Who do you know that has a stock portfolio, that has not lost a large piece of it since the beginning of the financial crisis in 2008? Computers, set up for "programmed trading" may account for up to 45% of the trading volume on any given day. Is there an opportunity for the individual investor anymore? And if so, where?
The purpose of this blog is to explore exactly that. How can we invest profitably, and avoid being ground up by the hedge funds, programmed traders, and the Big Names on Wall Street?
Generally, Buy and Hold has been discredited. Those who lost the most were Buy and Hold "investors". I have this word in quotes because I do not believe they were investors. They bought stocks like other people buy lottery tickets. Sometimes they win. Anymore, rarely.
The difference between holding an investment and managing an investment is like the difference between holding a bucket of water, and pumping water from a properly located well.
Investing is at least a part-time job.
There is no other way to look at it. You have to look at your investments at least as often as you would water your garden. And doing this, (or not) will give similar results. Trading stocks and options is, in my opinion, the most effective way to grow and protect your assets.
You may be thinking "But I know nothing about it." Maybe so, but if you are reading this, you are learning already. Maybe you are thinking "I have heard that trading stocks is dangerous." Yes, it can be dangerous, but, holding stocks while they fall by 25%, 50% or 75% is EXTREMELY dangerous! Even the safety of holding cash has it's risk. Zero growth, and erosion by inflation.
Let's take a look at several methods, or "plans" for investing, and at the work, and risk that accompany them.
1. "Buy and Hold" or "Hire a Money Manager" are the LEAST rewarding, and MOST dangerous. Why? Because no one is watching your investments! The Pony Express rode a number of horses to death, but they had the good sense to get off of them! A family member had a "money manager" who put her into AOL stock early, and the price doubled over a number of months. Then it backed off. Then it was down 20%, and then 35%. Ultimately, it ended up at 2/3 of her buy price. Why? He never had any plan to sell.
I interviewed this man later, and I'm sure it was not fun for him! I asked him what circumstances would make him sell that stock. He looked puzzled, and replied "We HAVE no plan to sell that stock. It is a good stock!". I pointed out that after doubling, it had dropped by 70% in value. How good was that?
He responded "It'll go back up." He would not put that in writing. I know, because I ASKED him to!
I subsequently interviewed 8 brokers on her behalf, and not one ever had any "when-to-sell" strategy at all. We compromised on a broker who was very good at locating safe, but high yielding stocks. Given that these do not move nearly as far up and down, it was the best we could do. The worst of these brokers may also trade your account heavily, generating large sales commissions for them, and large losses for you. And then there was Bernie Madoff...
2. DIVIDENDS: If you hold a stock, and it goes up, you get extra money. If it goes up and also pays a dividend, then you get MORE extra money. If the stock drops, and you have a loss, a dividend will reduce that loss. So, dividends are good. Right? Right! But because most stocks pay dividends in the range of 1% to 3%, you will make money, but never big money, with dividends.
The best, safest, and most reliable income has come in recent years from buying high dividend stocks at reasonable prices, and writing covered calls, or "offers to sell at a higher price" each month. In this system you can earn an annual dividend of 3 to 5%, but still earn 2 to 3% MONTHLY by selling covered calls. This can yield over 30% per year, and is the single safest way to earn such high yields.
"The financial industry is very large and very profitable. The service it pretends to provide is helping to match worthwhile investment projects with the capital they need. The service it actually provides is separating fools from their money." - The Daily Reckoning
HOW TO WIN WHEN OTHERS ARE LOSING
The answer is to make your wins as large as possible, and to avoid losses. Of these, the second is the more important. I have seen various services brag, in a bad year, that they "were only down 3%." To me, that is not a win. I can stock the money in my mattress, and have ZERO percent loss. If you have read this far, you are beginning to realize that only YOU can protect your money. No one cares like you do. It is time to learn about this stuff. I believe that stock options are the key.
WHAT ARE STOCK OPTIONS?
A stock option is a contract that you can purchase, or, you can create and sell. A call is a bet that a stock will go up. A Put is a bet that a stock will go down. Here is how it works:
If someone holds 100 shares of Caterpillar (CAT symbol), as of Friday January 13, 2012, it is worth $102.48 per share. If you are the owner of these shares, you can make money by selling a Call Option for these; that is, you can say "I will let someone take these shares from me at a price of $105.00 (the "strike price") between now and February 18, 2012 if they will pay me $2.65 per share. So, because Options contracts always are for 100 shares, you would receive $265.00, or 2.52% return for about 39 days. This earns you an annualized rate of about 24%. OK, so say we sell such an option. How do we do it? We call our broker, or get online with our account, and we "Sell a Feb 105 Call on CAT". If you own Caterpillar at the time, then this is very easy. If you do not, don't do it. By the way, your brokerage account will need to be "set up" for trading options. If you want complete freedom to trade these, you have study this subject until you are familiar with it. They will ask how much experience and knowledge you have, and if you have none of either, they may not allow you to trade options, to avoid liability for themselves. So, you decide how you want to answer them.
CALL OPTION EXAMPLE: Let's look at what happens next, once the Call option has been sold. Remember, the stock price will either go up, go down, or stay the same. First, the $265.00 is yours to keep, whatever else happens. Notice that the strike price used was the next one higher than the current stock price. This is referred to as the "first out of the money strike price". Out of the money means "higher than current stock price" for calls, because that is the next stop in the price direction that the option buyer wants to go, but it is not yet there.
