Someone once created the phrase, "Picking up nickels in front of a steam roller" as an metaphor for investing. Some investors will indeed go out of their way to pick up small gains, while ignoring the massive destruction that slowly bears down upon them.
Small Gains, Large Risks, Terrible Result
In practice, there are countless examples of taking small profits with larger risks lurking. Here are a few of them.
The first example is covered call and other options trading. With covered call trading, the investor buys a stock and simultaneously sells an equal allotment of call options against their shares. This transaction caps the investor's potential return, requiring them to sell the stock at the strike price, while leaving them completely exposed to all of the underlying stock's downside risk. The reward for this transaction is the option's theta, or time value premium. As a trader of covered calls in the past, I have noticed a trend. The best rewards in these trades tend to occur when a stock has been moving strongly in one direction, up or down. Thus, a trader would be stuck with shares on a downward spiral or selling too early as the stock rallies. The actual losses, or the opportunity cost from lost gains, is the steam roller of this scenario.
A recent example of a covered call trade with a hefty time value premium is Superior Energy Services, Inc. (NYSE:SPN). Investors, at the time of this writing, could purchase shares for $9.59 and sell the July 21, 2017, $10 strike calls for about $0.55. The option premium, once collected, would amount to cash income of 5.7% of the value of the underlying stock. Since the options expire in about a month, the yield on that trade would be almost 69% annualized. It's a tempting idea. Until you see the 3-year chart.
Those shares, purchased at $9.59, might not be worth $9.00 in another month. This company lost 60 cents per share in the 1st quarter of 2017. Energy prices remain low and supply remains high. Not a good combination. Investors in this stock could easily be steam-rolled.
Merger arbitrage, like covered call trading, has a limited upside but an unlimited downside. For example, a buyout of Genworth Financial (NYSE:GNW) was announced in October 2016 for $5.43 per share in cash. The stock currently trades at $3.63, but in the weeks leading up to the time the deal was announced, the stock surged to $5.25. By the end of October, shares were trading close to $4.00 and investors buying into the deal got steam-rolled.
An investor could purchase the stock in the market and wait for the deal to close, pocketing a nice profit. For some reason, however, the market believes this deal isn't going to happen.
An example of a deal that might not happen is the previously announced acquisition of Rite Aid (NYSE:RAD) by Walgreens (NASDAQ:WBA) in 2015. The FTC has still not approved the merger, leading to lots of speculation on each side of the debate. The planned buyout price for Rite Aid was $9.00 per share. Shares now trade just over $3.00, and investors have also been steam-rolled.
In each of these scenarios, investors were willing to take a large risk for small reward. It's almost a psychological disorder. As humans, we always tend to downplay the risks.
Pessimists Live Longer
Americans, in particular, are optimistic about their own personal futures. About 84% of people living in the United States believe that their lives will be better in 10 years. Most people believe they will live longer than science predicts, but in an interesting twist of fate, pessimissts tend to live longer than optimists. The point being that people that are focused on the risks may have better behaviors that prevent them from doing themselves harm.
Example: If I have an overly optimistic view of my own health and I am 100 pounds overweight, I will continue to eat jelly donuts. I may even eat two or three times as many jelly donuts as my friends. To change my behavior, something terrible might need to happen. Then, my perception of my own risk-taking will change.
We Are Stock Market Gluttons
Investing in overvalued equities, in a broader sense, has the same problem with grand levels of optimism. Investors, already fat with gains, are gorging themselves on figurative "jelly donuts" in the stock market.
Evidence of this is found with the cyclically adjusted price-to-earnings ratio, which is soaring to levels seen during the dotcom bubble. Valuations are too high.
You can also see this risk-taking behavior with the growth in margin debt. People are using debt to buy stock.
But, perhaps the easiest place to see it is in the high-flying assets making up this current bubble. Bitcoin (COIN) is up over 1000%, on a parabolic trajectory. This is a currency that has no formal backing by any government. It's used by criminals and hackers to hide their money. Yet, Wall Street is buying it up like hot fresh jelly donuts.
Tesla (NASDAQ:TSLA) is surging, despite no earnings, on the hopes that consumers will buy electric cars in masse. This includes a future electric pickup. Big leaps. Big risk. High valuations. The company is 1/20th the size of rivals General Motors (NYSE:GM) and Ford (NYSE:F) but trades at a higher valuation. Given the fact that competitors like Toyota (NYSE:TM) are making hybrid sedans with 53 mpg, there's a lot of reason for TSLA investors to worry.
Netflix (NASDAQ:NFLX) is also going parabolic on high expectations of international growth. All the while, the market's valuation of the company has stretched, with higher and higher fundamental valuations.
This is not to say any of the companies mentioned here are terrible. In fact, most of them are just fine. The problem is not with the companies themselves, but rather with the underlying valuations of the companies' stocks, which are priced for perfect strategic execution. That just won't happen.
When an investor's perception of reality is dashed, that's when you see prices plummet. Investors tend to react wildly on both sides of the risk equation. We over- and under-price risk.
Go Short or Raise Cash
If you feel the need to buy stocks like Tesla, Bitcoin, and Netflix, you might want to hedge that position by shorting the market. Of all the major indices, the Nasdaq 100 has the highest valuations and the lowest dividend yield. You may take a position in the ProShares UltraShort QQQ ETF (NYSEARCA:QID-OLD), but increasing cash may be an option that is just as good.
Disclosure: I am/we are short QQQ.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.