Growing A Small Portfolio – Expensive Stocks VS Cheap Stocks

It’s always a difficult choice trying to decide what approach to take to start investing through selling puts or covered calls when capital is limited. An interesting e-mail recently from an investor wondered about the problems of a small account with little starting capital and an “expensive” stock such as Apple Stock versus a “cheaper” stock for investing. Let’s review the question. (my adjustments are in brackets)

Investor Questions:

I agree (that) put selling is superior to covered calls. Teddi, yesterday I spoke to a guy who has a site dedicated to covered calls. Dont know how good he is, but he included a phone number and I did speak to him for a few minutes. Due to call him again. It’s very simple : (about) the learning part of course. I just need a service where I can make simple but consistently profitable, win ratio of 80%+, month after month, & preferably weekly now that weeklies are available. The big problem is I am a SMALL account with little starting capital. I can’t write puts on apple (stock) or even anything above, say $50 which means you’d need $5000 in the account. Can we get decent premiums % (percentages) on LOWER-PRICED stocks? Is that possible? And do you do trades like that? Many people aren’t rich; don’t have $50k to ‘play’ with. Thank you!

My Answers:

I receive a fair number of similar emails to the above one so I thought this would be worth sharing. I believe strongly in being realistic. Everyone starts with a small account and works towards building that account into a larger portfolio. There is no fast way to make money in investing. The risk to capital being used increases depending on the risk of the trade itself. This is why I stay with large cap dividend paying stocks that should the trade not work out, I can still earn profits and continue to work towards eventually getting out of the trade profitably. When investing in any position consider what might happen when a stock you are trading against should collapse unexpectedly. Are you going to take losses or will you stay and work toward keeping the trade profitable?

It’s Not The Stock Price It’s The Stock Itself

I started off like everyone else. I had a very small account and after losing almost half of the original capital with a full service broker I decided instead to turn to taking care of my own investments. I felt that if a broker who is supposedly trained and has experience can lose half my capital, then I could hardly do worse. What I did learn was that it is not the price of the stock that matters, whether it be Google or Apple Stock for $500 a share, Priceline stock at $1200 a share or Coca Cola Stock at $40 it is the stock being traded against that is important and knowing what strategy to use, when to use it and when to move on to another stock.

Using Small Capital Strategies

A small portfolio of $5000 can be easily split up into a number of trades. One of the key aspects is using the right strategies. A good strategy for small portfolios to start off is using credit put spreads.  I will use closing figures from Thursday April 17 2014 for a few examples of what a small portfolio could accomplish. There are no commissions taken into the calculations below.

Apple Stock – Credit Put Spread – At Risk $1328.00 – Gain $172 – 11%

The “expensive” Apple Stock is not as expensive as you may think. Instead a credit put spread is used. This means you sell a put strike at support levels and on dips in the stock and buy a put on rises during the same day. Because the amount of capital available is small, you have to buy the long put first and then sell the short put to stay within brokerage guidelines. With a credit put spread you have defined your total loss as soon as you buy the long put at $485. That means that if the stock collapsed below $485.00, your total loss is $500 where you sold the put less $485 where you bought a put for a total loss of $1500 less the $172 you have earned. Total amount of capital you can lose no matter how far the stock collapses is $1328.00.

At the close for the day on Thursday an investor could sell the April 25 expiry $500 put option for $265.00 and then buy the $485 put option for April 25 for $93.00. The amount of capital at risk is $1500 less $172 gain for a total risk of $1328.00.  This trade is only two weeks long and can be closed at any time. If Apple Stock started to fall and reached perhaps $505, an investor could buy back the $500 short put and end the trade there. This would control possible losses and keep it very small to not do much damage to the $5000 capital base.

apple-stock-put-spread-apr-17-14

Apple Stock Credit put spread

Cisco Stock – Credit Put Spread – Risk $1385.00 – Gain $115 – 7.6%

Another trade that could be set up with the portfolio is 5 credit put contracts on Cisco Stock. For this trade I would sell the May 17 expiry $22 put strike for .27 cents at the close on Thursday April 17 2014 and I would buy the $19 put strike for 4 cents also on May 17. This would mean a gain of 27 less 4 = $23 X 5 = $115.00.

cisco-stock-apr-17-14

Cisco Stock credit put spread

Cisco Stock – Credit Put Spread – Risk $1335.00 – Gain $165 – 11%

A third trade that could be set up with the portfolio is to establish 5 credit put contracts on YUM Stock for April 25 2014 expiry or about 2 weeks. I would buy the $69.50 put for .22 cents on Thursday Apr 17 at the close and sell the $72.50 put strike for .55 cents at the close as well. Both of these would be for April 25 expiry. Total gain would be $55 less $22 X 5 = $165.00. Total capital at risk of loss would be $1335.00

YUM Stock Apr 17 2014

YUM Stock credit put spread

This is of course just a sample of ideas but when the amount of capital that is available for trading is small, credit put spreads make a lot of sense. They limit losses and keep investors from setting up too many option contracts when they are still learning. Once the learning process is complete and the trade strategies is learned, then an investor can step beyond the $5000 and add in margin which for the above trades would be as high as 55% depending on the brokerage being used. Some will be higher and others lower.

Capital At Risk – $4048.00 – Cash Available = $952.00 – 19% in reserve.

The total amount of capital at risk in the above three trades comes to $4048.00. The total income earned is $452.00 for a return of 9%. Two of the trades are bi-weekly, so this means the capital can be reinvested again within a couple of weeks or even sooner if the stock moves higher.

