March 13, 2024 • 26 mins
Unlock the secrets of smart stock exits and options trading with the formidable expertise of Steve Davenport and his co-host Clem Miller. In a spirited exchange, we peel back the layers of using call options to gracefully bow out of stock positions, all while potentially padding your returns and softening the tax blow.
Steve guides us on selecting the right options that go well with your target prices and volatility—especially when earnings announcements loom large on the horizon. We don't shy away from potential behavioral pitfalls either, such as the sting of watching a stock ascend after you've sold your options. We offer advice on selling in increments to soothe any seller's remorse and smartly manage opportunity costs.
As the conversation deepens, we wade into the complex world of volatility and its influence on options trading, where the numbers tell only half the story. Here, volatility is a dance of mathematics and personal risk appetites, played out against the backdrop of life's major financial goals.
As we wrap up, we scrutinize the tug-of-war between retail and institutional traders and dissect the tell-tale signs of an overvalued stock. For investors keen on refining their strategy and navigating the markets with finesse, this episode is an essential listen.
Steve guides us on selecting the right options that go well with your target prices and volatility—especially when earnings announcements loom large on the horizon. We don't shy away from potential behavioral pitfalls either, such as the sting of watching a stock ascend after you've sold your options. We offer advice on selling in increments to soothe any seller's remorse and smartly manage opportunity costs.
As the conversation deepens, we wade into the complex world of volatility and its influence on options trading, where the numbers tell only half the story. Here, volatility is a dance of mathematics and personal risk appetites, played out against the backdrop of life's major financial goals.
As we wrap up, we scrutinize the tug-of-war between retail and institutional traders and dissect the tell-tale signs of an overvalued stock. For investors keen on refining their strategy and navigating the markets with finesse, this episode is an essential listen.
Straight Talk for All - Nonsense for None
Please check out our other podcasts:
https://skepticsguidetoinvesting.buzzsprout.com
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Transcript
Episode Transcript
Available transcripts are automatically generated. Complete accuracy is not guaranteed.
Clem Miller (00:03):
Hello everybody, welcome to Skeptics Guide to
Investing with Steve Davenportand myself, clem Miller.
Today we're going to be talkingabout using options to exit
positions.
As many of you know probablyall of you know markets have
been reaching highs recentlystock markets and it leads to
(00:27):
the question at what pointshould one exit the market as a
whole or individual positions?
Today we're going to talk toour options expert, steve, about
how you use options to actuallyexit positions.
With that question, steve, howwould one go about using options
(00:55):
to exit?
Steve Davenport (01:00):
Options have two different types.
There's a put option, whichgives you the ability to sell,
and there's a call option, whichgives you the ability to buy.
The way that you do this whenyou want to sell something is
you would sell a call option,which would give the person
(01:21):
who's buying the call option theright, but not the obligation,
to buy at a price for a periodof time at a level in the future
.
For example, if we have Nvidiatrading at 9 something, 25, and
you said I think that it's goingto have trouble going through a
(01:44):
thousand, but if it does, I'dbe willing to sell at that price
.
You look and you say whatoptions are out there for Nvidia
?
Nvidia has a lot of volatility,so you're going to get
compensated very well for this.
You look and say, okay, I'mgoing to sell a thousand level
(02:06):
or an option priced at athousand for Nvidia and I'm
going to do this for threemonths and I'm going to collect
$50, $100.
It's really just the conceptthat you're taking the price and
you're getting paid the premium.
(02:26):
Now it's really about trying toinstill some discipline.
When you think about selling,there's really always trouble,
and that trouble is taxes.
I think that the simplestconcept is that you want to sell
(02:48):
your stock, not all of it.
You're usually trimming it atsome price in the future and
each option controls 100 shares.
In this example, with the priceof Nvidia being so high and
people may not have 100 sharesand that may make it hard for
them to do this strategy, theidea is put an option out there,
(03:13):
get paid and if you hit thatprice you're satisfied.
If you don't hit that price,then you don't sell it and you
just collect the premium.
In any example let's say thatNvidia was 910, and you put out
an option at a thousand and it'sgot a July expiration then if
(03:39):
it goes up $90 more dollars or10%, then you'd say, hey, I've
paid.
If capital gains are 15% or 20%, I've saved 10% of it by the
increase in the price plus thepremium.
