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It is a function of human nature that, in most cases, people will do whatever it is that makes them feel the most comfortable. This is true in terms of lifestyle and it is also true in terms of investing. And when it comes to investing, the majority of individuals are so sufficiently frightened of the “unknown” (“I have no idea about what the stock market will do next”) that they turn their investments over to someone else to “manage." Typically, this amounts to having someone who convinces you that he or she “knows more than you do,” and puts your money in some particular group of “carefully selected” stocks or mutual funds that ultimately correlate about 96% to the movements of the S&P 500 index. In other words, they do the stuff that most of us could do ourself if we invested a little time, effort and energy in the process. In fact, some research suggests that a financial section and a dart board might work as well or better. Of course, then we would have no one to blame but ourself if things go south. Isn’t that inconvenient? One of the purposes of this weekly column is not only to teach you things that maybe you don’t already know, but also to simply encourage you from time to time to take a closer look at the possiblities in terms of taking control of your own financial future.

Rather than suggest that you consider investing in a nice “growth” fund, let’s take a look at some possibilities a bit outside the mainstream—stuff definitely guaranteed to make the average investor “uncomfortable.”

Going Ultra

The Profunds mutual fund family appears to have hit the mother lode of exchange-traded funds (ETFs) with its line of Proshares “Ultra” ETFs. These funds are designed to track a particular stock index or a particular industry group index. However, these funds also have a “little something extra” going for them, for each fund is designed to fluctuate at a rate of two times the underlying index or group. In other words, if you are good at market timing you can now make twice as much money as you could otherwise. And the fun doesn’t end there. There are also “inverse” funds, referred to as ProShares “UltraShort” funds. These creatures are designed to trade two times the inverse of the underlying index. So, for example, if the underlying index is down 2% today, then the accompanying “UltraShort” fund should gain 4%. So the good news is that if a trader or investor is bearish on the market or a given segment of the market, he or she no longer has to either sit there and “take it” or move into boring old cash. That same individual can now make a ton of money instead. What a concept.

Of course, there is no free lunch in investing, and these Ultra, or “leveraged,” funds are no exception. For just as these funds offer two times the profit potential of standard index ETFs, they also require the investor to assume two times the risk. So if you buy an Ultra fund and the underlying index declines a mere 5%, you will suddenly be sitting with a 10% loss.

So why take the risk? Consider some of the performances of these funds of late. Table 1 displays the top performers over the previous 120 trading days ending 11/14/08:

Table 1 - Top Performing “Ultra” Funds

There were obviously some pretty noteworthy returns garnered in the past few months. And wouldn’t have been nice to have made a lot of money instead of getting clobbered during the recent market meltdown? UltraShort funds afford you that opportunity.    

Still, these funds are clearly not for everyone. Big swings are the norm these days, and these funds are making swings that are two times the big swings that the markets and the various groups are making. This typically requires a certain mindset and a certain level of backbone that most investors quite frankly simply do not possess. Still, the point here is not that everyone should rush out and start trading leveraged and inverse leveraged funds. And even if they did, it doesn’t mean that they have to put all of their money into leveraged funds. The point here is simply to alert you to the possibilities available to you and to encourage you to do some homework and make an informed decision regarding the potential uses of these, ahem, “exciting” investment vehicles.

Let’s be honest. Most people would say that they simply don’t have the stomach to trade these things, which certainly makes sense on the face of it. And yet, interestingly, many of these same people apparently did have the stomach to sit fully invested and watch 30% to 50% of their portfolio vanish into the ether over the past several months. Ironic, no? At the very least this unfortunate trait of human nature brings to mind the possibility of using these funds simply as a hedge during those times when you just can’t bring yourself to sell any meaningful portion of your portfolio. Just a thought.

Options on Futures

Let’s face it: there are few better ways to get people to stop reading than to invoke the phrase “options on futures.” The average investor tends to look at both of these domains as something from another world. And without question there is a learning curve involved in trading options and/or futures, let alone options on futures. Still, let me remind you that simply reading the following text in no way obligates you to rush out and start trading options on futures. No one will show up at your door and demand that you enter a long condor or else the wrecking ball will come through your front window. Remember, we are simply trying to “expand our horizons” here. So please consider the following possibilities.

Much has been made of the sharp decline in grain prices over the past five months. Some feel that the decline in the price of corn has been overdone to the downside. Now if one felt compelled to play a potential rise in the price of corn, the simplest approach would be to buy a corn futures contract. This involves putting up $2,025 in margin money to buy roughly $19,000 worth of corn. This is understandably a bit unverving to the uninitiated. But the fact is that there are much less risky possibilities.

Figures 1 and 2 display a position known as a “long collar” on March corn. This trade involves buying one March corn contract at $3.97 a bushel, buying one January 400 put option and selling one January 480 call option.

Chart 1 - Corn Long Collar

To enter this trade you would put up $2,025 margin money to buy the futures contract and would pay $1,075 (which is the difference in value between the option bought and the option sold). As you can see in Chart 3, your worst-case loss for this trade is $925, which would occur if you held this trade until January option expiration and March corn was below $4.00  bushel. If corn were to rally instead, this trade has a profit potential of $3,075.

 

Chart 2 - Risk curves for Corn Long Collar

Now the purpose here is not to argue the likelihood of corn rising or falling in price. The purpose here is to alert you to the fact that it is possible to trading “volatile” and “risky” commodity futures in conjunction with an option trade while limiting your risk to a very manageable amount. The same can be done with stock options or stock index options or FOREX options, options on ETFs, etc.

So, in the end, a handful of people will learn a strategy such as a “collar” and enjoy low risk trades from that day forward. The vast majority of individuals, however, will dismiss this “inane” discussion of such an “arcane” strategy and simply go back to their nice, comfortable “growth” fund managed by that handsome young fellow who appeared in a recent interview with his arms folded and his head cocked just so and that smug “I know more than you do” look on his face. You know, the guy who’s down 40% since September. Strange place, that comfort zone.

Summary

Most individuals approach the world of investing as something that is simply far too complex for them to get a good enough grasp of to have a chance at succeeding on their own. Well, if you have been taking advice from a “professional,” please take a moment to consider your results over the past twelve months. Then ask yourself if that is really the best you could have done. It’s probably (hopefully?) too late to load up on UtraShort funds and making a killing. And selling all of your stock market holdings and buying UltraShort funds after a 40+% decline in the stock market just smacks of closing the barn door after the horse has left. But once again, the primary point is simply to “learn our lessons” and to resolve never to stoically “go down with the ship” again. It is simply not necessary to do so.

And a life raft with a rudder that allows you to steer is always a better idea.  

To search for previous articles written by Jay Kaeppel, please click here.


Jay Kaeppel
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site

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