Posts filed under: Podcast

(Part 6 of ten-part series on Financial Truths)

Section 1: Intro to Options

Section 2: Professionals Sell More Options Than They Buy

Section 3: Sell a Covered Call Against a Long-Term Holding

Section 4: Sell a Naked Option

Section 5: Sell a Spread

Section 6: It’s Got Options, But Should You Really Trade It?

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Section 1: Intro to Options

  • Calls and Puts
  • Options are defined by: Type (call or put), ticker symbol, strike price, and expiration date
  • Intrinsic value vs. time value
  • Constructing a profit graph
  • Long Call

    Long Put

    Short Call

    Short Put

    Long Strangle

  • Certainty vs. Probability: If you can eliminate a certain range of prices from the range of likely outcomes, OR isolate a couple scenarios that are most likely to occur, you can set up a trade with options that captures that hypothesis

Section 2: Professionals Sell More Options Than They Buy

  • Options are a form of leverage
  • Do you want to be the bank or the borrower?
  • Buying time costs money

Section 3: Sell a Covered Call Against a Long-Term Holding

Section 4: Sell a Naked Option

    • Collect premium up-front
    • Hold cash or margin reserves to back the position until expiry
    • It’s possible to lose several times the premium you took in
    • Importance of position management
    • Example:

Section 5: Sell a Spread

  • Same as selling a naked option, except you also buy an option having the same expiration date and a more extreme strike price
  • Position has a net credit (premium in your pocket)
  • Advantages and disadvantages

Section 6: It’s Got Options, But Should You Really Trade It?

  • Bid-ask spread: don’t get ripped off
  • If premiums are very rich, ask why

 

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(Part 5 of ten-part series on Financial Truths)

Section 1: The Efficient Market Hypothesis

Section 2: Who Is Your Competition?

Section 3: What Is Your Edge?

Section 4: The Wrong Ways to Use Technical Analysis

Section 5: Certainty vs. Probability

Section 6: The Winning Way = Big-Picture View + Timing Tools

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Section 1: The Efficient Market Hypothesis

  • Definition and forms: Weak-form, Semistrong-form, Strong-form
  • Why the efficient market hypothesis does NOT hold in the real world

Section 2: Who Is Your Competition?

  • The vast majority of shares are held by institutions or individuals who cannot or do not transact frequently
  • Paper by Edward Wolff of NYU – chart on top of page 15
  • Active vs Passive: Approx. 2/3 of US equity fund assets are classified as “actively managed”, 1/3 passive – statistic from Bloomberg article – but are they really “active?”
  • Who’s actually trading, reacting to new information that should affect prices?

Section 3: What Is Your Edge?

Section 4: The Wrong Ways to Use Technical Analysis

  • Ignoring one or more of the dimensions: Price, Pattern, Momentum, and Time (credit to Robert Miner – I recommend his book)
  • Magic indicators
    • Overbought and oversold indicators ARE NOT trading signals
    • Trading on momentum signals (e.g. Stochastic or MACD crossovers) by themselves will generate losses
    • “Bearish crossovers” marked by red lines would have produced large losses and significant trading costs, if used as signals to go short.

  • Trend-following: generates huge losses at major highs and lows, and repeated small losses in choppy markets
    • A simple method of trading moving average crossovers (20-day over 50-day) produced 6 wins, 11 losses, and lots of trading costs. Awful!

  • Failing to make a trading plan
  • Failing to make a risk management plan or to adhere to your plan
  • Ignoring trading costs and the cost of leverage

Section 5: Certainty Vs. Probability

  • You can never know for certain what the market will do
  • Technical analysis, when used correctly, identifies high-probability zones

Section 6: The Winning Way = Big-Picture View + Timing Tools

 

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(Part 4 of ten-part series on Financial Truths)

Section 1: What Is Diversification, and How Do You Measure It?

Section 2: Determine Your Personal Risk Tolerance

Section 3: Set a Baseline Asset Allocation

Section 4: Define Ranges (Min/Max) Around Your Baseline Asset Allocation

Section 5: Trade and Invest, Staying Within the Ranges

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Section 1: What Is Diversification, and How Do You Measure It?

