What is investing? Wikipedia defines investment as the following: “Investment is putting money into something with the hope of profit. More specifically, investment is the commitment of money or capital to the purchase of financial instruments or other assets so as to gain profitable returns in the form of interest, income (dividends), or appreciation of the value of the instrument”.
So what does that mean? We all know what money is, it’s the stuff we carry around in our wallets (hopefully), so what are financial instruments? Specifically they are:
• Stocks,
• Bonds,
• Treasury Bills,
• Mutual Funds,
• Exchange Traded Funds (ETFs)
• Options and other derivatives,
• Property, or
• Currency.
Investing therefore, means that you spend your money and in return you receive one or more of the above financial instruments. ‘Profitable returns’ refers to:
• Interest – this is what a company will pay you for the privilege of using your money. Think of a savings account at a bank. You give the bank your money and they use it to lend to other people and businesses. The bank pays you a small amount of interest for the use of your money.
• Income (dividends) – this is a form of profit sharing. When a company makes a profit, they pass some of those profits back to the owners of the company (some they keep to reinvest in the company to help it grow or survive during down times). As a stockholder you are an owner of the business and entitled to a share of the profits that are distributed.
• Appreciation of the instrument – this refers to the increasing value of whatever it is that you bought. For example, if you bought your home for $100,000 ten years ago and today you could sell it for $150,000 you would say that your real estate (real property) had appreciated by 50% or $50,000 in this example.
This all sounds good, but there is more to consider before you plunk down your money and expect to earn a luxury vacation in Cabo San Lucas. Your education is just beginning and the fun is about to start.
You need to understand what your financial goals are and what your position is on risk management. Your goals may include:
• The need to draw an income from your investments,
• Saving for a vacation or major purchase, or
• Planning for your retirement.
Whatever the case, you need to find out, because the answer will determine how you invest.
Many people believe that the more risk you take with your investments, the more reward you receive. This is true to a certain extent. It is also true that the more risk you take, the more likely you are to lose your entire investment. What we are talking about is called risk management and it is very important to understand. Every person is different when it comes to risk. In general the older you are, the closer to retirement you are, the less risky you want to be with your investments. This is because the older you are, the less time you have to recover from a big loss.
For one to succeed in the stock market on their own, they need to commit to learning and commit to having fun. Yes fun. Investing on your own can be very liberating and very rewarding, but if done in ignorance it can be very dangerous as well. Beginners should scan the business section of the local newspaper and look for names of companies that they recognize. Read those articles and get a feel for what is happening with those companies and how they work. Even Warren Buffet, the greatest investor of all time, doesn’t invest in companies that he doesn’t understand.
Using stock charts can provide a wealth of information about how a company is trading. Charts can provide hints of a coming rally or just the opposite is about to ensue. Combined with other buy and sell signals stock charting is a very useful tool.
Charting works because on a large scale human nature is predictable. Not individually of course, but when you are talking about large numbers of people – like everyone who is trading stocks. It is because people follow predictable trading patterns that there are certain chart patterns that can be worth a gold mine. (see my previous post)
These areas of a chart that coax people’s behaviour into buying or selling are often called lines of support and resistance. Don’t be fooled by the name however; they are zones, not hard and true lines. These zones are flexible. In fact, if you see a breach of short term support during an intraday move, you could be getting a signal of strong buyer support.
Winthrop Realty Trust, Inc
Take a look at the above chart of Winthrop Realty Trust, Inc. There are two patterns here to note.
First, look at the blue support line. Throughout most of October the price of FUR dropped below this line, but only intraday. Every time it dropped below the line there was strong buying that pushed it back before the end of the day’s trading. This is a terrific signal that buyers were willing to add to their positions during intraday weakness. Investors were unwilling to sell shares during these weak points. Another key point to note is that volume was strong when it finally did break out.
Secondly, we have a rising wedge pattern. This is very bullish and indicates that a strong rally may soon occur. Again look at the blue support line. Investors were buying the price dips and over time were not willing to let the price fall as far as the day before. The red resistance line indicates that there was reluctance on the part of buyers to pay higher prices. Again for most of October the maximum price investors were willing to pay was around $13. Eventually these two lines meet and the enthusiasm of buyers usually overpowers the reluctance of resistance.
It is a good idea to wait for the market to close before pulling the trigger on your trade. Volume is used to confirm a move in one direction or another. If you had been scared off by the intraday moves below the blue support line you would have missed a lovely break out above the red resistance line.
I seem to be a little early when I’m trying to call a market top. Like 2 weeks early, and during those 2 weeks my positions are underwater. And I get nervous. Then the market reverses and I’m back in the black. This happened all summer long. I’m kicking myself to hold off making trades since I’m always a little early.
Back in April of this year (2010) the S&P 500 had made a huge run off the February lows, but by the middle of that month I had figured that that was enough and I started buying puts. (Recall that if you buy puts you are hoping for stock prices to fall so that your puts will profit). What happened? Well the S&P 500 kept rising and my puts kept falling in price.
Finally the first week in May occurred and prices crashed in a hurry and I made some very nice profits. But they could have been so very much better.
