2016 Financial Markets Don't Look Rosy, Here's Why I'm Giddy

By | December 22, 2015 Leave a Comment

Chaos is Money


As some of you might know, I work for a community-based financial institution as what one might call a "financial analyst. What might surprise you is, my position has nothing at all to do with telling you how to manage your personal finances, or where to invest your money in the market.

I only do that here, on this website. If I did that for a living at my dayjob, I'd have a clear conflict of interest in writing for this lovely blog you've happened upon. 

But I do work with these types of people--the ones who like to go out with their crystal balls among my company's unwashed masses, telling them where the stock market is supposed to go, when it's going to happen, and what's surreptitiously causing it. They tell people what to do in the market when things aren't looking so rosy in the near future.

If you've been reading very long, you know my opinion about most wealth advisers such as these. It's not entirely positive.

You also know my position about stock market prognosticators--no one can tell you with any certainty where the market is going, when you'll see it happen, and identify with any absolute certainty what's the catalyst. But some people do try--in fact, lots of rich people out there think they know exactly what the market is going to do. This year, they think it's not looking too rosy. In fact, things look downright chaotic. And that's fine.

I don't try to prognosticate or predict market movements--most of what I do is much more simple, and not even very sophisticated. In fact, it's surprising to me how many people take me seriously. Most of what I know can be gleaned on your own in the vast world of the internets.

Oh, I guess this is the internet.

What Do I Do Here?

On top of extolling the virtues of cultivating good personal financial habits, and railing on general financial stupidity I see around me in the world, what I most enjoy writing about on this site has to do with investing--growing and preserving wealth. It's what I'm most passionate about. Investing puts the "giddy" in me.

What I do in that regard is simple. I research companies, sectors, commodities, and funds which I perceive as safe, solid investment opportunities ("rosy" investments), and build "shopping lists" of sorts from which I craft successful long- and short-term opportunities for profit. 

The strategy from there is simple. I keep this "shopping list" in the back of my mind, and wait for "hiccups" to occur in the market, which causes fear for most investors, and temporarily skews the prices of these different investment vehicles into territory favorable for comparatively high returns and low risk. 

Not surprisingly, the best opportunities in the market arrive when there is absolute pandemonium  in the streets of the financial world--when things are all but "rosy." The chaos which ensues when market participants panic is what creates these money-making opportunities. It's a time when money and wealth are shifting from the foolish and finicky, to the patient and prudent.

What else characterizes market panic such as these?

Investors become willing to pay outrageous prices to "insure" their investment portfolios (using stock options and other instruments) against the losses they're likely to incur on the risky investments they've jumped into in the months leading up to the chaos, positions they most likely only entered because the rest of the thundering herd couldn't stop talking about it at the water cooler, or on CNBC.

I know what happens to herds. There's an entertaining little biblical account about one such herd of pigs which ended up diving off a cliff after being possessed by what I can only assume were the ghost ancestors of today's foolish market participants. Those hogs drowned, and the spirits were left without a pit to piss in. 

Watching the Market Pigs Drown

Watching the pigs of the market drown (i.e., watching fools lose money) is a fascinating, but harrowing and enriching exercise. In the second week of August earlier this year, I wrote about how most of these market pigs (or ostriches, pick your favorite animal) had their head in the sand about the actual condition of the financial markets, and warned that soon we'd see a market correction precipitating a larger eventual financial meltdown, and that most were going to be taken unawares.

Just seven short days later, the market experienced its biggest drop in over three years. 

Nobody likes to watch pigs get slaughtered, but the reality is, this is inevitable. If you can handle the stench of chaos, and have the guts and gumption to step into the chaos and pick up the bargains you know exist, you can make a killing. 

That brings me to today. I recently sat down with one of the financial advisers where I work for a friendly market conversation. 

Surprisingly, he echoed sentiments similar to much of what I see being talked about by the only sources I trust in the financial world. Despite recent pullbacks, today's markets are still a bit frothy. There's not much room for upward momentum for stocks in the coming year. Couple that with a few  other things--such as bubbles in auto loans and student loans, not to mention the breakdown of the junk bond market--a precursor to absolute market disaster--and we both arrived at the same conclusion: we MUST remain cautious, but bullishly so.

This surprised me, and honestly it restored my faith somewhat in some advisers. For once, someone who gets paid money to manage other peoples' money, actually agreed with me (me, being someone who makes their own money grow regularly).

I mentioned to him briefly my involvement in using alternative investments--stock options, which I talk about a lot on this website--alongside traditional equities (stocks), in order to generate above-average market returns. 

His response was typical. "That's risky stuff. I'd advise you to stay away unless you really know what you're doing."

