SMSF Investment StrategiesSharing Simple Strategies for Self Managed Super Funds

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Buy safely and profit from your mistakes

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I just learned a new investment strategy that has completely changed the way I would buy stocks in a bear market. I wished I had known about it last year when I started buying stocks with a view of holding for the long-term. In my May 6 blog post, I talked about buying XLF, a popular financial ETF in late 2008 because I felt the financial stocks were oversold due to panic in the market after the Lehman Brothers collapse. I bought this ETF with the belief that the good financial companies will eventually recover. I was a little too early in entering the market and bought 1000 shares of XLF at around $13 per share in Dec 2008 and the price continued to fall until a low of $6.

This investment strategy recommends that we always buy stock with enough put options to cover the stock for the initial few months. The put options will limit your losses should the stock price not go up as you expect. Using the backtesting tool on my broker’s platform, I found I could have bought XLF Mar09 13 put options for $2.25 and this would have limited my loss to a maximum of $2250 (the cost of the 10 put options needed to cover my 1000 shares), no matter how low the price of the stock goes because it guaranteed me that I can always sell my XLF shares for $13 which was the price I bought it at.

In March 2009, when the put option expired, the price of XLF was $8 per share. At that point, if I decide I do not want to hold XLF anymore, I could have exercised my put options and sold my stock for $13 and walked away with a small loss. If I believe that the XLF price will recover, I could sell my put options which would be worth $5000 at this stage ($13-$8 = $5 x 1000) and used this “insurance payout” to buy more XLF at the reduced price of $8 per share. I could have bought another 400 shares for $3200 and have enough money left over to buy 14 contracts of Jun09 8 options to protect my 1400 shares. By June 2009, the price of XLF had already gone back up to $12.50 per share. If I sold all 1400 shares at this price, I would get $17,500. After deducting the cost of the put options and commissions, I still would have a net profit of $2000 which is a 16% profit over my original investment of $13,000 for 1000 shares. If I were simply a buy and hold share investor, I would not have broken even yet!

This strategy is similar to the dollar cost averaging (DCA) strategy where you buy more shares on the way down to lower your per share cost. However, the DCA strategy requires you to fork out new capital for each share purchase whereas this strategy does not require you to come up with additional capital. You simply use the cash from selling your puts. Another beauty of this strategy is that your stock is always protected by puts which will limit your losses to a very reasonable level no matter what happens.

I would definitely consider using this strategy when I buy fundamentally good stocks which I plan to hold for the long term, when I think they have hit bottom. It gives me downside protection should I be wrong and pays me a handsome profit when the stock bounces back eventually.

I learned this strategy from an online options course which I bought to help me fine tune some option strategies which I use in trading for my family investment company. The course covered a number of wealth building strategies using options but some are more complex and require a deeper understanding of options. This course cost US$197, which is really value for money compared to the options courses I have seen which typically cost upwards of US$3000 and usually cover very basic strategies. For more information about this course, check out

Option Income System – Trading as a Business

Christina

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