These Investments Quadrupled My Portfolio

Abraham Maslow once said, "When the only tool you have is a hammer, it is tempting to treat everything as if it were a nail."

Just about a year ago, as we continued to struggle with the aftermath of a financial meltdown and a decidedly pessimistic stock market, I looked at the landscape of deeply discounted stocks and made this bold prediction: The U.S. markets and economy would rebound from the mess we were in.

OK, so it wasn't that bold. And I figured if I were wrong, we'd all have bigger problems to deal with. So I took out my trusty hammer and started driving nails.

Hammer time!
I purchased two-year call options -- LEAPS -- on stocks that were not only significantly depressed, but whose options weren't pricing in significant gains. LEAPS are bets that a particular stock will be higher (calls) or lower (puts) in a year or two.

I started with Goldman Sachs (NYSE: GS  ) , which at the time seemed well-positioned inside and outside the government to succeed … nail! I saw Red Hat (NYSE: RHT  ) continuing to benefit from a move to open source software … nail! Cemex (NYSE: CX  ) , a global leader in cement, was certain to rally on worldwide infrastructure spending … nail! Western Union (NYSE: WU  ) , with its growing international business … nail! Legg Mason (NYSE: LM  ) … nail! Verizon (NYSE: VZ  ) … nail! I was very close to adding Caterpillar (NYSE: CAT  ) , but a coworker convinced me that there was more pain ahead for that stock.

By the time I had put the hammer down, I had purchased seven positions in the six stocks, all long-term call options set to expire in January 2011.

There's good news and bad news
Fast forward 10 months to mid-October. The value of the portfolio had quadrupled to create a gain of $100,000.

That was great -- except that the LEAPS still had 14 months until expiration, and new risks were emerging within the portfolio. Between October and November, the gain dropped by $30,000. All of a sudden, I was less worried about the market over the next 12 months, and more worried about how to protect my remaining gains.

As I looked in the toolbox and only saw that lonely hammer, it was painfully clear that I needed a more sophisticated options strategy if I wanted to truly manage my portfolio's risks.

Finding new tools
Fortunately, I have access to Jeff Fischer and the team at Motley Fool Options, which uses options to reduce volatility and generate income beyond what's available from solely buying the stocks.

With the help of Jeff and the team, and in front of the Options community, we analyzed each position, discussed multiple alternatives, and formulated a series of trades that met my objectives.

For instance, Jeff gently but convincingly persuaded me to close out my huge Goldman gain, arguing that it was all time value and could completely evaporate. After reading that I was planning to buy puts on Red Hat, he pointed out that I was risking resetting the long-term capital gains clock, even though I had held the calls for more than 10 months.

Jeff even abstained from chastising me for purchasing Verizon without a solid thesis, and then compounding the mistake by holding the option as they circled the drain. "At least you'll have something to offset some of your capital gains," he said, focusing on the bright side.

In the end, I had fewer but more strategic options investments, and less risk.

Lessons learned
Along the way, I learned several lessons that are useful for anyone interested in options.

  1. It's the stock, stupid. To get the options trade right, you have to have a solid understanding of the underlying stock, as well as a working hypothesis about what that stock will do in the future. Not having a real investing thesis for Verizon led me to a 97% loss.
  2. Watch the time value. As the option gets closer to its expiration date, there's less opportunity for the investment to hit its strike price, so the value of the option declines.
  3. Expand the toolbox. For example, selling calls while owning the underlying stock can be a great way to generate a little immediate income -- or, if the stock drops, lower your cost basis. There are several other strategies that the Options team uses to minimize risk while focusing on great stocks.

What's next
I have been so impressed with the talent of the Motley Fool Options team that, for the month of January, I'll be taking my own money and investing in every recommendation they make. So if you're interested in options, and looking for the right opportunity to jump in, I invite you to join me as we get smarter, make money, and have fun on our way to a better investing experience.

If you'd like to learn more, just put your email in the box below.

Head financial Fool Ollen Douglass owns options on Red Hat, Western Union, and Legg Mason and owns shares of Cemex. He dumped the Verizon calls and cashed out the Goldman options for a nine-bagger. His kids now think Goldman CEO Lloyd Blankfein is Santa's secret helper. Cemex and Western Union are Motley Fool Stock Advisor choices. Western Union is also an Inside Value pick. Motley Fool Options has recommended writing puts on Western Union. The Motley Fool owns shares of Legg Mason. The Motley Fool always exercises its option to include a disclosure policy.


