Beating Buffett

Philip Davis’ outstanding and insightful web site had a nice piece this week discussion feedback from a reader and Phil’s response. Here is an excerpt that sums up their exchange…

Regular readers of my own postings here know I rarely buy options (except to close) for all the reasons described above. Don’t be one of PT Barnum’s suckers just to keep Wall Street professionals in new BMW’s. When you read that, “Somebody bought 3000 contracts of some out-of-the-money calls so ‘follow the paper’ and join them,” ask yourself… who sold them those 3000 contracts? I’m willing to bet it was a professional on the other side of that trade.

Is there any other area of life where amateurs think they can compete against professionals on a level playing field and come away winning?

That’s my two cents worth. Only you can decide which side of the trades you want to be on.

Many online and casino poker players believe that their exceptional skill levels can overcome the ‘rake’ – the amount that the house removes from each pot before the winners are paid.

Poker requires extensive knowledge and money management skills to have any chance of success. The question becomes, “If you have that requisite experience and savvy can you translate it into consistent profitability?”

No Limit Texas Hold ‘Em is the most popular online poker game these days due to extensive and glamorous TV exposure. Let’s look at what happens when a full table of eight sits down at a casino’s poker room table. Let’s assume that each future poker star buys in for $100 in chips.

Total stake at the table = $100 x 8 = $800.

While ‘playing time’ for hands varies, you might expect to have at least 12 hands of Hold ‘Em completed during each hour of play.

The house typically rakes 5% of each pot as their ‘cost of hosting the game’ before the winning hand collects the remaining balance of the pot. If a typical ‘no limit’ pot averages even $60 then the rake will be $3.00 per hand (5% of $60). With 12 hands dealt per hour that means that the house will extract $36 per hour from the collective table stakes.

After 8 hours of play the house will have raked off $288 or 36% of the original $800 put up by all the players combined. After 16 hours that rake would be $576 or 72%. After one 22-hour marathon session the house would theoretically be holding $792 [99%] of the original $800 brought to the table.

How can this be? The same players do not typically sit there for 10 – 20 hours. Losing players get wiped out due to ‘bad luck’ or ‘tough beats’ and leave their seats open to new suckers who come in with their $100 buy-ins to replenish the chip count at the table. Winning players don’t notice or mind the rake as they are temporarily ahead of the game and collecting the pots. Losing players don’t worry about the rake because it’s only paid by those who win the hands.

Each of the eight poker players felt they had good analytical skills.  The actual distribution of winning hands is likely to have been pretty random. The luck of the draw tends to even out over time. What’s certain is that, by day’s end, 99% of the original $800 table stake has been drained away by the ‘modest’ 5% rake.

Why play a game where you are almost certain to lose?

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THE STRIKING PRICE

Monetizing the Fear of Others

By STEVEN M. SEARS  -  Barrons

Selling puts in order to buy stocks at good prices is expected to be a key options-market theme this year.

IF YOU LIKE BUYING STOCKS smartly, you’ll love selling puts.

The strategy lets investors buy stocks at below market prices, which will increase investment returns if stocks behave as expected.

In 2010, many traders anticipate that stock prices will advance in response to spreading financial stability, and a resumption of economic growth, which supports the use of options strategies, such as selling puts, that do not limit potential gains.

Many investors and traders feel the risk in 2010 is not missing additional stock rallies, whereas the risk in 2009 was hedging against systemic risks and the collapse of major companies and economies.

Investors who share this bullish view common amongst many options traders can take advantage of remaining investor angst that is responsible for robust put prices.

In essence, selling puts lets investors leverage the residual fear that many big investors feel about another stock decline.

When investors are afraid that stock prices will decline, they buy defensive put options. Put options increase in value when stock prices decline. Conversely, call options increase in value when stock prices advance.

In 2009, selling calls and buying puts — either in tandem or individually — was a key strategy theme in the options market. In 2010, selling puts and buying calls will likely emerge as key themes.

Anyone who sells puts effectively takes advantage of the residual concern amongst many major stock investors that stock prices could decline if the sleeping hobgoblins of the economic recovery, including inflation, reassert themselves. This concern is prompting many investors to continually buy puts on stock indexes and individual shares.

This fear among major investors creates opportunities for nimble investors to sell out-of-the-money puts that expire in one to three months on stocks that they would like to own.

Say an investor would like to own Apple (AAPL). With the stock around $212, investors could sell February $210 puts that recently traded at $10. If the stock declined below the options $210 strike price, they must buy the stock, though the purchase price is offset by the $10 received from selling the put. If the stock price continues to advance, the put seller can pocket the $10 for selling the put.

Melding trading strategies with stock investments always seems easy when described in columns or investment strategy pieces. But when money is poured into the ideas, the situation can get complicated fast if market conditions change. Anyone who uses options to more cost-effectively buy stocks, or to leverage returns, will be well served by regularly monitoring positions.

The 2010 market outlook seems bright and bullish, but one of the key lessons of 2009 is that it pays to be paranoid.

Wal-Mart [NYSE:WMT] July 2, 2009 $47.79

52-week range: $46.25 (Feb. 2, 2009) - $63.85 (Sep. 19, 2008)

Dividend = $0.2725 quarterly = 2.28% current yield

While business is not exactly booming right now Wal-Mart still is expected to post another all-time record fiscal year when things wrap up next January 31^st. Zacks looks for EPS of $3.56 and $3.89 for FY 2009 and 2010 respectively, up from FY 2008’s $3.42.

The dividend was raised 15% in the June quarter to an annual rate of $1.09 giving WMT shareholders a decent and well covered 2.28% current yield. This is the highest yield in WMT’s history. Revenues of over $401 billion in FY 2008 made Wal-Mart the world’s largest retail operation.

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Southern Union [NYSE:SUG] Jun. 16, 2009: $17.85
52-week range: $10.60 (Nov. 21, 2008) - $27.24 (Jul. 1, 2008)
Dividend = $0.15 quarterly = 3.36% current yield

Southern Union* operates an array of regulated and unregulated natural gas assets divided into the transportation and storage, gathering and processing, and distribution segments. The transportation and storage assets, comprising one of the nation’s largest LNG terminals and a pipeline network stretching from Texas up through the Midwest and across to south Florida, generate the lion’s share of cash flows.

* Company profile from Morningstar

2009 may turn out to be the second down year-over-year earnings comparison for Southern Union since 2001. Value Line sees a slight gain while Zacks projects a small dip in EPS versus 2008. Regardless of which view turns out correctly SUG shares are looking like a bargain.

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Symbol: CBRL - Jun. 12, 2009 close: $28.08
52-week range: $10.67 (Nov. 21, 2008) - $35.18 (Apr. 22, 2009)
Dividend = $0.20 quarterly = 2.85% current yield

Cracker Barrel Old Country Store, Inc. is principally engaged in the operation and development of the Cracker Barrel Old Country Store restaurant and retail concept (Cracker Barrel). As of September 24, 2008, the Company operated 579 full-service Cracker Barrel restaurants and gift shops in 41 states. Cracker Barrel stores are intended to appeal to both the traveler and the local customer. The format of Cracker Barrel stores consists of a rustic, old country-store design with a separate retail area offering a variety of decorative and functional items featuring rocking chairs, holiday and seasonal gifts and toys, apparel, cookware and foods, including various old fashioned candies and jellies.

• company profile by MSN MoneyCentral

Fiscal 2009 will likely mark the ninth straight year of improved EPS for CBRL despite the poor economic conditions. (FYs end July 31 of the same year). The dividend has been increased significantly in each of the past six years growing from two cents to eighty cents (annually) since 2003.

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