Of course stocks are risky. When you buy a stock, thereís a 50% chance it will go down instead of up. Itís like flipping a coin. Then why play if you can't win? Because you can win and because at least in the stock market, investment risk is your only risk; there is no liability risk. That means you canít be sued for owning stock in a company that screws up, and that means you cannot lose more than your investment which cannot be said for real estate which is fraught with liability risk.
So, how do we beat the stock market when stock picking odds are no better than flipping a coin? Because the stock market game is not quite like flipping a coin, itís more like the casino game of roulette. So letís consider the game of roulette because if†you can beat roulette,†you can beat the stock market.
The roulette wheel†has 18 black spots, 18 red spots, and also 2 green spots. The green spots are ď0Ē and ď00Ē, and when the ball lands on either, the house wins. †So that on any given spin, the probability of you winning is slightly less than 50%. In other words, over time, you lose. But you donít want to lose, you want to win. So how do you win? Simple. Own the wheel! and its green spots! Be the house. So that the odds of you winning on any spin are slightly greater than 50%. That little tilt in the odds is why the house is rich and why the players are not.
But, you complain, Iím not Donald Trump, I canít build a casino, and I canít own the roulette wheel or its green spots. Ahah, I reply, but weíre not talking about roulette, weíre talking about the stock market, which, like roulette, has two green spots and anyone, including you, can own them. The stock marketís two green spots are dividends and option premiums.
We buy investments, any investments, because†we expect to make money in two ways: appreciation and cash flow.†Thatís true for stocks as well. Any stock we buy, we buy hoping it will appreciate. But in addition, some stocks we buy because of an immediate cash flow; namely, dividends.
People†generally talk about two kinds of stock:†income stocks which pay dividends, and growth stocks which donít.††The idea is that some companies (most companies) think they can put that money to better use growing the company than to pay it out to its shareholders as dividends. Therefore, they reason, they should retain it, and shareholders will, in time, be grateful because the share values will appreciate faster.
But hereís the nasty secret: Income stocks (dividend paying stocks) are just as likely to appreciate as growth stocks, so it makes no sense for you to not be collecting dividends. To buy a stock that pays no dividends is a fools game because then you really are just flipping a coin.
Let's consider three possibilities (1) your stock goes up, (2) it goes down, (3) it flutters and see what happens.
Basically then, there is never a good reason to buy a non-dividend stock and every reason to buy dividend paying stocks. Unless, of course, you know that a stock is going up, then, yes, of course, buy it. But thatís like knowing that the roulette ball is about to land on red. Maybe some gurus really do know, but thatís not the game I play. There are only two things I know for sure: (1) I donít know which way a stock is going to move, and (2) I want to win anyway. Thatís what the green spots are for, and the first green spot is dividends.
Now, the second green spot
There are two kinds of options: calls and puts, and I use both. But before you understand how to use options to win, you will have to understand how they work. Letís first consider that there are six ways to trade the stock market. They are:
Thatís it. Oh, there may be a few other exotic instruments like derivatives for example, but I donít understand such things and would never mess with them. My world of investing is these six trades. But why bother, you ask. Why options. Well, suppose youíre happy with your dividends. Suppose youíre making, say, 5% on your dividends which is good. Thatís better than youíll get from your bank. But suppose you could make, say, 20% trading options? Would that make you even happier? Thatís whatís in view here.
Now, a whirlwind tour of what options are.
What is a Call? A Call is the right to buy 100 shares of a stock (the underlying stock) at a pre-set price which is called the strike price. Calls have expiration dates, so that after that date, the Call cannot be exercised and is worthless because it has ceased to exist. Before expiration, if the stock price is greater than the strike price, the Call option is said to be ďin the moneyĒ; meaning that it has intrinsic value; meaning that its owner can exercise it to purchase shares for less than they are worth.
What is a Put? A Put is the right to sell 100 shares of a stock (the underlying stock) at a pre-set price which is called the strike price. Puts, like Calls, have expiration dates, so that after that date, the Put cannot be exercised and is worthless because it has ceased to exist. Before expiration, if the stock price is lower than the strike price, the Put option is said to be ďin the moneyĒ; meaning that it has intrinsic value; meaning that its owner can exercise it to sell shares for more than they are worth.
If you buy a Call, you are betting and hoping that the stock price will go up to somewhere above the strike price (the higher the better) by expiration day. If you buy a Put, you are betting and hoping that the stock price will go down to somewhere below the strike price (the lower the better) by expiration day. What makes this game of options buying profitable is the fact that a small movement in the stock price is reflected by a large movement in the option price. So, for instance, if a stock price went up 10%, the Call price could double. But on the flip side, the Call (or Put) could expire worthless. And that is the high risk / high reward game that option buyers understand and play.
