defensive investing - the dollar vigilante · investments. you’ll want to keep this kind of...

Beginner’s Guide To

DEFENSIVE

INVESTING

A primer to investing

within the context

of business cycles and sectors

By Ed Bugos with Jeff Berwick

[TheDollarVigilante.com]

A TDV Investment Primer

2

´THE GUIDE YOU NEED IF YOU’RE JUST BEGINNING

If you are already an experienced stock, option or FX trader or

investor, then this guide isn’t for you.

Due to a large increase of new subscribers we have been seeing

and receiving a lot of “beginner” type questions about basic

investing.

As part of our role in providing you a good service we have

written this “beginner’s guide” for all those who are new to

investing in stocks or options.

In this guide we will go over:

Why you should consider investing in stocks and

options (and why you should be aware of the risks also)

Using an online/discount broker or a personal broker –

which is best for you

The basics of buying/selling/trading stocks in a

business cycle – defensive – environment.

The basics of option trading and the real risks involved

TDV’s thesis on why it is a good time to be buying gold

and silver mining stocks as well as special situations

ABOUT JEFF BERWICK

Jeff Berwick’s entrepreneurial career began in his early 20s

when he founded Stockhouse.com, Canada’s largest financial

website in 1994. He served as CEO and on the board of

directors up until 2006. Today, he is Chief Editor of a

successful financial publishing company, The Dollar Vigilante,

which includes both a well-regarded newsletter and financial

services with an emphasis on privacy and asset-protection.

Beginner’s Guide to Defensive Investing

3

ABOUT ED BUGOS

Ed Bugos’s investment career began in the late 1980s after the

stock market crash of 1987. He worked for several well-known

brokerage firms through the 90s where he was mentored by one

of the best exploration and mining analysts on the west coast.

In 2000, he retired, warning investors about the dangers of the

tech bubble brought about by the easy money policies of the

Fed, and expansion of unsound credit by the commercial

banking system – forecasting a new bull market in gold and

collapse of the “strong” US dollar. His prediction for gold was

that it would hit $2,000 by 2013. He successfully predicted

several developments in the 2000-11 period, including both

bear markets in US stock prices from 2000-02 and 2007-08.

Ed co-founded The Dollar Vigilante newsletter with Jeff

Berwick in 2009-10, and has been helping investors protect

their wealth from the confiscatory policies of the central bank

and the commercial banking system. In addition to his track

record in providing investment advice, he is an economist and

student of the Austrian School of economics.

Ed is a financial analyst and investment strategist, and The

Dollar Vigilante’s senior precious metals analyst.


4


by Ed Bugos

T.D.V.

Additional contributions by

Editor-in-Chief and CEO

Jeff Berwick

A SPECIAL LIMITED EDITION, 2016

www.TheDollarVigilante.com


5

The Dollar Vigilante needs no disclaimer. Everything we say here is what we believe.

Furthermore we need no disclaimer because we believe that all nation states, governments,

securities agencies or other legislative bodies are illegitimate and we do not recognize them nor

believe we need their permission to say what we feel about any topic and frankly think it is

hilarious that people think a government body should be there to protect them.

However, because we know that all manner of government agencies will come after us just for

showing such disdain for them we are going to include a standard, cookie-cutter disclaimer below

just to keep them off our backs. Enjoy reading it, you bureaucrats.

Information contained in publications of The Dollar Vigilante (www.dollarvigilante.com) is

obtained from sources believed to be reliable, but its accuracy cannot be guaranteed. The

information contained in such publications including this book is not intended to constitute

individual investment advice and is not designed to meet your personal financial situation. The

opinions expressed in such publications are those of the publisher and are subject to change

without notice. The information in such publications may become outdated and there is no

obligation to update any such information.

Jeff Berwick, Ed Bugos and other analysts or employees of The Dollar Vigilante may from time

to time have positions in the securities or commodities covered in TDV publications and related

presentations. Any Dollar Vigilante publication or web site and its content and images, as well as

all copyright, trademark and other rights therein, are owned by The Dollar Vigilante (TDV). No

portion of any TDV publication or web site may be extracted or reproduced without permission of

The Dollar Vigilante. Unauthorized use, reproduction or rebroadcast of any content of any TDV

publication or web site, including communicating investment recommendations in such

publication or web site to non-subscribers in any manner, is prohibited and shall be considered an

infringement and/or misappropriation of the proprietary rights of TDV.

Some parts of this narrative have appeared in other places in other forms.

Copyright 2016 and beyond © All rights reserved.

T.D.V


6

TABLE OF CONTENTS

Introduction

Section 1: Investment Building Blocks

1. What Are Stocks?

2. Why Invest in (Common) Stocks?

3. What Are Exchange Traded Funds / Trusts?

4. What Are Options?

5. Structure And Syntax

6. Why Use Options?

Section 2: Brokers

7. What Kind of Platform Is Best for You?

Section 3: Investment Strategies

8. Austrian Free-Market Investing

9. Basics of Investing

10. The Task


7

11. Valuation Methods (Common Stock)

12. Technical Analysis

13. What Are Trends?

14. Fundamentals Vs. Technicals

15. Contrarian Investing

16. The ABCs of Shorting

Section 4: Options as Necessary Tools

17. Option Pricing and Valuation

18. Option Strategies

Section 5: Risk and Reward

19. Option Risk

20. Stock Risk

21. Conclusion: Promise of Precious Metals


8

INTRODUCTION

This is a book for investment beginners. As a result of our

Shemitah analysis this past year, we received thousands of new

subscribers and many didn’t know very much about investing.

So we decided to write a primer to help our “newbies.”

We hope you like what you see. It deals with investment

fundamentals in a rational way and also puts building wealth

into a larger “defensive” perspective that supports everything

we do.

The first section of the book involves the building blocks of

investing: stocks, funds and options. We describe them and

ways that they can be used.

The second section of the book focuses on choosing someone

to aid your investment process. You can choose from full

service or discount brokers, among others, and we give you

some insight into what might be right for you.

The third section of the book deals with a variety of investment

strategies and shows how they can be used together to develop

an insightful analysis.

The fourth section of the book gives you insights into using

options as tools to better develop and control your larger

investment strategy.

The fifth section of the book deals with the risks inherent in

using options and stocks and also summarizes more general

business-cycle risks.

This last section leads naturally into a discussion of the mining

sector, which may soon become the hottest investment sector

around. A discussion of the risks and rewards focuses on the


9

lucrative history of mining stocks as well as their historic

difficulties.

The chapter ends with a general conclusion summarizing the

book and its sections.

In reviewing the above, you’ll note that we provide you with an

idiosyncratic perspective on the kind of trading and investing

we do. Thus, you won’t find information on fixed income,

mutual funds or commodity futures.

We’ve tried to stick to the basics that we utilize in order to

simplify what’s necessary and concentrate on what’s important.

Therefore, this is our “beginner’s guide” as well as yours.

Defensive investing

This book, as we stated above, provides the ABCs of investing

within the confines of our “style.” It’s a practical book. We’ve

tried to stay away from a lot of theoretical information about

such concepts as Modern Portfolio Theory and index vs. active

funds. However, one theoretical overview is very important

and that’s what we call “defensive” investing.

There is a general approach you ought to be taking regarding

investments. You’ll want to keep this kind of investing in mind

as you go through this book. It should undergird your larger

activities.

You see, it’s not just enough to understand “investing” if you

don’t also understand the system itself. This crony economy

has been set up to ensure that people have a difficult time

getting wealthy or even staying solvent.

In America and probably throughout Europe, the majority are

living paycheck-to-paycheck or even worse. In the US

certainly many families are deeply in debt. This is not just


10

happenstance but has occurred because of the way modern

economics operates.

Modern finance is built around central banking and began in

1913 with the creation of the Federal Reserve. Today, the

Federal Reserve is the most important central bank in the world

and supports the dollar, which is the world’s reserve currency.

The problem with central banks is that they are empowered by

the government, which basically allows the central bank to

determine the quantity of “money” and price of credit.

But for simplicity’s sake, we’ll boil it down to this: Central

banks have the right and authority to issue as much or little

money as they want. As a result, the amount of money in the

system never corresponds to market demand. Usually, central

banks (or the bank cartels they support) manufacture too much

money and unbacked credit, and this causes tremendous booms

and then horrible busts leading to recessions and depressions.

There is a name for this process. It is called the “business

cycle.”

When the business cycle begins, it is at a time of near

exhaustion when a depression or recession is evident in the

economy.

Gradually the banks expand money, as they hope that by

making credit plentiful, they can raise the economy’s “animal

spirits.”

Depending on certain factors and expectations the money

printing, by driving interest rates artificially low, can help

create a new “boom.” This new boom may be both transitory

and unhealthy but as it occurs, it will be hailed as a true

“recovery.”


11

As the central bank prints more and more money, the recovery

widens and deepens and people begin to get rich in numerous

ways via industrial opportunities, entrepreneurial activity and

even investing. Since the cycle itself is artificial, borne up by a

virtual counterfeiting of money, it must sooner or later become

unbalanced. The surges of money and credit that make people

feel rich are eventually exposed because the investment

required to fund various projects cannot be supported by actual

savings.

Either prices start to rise for the resources necessary to

complete the projects, or the central bank tries to rein in its

money creation in order to avoid such an inflationary outcome

before it happens.

Mostly, at this point, panic sets in: Markets crash, businesses

go bust and the recession or depression rolls across the land. It

is not a good system – in fact it is a terrible system – but it is

the one that modern economies around the world are subject to.

And it is within this context that modern investing takes place.

Very few “mainstream” resources will be clear about the

destructive nature of central banking or the difficulties it

creates for investors. But here at TDV, we make it our mission

to explain clearly how the modern economy works and to

provide our subscribers and readers with a “defensive”

investing approach that should offer profits for people who

follow it.

We recognize market distortions and take advantage of them.

But we never fool ourselves into believing these distortions are

in any way either natural or normal. We deal with the system

as it is, not as we wish it would be. You need to approach it the

same way.

Understand the mechanics of investing but also keep in mind

the larger business cycle. When the economy is on fire with


12

speculation, your investing will tend to be different than the

investing positions you might take during a time when the

economy has just entered the “bust” phase.

Within this context, by the way, it is sometimes better NOT to

be invested at all, or to have very little exposure to traditional

investments. When markets are at their tops – and some

evidence exists we are at that point as of this writing – one

needs to be very careful about making certain commitments.

So take advantage of everything in this book to better

understand your position as regards your portfolio, but in doing

so make sure you take the time to understand the “bigger

picture.”

