It's that time of year again.
I've started studying for the third (and final) CFA® exam, and my readers are
"treated" to my theories of the market and trading. No stock
picks today; put your thinking caps on!
CAPM: Nice Theory, Too Bad About the Market
In Level II of the exam, we studied efficient-market theories, such as CAPM
I actually like an elegant theory (I spent nearly decade of my life studying
mathematics), but as a market practitioner, I know the market doesn't work that
way. I learned this lesson the hard way.
Early in my investing career, I would short overpriced stocks. For
instance, I twice shorted Amazon (NASD:AMZN)
in 1999. At the time, Amazon was bouncing up and down between $50
and $100 (split adjusted), and, looking back 8 years later, it was clearly
overpriced even at $50. After all, it's only at $88 today, meaning the
annualized return from buying the stock in 1999 at $50 has been about 7%, while the
expected return under CAPM for a stock with a Beta
of 3.02 would be around 18%
per annum. (Assuming a 6% risk-free
rate equal to the ten year Treasury note yield at the time, and a very
risk premium of 4%.)
Put another way, if Amazon had been fairly valued according to CAPM at $50 in
1999, it should have been around $190 in 2007, when in fact it mostly traded below
$100. It should never have fallen below $6 in 2001.
Looking back at my records, I actually made money on those two shorts (I
made $4,661 on the first and lost $3,045 on the second), but it's the loss that
stuck in my mind and prompted me to use this example. After I closed out
the first short near $50, the stock rebounded to $59 and I shorted again.
It kept on rising, and I got cold feet and took my loss at $65 (I also needed a
tax loss, but that didn't make it hurt any less.)
Although I didn't know it when I sold, if I'd tried to wait for the stock to
start falling again, as it did in 2000, I would have had to ride through a paper
loss of $24,000 before the stock fell to where I was in the black again.
Even people who have the margin balance to ride through a reversal like that
find it very hard to do emotionally.
The lesson I took away from that (and a couple of other painful shorting
episodes), is that CAPM alone is a lousy theoretical basis
for investing or trading. I still do occasionally short, as I
am currently doing with First Solar (Nasdaq:FSLR),
but I generally take smaller positions and do not rely solely on valuation.
My primary investment framework is Behavioral
Finance, actually a grab-bag of theories which focus on investor psychology
to explain market behavior that cannot be explained by traditional theories such
as CAPM which assume market efficiency. To my pleasure, Level III of the
CFA® exam contains considerable material on Behavioral Finance, which I am
The Winner-Loser Effect
One of the most widely documented market behaviors which cannot be explained
in an efficient market is the Winner-Loser
effect. Put simply, stocks which have performed badly over a period of
a few years tend to outperform stocks which have performed well over the same
period in subsequent periods. I take this to mean that, all else being
equal, I should prefer to buy stocks which have performed badly over the last
couple years to stocks which have recently done well.
This is harder than it sounds. I think the easiest way to demonstrate
this is through introspection. Compare this chart,
original article about Electro Energy (NASD: EEEI)
to this more recent chart of the same company:
Looking at the charts, which of these stocks would be easier to buy? If
you can honestly tell yourself that the first would be easier to buy, you're
very unusual. I personally would have a much easier time getting myself to
buy the second chart, and was only buying the first chart and the dip that
followed because I know that I have face my fear to make
People who bought EEEI at $0.50 when I first recommended it (and managed to
hold not sell when the stock dropped as low as $0.30) are now sitting on a 70%
gain in just a few months, and can look forward to participating in the same
gains that someone who bought it in response to my Top
Ten Picks for 2008 article. (I'm almost certain that the reason the
stock jumped 40% on December 31st was because of that article... there was no
other news relating to the stock that day, and most of the move was due to a
single large purchase a few minutes before the close. If you were that
buyer, I strongly suggest using limit orders when trading a thinly traded stock
With small cap stocks like Electro-Energy, the only way I have to make sure I
buy them when they're down is keeping a tight rein on my emotions, but with
larger capitalization stocks which have exchange-traded options available, I
have a trick that makes it much easier. Consider another pick from the
same article, FuelCell Energy (NASD:FCEL.)
