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Stock Brokers and stock promoters
Strategy: since brokers and promoters are probably going to be closer to the markets and to particular stocks than the average person, they should be able to make good stock recommendations.
My History: back in the early 80’s my parents recommended stock picks to me via their stock promoters. I didn’t invest much, I seem to recall making a little money off of one of the promoter’s picks but the other picks did terribly and I never went looking for more picks. Of course back then I believed everything the promoters were saying without doing any kind of research on my own. I guess I got what I deserved.
Lesson Learned: oddly enough even though I’ve been involved in the investment industry since the 90’s I don’t recall ever coming across a stock promoter. Perhaps they were more popular when my parents were investing. I’m not a big fan of stock brokers because I think they have a conflict of interest when recommending stocks i.e. they generally make money (commission) when you buy or sell stock which gives them an incentive to make you buy or sell. Since I’m not looking for advice, I do all my trades through the discount broker TD Waterhouse. TD’s not the cheapest discount broker around, but it’s the most convenient as that’s where all my bank accounts are held. If I didn’t have a relationship with the TD, I’d look at doing my trades with a cheaper brokerage firm.
Mutual funds
Strategy: let someone else manage your money. Since the people running mutual funds are supposed to be more knowledgeable and skilled in investments than the average person, they should be able to your money than you (assuming you are an average person).
My History: back in the 80’s mutual funds were all the rage and I ended up in a Templeton Growth fund right about when the market had peaked. I remember paying an obscenely high upfront fee of 8-9% just for the privilege of owning the mutual fund. I think I held the fund for 2-3 years and broke even. Later in the 90’s I invested in a China fund and an Asia fund and sold out 1-2 years later flat or slightly down. I was convinced that China would do well but after a year or 2 of flat or down returns I figured I could put the money to better use elsewhere. Too bad, as I missed the big run up a few years later.
Lesson Learned: the only mutual funds I invest in now are the money market funds. If I wasn’t actively managing my portfolio I would consider a passive index fund or exchange traded funds only. I just don’t believe an actively managed mutual fund can outperform the market not after taking into account all the fees.
Day trading
Strategy: by using technical charts or acting on news before the market can react, you might be able to make money by spotting certain trading patterns e.g. when a stock makes a big move and has heavy trading volume, often this is followed shortly by a correction.
My History: In the early 90’s I started working at TD Waterhouse as a discount broker and given the proximity to the news releases, I tried a little day trading. By day trading I mean watching for a company to make a news release and then quickly buying the stock. The theory was that since we were just seconds away from the news release, we could buy the stock before the stock responded to the news release. I and other traders failed as we bought stock without fully understanding the news release. The one stock that comes to mind was a junior diamond stock that had just released news that it had found diamonds in a kimberlite. As soon as we saw the word diamonds, we bought the stock, not fully appreciating the fact that the diamonds were so small that they had no commercial value. This kind of trading ended up losing money, but didn’t result in large losses.
Lesson Learned: I don’t day trade now as I don’t believe money can be made that easily through technical trading, though I know someone that can trade successfully.
Analyst Reports
Strategy: stock analysts make a living by writing reports detailing whether a stock is a buy or a sell. Since they follow a limited number of stocks, they should have an upper hand at determining if a stock is underpriced or overpriced.
My History: in the mid 90’s I started working in the treasury department of a large Canadian bank and had access to the equity analyst reports. My strategy was to buy the stock that had the highest percentage gains forecasted. Some of the analyst recommendations worked out, some didn’t. Overall, I probably came out about even. At this point, I still wasn’t doing any of my own research.
I bought another diamond stock (Southernera) based on an analyst recommendation without fully understanding the economics. The report was correct in that there were a number of diamonds of high quality in the staked area and they even put an estimate on the value of the diamonds. I foolishly took the value of the diamonds and divided it by the number of outstanding shares to come up with a value per share. Of course the stock was trading substantially lower than my calculated value so I bought the stock expecting a nice 2-3 bagger minimum. What I (and the analyst report) failed to calculate was the cost involved to get the diamonds out of the ground and to the market. Turns out the costs were so substantial that the company wasn’t able to economically mine the diamonds. Of course I lost money on this investment.
Lesson Learned: I still read analyst reports, as the reports usually have a lot of useful information, but now I make sure I research a company and the industry before acting on the recommendation. I’m still wary of analyst recommendations given that the majority of recommendations are skewed to the positive. I find it is best to read a number of analyst reports from the same firm on stocks in the same industry as then you’ll be able to get a better sense of the firms ranking system.
Momentum Investing
Strategy: buy/(sell) a sector in the early stages in the hopes of closing out the position when more people have caused the sector to go up/(down). The tech and housing bubbles are examples of where if you had bought early, you could have made a lot of money even though the fundamentals weren’t supportive.
My History: in the year 2000 the Internet and biogenetic stocks were going through the roof. I never bought into internet stocks as they seemed outrageously priced to me. I did buy into the biogenetics that had a good story to sell, but little in the way of financials. Decoding the human genome and using this information sure has a lot of potential, but I still think it is years away before a company will be able to make money doing it. I ended up losing money when the high tech bubble burst in 2001/02
Lesson Learned: I don’t use momentum investing to join the crowd, though I have noticed that whenever I buy puts on US stocks, I seem to buy 1 day too soon and sell 1 day too late. Perhaps I’ll use a little momentum investing before I buy my next put.
Shorting
The Strategy: shorting a stock is where you sell a stock with the intention of buying it back at a lower price.