This is one reason why you will want to continue to subscribe

to our TDV newsletter. We don’t simply make

recommendations, we provide the larger context. And that

context includes timing – not short-term timing, but timing that

extends over months, years and even decades.

Let’s talk about timing.

Our current financial system can be traced all the way back to

the national bank act under treasury secretary Salmon Chase,

created just before Lincoln waged war on the Southern States.

Events that followed inevitably led to the revolution of 1913

when the Federal Reserve System and the Income Tax act were

created, producing the first great artificial boom in the 1920s

that led to the first great depression in US and world history.

Rather than admitting the causes of the bust, the government

abandoned the gold standard with as much force as it could

muster, making the ownership of gold illegal with the

punishment of fines or jail (until the mid ’70s). After World

War II, Lord Keynes and his proponents created a phony gold

standard (Bretton Woods) under which individuals were still


13

not allowed to own or use gold as money but where world

currencies were fixed against the US dollar. The US

government had to make the dollar gold redeemable for

national governments and their central banks.

Following the war, the Federal Reserve bank embarked on a

massive interest rate suppression – the first time it pushed

interest rates to near zero – in order to enable the US

government to pay down its war debts. The Kennedys followed

suit in the 60s and through the early 70s, when a combination

of events including the Viet Nam war created so much price

inflation that the paper – “fiat” – markets lost their upward

momentum.

The Federal Reserve in particular lost leverage and in 1971

Nixon abandoned the phony gold standard. This was the birth

of our current system, based on economist Milton Friedman’s

vision of floating fiat currencies and an expansionary central

bank.

In 1971, thanks largely to the enormous amount of inflation

created by the Fed in the preceding decades under the fixed

exchange rate regime (BW), the US dollar was overvalued, and

that led to a period of soaring price inflation and interest rates.

It took drastic medicine to make a change. That medicine was

administered by a new Fed chairman, Paul Volcker. After

Volcker raised interest rates to nearly 20 percent, the third

elongated bull market since the Fed’s creation took off in the

1980s and really didn’t subside until 2000 with the dotcom

bust.

After that, the Fed began to print money again but the stock

market was so dislocated that the money flowed quickly into

various parts of the economy and created other asset bubbles.

One such bubble was in “subprime” real-estate loans.


14

Eventually, it became clear that most of these loans would not

be paid back and US markets, and then banks, began a slow-

motion collapse that culminated in 2008 when some US

markets lost half their stated value. The Fed hastened to “bail

out” banks not just in the US but also around the world with

short-term loans that in many cases were never paid back.

Other central banks printed money as well and the result was

such that more than half the money in existence today was

created after 2008.

Economies around the world didn’t spiral down into an

immediate global depression. Instead the world was simply

afflicted by an ongoing, endless slump. That’s what is going on

today. Nobody knows what companies and banks are solvent

and which ones are not.

The so-called “recovery” is one in which a lot of central bank-

printed money found its way into stocks and bonds and real-

estate but the REAL economy is still in a slump worldwide. In

other words, after two bull markets, both lasting about 20 years

apiece, we are now in a 15-year bear market cycle that provides

more opportunity for precious metals than purely paper assets.

Sectors are available for investing, but the sectors are a good

deal different than the ones that have held promise in the past.

This is the environment that is probably going to continue for

at least the near future and perhaps a lot longer than that. This

is the second time in the Fed’s 104 year history that it has

pushed the rate of interest to zero for a decade (the last was in

the fifties), and as a result there is lots of money sloshing

around in various investment sectors. But it makes no

difference. People are scared and mistrustful. There is no

confidence. The fundamentals of the central bank economy are

finally being questioned, as well they should be.


15

Sectors

A sector can be a specific area of a market – certain kinds of

stocks or bonds such as “industrials” or “energy.” Gold, silver,

or alternative currencies like bitcoin (or the swiss franc,

historically) are part of a currency asset class, much like equity

is an asset class, real estate is another asset class, and fixed

income is another.

But each of these classes can be further divided into sectors or

segments. In fixed income, you have high yield and junk

bonds, but also, different industries or geographical location.

Savvy investors will create portfolios that take into account not

only the business cycle but also sectors or asset classes that

have done well over time within the context of a given business

cycle.

Today, in some senses, we remain in a bear market for stocks

and bonds that has been ongoing since around 2000. The

mainstream media will not tell you this. They will pretend a

recovery is going on IN DOLLARS. But central banks have

been printing excess money since the early 2000s and this has

distorted the market and created asset bubbles that have grown

and then popped. There is no REAL recovery, no basic,

fundamental energy. No Paul Volcker to raise rates and

bankrupt weak companies and allow strong ones to take over.

Since the early 2000s, markets have been the victims over and

over again of bubbles that grow and implode. We saw this take

place in 2008-2009 and now we’ve seen it take place in 2015-

2016. In fact, this is an exceptionally risky time to invest and

here at TDV, being practitioners of defensive investing, we’re

well aware of the risk. As we present the information in this

book to you, we’ll also try to put it into the context of business

cycles.


16

This way you’ll know not only what kind of instruments you

can use and how to use them, you’ll start to get a sense of when

you can use them and in what proportion. Obviously at the

beginning of a bull market for stocks and bonds, you might

want to buy more of those paper assets. You may not believe in

the way the system works but you’ll take advantage of the

system as it is in order to generate maximum profits for

yourself.

You don’t have to believe in central banks or in the modern

economy in order to exploit certain opportunities.

With this in mind then, please take a look at the following

pages and visualize how you might want to build your portfolio

were you willing to place money in various markets.

You don’t have to do so, of course, but by the end of this book

you should understand how you MIGHT approach markets in

this environment or any other. Granted, you might need a good

deal of practice and additional analysis to build a portfolio that

you were comfortable with. Alternatively, you might decide

you are more comfortable staying out of the market entirely.

However, as famous investor Doug Casey has said, “There’s

always a bull–market somewhere.” If you take advantage of

information in this book and add your own additional reading,

you will soon be in a position where you can figure out what

you want to do and take action to pursue it. You will be well on

your way to financial literacy, which is very important in this

day and age.

To put it bluntly, the mainstream media provides you with

endless amounts of misinformation, and you need to arm

yourself with real truth about the world in which you live to

protect your portfolio, yourself, and your family’s prospects


17

SECTION 1.

INVESTMENT BUILDING BLOCKS:

STOCKS AND OPTIONS


18

1.

WHAT ARE STOCKS?

From a defensive standpoint, it may not be a very good time to

buy most stocks as of this writing because markets are pumped

full of currency central banks have been printing irresponsibly.

Such money-printing inevitably creates asset bubbles and in

late 2015 and now 2016, these asset bubbles are in danger of

collapsing. However, stocks are basic investment items and can

provide us with a variety of potential profits. While many

sectors are probably still overbought and the market has been

gravely distorted, opportunities in precious metals and the

stocks based on precious metals may be available.

I won’t continue this discussion right now because I want to

introduce you to stocks generally. If you want to find out more,

you can skip to the back of the book or simply read-through

and discover the additional information within the structure

we’ve laid out within the sequence of this book. So back to the

general discussion.

There are many classes of interest in a given enterprise:

Equity (stock owners, partners, proprietary ownership)

Creditors

Employees, management, directors, etc.

Government

Customers

And other “stakeholders”

A stock represents a financial claim on a share of a business or

private enterprise. It is your “equity” interest in the

organization, i.e., a claim against the net equity and the assets

of a company, typically after secured bondholders. If you own

“stock” you are a shareholder in the enterprise.


19

Unlike a stakeholder, which government officials decree as

ANYONE that “can affect or be affected by the organization's

actions, objectives and policies,” equity owners benefit from

the profits of the enterprise – whether distributed or

cumulative. Unlike a partnership, proprietorship, or other profit

sharing interest, owning a stock usually implies owning a share

of an incorporated limited liability entity or a legally structured

joint stock company, which may also be subject to varying

tax/regulatory treatment, depending on jurisdictional factors.

Additionally, the shareholders in the entity, or their proxies,

may elect a board of directors, which (supposedly) answers to

them.

Certificates in physical form are rare these days. Mostly they

are in electronic form, which has many conveniences,

especially for traders. There are also different kinds of stock.


20

Common equity, the most standardized, comes with voting

rights but ranks below preferreds and secured creditors when it

comes to distributing profits or assets. Preferred shares often

have more specialized rights (not usually voting rights), or

terms or features, and usually pay dividends. Common shares

may also pay dividends.

Options, warrants, rights (and futures where relevant) are all

derivative, representing the right to own something at some

price and future date.

Futures contracts differ slightly. While they do represent

ownership (not just a right) of the underlying asset, they are

still derivative to it.


21

2.

WHY INVEST IN (COMMON) STOCKS?

The benefits of liquid stock exchanges

Aside from the limited liability and obvious benefits of

“ownership” in the enterprise, the best reasons to own common

stock is their general liquidity (marketability) and standardized

legal form. A stock tends to be a stock the same here as most

places, with minor differences.

The massive development of stock exchanges over the past

century allows you to buy a share in almost any growing

business or industry (or trust or pool that invests for you), and

yet be able to dispose of it in an instant. Thanks to stock

exchanges everyone can be a capitalist!

Investors today can buy shares in something as safe as a utility

that has been around for 100 years, or something that is just

starting up, a 3-D printer, an exploration stock, a biotech, and

so on; even if all they have to invest is a few hundred dollars.

The range of stock available covers the entire gambit of risk,

strategy, direction, asset, enterprise, etc. The range of diversity

mirrors a society’s attitude toward trade.

Ludwig von Mises said that you can tell a capitalist economy

from a socialist one just by whether it has a stock exchange.

The reason is that in a socialist economy, the state owns and

controls the means of production, so there is no need for the

market to price and trade them.

Naturally, the more capitalistic the society, the more diverse,

liquid and functional the exchanges are likely to be. This grows

with specialization and the accumulation of capital over time.

The exchanges allow more and more people to participate in

the development of the economy.


22

Stock exchanges open the door to investment opportunities you

would never otherwise have – i.e., sort of like the economic

function of money is to facilitate exchange, the function of

stock exchanges is to facilitate the development of capital. The

sounder they are, the better they work.

Dividends – a historical benefit

Some people invest in stocks for the dividend income, which

may offer definite tax advantages over interest income in some

countries. Most invest for growth or capital gain. That’s the

gist of it. Common stock can meet all of your needs and then

some; arbitrage opportunities, trading, derivatives, or

wallpaper. However, the dividend model does not suit the our

investment strategy at the time of this writing.

In fact, this model is broken now that the central bank has

practically abolished meaningful interest rates over the past

decade. While the origin of this state of affairs goes back

decades, the US Federal Reserve System’s zero interest rate

policy, followed by many governments worldwide this past

decade, has created frothy and unrealistic values in almost any

security that pays a reliable stream of dividend or interest.

