The Mighty Mesa

A Tested Options Strategy Designed to Never* Lose Money (and Just Might Make 36%)


PART I: THE STOCK MARKET WORLD

WHITHER GOETH THE MARKET?
The large number of stocks they cover means that random errors in individual stocks become insignificant. Analyst errors on individual stocks tend to cancel each other out.

BUYING STOCKS AND MUTUAL FUNDS
An analyst down-grades the stock.

The company fails to meet expected quarterly earnings.

The company meets “whisper” earnings number but falls short of sales expectations.

The company meets the “whisper” numbers but issues a gloomy outlook for the future.

Cooking the books

Back-dating management stock options grants

The company loses a big contract to a competitor.

The market as a whole falls, taking down most stocks with it.

If you still insist on buying individual stocks regardless of the miserable odds of being successful, there is an options strategy that works better than the outright purchase of the stock. If the stock goes up, the strategy will result in far greater percentage gains than if you had bought the stock instead. And if the stock stays flat, you will make a small profit – something you wouldn’t make if you just owned the stock.

On the other hand, in terms of mutual funds, year after year millions of investors pay mutual fund managers billions of dollars to underperform the market. “Most of my investments are in equity stock funds.” Even a famous stock broker agrees that “Most of the mutual fund investments I have are approximately 95% index funds.”

Pity Your Broker. Your broker will most certainly never tell you about trading options.

Commission rates of full-service brokers are too high for you to make money trading options especially the kind of spreads the author recommends

Everyone ‘knows’ that options are extremely risky. Most options expire worthless thus; option traders must be losing their shirts if he recommends options to you because, you may sue him if you lose your money.

The Analysts. If brokers really don’t know which are the best stocks to buy, what about the analysts?


PART II: THE WORLD OF OPTIONS

STOCK INVESTING VS. OPTIONS INVESTING
The biggest differences between the world of stocks (or mutual funds) and the world of options can be explained in mathematical terms. Stocks change arithmetically and options change geometrically.

Comparing the arithmetic changes in the stock portfolio with the expected geometric changes in a Mighty Mesa portfolio, these things are true:

If the underlying stock stays flat or goes up by 1%, 2%, 3%, or 4% during one expiration month, the portfolio value will increase by an average 4%-10% after commissions.

If the underlying stock stays flat or goes down by 1%, 2%, 3%, or 4% during one expiration month, the portfolio value will increase by an average 4%-10% after commissions.

If the underlying stock goes up or down by 5% during one expiration month, the portfolio value will most likely break even (on average).

If the underlying stock goes up or down by 6% or more during one expiration month, unless adjustments are made, the options portfolio will lose money. That loss could be doubled or more of the percentage loss in the underlying stock.

If the underlying stock falls by 15% in one expiration month, unless adjustments are made, the options portfolio could lose 40%.

PUTS AND CALLS 101
Basic Call Option Definition. Buying a call option gives you the right (but not the obligation) to purchase 100 shares of a company’s stock at a certain price (called the strike price) from the date you buy the call until the third Friday of a specific month (called the expiration date).

People buy calls because they hope the stock will go up and they will make a profit, either by selling the calls at a higher price, or by exercising their option.

Basic Put Option Definition. Buying a put option gives you the right (but not the obligation to sell 100 shares of a company’s stock at a certain price (called the strike price) from the date of purchase until the third Friday of a specific month (called the expiration date).

LEAPS are long term stock options.

CALENDAR SPREADS AND BUTTERFLY SPREADS
Calendar spreads are the basic foundation of the Mighty Mesa Strategy. They involve buying an option that has several months of remaining life and simultaneously selling another option in the current month with both the long and short option having the same strike price. Since the longer-term option will always be more valuable than the short-term one, buying the spread will involve the outlay of some money (when you place the order, it is called a debit).

A butterfly spread is an interesting options tactic if you think you know where a stock will end up at expiration.


PART III: PUTTING THE MIGHTY MESA STRATEGY TO WORK

SETTING UP A MIGHTY MESA:
Calculate the desired break-even range of possible stock prices (for SPY, it is recommended about 8% in either direction from the stock price).

