By Dr. Jim Dahle, WCI FounderI am generally a fan of boring, long-term, low-cost investing techniques. While I think financial markets are fascinating to watch and learn about, I mostly invest like a grandma. That allows me to invest my time actively and my money passively, and most importantly, I can disappear into the boondocks for weeks at a time without having to worry about my investments. Many other successful investors feel the same way. For them, investing is the act of putting money into successful businesses highly likely to be profitable over the long term and leaving it there until that profit shows up. They view themselves as long-term owners, not gamblers.
Thus, they turn up their nose at others who invest in a short-term manner or, worse, treat the stock market like a casino by making short-term bets. These bets frequently take the form of options, futures, margin, and short-selling. New investors may not understand what these techniques really are and their useful functions. As they learn, they may mistakenly think these are “advanced” investing techniques and that it is a natural progression to start using them as one learns more.
Are these techniques the four horsemen of the financial apocalypse just waiting to ruin your financial life, or are they something that white coat investors should consider using?
Options Investing
Options are a “derivative.” You're no longer investing in the underlying business, but instead, you're making a bet on what the price of the business (in the case of a stock) or businesses (in the case of a fund) is going to do in the short term. There are lots of different options and option investment techniques, but broadly speaking, they can be divided into calls and puts. Each of these types of options can be bought or sold.
For example, if you believed the market was about to go up sharply, you would buy a call option. Perhaps you buy an option to purchase 100 shares of VTI at $200 per share. If the price suddenly went to $250, you could exercise that option, buying those 100 shares at $200 ($20,000 total) and then you could turn around and sell them for $25,000, netting yourself a cool $5,000. Even after paying for the cost of the option (say, $500) you still received $4,500 for making that bet. And there is no rule that says you can only buy one contract. If you bought 100 of them, you could have made $450,000. Do that correctly a handful of times, and you could retire. The option eventually expires worthless, although the option itself can be bought and sold up until the expiration date. Obviously, the further VTI gets above $200 a share, the more valuable that option becomes. The price of the option itself can be dramatically more volatile than the underlying security, creating a casino-like atmosphere with plenty of high-stakes bets.
A put option is just the opposite. If you think the market is going to fall, you could buy a put on VTI. Perhaps you bought the right to “put” your shares to someone else at $200 a share. If the value of VTI then falls to $150 a share, that's a very valuable put. A typical option buyer has many small losses and an occasional big win.
Just like you can buy these options, you can also sell them. Most of the time, you'll earn a little premium for doing so. You still own the security, you get any dividends it pays, and you earn perhaps $500 for selling that option. However, you'll occasionally have to make good on that option, and the call or put you sold will be exercised. A typical option seller generally has many small wins and an occasional big loss.
When Might a WCIer Want to Use an Option
Betting on the market short-term isn't good investor behavior, but there are situations when even a competent, long-term investor might want to use an option. Imagine you're stuck with a low-basis, legacy investment in an individual stock where the tax cost of selling is just too high. You can hedge against the drop in value of those shares by purchasing put options. If part of your compensation was shares of your company but you were required to hold those shares for a year or two before selling them, you could also use a put option to insure against losing that compensation. Maybe better to lose $5,000 in option premiums than $50,000 in “salary.”
More information here:
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Futures Investing
Another derivative to be aware of is a futures contract. These frequently show up in the commodities market. Traders use futures to bet on the direction of commodity prices. Think of a “future” as a contract that obligates a buyer to purchase a certain amount of a commodity at a certain price on a certain day and obligates the seller to sell that same amount of the commodity at that price on that day. If you think the price is going to go up, you would buy it now and lock in your ability to buy it at something similar to today's price. If you think the price of something you own is going to go down, you might sell a futures contract to lock in your price. Most of those buying and selling futures contracts are just speculating on the price of oil, gold, pork bellies, orange juice, or other commodities. It's a zero-sum game before costs, and a negative-sum game afterward.
When Might a WCIer Want to Use a Futures Contract
Some airlines (famously Southwest) hedge their cost of fuel by using futures contracts. I suppose if gasoline was a major part of your household budget, you could do the same. However, this can also be done with the cost of housing. You can essentially transfer the risk of the cost of housing going up dramatically to someone else. Perhaps if you wanted to buy a house and had the money to do so but needed to wait a year to complete a fellowship before buying, you could buy a futures contract that would become much more valuable if the cost of housing went up during that year. Then, you could use that additional money to help with your down payment.
Margin Investing
Margin is just investing using borrowed money. Since most investors do have debt, most investors actually are “investing on margin.” However, margin generally refers to using a margin account in combination with your taxable investing account. These accounts allow you to use your investments as collateral to borrow money, which is then invested into more investments. What could go wrong, right?
If your expected return on your investment is higher than the cost of that debt, you would expect to come out ahead. This is pretty similar to what real estate investors are doing with mortgages (leverage). The main problem with margin, of course, is margin calls.
