October 12, 2015

Be MacGyver When Investing

There are two truths I've learned about the world of finance.

Number 1: Nothing sells in the news business like a good crisis! Especially a stock market crisis...

And Number 2: A good crisis in the world of finance is a terrible thing to waste.

Crises happen all the time, usually small ones every couple of months. And people lose tons of money when they happen.

That's because, for the most part, people make stupid decisions with their money. They get emotional during crises, and make irrational decisions. When you couple that with the fact that most people get into investments in the first place for completely irrational reasons, the result is that there's a ton of money to be made by being on the opposite end of what the losers in the market are doing.

It's tough luck for the losers, but great luck for you, because you're not stupid.

Don't get me wrong--I'm not happy that people are stupid with their money. My goal is to educate and inform people to point where they can make wise decisions with money, be successful with investing, and become financially free... but I'm also not in denial about the driving forces of human nature.

And understanding basic human nature, in investing, is big money.

As I've mentioned before time and time again that it's possible to make money in any market--whether it's going up, going down, or going nowhere ("sideways").

You'd think that it's easiest to make the most money when markets are going up constantly... and you'd be wrong.

Something you need to realize is that markets go up a heck of a lot slower than they go down... a bull market that's produced 10% gains in the stock market over a period of six months to a year can disappear in a matter of days, leaving you with nothing. That' a lot of wasted time. We want to avoid that.

On the other hand, during a crisis you can make a hundred times more money in a single day than you could on any other normal day, if you know how to do it, and are well-positioned and well-disciplined.

There's nothing immoral, illegal, or unethical about this. It's no different than walking into a pawn shop and buying a rare item that's on sale for $20, when you know it's worth $200, and can turn around and sell it for that price.

That's why today I want to explain how this is done, and hopefully empower you to take the steps so you're able to take the right steps to make a killing, while others are getting killed. You'll learn how to be MacGuyver when the market's a ticking time bomb.

MacGyver always seems to find himself in supremely effed up situations. He's either the target of evil machinations, or he has to clean up the mess that someone else has gotten themselves into. And, he has to be nimble, efficient, and quick in order to make it out alive.

That same analogy applies to short-term investing.

One of the best Charts to Use When Speculating

Short-term market opportunities often evaporate just as fast as they appear, and we need to be keen of that fact. If we're in things for the short term, dealing in volatile instruments, we have to realize that we almost literally have a ticking time bomb in our hands with our livelihood strapped to it. If we're not nimble, and on top of things, we're going to explode.

Here's the biggest tool in my arsenal for identifying short-term profitable setups.

The "Fear Gauge." I've written about it before... in fact, I just wrote a nice little article a couple of weeks ago, about how volatility is your friend. Read through it along with this one.

The Fear Gauge is otherwise known as the VIX, or Chicago Board of Options Exchange's volatility Index. Here's what it looks like recently:

Note the extreme change in volatility conditions during the August debacle.

The VIX is called the "fear gauge" because it measures how high a price people are willing to pay to protect their investments.

In this chart, you can see how complacency suddenly turned to outright terror, and how completely desperate people were to buy insurance against loss on their portfolios.

The standard way to execute this protection strategy is with a "put option," and this chart effectively tracks the price movement of this instrument. It more than tripled over a period of just two days.

As the markets began tanking in August, millions of investors and institutions stepped in at once to buy insurance on their stock holdings. This panic-buying bid up prices to levels not seen in over four years.

When someone buys a put option, they're setting a minimum price they'd be able to sell their investment for in cases where the market takes a big drop.

It's no different than buying an insurance policy for your home or automobile. If your house is worth $200,000, you take out a $200,000 policy for it, no less, and you pay a premium. Then, if your house burns down completely in a fire, the insurance should make you whole up to $200k.

It's the same with portfolio insurance. If the current price is $21 on your investment, and you don't want to get less than $20 per share for your investment in the midst of a market panic, you buy a put option with a $20 "price floor", known as a strike price. Then, if the prices goes to $19, you get to still sell yours for $20 up until the expiry date of the option.

Let me point out that all of the positions I recommend investing in for the long haul don't require insurance of this nature. We buy them when they sit at a substantial discount to market value. Their prices are stable and predictable, falling little during panics, and rebounding quickly even if they do. I wouldn't, for example, recommend something that could lost 30% of its value over the next few months...

On top of all this, we use options to generate income on these same companies whose fundamentals we know are sound, resulting in basically a risk-free cash flow. That's because the risk inherently involved with using options evaporates if we have a well-balanced portfolio composed of companies whom we know won't be in the gutter next month.

The safest way to use options is to be the seller, not the buyer. Tying this back into our insurance example along with the VIX discussion, we capitalize on market fear by selling the portfolio insurance that others were so willing to buy at three times its normal value.

Just like insurance companies collect insurance premiums from you like clockwork every month or every year, it's fairly simple to form a strategy of profitably selling options on a regular weekly or monthly schedule, on stocks you wouldn't mind owning (and which you can buy at a discount to current prices thanks to the option), or stocks you currently own, which you'd like to sell for a big, juicy profit.

By "big," I'm talking in the range of 1-4% per month, depending on the level of volatility. It doesn't sound like much, and it won't make you rich overnight... but compared to the market's 70-year average return of 12.8%, this is absolutely, hands down, the best and most-safe strategy . In fact, this is how the big investment banks make all of their trading profits, day after day.

Invest With Success, Like the Big Banks Do

Here's an example of how this works.

