What is Option Delta?

Trading options without knowing your greeks is like flying a plane without looking at your flight instruments. Knowledge of your greeks is ABSOLUTELY NECESSARY to trade options. They are like the “vital signs” of your portfolio, that can tell you if your portfolio is healthy, or about to get sick. The more complex your option strategy, the more important it is to be able to read these signs – they’ll help you to extract more money from the market, or avoid losing money in the future.

There are a few greeks you need to know (mainly delta, gamma, vega, and theta), but we’ll start with delta.

 

Option Delta

Delta is the simplest greek to understand.

Delta is the expected change in price of an option when the underlying asset moves by $1

This means that if you have an option with a delta of 0.5, then for every $1 increase in the stock, the option should increase by $0.5. On the other hand, if your option had a delta of -0.5, then for every $1 increase in the stock, your option would LOSE $0.5.

Call options almost always have POSITIVE DELTA between zero and plus one. They INCREASE in value as the underlying asset goes up.

Put options almost always have NEGATIVE DELTA, between zero and minus one. They DECREASE in value when the underlying asset goes up.

optiondelta2

 

As expiration nears, the delta of an in-the-money call will move towards 1, whereas the delta of an out-of-the-money call will move towards zero. This is because, as expiration nears, the in-the-money call is likely to be exercised and turned into stock, whereas the out-of-the-money call is unlikely to be exercised so is virtually worthless and won’t react to the stock’s price movement at all.

For puts options it is very similar. The delta of an in-the-money put will move towards -1, whereas the delta of an out-of-the-money put will move towards zero as it becomes more obvious that it will be worthless at expiration. This means we can think about delta in another way:

We can think about option delta as the probability that the option will end up in the money at expiration. For example, a delta of 0.5 means that there is about a 50% chance that call option will end up in-the-money at expiration. A delta of -0.2 would mean there is about a 20% chance of that put ending up in-the-money at expiration

Now while this is a useful way to think about delta, you should be aware that it is not a proper textbook definition – it is really a side-effect of the way delta is calculated.

The following table is real data taken from a broker that shows the deltas of individual calls and puts with various strike prices, when the stock is at 1160 (the blue highlighted row).

Screen Shot 2013-12-30 at 5.38.05 PM

 

In this example the underlying asset is the Russell 2000 index currently trading at 1160. The bright yellow line highlights an in-the-money call option and an out-of-the-money put option. The bright blue line highlights at-the-money call and put options. The bright green line highlights an out-of-the money call option and an in-the-money put option. Notice how the deltas of the calls decreases as the strike price increases, and how the deltas of the puts get more negative as strike price increases. The table shows very well how delta is affected by the how close the strike price is to the price of the underlying asset. Here is a graph of that data above that shows the same thing:

DeltaPrice

How stock volatility affects option delta

If we think about delta as the chance that the option will end up in-the-money at expiration, then clearly the volatility of the stock will affect an option’s delta. If the stock moves up or down by 50% or more every day, then there is plenty of chance for almost any option to end up in-the-money. Take a look at Tesla (TSLA). This is a stock that is very volatile, so even when the stock is at $200, there is still a moderate chance that within the next month it could fall to $100. This means the delta of a $100 strike put option might be around 0.1 or 0.2. Compare this to McDonalds (MCD), which is a very stable company whose stock hardly fell at all during the 2008 crisis. If the stock is trading at $100, there is only a very small chance that it will fall to, say, $50 within the next month. This means the delta of a $50 strike put option would be very close to zero.

If the volatility of a stock changes, it can change the deltas of the options. and cause you to make or lose money pretty quickly. When prices of options change due to changes in stock volatility, we call this VEGA RISK.

 

How time to expiration affects Delta

If we think about delta as a measure of the probability that the option will expire in-the-money, then it is common sense that if an option is way out-of-the-money and has very little time left until expiration, then it will have a delta close to zero, as there is very little time left for the stock to move a lot. If it is already way in-the-money and has very little time left until expiration, then it will have a delta close to 1 (if it is a call option) or -1 (if it is a put option). Essentially, at expiration, a call’s delta MUST be either zero (out of the money) or +/- 1 (in the money). Therefore, as time moves onward, deltas of options tend to gravitate towards these values. Take a look at this chart. With a lot of time left until expiration (171 days) the line is fairly flat. As time to expiration decreases, the line gets more curvy – i.e. the delta gravitates towards 1 or -1.

