From $15.90, minus $18.30. It’s $2.04. We have to multiply that by 1100 shares, because that’s how many shares I have now. That’s a gain of $2640. Remember, I lost $450 on this. I will subtract the $450 that I lost on my initial position, and I would have purchased 5 of these, for approximately $300 in protection. That’s $900 in additional protection on the stock, in the form of put options. That leaves me with a profit of $1290, in which the stock only rose from the $17.90 that I purchased it, to $18.30. That’s only 40 cents.
Do you see that? I purchased the stock here. It dropped here. I cashed in my insurance policy, bought additional shares of the stock. It rose up, and now I’ve sold it here for $18.30, which is only 40 cents above where I purchased it. I made $1290.
You see how powerful this strategy is. I could have sold it at that point, and retained my $1290. However, in most cases, what I’m interested in is dealing with the stock over a longer period of time. As the stock moves higher, I would now also sell my existing puts, and using some of my profits of a higher position in the stock – I would use that to purchase additional puts.
In most of the cases, if the position starts out badly, like this one did, I would use the insurance policy by cashing it in, to purchase additional shares of stock, every time this dropped. I could have done this a number of different times, actually. I could have purchased an insurance policy here by buying the puts, have it run up, and sold the puts I have here to buy additional puts here. I would then let the stock run down, cash in my insurance policy, and buy another 40 or 50 shares of stock.
Then I would let the stock run up, and purchase additional put options. If the stock fell down again, and so forth, all the way up until I reached a higher level. However, in many cases in which the stock had fallen dramatically, and you purchased additional shares of stock at a lower level, a lot of times what I’ll do – I’ll feel like the stock has failed to perform. I’ll wait for that additional rise in price, and then cash out, at a $1290 profit. Then I will go look for a different stock, one that has a greater potential on the upside.
The idea is to use your insurance policy that you purchased on the puts, in order to purchase additional shares of stock on a lower level, if the stock does drop. That is something that generally, only professionals do. Now, you have the knowledge as well, on how to do this.
You may have read in other investment books about dollar-cost averaging. For example, let’s say you were purchasing stock back here, when the stock was at $26. If we go back to this level up here – let’s say you purchased the stock here. Dollar-cost averaging would mean that not only would you purchase the stock here, but as the stock dropped, you would purchase additional shares.
That means putting more money out of your pocket. In this case, we invested $17,900 in the purchase of this stock. We used our insurance policy to purchase additional shares of the stock, when the stock dropped. We did not take any more money out of our pocket in order to purchase those additional shares, or the insurance.
Here, if you were to do traditional dollar-cost averaging, it means that you would purchase additional shares of stock out of your pocket, in order to increase the number of shares that you were purchasing. That would be a really horrible plan. As the stock continued to drop, you would continue to buy more and more shares, with more money out of your pocket. This would cost you many thousands of dollars.
If I was to purchase shares of the stock at $26, I would have an insurance policy – remember, I like to have it very tight upon initiating positions. My maximum loss is only going to be between $400 and $500. At that point, I probably would have bought something in the $26 or $27.50 strike price puts.
Then, as the stock dropped down to $22.50, I would have been able to cash in a $4000 policy, at that point, use some of that to buy some additional protection, and use the rest of that to buy additional shares of the stock.
That is the difference between this type of a strategy, and dollar-cost averaging. This is a truly dynamic way to trade, because your insurance policy – the puts that you put into place when you initiate a position allows you, if the stock does drop, to purchase additional shares of the stock.
When the stock does eventually increase in price, you could have purchased insurance policies all the way down this decline. Let’s say you started with an initial position of 1000 shares. By the time it reached $17 a share, you could have had 3000 shares of the stock, with the additional cashing in of the put options you had as insurance.
Now, with 3000 shares of the stock at $17, and it rallies up to $18.50 – now you’re making close to $4500 in profits, just from a small rally in the stock, with no extra cash out of your pocket whatsoever. If a strike price was not available, in which you felt comfortable with your insurance position, you could have created a synthetic strike price. You can do this by splitting the number of put options that you were going to purchase on the way down.
This is truly a dynamic way to generate spectacular returns in the market. It’s actually a way for you to dramatically increase the amount of profit that you will be able to collect.
Let’s take a look at Cisco for a second. Imagine purchasing the stock for Cisco at $29, back here in 2004, only to see the stock dramatically decrease in price, down to $16.50. Without insurance, you would have lost approximately $12.50 a share. With insurance, you could have cashed in those policies, every time it went through your strike price, before expiration. Cash in those policies and purchase new puts, all the while using your put insurance to accumulate additional shares of the stock.
Once it gets down to this point here, you would have had – you maybe started out with 1000 shares of stock. By the time it reached this point, you would have had maybe 2000 shares of stock, and then seen a dramatic rise in price, all the way up to $29. Your insurance would have actually helped you accumulate additional shares. At $17 to $29, that’s a $12 increase in price. On 2000 shares of stock, that’s approximately $24,000 in profits.
Your initial cost was only $29,000, for an initial 1000 shares of the stock here. You see how powerful that is? You would have gotten to the point where the stock was at the exact same level that you purchased it, back in the beginning of 2004. In 2007, you’re back at $29. You would have made a $24,000 profit on your $29,000 investment.
Yeah, it would have taken you a couple of years to get back up to that level. If you just purchased $29,000 worth of stock, without any type of protection, without any put protection whatsoever, and no insurance policy on the stock at all – you would have only seen a breakeven on this position.