Sounds like it should be a title for a movie, doesn’t it? With all seriousness though you can and should be using this strategy especially in a nasty bear market. Lets face it, who really knows when we are at the bottom? Stocks that look like a bargain today can have their values halved in a short period of time. Does that mean you sit on the sidelines and wait for a recovery? The answer is yes, but that is a lot easier said than done. Very few people will invest at the bottom of the market. In fact most people wait till it’s too late to get into the market. With this simple plan you wont have to wait, and you wont have to worry about whether you purchased the stock too early or should have waited. If you follow the strategy as outlined you will be able to purchase a stock at a discount to the current market price and if not still make a return that is above average expectations. Did I get your attention?
A short while ago I wrote Bottom Fishing With the Bears outline a procedure of investing in bad markets. Now I would like to show you another strategy to use for bear market investing, in fact it will work in all kinds of markets as long as you are an investor with realistic return expectations. At this point I would like to urge you to read Bottom Fishing With the Bears, both strategies can be used simultaneously and have the potential to become an important part of your investment planning. Don’t kid yourself serious investing requires planning! Anyone can buy shares in a company but overlook the second and most important part of investing—proper money management.
Bottom Fishing With the Bears used a fictional company trading on the NYSE (New York Stock Exchange) under the symbol DOG. This illustration will use an ETF (Exchange Traded Fund) which is composed of the largest DOG companies in the United States and trades under the symbol (you guessed it) DOGS. Keep in mind that although the stock is fictitious the actual illustration is based on an actual ETF comprised of DOGS and it does trade on a major U.S. stock exchange. We want to keep the strategy as real as possible without giving any specific investment advice. It’s the plan that I would like to focus on and leave the investment decisions and selection in your capable hands. Yes I know I’m stroking you a bit, but since you took the time to read this far you demonstrated that you are open to new ideas and do have enough common sense to decide for yourself.
Back to the Simple Plan: Buying shares at a discount to the current market price. How is it done? Though the concept is simple, take sometime to reread the strategy since some of the instruments used can be complicated and require full understanding. Don’t rely on anyone else, learn it yourself before you begin implementation. There are three things you will require immediately before you begin. They are money, cash brokerage account and an options account. While the first two are obvious having an options account may be unfamiliar. However, you will need all three.
Having everything in place and your account funded with $10,000 in cash, I would not recommend that you should use this strategy with less. We are buying quality investments not speculating. Anything less and your return will be diminished by commission costs. At the $10,000 level the commission costs are almost insignificant, depending which financial institution you have your account. Now that you are ready to go, lets see how and what you would do to buy shares at a discount in the ETF of DOGS.
As of this writing DOGS ETF closed at $8.24 per share. Remember though it’s for demonstration purposes only it is based on an actual trading ETF. Since DOGS is composed of some of the largest U.S. institutions beaten down by the current market conditions, this may be a good time to jump in and invest. Since the market is bad you are not sure whether the shares will go even lower or whether they bottomed out at this level. Your obvious choice is to go out and purchase 1,000 shares of DOGS at $8.24 for a total investment of $8,240 before commission. The rest of the illustration will be based on costs before commission. That’s one way and most of us are familiar with this method. Nothing new here. However, let’s look a little deeper and see what we uncover.
At the time the shares of DOGS closed at $8.24, its 6 month $8 PUTS were trading at $2.34 per PUT. What is a PUT? Good question, I’m glad you asked. A PUT is an option giving the owner the RIGHT to SELL 100 shares of an underlying instrument at a specified price by a specified period of time. In our example for instance the owner of a PUT with a strike price of $8 has the RIGHT (not an obligation) to sell 100 shares of DOGS to the seller of the PUT (also called the writer) at $8 per share at anytime during the 6 month period regardless of the price of the stock. On the other hand the seller or writer of the PUT has an OBLIGATION to purchase 100 shares of DOGS at $8 per share during this 6 month period regardless of the price of the shares. Got all that? If not read it over again before I show you how you can benefit.
Rather than outright purchasing 1,000 shares of DOGS at $8.24 you place your funds into a high yield money market instrument. Then sell (or write) 10 six month $8 PUTS on DOGS for $2.34. Since each PUT represents 100 shares and you sold 10 PUTS you are now OBLIGATED to purchase 1,000 shares of DOGS at $8 per share. For this OBLIGATION you will receive $2,340 ($2.34 x 100x 10). These funds are yours to keep. During the next six months three possible scenarios can occur with DOGS. The price of the stock can go up, down or stay the same. Correct? Well let’s see what happens with each scenario.
The shares of DOGS go up in six months. In this case your upside potential is limited. You are limited to the price you would through ordinary method purchased the stock plus the premium on the PUTS you received ($8.24 + $2.34=$10.58). Anything above $10.58 is your cap. However should this happen your return by using the simple plan is 28.3 percent in six months. This does not include the interest earned on your original capital of $10,000. All in all a pretty good return, a 57 percent annualized rate of return. Should the shares of DOGS remain at $8 or any amount above your return will be exactly the same as above.
On the other hand should the price of the stock drop below $8 per share during this 6 month time period the owner of the PUTS will sell you 1,000 shares of DOGS at $8 per share and you will be OBLIGATED to purchase the stock at $8 per share or $8,000. However since you received a premium for selling (writing) the PUTS your actual cost for 1,000 shares of DOGS is $5,660 ($8.00-$2.34 x 1,000= $5.66). As long as the stock is $5.66 or higher you haven’t lost anything. Had you purchased the shares outright at $8.24 and the stock is trading now at $5.66 your loss would be $2.58 per share or 31.3 percent as opposed to zero. Also, keep in mind that you now have 1,000 shares of DOGS at a cost of $5.66 per share. Any increase from this point is a profit in your pocket.
Think of this strategy as an alternative to outright stock buying. It’s a great way to bottom fish. As I have mentioned before, very few people know when we are at the bottom. Some of us get lucky and buy at the bottom, but this is an exception and not the rule. Investing requires careful planning, luck happens but should not be relied upon. I am reminded of a saying that a broken clock is right at least twice a day. However, I prefer having once that runs. What about you? Apply this Simple Plan to your investment ideas and workout the possible returns. It’s worth the effort.
Ivan Cavric is the president and managing director of PrimeQuest Capital Corp. Ivan Cavric is also managing consultant of Associated Financial Corp. For over 20 years Ivan Cavric has been involved with venture capital and start up companies. During this period Ivan Cavric has been on advisory boards of several public, private and start up companies providing management services and personnel.
Ivan Cavric
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