One of the most difficult parts of investing is making the decision to buy or sell a position. It’s not so much even a question of whether or not we have the technical/fundamental understanding required to make such a decision, as much as it is an issue of emotion. Have you ever been so married to a stock that you wound up taking a hit before you refused to sell? Have you ever procrastinated off buying a stock that popped because you wanted to wait it out for a better price point?
More often than not, we find ourselves too comfortable with our portfolios. Unfortunately, there is no such thing as a safe portfolio, and as soon as we get so comfortable that we stop basing our decisions on real research, we get burned. Over the next few articles, I’m going to teach you a couple of tricks to keep your portfolio fresh, and to encourage yourself to keep doing your due-diligence.
My biggest problem as an investor is indecision. I’m always afraid that I’m buying into a bankruptcy story when I’m following a value play, and I’m always afraid that I’m missing out on some amazing unforeseeable upside when I’m taking my chips off the table. Worse yet, I’ll sometimes find myself second guessing decisions by buying back into a stock that I sold based on strength, or selling off as soon as I see some trouble on my latest purchase.
Being a wannabe quant at heart, I always follow up on these failures by crunching the numbers just a little bit harder, hoping to find some sort of mathematical insight that will tame my itchy trigger finger for next time. After working on it for a while now, I can promise you that there is no quantitative solution to this sort of thing. However, I can assure you that there is a simple solution to pursue that takes on a much more passive approach to cashing out.
As personal investors, our main goals of investment center on cash flows. This means that any buy or sell decision we make should be centered entirely on this objective. With that goal in mind, we must ask ourselves: “How is it that a purchase transaction generates consistent cash flows for a portfolio?” What about a selling transaction? They don’t really. Purchasing creates a net outflow, and a sale creates a one-time inflow for that equity. Gross! I don’t want money once, I want it repeatedly for the rest of my life! This is where options come into play.
Think of the following strategy as being similar to the cash-back rewards on your credit card. You spend money, the company gives you a percentage back, and it’s extremely psychologically rewarding. When we look at taking on a new position into our portfolio, instead of purchasing it, why not just sell a put on it? Find a price point that you want to buy at, and then sell a cash-covered put into the market. If the stock meets that price point, then you are rewarded by being sold the stock at the desired price, with an additional cash bonus from the premium.
If the stock moves unfavourably, don’t worry about it, the contract will expire and you can just wait it out without really have risked any capital (note: make sure you still hold enough cash in your account to cover the balance should someone execute the contract on you). Interested in getting into the position at the current market price, but still want to benefit from the premium? Why not go all out and sell a put that’s deep in the money.
If you’re willing to take the time to phase yourself into the market by dedicating more of your capital or margin towards being cash (which is risk free by the way) for covering your put positions, you might find it to be extremely profitable to simply sell deep puts into the market to establish positions in equities that you would have bought anyways in the first place.
The trick to using this strategy is to apply options as if they are really worth their full intrinsic value, even though you’ve only applied a small amount of cash for the transaction. Better yet, this cash is only at risk for a very short period of time, meaning you can easily re-adjust your positions without having to worry about indecision as being an issue. All you need to do is balance the cash positions to match your positions, and make sure that you are only engaging in transactions for securities that you want to own in the first place. It is really great for helping you test out a position before you jump in.