Delta affected by time

This results in something interesting around option expiration time – the deltas of at-the-money options tend to swing around wildly. Here’s an example:

Say you have a call option with a strike price of $25 and there is only one day left until expiration. The stock is also currently trading at $25, so the delta of the option is around 0.5. If the stock increases to $26, the probability of the call ending up in-the-money just increased a LOT simply because there is not much time left for the stock to go back down before the option expires. If you owned this call you would have suddenly made money on it. If you had sold it, you would suddenly have lost most of your money.

This is why trading options around expiration time can be pretty dangerous – small changes in the stock can cause very large changes in delta, and therefore very large changes in your profits.

This neatly introduces us to a second greek you need to know – GAMMA. Gamma is the rate of change of delta, i.e. how quickly delta changes. We don’t generally want delta to change too rapidly because it means we can lose (or make) money very quickly. As we approach expiration we say that our GAMMA RISK increases – our rate of change of delta increases which means that even though we’ve made money up until that point, we can lose it all in a matter of hours.

The Best Free Stock Screeners

A friend of mine once called the internet “an ocean of crap with a thin layer of cream on top”.

The internet has democratized stock research and put the tools of professional investors into the hands of retail guys like you and me. In the past, people would pay exorbitant amounts to be able to get access to information that can now be reached at the click of a button. However, there is also a lot of garbage out there.

Here are the best stock screeners you should be using, measured by ease of use and breadth of screening criteria.

 

StockRover – Best All Round Winner

This web-based screener has pretty much everything you could want, including decile rankings, industry comparisons, and more financial ratios than FinViz. The software also has a bunch of pre-loaded screens, portfolios, and stock “grading systems” that can provide a starting point for your own research. The site has a more sophisticated feel to it than many of its competitors, and it surpasses them in ease of use, making it my go-to screener. The software also includes a pretty useful charting feature with graphical representations of events such as dividends or earnings, or max drawdowns over a specified period. Altogether, there are enough features in this screener to warrant keeping it open on one of your screens for most of the day.

 

FINVIZ – Best All Round Honorable Mention

This screener has about the same selection of fundamental and technical screening tools as StockRover.com, all packaged in an easy to use web-based form. This screener comes in a close second for the wide variety of things it can do, which should satisfy the majority of investors. One of my favorite features is the charts, where trend lines and support/resistance lines are automatically drawn on. However, a few minor gripes prevent this from being the standout winner.

Firstly, if you’d like to pre-load your own portfolio or watch-list, you are limited to 50 stocks. This is no big deal for most investors, but if you have your own larger list of potential stocks that you’d like to screen, you have to set up a number of separate portfolios.

Secondly, you can only filter by absolute values, rather than values relative to peers. If you want to work out which stocks are in the cheapest decile or quartile for their industry on a P/B basis, you have to work it out yourself.

Lastly, and less of an issue for many people, is that they don’t have EV/EBITDA. I understand they can’t accommodate every ratio for every investor, but given the growing consensus of this ratio as one of the best valuation metrics I would have expected to see it in this screener.

 

Google Drive/Google Finance/Yahoo Finance – Best for Customization

Google finance offers one of the simplest stock screeners out there, but when combined with Google Drive the power of the site is properly realized. Prior to using StockRover I made my own stock screener by pulling data from Google Finance and Yahoo finance into a spreadsheet on Google Drive. The data you can pull from Google Finance is fairly rudimentary, but once you have the data in your spreadsheet you can search and manipulate it the same way you would any spreadsheet data. Here is a quick idea of what you can do using Google Finance, and here is an even better version using Yahoo finance.

If you have enough time and desire to build your own screener, I would definitely recommend it, but just be prepared to do a lot of work on it. Currently I use Google Drive for monitoring my trades and maintaining records as the data is so easy to manipulate and filter, but I use standalone sites for normal stock-screening.

Which Stocks Should we Sell Puts On?

This is the blueprint I use to find the stocks I can sell puts (or covered calls) on. It’s pretty simple – we’re essentially looking for good stocks that are trading cheaply and have some downside protection.

We have 3 basic steps for finding good stocks on which we can sell puts. We need to:

1) Find good stocks

2) …that are trading cheaply

3) …and then enter the trade at the right time.

So let’s take a look at how to use a free screener to find these stocks.

treasure_map
Finding good stocks can be tricky

 

1) Finding good stocks to sell puts on

A good stock for a dividend value investor is a company with a significant competitive advantage (often called an “economic moat”) with a consistent cash flow to support a stable, growing dividend.

