Why I Believe in Active Investing

Why do I support active trading, when only about 15% of all investors even work with options? Why do I actively engage in something that hardly any of my peers even know about? Why do I keep posting about how much better it is than passive trading, when clearly, the average person, the media, and the industry as a whole do not agree?

Because I believe in it.

I truly think that actively trading is the path to success, if implemented correctly. I don’t think that it is nearly as risky as people think it is. I don’t think that it is beyond the average person’s comprehension. And I don’t think that people should be afraid of it anymore.

I was invited to write for MindSumo.com on the topic of active trading. I am an active member on mindsumo, having completed many of their challenges (and won a few!). I support the company, and I believe that their mission is to help college students overcome the barriers of life.

I think that being afraid of the stock market is one of those barriers. I wrote this piece in hopes to convince my peers (and everyone else) that active trading is a supplemental to success. It is a way to earn income, in  a short time period, manipulating probabilities to determine our personal risk/reward preferences. I hope that the article below, if not convincing, is at least a bit of an eye-opener. So, without further ado (hang onto your hats, it’s a long one)-

How I Would Invest $500

College students and money. When the two are mentioned together, its seems that the phrase “not enough” should go in front of the word money. The sad saga of college students and not enough money.

Not enough money to handle the tuition payments, the car payments, the rent, all the expenses that officially make you an “adult”. It seems like every dollar that we earn passes right through our hands, off to pay some outstanding bill. On the occasions where we actually have a surplus, where we make more than we owe, it’s time for celebration. And the best way to celebrate is let that money make you more money!

Here’s where we utilize the stock market to our advantage. The market, which seems so abstract and confusing, is actually a really great place to invest your money (most of the time). Rather than letting your hard-earned cash sit in the bank, or underneath your mattress, we can utilize the intricacies of the marketplace to generate returns on our investment- let our money make money.

I’m going to describe two different ways that we can invest in the market. We can buy and hold stock, or employ options to put on different trading strategies. The first is considered a “passive” strategy, where we buy, wait a few years, and then collect our profits. The last way is “active” which allows us to get out of the trade in about 45 days and use the laws of probability to our advantage.

So let’s say that you earned $500 from a summer internship. Rather than placing it in a savings account, you decide to explore the different possibilities that the stock market offers you.

When we buy stock, it’s best to invest in companies that we know with products that we support. We would only buy stock if we expect the price of the stock to increase, thus we would only buy stock if we expect that the company is going to do well. So if you really love yoga pants, buy Lululemon’s stock. Or if you love iPhones and iPads and iEverything, buy Apple’s stock. Target is a versatile company that has products that appeal to everyone, so let’s put our $500 in that stock for now.

Target is currently trading for $65, so we can buy 7 shares of it for $455. The good part about buying stock is that the potential profit is theoretically unlimited- the price of Target can keep on going up until infinity, which technically means that our profit literally infinite! Also, our potential risk is capped at what we invest in the company, in this case, $455 (7 shares x $65 stock price).

However, buying stock is pretty expensive, and we only can make money if the stock increases in price, which happens only 50% of the time. We can look at probabilities to get a gauge of where the stock should be in a certain amount of time. For example, there’s an 18% chance that the stock price will be above $70 in 33 days[1]. But we normally invest in stock, meaning that we are planning to hold on it for far longer than 33 days (more like a few years). In that time period of a few years, the stock can do really well, or do really poorly.

Just to give you a gauge of median yearly returns, the SPY, which is an ETF (a particular type of stock) that tracks the market as a whole, has a yearly return of about 5.8%. Extrapolating that to our Target trade, that means we should make $25 a year with our 7 shares ($455*.058).

But it never works quite like that. According to a study of 30 broad stocks done by tastytrade.com, buying shares like we did in Target is profitable only 59% of the time. Also, the largest loss experienced was 65% of the original investment. In our case, we would lose almost $300!

What if I told you there was a way to effectively multiply your profits, while reducing your risk, the time you spent in the trade, and using the passage of time to generate additional returns? When we buy stock, we can only make money 50% of the time, assuming the stock goes up, we normally have to hold the stock for a long period, and the passage of time provides no advantage.

Buying stock is passive trading. Let’s talk active trading.

Active trading is basically a bunch of different strategies that we can employ using “baby versions” of stocks, which are called options. There are 2 categories of options, calls and puts, and depending on the price of the stock that they track, cost anywhere from 1 cent to about $8.

Active trading involves combining calls and puts into different strategies. So rather than simply buying the stock outright, we would perhaps buy a put and sell a put (likewise, we could sell a call and buy a call. Or sell 2 puts. Or sell 3 calls and buy 1 put- the strategies on options are truly infinite!).

