What if a stock has run out of steam and we’re anticipating a period of consolidation or lower volatility for a period of time? What if we have identified a range-bound stock and we want to take advantage of this price pattern behavior? We can achieve this by trading low-risk, high-reward options strategies! The two strategies we’ll discuss in this chapter are the Butterfly and the Condor, both of which produce profits provided the price remains within a certain price range, determined by the Exercise prices we select.
Butterflies
The Butterfly involves the following steps (you can use all calls or all puts with the Butterfly—you cannot mix the two):
Butterfly with Calls
Step 1 Buy 1 lower strike (ITM) call
Step 2 Sell 2 middle strike ATM calls
Step 3 Buy 1 higher strike (OTM) call
There are two key points here:
- The ratio between buying the ITM call, selling the ATM calls, and buying the OTM call is 1:2:1.
- The distance between the three adjacent strikes must be equal, with the middle strike being ATM or as close to ATM as possible.
Read the rest of this entry »
Delta The speed of a Straddle’s position accelerates dramatically Near the Money. Delta is
negative when the stock price is very low and accelerates into,a positive value when the stock price is nearer and above the strike price. This shows us that when the stock price is lower than the strike price, further down movement is profitable, and when the stock price is higher than the strike price, continued up movement is required from the stock to make the Straddle profitable. Delta’s profile is somewhat “S’ shaped. Delta will generally be less than one (for one contract) when the stock price is ATM. This signifies that at that point, the value of the Straddle will vary with the stock price, but at a reduced speed.
Gamma Gamma is always positive with a long Straddle and peaks where delta is rising at its
steepest angle. This invariably occurs Near the Money, indicating that the Straddle is very sensitive to swings in the stock price at these levels.
Theta Time decay affects the Straddle detrimentally. Theta assumes a “V” shape and is almost
entirely negative, forming its trough At the Money. This makes total sense because with a long Straddle you are buying two options premiums and are heavily exposed to time decay. Where the stock price is far lower than the Straddle strike price, theta can have a fractional positive value.
Vega Vega is entirely positive and forms a mountain-top shape, peaking At the Money. With the
vega value peaking ATM this indicates to us that a small increase in volatility is going to increase the value of our Straddle position markedly. Read the rest of this entry »
Delta Delta peaks in between the two strike prices (i.e. near the money)—notice the difference
between the one-month Delta profile and the one-week delta profile. This shows us that small movements in the underlying stock price at these levels will have a more dramatic impact on the value of the Bull Put position. Delta becomes much more sensitive as time decays. This means that the Bull Put risk profile itself becomes much more sensitive as time decays. This is because Time Value is depleting to negligible levels, and so the stock movement is being followed almost exclusively by Intrinsic Value at these levels. Notice that as the stock price veers away from the money (on both sides), Delta is hardly sensitive at all and that the most sensitive Delta action is occurring close to the two strike prices.
Gamma The acceleration and deceleration of Delta is reflected in the Gamma values. As you would expect, Gamma peaks in positive territory where the stock is just below the lower strike price and troughs into negative territory where the stock is just above the higher strike price. Read the rest of this entry »
Is your advisor or broker honest with you about his motivation and how he is compensated? Beware of brokers who try and sell you that their superior performance and low annual fees will more than compensate you for a 5 percent upfront charge. You should not pay a load or sales charge when buying a mutual fund, but people routinely do.
Similarly, steer clear of advisors who use “soft dollar” commissions to pay for their bills. These commissions encourage advisors to trade your account and create more revenue for their firms. Finally, run from brokers and advisors who push their own in-house funds. They are given incentives to push these funds without regard to their fees or performance. This doesn’t mean that all in-house funds are bad, only that these brokers and advisors are not always considering if they’re the best investments for you.
Sloth can cause you to give any of these advisors a pass or fail to realize what they’re up to. You may also lust after advisors with great reputations and who offer promises of incredible performance, overlooking their fees or questionable tactics. The best way to honor your financial advisor is by choosing one whose only fee is based on a fixed percentage of the assets you have under management and evaluate this individual based on comparisons with a reasonable benchmark. Read the rest of this entry »
I am always amazed when investors fail to consider after-tax returns in assessing their performance. Perhaps this oversight is a direct result of the sin of pride—they can’t puff up their feathers and crow as loudly with an after-tax return number. Perhaps it’s a result of envy—they are driven to brag about their great results and lesser results won’t allow them to respond effectively to their feelings of envy. Perhaps it’s simply sloth— they are too lazy to think about the difference between after-tax returns and pre-tax returns or to do the math. Whatever sin causes them not to obey this commandment, they end up deluding themselves about how well their investments are doing.
