We have gotten a lot of great feedback from our investment newsletters and websites, including Penny Logic. Our free and premium letters and services have been subscribed to by both novice and experienced traders and we couldn’t be happier with the engagement we have been having with our readers. One question that often comes up is that from very new traders who ask if you really need the recommended $3000 as used in our 3-For-5 Project and One-For-One Project model portfolios. Although you could follow these letters with less in your account, I think you would be disappointed with your returns. The average gain of each successful 3-For-5 Project newsletter recommendation is about 15%. With only $1000 in play you are only profiting $150 per trade and giving away about $40 in trade commissions. That along with the losses everybody takes once in a while will make you very slow out of the gate. Think of it this way – our 3-For-5 Project model portfolio started with $3,000. When you include trading costs you would have an 86% profit ($2,588 profit) in 18 months’ time. If you only started with $1,000 you would have a 40% profit ($402 profit) in 18 months’ time. Those trading fees really make a difference when you are a small trader. That’s why most investment services recommend not trading with less than $5000. We have a little different philosophy, but $1,000 is still a little slim.
One of the better ways you can leverage $1,000 is through trading options. Many readers tell me that they tried learning more about options but had trouble understanding the principle. I can empathize that no one would want to put their hard earned money into an investment they don’t fully understand. Truth be told though, trading the simplest of options (which is called “buying a call option”) is as easy as shopping for a little black dress.
Imagine a woman named Cindy who walks down a street and spots a little black dress in a boutique window. Not just any little black dress, but THE dress. Cindy has been looking for the perfect LBD since that Pico de Gallo incident at Chalupa Charlie’s and runs into the store praying for it to be her size. It is, but the dress is pricy – $1,000 bucks. She can’t buy the dress at the moment without breaking her budget but she does know that in about two months she will be getting her yearly bonus. She figures that buying the dress would be a great way to treat herself for a year’s worth of work well done, but she is almost certain the dress will get snagged off the rack before then.
Cindy talks to the boutique owner and learns that the dress is custom made and only 30 are in existence. This intrigues Cindy even more and she talks to the store owner about her dilemma. The owner takes a liking to her and makes her an offer. If Cindy is willing to give her $50, she will put the dress in the back and give Cindy a slip of paper that will allow Cindy to pick it up in two months for the price on the tag – $1,000. Cindy asks if the $50 she would hand over today be a deposit towards the dress. “No” replies the owner. “You see, I’m taking up space in my back room to hold a dress for two months that I can sell today. Besides, I’m committing to the $1,000 price. I am promising not to raise the price for two months and I don’t do that with any of my other dresses. Also, who knows if you are actually going to ever come back? The $50 is for my time and risk in the deal”. Cindy sees the owner’s point and plops down the $50, figuring that’s less than a night out at Chalupa Charlie’s and she doesn’t see herself going back anytime soon. The Pico de Gallo incident is a haunting one. As Cindy heads for the door, the owner chimes in “Remember, that slip of paper is good for up to two months from today. If you don’t come back before then the dress goes back on the rack and I never met you!” Cindy waves and leaves.
During the next five weeks, life happens. Her car needs a new water pump and her cat needs emergency surgery. Not only is her bank account sparse, but she’s already dipped into her credit cards and advanced herself her bonus money. Cindy realizes she has two choices in front of her. She can hope for a miracle and come up with the money for the dress in the next three weeks, or she can just forget about picking up the dress. The $50 she plopped down at the store a while back is gone regardless, but still she feels a bit foolish for getting involved with the shop owner before she had the money in her pocket.
The next weekend Cindy is watching the Super Bowl with her friends and she can’t believe what she sees on the television. Beyonce is on stage for the halftime show, rocking the same little black dress as the one in the store. Not THE same dress, since the boutique owner promised her that it would stay in the back for at least three more weeks, but it is the same exact design. Some phone calls the next day and a few fashion magazines confirm this. It so happens that the boutique owner sewed the same dress for Beyonce. A check online shows that the dress she saw in the window a few weeks back for $1,000 is now worth $15,000. “Wow!” says Cindy. “This is a no brainer! Now I have to pick up that dress. It’s worth $15,000! I just have to come up with the $1000 for the dress and sell it!”
Actually, this isn’t Cindy’s only choice and if Cindy has already decided to sell the dress it may not even be the best one. This is where many new traders get lost when they try to learn about trading options. Cindy doesn’t have to sell the dress to make money. She can also sell her slip of paper. Selling the piece of paper has less risk associated with it, doesn’t it? Suppose she got together the $1000 to buy the dress and before she gets a chance to sell it Howard Stern decides to sport the same dress on America’s Got Talent. The price of the dress plummets to nothing and Cindy is out $1000. Instead if she sells the paper, which she already owns in full, she lays out nothing more than what she already did – the $50. Cindy decides to do this and sells the slip of paper to a friend for $11,000. Cindy makes $10,950 on the deal and her friend got a $15,000 dress at a $3,000 discount (remember, her friend has to actually buy the dress for $1,000 in addition to buying the slip for $11,000). Everyone is happy, except of course the shop owner who allowed her good heart to cost her $14,000 in potential profit.
If you understood Cindy’s story then you now understand the fundamentals of buying a call option. With a call option (in the dress example, the slip of paper), you pay a premium (in the dress example, the $50) to be given the right to buy 100 shares of stock (the little black dress) at an agreed-to price, called the strike price (in our example, the price of the dress – $1000) before the option’s expiration date (in our example, the two months). Just like Cindy’s case, you can either trade in option and pay the strike price and get the 100 shares of stock or you can sell option itself to another trader before it expires.
In order to hit a gold mine like Cindy, you need a “Beyonce Event” to occur which will raise the price of the option’s underlying stock before its expiration date. To do well trading options you need to find a source of stock predictions which not only speak to how much a stock is expected to appreciate in price, but also in what amount of time.
In the next set of posts we will be talking about how to read an options chart and how to use an options calculator. For now, take a look at our public predictions page and read a little more about how you go about buying and selling back call options. If you have any questions, you know where to find us.
Happy Trading,
–Russ