THE THIRD DIMENSION OF INVESTING / BARRON´S

Tuesday, August 18, 2009

THE STRIKING PRICE DAILY

The Third Dimension of Investing

By STEVEN M. SEARS

Buy and hold is for losers. Here's an options-based strategy that the pros use.

ONE OF THE POTENT LESSONS from the recent credit crisis is that investors who ignore the life cycles of their stocks are likely to lose more money than they make.

Buy-and-hold investing, as the primary stance for investors, is seriously wounded and discredited by the past few years of market tumult. Going forward, investors need to learn to think like traders and view their stocks multidimensionally.

When major investors like Credit Suisse, Goldman Sachs or Pimco have an investment idea, they reflexively think multidimensionally and tap the collective insight of the firm. They look for the cheapest way to express their thesis. This could be with bonds, equity options, stocks or some complicated combination of all three.

A simpler way for stock-oriented investors to think more contextually is simply to use options to better navigate the market. There are simple, limited risk strategies that all investors need to know as volatility is increasingly part of the global financial markets.

Consider technology stocks: The Nasdaq 100 (QQQQ), the primary proxy for the technology sector, is up about 29% this year, and has outperformed the Standard & Poor's 500 index by about 21%.

Technology stocks have been boosted by their low debt-to-equity ratios as investors have avoided stocks with heavy debt burdens. In addition, many investors think technology business expenditures will soon resume, and this expectation has further boosted technology stocks.

Yet, there is a disconnect between stock and options prices. Single-stock technology-implied volatility is at its lowest range in two years for most of the sector, says Sveinn Palsson, a Credit Suisse derivatives strategist.

The low volatilities provide an opportunity for savvy investors to sell stock and replace their shares with relatively low-priced call options. This is a prudent way to realize profits, and avoid giving back "paper profits" if a further delay in business spending sparks a technology-stock selloff.

"Monday's selloff is a reminder of the ongoing macro risks plaguing equity markets," Palsson says.

One way to combat this risk is to initiate stock-replacement strategies that replace shares with a call option. This strategy lets investors profit from additional upside in the shares, while cashing in profits and limiting the risk to the amount of money spent to buy the option.

The strategy is capital efficient, enabling investors to free capital and invest it elsewhere -- like bonds to reduce risk, or maybe even another stock or an exchange-traded fund.

Consider shares of IBM (ticker: IBM) as an example. With the stock at $116.86, investors can replace shares with a January $120 call; the cost of the trade is $6.60, or 5.65% of spot (cost of the stock), freeing 94.4% of the total notional invested in the stock.

"This trade locks in a bulk of the 38.9% return year-to-date for IBM, while the max drawdown is limited to the premium paid," says Palsson.

Realize profits. Maintain upside exposure at the same time. Limit risk. Welcome to the third dimension of investing.

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