Dear Investors,
Lately, I’ve heard from a few different people about some disastrous trading experiences that have occurred from following newsletters and/or broker recommendations. These stories really can be upsetting as people are basically lighting their hard-earned money on fire on activities where the odds are stacked against them. I wanted to write about a few things to watch out for.
During just about any market downturn, questions are asked about if it makes sense to buy puts to “protect” the portfolio. In some strategies, buying puts can be a form of insurance, in that puts increase in value when the underlying stocks decline in price. This is the opposite of a call, which increases in value when the underlying stock increases in price. The idea of buying “protection” sounds wonderful, but it can be a little misleading when it comes to purchasing puts. Below I’ll outline a few of the big problems:
Buying options and puts in particular, is a very expensive endeavor. You must pay a premium each time and the higher the implied volatility in the stock or index, the more expensive the puts are. It isn’t uncommon to have to pay a minimum of 4-6% in premium to partially hedge your portfolio, which comes directly out of your returns. When the puts expire worthless, you lose 100% of that hedging cost. One might argue, this is the same with any insurance, but I’ll explain a key difference. If you buy fire insurance for your home, you pay a premium, which you also lose if you don’t have a fire. However, if you indeed have a fire, you are able to collect on that insurance and it will materially mitigate an absolute financial disaster.
“It isn’t uncommon to have to pay a minimum of 4-6% in premium to partially hedge your portfolio, which comes directly out of your returns. When the puts expire worthless, you lose 100% of that hedging cost.”
When you buy options, you are betting on two things simultaneously. You are picking the direction and also the timing at which the stock will move in that direction. That is exceptionally hard to do consistently and in most cases is impossible, which is why you won’t find any option buyers in the Forbes 400, but instead you find investors in actual businesses. Even the best stock pickers struggle with timing. A stock can be a great investment, but still sell off in the short-term with the general market, or a broad industry downtrend. The problem with buying the options is that time is constantly working against you. Time is one of the important factors in the pricing of options, so even if you are 100% right on the direction of the market move, but you are slightly wrong on the timing, the option purchase will still likely be a big loser.
Like any form of insurance, the majority of puts you buy will lose you money. That can be very challenging for people to deal with emotionally and financially. Stocks are built to go up over the long-term, so it can be immensely agitating when you are throwing away money. What is so frustrating about purchasing options though is how difficult they can be to manage. Let’s say you bought puts on the S&P 500 to hedge your stock portfolio and you actually guessed right on the timing. Right after you bought the puts, the market drops 10% and your options have tripled in value, helping to offset a portion of your losses on your long-stock portfolio. At this point, you are faced with a difficult predicament. The point of the puts is to hedge your portfolio so since you are still long stocks, it can make sense to keep your puts to maintain the hedge, otherwise you will no longer have the protection.
However, if the market rallies, those puts decrease in value and as time elapses, they could ultimately end up worthless. If you exit the puts and the market drops another 20%, you are going to be very mad at yourself. If you hold the puts and the market rallies, you will be frustrated you didn’t cash out the puts. So not only do you have to be right on the timing and direction of the entry into the puts, you also have to be right on the exits of them. Imagine doing that consistently and how realistic that really is. Many people will try to say that technical analysis or some magical newsletter is the key. Show me the chartist in the Forbes 400, or the newsletter writer for that matter. Fire insurance definitively protects you if you have a fire and there is no need to predict whether the fire will get worse or not, like you do when you buy put options.
I am not kidding you that I have seen firms where 95% of the clients lose money, many of which lost everything. The quickest way to do that is via the purchase of options. The other easy way to lose just about everything is by using too much leverage. At T&T Capital Management, everything is geared towards giving you the advantage, instead of being the sucker at the roulette table.
“I am not kidding you that I have seen firms where 95% of the clients lose money, many of which lost everything. The quickest way to do that is via the purchase of options.”
We protect our portfolios via a number of ways.
• Firstly, we only invest in undervalued securities, which we find utilizing extensive research and analysis.
• Secondly, we take advantage of the fact that historically about 3/4ths of options expire worthless, so we sell cash-secured puts and covered calls on these undervalued securities.
• We don’t buy options and gamble.
• We ensure that in each security that we own, we have a substantial margin of safety. This means that if things go worse than we expect, we have a cushion to protect us from losses.
By selling cash secured puts, we obtain a further cushion from losses from the discount in the strike price to the market price, and the premium that we collect. Often that cushion can be 10-15%. All we need to do is let the time elapse on the options to see the full benefit, which of course is the opposite of buying options when time is working against you.
The reality though, is that many people will be suckered into buying options. The pitch is sexy. Trading sounds so great, as they sell it as though you can make money in any market conditions. Sadly, retirees often fall victim because they find themselves with far more time on their hands all of the sudden, so it seems like it can be fun and lucrative. Short-term trading is like gambling and even when you make money a few times, you almost always will be a net-loser in the game. If something sounds too good to be true, it usually is. Investing successfully can be boring but it is immensely lucrative. There is a huge opportunity cost to not investing intelligently.
“The reality though, is that many people will be suckered into buying options. The pitch is sexy. Trading sounds so great, as they sell it as though you can make money in any market conditions.”
If someone is pitching you on some exotic option-buying strategy, here are some things you can ask for to make sure you are seeing the full picture.
1. Can I see actual statements covering at least 5-years of trading using this specific strategy? Also, I’d like to see statements corresponding to any other strategy your company has been pitching over the last 5 years.
2. What percentage of your net worth do you have in this strategy you are selling? Does that number match the statements? How about your family, are they invested?
3. What are the total costs per annum and how do they compare with alternatives?
4. What percentage of my gains are long-term versus short-term and how can this be tax-efficient?
5. How are you being compensated?
Keep in mind that trade suggestions and actual trade prices can be very different. Focus on the actual prices, as opposed to the stated price at the time of the recommendation.
My intention in articles like this is only to provide insights from our team’s experiences in the industry. Collectively, we have nearly a century of experience between us and many of you know that we are ardent students of history too. We take tremendous pride in what we do and the fact that we invest our own money in the same strategies as our clients do. It is a tragedy when we hear about people being taken advantage of in this industry and we will do everything we can to give you the framework to not be a victim.
Often times the sales person doesn’t know better but just follows the company line. Not everyone is a mastermind conman, but naivete can be just as costly. As always, please don’t hesitate to use us a vetting resource for any financial questions. I’m proud to say that we have successfully talked people out of a variety of different Ponzi schemes and other costly mistakes, so we are always willing to take the time to help. I can be reached at 805-886-8140 anytime.
Thank you very much and as always, we thank you for your trust and business!
Sincerely,
Tim Travis