November 6, 2008
Protect Yourself in The Stock Market!
By Andrew Ralph
Unless you’ve been living in a cave somewhere, you’ve probably noticed the world is in real trouble. Businesses are going bust, global corporations are bankrupt, people are losing millions (and in some cases, billions!) and markets around the world are falling off a cliff. Basically, the financial world is going to hell in a hand-basket!
And if you believe the headlines, it will almost certainly take the rest of us with it.
If you’re an investor or trader in the stock market, it’s virtually impossible to make any money right now. Right? And if you are crazy enough to even try, you are putting everything you’ve got at risk. Right?
Well, not necessarily. There’s a big difference between the average trader or investor, and ‘smart’ traders or investors. The difference is this: knowledge and education! Education in the use of different strategies, combined with the knowledge of which strategies to use in these difficult times.
Being able to use different strategies in different market environments means you are always in a position where you can make good profits, regardless of what’s happening in the world.
And right now, you need the strategies that can handle the current volatility, otherwise you’ll be broke before you know it.
It was one of the greatest investors of all time, Warren Buffett, who said it best: “There are two rules to being a successful investor: Rule number 1): Protect your capital. Rule number 2): Refer to Rule number one!”
That’s never been more true than it is right now. With the volatility in world markets of late, the most important feature of any investment must be capital protection. If you don’t protect your bank, you can lose the shirt off your back (and the rest of your clothes!) in very short time.
But investors around the world are running scared, simply because of ignorance. The one thing most investors aren’t aware of is this: Armed with the right knowledge and strategies, you can protect your capital AND generate a healthy income
In this article we’re going to discuss the importance of doing exactly that – protecting against a material downwards movement in the price of any stocks we own, while still earning a monthly income. We’ll call it ‘Protected’ Renting Stocks. This is known in financial circles as a ‘Collar’ – essentially an adjustment to Selling/Writing Covered Calls.
Whatever you call it, there are a few simple concepts you should be aware of, and for those that aren’t familiar with the Renting Stocks strategy, in simple terms it has three simple steps:
1. Purchase the Stock;
2. Rent it out; and
3. Collect your Rental Income (which will be in your account the very next day!).
To rent a stock you simply sell a call option. It’s a simple process that has been a proven investment strategy for decades, and can provide you with a regular income. You simply choose a level that you would be happy to sell your stock at, called the Exercise Price (or the Strike Price) and the time you want to rent your stocks for (usually 3-6 weeks). Once you’ve chosen the call option, you then sell it and receive the rental income, called a premium. That premium is in your bank account the very next day, and is yours to keep no matter what happens to the price of the stock.
The downside to the standard Renting Stocks strategy is you can lose a large amount of capital during a market correction. If the price of your stock goes down, to put it simply – you lose money. That’s not fun, and that’s exactly why we do it a little differently.
We will talk about a fourth concept in a moment, which is where the ‘Protection’ aspect of Renting Stocks is introduced, and is the most crucial step for long term success.
Before we do, let’s take a look at what happens after you rent your stock. During the rental period (usually 4 weeks or so) there are three things that can happen to the price of your stock:
1. The price goes up.
If the price goes above our exercise price, we will be forced to sell our stock at that price. Of course, if we have set our exercise price higher than the price than we paid for them, we make a capital gain (extra profit) on top of the Rental Income. This is our best result which gives us the highest profit. If we still like the stock going forward, we simply purchase it again and start from the beginning.
2. The price goes sideways.
If the price doesn’t move much either way and it stays below the exercise price, we keep our Rental Income, and we still own our stock. In that case, we simply rent them out for another month at the first available opportunity, and receive more income. We can do that over and over again.
3. The price goes down
There are essentially two completely different situations here, so we’ll separate them and discuss individually:
a. The price goes down a little (<20%).
This situation is really no big deal. We simply keep our rental income, and we still have our stock, so we just rent it out again. If we don’t sell our stock, the loss is only on ‘paper’ – compared to real, cold hard cash we are receiving in rental income.
