With Far Less Risk Than Simply Buying Stocks
By Alan Gula
Markets aren’t supposed to work this way. Most economists and academics will tell you it can’t happen… The “efficient market hypothesis” says it’s impossible…
That’s the financial theory that professor Eugene Fama developed at the University of Chicago in the 1960s. Fama argued that no one can consistently beat the market, because prices on traded assets already reflect all publicly available information…
It soon became the conventional wisdom on markets… except it’s not always true.
The reason ideas like the efficient-market hypothesis gain traction is that they offer a kind of symmetry… And people love symmetry.
Behavioral studies prove this: People with nearly symmetrical faces are consistently rated as being “more attractive.” The same is true for architectural designs, like bridges and buildings. And although we can’t prove it, we believe humans innately believe in philosophical symmetry. Most people believe you get what you deserve. They believe in some kind of cosmic balance.
The efficient-market hypothesis offers a kind of symmetry… a balance. The market knows all and accounts for everything… It is always in balance, at equilibrium.
It’s comforting… but the real world doesn’t work like that.
Asymmetries are found in almost every part of the natural world. Take your body, for example. Your left lung is smaller than your right lung – it’s missing one whole lobe. Your lungs are built this way because your heart is asymmetrical, too. The left side is larger than the right. Interestingly, almost all biological organisms are asymmetric in at least one dimension. The imbalance develops because of the way cells divide.
The world frequently doesn’t work exactly like the models suggest it should. Asymmetry is actually the norm, despite the human preference for symmetry.
In finance, one symmetry we’re taught is between risk and reward. This makes sense intuitively. And people want to believe it. It seems fair. If you want to succeed, surely you have to take big risks. But that’s complete nonsense.
Instead, you can use what many investors call “risk” to make triple-digit profits. But only if you know where to look…
Peering Inside the ‘Alpha Window’
I call it the “Alpha Window.” It’s an event that happens only about 1% of the time the markets are open. And when it does happen, it only stays open about five days, on average, since we started using this strategy in 2012.
You see, this window opening reflects an unusual, dramatic mispricing in the options market.
So what is this window exactly?
Fear in the market… measured by what’s called the “volatility index,” or the VIX.
The fear I’m referring to could be caused by anything. I’m sure you’ve seen it before…
The president makes an offhand comment about a certain company or sector. A company’s huge miss in earnings brings a market sell-off. A war starts… or an important bank defaults. Even a rumor can cause investors to be afraid and get out of the market.
If you want to succeed, surely you have to take big risks. But that’s complete nonsense.
Any of these events can cause the market’s volatility to spike. That’s why we call the VIX the stock market’s “fear gauge.”
The VIX tracks the prices of options on all the companies in the benchmark S&P 500 Index.
When the VIX spikes, it shows that investors are worried and willing to pay a lot more for options with downside protection.
That’s the sweet spot for this Alpha Window.
Increased volatility means that the higher the VIX goes… the bigger the difference between some call and put options on certain stocks. In this environment, you can make a lot of money on these huge mispricings…
February’s Volatility Spike
It’s hard to pry investors away from one of the market’s best-performing assets when it’s rising.
In February 2016, the U.S. stock market hit a bottom. From there, the S&P 500 gained more than 50% to the end of January 2018. It was an impressive move.
During most of that time, the market was as calm as a millpond. The VIX hadn’t risen above 20 since November 2016.
Remember, as we said earlier, the higher the VIX, the more people are willing to pay for downside protection in the form of put options… and the more nervous they are about the market.
But for more than a year, investors had nothing to worry about.
They were so confident that “shorting volatility” – betting that the VIX would continue lower – became a popular trade. And one of the most popular short volatility products made the S&P 500’s 50% gain seem pedestrian. It rocketed 686% higher from early 2016 to the end of January this year.
But in February, the tide turned… The stock market began pulling back, and the selling intensified. On Monday, February 5, the S&P 500 closed with a loss of 4.1% – its largest percentage decline since August 2011.
Amid the stock market rout, the VIX spiked to more than 38 on Monday afternoon. In one trading day, the index had more than doubled. It was the largest one-day increase in the VIX’s history.
Anyone betting on declining volatility was crushed. In particular, the VelocityShares Daily Inverse VIX Short-Term ETN (XIV) and the ProShares Short VIX Short-Term Futures (SVXY) were both popular products designed to short volatility.
On February 1, these two products had a combined $3.5 billion in assets. As of the close on February 5, they had just $135 million. The spike in VIX futures had wiped out more than 96% of their value.
And investment bank Credit Suisse – the issuer of XIV – decided to “kill” the product. Basically, any daily decline in indicative value greater than 80% can trigger a redemption – as stated in the product’s prospectus.
Meanwhile, SVXY lives on… although everyone holding it had their position obliterated.
And the spectacular short-volatility blowup is actually good for anyone interested in the Alpha Window we mentioned earlier. Now that the risks of recklessly selling volatility have been laid bare, we should start to see these Alpha Windows open more often…
The Market Isn’t Fair
The richest investors rarely do things that are “fair”… In fact, many very wealthy people have made a lot by financing companies directly on terms that were absurdly unfair. The more unfair, the better.
