Money and Portfolio Management with the PCCRC. PART I

In a recent video clip, Howard Gold of “The Money Show” recommended “Don’t buy stocks”
http://tinyurl.com/4866mm
His point: Trading individual stocks is risky. Take Bear Sterns for example, many people lost as much as 90% of their investment in just a few days!

His bottom line: Invest in a diversified portfolio.

But what about those of us who want to trade for a living, beat the market and even get rich in the process?

Sure, we can all buy a S&P500 indexed, and wait 30 years making 12.5% a year and “grow” our portfolio, but that is not going to make us rich, let alone make for a very profitable business.

If we want to be profitable traders, we have to beat the S&P500 by, say 10% or more. We have to make money in down years to justify trading as a profession. This is quite a daunting task, isn’t it? even if we spend countless hours of “homework” a week. Not to mention the capital outlay to trade stocks. I know because I did this for a long time, during the 90’s. Yet, all the time and effort did not save me from big losers. And I don’t mean stocks like Bear Sterns or Enron. I mean Apple Computer, Intel and Scholastics. These stocks regarded as good stocks today, did have their >30% fall in price overnight at some point in their history. These three happened to me, all within a 5 year period. So don’t think it can’t happen to you, with one of those stocks that you regard as heroes today. Some might say that owning stocks is OK as long as you have stop loss, but it is quite disheartening to see your profits accumulated over months and sometimes years vanish overnight, in such cases, a stop loss won’t save you from the collapse.

If you own stocks, the main tool in portfolio management is diversification. However, the more you diversify, the more difficult it is to manage your portfolio, the larger the number of stocks you most own, and the larger the hours of homework. This is hardly the way to reach the freedom to travel and escape the daily routine. In fact, you’ll just be changing one job for another. Assuming that you DO diversify, and do your homework, are you protected against the collapse of your stock? Not really. I certainly would not have expected anything bad from AAPL, INTC and SCHL at the time they caused me huge losses. Just days before the collapse of Bear Sterns, Jim Cramer was saying that it was OK to hold the stock, and he lives and breaths that industry!!! Further, in the late 90’s, you would have noticed, as I did, that any portfolio that was not heavily invested in technology, grossly underperformed the markets. Remember, your goal here is to outperform the markets. If you cannot do that, then you may as well get a day job and buy an S&P indexed fund.

Using options, you can certainly create defensive approaches to stock trading. You could sell “covered calls”, but this is not a protection against a catastrophic collapse in a stock overnight. It is more like a way to take some profits during a sideways market. Buying puts is a strategy known as “married puts”. This is more like buying insurance on your house or car, but there is a deductible, and it would only pay off if the fall is significant. Not to mention that buying puts routinely is going to cut into your profits. There is a time limit to any options, they are like melting ice, so you have to renew them often, unless you buy LEAPS, but these are expensive. You can reduce the cost by selling those covered calls. This is the “Collar” strategy, but if the stock rallies strongly, you will miss out on most of your profits. Ironically, the covered call is the synthetic equivalent of a short put, the married puts is the synthetic equivalent of a long call, and the collar is the synthetic equivalent of a bullish vertical spread. So you could actually use these options strategy and obtain the same result without the big cash overlay of stocks.

Options are not without risk. I was once told that when you go from one option’s strategy to another, you are merely shifting the risk from one Greek to another. Therefore, understanding the Greeks and how they affect your options is paramount for the appropriate management of your portfolio. The different option strategies provide ways to DEFINE your risk in advance. While a stock position may go to a value of $0, people more often think that they could probably absorb a 10% loss, before exiting the trade. For a $100,000 stock portfolio with 10 stock positions, a loss of 10% in one of the stocks represents a 1% loss in the portfolio. This is easily absorbed by the individual investor that may say to himself: “I am a long-term investor, I can wait until the stock comes back”. AAPL did come back, and the fall from $63 to $28/share and then eventually $12 during the early 200’s seems like nothing because AAPL is now trading at $184 after 1 split. That is little comfort for Bear Sterns and Enron investors. It took AAPL 5 years to exceed the highs of 2000, and that was a good stock!

Managing each trade is usually called “money management”, implying that if you have profits, cash your money out and move on. Portfolio management implies that you need to reduce the risk across your portfolio, so that you are not suddenly taken off guard by a global event such as 9/11 or black Monday and lose a big chunk of your profits accumulated over months to years. Money and Portfolio management become critical issues for someone like me, who wants to have the freedom to go to Africa and disappear for 20 days or more, without access to the internet or a telephone. The day is coming when you’ll have access from remote places, but who needs to worry about his/her trades when on vacation? What if a catastrophic market event hits your portfolio and you do not have access to exit your trades?

I will continue to develop this subject in upcoming articles.