Using Options to Buy Stocks. D. Eisen

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There comes a time in the life of every investor when he or she runs out of money to invest: the birth of a baby, purchase of a home, a second child, braces, another baby (oops!), and, later on, tuition payments, wedding expenses, a second home. All of these can temporarily suspend regular investment plans. Permanent crimps in investing can arise when retirement plans are fully funded or retirement itself commences. Professionals and nonprofessionals alike are subject to the laws of supply and demand, and can find themselves at times between jobs, underemployed, or just plain out of work. These things happen to us all, and for most, the idea of maintaining regular investment plans during such tribulations seems impossible. Where will the money come from? I have been a regular investor for over three decades, faithfully putting aside the dollars needed for retirement and stuffing them into stocks, bonds, and mutual funds.

Imagine my surprise the day my financial adviser informed me that my retirement plan was now fully funded. This was a good-news/bad-news situation. The good news was that I would now be able to retire at 60 percent of my peak earnings for the rest of my life. The bad news was that as a compulsive saver and avid investor, I would no longer be able to contribute new capital with which to play the market, either for the purpose of buying new issues or for acquiring additional shares of my favorite companies. I could sell existing equities to do such things, but as an inveterate "buy-and-hold" investor, I was loath to trade in any of my equity holdings.

My need to continue my investment program beyond what I was legally permitted to contribute to my retirement plan was driven by four concerns:

1. What will happen if I outlive what the actuarial tables said were going to be my golden years?
2. Will there be enough in my retirement plan so I can spoil my grandchildren while I am still alive, yet leave enough in my estate for my wife, my children, and (alas) the cut due the Internal Revenue Service?
3. I knew I would miss the research, discussions, evaluations, and decision making that go into the selection and buying of stocks.
4. And, hey, the difference between being an old man and an elderly gentleman is money.

The first strategy that occurred to me for continuing my investment program was to go on margin. Most brokers will lend you up to 50 percent of the value of your account to buy more stocks. The trouble with this method is that you have to repay these funds with interest. The interest rate is high—often higher than what can be safely earned on bonds, preferred stock, and even the appreciation on many growth stocks. You can see online and live nikkei 225 futures chart and ftse 100 chart Furthermore, the specter of a dreaded margin call because of a market slump, however temporary, made me (as it does most investors) very leery. It then occurred to me that there is a great way to acquire stocks without trading what you've got or using borrowed funds.

Simply stated, the method involves selling long-term options on highly rated companies and using the premiums received to further your investment program. There is no interest paid on the funds received; the funds never have to be repaid (because they have not been borrowed); and the equity requirements needed to do this are much lower than those for regular margin buying. Although I adapted and perfected this technique to suit my own needs and situation, it can be used by any investor who has built up some measure of equity and would like to acquire additional stocks without contributing additional capital. As you will see later, the potential benefits far outweigh any incremental risks, especially when appropriate hedges and proper safeguards are incorporated.

What makes this technique so effective is that it exploits the fact that option prices do not reflect the expected longterm growth rates of the underlying equities. The reason for this is that standard option pricing formulas, used by option traders everywhere, do not incorporate this variable. With short-term options, this doesn't matter. With long-term options, however, this oversight often leads the market to over- value premiums. Taking advantage of this mispricing is the foundation of my strategy. I have been using this technique for the past five years—very cautiously at first because of the newness of these
long-term options (they were invented in 1990) and the almost complete lack of information regarding their safety and potential.

It was this lack of analysis that led me to start my own research into the realm of long-term equity options. Having determined their relative risk/reward ratio, I am now very comfortable generating several thousand dollars a month in premiums that I use to add to my stock positions. I am often told that what I am doing is akin to what a fire or hazard insurance company does, generating premiums and paying claims as they arise. A better analogy might be to a title insurance company because with proper research, claims should rarely occur.
This book is divided into four sections: The first one consists of Chapters 1 through 5 and describes the basic approach in using long-term options to further investment programs.

The second section, Chapters 6 through 12, refines this approach and shows how to institute controls to reduce risk. The potential reward and the long-term safety of the basic approach and refinements are established through extensive computer simulation and backtesting. This is accomplished by going back ten years and asking what would have been the outcome if the various techniques had been applied in as consistent a manner as possible during that period. The third section, Chapters 13 through 15, contains the analytic formulas for the rapid computation of volatility and option premiums for both European- and American-style options.

The 1997 Nobel prize in economics was awarded to Myron Scholes and Robert Merton, who along with Fischer Black were the original developers of these formulas. With minor variations, they are still used today for calculating option premiums by market makers and option traders alike. Although college mathematics is needed to understand the formulas, the short, simple algorithms given for their numerical evaluation can be used by virtually anyone who knows BASIC or can set up a spreadsheet on a personal computer. For readers without access to computer tools, there are various appendices containing tables for looking up option premiums and assignment probabilities.

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Very nice post, good luck!

Very nice post, good luck! ;-)

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