Place a small number of calendar spreads (2-5 months of remaining life for the long side, one month of remaining life for the short side) at strikes just below and above of the starting stock price. Use puts for the calendar spreads below the stock price and calls for calendar spreads at strikes above the stock price unless, there is a price advantage for those closest to the stock price.

In other words, if the call calendar spreads are less expensive, they can be used for strikes slightly below the stock price.

Place a larger number of calendar spreads at a strike approximately half-way between the stock price and the lowest strike in the break-even range that you have previously selected.

The number or spreads should be at least double or triple the average number of calendar spreads that are placed at the various higher strikes.

For the most conservative portfolio, set aside 10% of portfolio value for possible adjustments.

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Crash-Tested Investment Strategies that Beat the Market

The Big Idea
It worked once again during the market decline that began in 2008. In The Seven Rules of Wall Street, Sam Stovall, master investment strategist and expert on stock market history, presents seven familiar sayings that not only convey enduring truths but also serve as superb investment strategies.

In this engaging guide, Stovall subjects his chosen sayings to the facts of history and to his own personal experience. When it comes to building a portfolio, for instance, should you “let your winners ride, but cut your losers short”? Absolutely. “On average,” Stovall writes, “the 'winners' beat the market by a near two-to-one margin.


Why You Need This Book
This fun and lively book provides an abundance of wisdom in remarkably few words – proving that investing books can be as entertaining as they are educating. To support his conclusions, Stovall complements his sharp insight with the results of detailed back-testing, as well as tables and charts drawing on decades of stock market data.


Rule 1 – Let Your Winners Ride, But Cut Your Losers Short
Contrary to popular opinion, it’s been more rewarding to invest in those industries that recorded the best price performances over the past year, while avoiding those with the worst. In this case, “Buy Low, Sell High” doesn’t typically work in the short run!

No investment technique works all of the time. The Let Your Winners Ride, but Cut Your Losers Short rule underperformed the broader market three years in a row, from 1987 to 1989, yet it beat the market 10 years straight from 1971 to 1980, including the mega-meltdown years of 1973 and 1974.

Investors typically fail before rules do. In other words, investors tend to give up on a rule after one or two years of underperformance – just when the rule is likely to work again. And to compound matters, they switch into another rule that just has a lengthy hot streak.

As luck would have it, that rule would then likely hit a cold streak.
So either embrace a single rule that you favor most and stick with it, or embrace two rules, directing half of your money toward one rule and the other half toward the second rule.


Rule 2 – As Goes January, So Goes the Year
The first month of the year has been very accurate in forecasting the coming year’s performance for equity markets, sectors, and industries. Developing a January Barometer portfolio for either sectors or industries is amazingly simple – just select the three S&P 500 sectors, or 10 industries, that posted the best performances during January and hold them for a year.

You may also be surprised to find out that the January Barometer portfolios frequently beat the market whether the S&P rose or fell in January.

You even find out which sectors or industries to avoid. Just as with the Let Your Winners Ride portfolio, the performances of the industries and sectors in the January Barometer portfolio show that investors can save themselves a lot of heartache by avoiding the three sectors and 10 industries that posted the weakest performances during this opening month of the year.


Rule 3 – Sell in May and Then Go Away
The market and most sectors typically take a “price-appreciation vacation” during the summer months.

From April 30, 1990, through October 31, 2008, they could have turned a 5.8% return into a 10.0% annual compound rate of return. Sweet!

In 2008, while the S&P 500 fell by more than 30% from May through October, the S&P Consumer Staples and Health Care sectors fell by about half that amount, improving not only on their frequency of beating the S&P 500, but also the margin by which their average compound return beat the market.


Rule 4 – There’s No Free Lunch on Wall Street (Oh Yeah, Who Says?)
By diversifying among sectors that zig when others zag, some investors have historically been able to get both a higher return as well as lower risk. If Sir Isaac Newton had a law of motion related to the stock market, it probably would have sounded like “for every level of return, there’s an equivalent level of risk,” meaning that the higher the returns you hope to achieve, the greater the amount of risk you should be willing to accept.

If you expect a high-price return, then you have to expect to experience an elevated level of risk, either in the form of price volatility or the potential loss of your original investment.

