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Buying Stocks and Stock Call Options


Buy stocks and stock call options in a way that honors momentum investing, diversification, and tranche investing.


The tranche table at the end applies to stocks, funds, call options on stocks and funds, and put options on stocks and funds.

Value versus momentum

Value investing

In narrow definitions, value investors seek unpopular companies that are undervalued and growth investors seek companies with sustainable growth. This incorrectly implies growth investors do not consider value. Furthermore, these definitions exclude many value investors.

In a comprehensive definition, value investors try to determine what a company is worth based on its present position or could be worth with changes. They might be passive investors seeking undervalued companies, activist investors who plan to increase value by having a voice in management, or private equity investors who plan to increase value with radical restructuring.

Respect successful investors. Charlie Munger said: "You don't have to be brilliant, only a little bit wiser than the other guys, on average, for a long, long time." Do not attempt security analysis unless you are a little wiser than professional value investors.

Also, do not use stock ratings from advisory services. These ratings cannot be trusted (#tests).

Do not use value ratios either. Value ratios include the P/E (price/earnings) ratio and the PEG ratio, which is the P/E ratio divided by the expected percentage earnings growth rate for the next three to five years.

The PEG ratio is better than the P/E ratio because a rapidly growing company deserves a higher price than a slowly growing company with the same earnings. However, stocks with low PEG ratios do not outperform stocks with high PEG ratios (#tests).

Momentum investing

Price trends persist longer than random behavior would suggest (#tests). A value investor, confident a company is undervalued, might go against the trend.

Most investors are not smart enough to be successful value investors. They should practice momentum investing instead by buying into strong uptrends and selling when uptrends reverse.

Some investors average down, which means reducing the average cost of a security by buying more after a decline. This makes sense for value investors, but is unwise for momentum investors because the decline is more likely to continue than to be reversed.

Diversification

Companies are classified in various ways. There are usually two or four tiers. There are about ten groups, called sectors or industries, at the top tier. There are more than 100 groups, called industries, sub-industries, or sub-sectors at the bottom tier.

These schemes have too few groups at the top tier, so most portfolios must have more than one holding in the same group. Using the bottom tier instead eliminates this problem, but some groups in the bottom tier are highly interdependent.

To address these problems, I have defined 75 groups based on the sector/industry scheme used at finance.yahoo.com. The result is a single-tier classification scheme with more groups than provided by the top tier of other schemes and whose groups are less interdependent than the bottom tier. On rare occasions I override the sector/industry scheme if I believe it is inaccurate.

Three of these groups are prohibited. Any company in the Conglomerates group is involved in many industries. The Real Estate group is an asset class that is covered by the real estate (#realty) strategies. The Precious Metals group is an asset class with a history of underperformance (#choices).

It is not always necessary that companies be in different groups. Diversification is adequate if a company is in the same group as another but has a different end market.

Tranche investing

Tranche investing means investing periodically with a fixed tranche size. The proper tranche size is found by trial and error. It should be stepped down if you frequently cannot make an investment due to insufficient cash. It should be stepped up if you are finding it difficult to become fully invested, and it is not because a weak market is creating a plethora of trend reversal #sell signals.

Tranche investing is similar to dollar-cost averaging, which is also called income averaging. Purchase amounts are independent of security type in dollar-cost averaging, but purchase amounts are less for options than for stocks or funds in tranche investing.

The purchase amount for stocks and funds should be about equal to the tranche size. The purchase amount for an option is based on the market value of the underlying security, but an adjustment is required because tracking of the underlying security varies from 0 to 100%.

Call and put options with identical strike prices and expiration dates jointly track the underlying closely, and each tracks at about 50% when near the money. An option is near the money when purchased (#lists), so the purchase amount for options should be doubled.

This table shows the recommended number of shares for an opening transaction. For options, the price ranges are for the underlying security and the number of contracts is twice the number of shares divided by 100. For a larger tranche size add one or more zeroes to the tranche size and split the added zeroes between the price range and the number of shares:

tranches