IF THE STOCK RISES: If the price of Caterpillar stock rises to $110.00 at any time between your purchase date and the option expiration date of February 18, the buyer of that option may "execute it" and take away your 100 shares at $105.00, earning himself $110.00 - $105.00, or $5.00, less the cost of his option, or $2.65. His net would be $2.35 on an investment of $2.65 or, 88% return. You have a guaranteed, in-hand $2.65 from him, and if he executes his option to buy your stock at $105.00, you earn $105.00 - $102.48, or a price $2.52 higher than the stock was when you sold the Call. Your return is 5% in 39 days.
Does it sound like he got the better deal? Maybe not. Lets look at the other two scenarios. Clearly, the more the stock goes up, the more the option buyer can make, and some of these returns can be phenomenal. But remember, 80% or more of all option contracts expire worthless. So, the odds are with you, not with him!
IF THE STOCK PRICE REMAINS THE SAME: Let's say the CAT stock remains at 102.48. The option buyer has purchased the right to your stock at $105.00 per share. He can buy it at any time for $102.48, so, he will not exercise that option. You keep the money. He slinks away, chastened.
IF THE STOCK DROPS: What is the stock drops? Say it dropped from $102.48 to $100.00. The option buyer has no interest in buying your stock for $105, so again you keep the money, or the "premium". But your stock was worth $102.48, but is now worth only $100.00. You lost money! True, but you still got to keep his 2.65. Instead of losing 2.48, you actually gained $2.65 minus 2.48, or $0.17. The moral of this story is:
"For stocks you plan to hold for a while, you can greatly increase your return
or reduce any loss by selling calls against it."
At this point you may ask "Yes, but what about the stock I sold? I didn't want to sell it!" Simply buy it back. You got 5% in 39 days or, a 46% annualized return. Wouldn't you like to do that ALL the time?
And remember, whether you still own the stock, or whether you decide to buy it back, when that option is exercised, or expires in February, you can do it all again! Now you would sell the March call, which as of this date, is selling for $6.10, or $610.00 per contract (for 100 shares).
Why is the March Call so much more expensive than the February Call? It is because you are paying for the TIME. Now the option buyer has time to wait for the stock to go up, or, even to drop and go up again. So, it costs him more.
PUT OPTION EXAMPLE: A Put option is the opposite of a call option and carries higher risk. The seller of a Put agrees to BUY the stock from the seller at a given strike price (, by a given date. Let's make an example like the one above, but for a Put. Using the same stock, and the same dates, we would sell a Put for one of two reasons. First, he will sell a Put because he thinks the stock will go UP, and so the Put will expire worthless, and he just keeps the money. As of this date, the price for the February CAT 100 Put is $3.15. Notice the Put, or "bet that CAT drops", is LOWER than the CAT stock price of $102.48. You can actually use any price you like, but, for beginners, it is often easiest and less confusing to use the "first out of the money strike price" for Puts or Calls. First out of the money means the next available Option strike price, in the direction you want to go. (In this case, higher).
The second reason he would sell a Put option is because he was going to purchase the stock anyway. THIS way, he gets paid to buy it!
In the first case, if CAT rises, he just keeps the $3.15. And he actually made NO investment, so the $3.15 is pure profit. Because any stock CAN drop, he must be ready to buy 100 shares of CAT at 100, even if CAT drops to 90. To sell this Put, he needs to have at least $10,000.00 cash in his account.
In the second case, where he was going to buy the stock anyway, he might use a higher strike price. With the CAT stock at $102.48, he might prefer the Feb 100 Put, but if the object is to actually acquire the stock, he should use a higher strike to make sure it is in the buyer's interest to execute the option and "put" the stock to him. If the stock should rise a point or two, the buyer would still make money putting the stock to the seller if the strike, or sell price is $105.00, like the Call was. In this case, since the stock price is already below 105, there is a good chance he would get the stock. Plus, instead of selling a 100 Put for $3.15, now he would sell a 105 Put for $5.68! If CAT stock stays below 105, he will get 100 shares at 1.5, less 5.68. His real cost for those shares is now is about 99.32. This could be much better for him than just buying it at 102.48!
The BUYER of the Put is betting the stock will fall. He would buy the Put with a strike of 100 or lower because it is much cheaper for him. If he bought the 100 Put for $3.15, and the stock dropped below 96.85, he would make a nice profit. Again, if it rose, or if it dropped less, he would lose his investment entirely.
RISK: Are options risky? They can be if managed badly, but are often used to REDUCE risk. The example of holding 100 shares of Caterpillar shows that by selling Calls against your 100 shares, you can earn income to increase your return, or to reduce your loss.
Buyers of options must remember that 80% or more expire worthless. the conservative position is to SELL options, not to buy them, given the "80% worthless" scenario. On the other hand, you can participate in the increase in Caterpillar stock price by cheaply buying a call. You can spend $10,244.00 to buy 100 shares, or, you can spend $265.00 to benefit from the stock rise in almost the same way. Which is riskier? $10,244.00 at risk or $265.00 at risk? The mistake many make is to put their whole $10,244.00 account into Call options, which would buy 10422/265 or 40 options contracts. This would be very similar to putting $10,422 on red at the Roulette table. If you don't win, you lose all of it, and you are out of the game. the name of the game is to stay IN the game!
