Insurance and Credit

Many traders view stock options as only a short term trading strategy. The idea of a highly leveraged bet with the potential to make big bucks quickly appeals to the risk taker inside all of us. Just like a card counting black-jack player, options can be used to make consistent short term gains, provided the player is careful, and knows what they’re doing. But while stock options are usually employed solely by that clique of high-risk, high-reward traders, they actually have enormous benefits that tend to go unnoticed by many a long term investor.

The stock option strategy I’m about to reveal isnt often used. Indeed, I’ve only briefly heard mention of them on obscure websites, and even then, not in enough detail to give an example. So here it is, what I believe may be the best kept secret from long term investors on wall street. The stock option strategy for the long term investor.

Its the vertical option spread, using leap options. How this investment works is you buy one option, while simultaneously selling another option for the same month, but at a different strike price. While XYZ is often my generic ticker, I will use a real company in this case. Keep in mind, this is NOT a recommendation. In fact, it would probably be a terrible idea to invest in the example I’m about to give. Its just an example. Yet to get realistic prices for this strategy, it may be helpful to use a real stock.

note:I wrote this part of the article about a short time ago, prices may not be 100% current. So GE is currently trading at 10.41 per share. In this example, let us talk the January 2011 options, giving GE a large amount of time to go the way we think it will. So if you thought GE was an excellent long term buy, it would be reasonable to think it’s going to at least $20 per share by that point. By January 2011, consensus is believe the recession to be over, and that single development alone should lead to a substantially higher stock price.

To do a vertical spread, you have to buy one option, and sell another one. Giving our price target of at least $20, and given the current price, 10.41, I would buy the 12.50 strike call option, and sell the 17.50 strike call option. The 12.50 option can be bought for 2.71 at the moment, while the 17.50 can be sold for 1.40, giving us an total cost of 1.31 per share for the vertical spread.

Now lets analyze this trade for a second. If General Electric is trading under 12.50 on the January 2011 expiration, both options expire worthless, and the 1.31 per option spread invested is gone. On the other hand, if General Electric is trading above 17.50, then the 12.50 option will be worth exactly $5.00 more then the 17.50 option, and so the position is worth $5.00 per share. If its between 12.50 and 17.50, the call we sold expires worthless, while the call we bought will have value equal to the difference between the stock price and the strike price; 12.50 in this case. How do you calculate the break even? Well we paid 1.31 for the vertical spread, so if its exactly 1.31 higher then 12.50 (13.81), then well be at break even if the stock is at that point.

That gives us an amazing return of 281% if GE is above 17.50, for an annualized return of 107% (holding period is 22 months). Due to the high potential for risk – a complete loss of investment if GE is below 12.50 in Jan 2011, you shouldn’t put more then you’re willing to risk in the trade. Definitely a speculative play. Yet with how much time there is, it is a much safer bet then short term options, and significantly more profitable then just buying the shares.

So now that the basic idea is out of the way, what are some examples of vertical spreads I would consider? I’m a strong believer in investing in emerging markets, so I am long term bullish on EEM (IShares MSCI Emerging Markets Investment Index). The January 2011 25-30 vertical on EEM is only going for about $1.88 at the moment, with EEM trading at 25.30 so I think that would be a superb investment. Above 30 it would be worth $5 at expiration, while below 25 it would be worthless. Unless the economy further deteriorates, I can’t imagine that occurring.

Along the same lines, I expect FXI (iShares FTSE/Xinhua China 25 Index) to go up. The “China miracle” isn’t over, merely in a subdued state due to temporarily reduced demand. The 30-35 vertical Jan 11 vertical would be worth $5 at expiration if FXI is above 35, which from its current price of 28.51, is perfectly within reason. That vertical spread currently has a $2 price, so that would be an even 150% return from now until January 2011.

A much more controversial play would be Bank of America. While the trader in me screams to short the stock, I foresee it being far more valuable then it currently is a couple years down the road. The simple reason is that yes; financial stocks have been hammered by the current collapse. Yes, some banking companies have went bankrupt, or have been on the verge of bankruptcy. Is the financial system going to completely collapse? No. Are out of control bank runs going to drive them out of business? No. Are people going to want to borrow money again after this recession ends? YES! Is pent up demand in housing going to cause a rush to buy houses at prices not seen in a decade? YES! Are banks going to profit from this? Most DEFINITELY. If BAC is above $10 at the January 2011 expiration, the 7.50-10 vertical for Jan 2011 would be worth 2.50, while only costing about $0.65. That would give a 286% return, or 108% annualized. The risk of course, is that BAC goes bankrupt, or BAC stays under the $7.50 per share mark past January 2011. In either case, you would lose your investment. Yet with prices as low as they are now, there isn’t a high chance of that scenario unfolding.