That's pretty good.
(04:00):
You're not worried as muchabout the impact on the taxes
you have to pay, because theappreciation makes up some of
that difference.
Clem Miller (04:12):
So, Steve, what's the downside really to doing
that?
It sounds like there's a lot ofupside, especially on the tax
front, but what's the downside?
Steve Davenport (04:22):
The downside is that the stock just moves down
quickly and then you would havewished it sold at 910.
People have this perceptionwhen they see a price and they
don't execute at all.
They don't sell a call, theydon't sell any shares and they
just sit and watch.
(04:43):
And after a while people startto realize, hey, could I have
handled this differently?
Do we have choices as investors?
Are we always learning?
And I think that's the key Areyou getting better at making
decisions and does your processhave some disciplines in place?
(05:05):
And so when a position gets lookat NVIDIA up year re you're
date up almost 90%.
It's had an unbelievable run.
It's a great company, we allagree with that.
But there is a point at whichyou sell.
I want to say nobody goes brokeselling winners, right, they're
(05:27):
taking profits and redeployingthem will not solve all your
timing questions, but it's astart and that's how we look at
the reason to use options.
There are multiple reasons.
One is a return enhancer, oneis a risk reducer.
(05:49):
But the other issue is if thestock goes down from here, will
you have regret?
And that's what we're trying tominimize regret, maximize return
and reduce risk.
I hope that we're all big boysand girls and we all realize
(06:10):
that we can make mistakes withthe use of options.
What you're trying to do ismitigate some of those mistakes.
Clem Miller (06:20):
So you already mentioned that it helps with
both risk and return.
It reduces risk and alsoenhances return.
But, steve, how do you actuallychoose the option that you want
to use?
Is it volatility or is it someother factor?
Steve Davenport (06:42):
Well, I like to look at target prices.
I also like to look at whetherthe person feels that a certain
price is what they'd besatisfied with.
If they bought it at $400 andit gets to $1,000 150%, return
(07:05):
feels very good.
So we look at volatility as anindicator because when you see
the volatility, you know thatthe price of the option is the
highest when the volatility isthe highest.
So if I'm comparing two optionsand one has a volatility of 48%
(07:28):
and the other has a volatilityof 55%.
I look at the historic wall forNvidia and it's 45.
I know that that 48 is betterthan the 45 average, but that 55
really stands out.
I look for volatility and whatusually happens is around
(07:50):
earnings announcements,volatility goes up.
Yes, around earnings, the pricecould go up and you could.
One of the risks that I didn'tmention previously is it could
go above that price.
If you're at a thousand and itgoes to $1100, on the next
(08:11):
earnings call you're going tosay I sold out at a thousand, I
got paid 50 or 60 dollars inpremium, but now the stock's
1100, which leads me to myoriginal comment that we've
tried to write on some amount ofnot the whole amount of shares
you own so that you stillparticipate with some of your
(08:35):
shares, but some of your shareshave been sold at a price.
That's when we talk aboutopportunity cost.
There's an opportunity that youmissed.
There are opportunities outthere for names.
For example, like we talkedabout in other podcasts, like
Tesla, there's a hugeopportunity cost that when you
(08:55):
could have bought that two orthree years ago and you would
have a great return.
But there are a lot of thingsyou do and don't buy certain
names If you can't explain orunderstand how the price is
going to be delivered to you interms of growth in sales, growth
in profitability.
With this example, I would likepeople to think there are
(09:21):
always opportunity costs and aslong as you're aware of them,
you feel much better in terms ofyour results.
Clem Miller (09:29):
Steve.
Tesla is a great example of alot of volatility, but I want to
make sure you and I understandwhat volatility is.
I think our audienceintuitively understands
volatility, but maybe doesn'tunderstand from an investment
perspective what that exactly is.
I'm wondering if you can sharewith the audience what we, as
(09:53):
investment professionals,consider volatility.
Steve Davenport (09:58):
Sure, volatility is typically the
standard deviation of the price,meaning the first derivative of
price is return.
The second derivative of theprice equation is volatility.
It tells you how the stock isgoing to behave over a longer
(10:20):
period.
So when you look at, there'sreally many definitions.
One definition of volatility isI don't want to lose money.
I lose money, I have a negativereturn.
That's negative volatility andI don't want that.