  • Diversification = Owning a variety of assets that are less than 100% correlated with one another
    • Every pair of assets has a correlation coefficient, a statistic (between -1 and +1) that measures how likely they are to move in the same direction over a given period of time
    • Example: A portion of the correlation matrix I use, calculated from historical data:
  • If the standard deviation (volatility) of your overall portfolio is significantly lower than the standard deviations of most of the individual assets inside it, you are well-diversified
  • Owning a few stocks in the same sector, or the S&P 500, isn’t enough diversification
  • For options (puts and calls), calculate the true underlying exposure (number of contracts * underlying share price * delta)

 

Section 2: Determine Your Personal Risk Tolerance

 

Section 3: Set a Baseline Asset Allocation

  • Map your investment universe
    • Long-term investors: use the short list of six major asset classes
    • Traders & active investors: use the longer list of asset subclasses, which includes the ten stock sectors
  • Start with your personal balance sheet (introduced in Episode 3); set Cash % = Cash Requirement / Total Assets
  • Divvy up the rest between stocks and bonds according to your age
  • Carve out a little for precious metals and commodities
  • Adjust up or down for long-term market conditions (prospective 6-14 years).  Learn how to make long-term forecasts here.
    • Traders & active investors: steer your stock allocation towards the sectors with the highest forecasted returns
    • Can use individual stocks, just make sure to account for the higher volatility

 

Section 4: Define Ranges (Min/Max) Around Your Baseline Asset Allocation

  • First, choose the following parameters:
    • Maximum permissible loss on a single position
    • Typical stop-loss
  • Calculate minimum and maximum in each asset class/subclass:
    • Max % = Max Permissible Loss Per Trading Position / (Asset SD * Stop-Loss Multiple)
    • Min % = (-1) * Max %, subject to any other restrictions on short positions
  • Make sure these allocations fit within your risk tolerance
    • Have us run your portfolio through our Trade Analytics Service – we do all these steps for you
    • If you want to do the math yourself: Estimate the expected return and standard deviation of returns, under different scenarios
    • Model with a lognormal probability distribution, and/or run a simulation
    • Sample:
    • Calculate the 1/N percentile of the loss distribution (the loss that occurs 1 in N years)
    • If greater than X, go back and change your baseline asset allocations until they fit within the risk tolerance you defined
  • Check out episode 10 for sample asset allocation ranges.  You’ll find a free, downloadable spreadsheet there.

 

Section 5: Trade and Invest, Staying Within the Ranges

 

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(Part 3 of ten-part series on Financial Truths)

 

Section 1: Why You Must Not Trade Until You Can Set Aside $15,000

Section 2: Constructing a Personal Balance Sheet

Section 3: Figuring Out How Much You Can Afford to Risk

Section 4: Your Road to $15K

Section 5: How to Develop Your Trading Skills While on the Road to $15K

 

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Section 1: Why You Must Not Trade Until You Can Set Aside $15,000

  • It’s way too tempting to use leverage
    • Many exchanges require as little as $2,000 to set up a new margin account.
    • Margin debt carries an interest rate almost as high as credit card debt.  E-Trade: 9.25% on balances below $10,000
    • Buying options?  This is another form of leverage, and often even more expensive than margin.  With more capital, you can sell options instead.
    • Futures have MASSIVE leverage: e.g. 18-to-1 for crude oil on the CME – you’ll blow up your account unless you’ve got a long track record of successful trading, either in a real money or paper account
  • Commissions and fees will eat you alive

 

Section 2: Constructing a Personal Balance Sheet

  • Assets
    • Bank accounts, investments, retirement accounts, businesses, home equity, vehicles, other property, etc.
    • Contra-Assets (reduction to assets): Example – taxes on tax-deferred retirement accounts, like 401(k) and IRA accounts.  Could be as much as 30% or more depending on tax rates when you retire
  • Liabilities
    • Home mortgage, auto loans, student loans, credit card debt, business debt, medical debt, personal loans, etc.
  • Net Worth = Assets – Liabilities

 

Section 3: Figuring Out How Much You Can Afford to Risk

  • Establish an emergency fund
    • Think of a scenario that would be devastating for you financially (but nothing far-fetched/crazy like the end of the world!).  For example, being out of work for 6 months and your family facing $3,000 of extra medical bills during the same time period
    • Account for ALL costs you’d face, including staying current on debt
  • Don’t plan to rely on outside sources of funding like credit cards, cash advances, personal loans, etc.
  • Consider going further – perhaps a 12-month emergency fund, or keeping a year’s worth of mortgage payments or rent set aside on top of a 6-month emergency fund
  • Keep all emergency funds safely invested in cash-equivalents
  • If you’ve got $15K left over to deposit, then go forward.  But be sure to establish a risk management plan and limits in advance.  I introduced this topic in Episode 2.
    • What is a “significant loss” to you?  10%?  20%?  Don’t mind if you lose it all?
    • Over what timeframe?
    • How often can you accept this loss?  1 in 10, 20, 30 years?  Or more often?  To determine this, imagine that loss occurred just now.  Think about what you would do.  A big reaction, like selling lots of assets or closing an account – or small reaction, just watch things a little more closely?

