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Making money in financial markets isn’t easy – but it’s not that hard, either.

I’ve always been intrigued by the idea of beating the system. I’ve tried quite a few times but never actually succeeded. I suppose my first effort was back during the summer between my junior and senior years in college when I traveled across the country and made a stop in Las Vegas. My game of choice was craps. At least at the time, craps had the most favorable odds – or, I should say, the least unfavorable odds -- relative to all the other casino games. (Newer games may have been introduced since, but I’ve not kept up.)

To cut to the chase, I came away realizing that, given the house advantage, gambling in a casino is a loser’s game; and gambling lost all its charm for me. Obviously, people can win at these games; but those are people who walk away before the inevitable long-term outcome is realized (i.e., losing).   In any case, following my Vegas experience, I redirected my effort to beat the system away from casinos and toward financial markets.

My professional life brought me to the world of derivative markets. My focus was largely on the use of derivatives for hedging purposes, but trading and speculative uses were inescapable as the other side of the coin. For a time, I traded options on individual stocks pretty aggressively.  Buying an option gives you the opportunity to make virtually unbounded gains, with risk limited to the starting option price (also called the option premium).  Selling options conveys the reverse attributes: unlimited loss with the maximum gain equal to the original premium. 

In my first option foray, I limited my activity to selling options. While the prospect of taking an unlimited risk in the hopes of earning a finite profit may seem to be a really dumb idea, it becomes more understandable if the premium is rich enough – especially if you also believe that the probability of any substantial change in the market price of the underlying asset is low.  I thought I could identify these “overpriced” options, and I sold them.  I did pretty well – for a while. The pitfall that I fell into was getting greedy. I expanded the scale of my option selling well beyond what I could afford. As Nassim Taleb so ably pointed out in his book, The Black Swan, if you wait long enough, low probability events will happen.  Lesson learned too late for me.

I switched to buying options.  With this strategy, you need to predict the direction of a market move correctly; and, if the option is held to its expiration date, the price change of the underlying asset has to be sufficient to surpass some breakeven price. It makes sense to buy an option if you believe the price would move in some direction beyond that critical breakeven price.  I came away from this experience realizing that winning and losing with a purchased options strategy comes in streaks. If you’re right, you win; if you’re wrong, you lose. You can count on both happening over time.

The same thing can generally be said about trading in individual stocks. Efficient market theory says that everything we know about a stock is built into its price; and stock prices will change as traders and investors react to new information.  People buy and sell reflecting their expectations about that flow of new information. Sometimes you can pick a stock that makes money, and sometimes not.

Keeping anything other than a diversified stock portfolio is too risky for my blood.  Ultimately, in constructing a stock investment, one should appreciate that by investing in a variety of mutual funds or exchange traded funds (ETFs), even the smallest of investors can expect to earn returns comparable to portfolios having the same makeup as major market indices.  The question is whether it makes sense to deviate from those constructions to try to beat those benchmarks or to settle for those benchmark returns.

For what it’s worth, most professional managers can’t consistently beat those benchmarks.  Obviously, you and everyone else are free to try; but in doing so, you should appreciate that as you deviate from those benchmark constructions, you increase your chances of both out-performing and under-performing. To my mind, benchmark returns are sufficiently generous, such that it’s not worth the time and effort to try to beat them, given the downside risk. 

As a point of reference, the S&P500 is the primary institutional stock market benchmark. Over the last ten years, the annual total return rate (i.e., inclusive of dividends) for this index averaged over 13 percent. Two of those years posted losses (a loss of 4.38% in 2018 and 18.11% in 2022). The other eight years posted gains.  The smallest gain occurred in 2015 at 1.38% and the largest was in 2019 at 31.49%, The lesson here is that the stock market can be volatile, and you can’t count on stocks – either individually or as a portfolio class -- necessarily appreciating during any particular short-term investment horizon.  That said, the odds look pretty encouraging for those capable of socking funds away for extended periods.  No guarantees, however.

As attractive as the returns on the S&P500 have been over the last 10 years, we can’t necessarily count on that performance being repeated in the coming 10 years. Regardless, an index replication strategy seems like the closest most of us are ever going to get to beating the system. My preferred vehicle for such a strategy is purchasing a single ETF with ticker symbol SPY. This contract trades like a stock, generates dividends, and delivers the same performance as the S&P500’s total return (or close to it).  But again, this strategy and this instrument are best suited for those funds that can be dedicated to a long-term holding period. If you’ve got the patience, I think this instrument/strategy is the surest way to beat the system (or your peers) that you’re likely to find.

Derivatives Litigation Services assists legal teams with litigation when derivative contracts play a role in disputed transactions. The firm offers advice and counsel on a best efforts basis but bears no responsibility for outcomes dictated by mediation or court judgments.

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