Similarly, some investors sell a stock before it becomes eligible for capital gains treatment. For investors in the highest tax bracket, the difference is 15 percent instead of 35 percent if they hold the stock for a year and a day. Gluttons, of course, lack the patience to hold their stocks for that long. Angry investors, too, may be so upset that a stock has failed to meet their expectations that they may sell it because they have so much animosity toward it, heedless of the tax consequences.
If you want to adhere to this commandment, ask yourself the following questions:
- Am I using every possible dollar in tax-deferred, retirement-type vehicles, such as IRAs or 401 (k)s?
- Am I taking full advantage of 529 college savings plans?
- When thinking about fixed-income investing in a fully taxable account, am I aware of all my tax-exempt options and what the net yields are?
This is a counterintuitive commandment. Normally, when the market experiences a significant downward trend, people sell off some of their holdings or even get out completely. Vanity makes it hard for people to face their portfolio’s decline in value. Anger with the market makes them want to get out. Instead, these down periods are opportunities to invest a bit more than normal.
In moments of doubt, consider these facts: The Dow dipped below 8,000 after 9/11/01, but then rose to over 10,700 within six months. At the beginning of the Iraq war in March 2003, the Dow went below 7,400 and was over 10,000 by the end of the year.
The market is more resilient than anyone thinks during the times when it reaches its nadir. Time and again, it has bounced back, and you want to be invested in it when it springs upward.
This one is simple. Don’t invest with vengeance in your heart or any heated emotion driving your decision-making. Wrath, envy, and vanity are three of the sins that can cause you to invest in highly emotional states. You need to be aware of your emotional temperature when considering an investment, and if you find yourself upset, thinking about getting revenge, or furious at friend, foe, or the investment vehicle itself, give yourself a time out for a day or longer. Calm investors have a far better track record than highly emotional ones, and you need to keep this in mind or you’ll become even angrier when your hot-tempered investment doesn’t pan out.
Thou shall not commit adultery chasing some flashy little stock of the moment.
As much as I repeat this commandment, I know that daily price movements seduce people into betraying their long-term commitments and go for the most attractive investment at that particular moment. To Put it more bluntly: Don’t buy something just because it’s “hot.” Once you recognize that it’s hot, you’re probably already too late. Force yourself to think long-term, even when you’re tempted by what seems to be a short-term sure thing.
Anger becomes a deadly investing sin when it isn’t managed. Anger in itself isn’t a problem; the actions it prompts you to take, though, can cause major losses. To help you prevent these losses, here are two sets of tips. The first relates to monitoring your investing moods; the second involves avoiding specific, anger-induced investing mistakes.
Mood Monitor
If you’re vulnerable to the sin of wrath, you need to be vigilant for signs of anger in all its forms when you’re contemplating your investments. Be alert for the following emotions and take the suggested precautions if you spot them:
1. A red-hot desire for vengeance. You want revenge against the market in general or a broker who you feel gave you bad advice or the media for ruining a great investment. When you’re contemplating a given investment, all you can think about is how the “enemy” will rue the day they crossed you. Your goal is not financial as much as it is that sweet feeling of defeating your adversary. Read the rest of this entry »
To a certain extent, all investors react to good or bad news regarding the market. Investing gluttons, however, overreact. They are so hungry for action, they respond to the rumor of a merger or the hint of regulatory move by buying and selling. They become so worked up at the hint of bad news involving a stock they’re holding that they reflexively sell; they become so eager for profit at possible good news that they immediately buy.
The irony is that these gluttons think they’re getting a jump on the market, but in reality, they’re lagging behind it. Stocks can often move before the first trade by 5 percent on good or bad news. As a result, investors that use good or bad news as a trigger for a trade usually are dealing with unfavorable price movement. They deceive themselves into thinking that by reacting quickly to a news report about a stock or a broader economic trend, they are going to get a jump on other investors. In reality, they are lagging behind the market as well as other investors who make less frequent but more strategic investing decisions. Read the rest of this entry »
1. Lose Money
Like Maria, most gluttons rationalize their investing behaviors. They equate action with money: You’ve got to play if you want it to pay. This may be true if you are a trader in Chicago Board of Trade, but for the rest of us, frenetic investing usually results in losses rather than in wins. Gluttons invest burdened by four weaknesses that they may be unaware of or that they may discount. Let’s examine these four vulnerabilities and why they should not be discounted: Read the rest of this entry »
Sloth is often a function of time. It may be that you don’t have the hours or don’t want to put in the hours necessary to be a good investor. That’s fine. Though there is a minimum amount of work every investor needs to do, you must find the right investing mode given the hours you are willing to expend. Your sloth may result from being in the wrong mode; you’re trying to do it yourself when you really should be relying on a money manager. The three modes, therefore, are:
- Doing it yourself
- Focusing on mutual funds
- Using a money manager
Read the rest of this entry »
In other words, don’t worship profits and take them just because you have them. As tempting as it is to book a profit when stocks do well, many times it’s wiser to hold on to the stock and wait for its price to rise further over time. Before making a decision, examine the company before you bought it, look at what has transpired since, and then ask yourself the following questions:
Have the earnings grown faster than market expectations?