Clem Miller (10:34):
Right.
Steve Davenport (10:35):
Very hard to eliminate that there's
volatility in terms of how am Irelative to my benchmark, am I
above my benchmark, below mybenchmark and relative
performance.
And I think there's absoluteand then there's relative.
And then I think thatvolatility has a lot to do with
(10:58):
your own personal circumstances.
So if you are depending on thatmoney for a down payment on a
house, if you're putting thatmoney at risk for your
children's college fund, thevolatility that you're willing
to absorb or experience goesdown as you get closer to that
kid going to college.
So therefore, you don't want tomake a mistake and you will try
(11:24):
to obtain less volatility,meaning less variation in the
price of the object or the stock.
So I think that we all havedifferent definitions of
volatility, but I would say themost consistent one is the
second derivative of price, orthe standard deviation of a
(11:47):
given return.
Clem Miller (11:50):
Yeah.
So, Steve, just to stay on thatpoint about volatility for a
second, since someone, ouraudience may not understand
derivatives, first and secondderivatives.
I have in my mind and maybe ouraudience should too the
standard bell curve, the bellcurve being the curve that looks
(12:15):
like the Liberty Bell inPhiladelphia, where you have a
bulge in the middle that goes up, which is the average, and then
you have the curve curving downto the left and you have the
curve curving down to the right.
Well, it's nice to have returnsoff on the curve to the right,
(12:37):
because it means higher returns,but what you're trying to
protect against is a lot ofnegative returns on the left
side of the bell curve, becausethen you're well below what the
average returns could be.
So that's what we're talkingabout here, just visually, if
(12:57):
you can visualize that bellcurve.
We don't want to be on the leftside where you have all those
negative returns.
Steve Davenport (13:06):
Right, I think about things in terms of Excel.
So when I say I have a columnof returns going back three
years weekly returns or dailyreturns and I click and say
equals standard dev of all ofthe items in the column, and
(13:29):
then that gives you a number andthen you say is this number
weekly, monthly or annualized?
And then you apply a number toannualize it.
So it's a mathematical concept.
But what I was trying to getinto is the personal concept of
what volatility is to theindividual.
(13:51):
I agree the bell curve.
The reason I don't like to talkabout the bell curve is that I
believe we know that returns areskewed towards the positive
side.
So while a bell curve is asimple concept and a good idea,
it's somewhat misleading andtherefore I don't think any
(14:14):
measure of return or ofvolatility is perfect.
Right, I like to give peoplemore answers that are really
relative to their own lifestyleand their own situations,
because then they can understandIit better.
All right, I'm selling nvidiaentity that has a lot of
(14:37):
volatility, good and bad andthen I'm putting it into
treasuries and those treasurieshave guaranteed me that they
will return what I or short termor cash If I'm not exposed to
anything but inflation and Ithink I understand what
inflation is then I can livewith that for the next two or
(14:59):
three months.
When I was young, we just boughta house, I was selling stocks
and putting it in cash and itmade you feel very good when, on
the day of your closing, themarket's down two or three
percent and all of your money issitting there in cash and
you're able to make thetransaction happen where the way
want to.
(15:19):
Yeah.
Clem Miller (15:22):
So, Steve, when I'm sure people are looking at
NVIDIA or other stocks and arethinking, well, when is it a
good time to sell?
After all price targets?
As prices go up, people tend toadjust their price targets
because they think, well, inVidya's reach this point, it's
(15:44):
going to go up even more.
So how do you address that?
Steve Davenport (15:49):
I think that one of the the biggest issues
with people is that once theysee a price, they can't accept
the price that's lower.
So we have a perception issueand it's a behavioral issue
where people are just alwayswanting something more.
You say I'm happy if this goesto a thousand, I'll sell it a
(16:11):
thousand, but if you're at athousand fifty, suddenly the
thousand doesn't feel that good.
So it's really working withagainst your biases, which is
your perception changes.
You say, oh, look at this newproduct, look at this new
application for AI and look athow it's going to lead to more
(16:31):
change.
There is always going to bepositive and negative events and
we tend to have a confidencebias that we think we understand
and we think the past is thepredictor of the future.
I think all of these things.
It's very hard for trees togrow to the sky.
(16:52):
It's very hard for things tokeep going up when there is
reasonable people who look andsay I've taken my profit, now
I'm going on to other ideas.