Part of the reason I chose to include it in the list is that its five year
performance has been lackluster, especially when compared with other alternative
energy stocks. Unlike EEEI, I had not been following it closely and only
had a small position before I wrote the article. However, I convinced
myself that the company has excellent prospects while doing my research, and so
I wanted to buy more.
Rather than putting in an order for the stock, I looked at the
longest dated options available, in this case options
expiring in July 2008.
I sold (or "wrote") a number of
July 2008 $5 FCEL Puts for $0.25 each when the stock's price fell on January
2nd. For each contract, I was paid $25 by the purchaser, and I am
obligated to buy 100 shares of FCEL at any time between now and July 19th for
$500, or $5 each. Keeping the necessary cash available until then, I not
only earn interest on the $475 of my money, but also the $25 I've already been
paid. If FCEL does not fall below $5, that put will never be exercised,
and my $475 has earned me about $36 in six months, or a 15% annualized return
(actually a little less because I had to pay a commission, but it's still over
If the stock price has fallen to $4 (a situation I find emotionally hard to
believe now, but one which I intellectually know is a real possibility) then the
put will be exercised, and I will have bought FCEL for about $4.75 a share, even
though it's trading around $10 now. The irony is that, although I'd be
jumping for joy at the prospect of buying FCEL for $4.75 a share today, experience tells me that
if the option is exercised next July, I won't feel happy about it at the time.
Here's what might happen: some bad news will come out about the stock in the
next four months, and the stock will fall to $4. I'll then be sitting on a
16% loss on my $4.75 per share investment in a "loser" stock. If
all that happens, and someone asks me if I want to buy more at $4 (16% less than
I feel would be the deal of the century if I could have it today), I'd almost
certainly say no. In other words, when I wrote those Puts on January
second, I tricked my future self into buying a loser.
Losers, in the long term, tend to out-perform winners, and this is a
loser I like for all the reasons
I outlined, even if I may not be feeling so happy about it in July. In
order to get in that position, all I have to do is to not sell the stock for a
loss. Not selling a loser you
already own is actually easier emotionally than selling and taking the loss.
That's what I mean by "tricking myself."
Getting Started Writing Cash-Covered Puts
If you'd like to try the above strategy yourself, I have some bad news.
While selling cash-covered puts and covered calls are actually lower risk
strategies than buying and selling equivalent amounts of the underlying stocks,
there are a lot of other things you can do with options that are much, much
riskier. For instance, you could sell the puts above, but decide you have
better uses for the $500 cash than leaving it in a money-market fund... until
the stock falls precipitously and you have to come up with the cash.
Regulators know about these risks, and they make investors jump though a lot
of hoops to get option trading permission. The procedure varies from
broker to broker, but there is usually a net worth requirement (as if money made
people smarter) and you also have to claim that you understand the risks
involved. Don't take short-cuts on this; just reading this article is not
enough! Get yourself a good book on options trading , or spend a few days learning about them online (you may have to
do some searching... I had trouble finding a free option information resource
that I would recommend. But I can tell you what to avoid: anything that
talks about getting
I don't actually know that the linked book is bad, but why waste your time?)
Check with your broker to see if your net worth qualifies you to trade
options. Study up on them if you need to, and then fill out your broker's options trading
My own broker was a day trader in the late 90's. Like most day traders,
he lost his money and had to go back to a real job. He says that the only traders he knew who made money were the ones who wrote puts on stocks
DISCLOSURE: Tom Konrad and/or his clients have long positions
in EEEI, FCEL, and a short position in FSLR.
DISCLAIMER: The information and trades provided here and in the commetns are for
informational purposes only and are not a solicitation to buy or sell any of
these securities. Investing involves substantial risk and you should evaluate
your own risk levels before you make any investment. Past results are not an
indication of future performance. Please take the time to read the full