I couldn't help but laugh on the inside. First of all, because he has to give this advice. It's his job to try to keep people from things he perceives as risky. Pity... it also showed me how little he knows about the best investment vehicles in the market. But secondly, I had to laugh because...


And here I was, getting told I'm risking my financial future with speculation!

Using options is easy, and it makes sense when the markets look chaotic and un-rosy. Options are meant to be used as portfolio insurance to protect what you currently own.... but also to generate income that even historical market returns in the long run simply can't touch. I use them in the way they're intended---mainly to pad my regular returns, not to speculate wildly or try to predict market movements with certainty.

Here's what I'm doing with options today to make some money going into the new, chaotic, un-rosy year of 2016.

I'm Net Selling You a Bridge

I've been watching the company Chicago Bridge & Iron (CBI) for a while now, and I'm finally ready to pull the trigger.

This company doesn't build bridges, and it isn't in Chicago. The company actually builds energy infrastructure all over the world. It's a 100+ year old company with a safe balance sheet, low debt, and half a billion in free cash flow sitting around. 

But the company's shares are 33% off their highs from earlier this year. What's up with that?

Investors have been worried about a big portion of CBI's business, its nuclear construction division. It's been involved with some troublesome projects across the US, and recently decided to take a big loss and sell off this less-efficient portion of its business. 

This was announced in October, and the stock had already been run into the ground by that time. It's even cheaper now, having had ample time to work off the news of the sale of this part of its business.

From a fundamental perspective, CBI is beautiful, as I said before. No revenue slowdowns or balance sheet issues. And from a technical perspective, the setup looks solid.

Here's a recent chart of CBI, which shows what I mean from a technical perspective.

Over the past several months, the stock has been been bumping up against a price "support" of around $37. "Support" is an indicator telling us the lowest price at which investors are willing to sell the stock.

Price floors give us a safe range to peg down a safe purchase price for the shares of a company or fund.

I've indicated that price floor with a red line here. As you can see, when the price did temporarily go below that area, investors were willing to jump back into the stock and buy, causing the price to rebound. And subsequently, anytime we've seen the stock price approaching this area, the same has occurred twice--even as recently as the last week.

Right now, CBI is trading around $39.10. Here's what we'll do to make a killing in just one month's time.

I'm willing to buy 100 shares of CBI right now, and sell a January 22 $40 call option against those shares. Right now, I'll get $1.25 per share for the option, for a total of $125. 

Here's what this means for the investment. Selling the covered call option means I buy 100 shares of CBI at $39.10 today and if the stock is trading above $40 on January 22, I'll be obligated to sell the shares for $40, earning $.90 per share, or $90 in returns, plus the $125.

Taking into account the capital gains and options premiums I collected, minus commissions on a standard brokerage account, I could net up to about $174.28 on this trade on a $3910 obligation in 30 days, or 4.43% in just 30 days. On an annualized basis, that's an astounding 52.2%.

That's why I'm giddy!

The option premium of $1.25 per share lowers our cost basis on the stock to $37.66, meaning by entering this trade today, I'm actually taking on less risk than if I simply bought shares of CBI outright at $39.10, because the price of shares can decrease by 3.7% from today's price before I even begin to lose money. 

If CBI is trading for less than $40, I have no obligation, I keep the $125, make 2.65% in one month (31.23% annualized), and next month I can either dispose of my shares at whatever the price is at that time, or I can sell another option against the shares for even more income--the more likely alternative.

Summary

It's important to understand opportunity cost when selling call options against shares of stock we own.

What I mean is, you have to understand that if CBI is trading above $40, we're giving up any amount of money we would have made by simply buying the stock by itself. It's completely possible the shares could make it all the way back up to $43 or $44, which is the current "resistance", or price ceiling for the stock, in which case I'd be forfeiting almost $2.75 per share, or $275 in additional gains.

Something similar happened to me several months ago with Intel, Inc. I made over 2% in one month by selling covered call options, but the stock appreciated substantially over one month's time, and I forfeited 10% in gains on the stock.

I don't worry too much about this, because of the "bird in the hand" principle.

No one can predict with an surety whether the future of a company's stock price is going to be rosy, or chaotic. So, instead of making predictions, I take calculated risks.

I'd rather guarantee at least the 2.65% gain over the next month which I get by selling the call option (the bird in the hand), than to sit back and hope that the stock appreciates by a few extra percent (the two birds in the bush, which I haven't caught). Sitting with that extra gain in my pocket, while the rest of the market tanks, would make me downright giddy.

Gains we have in hand are worth more than gains we are hoping for. But opportunity cost is the price we pay for growing our wealth little by little, in which process we win financial freedom in the long run.

If you have any further questions about how any of this works, drop me a line at thevillageid-vestor@gmail.com.

Live long and invest,

Jeremiah
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