One time I had a client tell me something that I will never forget.  I was doing an annual review with him and he had asked me if there was any way we could make more money next year than we did the current year.  The client was in his 70’s and we had both agreed to an allocation that was very conservative the previous year.  The allocation did make money, and overall the client was happy.

What the client asked me wasn’t anything earth shattering.  In fact, I get asked that all the time regardless of how good performance is.  What the client did say that really stuck with me was his response to my answer.  I responded by saying that we could definitely make more money, but we would have to take on more risk.  His response was, “I don’t mind taking on more risk so long as I make money from it”.

That seems to be a theme with all of our human nature.  We all want to “have our cake and eat it too”.  We all want to have great rates of return, but none of us want the risk.  So, it is with that in mind that I wanted to share this idea with the masses.  How can we have our cake and eat it too?

There are some stocks out there that have had some great rates of return that may be of interest.  I’m not going to give any specific names (I can only give them to clients).  This concept can be used with many different stocks.

Let’s say that I like XYZ stock and I want to participate in the upside that I believe is going to happen over the next couple of years.  It is currently trading at 35/share.  However, I don’t want to have too much downside risk on the stock.  That is where the power of options can come into play.     

Instead of buying 100 shares for $3500, I could buy a vertical call spread.  The reason that I like vertical call spreads right now is that with implied volatility at a historically higher level, I want to help mitigate volatility risk.  I don’t like diagonal or horizontal spreads right now because if implied volatility decreases, I’m locking in longer term premium and selling shorter term premium.  That can be a bad spot to be if the volatility comes crashing down.

Let’s get back to our spread.  I like going out a year and buying an OTM call spread.  For example, I would consider buying the 45/50 call spread about a year out.  The reason is that pricing isn’t bad (in my opinion) because the expensive 45 call has its high cost partially mitigated with the sale of the 50 call.  Typically, I like to look for a spread that would cost about $1.50.   That way, I have the potential to make more than I risk should the underlying stock rise above the short strike price of the spread.  In the example, we could simply use $150 and put the remaining $3350 in something safer. 

There are two key disadvantages to this trade.  The first is that if the stock goes to 44.99, and no higher by expiration, and we hold it until expiration, we will lose 100% of our risk when the stock when our way.  The second disadvantage is that if the stock does increase above the 50 level in the next month or so, it is not certain if you will get much of a profit.  The 50 call will work against you as the 45 call is working for you.  It is not until expiration that you can get the amazing risk/reward.  However, you will get some of the profit (most likely) regardless of when it happens.

I typically like to put in some type of contingent order once the stock goes above 50.  That means that if the stock goes below my short strike (after it is above it the first time), I will exit the trade.  Otherwise, I will wait for time decay to benefit me.

So, if you believe that the stock that you like will have a major move, and you don’t want to spend major cash, this is something to consider.

For more information, feel free to contact me at mtosaw@stcharleswealth.com.