1 in 1000 Invest Like This

By | February 16, 2016 1 comment

To Beat the Market, Be the Minority

It's ironic that while many of my friends call me up for advice during times of market pandemonium like we've seen so far this year, none of them ever lift a finger to do the things I claim will give them success in investing. Why is that?

I know for a fact, it's their mindset. They aren't willing to wrap their minds around any new concept or strategy which changes their worldview about they way they rest of the world has told them investing should be done.

Their financial advisers (who have a principal-agent dilemma), college professors (who have experience only in theory, not real world practice), and their favorite talking heads on TV (who are paid to talk and sell commercials) have all told them the same thing about investing, which is:

"That stuff is too risky. You don't know enough. You'll get burned."

Let me tell you, it's a lot easier than it sounds.

Let me show you what I mean.

Lessons Learned From Wall Streeters

I worked for one of the big Wall Street banks for a little over two years before jumping ship. During that time, I got to rub shoulders with a lot of experienced people, gaining valuable insights into strategies which the big banks use to make money without taking huge risks.

My work was in foreign exchange (FX) options--a type of financial derivative. And derivatives, used incorrectly, are, in the words of Warren Buffet, "weapons of financial mass destruction."

They did, after all, cause the financial crisis. But savvy investors don't use them recklessly. They use them prudently. I'll explain.

The FX traders I worked with would make huge bets--billions per day--speculating on the future exchange rates of the major world currencies. Sometimes their positions would pay off, and they'd make money... sometimes they wouldn't, and they'd get creamed. Sometimes they'd make out with pennies (times a million), and some days they'd get lucky, making more than their annual salary (including bonuses) for the bank.

During this time, as I watched the traders do their magic, I started to notice something about the highly-misunderstood products (options) they were using.

They wouldn't call up their friends at the other banks John-Wayne style, with guns blazing, trash-talking, shooting at the hip, hoping to make it big on some risky trade with the guy on the other end of the line.

They were only hoping to make a little bit here, and a little bit there, taking as little risk as possible, trying to get a near-guaranteed payout.

Let me repeat that. The successful traders made money for the banks, not by making billions of dollars' worth of risky trades, but by banking small, guaranteed payouts upfront... not by worrying about having to bank a huge upside which was only slightly probable, and which more often than not required the correct reading of a Magic 8-Ball.

Banks like Goldman Sachs use these same strategies to make money no matter what the market is doing: going up, going down, or going nowhere. In fact, they use these strategies to maintain a near 94% winning streak over the course of an average year.

By using the same strategies, we can do the same.

Here's How The Average Investor Can Do This

If we want the same kind of winning streaks as Goldman Sachs, we have to adopt the same strategies. It's not only possible, but probable. And easy.

We use stock options to do this, just like the big banks.

Before you turn off and tell yourself, "that's too risky," hear me out.

Typical investors using options John Wayne-style, are taking on a lot of risk. They buy stock options, hoping for a huge payout where the value of their options go through the roof. While that is actually possible, it's often difficult to do because so many factors are working against them.

Whey you buy stock options, you have to be correct on three things:
  • Timing of the price movement. Your hypothesis has to work out within a specific time frame
  • Magnitude of the underlying stock movement. The stock has to move to a certain point before you begin to make any amount of money
  • Direction of the underlying stock movement. The stock has to move in the direction you think it will
If any one of these things doesn't work out how you think, you're not going to make any money. In fact, you'll likely lose 100% of your total investment.

Wouldn't you like to be the guy on the other side of that trade? To bank 100% on your investment every time some financial John Wayne decides he's the world's next biggest, baddest, trader in the land?

Well, guess what.... we can be that other guy. We do it by being the seller of stock options, not the buyer. When selling options, you make money if the stock goes up. You make it if it stays the same, and you even make money if the stock goes down a little... to a point. As an option seller, time is working for you, not against you.

How I banked 15.1% In Three Short Months While the General Market Lost 9%

I can understand the allure most investors have for investing using index funds. They're well-diversified and require little maintenance and fees, so any potential losses are supposedly mitigated.

The problem is, when the entire market is turning down, index funds do no better. A massive, rising flood-tide eventually sinks all ships, to paraphrase the popular expression. It pays, therefore, to have individual positions which offset (or "hedge") general market losses---which ensure that if one part of your portfolio is losing money hand over fist, you at least have something that's making money for you.

The gold sector is good at helping to hedge general market selloffs.

Gold is a crisis hedge. It holds its intrinsic value over time much better than say, paper money. And people flee to its proxies when there are market crises. Just pull up a chart of the Market Vectors Gold Miner ETF (ticker symbol GDX), and compare it with the events of the financial crisis, and you'll understand what I mean. Alternatively, see how gold has performed since about mid-2011, as market volatility (which I liken unto the market "fear") waned, and you'll see a similar correlation.

I've been watching the gold mining sector for a while. It' s nearly 72% off it's five-year high, sliding off its highs as the gold price has gone into seemingly perpetual decline. There are tremendous deals to be had if you look in the right place.

Here's a short outline about how I've been using this sector to make money in gold while the general market's been sliding ever further into the gutter these past few months.

GDX, the market proxy for the gold mining companies, hit an all-time low of $12.47 in January. A couple of months before that, with GDX trading around $14, I decided that it was highly unlikely that gold miners could get cheaper than they were. I sold two put option contracts, agreeing to buy 200 shares of GDX if the ETF was trading below $14.50 on November 23. I was paid $96 for making this agreement. 