Thereís one more thing you should understand about buying options: 85% of all stock options expire worthless. So then, why do people buy them? Because the reward for being right is high.
But thatís options buying. What about options selling? Letís look at it this way: It's a bit like the 49íers not the football team but the gold rushers of 1849 when wanna-be gold miners rushed to California to strike it rich. A few did, but most didnít. But someone made money and consistently. Who? The shop keepers who sold lots of picks and gold pans and whatever else prospectors needed. If you buy options, youíre like those wanna-be gold miners, maybe getting rich but maybe going broke. But if you sell options, youíre like those shopkeepers, or like the Las Vegas casino owners who take a slice of everyone elseís winnings and losings with their green spots and other odds tilting devices. And that is the game I play. I generally sell Puts and Calls and only rarely buy them.
Buying Calls and Puts
The fastest way make a lot of money in the stock market (or to lose a lot of money) is to buy options (Calls or Puts). Consider: If you buy 100 shares of a stock, suppose it cost you $10,000 and the stock goes up to $10,500, then youíve made $500. But suppose instead you buy a Call on that stock. Now, instead of spending $10,000 you spend only $500. And now the stock goes up $500. What happens? The value of your Call increases $500 to $1000. So which is better? Make $500 on a $10,000 investment (a 5% increase) or make $500 on a $500 investment (a 100% increase)? Well, that's a no-brainer.
Now, you might think thatís easy to do, but here's the problem: 85% of all options expire worthless. And that is the big wrinkle. So, what is the risk? In one sense, buying Calls is less risky than buying stocks because you can only lose that small amount (in the case above, $500) whereas if you bought the stocks the entire $10,000 is at risk you'll probably lose it all if the company goes out of business. But in another sense, buying Calls is more risky than buying stocks because you are more likely to actually lose your $500. Why? First because, as I said, 85% of all options expire worthless, and also because once itís expired, your chanch to recover is done, youíre through. Whereas, if you buy the stock and the stock drops, you can recover it can go back up and also you can collect dividends. Buying stock, youíre not on a clock. But buying Calls, that clock is ticking, the stock price had better move up and soon or else.
Now, what about buying Puts? Itís exactly the reverse of buying Calls. When you buy a Call, youíre betting that the stock will go up, when you buy a Put, youíre betting that the stock will go down. In either case, you have to be right about the direction and the timing the stock price must go to where you want it to go before expiration or you lose.
But buying Puts has one additional advantage (that is, if you win a lot, there's no advantage if you lose a lot). And that advantage is: If youíve bought a lot of Puts and the market crashes big time as it did in 2008, then you make out like a bandit, because all those Puts you own not only double, but may triple or quadruple or more. Why? Because by buying Puts, youíve bet against the market.
When you sell a Call, you are obligating yourself to selling 100 shares of the underlying stock at the strike price, and that obligation lasts until the expiration date. If you donít own that 100 shares, you are going ďnakedĒ and thatís an awful risk to take. But if you own the shares, you are selling (or ďwritingĒ) a covered call, and that is a pretty conservative play to make. Itís sort of like leasing a house out with an option to buy. Youíre sort of hoping that the tenant doesnít exercise his option to buy it because you like the rental income. But if he does, thatís okay too because youíll make a nice profit.
So, what happens?
And thatís how itís done. But weíre not done yet, not by any means. We have one more step
Of course, in order to sell a Covered Call, you have to actually own the 100 shares to honor your commitment when you get called out. So you have to actually buy the shares first.
But what if you donít want to do that? What if youíd rather not own shares? How about this? How about if someone pays you a premium to sell their shares to you, then, when you own the shares, someone else pays you a premium to buy them from you? Now youíre doubling up. Well, the second part is already done. Writing a Covered Call is exactly that: someone paying you a premium for the privilege of buying your shares at the strike price. But what about the first part? How do you get someone to pay you for the privilege of selling you the stock in the first place? Thatís what selling Puts accomplishes.
When you sell a Put, that obligates you to buying a stock at the strike price. The bizarre thing is this burning question: Is that a good thing or a bad thing, to be forced to buy a stock at a discounted price? And the answer is: I donít know. Itís like the Zen question: If I accidently spill carpet cleaner on my carpet, is that a good thing or a bad thing? Oh, thatís deep. But seriously, if I sell a $50 Put on a $55 stock and the price falls so that now I have to buy it at the discounted price of $50 which price I might have wanted to buy it at anyway so that I can write covered Calls, is that a bad thing? Letís consider what has happened
And all of that is the bad scenario we hoped wouldnít happen when we sold the Put.
Well, then, whatís the good thing that we hoped would happen? What we hoped would happen was for the Put to expire worthless so that we never owned the stock at all. Then we just sell another Put, then another, and so on, putting premiums in our pockets for doing practically nothing.