Again in June I was sure the market was going to drop once again. Once again I started buying puts and once again the market kept rising. Finally, the end of June came along and ravaged stock prices even worse than in May. I realized some profits, but once again it could have been so much better.
Additionally, several of my puts expired in June and the move didn’t occur until after options expiration day. My puts were worthless, even though I had been correct on the direction of the move (in stock price). How frustrating – I was right but I still lost money. This is why most people are scared of options.
What about right now (middle of September 2010)? I feel very certain that we are due for a pull back. Many of the leading stocks are over extended. Most are at or above the top line in the Bollinger Bands. All are way over their 50 day moving averages and hitting resistance levels. October is coming and that has been traditionally a bad month for stock prices.
I started buying puts late last week – and once again the market keeps rising. I had a few September puts that will expire nearly worthless tomorrow, but most of my puts come due in October.
The smart thing to do is to establish small short positions and slowly leg into new positions. This lowers your per unit cost (if you are buying puts and the market still rises) and allows you to fill out your position. As this market extends even further the technical indicators are screaming for a reversal. When it comes it will be swift and steep.
A swift downside move is coming. If you’re chasing stocks higher you’re likely to regret it in the days ahead.
Be careful. Plan your trade and trade your plan
One of the best uses for options is to earn an income from your existing shares. To do this you employ a covered call strategy. Remember that when you buy a call option you are making a contract to buy 100 shares at a set price (called the strike price) on or before a specific date in the future. Now let’s consider the other side of this trade.
A covered call: This is one of the most basic options trades and a great way to get started with options. As the name suggests, you sell a call option against an existing share position in order to “cover” yourself. Because there are 100 shares in an options contract, you must own at least 100 shares of a company before you can execute a covered call trade.
You are agreeing to sell 100 shares (for each options contract) at a set price on or before a specific date in the future. You would typically set a price higher than the existing price. This is called ‘out-of-the-money’. If the purchaser of the options contract chooses to exercise the contract (your shares are called away) you are obligated to sell at the contracted price.
When you sell the options contract you receive a premium from the purchaser, which essentially reduces the price you paid for the shares. This money immediately goes into your account to be used however you see fit. You will only be called away (when the purchaser exercises the contract) if the share price increases above your agreed upon strike price.
If this happens then you will have realized a profit on the shares and you will have received the premium as well. Additionally, you will have received any dividends that the company issued (they go to the shareholder not the option holder).
In this way you can earn an income from your existing stockholdings in addition to your regular dividends and you can choose an acceptable level of profit if you do sell. While you are giving up a theoretical unlimited profit (since the share price could theoretically rise to the moon) you are reducing your risk and earning an income at the same time.
There is also a very real possibility that if the share price does not rise above your strike price before the agreed upon date (expiration date) then the options contract will expire worthless. This means that while you earned the premium you did not have to sell your shares. You can then initiate another covered call sell to earn even more income.
There are many uses for options in today’s portfolio, especially for those of us will smaller trading accounts, primarily because with options you can control a large investment at a fraction of the price of buying the shares outright. Additionally, options can allow you to short the market within your registered accounts through the use of put contracts.
It sounds great but keep in mind that unlike owning stock outright, when you own the option you need to be correct in both the direction of the move and the time of the move of the underlying stock price for you to make a profit. Otherwise your option will expire worthless.
Basic bullish strategy:
Remember that when you buy a call option you are making a contract to buy 100 shares at a set price (called the strike price) on or before a specific date in the future. You are hoping that the price of the shares on the open market will increase above the strike price so that you can profit. Profit by either exercising the contract and purchasing the shares at the strike price and then selling on the open market for a higher price. Or you can profit by selling the contract itself.
Basic bearish strategy:
When you buy a put option you are making a contract to sell 100 shares at the strike price on or before a specific date in the future. You are hoping that the price of the shares on the open market will decrease below the strike price so that you can profit. Profit by either exercising the contract and selling the shares at the strike price and then buying them back on the open market for a lower price. Or you can profit by selling the contract itself.
To novice investors selling shares before you have bought them seems problematic but in reality what happens is that you borrow them from your broker – sell them at the strike price, and you realize the profit when you buy them back on the open market at a cheaper price.
The above strategies – buying a call or buying a put – are just two strategies that one can employ to take advantage of the power of options. If fact these are quite basic strategies and more experienced traders use a combination of options contracts to both earn income from their existing shares, buy new shares at a lower price than they could otherwise, buy insurance for their existing positions and take advantage of large moves in the underlying shares no matter if that move is positive or negative.
Check back tomorrow for a discussion of some of these strategies, and how you actually use options to reduce your overall risk. The Chicago Board of Options Exchange website has lots of information on options contracts and how they work, it is worth a look at the above link.
Yesterday we talked about how to take advantage of the coming bankruptcy of General Electric. Specifically we looked at buying LEAP puts that would allow us to generate excellent profits when GE stock drops. The major advantage of this method over shorting the stock is that investors can do this within their registered accounts (RRSP or TFSA, etc), since Canadians are not allowed to short stock in these accounts. (Americans are also not allowed to short stock in their 401K accounts).