One of the easiest places to find a starting list of suitable stocks is the Dividend Aristocrats list. This is a diverse list of over 50 highly liquid, blue-chip stocks that have followed a policy of consistently increasing dividends every year for at least 25 years. You’ve probably heard of many of these companies – like McDonalds, Walmart, Coca-Cola, and Proctor & Gamble. If this list is not large enough, you can go into the Dividend Achievers list, which has similar requirements except that dividends only need to have been increasing for the last 10 years.

Of course, the best way is to get someone smarter than you to do the work first, which is why I also like to look at Warren Buffett’s top holdings, which is disclosed on a quarterly basis in the company’s 13-F filings. I generally use the StockRover.com stock screener which has Warren Buffett’s top 25 holdings pre-loaded.

These three lists will generally give me a universe of nearly 200 stocks, the majority of which a fairly high quality.

To make the list even higher quality, I use my stock screener (StockRover.com) to filter out any stock on the list that has a dividend yield of under 2%, or has a payout ratio above 70%. The payout ratio is how much of a company’s earnings is paid out as dividends. If this ratio is too high, then any decrease to the earnings in future will likely translate into reduced dividends. We want stable, growing dividends, so we prefer payout ratios under 70%.

These companies are leaders in their field, and likely have been for many years. If you want to filter the list further I would recommend screening by free cash flow (FCF) to sales. Free cash flow is the cash that is left over after the company has paid its bills and made any investments. Companies that can generate 10 cents of free cash or more on each dollar of sales (i.e. have a FCF/S ratio of over 10%) likely have a strong competitive advantage. Be aware though, that this high standard will make it very hard for some industries to make it through the filter (particularly retail companies).

 

2) Filtering for cheapness

Screening for cheap companies is essentially about working out what you are paying for an asset and then comparing this with what you are getting in return. This is why metrics for valuations of companies are often ratios of some form of PRICE divided by some form of RETURN.

Cheep cheep cheep
Cheep cheep cheep

The most basic valuation metric of this kind is the price to earnings (P/E) ratio. You are paying a certain price for a stock, and you are getting some earnings in return. Ideally the P/E ratio is low – i.e. you a paying a low price and getting significant earnings in return.

Alternatively you can use a price to book (P/B) ratio as a measure of cheapness. Again, here you a paying a certain price for an asset, but instead of using earnings as your return, you are using the book value of the company (what the company would be worth if it liquidated itself) as your measure of what you are getting for buying the stock.

There are a number of alternatives we can use for the PRICE part of the ratio, and a number of alternatives we can use for the RETURN part of the ratio, but the key is that they all measure the same kind of thing – the CHEAPNESS of the stock you are buying. The following chart shows the average annual performance of the cheapest 10% and most expensive 10% of large US stocks according to a number of different measures of “cheapness” between 1964 and 2009:

Data from "What Works On Wall Street" 4th edition.
Data from “What Works On Wall Street” 4th edition.

A gradual consensus is emerging that the best price identifier of cheap stocks is EV/EBITDA ratio. Interested readers should read this post at Greenbackd, but the basic idea behind it is that the price measure of enterprise value (EV) takes into account a company’s leverage, while the returns measure of EBITDA (earnings before interest, taxes, depreciation, and amortization) is less easily manipulated by companies compared to other forms of earnings.

However, what the above table clearly shows is that almost all value metrics work to some degree. As a result, I recommend using whatever is easiest to calculate in your own screener. StockRover is capable of ranking stocks by EV/EBITDA, which is great, but this unfortunately ignores the fact that we really should be comparing these ratios only within industries. StockRover can also rank stocks by P/E decile within their industry.

As a rule of thumb, I would consider a stock to pass the cheapness test if the EV/EBITDA ratio was under 15, or if the company ranked in the top 3 cheapest deciles of P/E within each industry. Using a stock screener, you can screen for these companies very easily.

 

3) Screening for the correct entry

We already have some downside protection by virtue of the fact that we have a list of good, dividend-paying stocks that are already cheap. These are stocks that we would like to own because their value will likely increase over the medium to long term. However, in the short term the stock may easily fall due to technical factors. Ideally, we would like to sell puts on a stock that has had (or is having) a pullback within the context of a longer term uptrend. This allows us to sell puts for a higher price (as stock volatility has increased), towards the lower end of the stock’s historical range, with greater upside for us in case we are assigned and the longer term uptrend continues.

To identify a stock that may fit these criteria I screen for an RSI below 50 (i.e. oversold to some degree), but above the 50 day simple moving average. I will also look at the chart of every stock that is in my filtered list to see if there is a defined resistance point, below which I could sell a put.

