The right tool can make all the difference between success and failure. We’ve all heard this statement in some form or another before, but what does it really mean? In life, the right tool is obvious and clear. In finance, it’s not always so obvious.
For example, say you own a house located within a flood plain. A large storm is coming, and you know that you need to fill large number of sandbags quickly with sand to surround your home and protect it from being flooded. Do you use a shovel or a spoon to fill the bags? Easy choice right.
Now consider the financial equivalent. Say you know a certain stock is undervalued based on your personal research. The company released positive earnings results a few weeks ago, but an overall down market kept the stock from moving higher. You know that the company will eventually pop – it’s just a matter of time. Now, do you buy the stock and establish a long position, or do you use long-term options and hope for a bigger payoff? Does this seem like an easy choice now?
In general, most of us only have a few financial tools at our disposal. Options, shorts and longs, both in individual stocks and ETF’s, are perhaps the most common. In the following post I will go over when and where to use these tools within your trading strategies.
There is certainly an allure associated with options giving the high leverage these investment tools offer to the common trader. For small swings in the underlying asset, traders can see huge gains and losses in their option prices. However, these outsized moves come with an asterisk of increased risk not only associated with the underlying, but also more importantly time.
All else being the same, an option will lose value simply with the passing of time according to the Black-Scholes equation. This “Time Decay” as it is known increases in magnitude the closer an option moves to its expiry date. Thus, short term options have an even higher risk associated with the passing of time.
So, with this in mind, when should you use options within your trading strategy?
Aside from hedging as insurance, which I do not currently practice, options can be useful instruments when a known catalyst will hit a stock in the near term potentially driving its price up or down significantly. Some of these events might include earnings announcements, geopolitical deadlines or other company specific events. If you have research that suggests movement one way or another around these events an option might be your best financial tool available to place a trade.
Another time options might be employed is within a pairs trading scheme, something I am currently researching in hopes of finding success. The issue with using options over the next tool, however, is again the time component to the trade. If your pairs play does not pay off quickly the trade will lose value over time simply from the passing of time. Thus, pairs trading within options should consider some known catalyst to help spur the movement.
Although a lot riskier than options, short positions offer the attractive option of taking a negative position on an underlying asset without Time Decay due to the movement of time. This does not mean that time has no impact on a short position what-so-ever.
To initiate a short position in a stock, all brokers require traders to have a margin account from which they can borrow the shorted shares. Once these shares are borrowed, or shorted, each broker will charge the trader a certain margin interest rate which is assessed daily for the money that is borrowed to short the shares. This fee does not change with time but increase linearly with each passing day. Thus, holding short positions for long periods of time can become quite expensive just due to the accumulation of margin interest.
However, in general these fees will be less than the cost associated with Time Decay. This is why for pairs trades or statistical trades with collections of shorts and longs, using shorts in lieu of options is usually the correct approach.
The most important thing to remember with shorts is the chance of unlimited losses. That’s right – you can in theory lose everything and more! If a stock you short explodes higher you will likely be asked to cover a margin call which could be 100%, 200% or maybe even 10,000% more than you initially collected from the short position. The point here the loss is limit less and this MUST be taken into consideration when executing trades with short positions in them.
Unlike options or shorts, long individual stock do not afford the opportunity to make money during a downturn, however, their risk is generally lower because they are not tied in any way to the passing of time. If you feel a stock is undervalued in some form or another, but don’t know of any specific catalyst that might drive it higher in the near-term, a long individual stock position is likely your best bet. If your research is correct, then you will profit at some point in the future regardless of when that catalyst finally hits.
This is by far the easiest tool to use. When purchasing a long position in a well-diversified ETF the long-term risk associated with losing all your money is extremely low. Barring an extreme black swan we have yet to experience in history (1929 and 2008 both rebounded over time), you will over time make money from your trade. This is the tool that most people should utilize when investing for the long-term especially if they don’t want to put in the extra research require to effectively use the other tools mentioned above.