I realize that at the moment I am saying this following a period

where the dividend trusts and high yield funds have been the

most popular if not profitable places to be in the post 2008 bull

run. However, those returns came largely as the result of the

capital gains produced by a policy of artificially suppressing

yields on government treasury bonds, i.e., and not from yields

alone, fed by increasing pay outs for example.

The Fed’s policy introduces more risk to the dividend model

than many investors realize. Even if one intends on investing in

something for the dividend these days, they are going to have

to accept the capital gains or losses model. In other words, it’s

a bit like fishing in rough waters.


23

Capital gains and protection from inflation

Let’s meet “gold bugs.” There are different kinds of gold bugs.

Sound money types. Tangibility types. Anti-

establishmentarians. Anti-capitalists. Anarcho-capitalists.

Although a lot of gold bugs tend to distrust any kind of paper

where the administrators are seen to have the ability to issue as

many pieces as they want (hence many tend to not like

investing in stocks generally) they are rarely consistent when it

comes to investing in mining shares.

Still, unlike a central bank which can decree money into

existence out of nothing, the corporation at least gets/creates an

asset in exchange for its issue of stock, i.e., its stock issues are

backed by real savings.

Even options are issued for some kind of labor capital, and

require capital to exercise, to acquire the actual equity. Only a

fractional reserve bank is capable of issuing a new certificate

(money) for savings already deposited. Such banks can create

new deposits only either by accepting new savings OR by

pyramiding on existing savings.

The point is that investing in shares is a relatively good way to

protect your wealth from a central bank’s inflationary abuses in

the long run.

It requires more work than simply investing in gold or silver

bullion or real estate, but it can also offer more gains and

opportunities also.

We categorize stocks as financial assets, consisting of equity

and debt, and other financial claims. In terms of their value to

investors as inflation hedges they compete with the two main

kinds of hard assets: precious metals and land or real estate.


24

But really, almost any type of asset should hold its value better

than fiat money over the long run.

Not all stocks rise together all the time. Some rise when others

fall, whether within a sector or between them. Sometimes they

are all too expensive together. Sometimes one or both of the

hard assets offer better value than stocks, while other times

stocks may promise more.

Regardless, whatever the case may be, stocks or their

derivatives offer a myriad of strategies to help the individual

investor protect his/her wealth or grow it under almost any

situation developing today.

At TDV, we love precious metals, real estate and certain stocks

over the long run. It’s the centralized monopoly on legal tender

and fractional reserves that undermine growth, which we hate.

Investing in stocks isn’t going to make you rich overnight.

Gambling foolishly may produce the odd rags to riches story

but generally, if you are prudent, you may expect returns of

anywhere from 5-15% per annum for a conservatively

managed non-leveraged equity allocation, or maybe if you are

a good speculator and trader you can earn returns of over 20%

per year, maybe more… maybe up to 50%.

But seldom more, at least not over the long term, or

consistently. You might make more on a single trade but unless

you wager your entire wealth on a highly leveraged situation

then your overall returns are not likely to do much better than

the above numbers. That doesn’t mean you can’t make

entrepreneurial gains as an insider creating your own wealth. A

lot of millionaires are made this way (more failures), and you

want to be invested in stocks where the insiders can create

wealth.


25

3.

WHAT ARE EXCHANGE TRADED FUNDS / TRUSTS?

There has been a proliferation of “exchange traded” products

over the past decade due to regulatory changes made by the

SEC in 2008. They have their roots in the concept of a “closed-

end” fund, which can be traced back to the late 19th century in

the US, or even further. They are the early 19th century

brainchild of a Dutch merchant named Adriaan van Ketwich –

created as a way to access and pool capital from small

investors.

A closed-end fund is an investment fund that invests in

something – in the 20th century this was typically a group (or

kind) of securities.

Later, investment bankers would expand the kinds of assets

these funds would invest in. Historically, however, a closed-

end fund was “closed” to new capital after being listed, which

gave rise to a premium or discount in the shares over its

underlying net asset value (NAV).

A closed-end fund was also typically passively managed, while

another form of managed fund, the mutual fund (i.e., or “open-

end” fund), emerged not long after, which was open to new

capital injections (only occasionally at first) and making

withdrawals on demand at the NAV.

Today, a mutual fund will issue new units or exchange old ones

daily as investors subscribe for, or redeem, them, at net asset

value. They don’t buy and sell them on liquid exchanges like

shares in closed-end funds.

An exchange traded fund is just an investment fund listed on a

public stock exchange except that it is no longer closed to new

capital; but, only select investment bankers and broker dealers

can subscribe for or redeem capital. As a result, the price of the

https://en.wikipedia.org/wiki/Closed-end_fund

https://en.wikipedia.org/wiki/Closed-end_fund

http://www.investopedia.com/articles/mutualfund/05/mfhistory.asp

http://www.investopedia.com/terms/m/mutualfund.asp

https://en.wikipedia.org/wiki/Exchange-traded_fund


26

trust trades more closely to the net asset value, but only the

dealers are allowed to arbitrage the discounts and premiums.

The modern ETF morphed into index, sector and country funds

in the nineties. However, in 2008, the SEC allowed the creation

of actively managed ETFs – using leverage, theme based,

long/short, etc., perhaps as Wall Street’s reaction to the

emergence of more flexible privately managed hedge funds in

the new millennium.

Nevertheless, the deregulation allowed for all sorts of formulas

and asset themes to develop a huge amount of these products.

Investors can now buy or sell currencies, short stocks, buy

commodities and invest in things that were not available to all

equity investors previously.

For example, consider the Proshares Ultrashort QQQ ETF,

which uses leverage to short the NASDAQ 100 and aims at

earning twice the inverse returns. Through this ETF investors

can now short the entire NASDAQ 100 with leverage, just by

buying one share of this ETF.

Previously they would have had to short specific proxies, or all

100 of those in the index, or they would have to open a futures

or option account. Now any old equity account can handle

complex trades.

The downside of ETFs

One problem with ETFs is that as part of their mandate some

are forced to recalibrate or reset the fund at the end of each

period (day).

For example, if the goal is to double the return of an index, or

group of shares, periodically, the fund has to use margin, which

means it will have to pay margin costs (interest), as well as

transaction costs in order to keep the weightings in line with

the targeted index – due to the effects of the margin. If it is a


27

short the fund may have to pay the lender a dividend as well.

This is one reason why the ETF and underlying asset may

deviate over the long run. If the underlying asset is moving in

the right direction (up for long funds or down for short funds)

the returns tend to compound in the investor’s favor, but if it is

moving in the wrong direction, or not at all, these things

compound against him.

This is unique to exchange traded funds, especially leveraged

ones, and not the case with mutual funds, closed-end funds, or

hedge funds.

It explains why this occurs,

The graph on the left is the ratio between the powershares

QQQ trust / ETF (unleveraged) relative to the NASDAQ 100

index, which it emulates. The trend is up because the index has

been going up and the changes (errors) all compounded in the

investor’s favor. On the right side is the ratio of the US oil fund

over the oil price. The oil price moved sideways in the 2011-13

period while this ratio fell, and when the oil price fell this ratio

fell harder. In this example the oil ETF underperformed.

But note it doesn’t always do this – note the upturn in 2013-14.

At any rate, we just want to point out, there can be large

deviations between the ETF price and the underlying asset due

to transaction and margin costs, and that these deviations tend


28

to work against the investor most of the time. In other words,

they are not necessarily suited to the buy & hold strategy. On

the other hand, the dealers have become adept at capturing the

short term moves for themselves, leaving the intermediate

cycle wide open to anyone with some sense of the future

beyond 5 minutes.

ETFs are also typically optionable, allowing for all kinds of

esoteric strategies to profit from. In my view, as mentioned,

ETFs are not investable for the long run and are too difficult to

trade in the short run; but they are excellent intermediate or

medium term trading vehicles.


29

4.

WHAT ARE OPTIONS?

To help with this section click this link and have it open in a

separate browser or tab while reading our synopses:

https://www.cboe.com/learncenter/glossary.aspx

An option is similar to a warrant or right. All of these

instruments represent the “right” to buy a given asset or

financial claim. Unlike warrants and rights, however, options

can also consist of the right to “sell” it. Warrants and rights,

moreover, can only be issued by the issuer of equity or debt

while options are contracts opened and closed by specialists of

the exchanges. Warrants and rights also have special

customized features attached with varying terms while options

are standardized contracts… with standardized maturities,

conditions, etc.

However, they are all derivative securities and represent the

“right” (but not the obligation) to buy (or sell in the case of the

option) the underlying thing… asset, commodity, financial

claim, real estate, etc.

Wikipedia defines it as follows,

.”.. an option is a contract which gives the buyer (the

owner or holder) the right, but not the obligation, to

buy or sell an underlying asset or instrument at a

specified strike price on or before a specified date,

depending on the form of the option.”

The two sides of an option

An option that offers a right to buy an asset or instrument is a

“call” option while an option that offers a right to sell it is

called a “put” option.

https://www.cboe.com/learncenter/glossary.aspx

https://en.wikipedia.org/wiki/Option_%28finance%29


30

Example

Imagine, you have an interest in a piece of real estate that you

would like to buy on Howe and Smithe in Vancouver worth

several millions of dollars but you haven’t got all the cash

together yet. You could in theory personally negotiate a call

option to buy it at some agreed upon price by some agreed

upon date for, say, a couple hundred grand. If the value of the

real estate goes up more than a couple hundred grand by the

time you exercise the right you have made money on the

option, and could just flip it without exercising the right to buy

the real estate.

Note that it only has to go up in value by $200k for you to

double your invested capital. The same leverage and rules

apply to stock and other kinds of options, except that you don’t

need to negotiate each contract and specify new terms each

time you buy or sell one.

Moreover, you could opt to let the option expire, unexercised.

Maybe the value of the real estate went down by $600k. Or

maybe the rest of your money never came through, or came

late. Whatever the case may be, you have no obligation as an

option buyer or owner to exercise it.

You have a right, but no obligation; and the most you stand to

lose is $200k. Essentially, you have leverage and limited risk.

The writer of the option, on the other hand, is on the hook; but

only if you exercise your right to buy his/her property. If you

let it expire they are free and clear.

But if you exercise the option then the property owner is

obligated to sell the real estate at the terms agreed upon in the

option contract.

Or he could buy the option back from you.


31

The same basic principles apply to understanding stock

options.

Contracts, open interest, trading volume

When you are buying stocks you are usually buying and selling

“float” – i.e., the stock already issued and in street form. As

mentioned earlier, the amount of shares outstanding at any

given time is up to the company’s executive team and board of

directors.