So if the price doesn’t drop much, we keep our stock, rent it out again and receive more premium, and keep doing that until the price goes up and we get exercised (see 1.)
b. Price goes down a lot!
This is obviously our worst case scenario, and the one we really need to protect ourselves against. When we say the price goes down ‘a lot’, we are talking about losing most of its value (think 80, 90 or even 100%).
Up until recently this rarely happened, but there have been many examples of late. A couple that come to mind are Lehmann Bros, AIG, and Bear Stearns, but there have been many others around the world.
The problems are not just limited to America. Take for example a company listed on the Australian Stock Exchange called Babcock & Brown ( BNB). This stock has lost 95% of its value in less than 12 months. It was once the darling of the market and couldn’t put a step wrong. If you were Renting Stocks this was a great company to trade as it kept going up and up, so you could keep renting it out and banking the capital gain on each new trade.
However, it would seem all good things come to an end… BNB went down from a high of $34+ to under $1! If you rented it out when it was near its highs, you have lost a significant amount of money, and it would likely take a decade or more in rental premiums to make up this short term loss (assuming you could time it perfectly and not get exercised (i.e. have to sell your stock) in the meantime).
So, what do we do to protect against this type of catastrophic – but increasingly more common – event? Simple: We insure our stock!
Like any other asset, we buy insurance on our stock, so that if the price does drop we have a guaranteed value we can sell it at. People insure their cars, their houses, their boats, their health – just about anything of worth is ‘insurable’ – but very few insure their portfolio of stocks (even though it can be worth significant amounts of money).
Just consider how much wealth has been lost in 2008 across the world on global markets. Literally trillions of dollars have been wiped away, sending many people who were planning on a wealthy retirement, back to work. Having insurance on your stocks to protect against such an event is crucial, yet amazingly, so few do it.
In a Renting Stocks portfolio, not only is buying insurance very easy to do, it’s very smart. The principle is simple: Sacrifice a little bit of the upside to protect against the downside.
Let’s look at BNB again. If we were doing that trade a year ago we would have purchased protection (insurance), which comes in the form of a Put Option. A put option gives us a guarantee we can sell our stock at a certain price in the future.
And remember, we are only trying to protect against a significant drop in price – not a small 10% or so decline – so we don’t need to insure the full price of our stock. We can buy cheap insurance that still protects most of our capital, meaning we still end up with a healthy profit after the cost of protection. There’s no hard and fast rule, but we normally buy insurance so our capital is protected to the tune of 75-80%.
So let’s say BNB was $29 at the time, and we rented them out at $30, and received a rental income (premium) of $2.50 for each stock. At the same time, we buy a put option for protection, at $24. That put option costs us 60c, which leaves us with net income of $1.90.
That $1.90 represents a Return on Investment of 6.6%, over a 4 week period. That’s good money. But even better, our risk is not the full $29 we paid for the stock, because we can ALWAYS sell the stock at the Put Option level – in this case $24. So the money at risk is only $5 ($29 we paid the stock minus the guaranteed sell price of $24).
Instead of ROI, let’s consider ROR – Return on Risk. Our initial income return is $1.90, and our risk is $5, so our ROR is a massive 38% for the month. Not bad at all!
Of course we are still risking $5 in capital, but if the stock price does come crashing down, we should be able to cover that gap with the income we are making by renting them out over a few short months.
Protecting ourselves against large losses in our portfolio means we can continue to make a nice healthy profit – in the form of a monthly income – even when the markets are as volatile as they are right now, without risking huge amounts of capital.
Assuming the worst can always happen you will protect you against the rare times that it does. In another 12 months when things settle down, you may be tempted to take all the income and forego the insurance as prices just keep going up. Don’t be tempted! The small sacrifice of spending a little bit of your profits on insurance will mean you can make a regular income from the market for the rest of your life, regardless of what’s happening in the world.
And better yet, having downside protection means you can always sleep well at night!
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