Read/Post Comments (22) | Recommend This Article (62)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 08, 2009, at 5:18 PM, tarmacmonkey wrote:

    sorry if i'm being dumb but how have you managed to lose 97% on verizon in the last year?

  • Report this Comment On December 08, 2009, at 6:44 PM, OPTIONNUT wrote:

    Timing is everything and with the March lows across the board it was pretty easy to make money in just about every transaction by going long...the last few weeks have given us all a reality check and this last week with GS, AAPL, AMZN, etc. all going down on excellent growth.

    Now, it appears the stock market and Tiger have lost their MOJO and to top it off sceptics think this will be the way in 2010!

  • Report this Comment On December 08, 2009, at 9:00 PM, dtarends wrote:

    I fail to see how writing call options can lower your cost basis in a stock. Did you mean writing put options and then exercising them if the stock price declines?

  • Report this Comment On December 08, 2009, at 9:12 PM, dtarends wrote:

    I fail to see how writing call options can lower your cost basis in a stock. If the stock drops, the call you wrote would become worthless and you would keep the premium collected, but how would that lower your basis?

  • Report this Comment On December 09, 2009, at 9:57 AM, clydejazz wrote:

    So, Western Union is a Motley Fool Stock Advisor choice, and Western Union is also an Inside Value pick, but....Motley Fool Options has recommended writing puts on Western Union.

    How does that work?

  • Report this Comment On December 09, 2009, at 9:59 AM, clydejazz wrote:

    So, Western Union is a Motley Fool Stock Advisor choice, and Western Union is also an Inside Value pick, but....Motley Fool Options has recommended writing puts on Western Union.

    How does that work?

  • Report this Comment On December 09, 2009, at 11:16 AM, TMFFischer wrote:

    Hi clydejazz,

    Writing puts is a defensively bullish strategy, and after the record market run we've seen, we're being more defensive than usual and thus right now just writing puts on WU in MF Options. We'd buy shares of the company cheaper via our short puts, but if WU doesn't decline, we'll earn the option premium instead and be happy with that profit. We like our prices on the trade.

    Fool on,

    Jeff

  • Report this Comment On December 09, 2009, at 1:20 PM, TMFCrow wrote:

    @dtarends

    "I fail to see how writing call options can lower your cost basis in a stock. If the stock drops, the call you wrote would become worthless and you would keep the premium collected, but how would that lower your basis?"

    You understand the situation well. Essentially, by writing calls you lower your break-even price on the underlying stock (by the amount of premium you collect). While it doesn't lower the price you purchased the stock at, it does help offset the overall cost (I prefer to think of it as generating income). The tradeoff, of course, is that you cap the upside of the stock. This is why picking the best stocks to write covered calls on is so important.

    "I fail to see how writing call options can lower your cost basis in a stock. Did you mean writing put options and then exercising them if the stock price declines?"

    You may know this, but for those following along: a cash secured written put and a covered call are mathematically equivalent.

    Thanks for posting,

    Nick

  • Report this Comment On December 09, 2009, at 1:29 PM, TMFCrow wrote:

    @clydejazz

    "So, Western Union is a Motley Fool Stock Advisor choice, and Western Union is also an Inside Value pick, but....Motley Fool Options has recommended writing puts on Western Union.

    How does that work?"

    All 3 positions are in alignment, but what you don't see in the disclosure is timing . Inside Value recommendation dates back to when WU was first spun off of one of their other recommendations whereas Stock Advisors picked it earlier this year in March at bargain basement levels. At MF Options we leveraged this TMF research and wrote puts to generate some income while hoping to pick up shares closer to Stock Advisor's entry price -call it cautiously bullish.

    I hope that helps. Thanks for posting,

    Nick

  • Report this Comment On December 09, 2009, at 3:30 PM, taxproblemscpa wrote:

    That's an awesome return on your investment. I hope you set cash aside to pay for the tax bill. Nothing is more frustrating than liquidating a position in order to pay uncle sammy.

    http://www.edisonaccounting.com

  • Report this Comment On December 10, 2009, at 9:34 AM, memoandstitch wrote:

    How do you buy LEAPS? Do you buy a put and a call in two separate transactions (and pay two commissions)?