As with stocks, you can short option contracts too. Each put or

call is basically a contract, and exchanges make it possible to

short calls or puts as easily as you can buy them. But unlike

shares, option contracts can come into existence merely

because of new demand.

The number of contracts outstanding (“open interest”) is not

determined by the custodians or owners of the asset, as in the

case of warrants or rights, but by traders and the market

system, rather spontaneously. However, the number of

contracts in existence (or open interest) is still akin to the

“issued and outstanding” share capital of a company while

volume indicates the number of contracts (shares in the case of

stock) traded in any period.

When you buy an option you might be creating a new contract

or taking over an existing one; and when you sell one you

might be closing a contract or shorting an existing one.

Transactions in options (as well as in futures) contracts are

considered opening or closing transactions, but for investors

the mechanics are the same as trading existing ones.

The specialists and intermediaries decide whether to open and

close the contract or to buy or sell it from you. Your broker

may write it thus,


32

Buy to Open, 1 XYZ June 21 35.00 strike call option

And to sell it before expiry,

Sell to Close, 1 XYZ June 21, 35.00 strike call option

For shorting or “writing” a call option the syntax would look

like this to enter into a short,

Sell to Open, 1 XYZ June 27 42.00 strike call option

And to cover your short,

Buy to Close, 1 XYZ June 27 42.00 strike call option

The syntax may differ for different brokers. Many don’t bother

writing open or close on the ticket, or in the order at all. The

firms and their specialists decide those details. Note that in the

latter situation above, if you did not cover your short buy

buying the option you may be liable to find and sell XYZ stock

at $42 even if it is higher at the time, or even if you don’t own

it and must scramble to buy the shares to deliver into the

contract… assuming that it is exercised. But there is no

obligation on the part of the buyer unless he chooses to

exercise the option.


33

5.

STRUCTURE & SYNTAX

Options all have an exercise price (or strike price). This is the

fixed price at which the owner of the option can buy or sell the

underlying.

They each also have an exercise date after which they expire.

On standardized options – on US/Canadian exchanges – this is

historically the third Friday of the month. There are basically

two types of options: calls and puts (LEAPS are “long term

equity anticipation securities”).

Standard calls and puts have expiry cycles of 3, 6 or 9 months

whereas LEAPS are 2yr equity options. Calls are contracts that

give the owner the right to buy the underlying asset or

commodity at a fixed price by a specified date. If the owner

exercises his/her right to buy, the seller of the call has the

obligation to sell the underlying at the specified agreed upon

price. Likewise, put contracts give the owner the right to sell

something at a fixed price by a specified date; and the seller is

obligated to buy it at that price if the owner exercises.

Options are used not just on stocks, but also, in currencies,

commodities, futures, bonds, real estate, mortgages… almost

anything tradable, including many market indexes and

averages.

Some options, especially index options, are settled in cash. In

such cases, you don’t actually buy or sell the indexes when

exercising – the clearing houses ensure that all profits and

losses are settled in cash.

Options syntax is usually stated with the following

information:

>> Asset Month Day Strike Option

https://en.wikipedia.org/wiki/Strike_price

https://en.wikipedia.org/wiki/LEAPS_%28finance%29

https://en.wikipedia.org/wiki/LEAPS_%28finance%29


34

For ex., a call option on the QQQ ETF with a $120 strike price

expiring on Dec 18, 2015 could be written as the “QQQ Dec 18

120 call” option.

If the QQQ is trading below its strike price, the option is

intrinsically worthless even though it may have a psychological

value until expiry.

When the strike price of a call is above the spot or market price

of the underlying stock the option is said to be “out of the

money.” When it is below it is “in the money.” So, in the above

case, if we had $110 calls on the QQQ and it was trading at

$115 then they would be worth $5.

A stock is “optionable” if it is over $5 (that’s one reason why

ETF’s like “NUGT” tend to roll back their issue when it falls

below that level).

Each stock, commodity, asset or whatever will tend to have an

array of outstanding options with different strikes and expiry

dates distributed around its recent trading prices. This array is

called an “option chain.”

Here is what one looks like,


35

The above chain lists the calls and puts around a given expiry

date.

There is a different chain like this for every different expiry.

The middle column in the table lists the different strike prices.

On the left of this middle column are different ‘calls’ –

associated with each of the strike prices – and on the right side

are all the different (or most liquid) ‘puts.’

Volume (Vol) represents the amount of contracts traded in a

given session with “open interest” (OpInt) representing the

total number of contracts outstanding on a specific option

contract. Also, Last = Last trade; Bid = nearest bidding price;

Ask = nearest offering price.

Important note: Option contracts on most North American

exchanges consist of 100 share board lots while prices are

quoted on a per share basis. Hence if an option is trading at

$10, this relates to the price of the underlying share, but one

contract will cost $1000 before fees.

We’ll expand on option valuation and option strategies further

below.


36

6.

WHY USE OPTIONS?

1. Leverage

2. Hedging

3. Risk management (limit losses, insurance)

4. Income (earn time premiums)

5. Sentiment indicators

Options offer many advantages. Option markets provide

opportunity for trading and hedging, or steady income.

The moment an investor enters into a futures contract, it is

different; they become obligated either to receive the good or

deliver it against full payment unless they exit or cancel the

contract before it expires. When it expires the good is delivered

against the full amount agreed upon at the time of the contract;

but until then investors can buy these contracts using very little

original capital, but lots of broker margin.

Option buyers don’t have to worry about delivery or margin.

This is not true of option sellers or writers (a writer is anyone

who initiates a new contract). Option sellers will employ

margin and have an obligation the moment an option is

exercisable (or in the money).

However, option buyers get the benefit of leverage without

magin.

Example of leverage

In order to buy 1000 shares of Agnico Eagle Mines here you

are committing about $27,000. The stock is optionable so some

brokers will allow you to use margin of up to $20k in the trade

at reasonable interest.


37

But let’s say that instead of the shares, you decide on a call

option to maximize your returns. At the time of writing, the

March-18 $26 calls (in the money) are trading last at $2.70 and

the March-18 $27 calls (out of the money) were still offered at

$2.20. We can buy them without having to employ any margin

debt, and yet we put up hardly 10% of the gross.

And although the contracts have a fuse in terms of time, we can

roll them over regularly. This costs fees and commissions, and

involves time premiums, but such are the trade offs and costs

of leverage.

At any rate, the stock only has to move $2 or $3 per share in

the option time frame in order for you to get a double, i.e., 10x

the return that you would get without leverage. But this is a

very risky way to trade.

If the stock falls below the strike price and stays there past the

option expiry we stand to lose 100 percent of our invested

capital.


38

Example of risk management

Instead of using options for leverage, you may want to use

them to limit your risks. The nice thing about options is that we

can dial the risk to just about whatever parameters we want.

They are very flexible tools.

Instead of risking 100% of your capital in the above option

trade on Agnico Eagle you may decide that you want to limit

your loss to 10% of your portfolio, plus or minus. The easiest

way to do this is with options.

By investing in the shares, with or without margin, you are still

risking whatever capital is put in. That could be the full

$27,000, or it could be a good portion of that, even if you only

put up, say, $8500 to start with.

But instead of buying 1000 shares in a cash or margin account,

you could buy 10 calls (each contract represents 100 board lot

of shares) for somewhere between $2200 and $2700, plus

transaction costs.

In this way you could limit your exposure to the trade to simply

the amount of the option contract, which works out to less than

10% of the gross amount of stock that you want to own and

control. The rest could be invested in a low risk asset paying

enough interest to cover fees.

This was just one example of risk management techniques.

There are many ways to use options in managing the risks on

various assets.

Example of insurance

The most widely understood example, besides limiting your

loss, is insurance. Let’s say, for example, we are long that 1000

shares of Agnico Eagle Mines in our cash account. It cost us


39

roughly $27,000, and we own the shares outright, or street

form, no matter in this case.

Rather than selling the shares and buying the right call option

to limit or control the downside loss, another way to deal with

it is to buy a “put.”

Recall that a put gives you the “right” (not obligation) to sell

something.

In this case you might consider buying an ‘out-of-the-money’

put option – i.e., like the March 2016 $25 puts, which last

traded at $1.26, or the more liquid $23 puts that last traded at

94 cents. These options give buyers the right (but not

obligation) to sell at $23 or $25, and remain worthless unless

the stock drops below those respective strike prices.

Hence, for a premium of about 3% of your investment you can

limit your loss to between $1.78 and $3.78 per share (i.e., 7-14

percent) for two months… probably this program may cost 15-

20% annually.

At the time of writing the gold stocks were under pressure so

puts are likely to be more expensive than usual, but it is still a

costly method.

Alternatively, you don’t have to protect 100% of your

investment, or you can vary the amount of risk you want to

take to find economies.

However, there are always trade offs.

Example of hedging with options

When a mining company wishes to hedge / insure its future

commodity production against a potential price decline it may

choose to sell some of it forward, if there are buyers, like in the


40

futures markets. Sometimes the buyers can also be private

bankers and other traders or suppliers.

Most producers use futures markets these days quite regularly.

But they may also use options on the commodity futures

contract to hedge.

Let’s say Agnico Eagle wanted to hedge a third of its annual

production against a price drop in gold it was expecting in an

upcoming quarter.

Rather than selling forward and committing to fixed terms

now, it could buy puts instead, as in our insurance example. It

could also sell out of the money calls in order to capture the

time premium that speculators are willing to pay for the right

that comes with that specific call option.

There are as many ways to hedge as there are option strategies,

some of which I will cover and summarize in a later chapter.

Generating income with options

While sitting on my 1,000 shares of Agnico Eagle, based on its

trailing 12 month dividend yield (1..2%), we may expect an

annual dividend of roughly 32 cents per share ($320) as a cash

return. This is considered income by most accounts. But there

is another way for investors to use their shares in order to

generate an income. They can write options.

This strategy is called a “covered write” and is explained in

more detail as one of four basic option strategies that we

selected to illustrate.

The strategy is covered if we own the underlying shares we are

writing (or selling) options against. Otherwise it would be a

“naked” write.


41

Recall that when selling an option we are potentially obligated

if the option is in the money. If we short sell a call we may be

obligated to deliver shares we don’t have, which means buying

them in the market.

That’s why option writing often requires margin eligibility

where buying does not. If you own the shares and the call

(option) owner exercises you may lose those shares at a lower

price. Another way to take the loss on the transaction without

losing your shares would be to buy back the option before

expiry. The loss works out the same. And if we wrote a put

against our share holdings we risk doubling up at a higher

price.