There's a retail weakness,which is when you see retail
(17:12):
traders dominating a particularname at a time and you see
institutional traders or buyersstarting to step back and you
say, hey, 80% of the buying isretail.
Now that's usually an indicatorthat the stock may have peaked.
The example of JP Morgan whenthe shoe shine boy tells him
(17:34):
what stock he should buy, herealizes it's probably time to
get out of this market.
I think that people just haveto be practical and say I can't
always buy things because I havea fear of FOMO, fear of missing
out.
I should be buying things thatI understand and I want to hold
for a long time and then, if itperforms the way I expected and
(17:58):
it gives me the result I wanted,which is I want to grow this
asset so that I can afford topay for my child's college or
car or house, when you get tothe target and you need, it's
wise to just take some chips offthe table and go to another
place where you think thatyou'll be fairly compensated.
(18:20):
So I think it's a very hardtopic and this is one of the
things that I don't think thereis a clear answer here.
Clem Miller (18:31):
But do you always do this in your portfolio or are
you selective about usingoptions?
Steve Davenport (18:38):
No, this is something that you apply as
needed and when you're havingtrouble figuring out what to do
and how to handle a stock, thisis one solution that should be
in your toolbag.
I think that when you think ofall of the things that you can
do I can sell, I can hedge, Ican write calls this should be
(19:04):
one of the things you thinkabout, and whether it makes
sense.
Every situation is differentfor every client and every
investor, so what I would say islet's just make sure that this
is a tool at your disposal sothat you have a chance to
eliminate some of that regret.
I think if it goes up to 1,050and then comes back down to 800,
(19:29):
not having sold that call willfeel very hard for you to think
about it as a choice.
On the multiple choice of whatto do with investing to try to
manage your risk and manage yourreturn, it always helps to take
some profits and allow yourselfsome choices in terms of other
(19:53):
things to invest in.
Clem Miller (19:55):
So, Steve, how do our listeners actually get
started with options?
They may not know where tobegin.
Steve Davenport (20:02):
So first year account has to be set up for
options so you can look at thefirm.
You have your assets, custody,that and there's usually an
option standardized optionagreement that you must sign.
That says you understand howoptions work and the risk
associated with the option.
I think it's a good way forpeople, even if they don't use
(20:26):
options, go through the process,learn about them, set up your
account for them and start slow.
Start slow and grow yourknowledge.
It helps you in the end.
If you ever needed to dosomething, you're set up to do
it.
I'm not recommending these foreveryone.
I don't think they're right forpeople who don't understand it
(20:49):
and read the document and say Idon't get this, then it's not
for you.
I think that for some investors, these should be a tool that
you have and the way you set itup is talk to your existing
advisor or talk to your existingcustodian and set your count up
for option.
Clem Miller (21:11):
So, Steve, I'm forging around in our mailbag
and I'm pulling out one here onoptions.
Do you think now is aparticularly good time to use
options?
Steve Davenport (21:25):
Yes, I think that, in terms of the move we've
had in the markets, I believethat this move has been
prolonged and has reached apoint where it's not fully
discounting all thepossibilities.
So when I see the 52-week highsthat we're hitting and I see
(21:47):
some of the level of disparitybetween the Magnificent Seven
and other names, these are allsignals that there perhaps is a
good time for you to sell calls,the buy-pots, or to hedge.
So I would say, yes, this is agood time to use those and I
(22:07):
would recommend people, even ifthey don't end up using them.
Understanding them is going tomake you a better investor and
ultimately allow you to havemore flexibility with how you
want to manage.
One strategy many people use isto sell calls in the next year.
So if we're in 2024 and I sella January 2025 option, I'm
(22:35):
putting that trade into the nexttax year and by doing it in
January, I'm not going toactually pay the capital gains
on that if it hits until Aprilof 26.
So it really allows you todefer into the future and manage
(22:55):
your last aspect of yourresults, which is taxes.
Clem Miller (23:00):
So Steve in 30 seconds or less.
What are the takeaways that ourlisteners should take from this
episode?
Steve Davenport (23:14):
So options are one tool that an investor should
use to help manage theiroverall portfolio.
Discipline matters, and whenyou use options like this, it
instills a discipline that saysI've identified a price, I feel
comfortable with that price andI'm willing to let my shares go
with that price.