Sometimes, however, one can find an investment strategy that delivers a free lunch: an investment that offers an improved return with lower risk. Investing in sectors with low correlations to one another has actually provided investors with above-average returns – even when factoring in risk or volatility.

Over the long term, sectors with low correlations have recorded advances and declines at a different rate of pace, as if they each marched to the beat of a different drummer. Highly correlated sectors, on the other hand, ascended the staircase of price changes as if marching to the same beat.


Rule 5 – There’s Always a Bull Market Someplace
Not all investors are Fred Astaire on the dance floor. This rear-view mirror approach to investing has a time-tested track record for picking near-term winners. The intent is to maintain an ownership of all industries that have had the highest trailing 12-month price performance.

Your goal is to buy high but sell higher. In addition, the number of holdings never changes. This makes the management of the portfolio fairly straightforward. A drawback to this rule for industries is turnover. The portfolio requires monthly fine-tuning.

What this rule endorses is that instead of picking sectors, industries, or stocks by trying to forecast where we are in the economic cycle, projecting which company will win a government contract, or guessing which way the dollar will fluctuate, let the market tell you where to invest your money.

With Rule 5, There’s Always a Bull Market Someplace, you can let the market tell you which areas to buy into and when to sell out.


Rule 6 – Don’t Get Mad – Get Even!
How could you have invested in the S&P 500, yet avoided such long-lasting portfolio carnage? Get small-cap performance with large-cap stability.

What should an investor take away from this rule?

First, if you are a buy-and-hold investor who is looking to neutralize the influence of cap size in your portfolio, and take advantage of the historical outperformance of smaller-cap stocks over larger-cap ones, then you should invest in the equally weighted S&P 500 ETF.

Second, you might want to rotate between the equally weighted and market-cap-weighted S&P 500 indexes. The equally weighted S&P 500, like the small-cap indexes, will likely outperform the cap-weighted index periodically. As a result, you may choose to gravitate toward the equally weighted S&P 500 when you believe smaller-cap stocks are likely to outperform other stocks.

Third is the extra octane an investor receives when substituting equally weighted sectors for market-cap-weighted sectors in the portfolios. The Summary, Ranking the Rules, summarizes the performances, volatility, and frequencies of outperformance for each of the Seven Rules of Wall Street, using market-cap-weighted and equally weighted sector indexes.

How you implement the rule Don’t Get Mad – Get Even is just as simple as the ways you implement the other rules.


Rule 7 – Don’t Fight the Fed
The Federal Reserve controls the cost of cash. During periods of rising interest rates, there has traditionally been almost no place to hide. Yet when the Fed has begun cutting interest rates, the equity markets have usually soared. Will your portfolio be ready for the ride?

Learn to identify which sectors are traditional leaders and laggards during these periods of interest-rate adjustments.

What is the one thing an investor should monitor in order to gauge the health of the economy and the direction of the stock market? Interest rates.

The mandate of the Federal Reserve is twofold: to promote economic growth and to keep inflation under control. In other words, make capital (money) abundant enough so that consumers and companies will be willing to borrow money in order to expand and improve their overall quality of life.

If the economy were a car, the Fed’s responsibility as a driver would be to maintain a safe speed. If the Fed wanted to speed things up, then they would step down on the gas by lowering interest rates. To slow things down, however, the Fed would need to tap or even slam on the brakes by raising interest rates and reducing the availability of capital.

The biggest challenge for the Fed is that our economy isn’t a little red sports car that reacts nimbly to the application of the gas pedal or the brakes. Instead, the economy is more like a supertanker whose response time is remarkably slow. It also takes quite some time for the economy to slow down as a result of higher rates.


And the Winner Is…
Of all the portfolios, the one favored the most is There’s Always a Bull Market Someplace, which uses equally weighted S&P 500 sectors. Even more encouraging is that this portfolio allows an investor to evaluate and adjust his or her portfolio every month.

Good luck!

BusinessSummaries.com is a business book summaries service. Every week, it sends out to subscribers a 9- to 12-page summary of a best-selling business book chosen from among the hundreds of books printed out in the United States. For more information, please go to http://www.bizsum.com.