It’s funny how quickly attitudes can change. Just a few years ago, most casual investors wouldn’t touch stock options with a 10-foot pole. Now the airwaves and the Internet are clogged with offers to teach the secrets of “options investing.”

That kind of talk is just plain dangerous.

Don’t get me wrong — I love the fact that more people are discovering the profit potential of options. I’ve been analyzing them for a long time. And since 1999, I’ve been recommending specific option plays for the subscribers of my Options Hotline service.

But despite our success at Options Hotline, I would never be naïve enough to call my work “investment advice.” When you’re dealing with options, you shouldn’t use the word “investment” at all. It’s speculating. And if you don’t understand the difference, you’re setting yourself up for a massive failure.

You “invest” in things like stocks, bonds, mutual funds, and even real estate. You focus on the long-term. Successful investing is like planting acorns and watching them turn into oak trees.

Speculating, on the other hand, is like playing with fireworks on a rainy winter’s evening. You light the fuse, and seconds later, it has either fizzled out or a huge colorful explosion high up in the sky has illuminated the whole world.

Options trading may sound like gambling. And for people who don’t know what they’re doing, it usually is. But seasoned traders know how to bend the odds in their favor. Doing that means having a healthy respect for a speculator’s best friend — and worst enemy — leverage.

Leverage is the magic that turns small price movements into large profits…or losses. It is found in many different guises, but the fundamental design is always the same. The leveraged speculator uses OPM (Other People’s Money) in an attempt to make more money than would otherwise be possible with nothing but his own funds. In other words, you augment your position with borrowed money.

It sounds dangerous…and if not managed prudently, it can be bad for your wealth. BUT, if leverage can be applied to situations with strictly limited risk, it takes on a more sensible aspect. It becomes…”super-leverage.”

Super-leverage is the art of profiting from changing prices, with limited risk. No margin calls, no demands for additional funds, no forced liquidations.

The instruments of super-leverage are exchange-traded stock options.

Options are tradable contracts that give you the right to buy or sell a specific underlying instrument at a specific price within a specific time period. For example, a May $100 Apple Computer call option gives the option-buyer the right to buy one share of Apple Computer for $100, anytime between now and option expiration on May 18, 2007. Today, with the price of one Apple share at $100.80, the June $100 call option costs $2.60. So for under $3.00, an option-buyer can participate in the upside of a $100 stock…but only until May 18.

That means a small move in Apple’s stock price can create a huge move in the price of the call option. In fact, that’s exactly what has happened over the last few trading days. Since April 19, Apple stock has jumped more than $10 a share, for a gain of nearly 12%. But over the same timeframe, the May $100 call option has gone from 75 cents to $2.60 — a gain of nearly 250%. That’s leverage!

But on the downside, options are wasting assets. They have strict expiration dates. If, for example, Apple Computer shares close below $180 on May 18, the May $180 call options would expire worthless. That is your risk.

It was once calculated that 90% of all options expire worthless. But that doesn’t mean you have a 90% chance of losing money. A successful options trader will offset eight or nine losers with one or two spectacular winners…and still have money left over. The trick to always coming out ahead is to develop a strategy and stick to it.

My dad, legendary options trader Paul Sarnoff, explained it best: “Every trader with imagination and talent goes into a specific commodity armed with a trading plan.” With his help, I developed a system I call my “Complete Game Plan for Trading Success.” Followed correctly, it can be a powerful tool to make sure you don’t get in over your head.

It starts with some simple calculations. Just ask yourself the following questions before you risk a single cent:

1. How much am I willing to pay for the option? As I said, you can lose 100% of the money you put into an option. So never bet more money than you can afford to lose. Once you’ve set your limit, stick to it. Don’t chase an option that’s more expensive than you want to pay. Either wait for the price to drop, or look for another one to buy.

2. What will I do if I’m right? Have a profit target in mind for each option you buy, and an idea of how long the move will take. Be realistic — what you honestly think will happen, not what you hope will happen. (If you can’t do that, don’t buy the option.) Again, stick to your plan — give the option some time to reach your goal. If you meet your goal, either sell right away or watch the option carefully and sell before it falls.

3. When will I get out if I’m wrong? This one’s tough. No one wants to admit they’re wrong. And everyone hopes they’ll eventually be proven right. That kind of thinking might fly in the face of stock investing — but when speculating with options, you’re up against the clock. The best thing to do is set strict stop-loss strategies — i.e., orders to sell if the option falls to a certain price. Getting out of a bad position before it’s too late is one of the world’s most overlooked wealth-protection strategies.

You should always speculate based on what you can lose, not what you can gain. Be prepared to handle trading losses. Never add to a losing position. That is how many players get knocked out of the game. You want to be in there when the market goes your way. You, or your broker, must monitor your positions closely. They don’t ring a bell when it’s time to get out, so make sure you have an exit strategy in place for each trade.

It may sound like a lot of work — but believe me, it’s worth it. I’ve seen options skyrocket 210% in three weeks… 472% in less than a month… even 260% in eight days…

Of course, I’ve also seen a good number of trades go nowhere. But following the Complete Game Plan for Trading Success, the odds are good you’ll still come out ahead.

Just never make the mistake of thinking that you’re “investing.”

Sincerely,
Steve Sarnoff
October 18, 2007

P.S.: If you are interested in the unlimited potential of these kinds of “speculations,” then you are in luck. My publisher has given me the chance to give away six free months of my options service, Options Hotline. So be my guest, check out this free report explaining it all to see how you too can pull in profits of 165%, 220% and even 300%, just like my current readers have

Steve Sarnoff

Steve Sarnoff has been picking winning options plays for his Options Hotline readers since 1995. He is a seasoned professional with years of experience in the markets researching trends. His concise recommendations prove his experience and demonstrate his exceptional capabilities to predict great option plays.

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