Stock Option Investing
(Leveraged Investing)

What is Leveraged Investing?

stock option investing

There is a world of difference between trading stock options and adopting what I call a stock option investing mindset.

[If you haven't done so already, please read my original essay, "Leveraged Investing or No Substitute for Planting a Tree" for a definitive explanation of Leveraged Investing.]

I have no beef against the option trader or speculative option strategies.

But in my experience, trading stock options, although potentially lucrative, has too many drawbacks.

Trading Drawbacks

  • It's a lot of work. It may not be day trading, but you're constantly on the prowl looking for good short term trades. And then, once you set them up, you have to spend much of your time monitoring your trades. Should you use stop losses, and if so, where do you put them? And if the trade is profitable, at what point do you close it out?
  • It's complicated. Trading stock options requires a certain level of proficiency with technical analysis. Technical analysis works - sort of. It works until it no longer works.

    Technical analysis is an art, not a science, and its most successful practitioners understand this. Technical analysis can be taught to a degree, but, if we're going to be completely honest, it's the rare individual who possesses the ideal combination of mathematical intelligence and technical instinct required for successful technical-based trading.

  • It's emotionally draining. If you're going to be a successful at trading stock options, you're going to have be emotionally OK with experiencing a certain amount of losing trades. The trading mindset doesn't seek to eliminate losses altogether, but rather to limit those losses while at the same time maximizing the gains on the winning trades.

    That may make sense on paper, and it's a great theoretical approach, but again, it's the rare individual who has the stomach for such an approach and who can actually pull it off.

    For most would-be traders, worry is the primary emotion. You worry about the bad trades that lose you money and then you worry about the good trades. Did you close it out too soon? Too late? It's unlikely, after all, that you played it perfectly and closed your trade at the precisely perfect time to fully maximize your profits.

Investing Advantages

So what exactly is stock option investing, or Leveraged Investing, as I call it, and what are its advantages?

The first important thing to realize is that stock option investing isn't simply taking an investment approach to options themselves. There are approaches that seek to identify undervalued and overvalued options, but those approaches are still about trading, not investing.

After all, options are not ownership of anything. They aren't pieces of a business. They don't allow you to vote with shareholders or share in any dividends or company earnings. They are simply contracts involving, to one degree or another, the potential future ownership of a certain number of a company's shares.

If stock option investing isn't about investing in options, then what is it about? Quite simply, stock option investing is about using options to become a better investor.

Options are great tools for leveraging the short term trading mindset. But what is less promoted is the fact that they are also great tools for leveraging the long term investing mindset.

Synthetic Value Investing

As far as I'm concerned, the jury is in, and the greatest, most reliable, consistent, and sustainable form of investing is value investing. Granted, it doesn't necessarily outperform all other forms of investing every single year, but over the long haul, nothing beats it.

Of course, that's a highly subjective statement because value investing doesn't have one simple definition:

  • For Benjamin Graham, it was buying into a company for less than the liquidation value of its assets
  • For Warren Buffett it's buying wonderful, growing, undervalued (or even fairly valued) businesses with the intention of holding them forever
  • For John Neff, it was focusing on low P/E and high dividend stocks
  • For Bill Miller, it's buying stock in any great company with long term growth prospects not fully recognized by the market in general
  • For Wilber Ross, it's buying distressed companies with potential in order to restructure and turn them around

The common denominator in all these examples is the idea of purchasing something for less than what it's really worth.

Contrast that with the dominant form of investing today which is essentially chasing whatever stock has recently gone up (that is if you're fortunate enough to have a market that is going up). Like technical analysis, that also works - sort of.

It works until it no longer works. You can make a lot of money investing in high growth companies - until the first sign indicating that growth is tapering off. And that's when you can start to lose a lot of money. What goes up really, really fast often comes down really, really fast as well.

The list of accomplished value investors mentioned above all have one thing in common. Everyone on that list is a whole lot smarter than I am and they all know tons more about valuing businesses than I do. And simply recognizing the superiority of their value-oriented investing approach isn't enough to duplicate their performance.

Unless . . .

In a nutshell, for me in any case, value investing is acquiring great companies as cheaply as possible.

So can we use stock option investing strategies to mimic value investing? Can we employ stock option investing techniques to acquire shares of stock in valuable companies for less than what others are paying for them right now? Is it possible to use stock option investing to lower our cost basis on stock as we purchase it and in the future as long as we own it?

The answer to all these questions is yes. The answer is Leveraged Investing. And there are only three real requirements, questions to which you yourself must be able to answer yes:

  • Are you able to identify quality companies? There is no master list available, and even if there were, it would be a subjective compilation. The important thing is that you possess some basis or framework by which you can differentiate great, good, average, and poor companies. If not, immerse yourself with the works of Benjamin Graham, the annualBerkshire Hathaway shareholder letters by Warren Buffett, and value-oriented websites such asMorningstar.
  • Do you have some basis for identifying a cheaply priced stock? Not all shares that have fallen in price constitute a sale. A number of companies' stock dropped by 50% or more from their highs and were still horrible buys - Enron, MCI/Worldcom, Fannie Mae, Freddie Mac, AIG, and Citigroup come to mind.

    You don't have to devise a complex and proprietary discount model to generate a precise fair value figure. The nice thing about stock option investing, or Leveraged Investing, is that it simulates value investing without you actually having to be a brilliant value investor. The more cheaply you can purchase stock in a great company the better, but once you own it, the goal is to continually lower its cost basis so that your original purchase price, in effect, is continually going down.

  • Are you willing, able, and eager to own shares in the companies on which you're setting up Leveraged Investing trades? If you're not looking to own shares related to these trades, you're still a speculator, not an investor (that's not a criticism, just a fact).

    And are you willing to hold the shares for the long term, up to and including the rest of your life? You have to rid yourself of the get rich quick mentality. Leveraged Investing allows you to get rich - not quickly, but not slowly either. It's more like get rich at a respectable pace.

None of the stock option investing strategies and approaches detailed in the Guide below are particularly difficult. In most cases, they are adaptations of other strategies laid out elsewhere on this site. What's most important isn't any particular system or strategy, but rather the level of substance you personally bring to that system or strategy.

Most of us know what works: systematic, consistent results repeated over time. Remember, the tortoise gets laid at the end. Stock option investing, or Leveraged Investing, just helps you out a bit on the time part so that you get to the finish line a little quicker and a little fresher.

For the traditional value investor, beating the hare is never in doubt. But for the Leveraged Investor, you get to beat a lot of the other tortoises, too.

The Essential Leveraged Investing Guide

Essential Leveraged Investing Guide "If you can, on balance, acquire high quality stocks for less than what others are paying for those stocks, and if you're able to generate additional returns above and beyond what everyone else is getting from those same stocks, you're going to do extremely well over the long term, and you're going to dramatically improve your life."

- The Essential Leveraged Investing Guide

free exclusive value investing with options report


Warren Buffett Zero Cost Basis Portfolio Current Equity Holdings:

KO - 125 shares
KMI - 100 shares
BP - 100 shares
MCD - 30 shares
JNJ - 25 shares
GIS - 25 shares
PAYX - 25 shares

Open Market Purchase Price: $20,071.83

Less Booked Option Income: $16,341.71

Tot. Discount: 81.42%
Adj. Div. Yield: 19.59%