Infinite Returns

There's an easy way to have infinite returns on your investments. Your percentage gain is simply your gain over your cost. Since your gain is limited by how a stock performs, another way to increase your return is to lower your cost. If you could get your cost down to zero, then your return would be infinite, since gain divided by zero is infinity(Don't get me started on calculus). How can you possibly get your cost of a stock to zero? It's really quite simple. Let's say you buy 100 shares of stock and over time it goes up by 5%. You could sell all 100 shares and take a gain of 5%, or you could sell 95 shares and get back all of the money you started with. In that case, your investment cost you nothing, so when you sell those remaining 5 shares in the future, you will have a gain with no cost. In this simple example, I might sell 97 shares so that taxes and commissions are paid for as well. Obviously, as your gains increase, the percentage of shares you have to sell to get your money back goes down as well. Lately I've been buying options that go up so fast that I am able to make about 20% on my initial investment by selling only 2/3 of the calls I bought. So instead of taking the 80% gain on my entire investment, I take a modest gain (20%) and get the rest of my options for free. I've been able to pull this kind of turn around in as little as a week. Just imagine if you could do this repeatedly and get free call options every week.

Earnings, Earnings, Everywhere

Now that we’re swinging back into earnings season, I thought that I’d make a few comments on the subject. Once a quarter, publicly traded companies release a quarterly report. That makes sense, right? The report is usually released first as a hardcopy, with a conference call following, to talk about the results. Both events typically happen after the markets have closed for the day. You can listen to the conference calls and read the report by visiting the company’s investor relations webpage.

When earnings are reported, it’s like a reality check to see if the investors have gotten it right over the last few months. Many analysts try to predict what the EPS, or earning per share, for a particular company will be. By the time earnings are released, the price of the stock tends to be priced at the level that would be appropriate if the average analyst’s estimates were correct. So if the company beat estimates, the stock will tend to go up and if they don’t meet the estimates, it will tend to go down.

All other things being the same, you want a company to have as high an EPS as possible, since that means for each share you own, the company has earned (you) more money. Of course you don’t get the money they earn, but solid earnings will generally make the price of the stock go up, which does mean more money for you.

The company that I’m waiting for earnings from right now is Research in Motion, who reports on Thursday afternoon. I hoping there’s good news to help my September options. Wouldn’t a merger with Palm be nice?

When a Bad Day is a Good Day

The market seemed to have a pretty rough day today. I was smiling all day about that. I hope tomorrow is even worse. Am I short a lot of stocks? Nope. Do I have lots of puts? Nope. Am I a sadist? For the last time, nope.
Here's why a down market gets my spirits up:
A lot of good stocks took a hit along with the bad ones. So when I buy tomorrow, or the next day, or whenever the market is about to start coming back, I'll be buying at a reduced rate. This strategy is particularly profitable with options, because it's likely the good stocks will come back from today's losses pretty quickly.

My Options Strategy

My latest guilty pleasure in the world of the stock market is options. They are generally considered (and often subsequently dismissed) as being too risky for most investors. A better way to describe it is that they have a different risk/reward structure than traditional stocks.

Here’s how the basics work:

A call option gives you the right, but not the obligation, to buy a stock at a certain price within a certain timeframe. A put option gives you the right, but not the obligation, to sell a stock at a certain price within a certain timeframe. That certain price is called the strike price and the timeframe ends at the expiration date, which is the third Friday of the month for which you bought the call. Each option you buy is called a contract and controls 100 shares of the underlying stock. For example, 1 contract of Home Depot AUG $40 calls would give me the right to buy 100 shares of HD for $40 per share anytime before the end of trading on the third Friday of August.

Why would I want a call? Well, calls are comparatively inexpensive. The HD $40 AUG call might cost me $100. Prices are quoted for a single share, so the call would be listed at $1, which would cost me $100 since the contract is for 100 shares. Let’s assume that Home Depot was trading around $35 when I bought the call. If HD stock starts going up, so will the value of my call. You might think that the price would have to go above $41 before the expiration date to make any money. That would be true if you planned to hold your calls until expiration. The other possibility is that you sell your call before expiration. Let’s say that Home Depot stock goes up to $37 within a few days of buying the call. That’s a 5.7% gain for the stock. The option might also go up by $2. In that case the option has gone from $1 to $3, which is a 200% gain.

One way options make you money is that for a smaller initial investment, you can control a larger amount of stock. Instead of spending $3500 for 100 shares of HD, you can buy the right to the gains on the stock above $40 for only $100. Of course the downside is that if the stock is trading at less than $40 when the option expires, you lose all the money that you spent on the option. Remember, though, that you could always sell your call before expiration to limit your loss.

Why would I want a put? Let’s say there’s a stock that I think is going to tank. If I own the stock, I would probably sell it. But if I don’t own the stock, I can still profit from it going down. One way to do that is to sell it short and then buy it back at a lower price. But to me, short selling is really risky, because if the stock takes off I could be out a lot of money. So an alternative to selling the stock short would be to buy a put. If the stock was lower than the strike price at expiration, I could buy the stock at the low market price and then exercise my put to sell it at the higher strike price. Of course the alternative would be to just sell my option before expiration so that I would not have to get involved with the actual stock.

My strategy for options:

I’ve seen many of my stocks dip down to about 90% of my purchase price while I’ve held them. So in a sense, I’m OK with, and somewhat tolerant of, a 10% loss in my stocks. So instead of spending all of the money I had allocated for a particular stock, I might only spend 10% of that and use it to buy options. The worst case scenario there is that the options expire worthless and I lose all of my money. But remember, I’ve only spent 10% of what I was planning on spending, so losing all of my money is really only losing 10%. The best case scenario is that the underlying stock takes off and I make a large gain on my options. I have been buying options to sell them within a few days or weeks, as opposed to holding them until expiration. So I’m looking for small moves in a stock to let me cash in faster through the use of options.

