Why Trade Options. Part I

A recent article by Mark Hulbert (MarketWatch) attracted my attention for two reasons. One, it focused on Richard Russell, “the granddaddy of the investment advisory industry, having continuously published his Dow Theory Letters advisory service since 1958.” Two, it brings into focus the advisability of owning a large stock portfolio – the main investment method since the end of WWII.

Edited (for brevity) excerpts from Hulbert’s article:

Richard Russell made a remarkable confession earlier this week. He said that he finds the financial markets to be so inscrutable that trying to time them is close to futile. He decided to invest a good chunk of the accounts he manages in a mutual fund that has a static allocation to several uncorrelated asset classes.

Russell has the cynicism that is borne of witnessing innumerable new strategies and approaches that have come onto the investment scene to great fanfare and then ultimately failed.

As an illustration of the mixed and divergent signals the market is sending, Russell writes: “I recently read the works of A. Gary Shilling and Bob Prechter’s Elliott Wave Forecast, and they provide really convincing reasons as to why we’re going into deflation. I read Larry Edelson and a dozen other advisors and they provide excellent reasons why we’re heading into hyperinflation.”

I sympathize with Russell’s argument, [but] after listening to [some], I was convinced that I’d be a fool to have any exposure whatsoever to the equity markets. Upon listening to others, in contrast, I concluded that I should mortgage the house to put everything into the stock market.

The first step towards wisdom in this business is to recognize that your chosen adviser might get it all wrong.

The late Harry Browne, one-time investment newsletter editor said:

“Almost nothing turns out as expected. Forecasts rarely come true, trading systems never produce the results advertised for them, investment advisers with records of phenomenal success fail to deliver when your money is on the line, the best investment analysis is contradicted by reality. In short, the best-laid investment plans usually go wrong. Not sometimes, not occasionally — but usually.”

Browne’s idea was to invest in a basket of asset classes, each one of which has a low correlation with the others. As a result, when any one of the asset classes is performing poorly, there is a good chance that the others will at least be holding their own — if not actually appreciating in value. Brown coined the name “permanent portfolio” to describe this approach, since it makes no changes other than periodic rebalancing.

Brown’s idea eventually manifested itself in a mutual fund, the Permanent Portfolio Fund. It is into this fund that Russell says he’s putting a good deal of the accounts he manages.

This commentary by Hulbert strikes me as heart-felt and true. Predicting markets is an impossible game. I know those who believe in technical analysis disagree, but TA is not easy to master.

To be honest, no one feels this way during bullish markets. I’m sure that many stood by and watched in utter confusion as the tech bubble was building at the end of the last century. How could anyone believe that ‘eyeballs’ was more important than cash revenue? But believe they did and the markets skyrocketed. Today, pundits talk about the obviously horrible economy that most Americans are feeling, and wonder how the market can be so strong despite the fact that industry is doing well by working at higher productivity with fewer workers.

The bears make a sound argument, but if you followed the bulls instead, you have a lot more money now than you did a scant two years ago. Equity investing is a very tricky game. I, for one, don’t play. I use options to hedge all trades, target steady growth (which is not always achievable), but know that I am exposed to neither the disaster of a market crash nor the rewards of riding a strong bull market.

If someone who has been writing a newsletter based on a market-predicting methodology (The Dow Theory) for more than 50 years has his doubts, how can any of us own stocks with confidence? I know I cannot.

Thus, I trade hedged option positions. They are not riskless by any means, but both profits and losses are capped and that suits me well. It’s the message that I have been trying to send to individual investors all over the planet. Hedging is a good idea.

Recognizing that stockbrokers know nothing and are merely salespeople and understanding that advisors do not get it right on a consistent basis tells me that minimizing risk while allowing for some growth is an investment method that should have more advocates and followers. Alas, the hype artists steal the good name from the options industry and who knows if the risk-reducing investment tool – the option – will ever be fully embraced by the investment world.

The bottom line is that there are already huge numbers of people who use options and volume records are being broken year after year. I just have the feeling that hedging with options is not the primary strategy.

Coming April 1, 2011

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4 Responses to Why Trade Options. Part I

  1. Mr. Mike 02/22/2011 at 10:32 AM #

    Mark, thoughtful article. My question: I know that you are a big proponent of collars. I heard that collars are best done for long periods, i.e. 10 to 12 months, and that you should use LEAP options to initiate. What say you?

    Mr. Mike

  2. Mr. Mike 02/22/2011 at 11:01 AM #

    Thanks very much. The author in a book I read promoted/recommended collars with LEAPS. Thanks for clearing that up for me.

    • Mark D Wolfinger 02/22/2011 at 11:23 AM #

      At one time I thought that having written a book makes one an expert of sorts.
      My mistake.

      This author has no clue – unless he included a lengthy description of the risks. I doubt the author did that.