Traders Edge Blog

Musings from the Editor:
Buy and Hold—Not so Much…

Death and taxes…two things assured in life, no doubt. Right up there would have to be…advice. Doesn’t matter the issue, you can count on receiving advice from some quarter (generally many, and often conflicting) as sure as you can trust the sun rising each morn.

Now some advice is good—truthfully intended for our benefit and more often than not appreciated. Other forms are well intended, but actually of no use—some even nonsensical. Take for instance the advice delved out by many a mother regarding never leaving the house without “clean drawers” on. You know, the “You need to have on clean underwear in case you’re in an accident” spiel. As well intended as that might be, fact is one accident tends to create another, of a sort…or, summed up more precisely by comedian Bill Cosby, “First you say it and then you do it.”

No matter the type, all advice contains some element of being self-serving. And there’s nothing wrong with that. Your mother’s advice is given out of love and is generally selfless in nature, but it still serves her because “she” wants you to be secure and happy in life—that makes her happy. Same holds true for the car dealer selling you a car or the expert providing you with guidance. Sure, any good advice comes at a cost, but you receive value or utility of some sort; both sides receive benefit, which is the very essence of good commerce.

Advice of a Different Sort

Then there is the advice that goes beyond the selfserving nature of marketing and that can be extremely detrimental…even dangerous. The type of advice that is misguided at best…some would label it downright deceitful. Knowingly or not, the advice is often condescending and cynical at its core, yet couched as if for our benefit.

There’s a fair argument to be made that the “buy and hold” approach long perpetuated by the financial services industry and on Wall Street is a classic example of just such advice. No doubt that sounds a tad incendiary and conspiratorial, but that’s not my purpose here nor do I view it in such cynical fashion.

That said, I do think it’s fair game to question the buy and hold approach—put it to the test, as it were.

Who does it Serve?

The message varies, but in general the overall argument is premised on the fact that over the long haul the markets have invariably gone up. Given that the all-time closing-level low for the INDU was 28.48 back in 1896 and the all-time closing high of 14,164 was set in October of 2007, that fact is incontrovertible.

In that light, it would appear that buy and hold does indeed hold water. Notwithstanding inevitable periods of volatility or decline, a person should expect to be duly rewarded over time for simply buying and holding shares of quality companies.

In fact, that’s been the coordinated mantle of the financial services industry for many years now. They have effectively created a collective marketing message that kindly instructs the mass assemblage of unsophisticated investors that they need not worry themselves with
matters financial. In a real sense, the message has been and remains “leave it to the pros” amongst many on Wall Street. For good measure (and our benefit…lol) they also tell us we can’t make money trading or investing on our own… but that’s another discussion altogether. Self-serving tripe if ever I’ve heard any… but I digress….

Cry Uncle or Hang Tough?

Back to the numbers, a move from 28 to more than 14k is indeed impressive. What those numbers don’t show is the price action in the intervening century. The INDU traded to a pre-depression closing high of 381.17 in September 1929. Within a couple years time it erased nearly four decades of gains. The INDU wouldn’t close above the 381 mark until 1954, some 25 years later.

Don’t know bout you, but holding for 25 years to get back to even (which actually doesn’t account for inflation) is beyond my comprehension or capability. I would most certainly have cried uncle…most likely at the least advantageous time. I suspect there are more than a few peeps who’d have acted in similar fashion.

But that was all an anomaly due to the depression, correct? Not so much… We’ve endured numerous periods of range-bound movement and a fair number of decade-plus bear markets in the interim. Objectively, we’re in one now. Even accounting for some impressive upside moves to record levels in 2007 and good rebound action from the market meltdown more recently, the SPX is still under water from 2000. In fact, the index returned a negative 18 percent between 2000 and 2010. The good news is the SPX is currently up nearly five percent from the 1257 close at the end of 2010… Sizzling!!!

K, enough jest…you get the picture. Simply stated, there have been myriad periods where buy and hold doesn’t work in the practical world. Fact is that at a certain point it’s no longer prudent to hang tough…it ain’t arm wrestling. In fact, one of the first things you should have learned as a trader or investor is that you never enter a position without having pre-determined a prudent stop—simple trade and account management.

