Low risk stock market investing

Whenever anyone first considers becoming an investor in the stock market, almost always they are attracted to the stock markets lure of huge profits and endless 5x and 10x winners.

It sounds so easy, find a stock you like that has a great story and is in a hot sector and go for it. Easy Huh!

But the painful truth is that the stock market is a perverse beast. It punishes over confident and over enthusiastic investors who back a sure thing and it rewards those who avoid risk. But how does that make sense? For years we’ve been told that reward is closely correlated with risk and that in order to make huge gains, you probably have to take huge risk.

The truth is that this academically accepted principal is simply not true. The stock market in many ways is counter intuitive. A close study of the world’s best investors such as Benjamin Graham, Warren Buffett and hedge fund giant Steve Cohen shows that they do everything in their power to first of all avoid risk. And only when they feel that they have done everything to avoid as many risks as they can, do they pull the trigger and make an investment.

So what if there was a better way to buy the companies you want to own? A way that allows you to be patient, to stalk the companies you want to own and only own them at a level below what you already believe is attractive. And what if you got paid to wait for the ideal entry price? That is, you got paid to wait for the stock to go from being cheap to ridiculously cheap. That is you got paid regardless of whether or not you ever get to own a piece of the company or not?

At United Global Capital, we spend an enormous amount of time trying to lower the risks our client’s face, to improve their returns and generate safer and more consistently profitable returns throughout the investment cycle. And what I’m about to show you is one strategy we use regularly with our clients to improve their chance of success.

I will warn you…………

This strategy does involve the use of OPTIONS, specifically Put Options. BUT……… before you click off this page and zone out because some imbecile told you options are too risky, I urge you to continue reading just a little further and you might just learn something. Something that can help you become a better and more profitable investor and help you invest the same way some of the world’s most successful investors do it.

Let’s start by rehashing what a put option is. The easiest way to think of a put option is to think of it as an insurance contract. Each put option has two parties, the insurer (the seller of the option) and the purchaser, (the buyer of an option). A put option specifically insures the purchaser against a price decline by locking in an agreed price at which they can sell their shares to the insurer (seller) within a specified period of time.

Each equity put option represents a standard parcel of 100 shares in the underlying company. As with any insurance contract, in order to buy that protection you must pay the insurer a premium for the right to that protection.

So essentially whenever a transaction in a put option occurs, the option buyer (the insured) will have the right, but not the obligation, to sell the nominated parcel of shares to the seller (the insurer) at the price nominated, known as the strike price. On the other side of the transaction, the seller of the insurance contract is obliged to buy that parcel of shares from the purchaser of the put option at the agreed price, regardless of whether he/ she/it could buy the shares at a cheaper price on market. To compensate the insurer for this obligation, the insurer is paid a premium up front at the time the transaction occurs and that premium is theirs to keep for good.

Now think carefully, when you consider who makes money in the insurance sector, is it the insurer or the person buying the insurance? Really, it’s a no brainer. If the insurance company does its job correctly, the insurer should always come out on top, even if they do sustain some short term losses.

And that’s where this strategy starts……..

You see, there is a better way to buy shares and it is used consistently by the pros. But if you are asking yourself why you haven’t heard of this strategy, it’s because they probably don’t want you to know about it. Think about it. The more sellers of options there are, the lower the price of the premium they receive on average.

Now when you think about risk and how it’s priced, when is the most expensive time is to buy insurance protection? If you have been reading the news lately, you’ll know that many insurers are talking about raising premiums AFTER recent loses due to Hurricane Sandy and other recent natural disasters. You see the most expensive time to actually buy protection is in fact after the risk has often passed us by. And that creates opportunity.

Now assuming you have done all your analysis and you are comfortable with the company’s financial strength and you have waited for the shares to get down to the price you think is fundamentally cheap, by simply doing one more step, by selling a put option at a price below what the market is offering, you can greatly improve your odds of success.

By doing this simple additional step, you will receive a premium, however you will only buy the shares if the price is below the strike price of the Put Option and then only if the buyer of the option choses to exercise the option (which is pretty much a given if the price is in fact lower). If you do this strategy correctly, and assuming you can generate similar levels of premium throughout the year, it’s possible that you could generate a nice little income stream that could infact exceed long term stock market returns of 10% to 12% compounded. Not bad hey?

It sounds crazy, but it is possible and that gives us an edge.

So let’s look at this strategy in action.

Leading into November 2012, Broadcom (NASD: BRCM), one of the world’s leading microchip manufacturers for smart phones and tablets, was caught up in a sector wide sell-off. I had been watching Broadcom for some months before making the trade.

Fundamentally the stock was very sound. It was trading on a P/E of less than 10x forecasted earnings and a PEG ratio of 0.8, meaning that when measuring the P/E multiple against Broadcom’s growth expectations, the company was cheap. Plus it held more cash in the bank than all its entire debt outstanding. So Broadcom was financially secure.

On 23 November I had been observing Broadcom bouncing off support for the past couple of days and at approximately USD$31 I sent out a recommendation to clients. But rather than rushing out and recommending clients buy Broadcom, I recommended they instead sell a January 2013 USD$30 strike put option for approximately USD$0.84 per share.

(Source: HUBB Integrated Investor)

So let’s just go over what happened.  I thought Broadcom was cheap. I would have been happy to recommend the shares at $31, but instead I entered into a contract to buy the shares at USD$30, one full US dollar below what it was trading at. And for that, our clients were paid $0.84 per share to possibly have to buy the shares at a price below what I thought at the time was already very cheap.

Now, several things could have happened:

  1. Firstly, Broadcom could have fallen below USD$30 by expiry on 18 January 2013 and my clients would have been obliged to buy the shares at a level that we viewed as being even cheaper than cheap. But because they received approximately $0.84 per share, they would have actually lowered their buy in price to approximately USD$29.16. Almost 6% lower than what they would have had to pay for Broadcom on market.
  2. Secondly, Broadcom could have traded in a range and closed near USD$31 and our clients wouldn’t have been able to buy the shares, BUT, they would have kept the premium of approximately USD$0.84.
  3. Thirdly, Broadcom could have sky rocketed higher and our clients would have missed the opportunity to buy Broadcom before the price rise, but they would have still kept the premium of approximately $0.84.

So, for the capital our clients had put aside to purchase shares in Broadcom, they could have earned 2.8% for the life of the contract, being 57 days. Assuming we could do similar trades throughout the year, it may be possible to achieve similar results, which could result in a very handy return!!

But as good as this trade is looking, (at the time of writing, Broadcom has two trading days left to expiry and currently trades at approximately USD$35), there are actually instances where these premiums can blow out significantly to levels as big as 5% for the equivalent 57 days, such as AFTER the US debt ceiling down grade in September 2011, and even as much as 8% for 57 days, such as AFTER the Lehman Brothers collapse in October 2008.

So, don’t put up with higher levels of risk. Try to avoid it as much as you can and focus on smaller and consistent gains. If you do that, you will start to see your portfolio generate the returns you want it to generate with much less volatility and with the odds stacked in your favour.

If you think this strategy for low risk stock market investing is something you’d like to explore further, please do not hesitate to contact us for a No Cost, No Obligation consultation on 03 8657 7640 or email [email protected]. We would be more than happy to review your superannuation, trust or personal investment strategy and give you the advice you need for safer and more consistent returns.

The information contained in this report is General in nature and has been prepared without taking into account your objectives, financial situation and needs. 

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