Investors Need to Be Particularly Careful Right Now

Investing

Many investors, including both individuals and institutional investors, get excited about the opportunities that high market volatility present. We need to be careful out there.

You don’t really know how confused that you are if you are among the confused. In order to be able to tell, you need some sort of benchmark to compare with, showing you the way, in order to be able to tell if you are on the right path or not and how far off of the path you may be.

It turns out that not a lot of people have thought about how we invest, how good our strategies that we widely use may be, or even comparing what we are trying to do when we invest with what we are supposed to be doing, striving to find the right methods to maximize our return while managing risk appropriately.

Even having some sort of idea of what the task is about, this maximizing return while managing risk properly, would go a long way to both understand the task of investing and to at least be directed in a better direction than the haphazard approach that is so widely practiced.

Without much of an idea of what we should be doing, there really isn’t any way to measure our degrees of success or failure, other than simply comparing results with others that are also lost. If we are holding stocks and see ourselves lose a quarter of our life savings or more over a period of a few weeks, and we’re just measuring ourselves against the fate of the crowd, seeing the market go down that much and seeing so many other investors in the same lifeboat even serves to placate us, this is not a good way to measure things.

This points us away from taking responsibility for our actions even less than we normally do, even causing us to think that our problems are merely caused by fate and blaming everyone and everything else but ourselves.

In reality, this would be akin to drinking ourselves into a stupor, getting behind the wheel of our car when the roads are slippery, and driving our car off of a cliff and wreck it and severely injure ourselves in the process. Sure, the slippery roads can be seen as an act of fate, but whether or not we should be driving on them in this state, and especially doing so in a drunken stupor, escapes us.

We could surely figure this out much better if we were actually talking about drinking and driving in dangerous road conditions, but miss this when we try the same approach to invest. We don’t understand we’re drunk because everyone else on the road is too, and we don’t care about road conditions because everyone drives drunk when the roads are this slippery.

To drunken investors, this isn’t going to hit home very easily, if at all, because they are drunk and don’t know what sober investing even looks like. It shouldn’t be that hard to figure out though if we only thought about what we are doing a little, for instance considering that we are supposed to be out to make money when we invest. We might think that we do this when we’re drunk, but it’s only because we are too drunk to know any better.

The biggest challenge for these drunken investors is that a lot of people who they look to for advice are just as drunk, or more. When the drunk is leading the drunk, things can get pretty ugly indeed, like the example of an investment advisor who persuaded a client of modest means to sell naked puts with gold futures options recently.

This was a conservative investor who knew nothing about options trading but got talked into this play by an advisor at least as drunk, and since he did know more about investing than the client, the client put his trust in him.

This would be a strong candidate for the most unsuitable recommendation of all time. The advisor told the client that during these difficult times, gold is the place to be. We can buy gold during these times, but this unfortunate client was told that the real way to do was to sell puts, where you only lose money when it goes down and you can make some easy money from options traders who are betting on it going down.

There are several big mistakes that were made here, with the first one being that you can count on gold being bullish during economic crisis. Gold had been on a strong bull run over the previous year and a half, and when this financial crisis hit, people got even more excited about its bullish potential even though it’s just not that simple.

We had warned our readers that there were some serious concerns with the volatility of gold for some time now, and this prediction most definitely panned out, if you look at gold’s chart lately and the wild swings, particularly the downward one that this unfortunate investor was talked into selling naked puts into.

Selling Options is the Last Thing You Want to be Doing While Drunk

There is nothing more dangerous than selling naked puts with options, and while this is dangerous enough at the best of times, it’s a lot more dangerous during periods of high volatility with an asset such gold which is so volatile anyway.

People are told that when you trade options, you only risk the money that you put up, and the worst thing that can happen is that you lose all your money. That shouldn’t be anything that we should find comfort with, but when you are on the other side of the trade, the options seller, you are not limited to losing all of your money as you can lose a lot more.

When you buy a put option on gold, you buy the right to sell a certain amount of gold at a given price. For instance, if gold is at $1610 per once and you buy a put to sell it at $1600, and the price goes to $1500, you have made a lot of money because you can buy it at $1500 on your own and sell it at.

You pay a premium to do this, and if gold stays above your strike price, you lose your premium, the cost of the option, which the trader that sold you the option gets to keep. However, if your option hits, you make the difference between your strike price and where the price sinks to, and you can make many times the cost of your option if you really hit a home run.

This means that the seller of this put makes a little when they win and can lose a huge amount when someone hits a home run against them. There are traders who make money selling puts, those with deep pockets who really know what they are doing and are adept enough to know when to hold them and know when to fold them, as well as how to hedge these positions properly, which is vital.

If we get caught in a bad spot with options contracts that we have sold, we can cover ourselves by buying the options which essentially closes our positions and limits our losses. If we sell a put option and it starts going against us, we can buy a put option to offset it and possibly even make money from the trade if the profit we make from buying the put exceeds the losses of the initial contract we sold. We can also short the asset and limit our risk the same way as selling covered calls where we own the asset, and when we do neither, this is called naked options selling and is very dangerous in the wrong hands, like drinking and driving during a big storm.

There are various strategies that we can also use to limit our risk, and while just selling a put involves unlimited risk, we can cap our risk in advance by buying a put lower down, where our losses will be limited to the difference between the strike price that we sold it at and the strike price of the put option we bought. If we therefore sell a put at $1600, we can calculate how much we are willing to lose and just buy a put at that price.