Past does not predict thefuture.
(23:36):
Just because it's run from 600to 900 is not mean that it's
going to run from 900 to 1200.
There is a caveat that youalways say the past does not
predict the future.
And then the last item is younever go broke taking profits.
(23:57):
My father was a tax accountantand he used to say if you keep
taking profits, you're alwaysgoing to be managing your cash
flow, and that's ultimately whatyou want is to have more
resources applied to more areasof the market so that you can do
well with your money.
So I'd say that keep it simpleand understand what you're doing
(24:23):
and learn.
Those are principles that applyto everyone.
Clem Miller (24:29):
So, steve, thank you very much for this amazing
lesson on the use of options inthis kind of market, and we
thank all of our listeners fortuning in and listening to our
podcasts.
So if you like these podcasts,make sure to like them and to
(24:54):
subscribe, and we look forwardto sharing with you on a future
episode of Skeptics Guide toInvesting.
Thanks, everybody.
Hello everybody, welcome to Skeptics Guide to
Investing with Steve Davenportand myself, clem Miller.
Today we're going to be talkingabout using options to exit
positions.
As many of you know probablyall of you know markets have
been reaching highs recentlystock markets and it leads to
(00:27):
the question at what pointshould one exit the market as a
whole or individual positions?
Today we're going to talk toour options expert, steve, about
how you use options to actuallyexit positions.
With that question, steve, howwould one go about using options
(00:55):
to exit?
Steve Davenport (01:00):
Options have two different types.
There's a put option, whichgives you the ability to sell,
and there's a call option, whichgives you the ability to buy.
The way that you do this whenyou want to sell something is
you would sell a call option,which would give the person
(01:21):
who's buying the call option theright, but not the obligation,
to buy at a price for a periodof time at a level in the future
.
For example, if we have Nvidiatrading at 9 something, 25, and
you said I think that it's goingto have trouble going through a
(01:44):
thousand, but if it does, I'dbe willing to sell at that price
.
You look and you say whatoptions are out there for Nvidia
?
Nvidia has a lot of volatility,so you're going to get
compensated very well for this.
You look and say, okay, I'mgoing to sell a thousand level
(02:06):
or an option priced at athousand for Nvidia and I'm
going to do this for threemonths and I'm going to collect
$50, $100.
It's really just the conceptthat you're taking the price and
you're getting paid the premium.
(02:26):
Now it's really about trying toinstill some discipline.
When you think about selling,there's really always trouble,
and that trouble is taxes.
I think that the simplestconcept is that you want to sell
(02:48):
your stock, not all of it.
You're usually trimming it atsome price in the future and
each option controls 100 shares.
In this example, with the priceof Nvidia being so high and
people may not have 100 sharesand that may make it hard for
them to do this strategy, theidea is put an option out there,
(03:13):
get paid and if you hit thatprice you're satisfied.
If you don't hit that price,then you don't sell it and you
just collect the premium.
In any example let's say thatNvidia was 910, and you put out
an option at a thousand and it'sgot a July expiration then if
(03:39):
it goes up $90 more dollars or10%, then you'd say, hey, I've
paid.
If capital gains are 15% or 20%, I've saved 10% of it by the
increase in the price plus thepremium.
That's pretty good.
(04:00):
You're not worried as muchabout the impact on the taxes
you have to pay, because theappreciation makes up some of
that difference.
Clem Miller (04:12):
So, Steve, what's the downside really to doing
that?
It sounds like there's a lot ofupside, especially on the tax
front, but what's the downside?
Steve Davenport (04:22):
The downside is that the stock just moves down
quickly and then you would havewished it sold at 910.
People have this perceptionwhen they see a price and they
don't execute at all.
They don't sell a call, theydon't sell any shares and they
just sit and watch.
(04:43):
And after a while people startto realize, hey, could I have
handled this differently?
Do we have choices as investors?
Are we always learning?
And I think that's the key Areyou getting better at making
decisions and does your processhave some disciplines in place?
(05:05):
And so when a position gets lookat NVIDIA up year re you're
date up almost 90%.
It's had an unbelievable run.
It's a great company, we allagree with that.
But there is a point at whichyou sell.
