidential

Low-risk StrategyBy now, you all know who the next President of the United States will be, and he has his work cut out for him. There remain plenty of work and tough hurdles ahead for America and the global economy.

In my view, it really doesn’t matter who won, as the problems are the same. Domestically, we have the national debt burden, job creation, weak revenue and earnings growth, the sluggish economic renewal, and the declining middle class. (Read “Please Save the Middle Class!”) Plus, you have the upcoming recession in the eurozone and the change in leadership in China.

Given all of these uncertainties, there is ample risk in stocks, and you need a good investment strategy.

Now you can buy into new positions and assume the risk, but a much safer investment strategy alternative is to play either upside via call options. In this is way, you can take advantage of any upward move in the equities market and manage the maximum risk you have at the same time via this option investment strategy.

Let’s say you feel the economic renewal will continue to drive automotive sales, but you also are a bit worried about a possible economic downfall if Europe and China tank.

You like what Ford Motor Company (NYSE/F) is doing and feel the stock may be heading higher. But instead of buying the stock outright, you can play Ford via call options that will not only add leverage to your trade but also limit the loss to the premium paid, which is a good investment strategy.

Ford Motor Co Chart

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Chart courtesy of www.StockCharts.com

Let’s take a look at Ford and assume you want an option investment strategy that equates to 1,000 shares of Ford. You feel Ford could rally to $14.00 by June 2014.

Assuming this, you buy 10 call contracts of Ford, which equals to 1,000 shares of the underlying stock. For every board lot of Ford, for example, one call option may be written.

Here are the mechanics. You are looking at the June 2013 expiry for the Ford in-the-money $9.00 call for a premium of $274.00. There are 1,001 contracts in open interest, so liquidity is not an issue.

The cost per contract of $274.00 equates to $2,740 for the 10 contracts. This is the maximum risk of exposure. If Ford fails to break $9.00 by the June 21, 2013 expiry, the premium you paid is lost in this investment strategy. The upside breakeven is $11.74, which is pretty good, given there’s a good chance Ford will trade above $11.74 by the expiry.

Now say Ford jumps to $14.00 by the expiry, you would make $2.26 per share or $2,260 for the 10 contracts for a leveraged return of 82.5% in less than a year.

Again, the maximum risk is $2,740, but you can nearly double your money if Ford simply moves up by $0.23 per share by the expiry, which is a good risk-to-reward investment strategy.

You can use the Ford example with many stocks that may interest you as a lower-risk investment strategy alternative to buying the stock.

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George Leong - Financial Planner, ConsultantGeorge Leong, B. Comm. is a Senior Editor at Lombardi Financial, and has been involved in analyzing the stock markets for two decades where he employs both fundamental and technical analysis. His overall market timing and trading knowledge is extensive in the areas of small-cap research and option trading. George is the editor of several of Lombardi’s popular financial newsletters, including The China Letter, Special Situations, and Obscene Profits, among others. He has written technical and fundamental columns for numerous stock market news web sites, and he is the author of Quick Wealth Options Strategy and Mastering 7 Proven Options Strategies. Prior to starting with Lombardi Financial, George was employed as a financial analyst with Globe Information Services. Add George Leong to your Google+ circles