As you can see, this strategy is not risk free. Nothing is, really.

It is risky to write call options into a rising market for the same

reason it is risky to short stocks into a rising market. Likewise,

it is risky to write (or sell) put options into a falling market.

The ideal time to write a call is when the share price does

nothing or falls and the best time to write a put is while the

market is rising or going sideways. You can see right off the

bat one easy reason why option writers have an advantage:

theirs covers two out of three possible scenarios. The idea is to

capture the time value in an option (the value over and above

its intrinsic worth) at a time when that value is higher than

average – during high volatility.

In our example, at the time of writing we can sell a 1yr Jan

2017 $25 put against Agnico Eagle for US$4.15. What this

means is that as long as the stock goes up or does not fall

below $25 in this time frame we can earn a pretty fat income

from bearish speculators. Combined with your dividend yield

you get paid 20% if the stock goes sideways, or more if it goes

up. If it falls to below $25 you end up buying more, which may

just suit your strategy too, if you are still accumulating.


42

Option prices and related statistics can provide useful

information, as in measuring bullish or bearish sentiment. Both

of the above are well known indicators. I like the put/call ratio

on the left in particular as it has served me well over the years.

The ratio takes the trading volume of put options as its

numerator and the volume of call options traded as its

denominator.

When it rises it reflects more activity in put contracts and vice

versa when it falls. Hence, traders can conclude that when it

rises there may exist too much pessimism and when it falls it

may indicate too much optimism. I use this in conjunction with

other factors in our stock market model. It is possible to use

options to calculate the value of assets in a backwards fashion

or as indicators in each asset.

The examples above demonstrate some of the most common

value in options for investors: insurance, leverage, hedging,

risk control, etc.

There are also ways to use options to earn a stream of income,

as you saw, or to indicate (or milk!) those rare contrarian

opportunities.

The stock business is not a zero sum game but the options

business is. In a casino, the house stacks the odds in its favor;

in options the odds favor the option writer. The dumb money

tends to buy options (because of the relative simplicity of it


43

all), the smart money uses the more complex strategies,

including shorting (or writing) them.

What puts the odds against the buyer besides the fact that the

buyer benefits from only one out of three scenarios (markets

actually move sideways something like 70-80% of the time) is

the time premium, which I will explain further below in the

section on valuing options.

But you saw the time premium in action in the examples above

where we are dealing with at-the-money options (in the above

examples).

The stock has to not only rise or fall, but it has to rise or fall in

excess of this premium within the time allotted in order for the

buyer to profit.

This premium is normally priced to favor the house over the

long run, which in this case can mean you, as the option writer.

Most frequently, option buyers lose simply because of this time

premium alone. If you are smart enough, as an option writer

you can generally capture this time premium, as explained

above. There are risky ways to do this (uncovered) and there

are less risky ways to do it (covered writing).


44

SECTION 2.

BROKERS


45

7.

WHAT KIND OF PLATFORM IS BEST FOR YOU?

In this day and age, investing can occur in a variety of ways.

One can use electronic facilities over the Internet or

methodologies that were popular in the 20th century and

continue to be used today.

Many people use some sort of professional help when they

decide to invest. Perhaps they have a financial planner who

takes care of it for them or a broker who provides some

insights and then makes trades on a frequent or infrequent

basis.

The main point to be made here is that while the financial

services business is a “people” business, those involved are

basically working for their firms. And these firms have

priorities that may not be yours.

For this reason, the “advice” you may get from such

individuals no matter how well intentioned is going to

represent priorities that may not be yours.

Of course such advice and counsel may be astute and yield

considerable results but only within the larger context we’ve

already discussed. It is up to you to determine your situation

within the larger business cycle and evaluate insights

accordingly.

A full-service broker may provide you with considerable

guidance – though always within the context of his employer.

A discount broker will offer you more efficient service without

the market discussion. What you’re comfortable with is up to

you.


46

The main decision – discount or full service

The first thing you have to decide is if you want to go with a

full service broker (which means an actual human who you

have a relationship with who can also advise you) or a

discount/electronic broker, in which you take the responsibility

to make your trades yourself without any individual advice.

A good broker will give you recommendations, provide

feedback to your thoughts and suggestions, and give advice

about when to buy and when to sell. He’ll also be of

considerable help when it comes to selling. Buying stock is

easy, but it’s in selling that you make money — and selling a

thinly traded stock can be difficult. The right broker will likely

sell your stock at a better price and terms than you could on

your own.

At TDV we have offered opportunities to Premium subscribers

in the past to get into private placement opportunities. This is

when having a full service broker is not only valuable, but

necessary. With a good full service broker you can leave all the

paperwork (and there is a lot) to them… a good broker will just

send you scans for your signature.

While an online broker may cost less, a quality brokerage firm

can assure you of just what you’re buying, give you a second

opinion on your portfolio decisions, help monitor your

portfolio, answer your questions, address your concerns, and

keep you informed of any issues happening in the industry.

Depending on the broker, you may pay more in commissions,

but – also depending on the broker – you may sleep better and

ultimately see greater returns on your investments

Unless you are very knowledgeable or your investments will be

very small, we suggest you use a full-service broker – bearing

in mind the caveats we presented at the beginning of this

section. The full-service broker is not, strictly speaking, your


47

“friend” or even your advisor. Treat him as someone who is

providing input of greater or lesser value. You need to bring to

bear your entire body of knowledge in this regard. You cannot

or should not make a trade in isolation.

Of course, if you have a large account with lots of positions –

or are dealing with warrants or private placements (which are

actively tracked in our alert services) – we highly recommend a

full-service broker. The more money you have on the table, the

more important it is that you work with a broker who is

thoroughly plugged in and has the latest technology available.

Brokers

Here is a list of some brokers that we know personally, and

have used (in some cases for decades).

Ben Johnson – First Securities Northwest

Website: http://firstsecurities.com

Tel: 1-800-547-4898

Tel: 503-224-1234 (Direct Line)

Email: [email protected]

Email: [email protected] (Personal Email)

I have known Ben Johnson for more than 20 years. When I first

started my internet company in Canada he was the first

reputable, well-known person to join our Board of Directors

and we have been good friends since.

In the mining investment world he is very well known and has

an excellent reputation. Anyone who is anyone in mining

knows Ben Johnson. His firm, First Securities Northwest, has

operated for over 30 years. They can open online accounts for

their clients. The firm has special expertise and experience in

options, ETFs, private placements, and gold and silver stocks.

The firm handles investors from any jurisdiction or nationality

except Canada. Ben, President and Owner of First Securities

http://firstsecurities.com/

mailto:[email protected]


48

Northwest, will personally handle the accounts of TDV

subscribers.

If you are going to be investing in many of our ideas and,

especially in private placements, Ben is your best option… and

he understands our focus here at TDV and is a subscriber so

he’ll likely know what you are interested in before you even

contact him.

David Hoang – The Elco Group

Website: www.TheElcoGroup.com

Phone: 242-367-2558

Email: [email protected]

David Hoang, and the Elco Group, are based out of the

Bahamas.

Elco Securities provides a trading services for individuals,

corporations and institutional clients for trading equities,

bonds, options, commodities and funds worldwide. Catering

sophisticated to first time traders, Elco Securities’ brokers can

guide and assist in all facets of trading. They accept clients of

all nationalities except residents of the Canadian province of

British Columbia.

David is available for trading via email, phone and Skype

calls/messaging and is easy to work with.

Discount/online brokerages

We can’t cover brokerages in every country as there simply are

too many. However, one of the ones we like a lot that caters to

international clients is TDV Direct Investing.

http://www.theelcogroup.com/

mailto:[email protected]


49

TD Direct Investing Website: http://int.tddirectinvesting.com

Location: Luxembourg

Nationalities Accepted: All except American and Canadian

We have used TD (previously called Internaxx) for years and

find the service is excellent (especially the telephone customer

service) and the fees are reasonable.

SaxoBank

Website: http://www.saxobank.com/

Phone: +45 3977 4000

Fax: +45 3977 4200

Founded in 1992 with 1,450 employees in 26 countries,

SaxoBank offers a sophisticated platform with 30,000 financial

instrument. A fully licensed and regulated Danish bank,

SaxoBank has the size and resources to provide a professional

experience for you.

Interactive Brokers

Website: https://www.interactivebrokers.com/en/home.php

US Toll free: 1 (877) 442-2757

US Direct dial: 1 (312) 542-6901

Locations around the world

This is another broker with a sophisticated platform and a

global reach. It’s been around for nearly 40 years and its Trader

Workstation (TWS) is a fully professional platform. The broker

also offers advanced trading tools including its Option Labs

that let you create “simple and complex multi-leg option orders

based on your own price and volatility forecast.”

http://int.tddirectinvesting.com/

http://www.saxobank.com/

https://www.interactivebrokers.com/en/home.php


50

SECTION 3.

INVESTMENT STRATEGIES


51

8.

AUSTRIAN FREE-MARKET INVESTING

Now that you know what stocks and options are, and where to

trade them, let’s discuss some of the basics of actual investing:

the analytical processes, portfolio construction, scenario

building, valuation methods, technical analysis, and other

important concepts. Please keep in mind this is not the topmost

level of investing. As already discussed, you need to use

business cycle analysis and sector analysis to determine where

you are in larger scheme of things. Before we move on,

however, I want to take this opportunity to introduce Austrian

investing, the kind of free-market investing that TDV is

founded on.

This economic theory, known as Austrian, developed the

business cycle analysis we use. It is central bank money

printing that drives the business cycle. Essentially, by

expanding the money supply and suppressing the rate of

interest the central bank cartels set in motion a few things...

1. Cantillon Effect: the redistribution of wealth and

purchasing power from those who hold old money to

whoever gets the new money – savers and fixed wage

earners to borrowers (including government), the banks,

wall street, and other cronies.

2. Debasement: rising price level and cost of living.

3. Hidden Tax: incentivizes and subsidizes large

increases in the public debt and government

expenditures that amounts to borrowing from future

generations.

4. Boom-Bust Cycle: as Austrian economist Murray

Rothbard said, “Boom / bust cycles are caused – not by

the mysterious workings of the capitalist system – but

by governmental interventions in that system”


52

When the central bank buys securities with its printing press it

creates reserves for the banks and inflates the value of those

securities. While the extra money doesn’t add to wealth it is not

neutral either. Since not all prices rise at the same time we get

the cantillon effect above, and because the money liquefies the

banking system it causes the rate of interest to fall, which

incentivizes #3 and #4 above, crowding out both private saving

and investment.