I want to say nobody goes brokeselling winners, right, they're
(05:27):
taking profits and redeployingthem will not solve all your
timing questions, but it's astart and that's how we look at
the reason to use options.
There are multiple reasons.
One is a return enhancer, oneis a risk reducer.
(05:49):
But the other issue is if thestock goes down from here, will
you have regret?
And that's what we're trying tominimize regret, maximize return
and reduce risk.
I hope that we're all big boysand girls and we all realize
(06:10):
that we can make mistakes withthe use of options.
What you're trying to do ismitigate some of those mistakes.
Clem Miller (06:20):
So you already mentioned that it helps with
both risk and return.
It reduces risk and alsoenhances return.
But, steve, how do you actuallychoose the option that you want
to use?
Is it volatility or is it someother factor?
Steve Davenport (06:42):
Well, I like to look at target prices.
I also like to look at whetherthe person feels that a certain
price is what they'd besatisfied with.
If they bought it at $400 andit gets to $1,000 150%, return
(07:05):
feels very good.
So we look at volatility as anindicator because when you see
the volatility, you know thatthe price of the option is the
highest when the volatility isthe highest.
So if I'm comparing two optionsand one has a volatility of 48%
(07:28):
and the other has a volatilityof 55%.
I look at the historic wall forNvidia and it's 45.
I know that that 48 is betterthan the 45 average, but that 55
really stands out.
I look for volatility and whatusually happens is around
(07:50):
earnings announcements,volatility goes up.
Yes, around earnings, the pricecould go up and you could.
One of the risks that I didn'tmention previously is it could
go above that price.
If you're at a thousand and itgoes to $1100, on the next
(08:11):
earnings call you're going tosay I sold out at a thousand, I
got paid 50 or 60 dollars inpremium, but now the stock's
1100, which leads me to myoriginal comment that we've
tried to write on some amount ofnot the whole amount of shares
you own so that you stillparticipate with some of your
(08:35):
shares, but some of your shareshave been sold at a price.
That's when we talk aboutopportunity cost.
There's an opportunity that youmissed.
There are opportunities outthere for names.
For example, like we talkedabout in other podcasts, like
Tesla, there's a hugeopportunity cost that when you
(08:55):
could have bought that two orthree years ago and you would
have a great return.
But there are a lot of thingsyou do and don't buy certain
names If you can't explain orunderstand how the price is
going to be delivered to you interms of growth in sales, growth
in profitability.
With this example, I would likepeople to think there are
(09:21):
always opportunity costs and aslong as you're aware of them,
you feel much better in terms ofyour results.
Clem Miller (09:29):
Steve.
Tesla is a great example of alot of volatility, but I want to
make sure you and I understandwhat volatility is.
I think our audienceintuitively understands
volatility, but maybe doesn'tunderstand from an investment
perspective what that exactly is.
I'm wondering if you can sharewith the audience what we, as
(09:53):
investment professionals,consider volatility.
Steve Davenport (09:58):
Sure, volatility is typically the
standard deviation of the price,meaning the first derivative of
price is return.
The second derivative of theprice equation is volatility.
It tells you how the stock isgoing to behave over a longer
(10:20):
period.
So when you look at, there'sreally many definitions.
One definition of volatility isI don't want to lose money.
I lose money, I have a negativereturn.
That's negative volatility andI don't want that.
Clem Miller (10:34):
Right.
Steve Davenport (10:35):
Very hard to eliminate that there's
volatility in terms of how am Irelative to my benchmark, am I
above my benchmark, below mybenchmark and relative
performance.
And I think there's absoluteand then there's relative.
And then I think thatvolatility has a lot to do with
(10:58):
your own personal circumstances.
So if you are depending on thatmoney for a down payment on a
house, if you're putting thatmoney at risk for your
children's college fund, thevolatility that you're willing
to absorb or experience goesdown as you get closer to that
kid going to college.
So therefore, you don't want tomake a mistake and you will try
(11:24):
to obtain less volatility,meaning less variation in the
price of the object or the stock.
So I think that we all havedifferent definitions of
volatility, but I would say themost consistent one is the
second derivative of price, orthe standard deviation of a
(11:47):
given return.
Clem Miller (11:50):
Yeah.
So, Steve, just to stay on thatpoint about volatility for a
second, since someone, ouraudience may not understand
derivatives, first and secondderivatives.
