When the Stock Market Becomes the Lottery

8/24/15

Sometimes, I'll Admit, the Market is the Lottery

Given the crazy market action which occurred today, there's no better time to discuss why speculation should be a part of your investing strategy.

I've written elsewhere about the virtues of an investment strategy which "marries" the concepts of real investing and speculation.

"Investing" involves taking a good portion of your money and putting into safe, long-term investments.

"Speculation" is the process whereby you take small portions of your investment portfolio, and put that portion into trades or investment instruments which you plan to hold short-term. Doing so will amplify your annual gains, and speed up your financial freedom date by decades.

The reason you will hold these investments for the short-term is because you "speculate" or you "think" that the market is going to move quickly in one direction or another, and you will make large amounts of money in a short time period.

For the most part, speculation is best undertaken by buying stock options, because the prices on options can move hundreds or thousands of a percent in a single day.

That's exactly what happened today when the markets tanked.

How This Lottery Works

To give you an example.... let's say I have been calling for market crash for a few months now (sound familiar), so I finally decided that last week, I was going to buy a put option, which is basically a bet that the stock market is going to take a turn for the worse.

The best way to play this would be to buy a put option on the S&P 500, since this index is a "proxy", or representation, of the market in general.

If I had bought a put option at the $191 range on Friday afternoon before close, today I would have roughly four and a half times the amount of money I invested initially on Friday. Here's a screenshot of how much money traders and speculators made today.

What I've circled in red is a ONE-DAY CHANGE in the price of the option.

I won't go into the mechanics on why the prices behave this way... that's a topic for another day. Suffice it to say, that if you have good timing, if you understand technical analysis, and if you can handle the emotional toil that speculation takes on your life, the process of speculating can make you a lot of money.

Typically, you don't put any more than .5% or 1% of your overall portfolio into a speculation... because it's too easy for things to move against you. But here's why it is significant.

By investing just 1% of my total money in a speculative trade, when that one trade quadruples overnight, I've just made a total portfolio return of 4% in just one day.

Mutual funds can't even touch these kinds of returns. I, for one, know that my employer-sponsored 401K is down 2% so far this year. If it weren't for the free money my company was giving me in that account, I wouldn't even consider putting my money there whatsoever.

Now, consider that there are even more volatile securities out there, like the VIX, or an index which measures the volatility of the overall market.

Here's a little screenshot which shows us that someone out there, some lucky trader, is going on a loooooonnnnggg vacation in a few weeks. In fact, depending on how speculative they are overall, we might even conjecture that someone out there will be retiring early.

The areas circled here in red are also ONE-DAY CHANGES in the price of these investments. Note the 11,150% gain someone made. That's 112 times their money. It turned $100 into $11,200. I can guarantee that really made their morning.

While everyone else is losing money hand over fist, this man or woman just found the down payment to their new home. All thanks to a healthy, controlled dose of speculation.

See you on the other side of this crazy correction.

Live long and invest,

Jeremiah