Virtual Trading – Trading Options Video 28 part 2

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There has got to be a better way to do it. There has got to be a better way to buy stocks, and not wait a year just to break even. That’s not only a waste of capital, it’s a waste of time. It’s not a very smart investment.

The actual strategy that I’m going to teach you in initiating positions, is rather different from anything I have heard anybody else talk about. If you work for a large corporation – I’m talking specifically about a public traded corporation – you may have a lot of stock options, or you may have stock that was given to you as part of your retirement program, or an incentive program of some sort.

I can imagine that companies like Enron or WorldCom, years ago, that were high-flyers, that were trading for lots of money – a lot of the people who worked for Enron or WorldCom had their life savings into the stocks, at those times. If you have stock in a publicly traded company because you work there, and it was given to you as an incentive, or as bonuses or something like that – if you’re holding that stock and it comprises the majority of your retirement or wealth in that company, let’s think of some other companies that have really hit on some hard times recently.

Let’s take Lehman, for example. Just imagine working at Lehman Brothers. Having the stock up here at $85. I bet a lot of the senior executives at Lehman, and a lot of the middle management, even, have a number of opportunities to purchase shares of the stock at different times, at pretty reasonable prices. Maybe they were even bonus stock, back when it was around $25 to $27.

It hit $85. What’s it selling for now? $23. If you were working for Lehman Brothers at the time, and you saw the stock up at around $85, and you did absolutely nothing to protect your investment, you would have seen it cut by 2/3 today. That’s a pretty tough way to wake up in the morning, to see that your stock is down another $7.

It’s a very tough thing to see. Yesterday it was trading at $35, and now it’s trading at $23. That’s a $12 decline in the stock. That is pretty rough. Things get pretty bad very quickly, with stocks.

I have told you, and I’ve mentioned throughout this course, that it’s very difficult to predict stocks. There are probably 1% of the entire population of the world, who can predict with any degree of accuracy, the future value of a stock. There has got to be a better way.

And there is a better way. Let’s go back to Starbucks here, for a second. I would imagine that even the people at Starbucks have stock. They have incentivized stock, or they have a share purchase plan, or some other benefit that they have, that allows them to purchase stock over time. People bought it back at $12, thinking, “It’s $18, it’s not too bad. We’re still up $6.”

That was 5 years ago. If I bought stock at $12, and 5 years later it’s only $18, that’s not a particularly good rate of return. When it was up around $40, what were they thinking? “Oh yeah, this thing is going to go up to $100.” They were thinking that their stock was going to continue up.

But the fact is, we can’t predict the future. We can’t predict what stocks are going to do. The only thing we can do is manage risk. We can benefit and profit from the management of risk.

The most common form of managing risk is simply to use options to protect your stocks. In other words, let’s say we go into Starbucks right now. Let’s say we wanted to purchase 1000 shares. If we took a look at it, 1000 shares of Starbucks right now, trading at $18, would cost us approximately $18,000, not including commissions. Our commissions would be about $15. With the shares trading at $18.01, it would cost us $18,000, or $9,000, in order to purchase the stock.

What does that do for us? Let’s go to our Analysis tab for a second, and take a look at exactly what this would do for us. If we had 1000 shares of Starbucks, if it goes up $2, you have made $2000. If it goes up $5, you made $5000. You make $1000 for every dollar that the stock goes up.

On the other hand, if the stock drops to $16, which is $2 lower, you lose $2000. If it drops $5, you lose $5000. That’s not a particularly attractive scenario.

Let’s go back to our Trade tab. The Think or Swim platform allows you to actually do something quite interesting. There are a couple of different numbers of trades that you can select, when you right click on any of the option symbols.

The most common way that you would be able to protect your stock holding is to simply buy a put in order to protect your holdings. There is a variety of different put options in order to protect your stock investment. How do you know which one to select?

The Analysis tab helps us to do that quite efficiently. However, there are a couple of different reasons why you don’t want to rely on the Analysis tool alone. Also, you want to use common sense.  The purpose of the selection process, and the goal of the selection process, is actually to get the stock to prove itself, before you make a large investment. Before you continue with the investment, or to protect your initial investment, when you set it up.

Let me explain what I mean by that. On the surface, you may believe that with the stock selling at $18, and you were to purchase $1000 shares of that stock, you would want to buy a put. A put would allow you to profit from the stock if it declines. Placing a put on a stock that you own is probably a fairly good investment.

Let’s just take a look. In our Analyze tab, we already have 1000 shares of Starbucks, at $18.01. Let’s go back to our Trade tab and select the 17.5 strike price put. If we wanted to buy a put on Starbucks, to profit when it goes down, we would select that.

Now, one contract of the July 08 17.5 puts, would cost us approximately $60. The price of a put is 60 cents, times one contract, times 100 shares of stock. Each contract represents 100 shares of stock. If we confirm and send that, we’ll see that it costs us $60.

In order to protect all 1000 shares of our stock, we need to select 10 contrasts. 10 contracts, at 60 cents, would be $600. That would be the cost of the investment, in order to protect our 1000 shares.

Let’s analyze this, and see what it does to our profit graph. You could say, “Why would you spend $600 to protect your shares? Doesn’t it limit your upside potential?”

It does, a little bit.

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