Play in the stock market casino

Play in the stock market casino

As an investment advisor, I am not supposed to admit that equity investment amounts to gambling. The industry line is that if you invest in good companies or mutual funds, keep a long-term perspective, and ignore the dips along the way, everything will be fine

As an investment advisor, I am not supposed to admit that equity investment amounts to gambling. The industry line is that if you invest in good companies or mutual funds, keep a long-term perspective, and ignore the dips along the way, everything will be fine. For a long time, I tried to ignore that little voice in my head that said "Something's not right." After all, stocks have outperformed all other asset classes over the past 100 years, the stock market has always recovered from collapses, and Warren Buffett is a buy and holds investor. Most traditional wisdom and rules of thumb have a large element of truth or they would not have become widely popular and embraced, but still, something does not seem right.

An ugly side of the investment creates this uncomfortable feeling. According to market data collected by Kenneth French at Dartmouth College, big business stocks have fallen 25% or more about 10 times over the past 85 years. This average is once every 8.5 years, although there are some long extensions where there were no sharp drops and other extensions as they came in groups. If you started investing shortly after the market went down (for example, 2002), your investments would have performed much better than if you started your investment life shortly before the fall (2000 for example). The Nikkei 225 (Japan) is currently down almost 75% over the past 22 years, destroying pension plans for an entire generation. Of course, Japan's problem has been the hot real estate market, multiple recessions, excessively high debt, and population aging. This can never happen in the US Finally, it's very difficult to invest like Warren Buffett. Goldman Sachs has never given me 10% permanent preferred shares. I also can't buy a company, install management, and hold them accountable for superior performance.

The truth is that investing in stocks is a gamble regardless of your time frame. The best fundamentals can be made meaningless by hedge funds that make flash trades with supercomputers or a change in government policy that changes investment rules (see General Motors). Like any casino, someone has an "edge". In Las Vegas, the edge in every game belongs to the house, which means that if you play long enough, the house will eventually take your money. Regarding investing in stocks, you may not lose your money, but if you play long enough, you will eventually face a huge downward market that recovers a large portion of your wealth. As a regular investor, you have no advantage. Hedge funds can have an advantage by front equity with quick deals. Politicians can have the advantage of using internal information legally. Warren Buffett can have an advantage by taking advantage of deals that are not available to ordinary people. The average investor is on the other side of these deals and is completely exposed to the whims of the market.

Example: Covered call strategy

To illustrate what an edge looks like, let's use a typically covered call option strategy, which has become so popular as investors look for sources of additional income and return. Covered call strategy includes buying stock shares and selling call options to generate additional income. A typical placement might look like this:

Buy 100 Apple shares for $ 450 a share

Sell ​​Covered Option Cover Contract of $ 475 for $ 9.20 a share

In this example, the Covered Call option expires in 75 days. If Apple shares remain flat for the next 75 days, the investor will get $ 9.20 a share for a 9.9% annual return. If Apple shares rise above $ 475 on the expiration date of the option, the investor holds $ 9.20 a share and participates in another $ 25 to estimate the share price for an annual return of 36.0%. If Apple shares fall, selling the option provides $ 9.20 price protection, so the investor won't start losing money until Apple drops below $ 440.80. The argument for this strategy is that selling calls provides additional income in the flat or emerging market, and some protection from falling in the falling market. It is the best of both worlds. So why does the casino take the other side of this trade?

Let's consider the risk profile of this Call Covered Call Center. As the share price rises, the short-term Call Center loses an increasing rate until it drops at the same price as the stock's rise. When the share price drops, the value of Call Gains is short, but it is set at $ 9.20 / share (the price that was collected for the call when it was sold). The net effect of combining a long position with a short position and a short sales center is that the profit resistance increases when the share price rises and the protection decreases as the share price falls. In other words, if the share price increases, you will have limited profit potential, and if the share price drops sharply, you will have the possibility of almost unlimited loss. This is exactly the kind of position your market wants because the edge is clearly on the market side.

Market maker side of the trade

The job of the market maker is to provide liquidity to the market by accepting buy and sell orders for stocks and options, and thus “market creation”. The market maker must always protect their account (or account) by closely controlling their potential loss. If his account explodes due to the stock moving in the wrong direction or an unexpected catastrophic event that shatters the market, his job has ended. The secret to survival when your career is based on trading stocks and options day in and day out is to drastically reduce potential losses and maintain an edge in the market. It's that simple, the same philosophy of any casino in Las Vegas.

A successful market maker will not have a wallet full of limited and unlimited uptrend call centers but may take the other side of the trade. Let's think about how that would look.

Selling 100 Apple shares for $ 450 a share

Buy a $ 475 purchase option for $ 9.20 a share

The combined position described above is slightly better from a prospect point of view. If the short position has lost its value due to the high share price, the potential loss is limited due to the high value of the call option. If the share price drops, the short equity position gains, and the value of the option are close to zero, which creates an increased profit potential. You can realize that the position with the limited risk of price hikes and an almost unlimited profit from price drops is exactly the description of the sell option, and in fact, reversing the covered call center is an artificial situation. If you are still following this, you will realize that the covered call is thus the same short sale option, which most people will instantly realize as being very dangerous.

There is still a problem with this situation that the market maker does not like. If he wrongly guesses and the share price goes up, he loses money, even if it's a limited amount. If nothing else, it is not a good idea to lose money, so let's improve the situation by adding another communication option.

Selling 100 Apple shares for $ 450 a share

Buy two options worth USD 475 for $ 9.20 a share

As the situation above improves, the possibilities for making money increase dramatically and the market advantage has turned in our direction. If Apple stock crashes, we make a lot of money due to lack of stock. If the Apple stock goes up, 100 Short Stocks will cancel one of the calls, but we still have the Call option that will make a lot of money. However, if the stock does not move, the options will lose time value gradually and we will eventually lose the amount we paid for the options. So, we still don't have the edge, but we also don't carry a lollipop bet on a covered call (i.e. short sale). Gaining a positive advantage requires adjusting the position from time to time to capture the value in relatively modest price movements in stock while maintaining the possibility of making big gains. This goes beyond the scope of this article.

Improve your chances

If you decide to try your BlackJack luck and the extent to which you know is that the goal of the game is to reach 21, the dealer will likely take all your money in a rather short time. The best way to play Black Jack is to be an agent. The second best way is to know the exact details of the game, memorize the odds for any given set of cards, and has an enormous ability to track the cards played (i.e. counting cards). If you do this well enough, the casino manager will conclude that you have captured the ledge and will fire you immediately.

The best way to invest is to obtain Warren Buffett's influence and wealth, or the special resources and privileges of a hedge fund, or to become a U.S. Senator. The next best thing for most of us is learning to recognize when we give up the "edge". Although most of us do not have the time and resources to invest just as the market maker, there are techniques that we can use to avoid handing over a large portion of our money to the market regularly.