One-Sided Approach

Back to the point of assessing buy and hold, the bigger issue is the fact that such an approach is one-sided. Yet the markets move in three-dimensional fashion—up, down, sideways, chop, reversion to mean, etc. Sometimes they move with conviction and more often than not they languish and chew up the same ground.

That being the case, it would seem folly to come to the table armed with a single strategy, the success of which is predicated on markets going up. Moreover, relying on a “wait it out” approach as a stopgap just seems…painful— very much like watching Lucy pull back the football on Charlie Brown over and over…

And, correct me if I’m wrong, but isn’t the point to make money? So why wouldn’t you arm yourself with multiple strategies, each optimized for the different types of action we see in the market. More to the point, each fashioned to work with specific trends over different time frames. Hmmmm…what’s a good way to put that concept so it makes sense? How bout “the trend is your friend?” Naw, it’s just not catchy enough—no one will ever use it. I’ll work on it…….

Bottom line, markets move where they will and at their own pace. Sometimes it’s pretty predictable and at other times…not so much. This simple fact tells me you have to apply different tactics for different market conditions and always stand ready (anticipating) to adjust your strategy accordingly…end of story!

Were it only true that a simplistic one-size-fits-all scenario, such as buy and hold, could deliver returns capable of securing our financial well-being. If so, we could all call it a day and go hit the beach, a favorite trail or manage to drop that handicap to single-digits.

Well, now that we’ve debunked it, we can surely expect the buy and hold proponents to leave us be. Color me jaded, but I don’t see that happening. Seems peeps just can’t stand to pass up the opportunity to dole out advice, no matter how misguided it might be.

My advice (c’mon, you knew it was coming)—check your drawers on the way out the door…

Happy 4th – enjoy it and stay safe!!

Louis Horkan
Editor

 

Louis entered the biz in the late 80s and spent over a decade working as a trader, instilling him with unique insight into trading and the markets. In 1998 he switched gears to become the group editorial director for a large network of award-winning, trading-focused newsletters. In 2002 he became the founding editor-in-chief for two financial trade magazines—each served approx. 40,000 independent financial advisers nationwide. He’s appeared on business TV, in the business press and on numerous biz-focused radio programs in the past. He writes market commentary and analysis most days and trades on a daily basis.

Coaches Corner:
Welcome!

Welcome to the Coaches Corner. It’s a great place to tap into a wealth of knowledge in each monthly newsletter. Our experienced coaches have decades of options trading experience and will share their thoughts, strategies and trading ideas in this section each month..

You’re sure to benefit from the thoughts and insights you’ll find in each issue of Coaches Corner, provided by some of the sharpest and most experienced option traders around. We plan to discuss issues ranging from specific strategies and trades to general market analysis and tips and tricks to help improve your trading—information you’re sure to find priceless.

Allow me to introduce myself. My name is Mike Curtis and I have been an active option trader for eight years now. I have personally coached and worked with hundreds of traders just like you, focused on helping them find a successful system that they can implement over and again.

Throughout years of trading successes, having personally paid some “market tuition,” and working with all types of traders to help them find their pathway to successful trading, I’ve found there’s ONE common mistake most traders make. I know sharing this bit of information can help any trader, whether you are a beginner just getting started or a seasoned veteran with years of experience.

Most traders entering into the world of option trading usually start out as option buyers— especially call options—as this closely simulates buying shares of stock, which most traders can relate to. Buying a call option gives you the right, without any obligation, to buy shares of stock at a specified price, called the strike price. For example, if you buy a 50 strike price call, you have the right to buy shares at 50. If the stock goes higher, the value of your call option will increase since you maintain the right to buy the stock at 50.

Sometimes your gains can be exponential when you buy a call option and catch a large move up in the stock. A 50 strike price call expiring a few months out in time might only cost a couple hundred dollars. If the underlying stock moves five to 10 percent, you could see your option contract almost double in price in some cases! (This is a generic example and there are several variables to consider, but it illustrates the profit potential)

Buying calls (or puts) can be slightly addictive mainly because of the high rates of return that can be achieved. You can see a couple-thousand dollar investment double or triple if the stock makes a decent move in your direction.

