Bad Investment Advice

I’ll take a break from disparaging penny stocks and fraud to discuss some hyped up claims of certain investment services.

The first ‘victim’ (I put that in quotes because everyone listed deserves to be excoriated) is Doug Casey (or Dave Forest, who is listed as the managing editor of the Casey Energy Speculator). This advertisement I received in the mail receives my ‘duh’ award. Is it not amazing that some of his picks have been up 570% (Cameco), 1500% (International Uranium), or 1000% (Strathmore Resources)? It would be, until we realize that the newsletter in question specializes in energy. Even a chimpanzee specializing in energy stocks, picking them randomly, could have easily compiled a similar short list of stocks with great returns, simply because we have been in an energy bull market these past few years.

Some might argue that point, saying that at least they knew to invest in energy. That is not the case–the newsletter has been around for awhile, so that is simply their specialty. But what if they predicted this energy bull market back in the late 1990s? Since they are specialized, they have to believe that their specialty will do well. In other words, no specialized newsletter can succeed if the author does not believe that his area will do well. Therefore, specialty newsletters, whether they be in technology or energy, will attract perma-bulls. Those that become bearish will leave the specialty or the field.

So do I think Dave Forest is an idiot? No. He may be brilliant. I simply do not know. In fact, if one had invested only in energy for the past 20 years, one would have done very well. That being said, a specialist in energy is in no place to say whether energy is a better investment now then real estate or chemicals. His expertise in one area will prevent him from impartially considering which industries will do better or worse than his own specialty. So if you do subscribe to a specialized investment newsletter or service, be wary of any claims about anything but that newsletter’s specialty. Also, make sure to diversify into other industries as well.

Okay, so Doug Casey is not exactly a charlatan. At worst, his newsletter was guilty of exaggerated advertising claims. Let’s move onward and upward to criticize worse investment advice. This time, let’s play with options.

If you do not know what an option is, then let me first tell you: do not use them. That being said, if you wish to learn more, then visit Investopedia’s article on options.

Now before I start with my rant, I will regal you with my analogical abilities. Let us say that you and I have a bet on who will win the Superbowl next year. I bet on the Chicago Bears; you bet on everyone else. Because the odds of some team other than the bears winning are so good, I will get a large payout should the Bears win (say, $100). However, should any other team win, you get a small payout (say, $1). Now, let us suppose that I am really sure the Bears will win. Why not increase my bet by 10 times? Then if they win I’ll make ten times as much, and if they lose I lose only a little? That is how leverage works–it does not change the odds of winning or losing, but increases the possible losses and gains.

In the above analogy, I am like a buyer of an option, whereas you are like the seller (writer). The buyer pays a small amount of money, has a relatively low chance of winning, but will generally make much money if he is right. The seller is almost certain of being paid a small amount of money, but has the risk of losing a whole lot more.

When looking at actual stock options, it is important to realize that the sellers are mostly divided into two types: one type is the arbitrage seller or market maker, which is only interested in making a small, guaranteed profit (basically, their profit amounts to a fee for the service of writing the option the buyer wants). These sellers will always take the opposite side of their bet in the stock market, so they do not have any risk. If this is above you, do not worry–the important thing to realize is that no matter what, they make a small profit. The other types of options sellers are in it to profit from superior knowledge. They are usually quite smart and experienced. In fact, they have to be, since their risk is huge if they miscalculate. For example, Richard Russell has a side business selling options.

The vast majority of options that are bought expire worthless. Keep that in mind as you read on about THE BULL MARKET THAT NEVER ENDS! That is what the advertisement for the Mt. Vernon Options Club screamed at me. Steve McDonald, I have to say, is either an idiot or a charlatan.

I will explain the common idiocy of covered calls a bit later, but first I have to take umbrage with his winning LEAP strategy with Chesapeake Energy (CHK). He recommended buying a $12.50 call option (option to buy) when the stock was below $10. Smart move. The next move was not so smart: he recommended selling the $15 call option. While this turned out okay, what this did was remove any possible gains should the stock continue to appreciate, while the downside risk was still present. What is even more amusing about this example is that for a heck of a lot less risk, an investor could have simply bought the CHK shares at $10 per share, and would now have a 300% profit!

Next up on my list of charlatans is Bernie Schaeffer, of Schaeffer Investment Research. Now, I have subscribed to his Options Advisor newsletter and found it to be okay–I did not lose much money. Of course, I did not pay for it–my brokerage gave me the subscription for free to try to increase my trading. (The long term record of the newsletter, according to Mark Hulbert, is horrid, though–an average annual loss of 4.7% per year for over 20 years, during the greatest bull market in history.) Besides a horrid track record, why do I suddenly call Bernie a charlatan? I do this simply because he leaves me no choice: his most recent actions have proven that he has no respect for his subscribers. He decided to offer a covered-call options newsletter for the low price of only $795 per year! What a great deal! So why do I not like covered calls?

