Monday, October 20, 2014
The market is down around 6% over the past three weeks.
We've been in such a strong bull market – with such low volatility – for so long, this little market correction caused many folks to panic.
But pullbacks like these don't portend anything. Despite what the financial headlines say... the market doesn't dip because of something the Federal Reserve Chair says or new developments in Russia or fears of this or that...
More often than not, there is no explanation. It's just the way markets naturally move.
And there's one way to increase your trading success during these market fluctuations.
Let me explain...
As I said above, the market naturally fluctuates.
One famous (and likely fictional) anecdote explains it best: A young investor once asked J.P. Morgan what he thought the market was going to do. The legendary banker responded, "It will fluctuate."
A 5% pullback usually happens about three times a year. A 10% decline happens about once a year. At these times, the panic-peddlers say it is the end of the bull market. It isn't.
These sorts of moves aren't uncommon. You can see that the current pullback is only a touch larger than little ones we've had consistently over the past two years. Those other moves weren't a time to panic. Neither is this one.
Of course, this doesn't mean the correction is over... We may have to weather some volatility along the way.
And someday, we will experience a true bear market. No doubt someday we'll suffer a 10% correction. Someday we'll have a 25% correction.
It's foolish to think you can predict when that will happen. We keep our eyes on the health of the market, but that's different than claiming to know where it's headed next.
But there's one way to increase your trading success when the market does get rattled... selling puts or covered calls. If you're not familiar with the idea of selling options, you can learn more here and here.
So how do market pullbacks benefit option-sellers?
First, when the market drops, volatility rises. You can see that each dip in the market coincides with a rise in the Volatility Index in the chart below.
The level of expected volatility is a key determinant of option prices. When people are fearful of a declining market, they will pay more for the same options than they would if the market were rising.
That means you can earn more income from selling the same options.
Second, when the market dips, quality stocks are available for a better price.
Every business has an intrinsic value. The price of its stock can fluctuate, but the business that it's based on – so long as it has real assets, sales, and profits – maintains its true value.
Valuing businesses is part art and part science. So you can argue about whether the real value of the business is $100, $90, or $80 a share.
But here's what you can say for sure...
If the true value of a business is $20, the stock could easily drop from $25 to $20. It may then even drop from $20 to $15. But that's less likely because now it's actually trading for cheaper than its true value.
The stock can drop from $15 to $10. But that's even less likely. Once the share price of a valuable business has dropped, each tick down will become less and less likely. The true value of the underlying business gives shares support.
Value investors compare the falling share price of valuable stocks to "trying to hold a beach ball underwater." As you push the ball further and further down, you work against increasing resistance... and the ball explodes to the surface with more force once you release it.
As option-sellers, our primary focus is to find stocks that will maintain their value until our options expire. So when we buy good stocks at a cheaper price, our "margin of safety" increases. The beach ball has already been pushed partly underwater and is less likely to decline from a lower price than it would be from a higher price. Simple as that.
When positions we already hold drift downward, we can sell another round of options and collect more income from the premium.
In short, the market will always fluctuate. But selling options on quality stocks will remain stable. And it can dramatically increase your trading success.
Here's to our health, wealth, and a great retirement,
Dr. David Eifrig
"Many individual investors tune out immediately when they hear 'options,'" Sean Goldsmith writes. "'It's too risky,' they say. 'It's too complicated... It's not for me.'" But in this success story, he shows how almost any investor can use options to invest with lower risk... and earn profits that are "far greater than what's possible by just owning the stock outright."
Doc believes selling options is one of the most valuable investing skills you can learn. "No other strategy offers a chance to safely profit, no matter what happens to stock markets," he says. Learn how to get started selling options in this interview with Doc.
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