The typical approach to investing over the years has been to buy and hold, or as us traders like to say, "buy and hope". I'm going to talk about two of the most basic approaches using options that are much more effective than the buy and hope approach. These two approaches can really be used by anybody that wants to take a stand and manage their finances on their own and for the better. And it is not something that will take 2-5 years to learn. Being presented with these concepts might also get the ball rolling and get someone excited to learn more strategies and really dive into the plethora of information available to the retail investor today. Again, this has nothing to do with chart speculation. These concepts are simply about reducing your risk and cost-basis, with the idea of increasing your average monthly return as well. These are alternative ways to manage your money on your own rather than give it to someone who pretends to know what they are doing to manage it “safely” for you. Now, chart speculating is pretty cool. And those that can do it profitably are pretty impressive. But you don’t have to be the coolest guy on the basketball court. Scottie Pippen won the same 6 NBA Championships that Michael Jordan won. Scottie wasn’t the coolest on the court, but he got the job done and has the same 6 rings Jordan has. I’m not sure if I truly believe that anyone can be a profitable chart speculator. But I am sure that the world can understand better strategies than the old buy and hope approach that we as a society have still yet to abandon. With the new age, technology, and resources available today it is time we advanced our level of understanding in the Finance industry to match the year 2015, and move away from 1950’s investing.
The first strategy I want to talk about is called a "covered call". This is when you buy shares of stock, and you short a call “against” those shares. Let's say Microsoft is trading for $50 per share. You buy 100 shares of stock, and you short the 52 Call Option for a $1.00 premium with 45 days until expiration. Shorting the 52 Call for $1.00 means you receive a credit into your account. We call this "collecting premium" because you literally get paid to make this trade. You get paid $100 ($1.00 * 100 shares); it is 100 shares because one option contract controls 100 shares of stock.... At this point the stock can do 3 things, it can go up, it can go down, or it can go sideways. If the stock goes down or sideways you get to keep that $1.00 premium you collected ($100). If the stock's price goes up but it does not go above $52 by the options expiration date then you still get to keep that $100. So the stock’s price could close at $51.99 on the option expiration date, and you would still be able to keep that $1.00 premium you collected ($100), as well as be up $1.99 on your 100 shares of stock that you had purchased initially. Now, if the stock's price is beyond $52 you cannot make anymore money on your position because every dollar you gain from your 100 shares will be negated by a dollar you lose from your option position. We call this a "high class problem". You can just close your option and move on with your life having only made 2 dollars instead of $2.50 or however much depending on how far the stock’s price went above $52. The great thing about this strategy is it protects you from downside risk. If Microsoft's stock price dropped down to $47, that means you are down $3 on your 100 shares you bought at $50 per share. But because you shorted that call option and collected $1, that means you are only down $2 all together on your 100 shares of stock you bought. Options can be used literally as insurance on our stocks/retirement portfolio's. Managing risk is how you achieve long-term success in this game. It boggles my mind how we preach that we need to buy insurance on our cars, houses, lives, but when it comes to retirement portfolios.. SCREW IT BECAUSE THE STOCK MARKET IS GOING TO THE MOOOOOON!!. Ridiculous. Now you might be saying I don't exactly have the capital to be buying 100 shares of $50 stocks, and I understand that. But we are taught as a society to put $10,000 into a "low cost" index mutual fund that tracks the market. When instead what we should be doing is putting $10,000 into the SPY. The SPY is an ETF that tracks that S&P 500. You can then go ahead and sell calls against the SPY and reduce your cost-basis the same way we were doing with Microsoft. If you do want to use this strategy on more stocks another alternative is to do a "poor mans covered call". For this, instead of buying 100 shares of stock we can buy a call option instead, which controls 100 shares of a stock, and we simply sell a call against it just as I explained above. I've seen several studies suggesting these approaches not only lower your risk but also increase your average monthly return rather than just buying and holding shares. Als o, the reason why options are g reat is because they allows us to control 100 shares of a $100 stock for a just a couple hundred dollars, but if I wanted to buy the shares outright it would cost me $10,000. That is powerful.
Now since that was so much fun let's start all over. The next strategy is to sell puts, but this time we will not be buying shares at the same time. So Microsoft is trading at $50 per share and we love this stock. We want to own it until we die just to give it to our kids so they can own it until they die. But instead of buying 100 shares outright at $50 per share we decide to sell the 48 Put Option for a $1.00 premium. WHAT A GREAT CHOICE! As long as the stock stays above $48 by the expiration date we will be able to keep the premium we collected ($100). In fact, because we collected $1.00 in premium it means our breakeven price is $1.00 lower than the 48 strike price we selected for our put option. This means we will not lose a penny as long as the stock is above $47 at the expiration date! We keep doing this... sell the puts every month until our hands bleed, and keep collecting that premium. Now, one day we are going to lose. Let's say MSFT drops down to $45 a share and it is expiration day. We can choose to be assigned 100 shares long of MSFT at $48 per share. Meaning, the stock we were ready to buy at $50 per share we are now able to buy at $48 per share. COST-BASIS REDUCTION BABY! Now instead of being down $5 on our 100 shares, we are only down $3. Again, we are reducing our risk, and that is how you stay alive to fight another day. Also, don’t forget about all the premium you’ve collected before that one loss. You can then continue to do this strategy whenever you want to increase your share count. If you don’t want anymore shares right now you can simply start the covered call strategy at this time.
The studies I have seen to support these strategies over buying and hoping have results that are astonishing. The covered call increases your average monthly return while lowering your standard deviation of movement in your P/L, thus lowering your risk. Selling puts, or put spreads mechanically every week in the SPX drastically outperformed the BEST performing mutual fund over the past five years! In the same time period the put spreads saw DOUBLE the return as the best performing mutual fund for those five years. For the cherry on top, the fee’s were double if you had invested in the mutual fund. It is time we get fed up with the buy and hope bullcrap we still preach to innocent investors in order to stimulate the 2 trillion dollar fee industry that is gassing up the yachts for these “money managers” that don’t understand these simple cost-basis reduction concepts themselves. It's real difficult to pick this stuff up off rip and I get that. My father is very good with numbers and I’m slowly starting to teach him true Finance but the learning curve is so steep in the beginning. And he only has about 2 hours a week to learn, and you probably need over 2 hours a day absolute bare minimum for 2-5 years straight if you want to be good enough to give yourself a shot at turning this into a career. But to understand simple strategies that reduce your cost-basis and risk like the ones shared in this article is something I'd love to see the whole world understand one day, as it really shouldn't take long to teach or learn. The real problem is we are not taught this in our school systems or financial media. Instead, in schools, magazines, and news articles we are taught to contribute the max amount we can to our IRA's or 401k's every year until we die and that way at age 65 we can be the same crappy investor we were at age 25 because we learned absolutely nothing in the process.
Welp, that's my save the world rant for the week. Please help share this and do your part to turn the world into a true financially literate society. Last Time I checked Warren Buffett wasn’t 25 and this isn’t the 1950’s. Times, resources, products, education, markets, and technology have changed. It’s about time we changed with them. Best trading to all.
You can reach me at..
@TraderStos on Instagram
**Please note that trading is risky and I am not qualified to give investment advice. You should invest your money at your own risk and only after you have done your due diligence. Do not take anything here as a recommendation to buy or sell any securities. I am willing to talk trading strategies and connect with other traders via email or instagram.