You Can Beat the Market, If You Control the Rules
By: Don Fishback
The following is an excerpt from Don Fishback's Options for Beginners
It sounds shocking, but it’s true. Making money trading can be incredibly difficult. Investment gurus will tell you that you have to be invested in the stock market to truly strike it rich. But that sure doesn’t protect you from declining markets. And if you want a safe investment, you sure aren’t going to find much inflation protection from a bank account paying less than 5%. In the past it’s been even worse, as some accounts have paid less than 1%.
The only true way to make a decent return and stay protected when the market heads lower is to trade – that is to buy stocks before the market rises and sell before the market falls. But based on the performance of most money managers, even that is extraordinarily difficult.
Trading boils down to just one simple rule: Buy low and sell high. It doesn’t matter whether you’re trading stocks, mutual funds, real estate, collectibles, or options. It’s just that simple. Yet while the concept is simple, the implementation has confounded novice investors, academics and professional traders since the beginning of organized financial markets. That’s because no one has been able to accurately figure out how high is high, and how low is low.
Sure, we’ve all seen and heard about those who have beaten the market for brief periods at a time. But only a small handful of traders beat the market for extended periods. There are numerous studies showing that investors would be far better off simply investing in a basket of stocks mimicking a stock index and then doing nothing, instead of placing money with a professional money manager.
This should not come as a major surprise. One look at the quarterly mutual fund statistics is evidence enough that even the pros, with billions of dollars in financial market research at their disposal, cannot beat the major market averages. It is a sad fact that over the long haul, about 70% to 80% of all money managers fail to beat the market. In other words, only 20% to 30% of all market professionals actually earn their management fee.
As if that 20% to 30% figure wasn’t bad enough, unfortunately, it’s a lot worse. That’s because the 20% to 30% that beat the market one year usually aren’t the same that beat the market the next year. This rotational aspect to managers means that, over a five year span, the probability that a money manager will beat the market during the entire five year span is less than 1/5th of one percent! There are nearly 5,000 stock mutual funds. During the five year period from the beginning of 1998 through the end of the year 2002, there were only five mutual fund managers that beat the S&P each year.
With so many people, many of them with millions of dollars in research resources, trying to beat the market, and only a select few actually achieving their objective, that should tell you how difficult buying low and selling high truly is.
So how is it, if buying low and selling high is so simple to understand yet so difficult to implement that virtually no one can do it consistently, that anyone could honestly expect to master any aspect of trading?
The key is to change the rules! No longer should you simply buy and sell an asset (a stock, a mutual fund or a bond) based on what you think is going to happen.
Options have been traded on exchanges for decades. You have probably heard stories of those who trade options. Those stories run from one extreme to the other. That’s because the leverage one can get from options is incredible.
In some cases, people have made millions using options. Top notch professional option traders can literally earn millions of dollars in profits each and every year. I personally know several who trading options regularly earned profits in the millions of dollars.
Success is not isolated by the pros. Even novices can hit the big one. Perhaps you know of someone who bought an option and had it quadruple in value in a matter of days.
At the other extreme, however, it is a fact that many people have lost millions trading options. You see, options can be a zero-sum game. Of course, there are exceptions to every rule. When options are used in a strategy that combines options with the underlying asset, such as a covered call, it is not a zero-sum game.
Another common practice on the path to financial ruin is repetitive losing. Unfortunately, just reversing the process – buying options – does not guarantee success. You see, buying options that are likely to triple and quadruple in price guarantees that the odds are against you. In other words, if you focus exclusively on buying cheap options, you will “hit a home run” every now and then. But more often, you’ll “strike out”. The problem is that few investors have the patience or tolerance to sustain a long string of losing trades while waiting for a monster winner. What typically happens is that they give up before hitting it big.
Both of these latter scenarios are, unfortunately, far more common for individuals than those “get rich” stories. The sad fact is that most people lose money, and in some cases, they lose big. But that’s because most option traders simply buy a call if they think the market is going up, or buy a put if they think the market is going down.
The dismal performance of individuals trading options should come as no surprise. Very few people know the name of the formula that professional traders use to correctly value an option. Even less actually know the precise formula itself. And virtually no one understands the probability implications in the formula. Is it any wonder, then, that novices would lose big if they’re buying and selling something that they couldn’t put a value on?
Putting the Probabilities on Your Side
Trading options has its ups and downs. For most traders, the wild swings are just too much to handle, both mentally and financially. But there are some very attractive aspects inherent in options.
First, the leverage available with options is enormous, and the return you can earn on your investment is enormous, whether you are a buyer or a seller. Also, buyers of options have limited risk. This is one of the most attractive aspects of options. And sellers of options automatically put the probability of profit in their favor when they implement a position.
Think of the following scenario. The stock market has dropped 10% in the last two weeks. Should you buy more stocks or should you sell everything? If you buy more, the only way to make money is if it goes up. In other words, your investment pays off only if you guess the market’s future direction correctly. If you guess wrong, you lose. The problem is, as noted earlier, most people, including the pros, guess wrong! Thus, when it comes to guessing market direction, most traders are losers.
Let’s talk about another scenario. During a recent 2-year period, the market has gone up or down more than 5% in a month (measured from one option expiration to the option expiration the following month) only two times! In other words, if the S&P 500 was at 100 at the beginning of the month, in order for it to move up or down more than 5% in a month, it would have to be above 1050, or below 950. Of the 24 months during that 2-year time frame, such a move above or below that range occurred only two times! That’s only 8.3% of the time. That means the S&P 500 stayed within a 5% range 91.7% of the time!
That final figure is critical. Because it means, if we can find a strategy that makes money as long as the market stays within that range, we will automatically have a strategy that has, historically, made money 91.7% of the time!!
By utilizing a strategy of this sort, we’ve changed the rules of the game! No longer are we concerned about the market’s trend, its cycle wave, its chart pattern, or any other factors. All we are concerned about is its expected range, or the magnitude of the market’s move. This is how we change the rules. We don’t care if the market goes up or down. We only care about the size of the market’s price fluctuations. It is important to also note that we are using the S&P 500 as an example. This methodology can be applied to any market, to any stock or to any stock index. Each market, however, needs to be individually analyzed for prior historical price fluctuations.