 

… and some final considerations

The last thing to do before entering a trade is to use your discretion to consider your total downside risk. It can be easy to get caught in a large downswing with little protection when you are sell puts. I like to look at previous drawdowns in the stock’s price (particularly 2008-2009) and consider whether my portfolio could handle a drawdown of that magnitude again. I like to look at when the company is reporting earnings, and when the next ex-dividend date is. Both of these should be available through your broker. Most importantly you need to continually ask yourself – DO I WANT TO OWN THIS STOCK?

The Iron Condor Explained

The iron condor is a VERY popular options strategy that you’ve probably seen advertised online by so-called “options gurus”. One of the reasons it is so popular is that the iron condor is capable of generating high returns regardless of market direction. Unfortunately the internet is littered with stories of iron condor traders who have lost everything when the market has gone against them – they did not fully understand the dangers on the iron condor, and mistakenly considered it to be a “low-risk” strategy

So, here’s a crash course on one of my favorite option strategies.

 

What is an Iron Condor?

An iron condor is an options strategy that involves simultaneously buying and selling multiple option contracts, such that you will make money if the underlying stock (or index) stays within a particular price range. This is what is so powerful about iron condors: they enable you to make money no matter which way the market goes.

The iron condor is made up of four distinct options (all on the same stock and the same expiration date):

1) BUY A PUT with a very low strike 2) SELL A PUT with a low strike 3) SELL A CALL with a high strike 4) BUY A CALL with an even higher strike

This gives us the following payoff diagram:IronCondorPayoff

This payoff diagram is actually an example of a real trade on the Russell 2000. In this example the Russell was at 1125 and we traded the following options:

1) BOUGHT A PUT with a strike price of 1025 for a debit of -$6.90 2) SOLD A PUT with a strike price of 1035 for a credit of +$8.10 3) SOLD A CALL with a strike price of 1200 for a credit of +$4.30 4) BOUGHT A CALL with a strike price of 1210 for a debit of -$3.20

If we add up the debits and credits from buying and selling these options, we end up with a credit of +$2.30 (which actually means +$230 dollars for our account).

Condor
A meaty condor

Now let’s consider what might happen between now and expiration. If the Russell 2000 index stays between 1035 and 1200, then all the options we traded expire worthless. This means that while we lost money on the options we bought, we made more money on the options we sold.

If the index rises above 1200, then the call we sold begins to increase in value (i.e. we lose money). However, above 1210, the amount of extra money we lose on the 1200 call is hedged by the money we start making on the 1210 call we bought.

If the index falls below 1035, then the put we sold begins to increase in value (i.e. we lose money). Once the index falls below 1025, then the put we bought begins to increase in value too, offsetting the money we are losing on the first put.

The most we can lose on this trade is -$770, which happens if the index ends up outside of our trading range of 1035 – 1200.

 

The Philosophy of Iron Condor Trading

While the act of trading an iron condor is very simple, the philosophy of the strategy is very different from that needed for equities trading.

Firstly, you must come to grips with the idea of selling rather than buying. You make money in iron condors primarily by selling overvalued options, and watching their value decline. The options we buy in an iron condor are simply hedges so we don’t lose too much money when things go wrong.

Secondly, when you sell options, you are actually selling two main things: volatility and time. A decrease in volatility will decrease the value of the options you sold – volatility is the key ingredient of options prices and is worth several articles in itself. In effect, we are collecting “volatility risk premium” – the difference in price between what people are willing to pay for an option, and what the option should actually be worth based on typical realized volatility. This is just like the way an insurance company makes money – people are willing to pay more for insurance than it should actually cost based on historical incidences. As time to expiration decreases,  the value of the options will also decrease. This puts the odds in our favor if nothing happens.

Thirdly, iron condors have a natural asymmetry to their return profile. If the risk is not managed appropriately, an iron condor will typically show many months of small gains, and then a very large loss. It is vital for new iron condor traders to realize this in order to manage their risk and capital appropriately.

 

Which Iron Condor to trade?

So by now you’ve probably already realized that there are a lot of variables involved in trading the iron condor. How you set up your condor really depends on your trading personality and risk tolerance. We’ll look at how to set up the “perfect” iron condor in the next post.