Has there been some positive event that may allow for greater growth in the future?
Be aware, too, that if you have held the stock for months or even years without much positive movement and it suddenly shoots up, your temptation will be to sell in what seems an anomalous period. Before selling, though, do your research and see if this really is anomaly or if it is just the start of a longer-lasting upward trend.
I remember buying Cummins, Inc. (CMI), an Indiana-based engine manufacturer, at $32 in 2001. The company was experiencing a slowdown in sales and earnings were declining. The stock struggled, bottomed out at $20 and finally recovered to the upper $30s by the middle of 2004. Relieved that the stock had made a respectable comeback, I sold at $39 and made a modest profit. What I failed to do was track a clear change in the sales and profit momentum of the company. My avarice got the better of me. If I had waited until late 2006, I would have seen the stock climb to $100 as earnings were poised to exceed $10 per share for the year.
If you’re an investing glutton or driven by lust, you’re likely to act first and ask questions later. While certain situations may call for immediate investing action, most require contemplation and investigation before making a decision. At some point, you probably bought a stock without knowing all the metrics, such as price-to-earning ratio, price to sales, cash flow, and book value. You’ve probably also bought a mutual fund without being aware of all the fees involved. You may have been so anxious to purchase a stock on the upswing that you failed to learn much about the company, including who the CEO is, the company’s products and services, its performance over the past year, and so on.
In almost all of these instances, you probably regretted your investment.
For long-term investors, slow is almost always better than fast. To remind yourself of this fact, consider the following scenario. You decide you want to buy the S&P 100 because you’re convinced that it’s going to do very well in the coming year. You’re well aware that it has increased in value significantly in the last week, and you want to make the investment before it goes too much higher. Your investment advisor tells you about a fund with a good reputation, North Track S&P 100 Index Fund (SPPCX).
The fund charges 1.88 percent annually or $188 per $10,000 invested. At first that rate sounds reasonable, and in your rush to invest, you may not investigate other funds and their charges. If this were the case, you might miss the S&P 100 Trust (OEF) that only charges .20 percent annually or $20 per $10,000 invested. If you assume the S&P 100 appreciates just 6 percent per annum, and you invest $10,000 per year, the difference in fees alone will amount to over $10,000 at the end of ten years.
Are you actively looking for the next Dell? Do you want to find a stock that is under $1 a share (as Dell was, split adjusted, prior to 1996) and ride it to $50 (which Dell reached in 2000)? If this is what your goal is, you are better off studying gambling techniques and visiting a casino. Trying to make a killing causes you to invest in stocks that carry a lot of risk and that have relatively low odds of rewarding the risks you take.
If you feel the urge to make a killing and you’re particularly vulnerable to sins such as greed and gluttony, here is a good way to follow this commandment. Tell yourself that if you want to make a killing, rather than searching for a rags-to-riches stock, your money would be better spent by taking a risk on:
- Opening a restaurant
- Starting an Internet grocery store
- Buying real estate
- Buying swamp land in Zimbabwe
I’m not suggesting you actually do these things, only that you should consider them and then realize how much risk is involved in trying to make a killing in the market.
When your neighbor, friend, relative, or colleague makes a bundle through investing, remind yourself to manage the envy you naturally feel. If you don’t manage this envy, you’re likely to copy his strategy or type of investment. It’s possible (though unlikely) that copying it may be effective in the short-term, but it is no way to meet long-term objectives.
Viewed without any context or history, a buddy’s great investment is not always what it appears. He may have been investing in food-related companies for years without much success, but he happened to be holding one food company stock that shot skyward because of some hugely successful product introduction. You are not privy to the years of futility as he pursued this approach; all you see is that a food company investment paid off handsomely. If you try and duplicate his “strategy,” you’re doing so without seeing the whole picture. If you possessed this broader perspective, you would never attempt to use his flawed approach.
Diminish your fervor to copy other successful tactics and techniques by asking your neighbor or colleague the following questions: How long have you had this particular investment? How has it done over the last three years? Have you ever had a similarly spectacular success in the past ten years? Have you been disappointed by your investing approach over the last five years? How were you disappointed? The answers are likely to make you less covetous.