Typically, companies that need a lot of capital (say, to drill a new oil well or find a new gold mine) will sell stock directly to individuals at a price that’s well below the market price of the stock. So if the shares are trading at $10, the financing might close at $8. Right off the bat, these private financiers are taking far, far less risk than buying the shares in the market.
But that’s not the only advantage. They also demand (and usually get) free warrants in the stock. A warrant is like a call option issued directly by the company. As you may know, the price of an option is determined in large part by the expected volatility of the stock. An option on a highly volatile stock is worth a lot. And these folks get them for free as part of the deal. They’re taking a lot less risk than regular investors.
In these deals, there’s tremendous financial asymmetry. They’re buying stock at less than the market price. They’re getting a call option, for free. If the stock simply stays where it is, they’ll make a small gain. If the stock goes up a lot, they’ll make a fortune.
You don’t need many deals like these to pan out well to earn a significant fortune in the market. I happen to know a few guys who’ve done it… several times.
Almost any investor can take advantage of this anomaly to amplify the gains you might make on stock investments… potentially big triple-digit gains on margin.
But the beauty of this Alpha Window strategy is that it’s a way for regular, individual investors to do the same kind of thing.
We already know the vast majority of investors – probably about 90% – will never believe what we’ve discovered. They will continue to believe that risk is always balanced with reward. That’s what makes sense. That’s what their broker told them. That’s what the finance professors teach. Except, again, it’s simply not true.
The Window we’ve found gives almost any investor… at almost any time… on almost any stock he wants to own… the opportunity to invest with lower risk and earn profits that are far greater than what’s possible by just owning the stock outright.
The best part is that almost any investor can take advantage of this anomaly to amplify the gains you might make on stock investments… potentially big triple-digit gains on margin. And you can do it without taking on any more risk than you would by simply buying the common stock – less risk, in fact.
A Simple Strategy to Profit From Volatility
To take advantage of this, you only need to learn a single, simple options-trading strategy.
Many individual investors tune out immediately when they hear “options.” “It’s too risky,” they say. “It’s too complicated. It’s not for me.” Please don’t give in to these common objections… They’re false and usually proffered by people who know nothing about options.
Understand that options are simply contracts that give the owner the right (but not the obligation) to buy or sell an asset (in this case, stocks) at a predetermined price by a specific deadline.
That’s it… stock options are just that – the option to buy or sell a stock. Options that give the holder the right to buy a stock are called “calls” – as in you “call away” someone else’s shares. Options that grant the holder the right to sell a stock are called “puts” – as in you are “putting” your shares to another investor.
In simple terms… a trader buys a call if he thinks a stock is headed higher, so he can buy shares at a lower-than-market price. He buys a put if he thinks a stock is headed down, so he can sell shares at a higher-than-market price. All else being equal, the price he pays is based on how much the market expects the stock to move in the future…
Since puts and calls based on the same underlying stock are subject to the same volatility you would think they should be priced the same. That’s what the conventional wisdom would tell you…
But that’s not how it works.
Just log onto Yahoo Finance, and look up any of your favorite stocks… Microsoft, Hershey, Walmart… Find where they list options prices and scroll through. Calls and puts with the same inherent value trade for different prices. Why is that?
Fundamentally, people are more scared of losing money than they are attracted to the promise of making lots of it. That’s why they pay more for the protection of puts than the promise of calls. Their twin emotions of fear and greed are out of balance… They are asymmetrical.
And in times of high levels of fear in the market, these gaps can widen to outrageous levels.
As simple as that sounds, it gives you a very powerful way to reduce your risk… collect income from your trading… and set yourself up for outsized gains down the road.
This strategy is very simple…
We find stocks we love… that’d we’d want to own for the long term. Then, we buy a call to capture the upside potential AND we sell a put to protect our downside.
That does mean that you need to have approval with your brokerage firm to sell uncovered puts. Brokerages typically require a minimum level of capital and experience before allowing clients to sell options. The application process is not onerous. It usually involves filling out a simple disclosure document.
Our goal is to increase the returns on margin we’re able to earn on our highest-conviction ideas. And at the same time, we’re lowering the risk we take to open a position.
The way to leverage our ideas is by buying call options. Call options give investors huge upside potential, while limiting risk to the premium paid for the option. (Remember, if the price of the underlying shares rises above the strike price on the call… we can buy the stock in the future for less than the market is asking…)
We pair our purchase of calls on these recommendations with the sale of a put. Doing so not only allows us to finance the purchase of our call option… It also provides us some upfront income and mitigates our risk.
Ultimately, this strategy is a way to boost your gains (and income) from many of the safest, most conservative stocks in the market… with even less risk than simply buying those same stocks. Once you know how to make this trade, you might not want to do anything else.
Alan Gula bought his first stock at age 14. He was immediately hooked and knew he wanted to pursue a career in finance. He’s worked at Goldman Sachs and Barclays Investment Bank and was a statistical arbitrage trader at an independent proprietary trading firm.
Today, Alan is the editor of Stansberry Alpha, a newsletter dedicated to a little-known trade in the options market… which brokers are very hesitant to talk about, and may even try to keep off-limits from you. If you’re interested in the specific trades, click here for more information about Alan’s service.