7 Reasons to Sell Puts on Stable Dividend-Paying Stocks

I sell puts options on high quality, value companies that pay a stable dividend. I’ve found that this is the put-selling strategy that maximizes risk adjusted returns and conserves capital. Selling naked or cash-secured puts is a great strategy in itself, but selling them on dividend paying blue chip stocks is even better. Here are the top reasons why this is one of my favorite strategies (file this under boring but important):

 

1) Recent Paper Shows “Significant Net Benefit From Selling Puts” 

According to a 2007 paper by James Doran and Andy Fodor, there can be “significant positive net benefit from selling puts.” The researchers examined the benefits and costs of 12 basic strategies to increase return on a group of stocks using the associated options. They concluded that not a single long options strategy outperformed the market. Conversely, they concluded that selling puts had a significant positive benefit, and that there could be some benefit from selling calls when the leverage used was high enough to overcome transaction costs.

 

2) Short Term Naked Options Are “Highly Profitable”

In a 2006 revision of a past paper titled “Is There Money to be Made Investing in Options? A Historical Perspective”, Doran and Fodor also found that over a long period of time (1970 – 2004) short-term naked option strategies were highly profitable, enhancing risk adjusted returns. They found that selling put options exploited the “crashophobia” of other investors. They also found that selling short-term at-the-money or out-of-the-money call options outperformed on a risk adjusted basis (even though it limited upside gain)

 

3) You Get a Higher Premium From Selling Options on Value Stocks 

Blue chip stocks tend to be more value oriented, rather than growth. In a paper titled “Systematic Variance Risk and Firm Characteristics in the Equity Options Market” Vadim di Pietro and Gregory Vainberg found that options on value stocks are more expensive than those on growth stocks. This makes selling options on value stocks more profitable. This is likely because value investors are more risk averse than growth investors, so as a result they are more likely to try to buy puts on their positions.

 

4) Option Sellers Have Better Returns When Using Low Beta and Low P/B Stocks

Another paper in 2008, titled “Implied and Realised Volatility in the Cross-Section of Equity Options” found that option sellers had a greater net return when focusing on low beta stocks with low P/B ratios. Blue-chip value stocks tend to have both low market betas and low P/B ratios, making them a good choice.

 

5) Lower Commissions for Same Position Size in Higher Priced Stocks 

As a general rule, blue chip stocks generally have a higher nominal share price than small cap stocks. This means that for the equivalent cash-secured position size, we will pay less in commissions for a higher priced stock than a lower priced stock. For example, if we had a $10,000 account, we could sell one put on a stock at $100, paying commission of under a dollar OR we could sell 10 puts on a stock at $10, paying around ten dollars in commission. Keeping commissions low means we get to keep more of our profits.

 

6) Large Cap Value Stocks Have Narrower Spreads, Better Liquidity, Greater Choice of Expiries

Large cap value stocks have narrow bid-ask spreads, plenty of liquidity (in case you need to exit a position in a fast market), and have more option expiry dates to trade. This means that trading blue chips significantly reduces your slippage costs and gives you more flexibility in timing your trades.

 

7) Stable Dividend Payers Have a Natural “Value Floor” in Their Price 

Because we are selling puts on stable dividend players (picked from the list of Dividend Aristocrats), there is a natural floor in the price of the stock. For blue chip dividend payers you are getting paid to simply hold the stock, and the more the stock falls, the greater the dividend yield (and the more attractive the stock) will be. For a high P/E or growth company like Tesla, there is no natural floor – the stock price is based on expectations of cash flow many, many years in the future. Our blue chips have an exceptionally long record of rewarding their owners with steady and increasing cash payments.

 

And those are the reasons why you shouldn’t just blindly sell puts on any old stock. Most importantly, you need to either be happy to own the stock you are selling a put on OR have an exit strategy before assignment. In the next post I’ll discuss why a COUNTERTREND strategy is particularly appropriate for the kind of stocks that we sell puts on.

Real estate vs. Stocks Smackdown – Why Houses Are A Bad Investment

Every now and again my parents ask me “so, have you thought about buying a house and settling down?”

Every time my answer is the same “it’s not the sort of investment that interests me”. And that’s the polite way of putting it.

Here are the reasons I can’t bring myself to buy a house:

giphy

1) Middlemen trying to scam you. In real estate, everywhere you look there is a middle-man trying to take your money. Attorneys to the left of me, accountants to the right. According to Zillow, the average closing costs are 2% to 5% of the cost of the house. Let’s say you’re going all out and getting a $500k house. That’s up to $25k of your money that’s just disappeared in “fees”. Alternatively, you can log into Interactive Brokers and buy $500k of a real estate investment trust for a commission of just a few bucks.

