When I first started investing - I felt that my investing returns were very mediocre simply because I had a small capital.
After all, if you are only investing $1000 - even a 100% return in a year will give you just $1000.
(To give some context, Warren Buffett makes an average return of 20.5% since 1965.)
It was only after I started learning options from a mentor that it completely changed that belief.
I know I know...some probably think that options are risky.
All I can say is risk comes from not knowing what you are doing.
If you are open-minded and keen to find out how you can invest with a small amount of capital, then read on!
So how can we invest with a small capital?
Well, we first have to define how "small" capital are we referring about.
And this definition is mine alone - but it provides us some ground to discuss how we can invest with a smaller capital.
How Much Is Considered Small?
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Well, for myself, I will take the average income in the US.
Of course, if you live in other countries, you can take the average income in your respective countries as well.
To me, a small capital is starting out with probably 1/3 of the average annual income in the US.
Again, these numbers are arbitrary - but you will see my point later on.
So how much is 1/3 of the average annual come? A quick Google Search tells me that it is $10,000.
So there we go - there is our definition for 'small' capital - just so we have some basis for this blog post.
So why did I choose 1/3 of the average annual income?
It is because if you could be more frugal and save money in creative ways - then soon enough, you should be able to save $10,000 for your investments.
TIPS
If your average annual income is less than $30,000 - and you are struggling to save $10,000 for investment - then here's my suggestion - don't invest.
It may sound harsh - but I find that your time should be spend raising your personal income, rather than investing.
Remember that investing is a game that takes money to make money. Check out my other blog post here, if you belong in this category.
It explains how you should invest your first $1,000 if you only have that much of an amount.
So now, that we gotten that out of the way and define for ourselves for a small capital is, let's dive in.
(Strictly speaking, this post could be "how to invest if you only have $10,000")
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Understand Yourself - Knowing Who You Are
The first crucial step is to understand yourself - are you an investor or a trader?
What is the difference?
Well, investing focuses more on the fundamentals of the companies whereas traders focuses more on the price action of stock charts.
If you are intending to be a trader - well, this blog post may not be suitable for you, since my background is more of a value investor.
But I have to stress that both are different vehicle that will make money in the stock market.
And if you are an investor, read on!
How To Invest With $10,000?
Let's be honest with the returns we are expecting - we are looking at around 8% return - a very conservative amount for investing in the stock market.
Besides, 8% is easily achievable if you are equipped with the right investing strategy, and after this blog post, you are going to see why.
In fact, I know that there are people who achieve easily 30% using this strategy as well.
So what is this strategy that we are touching on in this blog post?
What we will be touching on is using options to leverage a small investment portfolio.
In fact, this is a strategy I would use if I am starting with $10,000.
At this point of time, some people might be thinking, "Leverage? That's risky!"
Robert Kiyosaki said it best. "The more risky it seems, the more education you need."
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It is never about avoiding risk but learning how to manage the risk.
And this is my intention for this blog post where I outline the option strategy, its risk, and how to mitigate the risk.
The option strategy used is known as Long Call Strategy.
The Long Call Strategy
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What exactly is the Long Call Strategy?
Well, if you are completely new to options - here's a quick definition.
The term "long" has the same meaning as "buy" in this context.
So a "long" call - basically means buying a call option.
What does buying a call option means?
When you buy a call option - it gives you the right to buy 100 shares at strike price before an expiry date.
To buy the call option - you have to pay an option premium.
When buying a call option, there are three things to take note of:
- Strike Price - Refers to the agreed price between the option buyer and option seller.
- Expiry Date - Refers to when the validity period of the call option.
- Option Premium - The amount of cash the option buyer have to pay in order to have the call option contract.
Let dive straight into comparison between buying shares and buying call options by using real examples.
(The data used a real market data based on ThinkorSwim Backtest feature, OnDemand)
Let's say I am bullish on Coca Cola and wanted to buy around $400 worth of shares on 13 Nov 2019 - 4% of my $10,000 investment portfolio.
