Do the No Lose Stocks and Long Shot Options investing strategies work?

The intent of the No Lose Stocks (NLS) and Long Shot Options (LSO) strategies is to:

1) Protect my core capital, and yet
2) Still expose me to unlimited upside gains

Over the past few years we have experienced a large drop in overall market value and then a subsequent large gain in market value.

In October of 2007, the Dow Jones Industrial Average (DJIA) hit a high of about 14,000.

Roughly 17 months later, in March of 2009, the DJIA hit a low of about 6,600, a drop in value of roughly 53%.

Then roughly 13 months later, in April of 2010, the DJIA hit a high of about 11,200, a rise in value of roughly 69%.

These large moves are the kind of thing that these strategies were designed to capture, so I did some analyzing of the historical data to see whether or not the strategies actually did what they were intended to do.

Was core capital protected?

Happily, the answer to this is yes.

NLS protected my core capital by using put options that covered the entire initial value of the stocks that I purchased.

And LSO only used the interest that I gained on my core capital to purchase options that were likely to expire worthless.

Since the market dropped 53% and then only went up 69% from the low, that is still an overall drop of about 20%. The market still needs to gain another 25% (not including the most recent drop in value) to get back to 14,000. So anyone that purchased at the 14,000 level is still in a losing position.

But since my capital was completely protected, I did not lose any of my core capital in these market gyrations.

Exposed to unlimited upside gains?

This turns out to be not as good as I had hoped.

Although the market fell 53%, it then rose 69%. So in a perfect trade, an investor could have bought at 6,600, and then sold at 11,200 for a 69% gain in 13 months. Ideally NLS and LSO would allow me to get at least a piece of this gain. But that didn’t happen to the level that I hoped it would.

No Lose Stocks

With NLS, since the puts were paid for by the dividends, if the dividends were cut, then I could take a loss. I wanted to limit that loss to be less than 3% per year, so I avoided any trades where the dividends accounted for an overall loss in the trade of more than 3%.

But when a stock falls in value, the management will normally try not to cut the dollar amount of the dividend. So as the stock price falls, and the dividend dollar amount stays constant, the dividend yield goes up.

For example, a $50 stock with a $1 annual dividend has a ($1/$50) 2% dividend yield. If that stock falls to $25, then the dividend yield goes to ($1/$25) 4%. Due to my 3% loss limit, I would have taken a trade on this stock at a 2% yield, but would have avoided the trade at a 4% yield.

I analyzed all the trades from the beginning of the service to now, August 2008 to May 2010. I was looking for trades that met my 3% loss limit, needed to go up less than 50% annualized, and that had a gain on invested capital of more than 6%.

If a stock needed to go up more than 50% annualized to make a profit, then I assumed it was probably better to play that stock as a Long Shot Option trade instead.

6% is what I think the market returns over the long-term. I also think that 6% market “return” is only due to inflation, so I want a return of more than that on my investments.

NLS Analysis Results

In the time-frame of the 69% gain there was only 1 closed trade that would have resulted in an annualized gain of more than 6%.

The trade was on TWX, which had a large surprise upside move. From October 2007 to May 2010, this stock went from about $12.50 to about $34, a 172% gain. This is the same time period where the DJIA had an overall drop of 20%.

If I looked at trades that had not yet closed, and only considered the maximum profit they could have made so far if I had sold at exactly their respective peak, then from from January 2009 to May 2010, there were 10 trades that had a max profit of more than 6%, with 3% or less annualized risk, and 50% or less stock move to make a profit. 9 of these trades were in the late January 2010, early February 2010 time-frame.

The majority had less than 15% required annualized percent to profit. The max profits were from 7% to 18%, averaging around 10%. And all had “days to expiration” of less than 220 days.

So because of the tendency for dividend yields to go up when the market drops, NLS will probably not do well in the environment where the market is recovering from a large drop. The environment where NLS should do well is the one where we are in a bull market and making new highs, like TWX did.

I hesitate to draw too many conclusions from the unclosed trades since they haven’t had their full run yet, but it looks like I should only consider investing in the trades that need less than 15% annualized percent to profit. If those trades don’t exist in a given month, then the opportunities just aren’t there and I just shouldn’t invest in the NLS strategy that month. And if the stock is not making new all-time highs (as opposed to just trying to attain previous highs), then I should consider selling my position when it has a 10% or more gain.

Long Shot Options

With LSO, the idea is to buy the cheapest options with the interest earned off of my core capital. The service only picks options that have ask prices of less than $0.20.

