A little point should be very clear: investing for 1 year in stocks returns more than keeping the money for 19 years in a saving account ! The S&P 500, which is the major US index has returned roughly 18% YTD, as shown in the data taken from Google finance:
As a comparison, check below the list of the best US saving accounts:
The conclusion is simple: if you invest in the most simple vehicle of all, which is an ETF that tracks the S&P500, you get 18% for 9 months, which is equivalent to roughly 19years of returns with the best saving accounts that are available in the US right now to retail investors...
"The party line is that stocks historically have outperformed all other investment plans."
5 years and a few days ago, Lehman brothers collapsed and so did the world stock markets short afterwards. This anniversary brings back bad memory to most of us, expect to fund managers ! Why? Simply because fund managers typically show 5 years of performance in their sales prospectus. So mutual funds no longer need to remind you that they lost huge amounts in the 2008 financial crash. The crash happened 5 years so it is now too old to show !
To show you how data from graphs can easily be presented in a misleading way, we had a look at public data from the Index S&P500, which by the way already outperforms most fund managers (read article HERE). When you look at the picture below you see a 5-years graph of the S&P 500 on Google finance. The graph shows a very clear upward trend in the index, with the exception of what happened exactly 5 years ago. But still, this graph already shows a fantastic return on investment if you had invested in the Stock Markets on Sept 26 2008.
Now let us take some perspective and look at a second graph, showing 10-year historic for the same index price. The new graph shows a completely different story: there was a massive downturn in 2008, and it took 6 years for the stock markets to recover from it !
The conclusion is simple and it is a warning: when it comes to financial disasters, anniversaries are an occasion for fund managers to start forgetting about the past. And from now on losses stemming from the financial crisis will probably no longer be reflected on most mutual fund's prospectus.
The Google stock (NASDAQ:GOOG) trades now at about $888.18 / share. And to get the best market prices you might want to trade as the pros in round trading lots, which is 100 shares at the time. Which means that the minimum order size to get a good execution when trading Google is 100 shares at $888.18/share or roughly $88,818.00 (yes eighty-eight thousand something dollars). At the same time if you have bought Google shares you will only get paid with the increase in the stock price, as Google does not pay dividends!
So if you want to invest in Google in the same conditions as an institutional investor you should commit $88,818.00 on one single position for an investment in a something that does not pay out cash in dividends or interest payments. This is something that most private investor will simply never do! But at the same time Google remains a fantastic company with a huge growth potential. Actually the Google stock price went up +25% since the beginning of the year 2013 and when you look at their annual report you see so great figures that you think that this stock has a lot more to give.
So it is temping to buy 100 shares of Google but you probably do not want to put $88,818.00 on the table. What if we told you that you can get exactly the same position as holding 100 Google shares but with committing only $30.00 dollars instead of $88,810.00 ? That you can do with options! And here is how : you should buy a 890CALL option and sell a 890PUT option on Google.
A synthetic option position to replicate the payoff of the Google stock in December
Buying a 890CALL option expiring in december will give you the right to buy on the 3rd friday of december 100 shares of Google at price of $890,00 per share. So this right will be worth all the upside between the future share price and $890 in december and 0 if Google's share price ends up below $890. At maturity of the option your "long call" position will have then following payoff diagram, depending on the price of Google:
Selling a 890PUT option expiring in december will give someone else the right to sell you on the 3rd friday of december 100 shares of Google at price of $890,00 per share. So this right will be worth all the downside between the future share price and $890 in december and 0 if Google's share price ends up below $890. At maturity of the option your "short put" position will have then following payoff diagram, depending on the price of Google:
If you both go into a Long Call position and a Short Put positon you will have the following payoff diagram at maturity of the options, which is exactly the same payoff as if you buy today 100 shares of Google.
The cost of entering this position is extremely low
You can see in the diagram below the current market prices of option chains for Google with maturity in december. With this diagram you see the actual cost of entering the position described above. In order to enter the position you will combine 2 trading operations:
1- buy one 890 Call Option for $38.40/share, as option contracts are traded in lots of 100s you would need to cash out $3,840.00 for this single Call
2- sell one 890 PUT Option for $38.10/share, again as option contracts are traded in lots of 100s you will receive $3,810.00 for this single Put
Your net cash outflow will be extremely low: $3,840 - $3,810 = $30 !