There is however, another method of playing the market to the downside within your registered accounts, and that is with inverse ETFs. Exchange Traded Funds are essentially mutual funds that attempt to mirror a specific index in the market. They come in a wide variety and include one, two and even three times market risk as well as positive and inverse.
This means that if the index moves up 3% then the ETF will move up 3%, 6% or even 9% depending upon which fund you’ve chosen (or drop 3%, 6% or 9% for the inverse ETF).
If you buy shares in an inverse ETF like Horizon’s TSX60 (symbol HIX) which is a one times market risk fund then when the TSX60 drops in price your fund (HIX) rises by the same percentage. For example the month of May 2010 has been terrible for the markets. From the 1st of May to the 24th the TSX had about an 8.9% drop. The HIX, since it mirrors the TSX60 and is also an inverse fund, had a rise of 8.5%. That’s a very nice gain during a terrible three week period.
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If you had bought the two times market risk ETF called TSX60 bear plus (symbol HXD) you would have realized an 18% gain (from $11.18/share to $13.20/share). 18% in just over three weeks is sensational. Annualized that works out to a nearly 270% gain.
This all sounds amazing, but of course there is a catch. These ETFs are designed to match the daily performance of whichever index they are following, and as such they reset each day. What this means is that if there is a large sustained move in the index (like we’ve just seen) they will perform as expected. However more often the indexes move in fits and starts from day to day. The ETF will try to match the day’s gains or losses and over the long term will fall short of expected performance.
This is why I recommended a LEAP option rather than an inverse ETF. Also with the LEAP you can play an individual stock rather than an entire market segment. Basically the LEAP is a much better way to go - for these three primary reasons...
• Just like an ETF, it gives you the chance to benefit from a sustained move lower or higher.
• It requires much less cash upfront, which provides greater leverage.
• It gives you lots of time for the move to play out as you want it - up to three years in some cases.
Sometimes you want to play an entire market segment (like when the price of oil spikes and you know the transportation sector is going to get hit hard with high gas prices, but you don’t know which individual company will be impacted the most) and ETFs are the perfect way to do so. They have very low management fees, can be bought within your registered accounts and can take advantage of moves lower or higher.
For General Electric however you are better off with the LEAP play mentioned yesterday. Just remember that bulls make money in the market, bears make money in the market, but pigs get slaughtered. Don’t be a greedy pig.
One way to play the pending bankruptcy of General Electric is to purchase LEAP puts. In a registered account (RRSP or TFSA) you cannot short stock directly, however you can purchase PUT contracts. A few weeks ago you could purchase the January 2012 $17.50 puts for under $3.25 per contract. Last week you could have sold those put contracts for $4.70 for a nice 45% gain in just two weeks. However I recommend that you hold out for more.
There are two types of equity options, calls and puts. A call option gives its holder the right to buy an underlying security, whereas a put option conveys the right to sell an underlying security. The option also spells out the price you can buy/sell the security and the date that the option expires.
Essentially you are agreeing to (for a CALL) buy shares of a particular company for a set price anytime into the future up to a particular date. For a PUT you are agreeing to sell shares of a particular company for a set price anytime into the future up to a particular date.
Long-term AnticiPation Securities, or LEAPs, are just longer term options. You can exercise them any time you wish (up to the expiry date) or trade them just like you would any common shares through your broker.
So if you had purchased the LEAPs contract mentioned in the first paragraph you would be agreeing to sell General Electric common stock for $17.50 per share. And you would be agreeing to do this anytime you would like between now and January 2012. You would have paid $3.25 per share for this right.
Since each contract controls 100 shares your purchase price would have been $325 per contract plus brokerage fees. If GE stock drops, between now and January 2012, below $14.25 then you realize a profit from the contract.
Say the stock falls to $12 by January 2012. You could exercise the contract by buying GE stock on the open market for $12/share and immediately sell it for $17.50/share. Remember this contract cost you $3.25/share so your profit would be $17.50 minus $12.00 minus $3.25 equals $2.25 per share. (Not including brokerage fees).
Now imagine if GE stock went to $0.01/share. Now calculate your profits.
Alternatively, you could just sell the contract to someone else. In the above example you wouldn’t make the full $2.25/share but you wouldn’t have to outlay the capital to buy the GE stock and then exercise the contract by selling the GE stock. Simply selling the contract is much easier and less of a hassle.
The advantage of purchasing a LEAP contract rather than a regular option contract is that it gives you more time to be right. It gives you more time for GE to go bankrupt.
Each option or LEAP has both intrinsic value and time value. With GE stock at $12/share the intrinsic value of the put contract is $5.50 (since you could exercise the contract and realize a profit (or be ‘in-the-money’) of $5.50/share). However there is also a time value that can be added to the price of the option. Generally speaking, the more time there is before expiration the greater the time value of the contract.
Therefore, if GE stocks drops this year or even early next year not only will you be able to realize a handsome profit much sooner, that profit will be much larger too (since it will include the intrinsic AND the time value of the contract).
General Electric stock recovered slightly last week and these LEAP contracts can now be purchased for approximately $4. On any further strength in GE stock this next week, there might be a buying opportunity to take advantage of GE’s impending bankruptcy.