You can minimize the risk of a margin call by not borrowing anywhere near the amount that would cause a margin call. If you have a taxable account of $1 million, it's not very risky to borrow $100,000 against it. It is risky to borrow $500,000 against it. Depending on the location, type of investment, and broker, margin requirements can vary from 25%-100%. A 100% margin requirement means a security is not marginable. A 25% margin requirement means that at least 25% of the account must be your money, not borrowed money. If the percentage of your money in the account falls below the margin requirement, you will be asked to put more money into the account. This is a margin call. If you do not put more into the account within a few days, the broker will sell your shares to raise that money.
I find it fascinating that 20%-33% is typical and even “standard” with real estate investments but that 50% is the most that can be initially borrowed against a stock investment and nobody has a maintenance margin requirement below 25%. This is one of the advantages that real estate has over stocks. Lower, fixed, non-callable debt is more easily used. Of course, you could always borrow against your house and use that money to buy stocks, I suppose.
When a WCIer Might Want to Use Margin
Rather than investing on margin, borrowing against the value of your investment portfolio can be a very accessible means to get your hands on some cash. Maybe you want that cash to help a family member, buy a house, purchase an investment property, or pay off a practice loan. You can also use leverage if reaching your financial goals requires particularly high returns. I wouldn't be very comfortable with more than 75% margin, meaning 1/4 of the account is borrowed money. That way if the market fell 50% (as it does periodically), I would still be above the typical maintenance margin requirements of most brokerages (25%-35%). Be aware that brokerages can change margin requirements without giving notice. That's bonkers, right?
More information here:
How Market Timing Lost Me $200,000
Short-Selling
The last of our four horsemen is short-selling. In essence, when you buy a stock (whether directly or via a mutual fund) you are taking a “long” position. You own the stock. When its price goes up, you make money. It pays you dividends. You can also be “short” a security. When this happens you have borrowed a security from someone else (like a mutual fund) to sell. You sell it with plans to buy it back later, hopefully at a lower price. It is a method of betting that the market will go down. Since the market typically goes up long-term, this is a particularly risky bet, and it becomes more risky the longer you make it. To make matters worse, you have to PAY the dividends that you are used to receiving when you are long. If you sell a stock without actually borrowing it (or confirming it can be borrowed), this is known as a “naked short.” Naked shorting has been illegal since the 2008-2009 Global Financial Crisis, although there are still a few loopholes that allow it to be done.
When a WCIer Might Want to Short Sell
Similar to selling a put, short-selling can be a method of insuring the value of a security you do not want to or cannot sell from a major market drop. If you are both short and long on the same security, you're now insulated from market movement.
I don't advocate you spend a lot of time and effort investing using options, futures, margin, or short sales. However, each of these techniques does have uses beyond gambling in the financial markets.
What do you think? When have you used options, futures, margin, or short selling? How did it work out for you?
You could theoretically use protective puts as a hedge rather than bonds. For instance, if you went 100% S&P 500 (for instance SPY ETF), then every 6 months or year (as the market is going up) you determine your “take profit level” and then buy protective puts at this amount/cost for your whole (or even most of it) equity position, just to prevent a drop further than that level. Reset these puts periodically at some (gradually higher) interval so that your nest egg never goes below that. As long as the cost of these premiums of the protective puts is less than what you would have “lost” by holding fixed income (whatever your bond allocation would have been), you would come out ahead. And no bond risk too.
I’m thinking along similar lines. I recently received a large lump sum of cash that I would like to invest in the S&P 500. I know that historically it makes sense to invest all of it at once, but this is psychologically difficult. I could dollar-cost average in, but another option would be to sell puts, such that I receive income if the index continues to increase but buy in during inevitable drops.
I read somewhere that is how Buffet gets into his equity positions: he sells cash secured puts and collects the premium and then gets into the long position as soon as the equity drops a little. Buy it at a cheaper price, and get PAID to buy it (premiums), if you are going to buy it anyway. These are assuming equities or funds you value long term and plan to keep.
Maybe you should fix the psychology. Are you going to sell puts forever? If not, what’s different between right now and whenever you’ll stop selling puts?
The difference between right now and when I stop selling puts is price. Assuming the market dips a little, which it almost always does, I’ll buy in at a lower price than right now, and in the meantime get paid to wait. Over time I’ll dollar-cost average my way into the market at a lower average price.
Not sure which risk/cost is higher, the risk/cost of a put not working in a nasty market or the risk/cost of bonds. Maybe I should trust options more than I do.
Having a mortgage and doing taxable investing is somewhat equivalent to using margin.
There’s some literature that by holding a broad market ETF (let’s say SPY again) and running the “wheel strategy”, (an options strategy where you get into a long position on an equity/ETF by selling a cash-secured put, earning premium, then sell covered calls on your position, earning more premium until it is called away, then repeat the cycle) you can regularly beat the S&P in flat and especially down markets (not as much on a bull run, but still sometimes) with a better adjusted risk ratio. That’s something to consider.
