Page 61 - merged.pdf

•Five Greatest Ways of Winning in the Stock Market 41

some 10% over the next three months to 725 and you have £2,000 to invest. In this
example I am going to ignore the costs of dealing to keep it simple. Remember every
trade you make whether in actual shares or options is accompanied by a cost which
will have the affect of reducing the numbers you are about to read.

If you buy shares in ECP and your prediction is correct you will make £200 or
10% in three months, which is not bad. But suppose you want more. You could buy
a call option for 31p giving you the right to buy shares at 650p in three months time.
Your £2000 buys you about 6450 calls. When the price goes up to 725p you can
buy for 650p and sell for 725p at the same time. Your sale profit is 6450 × (725 –
650) or £4837, from which you subtract the original £2000 you paid for the option,
leaving a profit of £2837 – more than fourteen times the profit earned in trading in
the underlying shares. You have received return on your original capital of an out-
standing 140% in three months, a huge reward.

But a huge reward implies a huge risk. If the market goes against your predic-
tion the outcome can be dire. In effect you are buying the shares for 650p, the
option price, plus 31p, the price of the option making a total of 681p. If the price is
below that you lose. If the price in three months is 665p then your losses are 6450 ×
16 or £1032 and you have lost half your money. If the price drops below 650 of
course then you have lost the lot. The only people who cannot lose, naturally, are
the ones taking commissions on each transaction.

This principal of hedging and speculating can be applied to almost anything in
the stock market. You can, for example, hedge or speculate on movements of the
main market indices such as the FTSE 100. This means that your portfolio is pro-
tected if you were thinking of selling shares at a given point in the future. You can
bet on spreads of prices and so it goes on. If you need an insurance policy hedging is
a great idea, but if you decide to speculate, be sure you do it with money you can
afford to lose. Most financial advisers steer their clients away from speculating in
futures because of the huge risks, but as long as you can write the money off when
you place the bet its an excellent return if you are lucky. But don’t forget what the
man said – ‘No tears.’