I remember reading an article once basically stating the buy and hold strategy is a thing of the past.  That may very well be true…especially today.  Look what happened to GM and the shareholders after years and decades of ownership.

I remember that I had written about “Investing In Speculation” a couple of years ago, so I dug out my notes and this is what I found:

Here’s a question to consider.

Do you really invest in a company when you buy the stock on the stock exchange? No. You invest in the speculation of the stock’s price (excluding dividend investments). Yes you have invested your money, but the company you purchased had original investors for start up, etc.

When the early owners needed more money for growth and expansion, they issued stock such as an “IPO”, or initial public offering. Unless you or me purchased stock here, we simply bought out someone else that had already invested in the company.  But, probably the additional investors were the investment banks such as JP Morgan, not you or me. The investment banks simply sold the shares they bought to us as an IPO to the public.

For example, Investment Bank ABC purchased stock in Company XYZ. Then the stock brokers sold the shares to Joe Blow as either an IPO or later when the demand for the company pushed the value of the stock higher. If we didn’t get in here, we simply are buying out other shareholders.

The original owners made money when they sold shares to the investment houses or went public. The original owners may have kept control of the company and/or got a bigger salary for running a larger company.

What new buyers of the stock got is a small dividend depending on profits. But that’s okay, the dividend is what was wanted in addition to price appreciation (which is speculation because the principle amount of money invested is not guaranteed.  The value can go down big time!).

The difference between investing and speculating has to do with protecting the principal amount of money.  The short version is, investing maintains the amount of money spent; whereas, speculation doesn’t have guarantees and the value can decline or potentially lose great amounts of money if not all.

If the company doesn’t perform well, and the demand goes down, so does the share value and the invested amount of money. The company still continues, excluding bankruptcy and closing the doors.

So technically people do own part of the company, but unless it is a huge amount, most shareholders cannot control operations, salaries, board positions, etc.  In simple terms, people buy out other shareholders and invested in speculation.

So why would you or I want to buy and hold a company knowing you have no control over it or the price of the stock?

Income. We can generate income from selling options, which is similar to renting the stock.

Dividend income. If we use the cash that is produced from selling options and dividends, we have the opportunity to buy more shares or reinvest, or build cash.

This can give “growth” to our accounts even if the stock price goes down simply because the costs have been reduced by building cash and/or acquiring more shares; thus allowing the potential to sell more options and receive more dividends and grow the account.

Finally, if the shares are never sold, such as a buy and hold, without income from the sources just mentioned, is there really a gain?  Sure, on paper, but not in the checking account.

There are people who are technical traders and understand the complexities of analyzing charts.  However, here is something that I consider to be very simple.

The Gap.  I’m not saying you should do gap trading, but I do think this is a good indicator or where prices will go. And the reason I say this is because of the expression “all gaps get filled” or the “market abhors a vacuum”.

When it comes to gap trading there are many things to consider and you should at least familiarize yourself with them.  My point is not to advocate gap trading strategies, but rather to get you to be able to glance a chart and see possible opportunities or threats to your investment.

The reasons I like ETF vs. mutual funds are several as I’ve previously stated.

At the same time, mutual funds can’t hold cash – they have to buy.  To clarify, my understanding after talking to people who actually deal with mutual funds (not just investors like you and me) say that the funds cannot hold more than 10% of the portfolio in cash.  So if I give my money to a broker, he has to invest it.  That’s partially why they tell you to average down when the value is dropping.

Back to the gap. I was looking at an exchange traded fund last year and the price was in the $90′s range and going up.  However, there was a gap in the $60′s range.

So why would I buy at $90?  Well, the price went up to the $140′s that’s why.

But I’m not buying and holding and I’m glad that I didn’t because this year it went down to the $30′s range!

What I actually did was buy an option to sell around $90.  A put option. Although the ETF’s price went up and my option was losing value, after the price topped out and began to fall, my option value started to increase.  As the price fell into the $80′s and $70′s range, I was making money.

Are options risky and gap trading risky? Anything is risky if you don’t know what you are doing.  I’m still continuing my education as well.

But I do look at one thing before I put money in, and that is the gaps.  I don’t know that all gaps will be filled as prices are going up.  I hope so.  But I do look for the ones at the bottom to see if I could potentially lose a lot.

On the chart shown, #2 at least partially filled #1 on the way back up. However, notice the gap with the arrow that has not been filled at the bottom?  I’m not buying just yet.  I might just sell an option for the price in the gap in the mean time.

But until then, I’ll keep shopping the gap.

Are options risky? People are risky. 

Let’s say there is a company that I want to own. XYZ’s stock is trading at $50 today with a target of $60 in twelve months.

If I buy 100 shares it will cost me $5,000. If I have a stop loss of 15%, I could lose $750. If the price goes up to $60 per share I would gain $1,000.

$1,000 / $5,000 = 20% gain with a 15% stop loss as protection.

However, I like options.

In all likelihood, I won’t own a stock for three years. I’m not a buy and hold person, because too many things go on. See my post Buy and Hold.

So let’s say I want to control the stock without owning it. I’ll buy a LEAPS option. These are good for up to three years. I could gain, or lose, to the stock for three years without owning it.

Today’s price on a January 2012, $50 option is $8.10. One contract controls 100 shares. It would cost me $810.

Options use Delta as a way to gauge its performance, price, etc. If the Delta is .5, in simple terms, that means the price of the option moves $.50 for every $1.00 the underlying shares move. If the stock goes to $60, that’s an increase of $10. The option price moves $5.

My profit would be $500 on an investment of $810. The gain is 62% and my risk is $810 if the option expires worthless.

So here is one more thing to consider. If I took the difference between owning the stock and buying the option, I would have $4,190 sitting in the bank. At 3% interest (although it might have to be in a 5 year CD right), I would make approximately $125 per year. Take $810 – $125 and now my cost is really $685.  Also, I can close out my option and lose less if the stock goes bad.  However, my loss is much less than if I purchased the stock outright.

Although the gain is not as large in dollar amounts as owning the shares, neither is my cash outlay. And if this option is considered expensive, by looking at the implied volatility, I may just sell the option instead and get paid versus paying money. See my post Rollin Rollin Rollin.

Options are really pretty easy to understand, but there are things you must learn about them. I keep doing homework (homework is not just for kids in school).  Maybe someday I’ll be able to LEAP tall buildings in a single bound.