I have in my mind and maybe ouraudience should too the
standard bell curve, the bellcurve being the curve that looks
(12:15):
like the Liberty Bell inPhiladelphia, where you have a
bulge in the middle that goes up, which is the average, and then
you have the curve curving downto the left and you have the
curve curving down to the right.
Well, it's nice to have returnsoff on the curve to the right,
(12:37):
because it means higher returns,but what you're trying to
protect against is a lot ofnegative returns on the left
side of the bell curve, becausethen you're well below what the
average returns could be.
So that's what we're talkingabout here, just visually, if
(12:57):
you can visualize that bellcurve.
We don't want to be on the leftside where you have all those
negative returns.
Steve Davenport (13:06):
Right, I think about things in terms of Excel.
So when I say I have a columnof returns going back three
years weekly returns or dailyreturns and I click and say
equals standard dev of all ofthe items in the column, and
(13:29):
then that gives you a number andthen you say is this number
weekly, monthly or annualized?
And then you apply a number toannualize it.
So it's a mathematical concept.
But what I was trying to getinto is the personal concept of
what volatility is to theindividual.
(13:51):
I agree the bell curve.
The reason I don't like to talkabout the bell curve is that I
believe we know that returns areskewed towards the positive
side.
So while a bell curve is asimple concept and a good idea,
it's somewhat misleading andtherefore I don't think any
(14:14):
measure of return or ofvolatility is perfect.
Right, I like to give peoplemore answers that are really
relative to their own lifestyleand their own situations,
because then they can understandIit better.
All right, I'm selling nvidiaentity that has a lot of
(14:37):
volatility, good and bad andthen I'm putting it into
treasuries and those treasurieshave guaranteed me that they
will return what I or short termor cash If I'm not exposed to
anything but inflation and Ithink I understand what
inflation is then I can livewith that for the next two or
(14:59):
three months.
When I was young, we just boughta house, I was selling stocks
and putting it in cash and itmade you feel very good when, on
the day of your closing, themarket's down two or three
percent and all of your money issitting there in cash and
you're able to make thetransaction happen where the way
want to.
(15:19):
Yeah.
Clem Miller (15:22):
So, Steve, when I'm sure people are looking at
NVIDIA or other stocks and arethinking, well, when is it a
good time to sell?
After all price targets?
As prices go up, people tend toadjust their price targets
because they think, well, inVidya's reach this point, it's
(15:44):
going to go up even more.
So how do you address that?
Steve Davenport (15:49):
I think that one of the the biggest issues
with people is that once theysee a price, they can't accept
the price that's lower.
So we have a perception issueand it's a behavioral issue
where people are just alwayswanting something more.
You say I'm happy if this goesto a thousand, I'll sell it a
(16:11):
thousand, but if you're at athousand fifty, suddenly the
thousand doesn't feel that good.
So it's really working withagainst your biases, which is
your perception changes.
You say, oh, look at this newproduct, look at this new
application for AI and look athow it's going to lead to more
(16:31):
change.
There is always going to bepositive and negative events and
we tend to have a confidencebias that we think we understand
and we think the past is thepredictor of the future.
I think all of these things.
It's very hard for trees togrow to the sky.
(16:52):
It's very hard for things tokeep going up when there is
reasonable people who look andsay I've taken my profit, now
I'm going on to other ideas.
There's a retail weakness,which is when you see retail
(17:12):
traders dominating a particularname at a time and you see
institutional traders or buyersstarting to step back and you
say, hey, 80% of the buying isretail.
Now that's usually an indicatorthat the stock may have peaked.
The example of JP Morgan whenthe shoe shine boy tells him
(17:34):
what stock he should buy, herealizes it's probably time to
get out of this market.
I think that people just haveto be practical and say I can't
always buy things because I havea fear of FOMO, fear of missing
out.
I should be buying things thatI understand and I want to hold
for a long time and then, if itperforms the way I expected and
(17:58):
it gives me the result I wanted,which is I want to grow this
asset so that I can afford topay for my child's college or
car or house, when you get tothe target and you need, it's
wise to just take some chips offthe table and go to another
place where you think thatyou'll be fairly compensated.
(18:20):
So I think it's a very hardtopic and this is one of the
things that I don't think thereis a clear answer here.
