How to Beat the Stock Market With MINIMAL RISK

     Of course stocks are risky. When you buy a stock, there’s a 50% chance it will go down instead of up. It’s 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 can’t 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, it’s more like the casino game of roulette. So let’s 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 “0” and “00”, 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 don’t 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, I’m not Donald Trump, I can’t build a casino, and I can’t own the roulette wheel or its green spots. Ahah, I reply, but we’re not talking about roulette, we’re talking about the stock market, which, like roulette, has two green spots and anyone, including you, can own them. The stock market’s two green spots are dividends and option premiums.

Dividends

     We buy investments, any investments, because we expect to make money in two ways: appreciation and cash flow. That’s 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 don’t.  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 here’s 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.

If the stock goes up you profit from the appreciation and the dividend if there is one. If there is no dividend, to enjoy your profit you must sell the stock which ends your position. But if there is a dividend, you’re enjoying actual cash profit and you never have to sell the shares.
If the stock goes down, if there is no dividend, you’re stuck. You must either sell at a loss or hold until the stock rebounds which may never happen. But if there is a dividend, you have a third choice: collect enough dividends until they compensate you for your loss then you can sell at a break-even, even if the stock never rebounds. By the way, in a serious market melt-down, dividend paying stocks fall slower than non-dividend paying stocks. Why? Because as prices fall, the dividend yield goes up making the stock more attractive. So dividend paying stocks have brakes, whereas non-dividend paying stocks can find themselves in freefall.
If the stock flutters, if there is no dividend, nothing is gained, you’re going nowhere. Your stock must go up to make a profit. Further, you can’t realize that profit without selling which ends your growth. But if there is a divided, fluttering is a good thing because you are enjoying a continual profit which you can use to buy more shares which continually increases your dividends.

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 that’s like knowing that the roulette ball is about to land on red. Maybe some gurus really do know, but that’s not the game I play. There are only two things I know for sure: (1) I don’t know which way a stock is going to move, and (2) I want to win anyway. That’s what the green spots are for, and the first green spot is dividends.
Now, the second green spot —

Option Premiums

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. Let’s first consider that there are six ways to trade the stock market. They are:

Buy stocks,
Sell stocks (which includes sell stocks short which I never do),
Buy calls,
Sell calls,
Buy puts,
Sell puts.

     That’s it. Oh, there may be a few other exotic instruments like derivatives for example, but I don’t 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 you’re happy with your dividends. Suppose you’re making, say, 5% on your dividends which is good. That’s better than you’ll get from your bank. But suppose you could make, say, 20% trading options? Would that make you even happier? That’s what’s 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 “in the money”; 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 “in the money”; 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.
     There’s 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 that’s options buying. What about options selling? Let’s look at it this way: It's a bit like the 49’ers — 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 didn’t. 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, you’re like those wanna-be gold miners, maybe getting rich but maybe going broke. But if you sell options, you’re like those shopkeepers, or like the Las Vegas casino owners who take a slice of everyone else’s 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 you’ve 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 that’s 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 it’s expired, your chanch to recover is done, you’re 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, you’re 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? It’s exactly the reverse of buying Calls. When you buy a Call, you’re betting that the stock will go up, when you buy a Put, you’re 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 you’ve 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, you’ve bet against the market.

Selling Calls

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 don’t own that 100 shares, you are going “naked” and that’s an awful risk to take. But if you own the shares, you are selling (or “writing”) a covered call, and that is a pretty conservative play to make. It’s sort of like leasing a house out with an option to buy. You’re sort of hoping that the tenant doesn’t exercise his option to buy it because you like the rental income. But if he does, that’s okay too because you’ll make a nice profit.
So, what happens?