This meant that if I ended up buying the shares at $14.50, my actual cost basis on the stock would be just$14.02, because I got $.48 for share for the option contract. 

On November 23, the stock was actually trading at $13.33--well below the price $14.02. I ended up having to buy the shares, and wanted to turn that current "loser" trade into a winner. I waited about ten days until December 4 for the price of GDX to recover a bit (which I knew it would), which would inflate the call option premiums, and sold two call options contracts for $68 total, agreeing to sell the shares I bought at $14.02, for $15 if the price of GDX was above $15 on December 18, two weeks later.

The price wasn't above $15 on the 23rd, so I kept the premium of $68 free and clear, and agreed once again to sell my shares for $15 if GDX was trading above $15 one month later on January 22 (by selling another two call options). I was paid $54 for that agreement. Since I held my shares at that time, I collected $23.20 in dividends on those 200 shares a week later.

January 22 rolled around, and again, GDX was not trading above $15. So, I made another deal (using two call options) to sell those shares at $15, and was paid $52 for it.

At this point, you can see that a bit of cash has been piling up--without me ever even selling shares of stock. Since November, I was paid $96, $68, $54, $23.20, and $52, for a total of $293.20 in about three months so far.

How do things look right now? GDX is currently trading well above $15, so I'll likely be forced to sell these shares for $15 on February 19. 

Taking all these premiums I've received into account, I've lowered my cost basis to $13.034 on the shares of stock over the past three months. If I have to sell them at $15, per the obligation of the two call options I sold, I will make a total of $393.92 in gains, on a total outlay of just $2606 (the 200 shares at cost of $13.03).

That's a 15.1% return in 117 days, or 47% in annualized gains. Imagine if I could do this with my whole investment portfolio, year after year.

Guess what? I can!

When we sell put options, like I did above when I first started owning shares of GDX, we only agree to do it on stocks we are happy owning at the strike price (the price at which we agree to buy the shares). We never do it on stocks which could potentially lose a lot of their value. 

I regularly sell put options only on stocks which are unlikely to move very much, both up or down. This ensures that I'm not stuck owning something that has to recover 20-30% before I make a profit on it. Similarly, I only sell call options on stock that aren't likely to go up a whole lot. It also ensures that I'm not locking myself into selling something that somehow gained 30% in a month, which would force me to give up some huge upside. That leads me to this thought...

Currently, GDX is trading about $18. By having sold the call options on the shares I own, I am forfeiting over $600 in total gains on these shares. My returns could have been three times what they are.

That's the catch of call options. Sometimes, you end up forfeiting a good amount of potential upside when flukes happen--or if you sell options on the wrong kinds of stocks. It's definitely a fluke for GDX to rise 36% in a matter of two weeks.

This is an opportunity cost you have to accept when using options. But in the long term, I'm not going to care about giving up a few percent on the value stocks I typically use to sell options (stocks like INTC, CSCO, ORCL, and MSFT), if I generate returns in excess of 18% (or higher, as in the case of GDX) year, after year, after year. I say 18% because, typically I generate about 1.5% a month in cash flow for my portfolio by selling call or put options.

My long-term wealth gains will far outweigh the opportunity costs.

The Greedy Dice Game

No one invests this way, because they don't understand that smaller, repetitive wins over the long run, even if it's just once a month per position they own, add up very quickly, and far outweigh the average historical market return.

Play this dice game with a friend. You're the house, and you offer your friend 6 rolls of the die. He gets $3 for every time he can roll a 6. He gets 50 cents for forfeiting a dice roll (i.e., doing nothing), and for every time he rolls and doesn't get a 6, he owes you $1.  What does he choose?

The least likely outcome is the six.... he has five ways to lose, and only one way to win if he chooses to roll. He has six ways to win--and a guaranteed payout--if he does nothing, and has the same probably outcome as if he's rolled once and gotten a six. But he doesn't realize that.

The average investor is greedy. He only sees that he can make up to $18 if he gets all sixes--he's a GREAT roller, after all. He can do it. He doesn't even consider the downside.

He will lose $6 if he gets no sixes. But he can gain $3 by playing it completely safe.

Rolling six times, the sucker playing this game is likely to come out losing $2 overall, according to the odds.

Don't be like these losers... always take the guaranteed payout. Call options offer you this. Don't just buy stocks and hope they go up--or put all your eggs into one basket, counting on the huge payout which won't arrive. Collect income using call options while you wait for this to happen.

Why No One Invests Like This


Honestly, it does take a bit of study to understand the nuances and mechanics of how stock options work. But, it can be done by reading just a few short articles, which I have over here, here, and here.

If I would wager, I'd say that only 1 in 1000 use stock options in their investments because either they don't understand them, they've been told they're too risky (and they are, if used incorrectly), or because they've used them wrong in the past and been irreparably burned.

I would never subject you to something like that here. I only give advice that I'd want my grandma to hear.

Selling put options on safe value stocks actually lowers your risk, compared to buying a stock outright. The premium you receive for selling the put lowers your potential cost basis if you're put the stock.

But, a concept like that isn't something a lot of people can understand for some reason. They prefer the "buy and hope" strategy of buying stocks, and hoping the price goes up from there. There's no thought to decreasing downside risks, or using alternative methods to magnify the upside in the long term.

But, that's the average investor for you. Good luck to him.

Live long and invest,

Jeremiah


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1 comment:

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