Playing In The Stock Market Casino

As an investment advisor, I’m not supposed to admit that stock investing amounts to gambling. The industry line is that if you invest in good companies or mutual funds, keep a long-term perspective and ignore the dips along the way, everything will turn out fine. For a long time I tried to ignore that little voice in my head that said “something’s not right.” After all, stocks have outperformed all other asset categories over the last 100 years, the stock market always recovers from crashes, Warren Buffett is a buy-and-hold investor. Most of the conventional wisdom and rules-of-thumb have a sizable element of truth or they never would have become so widely popular and embraced, but something still doesn’t seem right.

There is an ugly side of investing that creates that uncomfortable feeling. According to market data put together by Kenneth French at Dartmouth College, large cap stocks have experienced drops of 25% or more about 10 times over the last 85 years. That averages once every 8.5 years, although there are some long stretches where there were no steep drops and other stretches where they came in clusters. If you started investing shortly after a market drop (say, 2002) your investments performed significantly better than if you began your investment life shortly before a drop (2000 for example). The Nikkei-225 index (Japan) is currently down about 75% over the last 22 years, which has ruined the retirement plans of an entire generation. Of course, Japan’s problem was an over-heated real estate market, multiple recessions, excessively high debt, and an aging population. That could never happen in the U.S. Finally, it is very difficult to invest like Warren Buffett. Goldman Sachs has never offered me perpetual preferred stock with a 10% yield. I also can’t afford to buy a business, install the management, and hold them accountable for superior performance.

The truth is that investing in stocks is a gamble regardless of your timeframe. The best fundamental indicators can be rendered meaningless by hedge funds doing flash trades with super computers or a change in governmental policy that alters the rules of investing (see General Motors). Like any casino, someone has the “edge.” In Las Vegas, the edge in every game belongs to the house, which means if you play long enough the house will eventually take your money. With respect to stock investing, you may not actually lose your money, but if you play long enough you will eventually experience a significant down market that will take back a chunk of your wealth. As an average investor, you do not have the edge. Hedge funds can have an edge by front-running stocks with flash trades. Politicians can have an edge by legally using inside information. Warren Buffett can have an edge by taking advantage of deals that are not available to normal people. The average investor is on the other side of these trades and is completely exposed to the whims of the market.

An Example: Covered Call Strategy

To demonstrate what the lack of an edge looks like, let’s use a typical Covered Call option strategy, which is becoming very popular as investors look for sources of income and additional yield. A Covered Call strategy involves buying shares of stock and selling Call options to generate additional income. A typical position might look like this:

Buy 100 shares of Apple stock for $450/share

Sell a $475 Covered Call option contract for $9.20/share

In this example, the Covered Call option will expire in 75 days. If Apple stock stays flat for the next 75 days, the investor will pocket $9.20/share for an annualized return of 9.9%. If Apple shares rise above $475 on the option expiration date, the investor keeps the $9.20/share and participates in another $25 of share price appreciation for an annualized return of 36.0%. If Apple shares fall, the sale of the option provides $9.20 of price protection, so the investor would not start losing money until Apple drops lower than $440.80. The argument for this strategy is that selling Calls provides additional income in a flat or rising market, and some amount of downside protection in a falling market. It’s the best of both worlds. So why would a casino take the other side of this trade?

Let’s consider the risk profile for this Covered Call position. As the stock price rises, the short Call position loses value at an increasing rate until it is falling at the same rate that the stock is rising. As the stock price falls, the value of the short Call gains value, but is capped at $9.20/share (the price collected for the Call when it was sold). The net effect of combining a long stock position and a short Call position is that profit resistance increases when the stock price rises, and protection decreases as the stock price falls. In other words, if the stock price happens to skyrocket you will have limited profit potential, and if the stock price drops sharply you will have almost unlimited loss potential. This is exactly the kind of position the market wants you to have because the edge is clearly on the side of the market.

The Market Maker’s Side Of The Trade

The job of a Market Maker is to provide liquidity to the market by accepting buy and sell orders for stocks and options, thus “making a market”. A Market Maker must always protect his (or her) account by closely controlling the potential loss. If his account blows up because a stock moves in the wrong direction or an unexpected catastrophic event crashes the market, his job is over. The secret to survival when your career is based on trading stocks and options day in and day out is to tightly limit potential losses and maintain an edge on the market. It’s that simple, and it’s the same philosophy as any casino in Las Vegas.

A successful Market Maker is not going to have a portfolio full of Covered Call positions with limited upside and unlimited downside, but he may take the other side of the trade. Let’s consider what that would look like.

Sell 100 shares of Apple stock for $450/share

Buy a $475 Call option for $9.20/share

The combined position described above is a little better from a probability standpoint. If the short stock position loses value due to the stock price rising, the potential loss is limited by the rising Call option value. If the stock price falls, the short stock position gains value and the option price approaches zero, creating an increasing profit potential. You may recognize that a position with limited risk from rising prices and almost unlimited profit from falling prices is exactly the description of a Put option, and in fact, the opposite of a Covered Call position is a synthetic Put. If you’re still following this, you’ll realize that a Covered Call is therefore the same as a short Put option, which most people would immediately recognize as being very risky.

There is still a problem with this position that a Market Maker would not like. If he guesses wrong and the stock price moves higher he loses money, even if it’s a limited amount. If nothing else, it just doesn’t feel good to lose money, so let’s improve the position by adding another Call option.

Sell 100 shares of Apple stock for $450/share

Buy two $475 Call options for $9.20/share

With the improved position above, the odds of making money are greatly increased and the market edge has shifted in our direction. If Apple stock crashes, we make a lot of money due to the short stock. If Apple stock soars, the 100 shares of short stock cancels out one of the Calls, but we are still left with a Call option that will make a lot of money. However, if the stock doesn’t move, the options will gradually lose time value and we will eventually lose the amount we paid for the options. Therefore, we still don’t have the edge, but we also aren’t holding the sucker bet of a Covered Call (i.e. short Put). Actually gaining a positive edge requires adjusting the position from time to time in order to capture value in relatively modest price moves in the stock, while maintaining the potential for big gains. This goes beyond the scope of this article.

Improving Your Chances

If you decide to try your luck at Black Jack and the extent of your knowledge is that the objective of the game is to reach 21, the dealer will probably take all of your money in fairly short order. The best way to play Black Jack is to be the dealer. The second best way is to learn the subtleties of the game, memorize the odds for any given combination of cards, and have an enormous capacity to keep track of what cards have been played (i.e. count cards). If you do this well enough, the casino manager will conclude that you have captured an edge and will promptly kick you out.

The best way to invest is to have the clout and wealth of Warren Buffett, or the resources and special privileges of a hedge fund, or become a U.S. Senator. The next best thing for most of us is to learn to recognize when we are giving away “edge”. Although most of us do not have the time and resources to invest exactly like a Market Maker, there are techniques we can utilize to avoid handing over a sizable portion of our money to the market on a regular basis.

In a casino, you can’t beat the odds forever. The same is true with investing.