"Only those who dare to fail greatly can ever achieve greatly" – Robert Kennedy
It seems fitting with so many tributes to Robert Kennedy this past week to include a quote from him that can easily be applied to stock market trading. Indeed the quotation may be considered analagous to Buffett’s famous adage: "Buy Fear and Sell Greed".
What is not so well known is that Buffett later revised his quote. Recognizing that few have the mental fortitude to trade bullishly in the midst of panic and bearishly in the midst of exuberance, he expanded upon his statement with this more recent remark:
"You know, I always say you should get greedy when others are fearful and fearful when others are greedy. But that’s too much to expect. Of course, you shouldn’t get greedy when others get greedy and fearful when others get fearful. At a minimum, try to stay away from that."
Moreover, Buffett commented that
"Stocks are a better buy today than they were a year ago. Or three years ago."
But how many will have panicked following Friday’s move and failed Buffett’s ammended statement? The likelihood is fewer still will have dared consider any bullish position.
At Stock and Option Trades, we were fortunate to side-step both Thursday’s greed and Friday’s fear. Indeed, in Thursday’s blog, we stated:
"Factoring in the fickle nature of the markets recently, it only reinforces the fact that caution and patience are needed when trading. We have seen far too many attempted breakouts fail during an unstable market."
With that said, we have commented that more aggressive investors can start to dabble (buying the fear). And by dabble, we mean scale gently into the market. We expected conservative investors could start to dip their toes in the water in the middle of this month and commented hitherto that we would favor this course of action ourselves.
That doesn’t mean sitting on the sidelines. We’re still trading as evidenced by each week’s Trade Alerts, but we’re still holding heavy cash positions. And we’re selfishly hoping for more to the downside so we can swoop up bargains at the bottom.
Even if buying stocks proves too difficult, it is definitely worth considering option premiums on bull put spread trades when panic levels really skyrocket. You will find numerous stocks during selloffs like Friday’s that have great fundamentals and will be great long-term winners, and are already undervalued; we mentioned one we’re keeping an eye on in this week’s Trade Alert.
The bull put allows traders pick a price point (on the short put option) that effectively contracts the trader to purchase the stock if it drops down to that level. If it doesn’t drop, all premium from the bull put is kept as profit.
The reason the strategy can be so effective is that a stock which is on sale now is considered to be trading at an even bigger discount upon a further correction. So, if we like a stock today, but are unwilling to purchase it today, based on the possibility that sentiment will worsen, we often pick a lower price point at which we would be willing to own the stock.
A very attractive aspect of the bull put spread is that it builds in a safety margin whereby the stock can continue to fall in the short-term and yet the trade can still profit as long as the stock remains above the short put strike price. In addition, the panic in the markets mean implied volatility is very high on put premiums, so selling these premiums while maintaining hedging and cushion room is a very attractive way of maintaining profit potential while limiting risk.
By entering a bull put, we pass Buffett’s first hurdle, which is not panicking when others panic and move towards the second hurdle of buying the fear. Instead of buying at the current levels, however, we agree to buy at even lower levels should even more fear permeate the markets. By so doing, we reduce the risk of catching the falling knife in the short-term but trust in the long-term fundamentals of a company.
