‘Stress Less Investing’

In Chapter 1 of my Wealth Building Formula book we learn that over the long-term common stocks have out-performed all other investment asset classes such as residential real estate, gold, Treasury Bills and Treasury Bonds by a wide margin. While there is no question that stocks are the leading asset class in terms of return performance, this out-performance comes with considerable risk. Since 1945 the S&P 500 Index has suffered eleven bear markets or on average about one bear market every five years.

Severe bear market declines are painful reminders that the extra returns associated with owning stocks also means increased risk. Conventional investment wisdom dictates that there is a direct correlation between return and risk and “the higher the return the greater the risk”.

But my colleague John Weston and I discovered many years ago that there is a way to participate in the superior returns provided by owning stocks and at the same time strictly limiting our risk to a small percentage of our investment. This can be achieved by buying an ‘insurance policy’ on your stocks that helps protect the value of the stock in the event the stock declines in price. This ‘insurance policy’ is initiated by buying a put option on our stock. This strategy is especially effective with dividend paying stocks as dividends can be used to help pay for the cost of the put option.

Many investors consider option investing ‘dangerous’ with a high probability that you could lose all of your money invested in options. While this is true for some option strategies this could not be further from the truth when it comes to purchasing put options to protect stock that you own. In our many years of investment experience, John and I have learned that buying put options to protect your stock investment is the safest, most conservative strategy available for investing in stocks and allows you to realize stock market returns with limited risk. I like to call this strategy the Wealth Building Formula Safety Strategy.

What is a Put Option?

Simply stated a put option is a contract that gives you the right to sell a stock at a specified price which is called the ‘strike price’ on or before the expiration date of the option. The price you pay for an option is called the premium. If you buy a stock and the related put option and then the stock subsequently declines in price, the value of the put option increases and thereby helps ‘protect’ your stock investment. This simple spread relationship allows you to realize the benefit of stock market returns while at the same time limiting your risk to a small percentage of your investment. Let’s look at an example trade from my Wealth Building Formula book to help you understand this important concept. Listed below are option prices for General Electric stock symbol GE. These option prices were obtained from the Chicago Board Options Exchange website at www.cboe.com.

WBF Safety Strategy

Let’s focus on the GE 35-Strike put option which is circled in the preceding quote table. The symbol for this put option is VGEMG. The premium price to purchase this option varies between 2.30 and 2.45 with a ‘bid’ price of 2.30 and an ‘ask’ price of 2.45. When purchasing this option we can expect to pay the ask price of 2.45.

Options normally cover 100 shares of stock. If we purchase one 35-Strike put at 2.45 we would pay $245 plus commission (2.45 X 100). The value of this put is determined by the price movement of the underlying GE stock. As GE stock moves up in price the value of the put will decline in value. Conversely, if GE stock moves down in price the value of the put will increase in value. Option expiration day is normally the third Friday of the option expiration month. In this case, the January ’07 put option would expire on Friday January 19^th 2007 or in about 22 months.

Let’s assume that we purchase 100 shares of GE stock at the same time we purchase the GE Jan ’07 35-Strike put option. GE stock was trading at 35.74 on March 9^th. Our total cost for this spread investment would be $3,819 plus commissions ($3,574 for 100 shares of stock + $245 for the option premium). The return analysis table that follows demonstrates how the purchase of the GE put option helps protect our 100 share investment in GE stock.

Put Option Protects GE Stock Investment

The row labeled ‘Stock Price’ in the table below assumes various prices of GE stock from 10.00 to 50.00 at option expiration in January 2007. The bottom row labeled ‘Profit or Loss’ lists the net profit or loss for the combination of purchasing the GE stock and put option for the various assumed stock prices at option expiration (listed on the ‘Stock Price’ row).

The first column assumes that GE stock closes at 10.00 at option expiration (circled) which is unlikely for such a high quality stock. Nevertheless, if GE stock closes at 10.00 then the value of 100 shares of GE stock would be $1,000 and the value of the 35-Strike put option would be $2,500 for a total value of $3,500. 

The value of the put option is calculated by subtracting the current price of the stock of 10 from the strike price of 35 and multiplying by 100 (35 - 10 x 100 = 2,500). Regardless of how much GE stock drops in price the combination of 100 shares of stock and the 35-Strike put option will always be worth at least $3,500.

Maximum Risk of $165 Regardless

Of How Far GE Stock Drops in Price

 If we add in the dividends received of $154 for owning 100 shares stock then the total value for the combination of stock value, put option value and dividends would be $3,654. Remember we paid a total of $3,819 for 100 shares of stock and the 35-Strike put option. If GE stock closes at 10.00 at option expiration (01/19/07) our maximum loss would be $165 (cost of $3,819 subtracted from current value of $3,654). Even if GE stock drops to zero our maximum risk is still $165.

Eat Well and Sleep Well

The last column in this return analysis table assumes GE stock is trading at 50.00 at option expiration in January 2007 (circled). Remember that we have 22 months of protection time during which we participate in any price appreciation in GE stock. The value of the stock would be $5,000 (100 shares x 50). The value of the put option would be zero. The stock price in this example is 50.00 which is greater than the 35-Strike price of the put option. At option expiration, whenever the stock price is above the strike price of the put option, the put will expire worthless. This is a good thing as we would realize a $1335 profit on our investment with only a $165 risk. That would enable us to eat well and sleep well!

Calculating Dividends

The dividends in this example total $154 for owning 100 shares of GE stock from March of 2005 through January 2007. This $154 dividend will cover most of the $245 cost of purchasing the protective put option. You can obtain stock dividends by logging on to www.yahoo.com.  Click ‘finance’ and then type in the stock symbol in this case GE. This will display a price quote for GE stock as well as current dividend information. According to Yahoo Finance GE is currently paying an annual dividend of .88 (88 cents per share or $88 per year for 100 shares).  

Average Return of 33.5% with Only 1 Losing Trade

 My Private Wealth Group Advisory Service at www.PrivateWG.com makes put option spread recommendations using the WBF Safety Strategy rules. As of today May 8th the recommended trades listed below currently have a $50,461 open trade profit and an average return of 33.5%. This is a great return for such a low risk strategy. The great advantage of this strategy is that there is no limit on your profit potential if your stock increases in price. This allows you to fully participate in the superior returns provided by stocks with limited risk. 93% of the recommended trades are profitable. Keep in mind that during the holding period of these trades there were three sharp market corrections resulting in a 1,545 point, 1,573 point and 2,342 point plunge in the Dow Jones Industrial Average in August, November and January.

 WBF Put Option Spread Trade Open Trade Record