In the Austrian theory of capital and interest, interest rates

reflect time preference, and serve to regulate the balance

between investment and consumption. Moreover, investment is

funded by savings. In the absence of intervention, falling

interest rates tell the entrepreneur that people are saving more.

This normally would mean that they are abstaining from

current consumption, which in turn would free up resources

that are being used in the lines of production closest to the

consumer.

Normally, if the drop in interest rates reflected a fall in time

preference and increased savings, prices of those resources and

capital goods closest to consumption may fall along with the

rate of interest, and the interest rate sensitive projects further

out on the production horizon begin to appear economically

feasible.

That is, investment in exploration, research, development,

infrastructure, or any project that requires a lot of investment

and time to cash flow would be possible and sustainable if the

market is dictating the rate of interest because then

entrepreneurs are merely responding to real preferences and

actual signals, which is the purpose of market prices. But when

the authorities force interest rates down using the printing press

they set in motion an investment boom that is not funded by

savings – i.e., that is not funded by an actual sacrifice in

consumption – but instead by a money supply expansion. In a

nutshell, the central bank has created mania after mania, bubble

https://mises.org/library/pure-time-preference-theory-interest


53

after bubble, and crisis after crisis, along with recessions,

depressions, and wars since its inception, through its

manipulation of money, credit and interest.

For another brief explanation see,

https://mises.org/library/austrian-business-cycle-theory-brief-

explanation

For students interested in the full exposition of the theory, see,

https://mises.org/library/austrian-theory-trade-cycle-and-

other-essays

There is a pdf file to download there.

https://mises.org/library/austrian-business-cycle-theory-brief-explanation

https://mises.org/library/austrian-business-cycle-theory-brief-explanation

https://mises.org/library/austrian-theory-trade-cycle-and-other-essays

https://mises.org/library/austrian-theory-trade-cycle-and-other-essays


54

9.

BASICS OF INVESTING

Once you have figured out the “seasonality” regarding the

economy, you’ll be better able to build or reconfigure a

sensible portfolio. Your broker or planner can help you with

this “defensive” process, by the way. But only within

parameters you’ve already set forth. You need to create the

initial structure or at least demand that it be considered. Let’s

look at how we analyze opportunities once we have decided on

our larger strategies. In “analytics” we define and contrast the

fundamental approach with the technical, statistical,

contrarian, and others.

Analytics consists of,

1. Fundamentals

2. Technical analysis

3. Statistical analysis

4. Contrarianism

5. Scenario building

What is a fundamental?

A fundamental is any cause or driver of change – positive or

negative – because change is what we profit from as investors

or speculators.

If nothing changed there’d be opportunity for neither a profit

nor loss.

The end of change is a new valuation, the product of a “re-

rating.”

Investors and traders are constantly discovering or battling over

a sustainable valuation by trying to take advantage of perceived


55

discrepancies between the current market price and underlying

value.

Please be advised that valuation is not “intrinsic,” and not easy

to judge, or “discover.” Importantly, it is constantly changing.

Investing takes work. Note to Marx!

It takes due diligence to really understand the fundamentals of

an industry, commodity, or company. The operative word is

‘understand’, and this process is ongoing.

The more we learn about a company the more we understand it

and the better we interpret its fundamentals.

But there is no end to this, if only because, as already

mentioned, change is a constant even for the company, inside

and out.

Nevertheless, even a diligent analyst can spend weeks and

months learning about a company only gain a fraction of the

insight held by management or long time shareholders. As an

outsider, you will always be at a disadvantage. However, this

does not eliminate the need to understand the company. You

can still profit from knowing it better than other traders. And

sometimes you still may know it better than insiders (although

you may not want to be an investor if that is the case!).

At any rate, the important object of understanding is how the

specific organization has created wealth and how it will

continue going forward. Ultimately, the goal is to arrive at a

valuation for the company’s shares, and we will introduce you

to a few of the quantitative methods of doing that in this

chapter. But first, let us briefly discuss two contrasting ways of

discovering or identifying good companies, understanding

them in a dynamic (or not isolated) environment, and how the


56

field of security analysis has changed from the pre central

banking era in the US.

Macro versus micro

The general framework through which an analyst investigates a

situation can be either top down or bottom up. Both have their

merit.

I use both myself.

I may use the top down approach if I’m tracking change that

originates in the macro sphere, say, via monetary policy, or

some kind of change in regulations with systemic qualities. The

investigation may include monetary, fiscal, foreign and other

government policies, or interference, as well as social or

demographic trends like the internet, privatization,

consolidation, war, emerging technologies or life changing

innovations.

Ultimately, as I follow a lead, I’m looking for an opportunity in

a stock,, commodity, currency, etc., so it is somewhat of a

homing tool, to help me zero in on an opportunity for a re-

rating or some change that I can benefit from as a speculator. It

might start with a hypothesis about what the central bank is

going to do with interest rates, or how the government might

amend tariffs or other terms of trade; but it will proceed to

discerning the economic implications and the subsequent

ripples through the economic system. It might lead you to

believe that a particular sector stands to benefit the most from a

possible rate cut.

The bottom up analysis is inevitable if you consider yourself a

value investor (as I do). This part of my job includes glossing

over a specific company’s financials (or whatever the key

variables may be for commodities or currencies if that’s what

we’re assessing), and may include some financial modelling,


57

comparative analysis within and between related industries /

sectors, ratio analysis, and so on… some of which will be

touched on further in this chapter. Sometimes we run into

opportunity this way as well as gather information for our

valuation.

But basically “top down” means understanding and

approaching an analysis by breaking down things to their

elements while “bottom up” refers to starting with the

properties and behaviors of the element(s) and moving up the

chain towards the ultimate aggregations, perhaps.

Fundamental (security) analysis

The best known book on this subject was written by Graham

and Dodd in 1934: “Security Analysis.” Download the original

free,

https://torontoinvestclub.files.wordpress.com/2014/07/security-

analysis-benjamin-graham.pdf

Or you can buy the latest edition, updated for all the latest in

wall street’s buzzwords and revisions,

http://www.amazon.com/Security-Analysis-Edition-Foreword-

Editions/dp/0071592539

The aim of security analysis – a “bottom up” discipline – is to

arrive at reliable estimates of value through a rigorous

accounting of all material or fundamental parts of the business

in order to reveal opportunities the market may have

overlooked.

This task is made difficult due to the sheer volume of other

investors and capitalists doing the same thing in looking for

exactly the same opportunities to exploit, i.e., the difference

between the market price and their valuation of the asset.

https://torontoinvestclub.files.wordpress.com/2014/07/security-analysis-benjamin-graham.pdf

https://torontoinvestclub.files.wordpress.com/2014/07/security-analysis-benjamin-graham.pdf

http://www.amazon.com/Security-Analysis-Edition-Foreword-Editions/dp/0071592539

http://www.amazon.com/Security-Analysis-Edition-Foreword-Editions/dp/0071592539


58

In other words, or perhaps, as the famous investment duo of

Ben Graham and David Dodd wrote, a security analyst is,

.”..concerned with the intrinsic value of the security and

more particularly with the discovery of discrepancies

between the intrinsic value and the market price.”

Although, they knew the idea of “intrinsic value” was

problematic,

“We must recognize, however, that intrinsic value is an

elusive concept. In general terms it is understood to be

that of value which is justified by the facts, e.g., the

assets, earnings, dividends, definite prospects, as

distinct, let us say, from market quotations established

by artificial manipulation or distorted by psychological

excesses. But it is a great mistake to imagine [it] is as

definite and determinable as the market price.”

And, as, economist Ludwig von Mises wrote in Human Action

(1949),

“Value is not intrinsic, it is not in things. It is within us;

it is the way in which man reacts to the conditions of his

environment.”

Value is just the meaning we humans attach to “goods.”

Somebody didn’t just stumble over gold and ‘observe’ that it

was supposed to be money. Nor was it God’s decision, as some

analysts believe. This value emerged out of human action, and

it only has this value to humans… not animals, and probably

not aliens. A thorough fundamental analysis includes studying

the industry, knowing the competitors, the history of the good

or service being sold, a financial statement (and ratio) analysis,


59

local politics, management and the people behind the deal

(including shareholders), scalability and scope of the story.

We want to understand or evaluate things like:

1. Assets, and their potential for growth

2. Solvency and capital structure (incl. history)

3. Profit and cost trends

4. Legal impediments or advantages

5. Management and share (ownership) structure

6. Industry demographics

7. Growth or dividend plans

But, in the end, the analysis must aim at an estimate of value,

and a reconciliation with actual market prices.

If you arrive at a valuation that is less than the market price it

may be worth buying; if it is above it may be worth selling.

This kind of arbitrage is loosely called value investing.


60

10.

THE TASK

Graham and Dodd wrote a seminal book on investing called

Security Analysis. They divided the analytical task of value

investing into three components,

1. Descriptive

2. Interpretative

3. Critical

The descriptive involves collecting and organizing all the

available data on a company or investment. When I look at a

new company the first thing I do is create a folder for it under

my “company's” file, and then import certain templates, i.e.,

like a spreadsheet to input their financial statement items, to

financially model, and to help collect data on as many aspects

of its business as possible… in the case of miners their mines

or deposits. This also includes important technical/official

documents, proofs, agreements, prospectuses, presentations,

third party research, press releases (public and private), etc.,

everything.

Once collected and organized, the analyst’s job is to read and

interpret it. One of the first things I do is read through the

news releases going back to inception, and write a paragraph or

two long synopsis on the company’s origin and background,

including key people involved in its creation or founding. This

is for my own records, perhaps as a hybrid of the descriptive

and interpretative task ahead.

This part of the analysis requires an analysis of accounting

statements, some financial modelling, and the manipulation of

financial data – via ratios and formulas – to measure returns,

per share data, margins, and other important concepts related to

valuation or comparison shopping.


61

In my career I’ve read numerous books on this and have

developed my own routines and ratios, and ways of doing this

that is customized to the mining industry in particular. Every

analyst that specializes in an industry will have gone through

the same type of process, ultimately developing their own tools

and methodology. For some examples of the most popular

financial ratios used, this video might work for you,

https://www.youtube.com/watch?v=4m23_Qpjdxg

For a more extensive list of ratios see,

http://www.aaii.com/journal/article/16-financial-ratios-for-

analyzing-a-companys-strengths-and-weaknesses.touch

And for a Wikipedia perspective on “fundamental analysis”

see,

https://en.wikipedia.org/wiki/Fundamental_analysis

After a thorough analysis, the emphasis turns to stress testing -

i.e., or the critical examination of the premises, conclusions,

and terms of the issue. This is where the analyst tries to poke

holes in an investment by reviewing every assumption and all

the legal terms of the issue, and also where he/she assesses a

base case or worst case scenario(s).

