Be the Casino, Not the Gambler, With Options

I've heard a lot of "financial gurus" like Dave Ramsey and such, radio personalities, plain vanilla financial advisers, and others extoll the virtues of "buy and hold." These are passive investors who recommend buying a stock, mutual fund, or other investment, and simply holding for the long term, doing nothing more.

It's not a bad strategy. In fact, it forms the basis of my own investment strategy as well. But I do more than that, much more.

Any time I make an investment, I like to due a good amount of deep due diligence looking at financial statements, press releases, shareholder letters, and prospectus, in order to get a good feel for how an investment is expected to perform for the long-term. In my mind, if you don't do this, you are taking more risk than you should be.

But today I don't want to talk about the basis of our investment strategy... I want to talk about ways that we can "juice" our baseline returns. Why is "juicing" returns important?

Small, Successive, Repeated Wins Make All the Difference

Let me answer a question, with a question...

What’s the difference in value of a portfolio of $10,000 which, for 40 years, is invested and compounded at a rate of 8%, compared to one that earns just 1% more—9%--over the same period?

If you're not too familiar with math, you might think the answer is "not very much."

Well, a “back of the envelope” calculation gives the 8% portfolio a value of $217,245. The 9% portfolio comes to about $314,094—a difference of 44.5%, or nearly $97,000!

That's more than "not very much."

When it comes to saving and investing, over time every little bit makes a huge difference.

If you had to choose between two investments to keep your money in for the next 40 years, and one pays a dividend of 2% and the other 3%, which one will you choose? Obviously the 3% option. For long-term investors, consistent returns and income is key. They live for the dividends.

Today I'll show you how I get dividends four times as often as typical investors.

These “dividends” are what is going to give us the extra padding in our portfolio to beat the returns everyone else gets. Only, with the the strategy we’ve discussed today,we’re going to earn not just 1-2% extra per year, but likely closer to 15-20%.

There is a little-known and widely misunderstood way for investors who buy and hold quality stocks on blue-chip companies to profit not only from share buybacks, cash dividends, and share appreciation, but also from what I like to call “monthly dividends.”

To safely receive monthly dividends, you have to do one thing:

Get paid 1-4% of the value of one of your stock holdings up front for accepting the obligation to sell the shares you own to someone else, at a significant profit, if the price moves above an agreed price.

This sounds difficult, I know (*sarcasm font*)... get paid up front... and be willing to profit by selling your shares next month if they're worth a lot more then than they are today.

The strategy to do this is called Covered Call selling. It’s also known as “call writing.” It involves the use of stock options in your portfolio.

If you’re here in the section on “Short-Term Trading and Investing,” I hope you know by now that much of what we cover here is going to utilize options—and that you shouldn’t be scared of the way we use them, which is much safer, more profitable, and much different than the way 99% of investors use options.

You see, options were originally designed to use as “portfolio insurance”, which investors could “buy” to hedge downside on their positions. However, today most “investors” use them solely to speculate. We’re taking advantage of their willingness to gamble away their money.

Speculators in options are always on the buy side. They buy stock options, which are incredibly volatile, and hope to profit by making short-term trades off the volatility. When they do this, time, probability, and emotion all work against them.

By being sellers of options, we have all these things working in our favor.

When speculators, really nothing more than gamblers, buy stock options, they are hoping to use leverage to make huge gains in short amounts of time. It’s like walking into a casino and throwing all your money down on the table. And if you know anything about casinos, you also know that the house always wins. The odds are stacked in their favor.

By selling options, we legally become the casino, not the gambler. And we can do this as often as we want.

To give you a brief overview, an option is nothing more than an agreement that gives the buyer the right, but not the obligation, to buy or sell shares at an agreed-upon price by a certain date if a stock is trading above or below an agreed-upon price.

The strategy we use involves call options. Buy selling a call option, we agree to sell our shares to another investor (the buyer of the option) at the agreed upon price if the underlying stock is trading above a certain price on or anytime before expiration.

Relate this Concept to Real Estate, Which We Understand, Right?

Here’s an example of how this works.

Let's say I own beautiful beachfront bungalo which I just bought for $100,000, but which is worth $120,000. Since I got an awesome deal, I'd like to turn around and sell the property for a profit. I have a buyer approach me about the purchase.

I make him a special offer: since property values are going up quickly, in exchange for him paying me $6,000 immediately, I will agree to sell him the house any time within the next three months for a lock-in price of $120,000, even if the home is appraised for more than $120,000 at that time.

Three things can happen here. First, if the property increases in value above our agreed-upon price, I sell it to the buyer for the lock-in price of $120,000. I still keep the $6000, and just made $26,000, or 26%, in just three months.

Second, the price stays the same, or goes up a little, but doesn’t breach the agreed-upon price of $120,000. I am obligated to do nothing, pocket the $6000, and sell someone else the same contract again in three months.

Lastly, the property decreases in value. The $6000 I got serves as a “buffer” against loss on the property, and technically I could sell the bungalo for anywhere down to $94,000 and still break even. The potential buyer doesn't want the property, and has no right to buy it from me, so he walks away. I could even sell another contract to someone else if I want, since we still think prices could go up.

We profit if the price goes up, stays the same, or even decreases by a little.

Now Relate this to Stock Options

Let’s say you own 100 shares of Intel, Inc. (NYSE: INTC). You bought at $25, and you think the share price may move up to $28 within the next month. You agree to sell your shares for $28, and in exchange, the buyer of the call option gives you $2 per share up front for the right to buy from you if the price moves at or above $28 anytime in the next month.

The $2 you received for entering this contract is referred to as the “premium.” The $28 lock-in price is referred to as the “strike.”

If the stock price stays anywhere below $28, you just made $2 per share (or $200 total) free and clear, with no further obligation. That’s a return of 8% in just one month. An 8% dividend. You can again sell another contract on the shares for another “dividend” next month.

If the price goes above $28, I sell the shares, still pocketed the $200, and make an additional $3 per share for selling a $25 stock for $28. That’s a return of 20% in one month. Outstanding!

If the stock goes down... we have a $2 buffer protecting us on the downside. This means, our stock could go down to $23, and we could still break even and sell if we wanted to.

Think about why this strategy is superior in many ways.

We make money if the stock goes above the strike, by receiving the premium plus the capital gains for selling the stock
We make money if the stock goes nowhere, by receiving the premium up front from the buyer
We can still actually make money on the deal even if the price goes all the way down to $23, at which point we break even.

It would be disingenuous of me to make you think this strategy is infallible.

For example, if you are dealing with incredibly volatile stocks, and the price tanks, the premium you got won’t do much to offset your losses. This is why we only deal options of relatively safe stocks. If we were to deal on them on a more volatile stock, and the price dropped by 50% or more, our butts get handed to us, and we won’t be helped much by selling more contracts.

Also inherent in a covered-call strategy is the fact that, by selling calls, we give up the right to any substantial upside gains. Like if the stock in my example went to $29, we are still obligated to sell at $28, and have forfeited $1 worth of gains we could have had.

Call writing strategies are not suitable if high price appreciation is likely. All you you’d be doing with this strategy is shooting yourself in the foot.

What we’re looking for with this strategy is to get income superior to typical dividend payments. It is best suited, in my humble opinion, to retirement accounts or value-based investment strategies where risk profiles should be extremely low.

And when our strategies are based around first identifying the most solid and predictable companies, then choosing which options to sell, we almost can’t lose.

Live long and invest,

Jeremiah