 

Section 4: Your Road to $15K

 

Section 5: How to Develop Your Trading Skills While on the Road to $15K

  • Absorb knowledge
  • Follow the financial news for 15 minutes a day: Start with Reuters
  • “Paper trade”, but pretend the numbers are real – celebrate wins, feel the pain of losses

 

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(Part 2 of ten-part series on Financial Truths)

 

Section 1: What is Volatility?

Section 2: What is Risk?

Section 3: How to Profit from Volatility and Risk

 

 

Section 1: What is Volatility?

  • Volatility: the variation in asset prices or other financial indices over a given time horizon.
    • Changes in stock prices
    • Movements in interest rates, currency exchange rates
  • Some of this volatility is random and unpredictable, but some can be anticipated by savvy investors who are skilled in technical and/or fundamental analysis
    • I believe that as you expand the timeframe, from minute-by-minute to hourly, daily, weekly, and monthly charts, you get less random noise and more predictable trends and patterns
    • Others believe the shortest timeframes are the most predictable
    • Both perspectives are OK!
  • Actual volatility: can be calculated from historical prices
  • Implied volatility: is the volatility for a future period of time, as estimated by market participants
    • As implied volatility increases, the prices of options (calls and puts) increase along with it
    • The Volatility Index (VIX), calculated by the Chicago Board of Exchange, measures the market’s expectation of the 30-day volatility of S&P 500 Index options.  The VIX is commonly quoted in the media
    • Exchange-traded funds that track the VIX, for short-term speculative trades: VXX, XIV

 

Section 2: What is Risk?

  • Risk is a specific type of volatility: the probability of suffering a loss of a certain size
  • Rooted in probability and statistical concepts
    • A wide range of outcomes can happen over a given time period, from large losses to huge profits
    • The simplest illustration is a bell curve: height represents probability, width represents range of possible outcomes (left=bad, right=good).  Two sample curves below:
    • The market doesn’t follow a bell curve in reality, but it’s a simple illustration
  • Risk is defined differently for every investor and trader
    • 1- You choose the amount that represents a significant loss to you (percentage?  dollar amount?)
    • 2- You choose the timeframe over which to measure profit/loss
    • 3- You choose how often you can accept this amount of loss (there is NO WAY to trade with zero chance of a significant loss)
    • What will you do if/when the loss occurs?  This determines how often you can accept that significant loss (1 in 5 years?  1 in 30 years?)
  • Most trading books recommend limiting the risk of each trading position one-by-one.  Simple, but misleading
    • Common rule: set a stop-loss at 1%, 5%, or 10% of your trading capital
    • Far better to understand the risk level of the entire portfolio of investments and trading positions together.  It’s more complex, but our Trade Analytics and Coaching services will assist you
    • Calibrate the risk level of your portfolio so it matches up with your definition of risk, determined by the 3 components of the prior step.  (1-Amount, 2-timeframe, 3-how often)
  • Your personal risk tolerance determines how aggressively you can invest in the markets, and what kinds of financial instruments you can trade.

 

Section 3: How to Profit from Volatility and Risk

  • Most important: Stay within your own risk management plan
    • Keep enough cash reserves OUT of the markets for things like: job loss, adversity, major purchases or down payments
    • Define a maximum loss over a certain time horizon, and know what you’ll do if it’s reached
  • When implied volatility is too high, sell options (calls and/or puts) to put those fat option premiums in your pocket
  • Keep extra dry powder for crises, panics, downturns, buying “fallen angel” stocks & bonds
    • When the market is stricken by fear, but better times are around the corner, you’ll be able to load up on bargains and wait for normal conditions to return
    • Many institutions aren’t allowed to invest in stocks and bonds below a certain size or credit rating, so they’ll be forced to sell
    • As long as you’re within your overall risk management plan, buy from them at “fire sale” prices
    • Example: VanEck Vectors Fallen Angel High Yield Bond ETF (ANGL) vs. oil ETF

 

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(Part 1 of ten-part series on Financial Truths)

 

Section 1: The old model of: go to school, get a stable job, get pension / save in your retirement accounts, buy-and-hold for the long run, retire with lots of money set aside – it’s dead, over, gone, buried in history.