A covered call is simply writing (selling) a call option when you own the underlying shares of stock. With a covered call, you benefit if the stock does nothing or goes up a little, and you lose when it goes down a bunch. Hmm, that sounds an awful lot like selling a put option! Wait, umm, yes–it is! A covered call is mathematically equivalent to selling a put. The only differences between the two are that with a covered call, you receive any dividends that the stock pays, and you pay twice as many commissions to your stock broker. Also, a put has more leverage. To be truly equivalent to writing a put, a covered call writer would have to have a lot of margin.

Would the dividends make the covered call strategy more effective than simply selling puts? Maybe if the stock pays a large dividend, but it turns out that stocks that pay large dividends are either not very volatile, reducing the payment you would receive for selling the call (such as utilities and REITs), or they are smaller or thinly traded, meaning that there is no market for the options. So that is not generally a good reason to use covered calls. The only good reason I can think of is in the case of large institutions that perhaps become short-term bearish on a stock, but cannot exit a large position in that stock without depressing its price. In that case, selling covered calls may make sense.

So why do so many advisors recommend covered calls? They do this simply because it is much easier to qualify (with a stock broker) to sell covered calls than to sell puts. In other words, they give this advice because there are plenty of fools who can take it. Shame on them.

Okay, now it is time for the worst investment advice of the day! I will now debunk the art (do not dare call it a science) of what I call squiggles, or chart analysis. At the very least I will debunk post-hoc model development and back-testing.

What is chart analysis? Simply put, it derives from the idea that everything that is known about a stock is evident in the price action of that stock. Therefore, certain types of price action (certain chart patterns) should predict certain near-term outcomes. At some level, this is quite logical. For example, as William O’Neil emphasizes with his CANSLIM stock trading method, big increases in the price of a stock are often caused by big money (institutional investors) buying that stock. Therefore, seeing a series of days in a short period of time during which the stock is up on very high volume would be a good indicator that a big mutual fund has started buying.

I have problems with technical analysis in general and charting specifically, because too often those who engage in it either do things wrong or they give themselves too much leeway, by saying “it may go up, but if this happens and it goes down, then it may go down some more,” or similar things. However, that is not the purpose of this article. The problems with charting I mention here are egregious and are not problems of the best technical analysts.

In the advertisement for The Options Optimizer, there are plenty of great examples of how much money could have been made using the system. There are pretty graphs of the prices of commodities and stocks with arrows saying “sell” right before a big price decrease or “buy” right before a big price increase. There are statistics of all the millions of dollars that you could have made by following this system on these occasions.

There is only one problem with this. Nobody made any profits using this system. Every single example is a hypothetical example of trades the system would have chosen. What’s wrong with this? In statistical terms, selection. It is incredibly easy to examine past results of any strategy, no matter how bad, and find some examples where the strategy worked. In fact, your strategy could be as simple as selling companies whose names begin with vowels on Mondays and buying them on Fridays while doing the opposite with companies whose names begin with consonants.

Amazingly, this strategy would work about half the time; the results in any given week will be randomly determined. When you later start your investment newsletter a year later, you can give hundreds of examples where your system worked beautifully. Just ‘forget’ to give any examples of when your system failed and you will be on the road to riches.

A second problem with many trading strategies that is also a problem with the Options Optimizer is that it suffers from over-optimization. Here is an example not from investing: let’s say I have an algorithm for predicting college grades from SAT scores. It is only correct about 60% of the time (which is nevertheless good). I want it to be better. So I use my sample of past students and I look at other factors. I throw in high-school grades, ethnicity, and a measure of the difficulty of their high-school curriculum. All these are logical predictors of college grades. However, I am still only correct 70% of the time. I look back through my data and find that when I factor in eye color, waist size, length of name, and number of vowels in the last name my predicative power increases to 95%.

The problem comes when I use this new algorithm on a new sample. I suddenly find that its predicative power has fallen below 50%. Where did I go wrong? Simply put, I optimized the algorithm for a specific group and I included many variables that most likely have no effect on college grades. This is called over-optimization. If you include enough variables, you can develop a system that is right 100% of the time for the sample from which it was developed. For all other samples (of students or periods of time in the stock market) the system will be very bad. Thus, any successful trading system should have as few variables as possible so that it can be effective with wildly different samples.

So what can you do to protect yourself from these problems? The simplest answer would be to stick to a simple, effective, proven investment strategy (such as value investing). If you wish to take large risks and probably lose money, then at least make sure that any ‘trading’ system you use has actually been used profitably by someone.

Disclosure: Net, I have made money buying and selling options. I do not subscribe to any of the services I mention above. I used to subscribe to Ricard Russell’s newsletter, and I enjoyed reading it, but I stopped because it was too expensive. I own CHK. I have a disclosure policy.

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