For an individual to succeed in the stock market, it doesn’t take blockbuster moves, or strokes of genius. No need for home runs. To win in the stock market it takes consistent base hits.
What do I mean by the phrase ‘succeed in the stock market’? In my world, success in the stock market means beating the historical index month in, and month out. I’m not going to be precise here. But let’s just say that the historical return in the equities market is 12% per year. Breaking that down to a monthly basis means success is anything more than 1% per month. If you get a 1.3% return on your money in one month you should be jumping for joy. If you get a 5% return per month, you should jump for joy. If you make 20% per month, you should jump for joy. I am going to define a ‘home run’ in the market as anything more than 30% in one month.
So much here depends on your expectations. But let’s talk about one possible scenario. You have $5000. You want to eventually replace your current income which we will assume is $50,000 per year. You come up with a strategy that will pay out 3% per month. You implement the strategy. It will take 10 years before you’re making $5000 per month. At that point, ignoring inflation, you would have succeeded.
Covered Calls
So what is a decent ‘base hit’ strategy? A very common strategy known as covered calls. Covered calls can be thought of as charging rent on stock you own. You wouldn’t buy a house, and just wait for it to go up in value. You would put a tenant in the house to produce income for other investments. But people constantly buy stock and simply wait for the stock to go up in value. You don’t want to do that, you want to charge rent on your stock by selling covered calls. This is one of the easiest strategies to do, but out of all the base hit strategies it has the lowest return, and the highest entry cost. You’ll probably need at least $10,000 before you start using this strategy, and the returns you can expect range from 1-15%. How do you implement this strategy?
1. Pick a stock you wouldn’t mind owning for a long time.
2. Buy100 shares of this stock.
3. Sell a one strike price out of the money call option against this stock. One contract for every 100 shares you own.
4. Wait for the call option to expire worthless, or be exercised.
5. If the call option you sold expires worthless, you just got free money.
6. If the call option is exercised, you made money as well. You have to sell the person you sold the option to. But remember that the option was exercised because the stock went up in value. You made a profit on the stock, and you still get to keep the option premium.
7. Repeat process monthly. If you weren’t exercised you simply sell covered calls on the stock you own. If you were exercised you will have to purchase the stock again to sell covered calls. If that happens though, why not try base hit strategy number two?
Selling Puts
Another ‘base hit’ strategy that is similar to covered calls is selling naked puts. Selling naked puts is like charging rent on the money that is sitting idle in your brokerage account. The logic behind naked puts is this. You’d like to own a certain stock, but you would only like to buy the stock if you can get a good deal for it. You sell a put on a certain stock. This gives you the obligation to buy the stock if it goes down to a certain price or below. For taking on this obligation, somebody pays you a premium. If the stock goes down, and you are forced to buy that is fine. You wanted to buy the stock anyway. But you’re getting a good deal on the stock because the stock has dipped down. How do you implement this strategy?
1. Pick a stock you wouldn’t mind owning for a long time.
2. Sell a put option against this stock without owning this stock.
3. Wait for the put option to expire worthless or be exercised.
4. If put options are exercised, sell covered calls against the stock.
5. If put options expire worthless, smile and repeat the process next month.
Option Calendar Spreads
Another ‘base hit’ strategy that is similar to covered calls is option calendar spreads. Option calendar spreads are like covered calls with a little kick. Calendar spreads work just like covered calls, with one exception. Instead of actually covering the call option you sell by the actual stock, you cover the call option with another option. A deep in-the-money call option practically tracks the underlying security dollar for dollar. So if you can buy a stock for $50/share you can probably buy a long term deep in-the-money option for $8-15 dollars. What this strategy amounts to is buying time value for cheap, and selling it dear. How do you implement option calendar spreads?
1. First you pick a stock you wouldn’t mind owning long term.
2. Buy a deeply in-the-money call option that expires in 3 months or so.
3. Make sure that the net-debit for both trades together is less than the difference between the contracts’ strike prices.
4. Sell an at the money, or one strike out of the money call option that expires this month.
5. Wait for the call option you sold to either expire worthless or be exercised.
6. If it expires worthless, try to roll out of the long term, in-the-money option with a profit of 5% or more if possible.
7. If the option is exercised (this is what you want to happen) take the money and find another option calendar spread. You probably made 15-20% on this trade.
Ironically, the strategy to use if you have the least amount of capital is the option calendar spread strategy. When your account size gets bigger, it is probably a good idea to diversify strategies a bit. With the right amount of margin, you can reverse these strategies to deploy them with securities that you think are going to go down.
How powerful is this strategy? I know a gentleman who routinely makes over 15% per month on his portfolio using these strategies. If you started out with $5000 and wanted to make the kind of money in the market that would allow you to quit your job, you would only need to get your account up to $33,000 in order to make $5000 per month in the market. My friend who makes 15% per month in the market could go from $5000 - $33,000 in 15-16 months.
I’m not planning on doing that. That’s way too far into fantasy land for me. I don’t expect those kinds of returns. As long as I am beating the index, I’ll consider myself successful in the market.
