Answers to some of your latest questions …

Over the last few weeks, I’ve covered a lot of ground in these Money and Markets columns — from dollar-cost averaging to more advanced options strategies. And naturally, a lot of you have been following up with great questions. So today I want to try and give you some answers.

Let’s start with a question from Pat, who asks …

“You used the example of selling a covered call option on a stock that you bought for $30. You set the strike price for $35 at a future date. Why would someone buy the right to buy the stock for $35 at a future date when they could simply buy the stock itself if it reaches $35?”

I should first point out that I was creating a simple hypothetical example with round numbers, not any actual situation. But the deeper question here is really important. Namely, what Pat is asking is, “Why do investors buy options at all?”

In the case of our example, the hypothetical investor is speculating on a rapid gain in the stock price.

We will assume that the stock is still trading at $30, the price you paid for it.

My initial column already pointed out all the various things that could happen to you as the person writing the option.

But what about the person who bought it from you?

Well, they are not just hoping the stock goes to $35 … they are actually betting that it will go well BEYOND $35 before the option expires.

Here’s the basic math behind their trade:

Say they paid $100 for the entire contract from you. (Again, I’m just making up numbers to keep it simple.)

They will now need the shares to go to $36 — $35 + $1 for each share covered by the contract — before they roughly break even on their bet.

And any move beyond $36 will represent profit for them (minus commissions and taxes, of course).

So, let’s pretend the shares actually go to $40 during the life of the contract.

As the person responsible for delivering the shares, your profit on the underlying position will be $5 a share since you were originally in at $30 and received the strike of $35 upon delivery.

Meanwhile, the person holding the option is making the additional $4 a share right off the bat … plus they can now ride the stock even higher if they so choose.

Upon first blush, it doesn’t seem like a great deal since they are actually making less money than you, right?

But remember this: They only risked $100 to buy the option … while you had risked $3,000 to own the actual shares!

In fact, just the immediate profit from the exercise of their option represents about a 400 percent gain!

And there’s one more thing to point out … they also could have sold their option to another investor during the life of the contract to lock in similar gains — or even greater ones depending on the stock’s movements — without ever having to exercise the option at all.

Therein lies the advantage of speculating with call and put options — your risk is strictly limited, and because they are leveraged investments, they give you tremendous profit potential for relatively small amounts of money.

Now, on a somewhat similar note, another reader named Robert recently asked me about taking profits on one of my recommendations. I’ll paraphrase his question (and omit the name of the company in fairness to my paying Income Superstars subscribers) …

“A while back you recommended a stock for your dad’s income portfolio. Now I am sitting on a 37 percent profit and wondering whether to stay with it or sell. I noticed that you tend to take profits when they reach this level, as you have with two other positions you recommended.”

Let me first say what a happy predicament this is, Robert!

Nothing pleases me more than hearing about recommendations that have worked out … and as you noted, we have already taken some pretty solid gains from other positions in my dad’s portfolio.

Regarding the stock you’re currently holding: I don’t think you can make a bad decision either way because it’s a great long-term dividend payer, though I would probably suggest taking the money off the table on that one given recent volatility in the markets.

An alternative is something that was suggested by another reader named Brandon — trailing stop losses. Basically, you place an order with your broker that instructs a sale at a specified price below the current one … and you continually move that price up as the shares keep rising.

This is a great way to take the emotion out of your investments … and to make sure that you lock in profits during downdrafts.

As far as my more general rules for profit taking? It really varies on the individual company.

Given the fact that my dad’s portfolio is designed to be relatively conservative, I do typically err on the side of booking gains earlier rather than later. But I always consider a stock’s moves against those of its peers, the broad market, and other relevant benchmarks before I make a final decision.

I certainly don’t have a magic number profit percentage I look for or anything. In fact, if a company is a solid long-term holding and nothing has fundamentally changed in its business … I’m happy to keep it in the portfolio indefinitely. In Wall Street parlance, this is the idea of “letting your winners run.”

Last but not least, I had a few comments on my recent argument in favor of dollar-cost averaging.

A reader named Frank pointed out that “You forgot to consider buying commissions in your example.” Meanwhile, MJ said that “an 18.6 percent return sounds nice on the surface but that’s over an entire four year period. The actual return is only 4.65 percent per year which is unacceptable to most investors including myself.”

It is true that my example didn’t include commissions, which would have likely lowered the overall return of the strategy. However, my feeling is that commissions are now so reasonable — especially if you choose a low-cost online broker — that they should rarely be a major consideration in adopting a particular strategy.

Moreover, if you are averaging into index funds — either through your brokerage account or an automatic retirement plan such as a 401(k) plan — it is entirely possible that you are NOT paying commissions at all!

The same can also be true of individual stock buys via direct purchase plans or dividend reinvestment plans.

But, okay, what about MJ’s point that, even if commissions were factored in, an 18.6 percent return isn’t acceptable?

Obviously, it’s up to each individual investor to determine what level of profit is acceptable to meet their particular goals and risk tolerances.

But I will say two things:

First, for a more conservative portfolio, and given prevailing interest rates over the last four years, I consider a consistent 4.65 percent annual return entirely acceptable. It certainly beats just having cash parked in a CD or money market!

Second, I wasn’t trying to say that dollar-cost averaging is the path to huge returns nor even the very best way to approach the stock market. Rather, it is merely a solid way to reduce your risk and still participate in equities without having to time things perfectly.

Remember, it’s always easy to go backwards and find the ultimate strategies and investments for any given period. But it’s a lot harder to predict what will do best going forward!

Best wishes,

Nilus