OptionSage submits:
Telemarketer: Good afternoon Sir, I’d like to tell you about an investment product that I believe you will be very interested in.
Me: Ok, tell me more.
Telemarketer: Our investment managers have consistently outperformed the S&P500 by a 3-4% points each and every year and expect to continue to do so through premium stock selection and diversification.
Me: So if the S&P500 loses 15% you expect to lose 11-12%?
Telemarketer: Well I would have said that if the S&P 500 makes 15%, you should expect to make 18-19%. But essentially you are correct yes.
Me: And, after fees, how much does that diminish by?
Telemarketer: Well you should expect a 2% flat fee.
Me: Thank you so much for your time.
This conversation with a prominent investment firm prompted me to consider the term ‘diversification’. The application of the diversification strategy meant the firm could legitimately claim that its investors would not underperform the market and moreover, smart stock selection might enable them outperform the market. But strikingly this implicitly means that results would always be tied very closely to the market.
Since fees were 2% of invested capital, this eroded much of the projected superior 3-4% returns above the market. In fact, the absolute return was predicted to be approximately the same as the market itself! This was essentially an admission to the investor that the returns will never be substantially different from the market no matter which way the market moves. What a failure!
Diversification in the conventional sense is an admission that investors cannot beat the market.
In finance, the efficient market hypothesis asserts that financial markets are "informationally efficient", or that prices on traded assets, e.g., stocks, bonds, or property, already reflect all known information and therefore are unbiased in the sense that they reflect the collective beliefs of all investors about future prospects.
If we believed in the efficient market hypothesis we wouldn’t be trading! If we believed diversification was the only applicable stock market strategy that reduced risk, we would likely give up because implicitly the returns would be close to the market returns also.
Instead of reducing risk through diversification, it is a much smarter approach to trading, in my view, to manage risk through options instruments. Although it would seem like madness to a financial advisor to invest all of one’s capital in a single stock, this can prudently be done when the stock is combined with options instruments.
For example, let’s assume that I have $175,000 to invest and I really like Apple (AAPL). I know that Apple is due to announce earnings on Monday so it would be crazy to simply commit all the capital to a stock purchase ahead of the quarterly announcement. However, I could combine a hefty stock purchase with some options instruments in order to construct a trade with acceptable risk and handsome reward potential.
The first thing I would like to do is insure my stock against a stock decline. Even if I believe the fundamentals of the company are strong, I should also be prepared for a surprise so I should buy long puts. Let’s assume I purchase long puts for Jan 08 at-the-money (strike 170) for a cost of $14.90.
These puts essentially protect my stock all the way to zero. But I don’t really expect the stock to decline to zero, even on a really poor earnings announcement. So, I might pick a level, below which I believe it is unlikely for the stock to decline. I know that over the past 10 earnings announcements that Apple’s stock has moved at most 10% to the downside and 13% to the upside the day after the announcement occurred. Since I am entering some longer term options, I might decide to build in a cushion in the event of a continued decline. So, let’s say I go down 20% or $34 from the current stock price $170. That nearest strike is the $135 strike, which offers put premiums of $3.15.
So far my trade looks like this:
Buy Stock $170.42
Buy Long Put Strike 170 $14.90 debit
Enter Short Put Strike 135 $3.15 credit
Now I don’t want to take all of the capital to pay insurance out of my own pocket so I am going to pay myself back through the sale of a short call at strike 200 for $6.80. The new trade looks like the following:
Buy Stock $170.42
Buy Long Put Strike 170 $14.90 debit
Enter Short Put Strike 135 $3.15 credit
Enter Short Call Strike 200 $6.80 credit
Cost Basis = $175.37
Reward = $200 – $175.37 = $24.63
Risk (assuming stock stays above $135) = $5.37
Now I can deploy all my capital to this one trade knowing that the most I can ever lose is $5.37 per share while my reward potential is almost 5 times that amount.
If I know how to adjust my positions well, I can make even more money and, in many cases, risk less! So can I put all my eggs in a single basket? Sure I can (once I know how to safely protect the basket). It’s fun to test new concepts virtual trading so why not give it a shot in a Virtual Trading platform.
Have a fantastic week!
OptionSage
