What is a Lever?
A lever is a machine. You can use something that is strong and light to move something that is big and heavy. I frequently find ways to use the tools I have to help me do something that might take two-or-three men to do – when I only have my own arms available. You can use levers when investing as well. You might want to learn how to use leverage wisely in your investing approach.
MARGIN: Investing Leverage Done Poorly with High Risk
There are some types of leverage that I do not recommend. For example, trading on margin (trading with money borrowed from your broker) has the potential for disaster. I’ve seen examples from the brokerage statements of friends who signed a document giving their broker authority to use margin in their accounts. It did not end well. In short, leverage is often the use of borrowed funds in order to undertake an investment or project. It is appealing because you might multiply the returns from an investment. However, leverage can also multiply the downside risk if the investment fails to perform as anticipated. If an investment is “highly leveraged,” it means that item has more debt than equity. Margin trading certainly fits that definition.
OPTIONS: Investing Wisely With Leverage
Trading stock options is one way to leverage your stock holdings and your cash to increase income while reducing or eliminating the risk of any loss. Of course, this depends on the types of options you trade. I have decided to focus on only two types of options: Covered Calls and Puts. A covered call is really just selling someone else the right to buy my shares within certain boundaries.
Intel as a Covered Call Example
For example, I recently did a covered call on my 300 shares of Intel (INTC). I sold three covered calls. In simple terms, the contract said, “I will sell you my three hundred shares if the closing price on Friday June 11 is at least $57.50. You have to give me $145 now for that option to buy the shares later.”
On Friday, INTC closed at $57.85, so I was obligated to sell and received $17,250 for my shares. In other words, this means I did not receive $57.85 per share. This means I made a profit on my sale, but it also means I no longer have shares of Intel. During 2021 I sold INTC covered call options nine times, providing me with $996.47 in options income. I also received dividend income of $312.90. As long as I own the shares on the Ex-dividend date, I also get the dividends. (If you do the math, you will see that the person who bought my shares paid more for the option than for the gain they realized on the share price ($0.35 x 300).
PUT PayPal as a Put Example
In May I sold two separate Put option contracts for PYPL shares. I repeated this in June two more times. Each time my contract price was greater as the prices increased: $240, $245, $250, and $255. In other words, each week I was willing to pay more for 100 shares if the share price dropped to that price. Because PYPL shares have been rising, I have not had to purchase the shares. However, I need cash (leverage) in my account as long as the option is open. Therefore, on June 11 I needed $25,500 in cash ($255 x 100 shares) to cover the put. Because PYPL closed Friday at $271.45, I did not have to buy the shares and I can repeat the process again if I desire. But don’t be hasty. Perhaps PYPL is ready for a pullback.
In May and June, I have made a total of $501.24 on my PYPL puts. This approach is only wise if I want to buy PYPL shares on a price dip. The risk is that the shares will drop below the contract price, causing me to “overpay” for the shares.
When you trade any options, be thoughtful about some dates. The two that I watch are the Ex-dividend date and the earnings announcement date. In general, I do not want to sell a covered call option on a dividend-paying investment and lose the dividend. I also don’t want to sell covered calls or puts when there is a near-term earnings announcement planned. Earnings can cause price volatility. Don’t sell contracts too far in the future. My longest contracts are usually less than a month long. Most expire at the end of the week.
Why does this all matter? Michael Carr offers some helpful advice. He realizes that Social Security is and will be insufficient to meet your needs in retirement. Even dividends might fall short if your total assets in your 401(k) or IRA are insufficient for a good income stream. Therefore, he suggests a third source of income: OPTIONS contracts.
Why You Need to Trade Options If You Ever Want to Retire
by Michael Carr, Banyan Hill Publishing, Monday, June 7, 2021
“Hedge funds use derivatives, futures or other contracts that allow them to increase their returns. Many of these investments aren’t available to individual investors. Individual investors can use options, and this is the only form of leveraged investment that is suitable for many individuals.”
We don’t need income from options to pay our bills. My Social Security and the dividends from our investments are more than enough. However, we seek to maximize our income so that we can maximize our giving. Selling covered calls and puts helps in that regard.