Faced with the choice between changing one's mind and proving that there is no need to do so, almost everyone gets busy on the proof.
— John Kenneth Galbraith
Is your reluctance to try something new holding you back from higher investment returns?
Imagine what your life would be like if you never tried anything new.
You would still dress the same way you did 10 years ago, eat the same food you did, and maybe even drive the same car as you did back then!
At this point you may be asking, what is he driving at?
My point is it's a lot easier for you to change certain things in your life than others.
And with investing, I want to argue, it’s no different.
I have always invested mainly in equities, and continue to do so.
But there times when it may be beneficial to make use of other investment instruments to maximize your gains.
The financial crisis in 2008/2009 was just such an opportunity.
During this period I made use of a product that I hadn’t used before and it gave me a 6.1% overall return on my portfolio in 2009, in spite of having just about no money invested in the market (around 80% in cash).
This is how I did it:
When share prices were plunging, volatility increased substantially. This was the ideal time to sell options, especially put options on companies I wanted to own in any case.
First a bit of information on options.
When you buy a put option it gives you the right, but not the obligation, to sell a security at a certain predetermined price (called the strike price).
You will have to pay for this right and the amount you pay is called a premium.
You would normally buy put options if you think share prices will decline. The put option will give you the right to sell your shares to the person that sold you the put option at the strike price.
The put option thus caps your loss at the strike price.
When you sell put options, you are on the other side of the transaction.
If you sell a put option it means that should the share price decline, the person that bought the option from you can sell the shares to you at the strike price.
Should the share price not decline below the predetermined price, the option will not get exercised and you can pocket the premium you received for the option.
Don't worry if this sounds very technical; it really isn't once you have worked through a few examples.
Back to the market conditions in 2008 and 2009:
This is what I did:
In 2009 the share price of Deutsche Telecom was very low, so low in fact that it was paying a dividend of close to 9%.
Needless to say, I was more than happy to own shares in the company at that price, or better at an even lower price.
I thus sold put options on Deutsche Telecom at a strike price 10% below the current market price.
This would give me the possibility of buying the shares at a price lower than the current price and receive a premium for the option I sold in the meantime.
I did this a few times for a few different companies.
Only one of the options I sold (on Nokia) was exercised. The remainder all expired un-exercised and this allowed me to pocket the premiums, giving me a nice profit in spite of not having anything invested in the market at that time.
Back to my point about trying something new.
Writing options was a completely new field of investing for me.
How was I able to make use of this new instrument in a relatively short period of time?
This is what I did:
- I took a few hours to read up as much as possible about options.
- I worked through a few examples to see if I understood it.
- I called a friend who was very knowledgeable about options and discussed the examples I had worked through to make sure I understood everything.
- I called my broker and made sure that I had the correct calculations in terms of brokerage costs and that I had the necessary authority to deal in options. (In Germany you have to certify that you know what you are doing or your broker will not allow you to deal in options)
- Then, and this is the important part, I did all the calculations to make a small first trade (calculated brokerage, break even prices), called the broker, and did the transaction.
At this point I thought I knew what options were all about and what the costs involved were, but I wasn't 100% sure.
This first small trade was a test to make sure my preparation and calculations were correct.
As you can probably guess, everything went well and I was a lot more comfortable with the following transactions.
After that difficult first step, to do the first transactions, it became a lot easier to do the next.
I first used this method when I invested in stock markets in countries other than the ones I was used to trading in (Hungary for example).
I first calculate the maximum possible brokerage costs, do a small first transaction, and then move on from there.
Here are the steps again in more detail you can use:
- Learn as much about the new market and/or instruments as you possibly can. You can do this through the Internet, reading a few books or asking knowledgeable friends.
- This is the important point: Learn as much as possible about the risks and the terms of the instrument or market you are looking at investing in. Draw up a list with two columns, one for risks and one for opportunities if you need to.
- Repeat the above two steps until you are relatively comfortable, to the point where you feel confident enough to be able to complete a small transaction.
- Call your broker and make sure that your account currently allows you to do these types of transactions. If not, you may have to open an account at a different broker or fill in a few forms to give you the authority to do these types of transactions. Here in Germany, in order to buy and sell options, I had to fill in a form which basically said that I was willing to lose all my money, that I knew what I was doing, and that the broker would not accept any responsibility.
- Start with a small transaction. This will give you the opportunity to make sure that your calculations are correct, and secondly, it will give you the confidence to move on from there.
It's a method that I’ve used successfully to move into new products and markets, and it has greatly benefited my investment returns.
Give it a try. I am sure it will do the same for you.
Tim du Toit