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Tuesday, February 27, 2024

28 Years Later

August 1979:  "Death of Equities" was the celebrated cover on the front of Business Week.  It was stated that: 

"For better or worse, then, the U.S. economy probably has to regard the death of equitities as a near-permanent condition – reversible some day, but not soon"

Business Week was not alone.  Indeed, fund managers joined in the prognostications of doom with comments such as:

"Knowing that stocks are cheap does not impel one to go on a buying spree; the future is clouded by many ugly questions"

These statements were made with the backdrop of the Dow dropping lower in the summer of 1979 than its 1969 level (mid-800s).  The dollar was weak, the federal debt was ‘shocking’ according to some and energy shortages were a cause for concern.  Moreover, concerns were prevalent over Iranian fundamentalists and many believed the country was in decline.  Fast forward over a quarter of a century and the dollar is again considered weak, the national debt was $9,045,644,843,195 at last count, Iranian fundamentalists still dominate news discussions and let’s just not talk about oil because that’s a whole topic by itself!

In 1979, the future seemed unclear and few were willing to pay bargain prices for equities.  Less than a year later, however, the Dow had risen by over 40% and Business Week pronounced the "rebirth" of equities.  The importance of buying into the unknown versus the known is evident.

Assume two investors purchase the same security at different points in time.  Investor Joe The Pro buys when the security is priced at $100 per share while investor Nervous Nelly buys the security after the security has risen to $140 per share.  Assume the security continues appreciating to $200 over the next few years.  Joe the Pro makes 100% while Nelly Nervous makes just 42%.  Every point the security rises increases Joe The Pro’s return by 1% whereas the same point increase only increases Nervous Nelly’s return by 7/10ths of 1%.  This may seem small but compounded over time the effects are staggering. 

Stock investors pay a premium for clarity and a discount for uncertainty.  If all you change in your trading is your ability to purchase uncertainty and sell clarity, you will more often than not find yourself following the old adage of "buying low, selling high".  Phil reminded us again this weekend of his rules in his article on "Taming The BEASt".  He declared his Rule #1 as "Always Sell Into Initial Excitement".  The excitement always follows the news that turns the unknown into the known. 

In options this concept of uncertainy is of particular importance.  As we navigate through earnings season, much is unknown about future numbers, margins, forecasts, metrics and analyst reactions to all of those items.  Options will reflect such uncertainties with above average implied volatilty levels.  Essentially these options are expensive as they price in wider price swings in the underlying stock.  If you are tempted over the next week to purchase long options on companies reporting earnings ask yourself what movement is required in the underlying stock to turn the trade profitable by expiration. 

For example, Google is trading at $637.39 at the close of business on Friday.  Next Friday, trading will cease on its October options.  A day earlier, however, it is due to report earnings.  As expected, its options are expensive.  But how expensive?  An October strike 640 call option has an Ask value of $17.50 while an October 630 put option has an Ask value of $14.40.  The combined purchase $31.90 would enable a trader profit no matter which way Google moves, provided it moves far enough.  How far?  The stock must move $31.90 above $640 or below $630 just to breakeven.  That means the trade will certainly be a loser if the stock trades between $598.10 and $671.90 on Friday’s expiration.  For 10 contracts, that’s a $31,900 bet that the stock will be outside the range or the money lost!

Bets such as these are quite speculative because you have absolutely no control over what that stock price will do on Friday.  This should NOT be the primary technique in your trading methodology.  Although you may be buying uncertainty, the options have priced in the uncertainty.  It is very different from buying a stock when the future is unclear.  Stocks are often cheap when the future is unclear.  Options are generally expensive when the future is unclear.  Strategies that lead to success for a stock don’t necessarily translate to its derivative. 

So, as you trade these next few weeks of uncertainty, be judicious in running the gambler’s gauntlet of straddles and strangles.  Perhaps, it would be more prudent to revisit some stocks that have been discarded unfairly.  It is a long-term game and long-term strategies should form a primary component of your trading approach.

Have a fantastic weekend!

OptionSage

 

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