If that sounds foreign don’t be shocked. Graham and Dodd

lived in a different era, where a business was judged solely on

the facts of the past… where forward looking analysis was

considered speculative.

But that was then… i.e., when speculative premiums were rare.

https://www.youtube.com/watch?v=4m23_Qpjdxg

http://www.aaii.com/journal/article/16-financial-ratios-for-analyzing-a-companys-strengths-and-weaknesses.touch

http://www.aaii.com/journal/article/16-financial-ratios-for-analyzing-a-companys-strengths-and-weaknesses.touch

https://en.wikipedia.org/wiki/Fundamental_analysis


62

How the Federal Reserve changed the landscape of security

analysis

In their book, Graham and Dodd said that,

“In the Introduction we expressed the view that the

experiences of 1927-1933 should not be taken as a

norm by which to judge the future of bond investment.

The same holds true for analysis as well, and for the

same reason, viz., that the extreme fluctuations and

vicissitudes of that period are not likely to be

duplicated soon again. Successful analysis, like

successful investment, requires a fairly rational

atmosphere to work in and at least some stability of

values to work with.” Graham / Dodd

Not likely to be duplicated soon again? Rational atmosphere?

We’ve covered the topmost layer of investing via business

cycle analysis. But when Graham and Dodd published their

book, Security Analysis, on the eve of Roosevelt’s gold

confiscation, and at the bottom of the worst stock bear market

in history (1933-34), they believed that the 1920's stock bubble

was a one-off event.

They weren't yet aware of a future where financial bubbles

would be the norm. The Fed was still a young beast at the time.

In their book, they remarked that before the world wars and

before the Fed, security analysis was confined to the

assessment of investment grade companies with a solid track

record of paying dividends and stable earnings. There was no

such thing as growth investing, yet. They distinguished

between investment grade and speculation by virtue of the

contrast between past and future. When the “prime emphasis

was laid upon what was expected of the future” instead of


63

“taking root in the past” the analysis was considered to be

speculative.

Back then, security analysts didn’t speculate. The emphasis of

the analysis was always on the past, considered to be factual.

For them the future was outright speculative,

.”..the future was uncertain, therefore speculative; the

past was known, therefore the source of safety.” ibid

That strategy worked fine in the pre Fed era before 1913, but

the Fed changed things up. No longer were security analysts

focused on dividends, balance sheet ratios, or book value alone.

And the base-case consideration was futile in the “new era”

where emphasis was put on the future. In the prewar (pre Fed)

era analysts were interested in iron clad and established

dividend returns, stable and adequate earnings, and a

satisfactory backing of tangible assets. By the late 1920s,

Graham and Dodd write:

.”.the public acquired a completely different attitude

towards the investment merits of common stocks… The

value of a common stock depends entirely upon what it

will earn in the future… an impressive theory was

constructed asserting the preeminence of common

stocks as long term investments. But at the time the

interest in common stocks reached its height, in the

period between 1927 and 1929, the basis of valuation

employed by the stock-buying public” departed more

and more from the factual approach and technique of

security analysis, and concerned itself increasingly with

the elements of potentiality and prophecy.” -Security

Analysis, Graham and Dodd, Ibid

Graham and Dodd saw it to be a “complete revolution in the

philosophy of common stock investment,” which went virtually


64

unnoticed by investors and media pundits. They pinned it on

two trends:

(1) an increasing frequency of accounting trickery and

declining reporting standards (which we now know is

a symptom of bubbles);

(2) the greater success of the forward looking growth

stories during the bubble years… i.e., the greater

success of the growth stock investor class. That class

(theme) of investing was a new phenomenon at the

time, newly emerged because the Fed made the value

investor obsolete… the old way was becoming

obsolete, as the returns on the new way were so big.

The old economy gave way to the new economy, if

you will.

Importantly, however, Graham & Dodd had no idea of the

cause of this instability or change but they understood its

implications,

“In the face of all this instability it was inevitable that

the threefold basis of common stock investment should

prove totally inadequate. Past earnings and dividends

could no longer be considered, in themselves, an index

of future earnings and dividends.”

And,

.”..the ultimate result was that serious analysis suffered

a double discrediting: the first – prior to the crash –

due to the persistence of imaginary values, and the

second – after the crash – due to the disappearance of

real values.” ibid

Nevertheless, many value investors even today practice the old

form of security analysis, trying to look for bargains based on


65

historical data. They find often that the market, because it looks

forward, has priced a business cheaply for a reason, and/or that,

often, if you want to own a business that is growing we have to

step up and pay the premium – which occurs, again, because

the market is forward looking. Indeed, all sorts of investment

styles have grown up around the Fed, and many of them as

successful as value investing in the traditional form. There is

growth stock investing, momentum investing, crisis investing,

ethical investing, etc., more than we can think of, or that

matters here.

In my own experience as a security analyst in this chaotic post

Fed environment, value is always relative to the future, not

past.

It’s true that the future is speculative but investors have to

become better at speculating if they are to survive this financial

environment. When Graham and Dodd wrote Security Analysis

in the early 1930s, the idea of common stocks as a long term

investment was only just coming into its own.

Since then there have been hundreds of books published on the

subject, mostly using the Graham and Dodd framework, but

also incorporating aspects of growth stock investing. One of

the best – but not only – successful investors in this latter camp

included Peter Lynch, who transformed Fidelity into the giant

fund group that it is today thanks to his own specialized mode

of analysis.

Lynch wrote a great book on it here,

http://www.amazon.ca/Beating-Street-Peter-Lynch-1994-05-

25/dp/B017WQC3XQ/ref=sr_1_7?s=books&ie=UTF8&qid=1

448278313&sr=1-7

http://www.investopedia.com/university/greatest/peterlynch.asp

http://www.amazon.ca/Beating-Street-Peter-Lynch-1994-05-25/dp/B017WQC3XQ/ref=sr_1_7?s=books&ie=UTF8&qid=1448278313&sr=1-7




66

Graham and Dodd knew full well that valuation was ultimately

speculative, which is why they preferred to anchor the analysis

in history. The future is too easily unanchored in their minds.

But there are ways to quantify or handicap the future in a sound

analysis without going off the rails or abandoning the tried and

true methods. We can be scientific about the future.

Certainly, we cannot avoid or ignore considering the future in

today’s stock markets. You don’t want to be stuck looking in

the rearview mirror at these speeds!


67

11.

VALUATION METHODS (COMMON STOCK)

1. Discounted cashflow basis (NAV and NPV)

2. Ratios: P/E, Book, Sales

3. Liquidation (break up) value

4. Yields: dividends, earnings

Despite the elusiveness in the concept of valuation, and its

inherent subjectivity, all of the above methods nevertheless

help anchor our perspectives and judgments of value. They

keep us honest. Perhaps the most solid of the above methods is

#3 (break up value) provided that there are ready markets with

transparent pricing or firm bids available for the assets of the

company.

Commodity and precious metals funds are the most obvious

example of this. Real estate funds, perhaps. But even a

business whose parts can be auctioned off, if you are about

what the buyers will pay for them, can be valued this way.

There may of course be different degrees of confidence in

trying to value the parts or assets of the business in the context

of liquidation.

But then we move into the speculative realm.

The other methodologies (above) are somewhat speculative. In

my experience, the absolute value arrived at is not nearly as

important as its relative value. What is the right P/E ratio?

The answer depends on socio-economic conditions: inflation,

interest rates, growth potential, etc. – just to name a few.

It’s much more valuable to compare the P/E ratios between a

group of companies and weigh their pros and cons separately to

arrive at a judgment about which one offers better value.


68

[P/E ratio = share price / earnings per share]

That is to say, I prefer to rank companies with their peers and

compare my ranking to the one that is implied in any of the

financial ratios. In theory, the discounted cashflow model (i.e.,

the calculation of the net present value of estimated future cash

streams) offers the best mode of deriving value and also of

understanding the entire business.

However, its inputs are almost purely speculative. The danger

with these models is that their quantitative foundation can fool

both the analyst and the investor into believing they are

objective. Ultimately, however, the more ways we look at an

investment, the better estimate of its future potential value we

may arrive at. Let’s look at two of the above.

Calculation of NAV (net asset value) is basically the sum of

the net present value of all the company’s expected future

income streams minus upfront capital invested – unless it has

already been invested, in which case it is a sunk cost from the

perspective of calculating NAV. Wikipedia defines the

discounted cash flow (DCF) model as follows,

.”..a method of valuing a project, company, or asset

using the concepts of the time value of money. All future

cash flows are estimated and discounted by using cost

of capital to give their present values (PVs). The sum of

all future cash flows, both incoming and outgoing, is

the net present value (NPV), which is taken as the value

or price of the cash flows in question. Using DCF

analysis to compute the NPV takes as input cash flows

and a discount rate and gives as output a present value;

the opposite process—takes cash flows and a price

(present value) as inputs, and provides as output the

discount rate—this is used in bond markets to obtain

the yield.”

http://www.investopedia.com/terms/s/sunkcost.asp

https://en.wikipedia.org/wiki/Discounted_cash_flow

https://en.wikipedia.org/wiki/Discounted_cash_flow


69

The time value of money, or “discount rate,” can be the interest

rate; but for our purposes as security analysts it is intended to

represent the opportunity cost of the investment, i.e., the yield

on the next best investment one forgoes to make this one.

Let us take you through a simple example of how it is

calculated.

Anvil Mining Company is starting up a new gold mine. Its

consultants estimate it will cost $500 million to build a plant

and start producing. They also estimate the plant has a 10 year

life, and that the operation will generate an annual net cash

flow of around $100 million per year (after all costs and taxes)

in each and every one of those years.

To get to that figure requires a lot of spreadsheet work with

estimates for the costs of all inputs for each year over the next

ten years. As an analyst you would have to verify the

legitimacy of those estimates. You could do this by studying

similar operations in order to compare the economics and by

talking to other experienced independent consultants or mining

analysts. This will not save you from being wrong.

Whatever estimate you come up with it is likely to be wrong in

the final analysis. However, you just have to be less wrong

than other analysts and investors! Going back to the numbers

above, all of the data is present to calculate an NAV except a

proper discount rate… adjusted for risk. I have a formula for

this but it is proprietary. In the end, as mentioned earlier, a

comparative ranking is more valuable than an absolute value.

Hence it may even be counterproductive to use a different

discount rate for each company. It may be easier to use a

common discount rate and then apply other filters separately.

It is typical for analysts to pick 5% today. Using that as the

discount rate for Anvil we would then punch the numbers into

https://en.wikipedia.org/wiki/Discounted_cash_flow#Discount_rate


70

our financial calculator or spreadsheet to arrive at a net asset

value.

