Traditionally Low Risk Investments meant low returns and High Risk Investments meant high return, however using the derivative based investment platform of Exchange Traded Options this old paradigm no longer applies.
Low Risk simply means in the worst case scenario losing only a small proportion of the original investment. Investing with low risk works well only if the necessary action is under-taken by the portfolio manager.
Even low risk investments have the potential to become high risk investments.
Low Risk investments can cause “complacency” within the portfolio manager simply because the investment has been labeled “Low Risk”, generally meaning plenty of time to correct a situation gone wrong. Mixed together with a “Trading Ego” can become lethal for the investment. When any investment is perceived as being “The Right Thing” then action can be delayed, causing high loss.
There is a very wise saying “Big Losses used to be little Losses”.
To ensure finding the Balance between Risk and Return a Trading Plan must be defined and strictly adhered to.
Diversification has been made out to be one of the “Safer” forms of investing practices. This however is not always the case. Take for example an Investor that diversifies across a range of market sectors. Investing in 3 “Blue Chip” Materials stocks, 3 “Blue Chip” Property stocks and 3 “Blue Chip” Financial stocks. Traditionally a balanced portfolio. This type of investment would be classified as Low risk (assuming that only a portion of the Investment Bank is invested. Investment Bank is discussed later). The assumptions here are that:
* “Blue Chip” have a level of perceived safety
* The market is consistently trending upwards
* All sectors travel upwards together
When viewed from a slightly different perspective this Low Risk Balanced Investment is far from that. This investment also assumes:
* Finding 9 winning investments, a grand feat in itself!
* Split focus can be managed
* Losses can be taken across multiple trades should the markets retrace (ego)
Humans have a very limited span of focus. Hold your hands up 6 inches in front of your face, and look at all the fingers tips in one go. It’s extremely difficult if not impossible. You may manage it for a few seconds, but then find your eyes wandering to a single finger or even away from your hands altogether. Now assume your fingers are your investments, if one investment is doing well it takes focus from the others, and if one investment is not doing well, this also can take the focus from the others. Profit Targets and Exit Losses can be missed by not having the correct focus and also the ability to take the necessary action.
Any Investment Plan should incorporate the appropriate amount to invest. Investing all (100%) of an Investment Bank brings with it high risk. One bad investment can demolish the Bank, making it extremely difficult to recover, let alone profit.
Investing too little also has the inherent risk of never reaching the desired profit targets.
Looking at the previous example of a balanced or diversified portfolio, the investment is only profitable if the majority of stocks rise. Given the volatility of current market conditions, sustained growth is proving difficult to achieve. Investing in Stocks simply relies on stocks gaining value, sideways price movement results in loss of time and drops in prices lead to financial losses as well as loss of time.
Therefore finding an investment platform that minimizes the risk of financial loss and time is essential.
Exchange Traded Options (ETO’s) or more commonly referred to as Options, provides such an investment platform.
Options are low cost in comparison to Stocks and also have the added benefit of being able to gain in value (Put Options) should the markets falls. Options are leveraged and therefore provide access to large gains with 30% or more possible within 3-5 trading days (with correct timing, much less time). Due to their leveraged structure Options also cost less than Equity Stocks.
Consider this simplified example of a “Blue Chip” stock currently valued at $34.
Buying 1000 shares would cost $34,000.
Buying an equivalent Options position covering 1000 shares (10 Options for US Markets or 1 Options for the Australian Market) could cost around $1370
Should this “Blue Chip” stock rise 1% then the following returns could be expected.
The stock price gains $0.34 per share and rises to $34.34 a gain of $340 on the investment (1%)
The Options rises to $1610 a gain of $240 (17%)
The equivalent dollar exposure ($34,000) in Options could return $5,906 which is $5566 more than the gains from the stock position.
As you can see from these figures Options can provide extremely good returns with little stock price movement and therefore can provide similar returns for much lower investment dollars. Lower Risk and Higher Returns.
Looking at a scenario where rather than increasing in price the same investment falls 1%
The stock price loses $0.34 per shares and falls to $33.66 a loss of $340 on the investment (1%)
The Options falls to $1130 a loss of $240 (17%).
However if the stock price was identified as falling and Put Options were purchased instead of a Call Options then a gain of $240 would be achieved, rather than a loss, which is inevitably when only using stocks as an investment platform.
Balancing Risk and Return using Options becomes an extremely powerful investment tool as both upside and downside positions can be taken at the same time. Using one side as the primary investment and the opposite side as the secondary investment to effectively insure against loss or a least minimizing loss.
Investing in this manner allows investors to trade two out of the three directions the market travels at the same time. Much higher target profits can then be aim for using lower dollars. With the correct primary to secondary ratios (which is uniquely stock and time related) an investment that turns totally in the “wrong” direction can become profitable.
Similar investment strategies are possible using Stock for the upside and Put Options for the downside coverage, however this type of investment is not as profitable as a pure Options position.
The proper ratios of Calls to Puts must be calculated to effectively maximize profit and minimize insurance costs whilst maximizing cover. This is specialized knowledge unless using a Strategy Calculator designed for the Options markets.
Having both sides of the market covered, up or down, also brings with it the potential to double win from the investment, where prices reached their intended targets then retrace back, bringing extra rewards.
Any investment in the stock market requires a complete understanding of the Risks and Returns.
Lee Rayson is a professional Options Trader and Wealth Mentor. He is based in Perth Western Australia. He is the developer of “Option Raider”, the most advanced Options Trading Software in the market today. He developed a leading edge trading indicator named RESIN (Rapid Entry/Exist Signal INdicator). It identifies market turns where no other indicator can. Lee actively trades, teaches and writes passing on his extensive market knowledge to those seeking to be successful in their investment careers. He has also developed many advanced mindset tools for re-programming losing mindsets into winners. From brain-wave entrainment to The Identity Creator, Lee has created a winning range of products to assist any one gain success in the Stock Market.
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