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Buying Stocks and Options
The strategy for buying stocks and options includes value investing, momentum investing, diversification, and income averaging.
Stocks
Value investing
Professional analysts determine the value of a stock from interviews with company officials, financial statements, reports, conference calls, and company websites. Unless you have access to company officials and are capable of digesting all this information, you should rely on the research of professionals.
This research leads to a price target for the stock, a buy/sell recommendation, the present value, or a forecasted earnings growth rate. Price targets and buy/sell recommendations are too short-term to be useful to investors. Analysts who look farther ahead do not release present values, but many release forecasted earnings growth rates.
Forecasted earnings growth rates divided into the price/earnings (P/E) ratio yields the PEG ratio. Although the P/E ratio is more popular, the PEG ratio is a better measure of value because a rapidly growing company is worth more than a slowly growing company with the same earnings.
The PEG ratio is far from perfect. A PEG ratio is compared with an arbitrary number to determine if a stock is fairly valued. PEG ratios ignore interest rates, which investors use to compare stocks with fixed-income securities. Forecasted earnings growth rates are unreliable. The formula leads to the ridiculous conclusion that a company without earnings growth is worthless.
Using a stock screener to find stocks with relatively low PEGs eliminates the need to measure the stocks against an arbitrary number and makes interest rates irrelevant. Still, PEG uses unreliable estimates in a flawed formula. Stocks with relatively low PEGs should be viewed as worthy of further investigation, not necessarily as worthy of purchase.
Momentum investing
Stocks move in exaggerated trends. A brilliant analyst, confident that a stock is undervalued, might go against the trend. Most investors should practice momentum investing by buying stocks when they are in strong uptrends.
Diversification
Diversification means having investments that move somewhat independently of each other. Diversification reduces risk by lessening the effect of a badly performing investment on the total investment.
Stocks are classified in various ways. There are usually two or four tiers. There are about ten categories, called sectors or industries, at the top tier. There are more than 100 categories, called industries, sub-industries, or sub-sectors, at the bottom tier.
I am attempting to define fifty diverse groups based on the sector&industry classification scheme used at Yahoo. Their scheme does not have enough sectors, and many industries have similar market behavior.
Income averaging
Income averaging, also called dollar cost averaging, means periodically investing a fixed tranche of money. This reduces risk by spreading money across time, just as diversification spreads money among investments.
Income averaging is not to be confused with averaging down. Averaging down means reducing the average cost by adding to a position after a decline. This is inadvisable because the decline is more likely to continue than to be reversed.
Invest a fixed tranche of cash on the first trading day before the 28th, except the 16th in December and the 21st in November. Adjust the tranche size if there is a substantial change in income or responsibilities, or if it seems surpluses or shortfalls will persist.
Cash in the account accumulates not only from budgeted monthly deposits, but also from dividends, interest, security sales, and extra deposits from windfalls. Exhaust excess cash by temporarily buying two stocks each period. Leverage insufficient cash by temporarily buying options.
Assuming commission and other fees of $10, an execution 0.5% worse than the last trade, and a maximum acceptable total cost of 1%, the minimum nominal tranche should be $2000. If your budget won't allow $2000 per month, buy call options in tranches of $500 or $1000. LEAP options are preferable because they offer the possibility of long-term capital gains.
This table suggests how many contracts or shares to buy, assuming an option cost of 20% of the value of the underlying stock. Multiply the number of shares or contracts by ten for tranches of $5,000, $10,000, or $20,000:
Options
Call options can be used to leverage cash. Put options can be used for hedging.
The strategy for buying call options comprises the entire strategy for buying stocks, except if cash is insufficient do not buy anything. The strategy applies to the underlying security, not the option itself.
Price behavior
An option can be at, in, or out of the money and can have a near, intermediate, or distant expiration date. Traders keep most of these options near fair value with respect to each other. However, there are differences in the costs and how closely they track the underlying securities.
If an option at the money is purchased and the option moves into the money, the profit approaches the profit of a position on the underlying security (long for a call or short for a put) minus the cost of the option. If the option moves out of the money or stays at the money as the expiration date nears, the loss approaches the cost of the option.
If an option in the money is purchased, the option will track the underlying security more closely but the price will be higher. If an option out of the money is purchased, the price will be lower but the option will track the underlying security less closely.
Common strategies
Options are considered to be so risky that your broker might not let you do anything more than write covered call options on securities in your account or write cash-secured put options. Writing is usually done for options that are out of the money to obtain income while having a low probability that the options will be exercised.
Covered call writing is done on securities that the writer wouldn't mind selling. Writers should instead sell the securities and buy ones about which they are more enthusiastic. Writing cash-secured puts is done on securities that the writer wouldn't mind buying. However, the writer might be forced to buy the security at the strike price when the current price is much lower and the security is in a downtrend.
Spreads involve buying an option while writing a similar option. A vertical spread involves two options that differ only in strike price. A horizontal or calendar spread involves two options that differ only in expiration date. Spreads are used for leverage and protection. A simpler way to get leverage and protection is to buy an option without writing an option.
Straddles and strangles are volatility plays. They involve buying a put and a call with the same expiration date on a security in the hope that volatility will rise sharply and unexpectedly. I don’t see how anyone except an insider can anticipate this.
Strike price, expiration date, and price ratio
Trading an inactive security can result in unfavorable execution. Covered call writers and cash-secured put writers tend to make options that are just out of the money relatively more active, hence more desirable.
The Black-Scholes and other models for pricing options incorporate volatility, but ignore current trends. Volatility can stay fairly constant for a month or two, but current trends can remain intact for years. Some LEAPs might be underpriced if the underlying security has low volatility and a strong current trend.
Put option hedges should expire as soon as possible after the October expiration of the negative January Barometer. Shorter term options must be rolled over. Longer term options cost more.
Price ratio is the price of a nonexistent option with a strike price equal to the price of the underlying security, divided by the price of the underlying security. The lower the price ratio, the more attractive the option. Expressed as a percentage, it is:
Rp = 100*((Lb+La)*(Up-Sp)+(Ub+Ua)*(Sp-Lp))/(2*(Up-Lp)*Sp)
- Sp price of underlying security
- Lp lower strike price, just below Sp
- Lb lower strike bid
- La lower strike ask
- Up upper strike price, just above Sp
- Ub upper strike bid
- Ua upper strike ask
- Rp price ratio
There is no need to calculate price ratios for put options. Models price options based on volatility, and in the short term volatility trumps trend.
Recommended strategy
In my opinion, this is the best options strategy:
- Do not write options.
- Do not use combinations such as spreads, straddles, and strangles.
- Buy options that are just out of the money.
- Buy call options only to leverage cash. Buy the most distant LEAPs.
- Buy put options only to hedge. Buy options that expire next November, December or January.