Sports Fans Understand How to Invest
Sports offers many lessons on life, which is why so many parents spend time taking their children to sporting events. Most parents realize their child won’t be awarded a scholarship for athletics, play in professional sports or become an Olympian.
Yet, even understanding the limits of success, they value the experience. They believe that many of the lessons that sports can offer are important to success off the playing field. Of course, these lessons include the value of teamwork and how working together can help the team achieve a common goal.
Another lesson children learn in sports is that a member of the team is important. In baseball, the player who reaches first base a large percentage of the time is just as valuable as the team’s home run hitter. The importance of “small ball” extends to other sports.
In golf, there’s a saying that “drive for show and putt for dough.” This means the long drive off the tee, a player’s first shot on a hole will be important. It will also generate attention. But, the ability to make the final shot, the putt covering just a few feet, may ultimately determine who wins.
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From Sports to Trading
We find these same ideas in the world of trading. Some traders are looking for the long ball, or the trade that will deliver large gains. They are equivalent to the home run hitter or the golfer with a long drive. These trades can be valuable but they may require a time horizon of years.
Elliott Management is a hedge fund that takes a long view. This strategy allowed them to walk away with a $2.4 billion return on a $117 million investment. That gain took 15 years and required the fund to battle the government of Argentina.
At one point in the battle, Elliott Capital persuaded a court in Ghana to seize an Argentinian naval vessel. It took two months for Argentina to get its ship back. Now, few of us have the ability or the knowledge to take on a country but Elliott swung for the fences in this trade and was rewarded handsomely.
On the other end of the trading spectrum are firms like Virtu Financial, a firm that may make 5 million trades a day. The company seeks just a small gain on each trade. According to a Bloomberg profile:
“Rather than go for big trades that could blow up and lose a lot of money, Virtu prides itself on making small amounts—as in $10—millions of times a day. Between the Watcher’s sporadic warnings on that Friday in May, the company was making markets in gold exchange-traded funds and futures. Over a series of 23 transactions in Chicago and New York, it earned all of $36.”
This strategy earns money for the firm almost every single day. The firm trades in the stock market with a market cap of about $3 billion. This is an example of how “singles hitters” can become successful on Wall Street.
Virtu reported its performance to the SEC when the company went public several years ago.
Source: SEC web site
The chart above shows the daily profits and losses between 2009 and 2013, covering 1,238 trading days. Notice that the company lost money on just 1 day and made money on 99.92% of the 1,238 trading days. The loss was attributed to an operational error, as the firm’s CEO explained:
“We mispriced an option and traded off value. That’s the risk of a market-making firm, that’s why you got to have a lot of risk control. Obviously we weren’t happy about that, it wasn’t a monumental loss, it was a couple of million bucks. We learned, we corrected, we put safeguards in place and it hasn’t repeated itself.”
Strategies for Small Investors
Trading 5 million times a day is impractical for individual investors. But, Virtu’s philosophy can be implemented, in a way. Individual traders can seek out high probability opportunities for small gains. Options are well suited for this strategy.
Among the strategies that can be successful is the short condor. This is a strategy that uses four separate options contracts. Each option contract expires on the same day but uses a different exercise price.
The risks and potential gains of the strategy are shown below. To traders, this picture might look like a condor.
Source: The Options Industry Association
The term “condor” in the strategy name is believed to come from the profit-loss diagram. A condor is a bird with an exceptionally long wing span for its body size. The horizontal line representing the range of maximum profit in the middle of the diagram for a long condor spread looks like the body a condor and the horizontal lines stretching out above the highest strike and below the lowest strike, look vaguely like the wings of a condor.
To some traders, this diagram looks like an upside down condor.
The short condor strategy limits the amount of risk and reward because it consists of positions that offset each other. If the price falls significantly, the position is protected because of the put options that was bought. On the other hand, if the price of the stock rises significantly, the position is protected by the call option that was bought.
A Specific Trading Strategy
Unfortunately, condor trades may be difficult to find. The best way to find trades, even for individual investors, is to follow Vitru Financial’s example and use software to identify opportunities. Using an options screening software, we identified a trade in Target Corporation (NYSE: TGT).
This trade consists of the following four actions:
- Buy August 18 $54 Put options at about $0.45
- Sell August 18 $55 Put options at about $0.65
- Sell August 18 $60 Call options at about $0.40
- Buy August 18 $61 Call options at about $0.25
Buying the two contracts will cost about $0.70, or $70 since each contract covers 100 shares. Selling the two contracts will result in income of about $1.05 or $105. Opening the position will result in a credit of about $35.
This is a high probability trade. Options prices models indicate the trade has an 80% probability of success.
It is also a trade that requires just a small amount of capital to enter. Most brokers will allow traders to open spread trades like this for the amount of risk on the position. A spread trade is one that involves two or more options contracts and is designed to limit risk.
For this trade, the maximum risk is equal to the difference in the exercise price of the puts or calls less the premium received. The difference in the exercise prices is $1, or $100 in total. The premium received is $35 which makes the maximum risk equal to $65.
The potential return on the trading capital risked is 53%, a relatively high rate of return for a trade that will be open for less than two weeks.
Short condors are an example of a high probability, short term trading strategy. This is the idea of “hitting for singles” or “putting for dough” in the sports world. In the trading world, it is an implementation of the trading style implemented by Virtu Financial.
This style of trading won’t be right for everyone. Many traders will prefer seeking out big trades rather than looking for ways to generate wins of less than $50 per week. But, for traders with small accounts, this style could be the best way to generate wealth given the high percentage gains that are possible.