Here’s an example of my first option trade:

The S&P Mid-Cap Spider (MDY) was had been down for a few days in a row. It was trading around $132. I bought two MDY $135 calls at $2.80 which were set to expire in about 40 days. Within two days, MDY peaked at $136 and I sold my options for $3.50. So in the course of three days I took $560 and turned it into $700. That’s a 25% gain in three days. I had set up a limit order to sell my calls at $3.50 and I’m glad I did. That day, only 10 options exchanged hands at that price and mine were among them. The window of opportunity to sell at that price was only about 5 seconds, so my limit orders really paid off. I knew what limit price I wanted because I had calculated what sell price I would need in order to get the gain I wanted, even considering commisions and taxes. If, instead of buying options, I used my $560 to buy MDY, I would have been able to buy 4 shares of MDY for $528. If I had sold them three days later, I would have gotten $544 for them. So instead of making $16 (hardly enough to cover commissions), by using the leverage of options, I made $140.

There are many more advanced strategies using options than the ones I’ve described here. There is a lot of good information available through websites and books on the subject. As long as my way of doing it keeps making me money, that’s the way I’m going to continue doing it.

One last note about options: Because there is always the risk of losing all of the money you put into them, there are usually some additional forms that you have to fill out with your broker before they will let you trade them.

Limit Your Costs

It took me a few trades to realize that the commissions for market orders and limit orders were the same at Scottrade. I had been using market orders because they seemed the simplest. Limit orders are really simple too, so I always use them now. When you place a market order, you buy your shares at the current ask price for the stock and sell at the current bid for the stock, i.e. at the market price. When you place a limit order, you specify the most you're willing to pay to buy a stock and the least you're will to take to sell a stock. The only downside of limit orders is that you might not end up buying or selling if the market price doesn't hit your limit. Avoid the mistake I made early on: Constantly raising my limit price until I bought the stock. If you want to be sure you get the stock, save yourself the time and just place a market order. In those cases where I did edit my limit price, it always seemed that the original price I had set was reached later in the day, i.e. impatience can cost you!

Thought of the Day

It's better to miss a pretty good deal than get a pretty bad deal.

Pain in Your Gain

Two things to remember, especially when you're first starting out in investing, are commissions and taxes.

Commissions:

After I made my first few investments I had a small amount of cash left in my account. So I picked a cheap ($10) stock and bought a few shares. The stock really took off and after a year it had gone up 20%. That's a pretty nice gain, but the value of my investment was so small that the commissions ate up a large chunk of that gain.

Lesson Learned: From now on, the absolute minimum that I invest in a stock is $500. Why? Scottrade, my broker, charges $7 for market and limit orders, which is about as cheap as they come. So to buy some stock and eventually sell it costs me a total of $14. I picked $500 as my minimum investment because $14/$500 is less than 3%. So the first 3% of my gains go to commissions and the rest is mine to keep (Except for Taxes, See Below) If my investment can't get me at least 3%, then it's probably not a good investment to begin with.

Taxes:
You have to pay income taxes on all of the gain you make on a stock. You pay it in the year in which you sold the stock. If you held the stock for less than a year, then it's a short-term capital gain and is taxed like regular income. So the rate is between something like 22%-35% depending on your income level. For a lot of people, it falls at 28%. If you held the stock for more than a year, then it's a long-term capital gain and is taxed at 15%. The year threshold is obviously also used for long-term/short-term losses.

Taken together, remembering taxes and commissions can significantly change your rate of return if you only have a small amount of money invested. If you make 15% on a $500 short-term investment, then you really only make 8%, because your gain is reduced by two $7 commissions, and $21 for taxes reducing your $75 gain to $40. If you want a true 15% on your $500 you would need to start with a gain of 25%.

In the Beginning...

There were times in my life when I considered getting into the stock market. Fear, inexperience, and a lack of confidence always seemed to persuade me away from it. It took falling in love with a company to get me past those barriers. The company was Google, and it was a long running love affair that continues, though to a diminished extent, to this day. I strongly believe that companies which are valuable to you because of the services they provide will be valuable to others and ultimately make a good investment. No company had every served my needs as well as Google. I was a regular on the Google Labs page and each new product seemed to be better than the next. There was also the nerd-factor helping with the enchantment: My educational background is in Electrical and Computer Engineering and at Google, that meant something.
When Google announced their IPO, I realized that my time had come. I opened up an account with a discount brokerage and had a whopping $800 at my discretion. I came into the game too late to actually get in on the IPO, so instead of the $85 offering price, I bought at the lofty price of $105 per share on the 6th day of trading, August 24, 2004.
As time when on, I started to see that Google, the investment, was as good as Google, the company. By the time I was able to buy more shares, I ended up paying $185 per share. Since then, I've sold some and bought some back, but there was nothing like that early thrill to kick start me into really enjoying the time that I spend looking for the next big one.

The Grand Entrance

People have all kinds of hobbies. Mine happens to be the stock market. That is not to say that I am an expert, have become obscenely wealthy through it, or will be writing a book about it any time soon. I simply enjoy it. If it seems odd that I would have a hobby at which I don't necessarily excel, please consider all the people who play golf on a regular basis with no hope of a corporate sponsorship or tour exemption anytime soon. I present this blog as a sampling of my thoughts, my flow of consciousness, on the subject of the stock market. I talk to a lot of people about the topic and would like to use this space to collect the highlights of those discussions as well as my current thoughts and strategies on the topic. I hope to be entertaining and insightful.