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Leverage and Options

The contingent-purchase strategy is based on the assumption that a number of conditions exist at the moment:

  1. The market is volatile; prices are down. The most likely market condition for contingent purchase is when prices have moved downward or are highly volatile. You want to be in the market but at you hesitate to take equity positions, fearing ongoing volatility.

    The dilemma is a combination of (a) volatile conditions and (b) concern that you will lose opportunities if you don't act now.

  2. You have capital available to open option positions. You must have capital available either to purchase calls or to leave on margin in the event that short puts are exercised. Looking to the future, if you do decide to exercise long-call positions, you need capital to complete your purchase as well. So, on the long side, you need to be able to buy calls—preferably in several different stocks—and later, to exercise. On the short side, you will be required to deposit funds to buy stock (equal to the purchase price minus put premium you earn or, on margin, a portion of the purchase price, often one-half). These requirements naturally limit the extent of contingent purchase in which you can afford to engage at any given time.

  3. You want to open contingent purchase positions in several stocks. The importance of diversification as a conservative model cannot be overemphasized. The basic theory behind contingent purchase is that you do not know whether a particular stock will rise or fall in the future, so you select stocks that meet your fundamental criteria, and you open contingent purchase positions in that range of stocks. If you can afford to engage in contingent purchase on four or five stocks at the same time, you increase your chances that they will end up being profitable decisions. The essential starting point is that stocks you pick must be stocks you would want to purchase if you were simply buying shares. In any contingent-purchase strategy, you limit your activity to stocks that meet your conservative standards based on fundamental analysis.

  4. You believe that contingent purchase—given current circumstances—is an appropriate conservative strategy. This strategy, like all market strategies, must be assessed in context and as part of a larger portfolio strategy. It is inadvisable to place all of your capital in options as part of a contingent-purchase strategy; your conservative portfolio should contain a foundation of strong growth stocks. Contingent purchase can be used to fix the price of additional shares of stock you already own or to ensure your right to buy shares in new stocks if and when price movement goes in the right direction. But given market conditions and your personal rules for picking stocks, the underlying issues have to be appropriate. If you select stocks for contingent purchase based only on option pricing, you violate the basic rules for portfolio management. Conservative investing is always based on equity value of the stock, and options are considered only as a secondary possible strategic means for acquiring shares.


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