Playing the Possibilities

	Bernie Schaeffer Schaeffers Research.com
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 "The sun will eventually blow up. That doesn't make this a good trade."
(Tony Dwyer - Minyans in the Mountains Conference -8/20/05)

Not only is Tony Dwyer a highly articulate and fact-based stock market bull who stands in marked contrast to many of his market persuasion who rely on blind faith and hope to carry the day, but as is evident from the above quote he also has quite a way with words. He made this remark at the closing panel discussion at Minyanville.com's annual conference in response to the gloomy scenarios being put forth by the bears on the panel. The logic of this remark should be serious food for thought for the bearish community, as it is a reminder that the doom and gloom may or may not come to pass, and even if it does (to quote Keynes): "Markets can remain irrational for far longer than you can remain solvent."

But there is yet another quote that comes to mind - this one from Nassim Taleb in his Fooled by Randomness book: "A seller of out-of-the-money options is betting that an event will not happen; a buyer of these options is merely betting that it may happen." This leads me to conclude that while the most rational approach might be to concentrate on the opportunities and ignore the fact that "the sun will eventually blow up," the most irrational approach is to concentrate one's investments in bets that it will not blow up.

Some clarification is in order. I have identified a number of sectors as possessing significant upside opportunity, most notably the utilities, the domestic autos, and the small- and mid-cap sectors. At the same time, I continue to see extreme vulnerability in the "mega-cap" blue chip and large-cap tech names. My method for trading these views is through buying call options on the "opportunity sectors" and buying put options on the "danger sectors." Put another way, I'm betting bullishly on the opportunities in the absence of the sun blowing up while at the same time I'm placing some bets on the blowup itself, but in neither case am I ascribing any certainty to these views. If I'm wrong, I will pay a price, but this price will be limited in advance to the premiums for the options I've purchased, premiums that right now are among the lowest in recorded options history.

Contrast this to the hugely popular strategy these days of selling naked put options or selling calls against stock at very cheap premiums - mostly on the mega-cap blue chips. Those who engage in this approach are betting that a blowup will not happen, because if it does their portfolios will assuredly blow up and all the nickels and dimes they've "successfully" scooped up along the way by selling premium will be revealed to be chump change. The sins of those who are 100-percent invested in blue chips are less egregious, as unlike the option sellers they are not giving away price appreciation potential for very little compensation. But if you are fully invested with no downside hedges you are also going to suffer severely in a market accident, and I'd suggest you be mindful enough of this possibility to hold a cash reserve of at least 20 percent - more if your risk tolerance is modest.

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