How to Evaporate Your Investing Fears

By | January 21, 2015 Leave a Comment

Reducing Investing Risk Through Simple Hedging


I know, it’s been a while since I’ve had a chance to preach and pontificate. It’s been as painful for me not to write or post, as I’m sure it has been for you to go without my musings on life, wealth, and money.

The only excuses I have for the nearly four-week hiatus on the blog are sickness, lack of sleep, high stress levels about employment opportunities, and other big life changes.

I know, trivialities.

That being said, all I can do at this point is apologize… and obtain your awesome by giving you something awesome and new to read, think about, and use to your advantage.

Today I want to talk about your future… your investing future... specifically, about a skill you need to pick up at some point in the future in order or you to kick butt and take names Vader-style in your investing!

I don’t know which level you’re at today in your abilities to make money out of thin air by investing, but I hope its moderate to high… even if not, read through today’s article and you’ll have a bit more clarity on a good place to shoot for, even if you’re a newbie.

It might take you a while to get here… you’ll probably have to do a lot of reading, researching, and understanding to get there, but I promise it will eventually happen… and once it does, you’ll be delighted.

It’s one of the most exciting and satisfying things in my adult life today. The feeling of genuinely understanding what’s going on in the market, and taking advantage of great opportunities I see before me.

It’s the feeling of success.

How Hedging Works, and How to Do It Simply


So here we go. Today, I’ll talk about one skill you need to gain in order to join the big boys’ and girls’ investing club.

I could talk to you today about a million topics. But I’m going to stick with the one which fascinates me the most, and the one which I’ve found to be the single most effective wealth-building tool for myself since I got into all of this myself roughly six years ago.

The skill is selling stock options.

If this topic turns you off, I have to tell you... I find your lack of faith disturbing! So before you leave or tune out, let me explain!

You might not know what a stock option is. That's fine. Or you might think you know a little bit about them, and if you do, you probably think that they’re risky, complicated, and too sophisticated for someone like yourself.

That’s where you’re wrong, and let me tell you why.

First of all, you should know the hard truth--stock options, as most “investors” use them today, have become mostly a gambler’s tool. Most people who dabble in stock options lose their rent money, the shirts on their backs, and their life savings. That’s because they’re stupid.

And it’s these ‘stupids’ who make you think that using stock options in any fashion is risky and overly sophisticated. After all, you saw what happened with options (otherwise known as derivatives) during the financial crisis. It was derivatives which caused the crisis.

Well, we do things the right way, and ‘stupid’ people are banned from this cool kids club.

So, what is the right way to use options?

Options were invented in the 1970’s as a way to hedge, or protect, an investment portfolio, almost like a small insurance policy against losses. That’s how we use them in The Village—as insurance against downward market spirals. The biggest difference is, in our insurance game of stock options, we become the insurance company. We collect the premiums and rarely have to pay out for a loss, just like most insurance companies you pay money to in your everyday lives. Smart insurance companies, with intelligent underwriters, rarely take a loss.

Let me explain how this works in "investing for b-d-sses."

Let’s say I own 100 shares of Wal-Mart stock, which I just bought today at $86.64. I believe that over the next month, Wal-Mart shares are going to move above $89.00. If that happens, I’m willing to sell my shares for $89.00 to someone, and make $2.36 per share, or $236 in all. That’s a one-month return of 2.7%.

I can get paid to sell my shares, using stock options. Paid to simply agree with someone to sell my shares to them at a price higher than what I paid for them. Easy.

Looking at the Yahoo Finance page, I see that other investors are actually willing to pay me $80 for this privilege. That’s because the stock options with a strike price of $89, expiring one month from now, are on sale for $0.80 per share. Since I own 100 shares, that’s $80 bucks I’m going to make for this agreement, in addition to the $236. A total of $316. If this plays out, I’m looking at a return of 3.65% in just 30 days. 

That’s outstanding! If I played that game twelve times this year, I’d see an annualized gain of over 43%. And the dividend I might get for holding Wal-Mart shares during that time is just gravy on top of that.

Where does the “insurance” part of this game come into play, as I had mentioned?

Well, we bought our shares at $86.64, and received $80 for agreeing to sell at $89 one month from now. But, what if the shares go down in price? That’s a possibility. We want to be insured against that happening to us.

When I entered into the agreement to sell my shares at $89, I received a premium, which offset the cost of my shares by about $.80. That means, I didn’t really buy at $86.64. I bought at $85.84. The share price can sink all the way down that far before I ever even start to be in the red on this trade.

That’s how the options we sell act as insurance. In case prices move down, instead of up like we think, we can still get out without losing any money up to a certain break-even point. My downside is protected on the trade, or hedged.

Do you see how simple this is? Doesn’t this beat sitting on your mutual funds in your 401k, that’s getting somewhere between 4-5% per year?

Here’s the best part. If the stock price is below $89 on the February expiration date, I still get to keep the $80 free and clear. It’s my payment for taking on the risk of having to sell my shares at $89 even if share prices were to move higher than that.

Our biggest possible loss when dealing with this strategy, called Covered Call Writing, is opportunity cost. I miss out on the opportunity of making more money and selling my shares if they are worth more than $89.

But who cares about opportunity costs, when we just made over 4% in one month?

Not me.

If my shares don’t go above $89 by next month, I’ll simply be selling another call option to someone at a price I think won’t be breached by the expiry of that option, to get premium free and clear, with low risk.

The Easiest Way to Guarantee Gains and Minimize Risk

There’s hardly a better strategy out there.

For more information, and more of a beginner’s explanation on stock options, read my post from earlier on call options, about how we juice our returns month after month with this and similar strategies.

Don’t miss out on this one. I promise you won’t be disappointed if you check it out.

Live long and invest,

Jeremiah

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