The price was at $52.25 and I will open two different bullish positions;
- Buying 8 shares @ $52.25
- Buy 1 Call Option at Strike Price 50, Expiry 310 days @ $430
So in short, I spent $418 buying 20 KO shares and $430 buying a call option.
The idea is I want to compare the return on investment between these two positions.
So let's fast forward two months later and compare our returns.
Fast forward to 13 Jan 2020 - KO share price has gone up by 7.22% and now at $56.02.
I want you to notice the difference in Return on Investment (%).
The profit on our call option is $265 which is 61.63% return.
Do you see why I said achieving an 8% annual return is relatively conservative?
We used roughly $400 in each investment and while buying shares gave a measly 7.22% return, buying a call option gave a whopping 61.63% return!
That is close to 9x more!
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By the way, in case you are wondering - if you invest using call options, you will not be entitled for any Coca Cola dividends.
But would you really bother with an extra 3% dividend yield if you can get a leveraged return of 61.63% with the same amount of capital?
Therefore, if I had to start all over​ - this is the strategy I will be using for a $10,000 investment portfolio.
Now, before we get too excited, let's go and assess the risk of using call options.
I have to warn you, it might get a little technical, but remember this.
"The more you learn, the more you earn."
The Risk Of Call Options
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We have seen the leveraged returns call options can provide us.
And leverage is always a double edge sword.
If the trade moved opposite, your losses will be leveraged as well.
Let's see what happens if a trade went against you.
In this example, we take a look at what happens if we took bullish positions on General Electric on 12 Jan 2018 when its share price was at $18.89
Again, we opened two bullish positions for comparisons.
In the above example, we bought 1 call option with the strike price of 15 and 154 days to expiry. This costs us $455.
For comparison - we bought 24 shares @ $18.89 each, costing us $453.36.
After 2 trading days, GE fell by 7.97% to around $17.385.
Let's take a look at our losses on our positions.
The losses incurred on our shares is only 7.97% or $36.11.
But the losses on the call option is 38.46% or $175.
So you can see, that call options are kinda like a double edge sword.
But does that means we should avoid call options altogether?
Well, as mentioned previously - if something is inherently more risky, we can either avoid it, or we can learn how to manage it and turn this risk into an unfair advantage.
How To Mitigate Risk
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We have now seen both sides, that an option can either work for you, or it can work against you.
Now, I want so share some guidelines so to to minimize the risk of your call options losing money.
The underlying reason for buying a call option should not be any different from buying a stock.
- Only buy a call option on a stock has good fundamentals and we believe will go up in the long term.
General Electric has poor fundamentals in the first place, so we wouldn't want to be bullish on such companies.
How do we know if companies have poor fundamentals?
Well, you can simply refer to the checklist I have done for my students.
If the company you intend to invest passes at least 5 out of 8 of the criteria, it is already half the battle won as an investor - because you are investing in a company with strong fundamentals.
So please be very picky about the companies you want to invest in - I have seen too many people who invest in poor quality companies and ended up getting burnt.
If you are new to investing, I strongly suggest that you follow the checklist which shows the financial ratios that I look out for in a company.
The next thing to do is valuation.
- Only buy a call option on a stock that is undervalued.
How do we know if the stock is undervalued?
Well, we need to do our valuation.
Valuation is complete topic on its own and if you are not sure about valuation - check out this video I have done.
Once you have nailed down the fundamentals and you bought the call option when the stock is undervalued, you will pretty much be "right" in most of your investments over
- Having a portfolio allows investors to make money even if they are wrong.
Remember that in the examples given - I don't invest my full 10,000 into a call option.
I invest only 4% of it.
The beauty of call options is that it does not require as much capital and yet gives you more returns than if you invested by buying shares.
Once you can follow this few criteria, you would have drastically reduce your risk of using call options.
What's Next?
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Well, it turned out that buying call options have more intricacies than you think.
I have not talked about selecting strike prices, expiry dates, - and stuff like, when would it be better to buy shares than compared to buying call options, when to take profits, when to cut losses, etc.
​In the midst of helping my subscribers, I am working on a long call options buying guide.
You might want to keep updated with this blog so that you are notified when this guide is out.