Choosing An Investment Strategy: So Many Choices

by: Reel Ken

Today's investor has an overwhelming supply of available investments. They can choose individual stocks, bonds, actively managed funds, index funds, strategic funds, sector funds, closed end funds, commodity funds, currency funds, MLPs, Gold funds,volatility funds, short funds, leveraged funds and if that wasn't enough ... funds of funds. Whew!

Adding to all those choices they can also trade options and futures on most of these. It's not a stock market - it's not a market of stocks - it's a supermarket. Walk down an aisle, pick a product, we've got everything you want.

Over 40 years of investing I've dabbled in every one of these. Some for profit potential and some out of curiosity. Some were over-done, some probably abandoned too early. Every investor should try a variety of vehicles and discover what works form them. If you're not happy with your results, try something a little different.

The next step is to fold this discovery into an overall portfolio strategy. What works for me may not work for you and vice-versa. In any event, here's where I've landed and I share it as one example of constructing an Overall Portfolio Strategy.

Stocks: Too big a universe. Pick just a few super winners for buy and hold. For me it's just Apple (NASDAQ:AAPL). I fully understand the product, the marketing niche and it's really easy to track just one stock.

MLPs: The perfect buy and hold product. I own Enterprise Products Partners (NYSE:EPD) and Linn Energy (LINE). The tax implications on sale have me locked in and forced me to ride out the 2008 drop. It's nice to be locked in for a 300%-plus gain. I'm not expecting big things in the future, but slow and steady is a nice component.

Options: The remainder, and 80% of my investing capital is options on ETFs. Some may consider this extreme, so let me explain.

First, why options? Today's market is dominated by hedge funds, prop trading and HFTs. Most retail investors stay away because they think "the games rigged." So do I. Options, at least, let me hedge against "flash crashes," manipulation, economic upheaval and the like.

The only way to make money owning stocks is if they go up. With options I can target a return and go long or short just by changing strike prices. By changing the strikes and delta, I can also alter my portfolio Alpha or Beta.

Option strategies also have a unique characteristic. They "evolve" over time. I pick my strategy and ignore the day to day fluctuations of the market. Emotional reaction is minimized. They are "logic based" not "emotion based." They aren't for everyone. I'm a "numbers guy" so logic, probability and the intricacies of options aren't problematic.

If the market is steady, options are a charm. Literally like taking candy from a baby. If the market is volatile, I let them play out and don't react to the "news of the day." Sure, I second-guess, but I let it play out. It's surprising how many times an initial move against my position reverses before expiry and turns into gains.

Second, why options on ETFs? Why not options on stocks? There are two things every investor must consider. Macro economic factors and individual stock performance. I have found that it is too daunting a task to try and deal with even as few as 10 stocks and all the macro issues surrounding them.

ETFs, dealing with indexes or sectors are simpler. The "Big Picture," if you will. For instance, I'm comfortable with the energy space. But, an individual stock, not only deals with any potential earnings miss, it could suffer a "Gulf Oil Spill." There is simply more risk in a stock than an ETF. Call me a fool, but I look to reduce risk.

For some reason (maybe a psychologist can explain) individual stocks seem to have a "love affair" syndrome that often clouds decision making. ETFs, on the other hand, are completely utilitarian and I have never had a problem discarding them.

Options on the SPDR S+P 500 ETF (NYSEARCA:SPY) are the most productive. It is liquid, less volatile, has reasonable spreads and easy to follow and understand. Market up, market down, I know the impact without having to check the tapes. Furthermore, strike prices are easily adjusted with my assessment of the broad market. This is a nod to simplicity.

Options are somewhat complex to begin with. Furthermore, they do require considerable maintenance. Melding them with simplicity wherever possible is helpful. Otherwise, it's pretty easy to get overwhelmed and make costly mistakes.

Options on iShares Russell 2000 (NYSEARCA:IWM) is the more aggressive play. This is more volatile than SPY and I play it alongside, but slightly differently, than my SPY position. I tend to go more neutral on SPY and more extreme long or short on IWM. IWM's volatility and the extra premium I receive on selling puts, gives the greatest profit potential when the direction of the move is guessed correctly. With SPY in "neutral" it provides "back-up" if IWM goes the wrong way.

Next, as mentioned, options on SPDR Energy Sector XLE. My macro play.

All three of these positions consist of a hedged play, selling near term puts and buying long dated puts. Mostly some variation of a calendar spread. I have written many articles detailing the various methods I use, for those that are interested. I've used options so frequently over so many years, and they are, now, second nature.

I certainly wouldn't recommend such an extreme option position to a "newbie." But I would recommend choosing the area you are willing to devote time and effort and go with simplicity elsewhere.

Some modest, un-hedged, put writing to diversify in Emerging Markets. Lots of choices, but I find the pricing on iShares China (NYSEARCA:FXI) and Brazil (NYSEARCA:EWZ) to be realistic. After years of following these two ETFs, I have a pretty good feel for their movements. Otherwise, I would probably go with iShares Emerging Market (NYSEARCA:EEM).

For anyone considering naked put selling, I would suggest picking an ETF that they can relate to, selling puts in modest amounts and try to develop a feel for how they react and their trading ranges. You might be surprised when you find the "sweet spot" that works best for you.

Gold: I sell straddles on SPDR Gold Trust (NYSEARCA:GLD) with a strike of $170. I can't give you a technical or fundamental reason. I have followed GLD for many years and it seems to "hang" when it gets to $170. The call part of the straddle just gives me a little extra hedge if it goes down. Once GLD breaks $170, and if it holds above, I may change the strikes, or abandon it completely. My "tip-o-the-hat" to speculation.

Each reader may find their own particular stock or ETF that seems to follow the GLD pattern. If you do, try it out with a straddle.

Some will notice that I own no bonds. Simple, I use options to manage my Beta, so I don't need to park money at next to no return to accomplish this. I am nearly 90% invested, all the time, and 80% hedged, all the time. Makes more sense, to me, at least, than a 60%-40% stock/bond mix. I have more "up," less "down."

One advantage of my Portfolio Strategy is that I can ignore all the "can't miss" touts we read about each day. There is just too much to choose from, too much chatter and eliminating non-essentials is the best way to focus on your plan.

It is my hope that the reader will be able to "see through" my particular positions and realize that it represents investment vehicles designed to work as a unit. It is not just a Hodge-Podge. This is what is important. Look at your overall capital and develop a reasoned game plan that you feel comfortable with. Don't just go with a scatter-gun approach.

Some will feel I'm nuts and others may take something good from all this. But, that's part of the quest to giving the reader something they won't see anywhere else.

Disclosure: I am long AAPL, EPD, LINE.

Additional disclosure: I buy and sell puts on SPY, IWM, FXI, EWZ, XLE and GLD