2) You have to put up a chunk of your own cash as a deposit. If we say 25% for this $500k house, that’s another $125k out of your account. The reason this annoys me is that I’m a strong believer in having your money work for you, not vice versa. This money you just plopped down will be the laziest money you’ve ever invested. It will do absolutely nothing because your house is not a productive asset. Your house is a wasting asset. If you do not continually spend money on your home, it will eventually be worth nothing. If you buy a stock you can hold it your entire lifetime without having to spend another dime on it.

3) You’re going to be spending money on it all the time. Just when you think everything works fine you’ll need to fork out a wad of cash for a new boiler. Then there’ll be a problem with the plumbing. Then the electricity. Then your basement will flood and you’ll realize what crappy insurance you have. Oh yeah, I forgot to mention that you have to pay insurance every month too. More paperwork. Whenever anything goes wrong in my current place, I call the landlord and he fixes it for me. I’m the boss.

4) Poor growth history. Ok, you might say it’s worth paying all these fees because you’re getting a good investment. Wrong. Robert Shiller, a Yale economist and coiner of the phrase “Irrational Exuberance” found that between 1890 and 2004 real house returns were just 0.4% a year. All that money that you could have compounding away in a productive asset (like a company) is doing virtually nothing for you. People who seem to think that real estate is a better investment conveniently tend to focus only on what has happened to house prices during their lifetime. They are confusing their own luck (investing in real estate during the biggest boom in history) with skill.

5) Your house will become an albatross around your neck. A long time ago a friend of mine was living with his girlfriend, when he came to me and said “you know, if we weren’t living together we’d probably have broken up by now”. And he only RENTED. If he had bought a place with his girlfriend there’d be no way to get away from her. What happens if your marriage goes south? What happens if you just fancy going to live in India for a few years? A house is an anchor that is very difficult to pull up if you ever decide you want to set sail.

6) Taxes. Unless you live in a caravan, your house is rooted to the ground. This makes it a very easy thing to tax. If a government changes tax policy on liquid assets, then people can move those assets pretty quickly. If a government changes tax policy on houses, that’s just tough for you. You can’t move a house unless it has wheels. But tax breaks are also one way that real estate closes the gap with stocks. The main tax advantages of real estate (mortgage interest deduction and no federal tax up to $500k on your principal residence) are pretty awesome. But just remember, stocks aren’t taxed every year, houses are.

7) High leverage. Every time I argue with real estate professionals about houses vs stocks, the effect of leverage invariably comes up. Everyone knows that you can get a huge amount of leverage when you buy a house. In fact, because houses are so expensive, you pretty much HAVE to use leverage. If house prices go up, this will benefit you. Real estate evangelists seem to think that this means the returns on homes will always be better than stocks, because stocks are frequently bought without leverage. Well, this argument is idiotic. With houses, you are pretty much forced to use leverage, which has its advantages and disadvantages. With stocks, you can CHOOSE to lever up if you want. Pretty much all brokerage accounts let you lever 2:1 (Reg T), and larger accounts let you use portfolio margining (up to around 7:1, equivalent or better than in real estate).

8) Low Diversification. Most people who own houses have way too much of their net worth invested in a single residence. If anything happens to this investment, they are out of luck. Because houses are so expensive, and pretty much demand leverage, you will find yourself pulling your hair out if it absolutely anything happens to it.

9) Terrible liquidity. A house will probably be the most illiquid thing you will ever buy. Selling it will take time and money, so you’d better be 100 percent sure you are buying the right home. If you mess up, you will have just lost a boatload of money. I like the fact that when I buy a stock, I can sell it a week later. Or a month later, or whenever I want the money back.


As a rule, I like my life to be easy and stress free. All the paperwork, middle-men, obligations, and stress that come from owning real estate is just not my idea of fun. If you invest in real estate, you need to know what you are doing. You need to have trusted partners. You need to do your research. Even then, if you use the same leverage as you would with stocks, you will underperform the stock market. With stocks, information is everywhere. If you want a passive investment… just whack your cash in an S&P500 ETF… and relax.

How To Get Paid to Buy Cheap Stocks

There’s this great episode of The Simpsons where Homer discovers that the reason he’s not that smart is that he’s had a crayon lodged in his brain since he was six, which reduces his IQ to 55. He goes to the doctor and gets it taken out, and discovers that without the crayon in his brain, he’s actually a genius.

homer-dohUnfortunately his newfound intelligence alienates him from his friends and family. So he decides to get Moe the barman to stick the crayon back up his nose and into his brain so he can go back to being the stupid but loveable guy he was before. As Moe pushes the crayon back into his brain, Homer gets progressively less smart. Moe keeps pushing it deeper until they realise he’s back to his old self when he announces “Extended warranty? How can I lose?”