About 5 to 10% of my portfolio is in a covered call option program run by my “financial guy” for himself and a few of his clients. He takes positions in major, dividend paying, US stocks and sells calls on them that, if the stock is called, will yield a 10 – 15% annualized return. If not called, the calls are resold. The costs of the program are subsumed by the overall portfolio management annual fee of less than one percent. Apparently finding the right stocks, timing and calls to generate these returns is time consuming. He was originally an accountant and considers this a challenge. The program does about 12%/year and he keeps reminding me that I should look at it as more like a part of my fixed portfolio than the equity side, because occasionally I lose on the upside if a stock takes off. We generally have long positions on the same stocks that have calls written, so I still get some benefit from a runaway stock. However most stocks in the call program are not likely to run and are often not called and resold multiple times. It’s a very conservative investment where the only downside is decrease in the value of the stock and the limit on the upside by the call strike price.
You should track this section of your portfolio against the funds/equities he is doing the covered calls on by themselves. I bet you are beating them during down and flat markets, and (if these aren’t huge growth stocks) at least having very similar results during up markets. As long as this is all in a tax protected account and it isn’t getting eaten up by fees, it seems like a decent idea for a percentage of the “hedge” component of your portfolio.
So limited upside and all the downside? What’s not to like (besides the AUM fees and individual stock picking)?
For stocks held long term, gains or losses are meaningless unless sold. The ability to make recurrent income from repeated call sales (up to four times per year) on the same stock can lead to significant returns on an underlying asset that would otherwise not produce any ongoing gain except dividends. As noted before, an annual return in the 10-15% range on a portfolio of stocks over and above asset appreciation seems reasonable.
I disagree with all of the assertions you made in that comment.
# 1 Gains and losses are real whether you sell or not
# 2 Gains are not just income and confusing the two can lead to lots of investment mistakes.
# 3 Expecting 10%, much less 15%, in income PLUS appreciation is far more than is reasonable to expect. It doesn’t take long to become very wealthy with long term returns like that.
Sorry, I wasn’t specific enough. Call strike prices are set above the cost of the stocks, so if the stocks are taken, annualized return is the sum of call premiums, stock appreciation and any dividends received.
Yes, you get the appreciation and dividends right up to the point where the stock ownership is called away from you.
Covered calls are best during sideways or down markets where recurrent call premiums can generate 5-8% annual returns on equities that remain relatively flat for extended times. As mentioned before, they should be considered more part of the fixed portfolio with a relatively predictable return, versus the equity side.
I’d be interested to see what the tax drag is on your strategy. Sold calls are taxed the same as regular income. If you’re a high income earner, maybe you’re in the 24+% marginal bracket. So reduce your returns on calls by around the same. While I tend to prefer income, the advantages of capital appreciation are #1, choosing when to take the profits (and pay the taxes) and #2, their treatment as LTCG if held for over a year. Last question, have you tracked the long-term returns of the stocks of companies which were called? Rationally, a call is exercised because there’s an appreciable difference between the stock price and strike price. If you’d held those stocks longer, I’m curious if you’d have not been better off. Since your financial guy like the challenge of finding these equities against which calls are sold, maybe he’d appreciate the intellectual exercise of determining the difference between your total return realized and the value of holding those equities to date. In fairness, until you account for the tax drag and the difference in the current value of the equity and what you realized, you can’t truly say the strategy is successful.
The call program is a sub account in my retirement accounts, so no current taxes are do. A fixed annual fee covers all my accounts, retirement and taxable, so there are no additional transaction fees for the call program. As mentioned most of the stocks used tend not to move a lot. For stocks that are more volatile, they sell calls on about half of the position and stay long on the remainder to gain some benefit if the stock takes off. I recently checked on returns; last 12 months, 12.3%, last 3 years, 11% annualized. Returns include call premium, any dividends paid (all stocks used pay dividends) and, if the stock was taken, the gain on the sale. There is always a gain because calls are not sold that would lead to a loss. (No eventual tax calculation included). This account is tallied in the fixed portion of assets, since it’s returns are fairly predictable and does better than other segments of the fixed portfolio. Some of the stocks in the call program are also held long in the equity accounts as well.
You are correct about determining the “success” of the strategy. Since the goal is a relatively stable, predictable return without worrying about the downside since, if the stocks decline, the calls are not exercised and they get resold. I agree it is not flashy, but it provides current income that funds a hunk of our RMD. I have been retired for almost 10 years, taken increasing RMDs each year and my assets are significantly greater than when I retired. We follow our WCI guru’s philosophy with substantial charitable donations and almost annual trips with our kids and grandkids (17 at last count). We consider that “success”.
As an aside, the majority of assets are on the equity side, with the obvious goals of growth and inflation protection, and they have performed very well.
What a contrast reading quality blog material like this insightful post….and then perusing the forum, subreddit, and Facebook group. Comical, yet sad to see so many doctors try to market time.
As far as borrowing against the value of your investment portfolio for cash, there are also pledged asset lines. I’ve not done it but I’m thinking about it. Thoughts?
Another option for margin later in life is to borrow on margin and spend that money rather than selling the securities.
Hopefully the asset appreciates more than the interest you’re paying but you also avoid the capital gains taxes and your heirs will get the step up in basis at your death.