Understanding ETF Options: Profitable Strategies for Diversified, Low-Risk Investing

UNDERSTANDING ETF OPTIONS

Profitable Strategies for Diversified, Low-Risk Investing

The McGraw-Hill Companies, Inc.

Excerpt

Rogue Waves

The phenomenon of rogue waves shows you why the environment is dangerous and how precautions must be in place. Rogue waves are ocean waves that are about 100 feet high. Such waves based on linear models should occur only once every 10,000 years, but based on recent historical observations, these waves may occur more often. Some have even hit cruise ships. One ship disappears every week in the ocean. Once thought to be caused by human error or mechanical failure, many of these disappearances are now blamed on rogue waves. Rogue waves can appear anywhere in the oceans without warning.

We see the same phenomenon in the investment markets. Rogue waves hit stocks all the time. These waves are unexpected news events. Such events cause stocks to leap up or drop down in price.

The book The Black Swan by Nassim Nicholas Taleb (Random House, 2007) helps explain the impact of improbable events. Black swans were thought not to exist until they were discovered in Australia. Today the term refers to highly improbable events, and the book indicated that these events occur much more often than you would expect and that they can have a dramatic effect.

Furthermore, chaos theory indicates that small changes can have big impacts. This is also true of the markets. In other words, certain events, even small ones, can have a dramatic impact on the daily markets today. When we see these improbable events, most people call them black swans, but because of the havoc they can wreak, I call them rogue waves.

An Example: Subprime Mortgages

An example of a rogue wave is the severe recession of 2008–2009. One of the major causes was the subprime mortgage bubble. Part of that problem was that the rating agencies were giving all these subprime mortgages a triple A rating. One of the reasons that these agencies were giving these AAA ratings to subprime mortgage packages, which were purchased all over the world, was that their models for determining the ratings had a worst-case scenario of a decline in real estate prices by only 15 percent. Unfortunately, what we saw was a decline in real estate prices by 40 percent, something totally improbable, but again one of these rogue waves.

Defensive Moves

In such an investment environment, it is critical that you make investments that have a lot of upside gain and minimal downside loss. Here, options are the answer. The option market is one of the places where you have greater safety to participate in the market. Also in options, diversification is necessary, and ETFs will help you diversify.

An important lesson learned here is that you need to make an honest appraisal of the worst thing that could happen to an investment that you are considering making. It is always more important to know the worst-case scenario rather than the best-case scenario. This is a key element in determining whether you will be a successful investor or not. This factor also tells you to be well diversified and to seek some protection in the options you buy so that rogue waves do not cause your major investments to tip over and sink out of sight forever.

Avoid Wall Street Pitfalls

In the movie Wall Street, the main character, Gordon Gecko (played by Michael Douglas), made a pronouncement that you should always remember. "Money managers cannot beat the S&P 500 index because they are sheep, and sheep get slaughtered."

Don't Follow the Money Managers

Not following the money managers makes a lot of sense. If we go back to the 1960s, mutual funds and money managers have had a difficult time beating the action of the S&P 500 index. In fact, numerous studies over the years have demonstrated that 80 percent of the managed funds have been unable to beat the market. (The difficulty of beating the market is probably why so many money managers leave the profession.) Actually, money managers are not sheep, but they still have a very difficult time beating the market.

The big question is: why are the best professionals on Wall Street not able to beat the market? One reason is that we are faced with a very efficient market. With computers becoming almost as intelligent as people and with an ever-increasing large number of skilled professionals analyzing stocks, most information about a stock is already in the market, and the price of a stock reflects all the information that is currently available to the public.

Don't Underestimate the Wisdom of a Crowd

There is another reason the market is so efficient—a smart crowd. For commanders, underestimating the enemy can be fatal. General Robert E. Lee underestimated the morale and skill of the Union forces at Gettysburg, and his army was defeated. General Ulysses S. Grant underestimated the strength of the Confederate forces at Cold Harbor, and thousands of his men were slaughtered. Don't underestimate your fellow investors or your competitors. You ignore them at your own risk. The crowd is smart.

There is an old saying that goes something like this: he (or she) who keeps his (or her) head while those around him (or her) are losing theirs, probably doesn't fully understand the situation. This is usually the case. If a stock is falling, the crowd knows something. Check it out. It's sort of like if you see a crowd of people running in the opposite direction you're headed—take note. There probably is a good reason for their flight, maybe wild elephants stampeding.

In most investment markets the crowd is very smart, smarter than the most intelligent people within the crowd. It is the crowd that determines the stock price, and when stock prices drop dramatically for no reason, beware! Indymac, WorldCom, and Enron all signaled that they were headed off a cliff by their price action, even though these corporations denied having any critical problems. The FDIC didn't even have Indymac on its watch list of troubled banks. Nevertheless, you knew the bank was in trouble when its stock price dropped below $2 a share. Knowing the fundamentals was useless to the investor, but the technical action of the stock price revealed the truth. The stock price action will always tell you if a company is in trouble.

In horse racing, the crowd is so smart that it picks the winner of a race 33 percent of the time and has done so for over 100 years. In the TV show Who Wants to Be a Millionaire, when members of the audience were asked a question, they were right over 90 percent of the time. Wisdom of the Crowd (Doubleday, 2004), a book written by James Surowiecki, will give you even more evidence of crowd intelligence. One important point he made in this book was that a group's decisions are better than the decisions made individually by the smartest people in the group; groups can make quite intelligent decisions.

Because the crowd is so smart and the crowd determines the stock price, it is difficult to win in the investment game. All the available information is reflected in that stock price. Therefore, the only time you get an opportunity for a bargain (and you should always be looking for bargains) is when the market overshoots on the upside or downside. Determining when it will do that is difficult, particularly when you're trying to predict the bottom of a market. You are supposed to buy stock when there is blood in the street, but in 2008 there was blood in the street for a long time, yet stock prices kept falling.

Don't Underestimate Lady Luck

In addition to the efficient market and the smart crowd, another factor to consider is Lady Luck. Many of the successful money managers of m
(Continues...)

---

Excerpted from UNDERSTANDING ETF OPTIONS by Kenneth R. Trester. Copyright © 2012 by The McGraw-Hill Companies, Inc.. Excerpted by permission of The McGraw-Hill Companies, Inc..
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.

---