To help you manage the three secondary sins just mentioned as well as the seven major ones, I’ve put together a list of ten things you should and should not do. They compliment the sins, in that they are action items as opposed to “warnings.” Just as the ten commandments of biblical fame suggest ways to avoid the seven sins, these commandments function in a similar manner. Keeping a list of these commandments handy next to a list of the sins should provide you with the model you need to maintain your virtuous investment path.
Let’s look at each commandment and how to obey it:
- Thou shall not convert thy neighbor’s investment
- Thou shall not make a killing
- Know thy investments better than thou know thyself
- Thou shall not make unto thee a graven image of profits
- Thou shall not take the name of the Lord in vain or issue nay foul-tempered oaths while investing
- Thou shall not commit adultery chasing some thy little stock of the moment
- Honor they mother, thy father, and the market in good times and bad
- Thou shall not steal from thyself by forgetting about taxes
- Thou shall not worship false idols or deceitful financial advisors
As we noted, angry investors sometimes lack a specific target and disperse their anger over the market in general. They rant about the market’s cruelty and indifference, and it is like ranting about fate. Many times, though, investors focus their anger on a specific person, group, or event. In some instances, this target is worthy of their ire—a CEO made a bad decision that negatively affected the stock price. In other instances, however, investors made mistakes and set up targets as scapegoats—they blame others for their oversights and lack of due diligence. Understanding what the common targets are and how they trigger our anger gives us a weapon to defend ourselves against it. Keep the following targets in mind the next time you find yourself furious at them for an investing loss: Read the rest of this entry »
It may be that as you look at the previous section and clearly identify yourself as a greedy rather than as a realistic investor, your response is, “So what?” You may rationalize this investing behavior as crucial to your success. You are aggressive, confident, and willing to take risks; you made a significant amount of money in the market in the past, and you intend to do so in the future, and the only way you know how to do so is by thinking big and investing like a big-time player.
In fact, big-time investors are big-time precisely because they aren’t greedy. They are highly successful because they understand the way the market works, do their homework, analyze their options carefully, and then make decisions with both short-term and long-term results in mind. The greedy investor, on the other hand, gets into all sorts of financial trouble because his greed is based on an unrealistic view of the market. Read the rest of this entry »
Greed is one of the most difficult sins to manage because it is always there. We invest to make money, and every promising investment raises the possibility of making a significant amount of money. We wouldn’t be human if part of us didn’t dream a bit about what might be. Good investors, though, keep that part of themselves in a controlled, isolated environment. If you are particularly vulnerable to the sin of greed, you’ll do likewise. Specifically, you’ll do some or all of the following:
- Invest slowly, knowledgably, and logically. Speed, ignorance, and reflex are the greedy investor’s enemies. Force yourself to move relatively slowly before making an investing decision, even when you’re certain that even a moment’s delay could cost you thousands. In the vast majority of cases, delaying your decision for a short period of time won’t hurt. In most instances, it helps because it gives you a bigger window of time in which you can think, reflect, learn, and talk about an investment. Greed preys on people who just react. When I say invest knowledgably, I mean do your homework. Learn about the fund’s or stock’s performance historically. Compare the fund or stock to the appropriate index or benchmark. Read as many reports as you can related to the investment. Don’t worry that your delay makes you spend an extra 50 cents a share because in the long run it won’t make a difference. Finally, logical investing means reasoning out your investment decision. When you hear a great tip or read something that makes you believe you’ve found a great fund that will make you millions, step back and write down the logical steps that have led you to this conclusion. Specifically:
Read the rest of this entry »
As you’re reading this, you may think to yourself, “I’m never going to commit this sin.” Everyone thinks this thought. When you’re reading about other people, their lustful investing behavior seems completely irrational. In the heat of investment decision-making, however, lust can hit you when you least expect it. Certain situations present themselves and rational thought takes a back seat to the moment’s infatuation. It pays, therefore, to be alert for the following situations where you’re most vulnerable to lustful investing:
There are all sorts of direct and indirect messages that make you feel your company stock is going to perform better than any other stock. You observe that your organization is extremely well-managed, that the company has great products and services and that its leaders are inspirational and honest. As our WorldCom example illustrated, it is not unusual for people to invest their entire retirement funds in their own company stock. You may receive stock options and other incentives to buy the company stock, and your boss or some other executive may assure you that it’s the best investment you could possibly make. In some cases, management may apply pressure for you to invest in the company and they may monitor your equity holdings. For some people, it feels disloyal to invest in any other company’s stock.
If this describes your investing, I don’t want to suggest that you’ve been brainwashed, but you certainly have been smitten. Why else would you entrust your livelihood and your life savings to one company? As great as your company’s management may be, people change companies. As wonderful as your company’s products are, new products with new technologies render established products obsolete. Read the rest of this entry »
