Moneywise24 Personal Finance

I have to admit I made a big mistake over the past few months. Actually, it is warned about in books, blogs, and websites, and still I did it. Call it a combination of laziness and wishful thinking.

My investment style

I invest a lot with options (in addition to other types of investments), and although I know it is a risky business, I find that options provide a great opportunity to use the leverage in both directions. I tend to take mid-term to long-term positions, aiming at selling them on the short-term or mid-term. I usually buy call options, using put options only to hedge an already existing portfolio. Read the rest of this entry →

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I bet everyone knows the term “hedgefunds”, especially since they have had a lot of negative publicity in connection with the financial crisis. Still, the main principle of a hedge fund is clever and straight forward: by allocating a part of the portfolio to anticipate on a downturn of the market, the portfolio is protected against sudden negative movements of the stock exchange. Hence, a hedge fund in a classical sense seeks to diversify its portfolio in such a way, that it can benefit from both a positive and a negative market.

I have been playing around with different methods in order to protect my (still small) portfolio against a sudden negative downturn. Since I know options quite well, I have used put options to protect my portfolio against sudden negative movements.

Option basics

The basic principle of a stock option is that it gives a right to buy (call) or to sell (put) a particular stock during a given period at a pre-set price. The fact of buying or selling stocks in this example is quite irrelevant, since a call option itself will increase in value when the stock’s price increases, and the put option will increase in value when the stock’s price falls.

Options can be bought on virtually anything, on stocks, oil, gold, or an index.

Buying a put option on a market index

Sometimes, concerns over a particular topic can result in sharp downward movements of the market. This does not mean that the stocks in my portfolio are bad, it is a momentarily event. If I buy a put option on a market index, I can profit from this sudden downturn market.

Since my strategy was only for the moment, I bought a put option with a relatively short timespan, say one month. Additionally, I bought an option which was out-of-the-money, meaning that the strike price is below the current price of the index; this makes the option cheap.

Last, I bought the put option with a very limited amount of money, and it made only 5% of my total portfolio.

What happened

Concerns over Greece, Ireland, the earthquake in Japan as well as political instability in the Middle East caused the index to drop by an average of 1% each day. The put option I had in my portfolio virtually exploded, since the expectation of a further decline of the markets were fed by the world news.

Although my portfolio, which in general is quite stable, fell with around 5% or 6% (I have quite some options in my portfolio, so profits and losses are considerable sometimes), my put option on the index increased by 200%. I sold the option with a nice profit, and was able to neutralize the losses on the rest of my portfolio.

Risks involved

Buying and selling options is not without risk. Especially when buying out-of-the-money options, where the price is purely based on expectation, the option can become worthless in a few days, or even a few hours. If the market does not move as you had anticipated, then you may expect to lose some considerable amount of money. Therefore, it is absolutely vital not to invest too much money into options (I would say a maximum of 10% of the total portfolio’s worth), but spread your portfolio between multiple products.

Another risk when buying options on a market index is, that sometimes particular stocks which are performing in the extremes (both positive as well as negative) may push the index contradictory to the general market sentiment.

Before investing in options, be sure to get informed yourself about this product, or speak with your financial advisor.

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I started investing my money actively around three years ago. My first approach was to invest a small amount of my money into mutual funds, in order to secure my retirement. But in addition to that, I wanted to get more active, invest a bit more of my assets, and start to invest in mid-term market movements.

A great way to do that is to build your own portfolio, using stocks and bonds. However, with stocks I found that you actually need a substantial amount of money in order to profit from it. If I only consider the commission I have to pay for buying the stocks, the smaller the invested amount, the bigger % profit I need to realize to get out with a good profit.

In addition to stocks, I have been using options for quite some time to profit from short-term market movements. However, options are also a great tool to profit from mid-term market movements. The profit can be much more substantial than when you invest in stocks, and a much lesser amount is needed to get out with a good profit. Also, I find options to be ideal if you want to ‘test’ the market, if you are a beginner.

Options may seem a lot more complex than they really are. Basically, options are are rights on their underlying value, in this case stocks, which simply gives you the right to either buy a particular stock at a certain price during a specific time range, or it gives you the right to sell a stock at a set price during a specific time frame. Of course you are not forced to exercise your right; when stock markets move, so will option prices, and you can simply sell the option at a later time.

I find options such a great tool due to the leverage effect they offer; whereas I might have had a 9% profit on a stock, I might have realized a 60% profit with an option on that stock. The key point is that you are anticipating the stock to move in a certain direction within a specified time, in stead of buying and holding your investment for years.

Options are very volatile instruments, and surely your potential to lose money is just as big as to earn money from it. Therefore, I assign only a smaller percentage of my portfolio to options. Still, I find them to be quite a good enrichment to my portfolio, and they helped me a great deal to play the market with only very small investments.