To wrap it up: leverage is the magic of options
Buying a 890CALL and selling a 890PUT on Google will require you to invest a total of $30.00 and this will grant you exactly the same payoff in december 2013 as if you buy 100 shares of Google for a total of $88,810.00.
So using option you can invest only $30 and still get a market position which is 3000 times bigger than your initial investment. This is the magic of options and it is called leverage: with a very little investment you can generate a very large return.
"Do you know the only thing that gives me pleasure? It's to see my dividends coming in."
John D. Rockefeller
Exxon Mobil Corporation is a company with a very straightforward business model. They extract, refine, and sell oil !
They do not operate in the most innovative industry: in the Oil Business the technology is not changing much, the cost of production is stable, the price in the market is stable and the demand from the consumers is stable. So nothing changes ! And the stock price of this company has shown no development at all, it stayed completely flat over the past 12months: the $XOM stock actually moved down 2.16% while the S&P500 gained 17%...
It is not that this company is doing bad by any means. It is profitable and pays good dividends at about 2.5% of the current stock price as seen below in this table copied from the company's page for investors.
EXXON is stable and the reason why EXXON's stock is flat is that nothing unexpected happens with the company EXXON. This company is seen by many as an extremely safe investment, after all the world is going to keep on consuming oil for a long time. So we know know that EXXON is by no means a bad stock to own, but if you actually own it you might be a little frustrated because you get too little to return return on your investment right now.
So now comes the trick! The first thing is that you should own the stock. You should actually own 100 shares of EXXON or a multiple of 100 since the options of EXXON are traded by packs of rights to buy/sell 100 shares. So let us assume you have 100 shares of EXXON, which is worth $8,798.00.
Then you can boost your returns on this invested capital of $8,798.00 in EXXON by doing the following: selling a straddle on EXXON. A straddle is the combination PUT+CALL around the stock price. For instance:
But then you trade options in packs of 100 so you actually receive 100 x $1.23 = $123. So you immediately pocket in roughly 1.4% of your capital invested in stocks price, according to the following equation
$123 option premium / $8,798 invested in stock = roughly 1.4%
What will happen when the Options expire, in exactly 5 weeks from now on the 3rd Friday of October?
This is a total profit of $323 on your invested capital of $8,798. This is roughly 3.6% in just 5 weeks (36% annualized rate!)
So do you understand ? The worst thing that can occur is that you have to buy in from this stock in one month time if the stock price suddenly goes down, which actually is great for you since you can be pretty sure of 2 things: Oil is something that people will keep on buying and EXXON will remain a dominant player in this game for quite a while.
The Chicago Board Options Exchange Market Volatility Index (aka VIX) is the most popular measure of the risk level. The reason is that it shows the current risk level perceived by the world biggest banks and investment companies, and these firms have thousands of highly-paid full-time analysts working on this so they should know what they are talking about.
Here is a little about the theory around this index: the S&P 500 volatility measures the price variations the prices of the 500 biggest US companies over time. Not going too much into details, we can say that the option prices on the S&P500 index increase due to the stock volatility according to the famous “Black-Scholes” formula. The VIX index is calculated by looking at the current market prices of S&P500 listed options, and by applying the “Black-Scholes” formula you deduct the theoretical volatility of the market as perceived by the world’s biggest option market makers. This is what is called the Implied Volatility.
It is very interesting because it tells you how afraid the World’s biggest investors actually are right now, which is why the VIX is often called “the Fear Index”. Actually VIX is a much better indication of the risks in the markets than the media since the journalists, after all, are not large market investors and the press have a tendency to magnify some issues so it becomes difficult to put things into perspective when you simply inform yourself by reading the news..
As a rule of thumb the market acknowledges that there very little risk if the VIX is below 20%. Between 20% and 30% people start to worry and safe havens, such as gold and silver, become the preferred investments. Above 40%, there is a panic going on.
The graph below is taken from a public site (Yahoo finance). It tells us very simply that the VIX is now a little than 15%, which is extremely low. The "Fear Index" is pretty much at the lowest levels since one year before the Lehman crash.
The conclusion is very simple: the biggest market investors are now feeling very safe of the prices in the market. Actually today is as safe as can be for people to invest in the S&P 500!
"As long as a stock is acting right, and the market is right, do not be in a hurry to take a profit."