Value investors are familiar with “Mr. Market,” a character invented by Ben Graham to explain the psychological component of the stock market.
I’d like to introduce you to his cousin — and show you how you can profit from the patterns that run in the family.
The concept is a simple one. Mr. Market is your business partner. Some days, he’s in a manic state, incredibly wild about the prospects of your business. He’s willing to pay substantially to buy out part of your stake in the firm.
Other days, Mr. Market is depressed. He thinks that things couldn’t get any worse, and he’s willing to sell you his stake in the firm for a song.
Mr. Market is a great way of looking at the psychological impact of investing in the stock market. But in today’s market, where investors have to be exceptionally careful about engaging in a “buy-and-hold” strategy, it’s best to meet Mr. Market’s cousin.
His cousin, Mr. Options Market, isn’t a business partner. You’ll often find him down at the local bar, where he’s willing to make side bets with you over the outcome of a specific stock.
When he says: “I bet you $50 that Apple shares will trade above $600 at the end of the year,” it’s really no different from betting on the outcome of a sport.
In essence, that’s what most options trades are: Side bets. Just like any man at a bar, Mr. Options Market can be sensible and intelligent. Most options traders follow a complex mathematical formula called the Black-Scholes model, which works most of the time.
But, just like his cousin, Mr. Options market sometimes makes mistakes. He’s not immune to slipping into despair when markets are selling off. He gets overly giddy at times too. That gives you the same opportunities to profit that his cousin has. But there’s another advantage too:
What Mr. Options Market won’t tell you is that buying from him is generally a sucker’s bet. Over 80 percent of options expire worthless — meaning that the side bets don’t even pan out. Selling options is much more consistently profitable.
If you own shares of a stock that have rallied quickly and may pull back, you can sell covered-call options to profit from a short-term pullback.
Conversely, if you want to buy shares of a company if they’d only fall a little more, you can sell put options that essentially pay you while you’re waiting to buy at a price you think is fair.
In flat and sideways markets, these sales can provide some nice cash returns — often 5 percent of more for options trading less than six months out. It’s a far cry above the pitiful yields from cash.
Take a lesson from Mr. Options Market: Stick to the sell side, and you’ll come out ahead in today’s fluctuating markets.
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