The premium that we receive for selling the put will be more than what we pay to buy it lower, and if all things go well, that will be our profit. If it doesn’t, we will lose the difference. This obviously requires much more skill and understanding then amateur investors tend to have, and this particular client had no prior experience trading options. This just seemed like such a sweet deal though as presented by the advisor, who only had a little more knowledge about options, but a little knowledge can be a dangerous thing.

As you might have guessed, this didn’t go very well for this client. He not only lost all of his money, he owes a lot more, and has been forced to refinance his mortgage to make up the difference that he owes. What really stands out with this example is that the client actually borrowed more than he needed to cover his losses because he wants back in this game to win his money back. Losing his savings and a good portion of his home equity wasn’t enough, and he may not stop until he is truly broke, and with retirement near, spending the final years of his life living hand to mouth while needing to make mortgage payments he won’t be able to afford in retirement.

People are also taking out big loans to buy dividend stocks these days, where advisors are positioning the most inflated dividends out there the same way as if they were like a life annuity. Annuities just don’t pay enough to make sense of this, but if you can get larger than average dividends, that can serve to fool people.

This is at best a fool’s arbitrage, where arbitrage involves pocketing the difference between two income flows. If you make a few percent on the difference, that can look good at first glance, until the reality of the fact that you have to pay this money back hits you, if it even does, as the people who do these things have so little understanding that they might not ever get it.

Let’s say you borrow money to buy a dividend stock or a basket of them and the current yield on the investment is 3% higher than your cost of borrowing. If that’s all we tell people, they will often eagerly put pen to paper to sign up for this, and don’t need to know anything else. They will be told that they are going to have to make monthly payments on this, but the light is shining in their eyes and they are twinkling from this 3% difference.

The mistake that they make is not seeing that paying back the loan will involve both principal and interest. We may be able to have the dividend cover our payments, which will involve long-term loans that will have us making payments on this for the rest of our lives and then some, as investors who fall for this tend to be older, and the payments that are covered by this need to be long-term.

If you just break even on this from a cash flow perspective, if you make $5000 a year in dividends for instance and you make $5000 a year in payments, this isn’t exactly a nest egg to retire more comfortably on as you are no better off. It gets worse though.

For others, who don’t take out long-term loans, this can even reduce their cash flow significantly, and there are investors who actually will do such a thing, taking out a loan that will have them with less disposable income every year for years because they are using money from their own pocket to pay back the loan on top of their dividend payments. This can end up spiraling to the point where they need to borrow more as a result of this trade, often racking up a lot of extra credit card debt which can lead to a real financial disaster.

We also have to consider that this is not an annuity and there is serious capital risk involved in holding stocks, high dividend or not, and especially with high dividend stocks. This capital risk can have serious consequences, especially during big pullbacks, and all you have to do is look at all the poor souls who held bank or oil stocks for their dividends and what has happened to their positions lately.

We might think that, while our life savings may have been halved in 2020, we will get that back and all we need to do is ignore this. That may or may not happen, and there are some oil stocks that may never get back to where they were a few years ago in our lifetimes, even if we aren’t that old.

Other sectors like bank stocks may come back soon enough, but what people really miss is the huge amount of lost opportunity when you hold a stock that goes down this much. You may have held the stock for some time and earned some nice capital gains, but when your stock tanks, this is like having a briefcase of money blow out the window while you watch in horror but lack the sense to just close the window.

This recent bear market has been a clear example of this, but so was the last crisis, when people were wondering if banks would even survive, and some did not, while people just watched their life savings go out the window. You may be able to make it back by starting over, even though the fruits of years of investing may now be gone, but why anyone would choose to have to remains clouded in a drunken fog.

On top of all this, there’s real risk that this cherished dividend which people are even borrowing to get a piece of may not be sustained, where the company may either no longer be able to pay it or may choose that a lower dividend is plenty sufficient. If your stock has tanked so much that your dividend is now 6% instead of 3%, and your stock has paid 3% faithfully for years, you very well may decide that 3% is enough going forward, especially if your company is hurting. They may also have to cut it altogether, and even that may not be enough to cushion the blow of the serious harm that these times may bring them.

The fact that your stock has gone down so much that your dividend has doubled does not bode well for your financial stability, and this is certainly a concern given our current financial crisis. This selloff may have been initially driven by fear, but the economic perversions that we have chosen since are very real and will have very real impacts.

We are in a situation so potentially dire that no one really knows how bad the damage will be, and this particularly involves the banking sector, which is even more linked to the economy than most stocks. We have drunk the Kool-Aid and are all in with our program of great economic sabotage, and while there is a floor to this, when people starve and we actually do get the level of unrest that Ray Dalio has been warning us about for a while now, our appetite for economic pain with this issue isn’t even close to being quenched, and the danger of a real collapse increases with each passing day.

We invest because we want to make money, but we also need to pay attention to the risk side of the equation, which is very real and very painful when we mess this up. So much money has already been lost needlessly by investors from this crisis, and the risk remains very high, perhaps higher than it has ever been.

Social distancing may not be such a bad idea right now, even though the chances of being infected may be minor, but the majority of investors have been well infected by all this, infected financially, and financial distancing right now is even more important. Stay safe.

Andrew Liu

Editor, MarketReview.com

Andrew is passionate about anything related to finance, and provides readers with his keen insights into how the numbers add up and what they mean.