How to Use Options to Protect Your Investment

How to Use Options to Protect Your Investment Posted: 24 Nov 2008 12:06 PM CST After reading the new biography titled "The Snowball" about Warren Buffett, I became interested in learning more about the stock market. I went out and purchased 6 different books on the stock market. One of the books I purchased was instrumental in Warren Buffett's education. This book is "The Intelligent Investor" by Benjamin Graham. Mr. Buffett specifically suggests that investors read and focus on just two chapters in this book. Chapter 8 - "The Investor and Market Fluctuations" Chapter 20 - "Margin of Safety - as the Central Concept of Investment" These chapters are very educational and required if you're serious about building wealth. The principles taught in these chapters apply to the stock market, real estate market and any business that you own. Put this book on your holiday wish list! In addition to "The Intelligent Investor", I also read several books on stock options. I've now put my toes in the water with options. Nothing too crazy. I'll share what I'm doing with you in today's post. My strategy has been to buy shares in good companies when the price drops. This has been fairly easy to do lately. For example, I purchased shares of one stock at around $51 share. I then turned around and sold "covered calls" on the shares I owned. Basically, I sold an option to someone else giving them the right to buy my shares at $65 dollars a share. They paid me $3.50 a share for this right. So I paid $51 a share and collected $3.50 a share and still own the stock. This means my actual out of pocket cost on this stock is now $47.50. Soon after this transaction, the stock dropped again. As I write this blog post, the stock is now trading at around $48 a share. I'm still slightly ahead because I have $47.50 invested and the stock is valued at $48 a share. Had I not sold the option on this stock, I would be down $3.00 a share. Here are a few things to consider: 1. In Income for Life, we buy a good home and then sell the home to a tenant/buyer on a rent to own program. The tenant/buyer pays us a fee upfront for the right to buy the home at a predetermined price during the rent to own program. This is the exact same thing that I've done with my stock. I've sold someone the right to buy my stock at a predetermined price for a set period of time. As you collect upfront payments on your investment home, your cost basis in the property decreases. So if you paid $100,000 for your home and you collect $5,000 upfront from your tenant/buyer, your cost basis has now dropped to $95,000. 2. If the stock I purchased does not increase in price, I'll be able to keep the stock and the entire option payment. I can then sell another "covered call" on this same stock and collect more money. The money collected would reduce my cost basis in the stock further. The same strategy applies to our rent to own home. If the tenant/buyer doesn't buy your home, you can collect another upfront payment and reduce your cost basis further. Depending on how many times you go through this process, you can continue to drive your cost basis down on your investment further and further. In my stock scenario above, the price of the stock dropped, but I'm still ahead because of the income received from the option sold. Selling options on your assets helps to mitigate against price decreases. 3. If the stock I purchased increases in price beyond $65 a share, I'll be forced to sell my shares. I'll collect a profit of $14 a share. I cannot see how this is a bad thing. Back to real estate - if the tenant/buyer buys out your home at the predetermined option price, you'll collect a nice profit on the home, too. The strategy I'm testing with my stock options is basically copy what we do in Income for Life with real estate. Buy an asset, sell an option on the asset to generate additional income from the asset. I never really thought much about it, but selling options on your assets allows you to hedge against loss. This strategy can be applied to real estate, just as easily as it can be applied to the stock market. The only difference that the stock market moves at a significantly faster pace. To be clear, I'm not suggesting you go out and start trading stock options. Stock options are risky and you can lose money. I've read several books and I'm playing the game with a very small amount of money. Instead, I'm hoping that you see how powerful it can be to sell someone else the right to buy your assets at a predetermined price.Take some time to digest this blog post, because I've dropped a pretty big investing concept on you! If you would like to become an Income for Life Member, apply at http://www.iflapplication.com/ Rob Minton