My history: I never short sold until 2-3 years ago. I made some correct calls with the old Air Canada and Stelco both of which went bankrupt and later emerged as new companies. Unfortunately even though both companies went bankrupt, I actually lost money as a result of the forced buyback by my brokerage firm (see below).
Lesson learned: the problem with shorting stock is that sometimes the brokerage firm needs the shares (that you borrowed to sell) back and they will simply buy back your position (often without notifying you). It is frustrating to keep having your short position bought back for you. I’ve only tried shorting stocks in Canada and this might not be such a problem in the US. I haven’t shorted a stock recently as my preference is to buy put options instead.
Notes: shorting can’t be done in an RRSP account and requires margin. If the margin requirement is 33%, you have to put up an additional 33% of margin in your margin account. If you short sell 100 shares at $10, you get $1,000 cash put in your account, but you would need to put in an additional $330. Unfortunately the $1,000 that is in your account doesn’t earn interest (at least, not at TDWaterhouse.)
Option trading
This might seem a little complicated which is the reason I’ve spent a little more time trying to explain the strategies. It’s not that difficult to understand and when you see that options can be used to reduce risk and generate very good returns, you’ll want to spend time trying to understand this session.
Strategy: options allow the holder to buy or sell a stock at a certain price for a limited amount of time. Options cost a fraction of the price to take a similar long or short position in a stock and they can therefore leverage your returns. If you buy the option and pay the premium, you have a long position. If you write (or initially sell) the option and receive the premium, you have a short position. If you have written the option and the holder exercises the option, you will be required to either buy or sell the stock at the strike price. Owning an option is a good way to share in the upside or downside movement in a stock without requiring a lot of money. Writing options is a good way to make money if the stock price remains the same or if the stock price goes down(up) for calls(puts).
Call Options: If you buy a call, you pay a premium in return for the option of buying the stock at a certain price for a limited amount of time. You are hoping that the stock goes up before your option expires. There is a time premium imbedded in the price of an option that can make up a small fraction of the option price or it can be 100% of the price. Obviously the more time an option has, the more it costs. An option with a strike price equal to the stock price is called At-The-Money and it’s price is made up only time value. A call option that has a strike price lower than the stock price is called In-The-Money. If the call strike is greater than the stock price, it is called Out-of-The-Money. Options that are At-The-Money have the greatest amount of time value. Options deep In-The-Money have the least amount of time value. Deep just refers to how much In-The-Money the option is; the more it is in the money, the deeper it is.
A covered call is where you write a call option against a stock you already own. If the call gets exercised, you have to deliver your stock. Since you own the stock, you are therefore covered. When a covered call position is exercised, your stock gets sold at the strike price. So if you wrote/sold a $66.00 call against a stock you own, your bank account would receive the $66.00 and you would no longer own the stock. If you don’t own the stock and you write the call, you are naked and if the call is exercised, you would have to buy the stock first to ensure delivery.
Put Options: Buying a put allows you to sell the stock and you are hoping that the stock goes down in price.
My History: while in the 90’s, I tried my hand at investing in put and call options. The usual strategy was to find a takeover target that had moved but still wasn’t trading very close to the take over price. I’d buy an out of the money put and call (straddle) in the hope that the takeover would fail and the stock would drop or that the takeover would succeed and the stock would go to the takeover price. I had a little success with this strategy but I seem to recall more losses than gains. Problem with this strategy was that the time value for both the put and call positions was too expensive. If you tried to buy shorter term options to reduce the time value imbedded in the options, there was a good chance that the takeover would get delayed and both options would expire worthless.
Lesson Learned: I use options quite frequently both puts and calls. I also take both sides of the options sometimes writing covered calls and sometimes buying puts. I’ve usually been right with the direction of my option strategy i.e. I’ve bought calls when I believe the stock is going up and bought puts when I thought the market was going down. Where I’ve been wrong is in trying to get too precise with the expiry dates. As you know, options that have a long expiry are more expensive than shorter dated options. In early 2007, I correctly predicted that the housing stocks (Toll Brothers, Pulte Homes, DR Horton) and the banking sector (Washington Mutual, Countrywide Financial) would drop as a result of the mortgage mess. I bought a number of puts, but I only bought a one month expiry since they were the cheapest. As luck would have it, on the week of the maturity the markets rallied and my put options either expired worthless or were sold for 50% of their original price. In the following month or 2 after my positions expired, the markets continued their trend down. So now when I buy an option, I buy at least 2 months of time value; the markets are just too hard for me to predict for a 1 month maturity.
Notes: if you own an option, the only time you would want to exercise it is at maturity or if there is a large dividend being paid out (in the case of a call). The reason you might want to exercise is because the owner of the call option is not entitled to the dividends (only the owner of the stock is entitled). If there are no dividends, you are better off simply selling the option and capturing some of the remaining time value rather than exercising. If you own a put and the stock is trading near zero, you should either sell or exercise before maturity as your maximum profit is when the stock is at zero.
If you are thinking of buying an option for a number of months, it is cheaper to buy the longer dated option rather than buying a shorted one and rolling it e.g. buying a 3 month option is cheaper than buying a month option 3 times. Similarly, if you are writing options, you will pick up more premium if you write a number of 1 month options rather than writing one longer dated option for the same amount of time.
Selling an option can refer to the initial writing of a position that creates a short position or it can refer to the selling of a long position. When I’m referring to options, selling means the initial writing of the option.