  • Report this Comment On December 10, 2009, at 11:02 AM, mikecart1 wrote:

    This articles is the epitome of using information to make an article seem better than it is. So the author either was perfect at his LEAPS calls or he forgot to mention his bad picks.

    Another winner from TMF! - NOT!

  • Report this Comment On December 10, 2009, at 12:10 PM, TMFDaddyO wrote:

    @tarmacmonkey

    "...how have you managed to lose 97% on verizon in the last year?"

    Specifically, in Dec 2008, I purchased Jan 11 calls with a 45 strike. I paid $2.70. By the time I sold, they were worth $0.09. (today, they're worth $0.30, btw)

    How do i let a position lose 97% of its value? I entered into these trades as a portfolio and defined an overall risk tolerance, not a position-by-position one. I fully expected to lose almost everything on one or two, but also expected it to be offset by one or two home runs.

    On of the things I learned from the options service was how to mitigate the risk a bit to create a less volatile risk-reward profile.

    This was definitely a learning experience on several fronts.

  • Report this Comment On December 10, 2009, at 12:23 PM, TMFDaddyO wrote:

    @ memoandstich

    "...how do you buy LEAPS"

    LEAPS are just long term options. It's the same process as buying a single call option. The expiration date is what categorizes a option as a LEAP. Anything with an expiration one year out or further falls into that category.

  • Report this Comment On December 10, 2009, at 12:28 PM, TMFDaddyO wrote:

    Mikecart1

    "...So the author either was perfect at his LEAPS calls or he forgot to mention his bad picks."

    Nether perfect nor forgetful. Goldman was my biggest winner (9-bagger) and Verizon my biggest loser (lost 97%). Both were disclosed.

    The other positions were between the two, but most were nice gains. Within the Options service, 100% of the positions, transactions, cost basis...everything was disclosed in front of the community. When I made the trades to get out, they were also published to the community in advance of the actions.

    We do outr best to be transparent. Sorry it wasn't clear.

  • Report this Comment On December 11, 2009, at 2:24 PM, anothernewguy wrote:

    I respectfully request that you minimize all the cheap sales pitches used in the "ads" for your various services and upcoming investment "opportunities"...I paid my money...just give me the facts...

  • Report this Comment On December 13, 2009, at 2:20 PM, Chinastocks55 wrote:

    CKGT.OB: China Kangtai Biotech.

    A top tier China agriculture play.

    Take a look at the NY Times stock page link:

    http://topics.nytimes.com/top/news/business/companies/china-...

  • Report this Comment On December 14, 2009, at 3:59 PM, VegasMartin wrote:

    VZ has been a laggard for the last 6 months until it broke out to the upside recently. I purchased this stock at around $32 in April and watched the stock be in the red for almost the entire summer. Now it's finally in the green as people saw that 6% dividend and wanted to get in. That's why I made the play and that's why it's paying off. Not a good stock to play from the options side, but just buy it and collect yield.

    http://www.ShootTheBears.com

  • Report this Comment On December 28, 2009, at 5:06 PM, wendee91 wrote:

    Amen to just the facts!

  • Report this Comment On January 02, 2010, at 8:42 AM, ayaghsizian wrote:

    @TMFcrow:

    Could you elaborate just a little.

    "You may know this, but for those following along: a cash secured written put and a covered call are mathematically equivalent."

    PreThanks

  • Report this Comment On January 02, 2010, at 9:00 AM, ayaghsizian wrote:

    @TMFcrow:

    I thought about it for a while and understand what you mean by mathematically equivalent now. This concept had not occured to me since I was in college and was learning about options.

    I use both these strategies on a monthly basis but in very different situations. I sell the puts when I wouldn't mind buying the stock at a lower price and I only sell covered calls way out of the money so I can usually continue to hold or sell for a good profit.

    An afterthought, dividend paying stocks may not be equivalent.

    Enjoy the new year everyone.

  • Report this Comment On February 17, 2010, at 10:09 AM, Schmax wrote:

    So what happened with the options trading in January, 2010?

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