If I have a $100k account, and the interest rate is 1%, then I have $1k per year, or $83 per month, to spend on cheap options. If the interest rate is 3%, then I have $3k, or $250 per month to spend on options. So the interest rate has a very large effect on how many options you can buy. Also note that for the same money I can buy 4 x $0.05 options versus 1 x $0.20 option.

I ran an LSO Calls analysis and an LSO Puts analysis for the entire life of the service. A “winner” trade was one where the trade made more than 6% on the invested capital at any point.

For example, if I wanted to buy a $0.05 option that had a year long expiration date, that would cost $5 for the 100 options + $2 in transaction fees (open and close), for a total of $7. If the interest rate on my savings was 1%, then it would tie up $700 of my capital to put on this trade. So in order for this trade to be a winner, the option itself would need to be worth more than 6% of $700 at the expiration date. Or in other words, the $5 option would need to appreciate to $42 or more.

Note, I didn’t limit this one to value at the expiration date only. I’m looking at the maximum profit possible. So this is not a conservative estimate.

LSO Calls Analysis

Of the total trades (6548), the ask prices fell out like:
$0.05 – 249
$0.10 – 859
$0.15 – 1715
$0.20 – 3725

Of the winners (247) the Ask price of the options fell out like:
$0.05 – 2.4% (6)
$0.10 – 16.2% (40)
$0.15 – 23.89% (59)
$0.17 – 0.4% (1)
$0.18 – 0.4% (1)
$0.20 – 56.68% (140)

The average gain on invested capital per trade (assuming a 1% interest rate return on savings) was:
$0.05 – 3.58%
$0.10 – 2.02%
$0.15 – 0.94%
$0.20 – 0.98%

If the interest rate return on savings was 3x higher, then the average gain per trade would also be 3x higher. So for example, for a 3% interest rate return on savings, you get a 10.8% return for .05 options.

Notice that the return on the $0.15 and $0.20 options was less than the 1% that it cost to get those returns. So at least for this time period, these trades did not produce a profit.

Also notice that the 249 x $0.05 trades cost $1245 over the entire approximately 2.5 years, or roughly $500 a year. So at 1%, that would require an account of $50k to be able to buy all of the $0.05 trades. And since only 6 out of the 249 were winners, it would be extremely damaging to the returns if I didn’t buy all 249 of the trades and missed one of the 6 that was a winner. The return on invested capital for the winners ranged from 25% to 300%.

The “Percent to Profit” didn’t seem to matter.

The time of the option did have some effect, but not much. Longer was slightly better.

The stock having dropped a significant percentage (75%) recently was also a factor in producing a gain.

So for me, this means that I need to concentrate on buying all of the $0.05 call option trades available in any month. And look for ways to get my no risk interest rate on my core capital to be a little higher. At 1%, I’d be getting a 3.58% return. But at 2%, I’d be getting a 7.16% return, which would be higher than the 6% that I’m targeting.

However, again, these return values are the absolute highest possible, and assume the investor sold at the very peak of the option’s worth. Since that is not probable, these are probably higher than what I would actually make in returns.

I’m curious to see how these kinds of trades do in the next bull market though, like the NLS trades, these should do better in that type of market as well.

LSO Puts Analysis

The results of this analysis were abysmal.

Of more than 2500 trades, only 5 made a return of more than 6% on invested capital. And those were all $0.15 or $0.20 options. So this strategy was not able to pay for itself and did not produce a gain over the given time period.

This is not too surprising though. The time period here is November 2008 to May 2010. So this only catches the tail end of the decline that started in November 2007 and went to March 2009. So I can’t really say if this is a good strategy or not.

My guess is that it is not a good strategy. I’m thinking that the return profile probably mirrors the LSO Calls, which means there would probably be a few trades that would win, but the great majority would lose. And so the few that would win would need to make up for all the ones that lost and then some to average a 6% return overall. Since puts have a natural limit to how much of a return you can make (the stock can only go to zero, no lower), there is a cap on the returns that each put could make, and so I don’t think you would see the 300% returns on invested capital needed to get that average 6% return.

Summing Up

My main concern of protecting my core capital was definitely covered by these strategies. So I’m happy with them from that perspective.

NLS didn’t do as well as I thought it would in the recent run up, but I suspect that it will do better in a market environment where stocks are making new all-time highs. The same goes for LSO Calls, although I think I will concentrate my investments on the $0.05 options regardless of how high a percentage the stock must rise to make a gain.

LSO Puts didn’t really get tested in an environment where it would be expected to do well, so I don’t know whether or not it is a good strategy. I’ll have to wait for a future down market to find out.

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