Unless you have several hundred thousand dollars to invest, you can’t get into a hedge fund. But there are ways that you can trade like a hedge fund and use the same tricks and strategies they use.
The largest tool of the hedge fund is leverage. As individual investors we have the ability to have margin in our accounts. And with margin, we can buy $100 worth of stock with only $50. Hedge funds can buy $200-300 and more of stock for the same $50. That is how they are able to make their market beating returns.
But there are tools available to small investors like you and me that can increase our leverage yet be relatively safe.
I am talking about options, LEAPS in particular. A LEAP is a long term option. Technically it is a long term January option. Buying one LEAP option that expires 2 years from now is almost the same as buying 100 shares of stock. Except that is does not cost as much, your loss is limited to the amount paid for the option, and you would not get any dividends if they are paid.
Let’s say IBM is trading at $80. You can buy 100 shares for $8,000. Or you can buy a LEAP option that expires over two years in the future with an 80 strike price for $2,000. That’s a lot cheaper. You still control 100 shares of stock but you had to put up a whole lot less money.
What if IBM goes down to $60? If you bought the stock you would lose $2,000. If you bought the option it might go down in value to $1,500. Even if it went down to $1,000 you are still better off.
Options are favorites of hedge funds because of the tremendous value of the leverage they provide. One of my favorite strategies is to buy far out LEAPS and then sells options against it to generate income every month. This is basically a covered call using the LEAP in place of the stock. Generating income this way allows me to lower the cost of the LEAP. And in many cases I can generate enough money to pay for the LEAP which then turns into a free trade.
So if you want to generate better than market returns and trade like a hedge fund, it is important to learn about all the tools available to the small investor. Leverage is one such tool that you can take advantage of with options.
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