If the stock price goes up and is above the strike price you may be “called out” (forced to sell 100 shares at the strike price). And on expiration day, you definitely will be called out. But that’s okay because you profit twice — from the call premium and from the appreciated price.
If the stock goes down, you will lose money like everyone else. However, you will lose less money because (1) you pocketed a Call premium, and maybe another, and maybe another, and (2) you are pocketing dividends because you wouldn’t even think about buying a stock that doesn’t pay dividends, would you? And so, with your Call premiums plus your dividends, you might actually be able to claw your way out of the loss even if the stock doesn’t recover. And this is how you sell at a loss and still make a profit.
If the stock flutters (which is what you really hope happens) then on expiration day, the Call expires worthless and you can do it all over again, sell another Call and earn another Call premium.

And that’s how it’s done. But we’re not done yet, not by any means. We have one more step —

Selling Puts

     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 don’t want to do that? What if you’d 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 you’re 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? That’s 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 don’t know. It’s like the Zen question: If I accidently spill carpet cleaner on my carpet, is that a good thing or a bad thing? Oh, that’s 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? Let’s consider what has happened —

I sell a Put and collect a premium. I hope the stock price flutters so that the Put expires worthless.
But the stock price drops below the strike price and I am forced to buy the shares.
I sell a Call and collect another premium. And if I reach an ex-dividend date, I will also collect a dividend.
The stock price rises above the strike price and I am forced to sell the shares.
So I have collected two premiums and maybe dividends and am back where I started, ready to sell another Put.

     And all of that is the bad scenario we hoped wouldn’t happen when we sold the Put.
     Well, then, what’s 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 let’s 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?

If you buy the stock you get dividends every three months. But if you sell a Put, as soon as that Put expires, you get to sell another Put, then another. Suppose you do this every month, or every other week? That might well outpace the dividends.
You get the Put premium up front, now, today. Whereas for the dividend, you have to wait for until the payout date.
When the dividend is committed to being paid out, the stock price drops on the ex-dividend day by the amount of the dividend. Therefore any gain you hope to make is mitigated by that drop. So that a dividend is not truely a profit until the stock price recovers; that is, the price grows back to what it was before that dividend hit. Nothing like that happens when you collect a Put premium which is instantly a profit.
Suppose you’re thinking about buying shares at a specific price, but before you press that “buy” button, the price goes up. Now you’re thinking, “Rats! I just got priced out,”because now you can’t buy at the price you had in mind. No problem. Just sell a Put. Now you’re in the game anyway and actually ahead of the game because you just pocketed a profit regardless of what happens to the stock. And if the stock does happened to drift back down, you buy it at the price you originally had in mind. And somebody paid you to do what you wanted to do in the first place. How cool is that?
But here’s the real point: You’re risk is the same. Whether you buy the shares or sell a Put, your risk is the cost of shares. The only difference is, if you sell a Put, you reduce that risk by the amount of money you put into your pocket at the start. So you’re entering the position already ahead by the amount of the Put premium. Now, do that over and over, and your risk moves toward vanishing.

How I Play the Game

     Okay, you’ve 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, I’m done and the $200 is mine to keep. If the stock flutters, I’m still okay, but I check more often.
     But if it goes down, I worry. I really don’t 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 that’s 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.
     Here’s what’s 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, it’s 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, I’m done, move on.
     So, what is the upshot? It’s 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 don’t lose! So how cool is that? Can you think of another game where the odds are so stacked in your favor as that? I can’t.
     Now, to be thorough, at the moment you enter the play and pocket that $200, you’re not really ahead $200, you’re 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, that’s 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 it’s never a mistake to put cash in your pocket.

Guarantees? Certainly Not!

     I know what I’ve 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. You’ve heard it said before and I’ll say it again: “Past performance is no guarantee of future performance.” I play this Put/Call strategy a lot and I win a lot. But I always keep in mind the risks.
     But doesn’t 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 “ride” 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 I’m done: (4), If terrorists nuke Las Vegas, the casinos certainly lose. What’s the likelihood of that? I shudder to think.
     My point is, you can’t hedge against everything — that’s why Jesus said, “Seek ye first the kingdom of God,” 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 you’ve 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.