It’s pretty much universally known that buying an extended warranty on most things is not worth it, and consumer advocate groups recommend against it. Now of course, with some things buying insurance is a great idea, but it depends on the product and the person.

It’s the same in the stock market – there are some people who really need insurance so that when the stock market goes down, they won’t lose all their money. These people, like people who buy extended warranties, are almost always overpaying for peace of mind. The people who need this market insurance are hedge funds or companies who are judged on their performance on a month-to-month basis. Individuals with a long term outlook will generally not benefit from market insurance.

This means that we are in a unique position – we are able to sell insurance to these folks. We get to collect insurance premium from them. And the more the market falls, the more scared they are, so the more we can charge for this market insurance. We can use this strategy to effectively get paid to buy stocks from these people at a lower price than the current market price.

This strategy of collecting insurance premium is known as writing “cash-secured puts”. It’s called “cash-secured” because you need to have cash in your brokerage account in the case that you have to “pay out” on the insurance you sold. The great part of this is that you are getting paid to buy good stocks at lower prices than you can get in the market right now. Let’s take a quick look at the mechanics of a cash-secured put below.


Let’s say you’ve identified McDonald’s (MCD) as a good stock you’d like to own. As I’m writing this, the stock is trading at about $99. It’s had a bit of a run-up, so ideally we’d like to own it at a lower price. If it fell to $97, then it would probably start to look like a good buying opportunity.

Wrong McDonalds
Wrong McDonalds

In this case we should sell puts on the stock with a strike price of $97. For selling this put option (which will expire in two weeks from today) we will receive $62. (the quote is 0.62, but remember that options generally have a x100 multiplier, meaning that each option is to buy or sell 100 shares, not just one). This is essentially the “insurance premium” we are getting paid.

Now what happens? Well, one of two things can happen:

UPMCD stays above the strike price ($97). In this case nothing really happens. Our net profit on the trade is the $62 we got from selling the put, that’s it. It doesn’t sound like much but that’s an annualised return of nearly 17% – pretty darn good, I’d say.

DOWNMCD dips below the strike price ($97). In this case, we may be obliged to purchase 100 shares of the stock for the price of $97 per share (which works out to be a total cost of $9,700, because each option is for 100 shares). This is why it’s called a “cash-secured” put – we needed to have that cash in our account, just in case MCD fell and we had to buy it. So what does this mean? It means you now own a high quality, dividend-paying company at a LOWER price than what you would have paid for it two weeks ago, AND you get to keep the $62 you got from selling the put in the first place.

Now what? Well, now you can congratulate yourself on buying a good company at a lower price that you would have done, OR you can turn around and start selling a covered call on it.


What are the risks of selling puts?

The only real risk of this strategy is that the company you sell a put on falls dramatically. This is why the strategy is just like collecting an insurance premium. In the example above, if McDonald’s had fallen to, say, $60 in those two weeks, you would have had to buy the shares for $9,700 when they’re only now actually worth $6,000. The person who had bought the put option from you would have saved themselves a lot of money by “insuring” their MCD position with that put option. So how do we reduce this risk of this?

  • We only sell put options on stocks we want to own. You need to be happy if you end up owning the stock because of the put you sold.
  • We only sell puts on high quality, dividend paying stocks with a low “beta”. These are boring, un-sexy stocks that your grandfather would own. These are stocks that have a history of increasing their dividends, and are less likely to collapse in value suddenly. McDonald’s would be considered one of these kinds of companies – over 2008, when the stock market was collapsing around it, shares of MCD actually rose from around $57 up to around $61. You shouldn’t be selling puts on momentum companies that can reverse gears in an instant (e.g. Tesla, or Netflix).
  • We only sell puts on these boring companies when they look like compelling value – they might be trading towards the low end of their P/E ratio, or at a discount to their peers, or they might be heavily oversold. Either way, the balance of probabilities is that over the long term they might increase in value.
  • We sell puts over a number of different companies in different industries. If you only sell puts on BP (BP), ConocoPhillips (COP), and Exxon Mobil (XOM) then you are vulnerable to a single risk factor – oil prices.
  • We also spread our risk out over a number of option maturities.

So there you have it. Selling puts on a stock you like is similar to selling insurance for those stocks. In the rare case that you might have to “pay out” on this insurance and buy the stock from whomever purchased the insurance, you get to own a good stock at a lower price that it previously was at. Be patient and cautious, and only sell puts on stocks you’d like to own, or you too will end up slapping your head and saying “D’oh!”