Although option trading has a very speculative image, I feel they can be treated very similar to stocks, if:

• I focus on up-trends. Markets tend to focus upwards on the long run. Speculating on market corrections or crashes can be quite risky, so I tend to focus merely on call options.
• I focus on a 3 to 24 month development. Stocks tend to make very swift market movements, and often stocks can dip for one or two months before increasing for months to come.
• I focus on fundamentally healthy companies only. I use the same kind of company analysis as I would have done with stocks. Technical analysis will also give me a hold on a stock’s trend and turning points, as well as whether the timing is good or not, but I will never invest in poor performing companies.
• Options can be very volatile, and sometimes a tiny negative stock movement can push the value of the option to a -40% loss, before increasing to a 60% profit. Still, if the value of my option drops below -50%, I consider it a loss, learn from the situation, and sell the option. On the other hand, I would sell my option at a profit of anywhere between 60% and 100%. I might buy the same option at a later time, if the timing is right.

You can read more on how options work in my previous post here.

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I have to admit, I don’t have the best ‘education’ when it comes to doing investments. I didn’t grow up in a family, that taught me all about finance, and even during my education International Business Management, investments and the stock market wasn’t dealt with in great detail.

I did my first investment in 1998… or rather speculation, when I bought an option in a company, which later appeared to have falsified its bookkeeping; and thus they went bankrupt. I didn’t touch investments for a few years. Then I learned a bit more about fundamental analysis, and I thought I got it… I learned about technical analysis, and I had thought I had understood it.

But it’s when I started reading about behavioral finance, that kind of opened my eyes. I realized that everything I had done wrong, and my losses were more the result of submitting to my emotions rather than bad analysis. I want to deal with three of these typical emotions, and how they can ruin virtually any potentially good investment.

Information Bias

One of the main problems, is that people are very subjective beings. I always found it strange that for some reason I found a lot of proof, supporting my belief about a particular stock, bond, or mutual fund. Then, it didn’t work out as it was supposed to, I panicked, and suddenly I found tons of material, supporting the opposite.

Information bias is a distortion in the perception of human beings. If we have an opinion of something, we unconsciously search for information that supports this opinion, or it seems to be dominantly present. As such, we may make wrong decisions. Information bias often exists since people want to go with the flow, or the masses. Not going with the masses might mean making a fool of yourself, or being put off as ridiculous.

Selling too early, selling too late

Being successful in the stock market often means limiting potential losses and letting profits rise. At some times, I have been guilty of doing the exact opposite: selling very early with a small profit, but selling much too late, letting my losses be driven up.

Relating to stocks, we often become very excited at small changes, and the bigger the change, the more relaxed we get. Therefore, many people tend to sell early at a small profit, being euphoric that they made a profit and fearing that they might lose it. On the other side, these people might become scared at having a small loss, hoping that the stock will recover. If this does not happen, often people tend to think that it would be useless to sell the stock now anyway, and the further the stock falls, the less emotional and involved they become. It is not unusual, that these people sell the stock at exactly the least beneficial point: when it has reached its bottom.

Making up for losses

Luckily I have been largely able to control this. However, many people want to make up for their losses, just as quickly as they occurred. This is very difficult, since a 50% loss requires a 100% profit to make up for it. Many people are willing to take more risks, and invest more money after they have lost some, just to make up for it. Some go bankrupt in their attempts.

I know I have a lot to learn, and I will certainly get more into this topic and write about it occasionally. Until then, I can recommend the following articles I found, which I find worth reading:

• Portfolio Management: The Pitfalls of Behavioral Finance
• Behavioral finance to the rescue?
• Why Smart People Make Big Money Mistakes (and How to Correct Them)

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I found myself in a typical situation yesterday, one that I have been trying to avoid since 2009. I was going over my checking account balance, and discovered a missing 100 Euro amount. Something wasn’t right, I felt like someone had stolen it.

I took a good look at my finances, and found an incredible amount of 100 Euro booked to the category ‘to go products’; I use this category for all unnecessary food and beverage items, which are bought quickly when I am going from A to B. Back in 2009, I just bought an item when I felt like it. I might have bought a coffee to go, even knowing that I’d be home in 2 minutes. I still do it every now and then, but usually only in the morning on my way to work, knowing that I’ll be traveling for an hour or so. But now, 100 Euros extra! An yes, having taken a quick glimpse in my ‘to go products’ category, I find the criminal: Starbucks.

I have to admit one thing though: Starbucks has launched a great and unique concept. They actually manage to sell qualitative, but overly-priced food and beverages. I am not sure about pricing in the States, but at Starbucks a muffin costs nearly as much as a sandwich at the bakery store. And I know a muffin will only compensate for that hungry feeling for 30 minutes or so. Still, their concept is so good, that it keeps drawing me inside when I pass. Yes, the frappuchinos are great, and so is the white coffee mocca, although I don’t want to know how many calories are in there.

As a rule of thumb, I always eat something when I go to the supermarket; it prevents me from buying all that food that I don’t need, and I can’t eat it all before it goes bad anyway. Now, I have to eat and drink before I leave the house, because Starbucks is waiting for me around the corner.

My action for change: every time I think about buying something at Starbucks, resist the urge and put 3.50 Euros to the side. When it reaches 100 Euros, invest the money.

Once I think about it… even if I’d spare myself 3 coffees at Starbucks each week, that would be 546 Euros per year that I could invest. At an annual rate of 8%, that is 66,801 Euros in 30 years, or by the time I retire.

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