Nothing pleases me more on the weekend than having an opportunity to chat with wily old investors that have “been there, done that and seen it all!” So, it was with great pleasure this weekend that I scheduled a chat with an old friend who has been around the real-estate investing block more times than he cares to remember.
In the midst of our discussion he spoke of his children. One son in particular had a penchant for starting a venture involving organic fresh food. Given the increased sophistication among the general populous towards exercise and diet in recent years I thought this sounded like a winning concept if he could execute well. However, it came as a surprise to me that my friend strongly discouraged his son from launching his company. Instead, he encouraged him to become an investor.
The reason behind his advice emanated from one of the habits discussed in Stephen Covey’s “7 Habits of Highly Effective People”, which is to “Start with the End in Mind”. For most of us, career and learning take up most of our formative years while investing is shelved to a later stage. The danger, as he perceived it, for his son was that he would work a lifetime, save a nice sum of money and one day would seek to invest it but would have no idea where to begin.
Just think about all the hours demanded of the average employee. So much time and energy is invested to save money and yet, at retirement, many people who worked so hard for the capital they saved, often deploy it quickly to “investments” without much due diligence or consideration. The old investing rule of thumb is that if you spend more time researching the purchase of a car then you do purchasing a stock that is comparably priced, it’s time to stop trading and start learning!
With that said if you know that you are going to be an investor, do all you can to learn as much about investing as possible as soon as possible. We are here to help in any way we reasonably can.
Digressions aside, let’s get to the concept of staging trades. Most novice investors follow the rash decision-making process I alluded to above. They find a trade, put all their capital on the position and then hope for the best! It’s just human nature and most of us have been there at some point or another. However, it’s not smart!
Instead, consider deploying capital in stages. If you like a stock, consider buying in increments that start small and increase over time. For example, if I liked a $30 stock and decided I would deploy $15,000 to the position, I might start with simply a $3,000 purchase. As the stock would move lower to a support level and assuming I was still comfortable with the fundamentals I would commit more capital, another $3,000. The second tranche of capital buys more shares and lowers cost basis, while I still have cash on hand to purchase additional shares on further declines.
The danger with this trading approach is that if the stock continues to decline and you run out of capital, you also run out of options; you are forced to remain with the losing position and hope for a reprieve via a stock rebound or cut and run. Options afford us the opportunity to assume much lower risk while also applying a staged approach.
Let’s assume that market uncertainty is at a peak. This is usually evident when the market is dropping fast and volatility is high (which it is – just take a look at the VIX that recently shot up to 28). Instead of trying to enter a directional trade, I could apply a well-hedged trade.
For example, General Electric is up almost two dollars since the start of the year, a gain of approximately 5% to just over $38 per share. Now, if I take a look at the dollar index, I can see that it dropped by over twice that percentage. So in real terms the dollars that General Electric was worth at the start of the year were worth more than the dollars it is worth now. Hence, even though the stock price has risen, the real return is negative.
Now I might decide that the business itself is not worth less than it was almost a year ago and I actually believe the stock will go higher BUT I am not convinced and wish to hedge so I could enter the following trade:
Jan 09 Strike 30 Long Call Debit $10.05
Mar 08 Strike 40 Long Put Debit $3.45
The cost of the position is $13.50 while the risk is simply the cost of the trade minus the difference in strike prices while I hold both positions.
Risk = $13.45 – $10 = $3.45
If you do the math you can see that no matter where the stock ends up by Mar 08 expiration, you can never lose more than that $3.45.
This position is very well hedged as it stands. Now if the stock makes a big move to the upside the long call is so far in-the-money that it will make more money each time the stock rises a dollar than the long put would lose, hence the overall trade would profit. If the stock dropped substantially, let’s say to $30 then I might actually be in pretty good shape also!
If the stock dropped to $30, for example, the long call would likely retain a huge amount of its value because it is so far out in time and sits at-the-money where extrinsic value is highest while the long put would be far in-the-money and would be worth at least $10. All in all, the long call might lose $6-$7 while the long put would gain at least $6.55 (because long put would have at least $10 of intrinsic value). So even on a big decline the trade is probably close to breakeven and potentially slightly profitable.
However, this was a “staged trade”. That means I entered the first phase when uncertainty was at a peak. But what should I do when uncertainty has dissipated and I am more confident in the direction of the stock price? At that stage I can start to short options either side of the stock price. For example, I could sell put options against my existing long puts as the stock rises and when resistance is reached again I could enter short call options to further reduce my risk in the overall trade.
This type of trading is solid and relatively safe. In a market where volatility dominates, this is a great strategy to employ to minimize account value fluctuations and still offers the potential to produce handsome returns over time.
Have a fantastic week!
OptionSage