But letís look at this another way. You have your choice. You can buy a stock and collect dividends which is a good thing. To do that you put, say, $10,000 into play which is now at risk. Or you can sell a Put which may require you to buy the shares for $10,000. Now, technically that $10,000 never leaves your account, but it is earmarked and is just as at risk as if you had actually bought the stocks. So, in either case, what do you get for your $10,000 risk?
How I Play the Game
Okay, youíve just learned a lot, and all of that you need to know. But now, how do you play
this game without losing? Here's what I do:
I sell an out-of-the-money Put (or Puts) and make, say, $200. That puts, say, $10,000 at risk but $200 in my pocket.
So, what happens now? Well, the stock price either goes up or down or flutters. If it goes up, I feel good and check it only now and then until expiration. At expiration, Iím done and the $200 is mine to keep. If the stock flutters, Iím still okay, but I check more often.
But if it goes down, I worry. I really donít want to own that stock. And if that stock price hits the strike price, I want to have already exited that position somewhere north of the strike price.
Now, you may have a different opinion, you may actually want to buy that stock at a discounted price, and some stocks, like maybe AT&T, are certainly worth collecting. But thatís not me. I look at a stock as a hot potato, something to be rid of as soon as possible. So when a stock price starts to drift down towards the strike price, I start watching it like a hawk.
Hereís whatís important: I am keenly aware that somebody paid me $200 to enter this position, so I am ahead $200 when I started. So, if I can hang in there until expiration day, that $200 is my profit. But right now, itís my cushion; in other words, I can loss that much, $200, and walk away with a break-even.
So, my question now is: if I exit that is, buy-to-close what will it cost me? And if the answer is $200 or nearly, I exit. No questions asked, no looking back, no more watching to see if that stock turns back up and I really should have stayed in, Iím done, move on.
So, what is the upshot? Itís this: If the stock goes up or flutters until expiration, I keep the $200. But if the stock goes down to dangerously close to the strike price, I exit and am out at a break-even or close to. So, if the stock goes up, I win and if the stock goes down I donít lose! So how cool is that? Can you think of another game where the odds are so stacked in your favor as that? I canít.
Now, to be thorough, at the moment you enter the play and pocket that $200, youíre not really ahead $200, youíre really behind. How so? Because if for some reason you want to exit that position one minute later and the price had not changed so that you could buy-to-close for exactly $200, thatís not quite break even. Why not? 200-200=zero, isn't it? No. Because you paid a fee to enter and another to exit. Those two fees (say $10 twice) are your loss ($20).
But what you need to think about is that each day from today to expiration, that Put loses value (time decay) until it is finally worth zero on expiration day. So as the calendar creeps towards that day, the more of that $200 is yours to keep should you need to exit hastily. Suppose a week goes by, and you want to exit for some reason. Okay, you buy back the Put and discover that it now costs only $100 because of the time decay. So, what is yours to keep? You get to keep $200, less $100, less the $20 fees leaving you with $80. Not bad. You may have done better to stay in to expiration, but itís never a mistake to put cash in your pocket.
Guarantees? Certainly Not!
I know what Iíve just told you sounds good, and it is good. It works for me consistently. But is it guaranteed to work all the time? No. Of course not. Youíve heard it said before and Iíll say it again: ďPast performance is no guarantee of future performance.Ē I play this Put/Call strategy a lot and I win a lot. But I always keep in mind the risks.
But doesnít roulette guarantee that the casino will win? No, not even that. But how can the casino lose? Several ways: (1) If all players bet black and black wins, the house loses. (2) If nobody plays, the house loses. (3) If, by the oddest stroke of luck, one player won, say, 20 times in a row and let each win ďrideĒ the casino loses a single dollar could become a million. Now, double that a few more times and the casino could really be hurting. That is statistically impossible but more unlikely things have happened; like, for instance, you being born after all, you did win a sperm race which was very unlikely. Roulette is, after all, gambling, even for the house. One more scenario then Iím done: (4), If terrorists nuke Las Vegas, the casinos certainly lose. Whatís the likelihood of that? I shudder to think.
My point is, you canít hedge against everything thatís why Jesus said, ďSeek ye first the kingdom of God,Ē which really is hedging against everything. However clever you†are, you could pick the next big loser, the next WorldCom or Enron or Lehman Brothers, or the whole market could just die like it did in 2008, and if youíve sold lots of Puts, you could be in big trouble quickly.
How do you avoid that? As an active investor,†well, just know your stuff and take your chances along with the rest of us. And if the market is going to die tomorrow, buy back all your Puts today, accept your loses, and get out. But if you are a passive investor and would like to know that there is no chance of ever losing money on the stock market roulette, then there is a way, one way. For that, you need to read my other article: Annuities.