The amount of cash still available is $952 or roughly 19% which is a decent amount of cash to keep behind when the portfolio is only $5000, for rescue strategies or other opportunities that may arise.

The return made for this period,  if it can be duplicated over the course of the year could return as much as 60% to 80% by year-end. But as mentioned further into this article, don’t aim for this kind of return. In fact don’t set any kind of annual percentage gain at all. Instead aim to protect the capital in use.

Advice To Beginners

The investing road is filled with holes. Some deeper than others. The chance of wiping out returns is enormous for the inexperienced investor. This is why I developed my website. To assist, teach, share and help investors of all backgrounds to understand that do-it-yourself investing does work.

Be Patient and Realistic

That means slowing down and becoming patient. It means becoming realistic in returns and what is possible. It means staying away from juniors, speculative stocks, penny stocks and the like because they can wipe out a $5000 portfolio in a day or two. In fact penny stocks are among the worse for drawing investors in and losing capital. It means staying clear of unrealistic offers or returns. I believe strongly in large cap stocks. The above three stocks all pay dividends and have institutional holders. That helps the stock in times of turmoil.

Paper Trade and Paper Trade Some More

Other advice has to include paper trading strategies until you have so few losses that you are comfortable trading stocks with actual capital. Paper trading through discount brokers is as exact as real-time trading but without real-time losses. Yet I hear every day from investors who believe the only “true” way to learn is to have your capital at risk. This is foolhardy. Paper trading today is identical to real-time trading. It can sharpen your skills and teach any investor how to apply a strategy to the point where they know it inside out. Losing capital is easy and losing $5000 can happen overnight. Learning how to protect capital is key. It takes years to build capital and grow it. It is easy to lose capital through trading without the knowledge of how to protect it.

Quality Discount Broker

Find a quality discount broker. Brokers fees are an important aspect of investing but so is the quality of the charting software, their support and the speed with which they execute trades. Open a number of accounts with different brokers and find that broker which is the best paper-trading platform you can like. Keep that account forever because no matter how good you become you will at times always want to paper-trade a new strategy or test out a theory and having the best paper-trading platform will provide that. Second is the importance of proper charting software. It must be in real-time and it must have all the basic technical indicators which I discuss daily in my various articles. Check out the daily market direction outlooks for the minimum technical tools you need. Remember, those are the minimum. Last make sure they have a 1-800 number that is answered quickly. No more than 5 or 6 minutes on hold. Sometimes you get what you pay for. Then as you progress and find you need little contact with the brokerage you can move to cheaper brokerages.

Learn To Close Trades Quickly

There is a lot more advice to be offered but the most important thing is to stay focused and consistent. Close trades quickly when they turn against you or you have captured 75 to 80 percent of the profit. Remember that the portfolio is small at $5000 and you need to protect the capital far more than you need the profits. Winning back lost capital is time-consuming and harmful to the entire goal of growing your capital. Compounding returns is paramount to success. Also remember that every penny earned should be rolled back into the portfolio to grow it as quick as possible.

Forget Percentage Returns – Aim For Consistent Winning Trades and Protect Capital In Use

Do not aim for any specific annual, monthly or weekly percent return when starting out. Instead focus on protecting capital by establishing trades that are far out of the money for smaller returns but better protection. Set up trades that are stacked in your favor so that each trade is consistently a winning trade. This builds confidence and will help when the portfolio is no longer $5000 but $25,000.

Match Your Own Returns

I grew my portfolio by matching every month whatever I made. If I made $250 in a month I matched it. This grew my portfolio quickly. Every time I had an extra $25 or $30 I put it in the portfolio. Every dollar helps to build a portfolio faster than just waiting for the monthly or weekly profitable trade.

Expensive VS Cheap – Understand Support Levels

Finally, forget expensive and cheap stocks. Those terms do not relate when looking for strong stocks to sell options against.  The price of a stock reflects everything from earnings, to future earning potential to investor enthusiasm or fear for a company. Instead focus on the stock pattern which I discuss in dozens of articles. Look for support levels and when starting out with a small portfolio, establish trades below those levels to have better odds of success with a stock.

I hope this has been helpful in showing how to think differently about building a small portfolio.

Covered Calls VS Selling Puts

I have written lots on this topic and obviously from the question you have read many of my comments. That said, there is a definite place for covered calls. They are a very strong strategy but again, just like Put Selling, I do not believe it is a matter of simply buying stock, selling covered calls and hoping for the best. I use a variety of covered calls strategies depending on the stock, the environment and the goal of the overall trade. Every strategy has its place and its time to be implemented. The strength of the investor comes from knowing what strategy to apply from the myriad of strategies available, at the right time.

A Simple Service

One of your questions was about a simple service. I do not provide a simple service. I believe strongly in learning through example to become a better investor. That is the purpose of the FullyInformed Membership. When I first started investing I found out quickly that there is no such thing as “simple” when it comes to investing for better gains than a bank certificate can provide. I learned that through understanding the strategies I was applying and the importance of protecting my capital, I built a portfolio that was no longer just for me but is wealth that can be handed down to my children and their children.

Summing Up

It sounds from your e-mail that you are just starting into your journey. It is exciting and if you are like me, thoroughly enjoyable. I love investing and I hope you have as terrific a journey as I have been blessed to be on. Good luck with your investing and perhaps some day you will become a member.

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