Buy Yourself Some Time to Profit

As an investor, it’s difficult to consistently beat the stock market.

Even the professionals have a hard time doing so. Analysts estimate that roughly 80% of actively managed mutual funds underperform their respective benchmarks.

The key word here is active.

Educated Guessing and Emotion Controlling

The stock market is forward looking. As an investor you have to make educated guesses about a company’s future prospects based on currently available information and estimates.

At the end of the day, an educated guess is still just a guess. Reality can turn out very differently.

Additionally, you have to deal with emotion, which is counterproductive when it comes to investing.

Keep in mind that benchmark indices are passive. Their values change automatically based on the value changes of the index constituents. Whether the stocks in the index go up or down, the index will fully capture that movement. There’s no such thing as human intervention to throw off the return of the index.

But when it comes to actively managed funds, managers often feel pressure to beat their funds’ benchmarks and may end up making moves at the wrong time. They have to deal with the two challenges mentioned earlier, educated guessing and emotion.

Importantly, market indices aren’t actual tradable products. You can trade exchange-traded funds (ETFs) that track an index, but not the index itself. There are no fees or expenses that reduce the return. Meanwhile, funds do charge fees and expenses, which lower the net return, which is the actual return for the shareholder.

If even professionals struggle, it’s totally understandable why many individual investors tend to have even more trouble beating market indices. Simply put, individuals have access to less information and they generally have less experience keeping emotions in check. They often end up being followers. They buy after institutional investors buy and they sell after institutional investors sell.

Swinging for the Fences

One way to avoid potential self-sabotage is to just invest passively. Purchase quality stocks and keep them long term. This works fine for investors who are perfectly happy with the buy-and-hold strategy. But for investors who are looking for frequent home runs, a passive strategy probably won’t suffice.

To get frequent monster wins, you need to make multiple bets on underappreciated stocks that you think will soon take off. Indeed, buying as low as possible, before others pile in, is a good way to maximize gains.

However, even when you have found that diamond in the rough, you still can’t be sure when the stock liftoff will happen. Even if you’ve done all the research work, there’s no guarantee you will be right about the stock. You could end up locking your cash in a stock that goes nowhere (or even goes down) when that cash could have been invested in a less risky stock, such as a blue chip.

LEAP of Faith

One alternate strategy to consider is to buy long-dated call options on stocks you expect will make big gains sometime in the near future but you aren’t sure when.

Options offer leverage, i.e. the ability to earn a bigger percentage return than if you bought the stock outright. But their main drawback is that they expire. If the stock doesn’t make a big enough move in your favor during the life of the option, you will lose money (perhaps even 100%) even if you are right about the stock’s direction.

A way around the time limitation is to buy a LEAP option (long-term equity anticipation security), which are options that expire in one year or more. The long expiration gives you more time for the stock to make a big move in your favor.

Compared to a shorter-dated call, you will have to pay a higher premium for a LEAP call, but if you are buying the call on a stock that isn’t getting a lot of investor love, the premium should be relatively low because few people are expecting a big jump in the stock price.

An Example of Leverage

Let’s say you are super interested in a $10 small-cap stock that hasn’t gotten mainstream attention. The stock’s been meandering between $8 and $12 for the last few years. However, you know the company made a change in management and you think the new team will unlock value that could send the stock to over $20 in the next 12 months.

To buy 500 shares of the stock you will need to pony up $5,000. On the other hand, let’s say the June 2023 $10 call is going for $2. If you buy 5 call contracts, it will cost you $1,000 to get a stake on the same 500 shares.

If you are right and the stock ends up at $25 at expiration, the call would be worth $15. You would have a profit of $1,300 per contract ( ($15 – $2) x 100), or $6,500 total, a 650% return. Had you bought 500 shares of the stock, your profit would have been $7,500, or $150%.

You may prefer to take the higher dollar gain ($7,500) even though it’s a smaller percentage gain. However, keep in mind that by spending $1,000 instead of $5,000, you leave yourself $4,000 in cash that you could use to invest elsewhere. Plus, the $1,000 option premium you paid is the maximum that you could lose. By contrast, in the case of the $5,000 investment in 500 shares of the stock, you could lose more than $1,000, which represents only a 20% drop.

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