The Lesson Some Investors Never Learn: Keep It Simple

by: Rocco Pendola

I love Tuesday mornings. I'm not ashamed to admit that a couple hours after the open every Tuesday, I receive an email from Sharebuilder announcing that "One or more confirmations for your Automatic Investment Plan are available online."

That's right. I have a Sharebuilder account. And I say it with pride. Sure, I have accounts with bigger, seemingly more sophisticated brokerages and mutual funds. And I like to trade and execute some options strategies that would just cost too much with a firm dedicated, for all intents and purposes, to helping investors dollar cost average. But, at the end of the day, my Sharebuilder account and a few Dividend Reinvestment Plans (DRIPs) provide the best bang for my long-term buck.

Lately, I've been on two interrelated war cries:

  • Be incredibly selective with low-priced stocks; and
  • Take a slow, steady and measured approach to options, focusing on the basics and shying away from low-probability trades.

That second point provides a lion's share of the focus in my stock option investing newsletter.

Ever since I started doing the newsletter, here's the most popular question I have received:

How much money do I need to be able to invest to get something from a subscription?

I'm not sure how it happens, but many of us are conditioned, by something or some set of somebodies, to think along those lines. While that's certainly a reasonable question, it, in my eyes, puts the cart before the horse.

In any of the work I do, I rarely, if ever, tout that I am going to give you winners and make you rich. I cringe when my email inbox gets flooded with pitches that would sound exactly like this if they were live video:

While that might be a tad extreme, it's not all that far from reality when you consider the promises people in the financial media make on a regular basis. People like to rip Jim Cramer, but he's tame in comparison to everybody from his apparent disciple Cody Willard to the cats promising thousand-percent returns.

When I come to a place like Seeking Alpha or pay for investment-related material, I do it because I want to be empowered to make my own decisions. I do not expect to make me rich for $50 a month or the Wall Street Journal to set me up for life for $200 a year, but I consider both indispensable. As the old radio tagline goes, they give me "news I can use."

As I articulate in the articles I write chiding many low-priced stocks, our psychological make-up often leads up to want to hit the home run we perceive can come from buying 5,000 shares of a $2.00 stock such as Sirius XM (NASDAQ:SIRI) instead of 20 shares of a $500 stock like Apple (NASDAQ:AAPL). When faced with this type of decision, we, even if unknowingly, seek out information to support our dream. And no shortage of it exists on the Internet:

Click to enlarge

And that's really tame for the message boards. Rationalizations abound as to why stocks like SIRI will surge higher. You can feel the emotion in the arguments. It just has to!

But, consider this. On the Nasdaq, 664 stocks currently sit between $1.00 and $5.00 per share. Only 124 of them (18.7%) increased in price over the last year. (It's worse if you include stocks under $1.00). Who knows? Maybe you're one of the lucky ones who rode Sunesis Pharmaceuticals (NASDAQ:SNSS) up 312% or TeamStaff (TSTF) up 306% over the last year. If so, more power to you. Pick my lotto numbers next time we bump into one another in the grocery store.

Of the 29 Nasdaq stocks presently trading for more than $100, 19 (65.5%) have appreciated in the last year. You'll get around 19 or 20 of 29 if you look at the last week's, last month's, last quarter's and year-to-date performance as well.

Just as we tend to think that it's somehow better to buy 5,000 shares of a stock that priced under $5.00 rather than dollar cost average into "pricier" companies, our minds also tell us that it's somehow more bullish to be deeper out-of-the-money when we buy call option contracts. I guess that makes sense on some level. Heading into Sirius XM's earnings report, I am almost certain that some of the more ardent SIRI bulls opted for the February $2.50 calls over the $2.00 contracts.

Have a look at the two charts, courtesy of

Almost naturally, emotion will lead SIRI bulls to hammer me for this comparison when, if they were actually interested in making money and limiting losses, they would use this information to inform future decisions.

Both contracts, of course, are losers on some level as options expiration day approaches and SIRI failed to break out post-earnings. Let's say you had $1,000 to spend on SIRI calls and you were bullish before earnings. Now, again, this is not an indictment for being bullish. Even though I disagree, I can see where you might be coming from.

As fellow Seeking Alpha contributor Little Apple pointed out prior to earnings, call activity spiked, particularly in the February $2.00 and $2.50 contracts. But, there are reasons why there was more volume and open interest in the $2 contracts than in the $2.50s before earnings and now after.

  • The smart long option play in this case, pre- or post-earnings, are the $2.00 calls, not the $2.50s, simply because the $2.00 calls have a much better chance of being ITM on opex day.
  • Pursuant to that, the $2.00 calls had and still have intrinsic value in them. Right now that's all they have. Extrinsic value, or time premium, accounted and still accounts for every penny (and now only one penny) in the $2.50 calls.
  • Smart traders were likely short the $2.50 calls, both to cover long stock positions and as naked speculation. Only inexperienced option traders or people shooting for a low-probability home run were long the $2.50 calls.

So back to the hypothetical $1,000 investment to support those points. For the sake of argument, let's say you bought the top in each call:

  • 35 contracts of the SIRI Feb $2.00 call at $0.28 each = $980 investment.
  • 250 contracts of the SIRI Feb $2.50 call at $0.04 each = $1,000 investment.

You held through earnings. You go to sell today:

  • You receive $0.13 each for the $2.00 calls, bringing in $455, equal to a loss of 53.6%.
  • You receive $0.01 each for the $2.50 calls (assuming you will actually being able to unload all or part of the position), bringing in $250, equal to a 75% loss.

Very simple lesson. The intrinsic value in the $2.00 calls saved you about $205.

Now, let's pretend things worked out well and SIRI surged an incredible 20% on earnings and traded for $2.58 right now. Assuming you have intrinsic value only remaining, the $2.00 and $2.50 calls would be worth $0.58 and $0.08, respectively. That's good for the following outcomes on the going $1,000 example:

  • You bring in proceeds of $2,030 on the $2.00 calls, good for a gain of $1,050 or 107%.
  • You bring in proceeds of $2,000 on the $2.50 calls, good for a gain of $1,000 or 100%.

I know which one I would have gone with. Keep it safe and keep it simple. That's exactly what I try to do in the newsletter and in my Seeking Alpha articles. Use all sorts of examples from the crazy to the conservative to delve into strategy, process and the innards of trades in hopes of achieving growth, income and a solid night's sleep.

Disclosure: I am long AAPL.