 

Girls Just Wanna Have Funds – Why You Should Invest Like A Lady (INFOGRAPHIC)

To the ever-lengthening list of things that women do better than men, it looks like we have to add the art of investing. Men are supremely, but mistakenly, confident of their abilities in the market, and it is this confidence that leads us down the path to ruin. So just relax, get your nails done, have a bubble-bath with a mimosa, and come back to the market when you can think like a woman. And above all – trade less often!

 

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easel.ly

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easel.ly

6 Things Options Services Do To Turn You Into A Sucker

Thinking of joining an options advisory service?

Sorry guys. The sad news is that you’d almost certainly be better off just sticking your cash in a bank account.

Take a look at the guy over at Terry’s Tips, who was sued by the Securities and Exchange Commission (SEC), after he allegedly lost between 60% and 100% of his clients’ money. And he’s still in business…

In fact, CNN Money says that you’d be better off just throwing your money in the nearest dumpster than subscribing to investment advisory newsletters. Mark Hulbert of Dow Jones Marketwatch notes that if you had invested $10,000 in a portfolio in 1980 following the advice of the best performing advisory service of the previous year, and then changed it each year to the top service of the previous year, you would have lost pretty much all of your money.

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Here are some of the tricks these guys use to try to turn you into a sucker:

  1. They focus mainly on things which sound positive but generally don’t mean much in options trading, like the win/loss ratio. Who cares? When I was in the graduate training class for the global markets division of a bank, some big-wig came in and asked us all “how often do you need to be right about the market to make money?” The answers we gave generally ranged from 50% of the time or more, but the guy just barked back “No. You only need to be right once”. And he’s right – who cares if you’re profitable on 80% of your trades, if you lose ALL your money on losing 20%? People who sell systems on the internet, that’s who.
  2. They have huge drawdowns but then “learn their lesson”. e.g. 5PercentPerWeek.com lost nearly 95% of its money in just a few days in June of 2011 (and they charge you $239 per month!). Even if you earned 30% per year (considered an EXCEPTIONAL return by absolutely anyone who trades professionally), it would take you nearly 12 years to make back this loss. And just think how much you’d hate yourself for those 12 years knowing what a sucker you were. These services always say they’ve “learned their lesson and changed their approach” after these huge losses… and then a couple of years later the same thing happens. They just lost nearly all your money – anyone who does that should be out of business, end of story.

  3. They hold losing positions indefinitely. Services will frequently “roll out” losing positions until they finally turn around. In the meantime these services give out new recommendations which you can’t act upon because your money is tied up in the losing trade. What’s worse is that they often don’t account for these losses in their monthly returns that they report on their website, because they don’t consider them actual losses until they exit the trade! If a hedge fund guy did this the SEC would ban him from trading and throw him in jail.

  4. They base returns on unrealistic entries and exits, and do not account for commissions. Unless the returns are audited by an accounting firm, there are no checks on the fills obtained by the service. They can pick a day in the past and then they can say they entered on the high or low of the day. What’s worse is that the more people who join the service, the worse the fills you are going to get – Take a look at the option chains for the RUT. You can see the herds of people rushing in and out of positions recommended by these services on the daily volume or open interest metrics. If you get caught in a fast market and need to exit a position quickly, good luck! Hundreds of other subscribers with the same positions need to exit too. And what about commissions? If you have a small account with a broker like OptionsXpress, then you are going to have a big chunk of you money disappearing in commissions (part of the reason I recommend Interactive Brokers and Options House), especially if the services insist on trading a lot.

  5. They assume you can invest 100% of your money in their winning trades. If you’ve ever traded Iron Condors before, you’ve probably learnt that you need to keep the majority of your account in cash for adjustments. That’s not the way the services work though – they’ll calculate their returns based on full investment of the account. If you try and do the same, you will get screwed when it comes to adjusting

  6. And worst of all, they back-test results. This is the most brazen way option services can convince you to join their sites. They simply find a “rule” that has worked in the past, and then post that they’ve made money every year with this rule. It looks great, but how many actual, real dollars have they made? None.

Unfortunately there will always be people peddling these services for as long as there are people willing to pay for them. I’m sure there are people out there who can beat the market, but those people generally aren’t running investment advisory newsletters – they’re running their own funds. Don’t be a sucker.

As always, remember the informal motto of Wall Street – CAVEAT EMPTOR (buyer beware!).