Because we used puts on this particular trade, that means that we want the price of the stock to increase. A put represents the right to sell the stock, so we want to sell at a higher price than we bought it. If we had used calls, it would mean that we want the price of the stock to decrease. This put combination (buy a put, sell a put) is called a credit spread, which is my favorite type of active trading strategy.

Credit spreads allow us to place a directional trade on the market, while defining both our maximum loss and our maximum risk, thus making it a “defined risk” trade. We know exactly how much we can lose, and exactly how much we can make.

We look to place these trades in about a 45-day time table. That means that we receive our profits in usually less than a month.

The mechanics of placing the trade are pretty simple. We simply sell a put relatively close to the stock price (so sell the $64 put with Target priced at $65) and buy a put a bit farther away (say, the $60 put) at a time table of 45 days. When we do this, we are establishing a spread that generates credit, in this case, about $110 worth in this case.

In this example, our probability of profit is 68%, meaning that we have a 68% chance to make money on this trade (18% better than just buying stock). Our maximum loss is about $300.

As I mentioned earlier, we would place this trade when we expect Target to increase in price. We want Target to stay above $64 (the put that we sold) plus the credit we received from the trade ($110). So as long as Target stays above $65.10, we will make money.

But that’s considered an “at-the-money” credit spread, in which the short strike (the $64 put) is extremely close to the stock price ($65). We can place an out-of-the-money put spread, in which the short strike is much lower than the stock price.

For example, we can move our short strike down to the $62 put, and move our long strike down to the $59 put. That would generate about $60 of credit, and a max loss of $240, but we have a higher probability (73% chance) of making the whole $60. In the previous trade, the 64/60, we only had a 68% chance of making the entire $110.

We can play around with all sorts of different strikes, depending on our personal risk preferences and desired credit. With credit spreads, we normally look to take in 1/3 the width of the strikes. So, going back to the 64/60 spread, we would look to collect $130 (4/3). With the 62/59 spread, we want to collect $100 (3/3).

Of course, this doesn’t always happen in the marketplace. The higher our probability of success, the less credit that we will receive. So an 80% chance of making profit generates smaller returns than a 60% profit. It’s all about the risk-return tradeoff. “Risk one to make one”, as they say. The more we risk, the more we can make, but sometimes, it’s better to play it safe and use probability to our advantage.

Another thing that this trading strategy offers is something called time decay. Also known as theta, this is the amount that an option (so a call or put) loses in extrinsic value each day.

The value of an option is composed of this extrinsic value and something else called intrinsic value. (value = extrinsic + intrinsic) Intrinsic value is the amount that an option is “in-the-money” by. So with our $65 strike price, an ITM put would be anything above that stock price. A $67 put would have $2 of intrinsic value. A call, on the other hand, would be ITM below the stock price. Therefore, a $63 call would be $2 ITM.

The extrinsic value is composed of time value and volatility. The more time that an option has left to expiration (that 45-day cycle) the more valuable it is. So as the option DECREASES in value over time, we get to reap those benefits. We collect the amount that it decays each day in the form of theta decay.

The trading screen will tell you exactly how much time decay you will collect. For example, we collect about 0.62 cents each day in the 64/60 credit spread, in addition to the credit that we receive! An extra benefit of trading options!

There are numerous active trading strategies that we can implement, ranging from iron condors, debit spreads, butterflies, naked options, etc. Also, most trades have a relatively high probability of profit (60%+, in most cases). Trades also, on average, collect about $150 in credit.

The key thing to take away is that there is a lot that you can do with $500. You could simply put it in your savings account, getting about $0.03 cents per year, or you could place it in the market. When you move into the market, you could buy stock, and let it sit through market fluctuations for a few years.

OR you take control of your finances and utilize options to your advantage.

Needless to say, active trading takes the cake. We can collect additional profits from the passage of time, manipulate our probabilities, and determine our own risk preference. So take your $500, and experiment with the market.

Options can be implemented in all types of stocks, which makes them incredible tools to profit from different market environments. The biggest setback with buying stock is that the stock HAS to increase in price. When we play with options, the stock can go up, down, and all around, and we can still make money. This empowers us to use our money to make money over shorter time periods. We can use the passage of time to generate additional profits. We can also manipulate probabilities, rather than settling for a 50% chance of being successful. So, basically, use your money to make money, and actively trade!

Disclaimer: These views are not investment advice, and should not be interpreted as such. These views are my own, and do not represent my employer. Trading has risk. Big risk. Make sure that you can balance your risk/reward, and trade small, and trade often.

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