I've always like the company Intel. It's at the head of it game, has unbeatable market share, leads the pack among competitors in chip innovation, and has sound financials. Its computer chips are in just about every device you've ever owned, including your phone, your PC, and the clock on your wall.

Intel is also a great "leading indicator" for the markets, meaning that when we see a market downturn, in the short term, we'll see Intel reflecting that trend before the rest of the market. The same is true when the market goes up.

Intel's a bit expensive right now at $32, but let's say I thought it was a bit undervalued, and would probably go up over the next month.

In this case, I'd consider owning Intel if it traded at $31, a 3.2% discount to current price. So, I could sell one put option contract, which expires on November 20, at a strike price of $31. In doing this, I agree to buy 100 shares of Intel at $31, even if the stock is trading below that price on the expiry date.

I go to Yahoo Finance, and look up the option prices for Intel. I see that I can sell the November 20, 2015 $31 strike put options for $0.76 per share, or a total of $76 for the contract.

So, I collect $76 in my account today, and I'm potentially obligated to pay $3100 for 100 shares of Intel on November 20, if shares are below $31. That's a 2.45% return on my potential obligation, in just 38 days.

I keep the premium of $76, free and clear, no strings attached. It should increase the cash balance of my account overnight.

On November 20, if the stock is still above $31, I still keep the premium, and have no further obligation. The put option expires automatically, and the buyer of the option on the other end of the trade loses 100% of their investment (just like when we pay an insurance premium, and don't have to make any insurance claims. We get nothing for our investment).

However, if the stock is trading below $31, my broker automatically buys the shares for me at that price. The $76 I got up front in option premium actually lowers my purchase price to $30.24 ($31 minus the $.76 per share in premium), so I'm actually profitable on the trade down to that level. If the price is lower than that, I take a loss.

But here's the key: In this scenario, I'm selling the option, confident that the stock won't be going lower (possibly because it is trading at the lower end of its range). When I take all this into account, I'm lowering the risk on the trade substantially from the get-go.

And, even if I end up having to buy the shares, next month I can then execute a covered call option strategy, to sell the shares I bought at a profit.

I would then sell a Call Option at a strike anywhere above $30.24, like maybe $32 (most larger stocks have options on the dollar, and every fifty cents), instead of a put option, which obligates me to sell the shares at that price, and collect the premium.

If conditions are the same as they are today one month from now (which is likely), I'd collect $61 for agreeing to sell my shares for $32, receive the $61 in premium, and make up to $1 per share when I sell the shares down the road (remember, I would have bought them for $31, and sold for $32).

At that point, I'd actually be up to 7.6% in just two months' time, for an annualized return of about 45%. Not bad at all.

To reiterate, this trade setup basically couldn't go wrong for us. Premiums are so thick right now, it'd be very hard to lose money.

But, how do you spot MacGuyver opportunities like this with the VIX?

The trick is to watch for times when the VIX is a ticking time bomb, about to explode--and to use your awesome skills to diffuse the bomb in your favor.

This is easy to spot.

Below is another chart of the VIX, this time with some added lines called "Bollinger Bands."

The upper and lower solid blue Bollinger Bands indicate the most likely price range for a stock. When the stock continually "bumps" up against, or closes outside of the bands, this is a huge signal that a price reversal is about to occur. I've circled these "bumps" in green.

So for the VIX, when the lower band is breached like around June 23 or so, this is a sign that volatility is about to increase in the markets, .i.e, the market is about to fall.

When the upper band is breached (multiple scenarios above), this indicates that the market should turn higher.

Right now, the lower band is getting "bumped." The more sustained the bumps are, the more likely we are going to see the market fall, at least in the short-term.

How can we play these moves in the market when we see the setups? If you're extremely maverick (or even worse, stupid) you can wildcat the market by buying a put option on the S&P, via the ETF symbol SSO. Any downward falls in the market within a few days should produce a tidy profit for you. But be careful: you can easily lose your shirt this way, if things don't go as planned. You're not guaranteed any profits whatsoever when buying options.

Alternatively, as suggested throughout this article, a safer strategy is to wait until you actually see the market fall, then quickly sell put options on high-quality blue chip companies like CSCO, INTC, ORCL, or MSFT while volatility is high. You collect premiums up front, and minimize risk.

The higher volatility is, the better profits you'll make with this option selling strategy, along with that of selling covered calls, as I've written about here and here. When you're "long", or buying options, you have to get in before the market moves in order to easily book the profits.

Conclusion: "MUST SELL OPTION"

If there's nothing else you take away from this article, I hope you've learned that your first thought during a market panic should be, "MUST SELL PUT OR CALL OPTION."

I may talk more about the mechanics of this later, but if you sell options when volatility is really high, and hold for a few days while it cools off, you can often buy back the option for a profit, even if the market or underlying stock has moved nowhere since then. That's because options are the price of volatility, so if volatility changes, so will the option price.

I hope this wasn't too much for you. There's a lot to learn about options trading, so PLEASE, PLEASE, PLEASE don't just jump in with both feet before understanding how it works to a "T." With options, you have a lot of capital on the line.

Please, do some research, or send any general questions you have about this concept, and I'll be happy to answer them (thevillageidvestor@gmail.com), although I can't provide individual investment advice for your situation.

In fact, if you have questions and send them my way, I'll tack them onto the end of this article for future reference, and other readers' benefit as an FAQ.

Live long and invest,

Jeremiah