Clem Miller (18:31):
But do you always do this in your portfolio or are
you selective about usingoptions?
Steve Davenport (18:38):
No, this is something that you apply as
needed and when you're havingtrouble figuring out what to do
and how to handle a stock, thisis one solution that should be
in your toolbag.
I think that when you think ofall of the things that you can
do I can sell, I can hedge, Ican write calls this should be
(19:04):
one of the things you thinkabout, and whether it makes
sense.
Every situation is differentfor every client and every
investor, so what I would say islet's just make sure that this
is a tool at your disposal sothat you have a chance to
eliminate some of that regret.
I think if it goes up to 1,050and then comes back down to 800,
(19:29):
not having sold that call willfeel very hard for you to think
about it as a choice.
On the multiple choice of whatto do with investing to try to
manage your risk and manage yourreturn, it always helps to take
some profits and allow yourselfsome choices in terms of other
(19:53):
things to invest in.
Clem Miller (19:55):
So, Steve, how do our listeners actually get
started with options?
They may not know where tobegin.
Steve Davenport (20:02):
So first year account has to be set up for
options so you can look at thefirm.
You have your assets, custody,that and there's usually an
option standardized optionagreement that you must sign.
That says you understand howoptions work and the risk
associated with the option.
I think it's a good way forpeople, even if they don't use
(20:26):
options, go through the process,learn about them, set up your
account for them and start slow.
Start slow and grow yourknowledge.
It helps you in the end.
If you ever needed to dosomething, you're set up to do
it.
I'm not recommending these foreveryone.
I don't think they're right forpeople who don't understand it
(20:49):
and read the document and say Idon't get this, then it's not
for you.
I think that for some investors, these should be a tool that
you have and the way you set itup is talk to your existing
advisor or talk to your existingcustodian and set your count up
for option.
Clem Miller (21:11):
So, Steve, I'm forging around in our mailbag
and I'm pulling out one here onoptions.
Do you think now is aparticularly good time to use
options?
Steve Davenport (21:25):
Yes, I think that, in terms of the move we've
had in the markets, I believethat this move has been
prolonged and has reached apoint where it's not fully
discounting all thepossibilities.
So when I see the 52-week highsthat we're hitting and I see
(21:47):
some of the level of disparitybetween the Magnificent Seven
and other names, these are allsignals that there perhaps is a
good time for you to sell calls,the buy-pots, or to hedge.
So I would say, yes, this is agood time to use those and I
(22:07):
would recommend people, even ifthey don't end up using them.
Understanding them is going tomake you a better investor and
ultimately allow you to havemore flexibility with how you
want to manage.
One strategy many people use isto sell calls in the next year.
So if we're in 2024 and I sella January 2025 option, I'm
(22:35):
putting that trade into the nexttax year and by doing it in
January, I'm not going toactually pay the capital gains
on that if it hits until Aprilof 26.
So it really allows you todefer into the future and manage
(22:55):
your last aspect of yourresults, which is taxes.
Clem Miller (23:00):
So Steve in 30 seconds or less.
What are the takeaways that ourlisteners should take from this
episode?
Steve Davenport (23:14):
So options are one tool that an investor should
use to help manage theiroverall portfolio.
Discipline matters, and whenyou use options like this, it
instills a discipline that saysI've identified a price, I feel
comfortable with that price andI'm willing to let my shares go
with that price.
Past does not predict thefuture.
(23:36):
Just because it's run from 600to 900 is not mean that it's
going to run from 900 to 1200.
There is a caveat that youalways say the past does not
predict the future.
And then the last item is younever go broke taking profits.
(23:57):
My father was a tax accountantand he used to say if you keep
taking profits, you're alwaysgoing to be managing your cash
flow, and that's ultimately whatyou want is to have more
resources applied to more areasof the market so that you can do
well with your money.
So I'd say that keep it simpleand understand what you're doing
(24:23):
and learn.
Those are principles that applyto everyone.
Clem Miller (24:29):
So, steve, thank you very much for this amazing
lesson on the use of options inthis kind of market, and we
thank all of our listeners fortuning in and listening to our
podcasts.
So if you like these podcasts,make sure to like them and to
(24:54):
subscribe, and we look forwardto sharing with you on a future
episode of Skeptics Guide toInvesting.
Thanks, everybody.
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