For the vast majority of people, the financial markets are not the place to get rich quick. While some short term traders will have tremendous success with these option strategies, long term investors can use these same strategies while focusing on the longer term, to achieve gains vastly exceeding those of the regular stock market, while limiting risk.

Learning forex trading should not be difficult. With decent understanding of money management rules and a good trading strategy, you should be ready for conquering the forex markets.

Always try to understand the big picture. You should start each trading session by looking at the daily charts and than zooming into 4hr, 1hr, 30min, 15 min etc charts. Forex trading is all about interpreting the past as well as about interpreting the future.

You need to know whether the market is ranging or trending before each trade. You should try to know any long term patterns that have developed by looking at the charts. By taking a general look at the different charts you will develop a feel of how the forex markets are behaving in the short as well as the long term.

You should try to figure out the general direction of the currency markets. You can use candlestick analysis and moving averages to identify long term patterns and reversals.

Bollinger bands applied to 4hr charts can be used to identify the daily trading range. Most of the price action is expected to be within the Bollinger bands. Any moves outside the bands can be viewed as short term abnormalities and ignored.

Do some scenario planning, once you have a general overview of the market. Make sure you know what news is scheduled to be released and what is the expected market reaction.

Understanding the big picture does not mean knowing the whole picture. You should only focus on your favorite pairs. It takes a longtime and effort to understand a currencys behavior, how it reacts to things like oil prices, interest rates etc. So concentrate only on a few pairs in forex trading.

You should always try to take notes and keep a daily trading journal. Start each entry in the trading journal by analyzing the general direction of the markets for that day. What you think how the markets are going to react to different news that is expected to be released that day? What should be your entry and exit for the trade. How many pips you are expecting to make?

After each trade, look at what went wrong and how to avoid it in future trading! In case of a good trade that made you pips, analyze how many pips you could have made more and how to tweak your trading strategy for better results in the future trades.

Keeping these general tips in mind while you are learning forex trading will help you a lot. Never ever trade without stop losses and practice on the demo account for at least three months before starting live trading.

I’ve been a Stock Trader for over 15 years, and know the business inside and out. I didn’t start at a fancy brokerage firm with sophisticated training courses. Instead, I made my success my own way, failing here, tweaking there, using seminars and self taught classes to learn what I needed as I went.

While my self taught training may have resulted in a slower success, I know a lot more about the real world of stock trading than a lot of those investment advisors out there who only know what their employer told them. One thing I have discovered over the years is that there are myths that continuously recur when talking to people about stock trading. Here are three of them:

The first misconception I’d like to dispel is that only certain types of people make successful stock traders. True, stock pickers (those guys who pick the big winners by consistently analyzing the market) are more often than not left brained thinkers , which is probably how this myth originated.

But I have found that trading stock has something in it for every type of thinker, and the trick is to find the process that works best for you. Frankly, I would hate to sit around and analyze stocks all day, but I have made a great living trading stocks anyway. Anyone else can too.

Second, is the belief that stock trading is speculative, and carries as much or more risk as owning your own business. Yes, people have lost everything in the stock market, and those are the stories the media loves to report on that intimidate a lot of people.

But I have learned that if you have the right process in place for setting your stops and limiting your risks to a level that you are comfortable with, it can really be a very low risk profession. For example, I have created a system for myself that allows me to trade with a 75% or more success rate, which is fantastic! I know of no other business that can give me that kind of low risk situation.

Finally, I hear again and again that to really make money in the stock market you must commit to it full time and then some. And I agree, this is absolutely true for some types of trading and particularly if you don’t have a good stock picking service. Then you have to do all the leg work in a fast paced environment. That does take a lot of time.

However, it is absolutely possible to make a great career out of trading stock for 2-4 hours a day, and having the rest of your time to do what you want. The trick is to have a process in place that is low risk and efficient with your time. How do you find such a process? There are a lot of courses available and it can be tricky to find the one that’s right for you. I advise you to investigate several options, ask questions (if there’s no one who will answer your questions, move on…life is too short to deal with bad customer service). Head into your research knowing the right process is there for you, and you will be on your way to success at stock trading in no time.