I have seen MANY traders narrow their focus and try to implement a trading plan consisting of 100percent call option buying. This is a path to a very short trading career in most cases. The problem with buying options is that options have an expiration date and depreciate. You determine before buying which expiration period you want to trade, but as that expiration date approaches the option will start to lose value. Imagine buying a new car for $50,000; after a few years that car will have depreciated by maybe 50percent or more. Ten years later that $50,000 car is only worth a few thousand dollars. Options depreciate at a similarly rapid rate, but on a shorter time frame. A portion of their value is ‘time value” and that time value will decay rapidly, especially on options expiring in just a month or two.

In my experience of working with hundreds of traders, purchasing a call option is one of the hardest ways to make money in option trading. The time decay working against you proves difficult to overcome. You could buy a call option, have the stock climb slightly higher, and still lose money. The stock could trend sideways or not move much at all, but the time decay can still cost you dearly. If the stock were to drop, you take an even bigger loss as the option loses value.

Options are fairly cheap compared to the stock price, so they are appealing in that sense as well, but that cheap cost can also lead to being reckless at times. It is not uncommon for me to see people take a 100percent loss on an option purchased that expires with no value. Luckily, people don’t usually invest as much into an option contract as they would into a stock position. That said, even with a cheaper option contract, the losses can really start to add up.

So how can we stack the odds more in our favor? How can we avoid falling into some of these tough situations that can occur when buying options? Let me clarify, we still buy options… once in awhile. It is a small piece of our overall trading plan and we always control our positions sizes. However, the bulk of our trading focuses on taking the other side of the option contract. We can really put the probabilities in our favor by being option sellers, so let’s talk about how this can really help improve your trading.

By selling options and taking the other side of the option contract, you flip the time decay on your side. Now as time decays you profit from it instead of the decay hurting your position. Why is this so important? Well, we ALWAYS know time will pass. It is really the only true constant in the market. Also, whether the stock moves in the direction you are hoping or if it just stays flat, you can still profit.

Here’s an example:

If a stock is trading at 101 and we sell a 100 strike put for $2.00, the stock could go up and the put would expire worthless. We’d keep the full $2.00 per share as profit, or $200 per contract. The stock could stay at 101 or drop a bit to 100 and we could still keep the full $2.00. In fact, we don’t start losing money (at expiration) until the stock drops below 98 per share, in which case we would need to buy back the sold put and close the position. That in itself gives us a statistical edge. The stock could move up, stay flat or move slightly down and we can still make money.

(Note – selling a put is a bullish/neutral trade while buying a put is a bearish trade. It is easy to get confused when thinking about selling options until you gain experience)

Next, we layer on a high probability setup (compelling news, strong reaction to earnings, a pre- announcement, etc.) where we know a stock is likely to behave in a certain way and now we’ve really stacked the probabilities in our favor!

Selling the option is only part of what we usually do. It’s crucial to add protection to your

positions when selling your options. If selling a put, you add protection by simply buying a put contract as well. This turns the trade into an option spread. If you sell an option without buying a position to cover (a naked position), your broker will most likely hold a large margin requirement for the position. Let’s look at another example:

Following the previous example, if the stock is trading at 101 and we sell a 100 strike price put for $2.00, we would then go out and BUY a protective put at the 95 strike price or lower. Now your broker will recognize your obligation to buy stock at 100, but you’ve covered the position by buying the right to sell at 95, capping your risk at $5 per share, or $500 per contract. Adding the protection covers you from substantial loss if the stock really falls apart, but if the stock still goes up, sideways or down slightly we can still generate a phenomenal profit with limited risk.

If you have never sold options before or traded option spreads in the past, I would recommend trying it in a virtual/paper account first. It is always helpful to get some practice to ensure you avoid silly mistakes before putting your hard-earned capital at risk.

The next time you see a stock that you feel is likely to move higher, consider utilizing this high probability strategy to take advantage of the move instead of simply buying the call. If you start incorporating more option selling and spreads into your trading plan, I think you’ll find yourself winning on more trades, being more consistent and experiencing fewer big drawdowns in your account equity curve.

Happy Trading!

Mike

 

Mike Curtis has been an active trader in the derivatives markets for 8 years. He has mastered the world of equity and index options along with spread trades, futures and foreign currency. He loves teaching and has personally coached over 500 individual investors needing help learning to apply a consistent trading method. Through his mentoring, he has helped hundreds of people change their financial situation through trading in the financial markets. He is a husband and father of 4 young children currently lives in Salt Lake City, Utah.