Section 2: You can easily become over-concentrated in a few highly correlated asset classes; correlations rise in a crisis

Section 3: “Leaving it to the experts” is leaving money on the table

 

 

Section 1: The old model of: go to school, get a stable job, get pension / save in your retirement accounts, buy-and-hold for the long run, retire with lots of money set aside – it’s dead, over, gone, buried in history.

  • Employment/population ratio (data.bls.gov) – peaked at 65% around 2000, down to 60% now and will keep dropping
  • Shift towards part-time jobs, freelancing: A survey by Upwork and the National Freelancers Union suggests that 55 million people, or 35% of the US workforce, made money by freelancing in 2016 – up by 2 million in the last 2 years. The largest growth rate has been in “diversified workers” who combine different part-time and freelance gigs into a full-time income. http://www.citylab.com/work/2016/10/the-two-sides-of-the-freelance-workforce/502955/
  • Today, 27% of private sector workers have access to defined benefit plans, and 58% to defined contribution (Bureau of Labor Statistics) https://www.bls.gov/ncs/ebs/retirement_data.htm
  • IRAs only became popular starting in 1981; Roth IRA began in 1997, 401(k) in 1980; there isn’t a long track record of them working for people from start to finish
  • Need a diverse skill set and good financial literacy to be successful today – take charge of your life
  • Fortune: nearly two-thirds of Americans can’t pass a basic test of financial literacy, 5 point drop since 2009 (http://fortune.com/2016/07/12/financial-literacy/ ).  Example – calculating interest on a loan.
  • Dave Ramsey: “Growth stock mutual funds make 12%/year”; Suze Orman says to dollar-cost average, it’s nonsense. Past performance does not indicate future results.

 

Section 2: You can easily become over-concentrated in a few highly correlated asset classes; correlations rise in a crisis

  • What does diversification really mean?
  • Examples of alternative assets that offer real diversification
  • Diversification is NOT: (but these are a start)
    • Having more than one brokerage account or retirement account
    • Different stocks, like in an ETF, mutual fund, tracking a market or index
    • A bunch of ETFs or mutual funds, tracking different markets or indices; all paper assets
    • Having money denominated in various currencies
    • Different paper assets like bonds (beyond a certain point)

 

Section 3: “Leaving it to the experts” is leaving money on the table

  • If you need your savings to be there for you when you retire, you need to know what you’re invested in, and why
  • Very few of the real experts are managing public money
  • They cost too much, extract lots of fees out of you
  • Some are compensated based on revenue they bring to the firm
  • Narrow-minded thinking, limited skill/knowledge of these experts, not looking at big picture
    • Thomas Picketty on demographics: In Capital in the Twenty-First Century (2013/2014), he states that global output grew at an average annual rate of 1.6% from 1700 to 2012, 0.8% of which reflects population growth and 0.8% of which came from growth in output per person.  Growth averaged 3.0% from 1913 to 2012, but this was largely due to population growth and is not sustainable.
  • Robo-advisors are selling a lie
    • Same type of garbage mathematical models that were used to justify mortgage-backed securities before the 2008-2009 financial crisis
    • Short time horizon, static models, not accounting for enough inputs or qualitative factors
    • Might seem cheap but what are you getting?  They don’t offer anything other than a very short list of ETFs, like a 401(k) – no PMs, no digital currencies, no country- or region-specific ETFs, no way to use options to manage portfolio risk.
    • Wash sales – not integrated with other holdings outside of that robo-advisor – false sense of security.
  • More sophisticated strategies achieve better results
    • Hedge funds (before they grew too large) – http://www.businessinsider.com/hedge-funds-and-sp-500-nearly-identical-2013-8 Hedge funds outperformed the S&P 500 only slightly from 1993-2006, but with much less volatility and far smaller drawdowns.  Risk management matters.
    • Private equity – https://www.bloomberg.com/gadfly/articles/2016-05-11/private-equity-has-diminishing-returns – The Cambridge Associates US Private Equity Index returned 13.4% annually net of fees from 4/1986 to 12/2015, with a standard deviation of only 9.4% (vs. Russell 2000 at 9.9% return, 16.7% standard deviation)
    • Picketty research (Capital in the Twenty-First Century) – the largest university endowments consistently outperform the smaller ones.  These have the funds needed to employ sophisticated advisors and invest in alternative assets that improve portfolio returns and reduce volatility
    • You can learn and apply many of the same strategies these sophisticated investors use to manage multi-billion-dollar portfolios.  In fact, you have an advantage they don’t.

 

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