The number of periods = 10

Discount rate = .05

Annual cash flow = $100 million

Upfront capex = $500 million

Basically we want to calculate the present (discounted) value

of each $100 million stream separately; add them together; and

then, finally, we want to subtract the initial capital costs that

still lie ahead. Here is the formula if you are mathematically

inclined:

NPV = ∑ {Net Period Cash Flow/(1+R)^T} - Initial

Investment

>> R is the discount rate, and T is the number of periods

Any financial calculator or spreadsheet program will calculate

it for you these days. The net present value of the above cash

flows at 0% (i.e., no discount) works out to exactly $1 billion;

at a 5% discount rate they are worth ~$772 million. And after

subtracting $500 million in capital required to get to start up

the project would have a net present value of $272 million. A

net asset value can be calculated after summing up the net

present values of all of a company’s projects and subtracting

debt.

This kind of analysis is fun but as Graham and Dodd warned

and we reiterated, it is speculative; the inputs are all

speculative.

There is no way to know what any costs will be in 10 years, let

alone gold prices. Nevertheless, it can also be a valuable

exercise to help you hone your judgment. Most analysts will

use whatever assumptions are generally accepted, or not too far


71

from the mean. But don’t be afraid to think independently

about these things, just remember to try to ground your

assumption in fact.

Ratio Analysis: the P/E ratio (price / earnings) is just the stock

price divided by earnings per share. For the market as a whole

this ratio historically has fluctuated from a low of about 8x to

as high as 40x – usually anything over 20x has been associated

with bubble valuations. Peter Lynch had a simple rule that he

applied to growth stocks. He would hypothesize that the right

value for a PE ratio equated to the company’s expected

earnings growth rate, which he would infer from its recent past.

For example, if Superstar Biotech Deal was experiencing

earnings growth of 35% per year for several years AND you

thought that was going to continue then a 35x earnings ratio

would be appropriate.

Here too, however, the comparative analysis is preferable in

my opinion. That is, I would rather compare a company’s PE

ratio to its peer group or competitors... or at least the overall

market.

The comparison having more value, though I have applied

Lynch’s rule of thumb many times. However, the present day’s

focus on forward PE ratios in my view just compounds errors.

The idea of these ratios is to anchor your judgment in

something concrete not to fool yourself into thinking they are

objective just because of their mathematical form.

Following is a brief outline of two other popular ratios: book

value and price to sales. Book value is basically equity per

share. Hardly anyone looks at this ratio anymore. It lost its

significance in Graham and Dodd’s era. It was a poor indicator

even regardless of the Fed. The reason is that it is based in

historical costs.

http://www.investopedia.com/terms/p/price-earningsratio.asp

http://www.investopedia.com/terms/p/price-earningsratio.asp


72

The accounting profession has made strides toward an

increasing emphasis on market and/or replacement values in

book making, and even these updated valuations can diverge

widely from true values of underlying assets. On the other

hand, the price to sales ratio is a relatively new ratio that has

come into its own during the bubble era in stocks (post Fed) as

compensation for the cyclically recurring negative earnings

brought about by a business cycle downturn.

Since it is common for earnings to go negative in the downturn

it is difficult to value a company in those times. Since sales

don’t fluctuate as much this ratio provides a more continuous

time series of changing values over time. As with all the other

valuation techniques this one too is better used in the context of

a comparative analysis.

Everyone has a different opinion about what a price-sales ratio

should be. Much depends on whether it is a cyclical or growth

company, or where it is in its cycle, or where the cycle is... as

well as the price-sales ratio everyone else is trading at in any

given moment in time.

Here is more on that,

http://www.investopedia.com/terms/p/price-to-salesratio.asp

The price to sales ratio for the S&P 500 is currently at about

2x, which according to the graph below is a historic high.

Note that in the post 90s financial environment, especially due

to the Fedclosed-end persistent zero interest rate policy, i.e.,

low interest rate policy, this is a new normal. Through most of

the 20th century, which was already more speculative than

Graham and Dodd ever predicted, this ratio traded well below

1x.

The new normal is now from 1x to 2x.

http://www.investopedia.com/terms/p/price-to-salesratio.asp


73

I believe this “new normal” is unsustainable and marks a new

transition (lower) in the monetary standard of the day, which is

dominated by the US Fed. For me, all of these valuation

techniques are different ways to measure what I’m looking at.

The more the merrier, but they are only a guide.

Ultimately the market is the final arbiter of valuation.


74

12.

TECHNICAL ANALYSIS

“A method of evaluating securities by analyzing

statistics generated by market activity, such as past

prices and volume. Technical analysts do not attempt to

measure a securityclosed-end intrinsic value, but

instead use charts and other tools to identify patterns

that can suggest future activity.” Investopedia Def.

The generally accepted fathers of this form of security analysis

are Robert Edwards and John Magee, who formalized it in their

1948 book, Technical Analysis of Stock Trends. The most

recent edition is available from Amazon at this link. I lost my

copy a long time ago when I lent it to a colleague back in the

day as a stockbroker. I first came across it as a college student.

In those days the internet was not yet available and you could

not yet chart stock prices on a computer. I had to draw each bar

in a large paper grid! Each day I’d carve out the high, low,

open, close, along with the volume bars on my very own chart.

Bar by bar, day by day, for my universe of stocks.And I loved

doing it!

Today I can retrieve dozens of stocks at a time all updated by

computers and available online through dozens of services.

Obviously now we can look at much more than ever.

Perhaps we lose something this way but I think not.

My favorite is www.stockcharts.com.

They also have a great educational resource available here:

http://stockcharts.com/school/doku.php?id=chart_school

http://www.investopedia.com/terms/t/technicalanalysis.asp

http://www.amazon.com/Technical-Analysis-Trends-Robert-Edwards/dp/0814408648

http://www.stockcharts.com/

http://stockcharts.com/school/doku.php?id=chart_school


75

I am only going to cover some of the basics.

If you wish to study this more in depth I highly recommend the

suggested website and reading the book by Edwards and

Magee.

The easiest way to explain the value of this discipline to a

beginner is to imagine the information presented in a chart –

using Sabina Gold as in the graph above here as an example –

in the way you might observe the action on the trading floor. In

the daily bar chart in our example above, each bar covers the

high and low price range for the day, with the opening price

marked by a small horizontal line protruding to the left of the

bar and the closing price marked by a small horizontal line

pointing right.

If the bar is black the stock closed up on the day and if it is red

it was down that day – same for the volume bars on the bottom.

The blue and red lines following the trend are moving

averages.


76

We could make a chart based on weekly bars, monthly, or, on

the other end of the spectrum, hourly, minutes, and even

seconds perhaps. To grasp the value of this data, try to imagine

a trading floor. In the movie 80s movie, “Trading Places,” for

example, we saw that traders made decisions often without

knowing the fundamentals or anything other than what the

crowd was doing at any given moment.

This is true in the real world too. Although trading floors are a

thing of the past, and trading desks are soon to follow, there

will always be an industry of traders, market makers, and

specialists to keep the market liquid. And while some may still

be endowed with specific knowledge of the order books and/or

flows, many trade simply based on “the action.”

In the old days, i.e., even before charts, brokers would have to

read their quotes off a physical ticker.

This first genre of technicians (before Edwards and Magee)

discovered that there were characteristics in “the tape”

indicating whether the buying or selling was considered

“good.”

I mention it to offer some insight into the value of data in a

chart.

The “tone” of the buying/selling

I used to read this “tape” in digital form (in the eighties and

nineties) on my computer before charting became so freely

available. In one of my favorite passages in “Reminiscences of

a Stock Operator” (a story about the boy plunger, Jesse

LIvermore, in the early 20th century), the young boy stumbled

upon a tip. He couldn’t wait to use that information as a way to

get in with a top trader. But when he relayed it, instead of

immediately buying, the trader started selling. This puzzled the

boy, and he left the traderclosed-end office disappointed by the


77

whole experience. He would later find out the trader was only

testing the market to see how sound the rumor was; i.e.,

whether it could take the selling.

In other words, he was taking the marketclosed-end

temperature, trying to see how it responded to this or that… he

was measuring the “tone.” If the rumor was true the market

should be able to absorb everything heclosed-end got, he

reasoned! When it did, he turned around, covered, and went

long, vindicating the young boyclosed-end tip. The ‘action’ of

the market can be informative.

It talks to those who listen and understand its language.

It is easy to forget but it is this kind of insight that is at the

foundation of technical analysis; you don’t see a trading floor

but you see all the data a floor trader reacts to in one fell

swoop, going back days, weeks, months, or years. The floor

trader is reacting to the same information except it is imprinted

in his memory based on his intraday experience. Before

introducing you to the main elements of technical analysis let

me make a few important qualifications about its fundamental

value.

Some qualifications on T.A.

There is no magic to technical analysis. It can’t tell the future.

In its basic form it is just a series of empirical observations and

some theoretical behavioral inferences derived from an

analysis of the data. The basic idea is to draw conclusions from

the behavior of prices and changes in volume, much like the

old floor trader would of the action. The chart is simply an

innovative way to present this data all at once, and over any

period. There are a few common errors made by most people

on this subject.


78

There are those who put too much faith in it and those who

discount it too far. Some people, including technical analysts

Robert Edwards and John Magee, for example, believe that the

fundamentals are fully priced into the market, and that

“traders” should ignore them altogether. They believe the

market is so efficient that a fundamental analysis is not only

futile but that it also clouds oneclosed-end objectivity. Purist

technicians in my mind, personally, are just as bad as

economists who ignore the charts completely – citing the

random walk hypothesis – i.e., who ignore the fundamentals

completely – or the efficient market hypothesis.

The chart does not foretell a future. But it gives us necessary

information about the past as a starting point to judging the

future.

For those interested in Elliott Wave, see the Wikipedia entry,

https://en.wikipedia.org/wiki/Elliott_wave_principle

It is thought of as a form of technical analysis because it relies

on price and volume charts, identifies patterns, and draws

conclusions from the same data as a classical technician.

I will not be covering aspects of this discipline, as I do not use

it in my work. My criticism of this form of technical analysis is

that it presumes that the charts can tell the future.

When I practice the discipline I try to stick with what the chart

tells me about past behaviors (patterns in prices and volumes),

leaving me to decide their outcome. For instance, Edwards and

Magee developed theories to explain why prices and volumes

behaved as they did – and they did not try to claim that the

future can fit into a few basic patterns.

One final qualification: We have a separate section below

dealing with the subject of “statistical analysis” which should

https://en.wikipedia.org/wiki/Elliott_wave_principle


79

not be confused with technical analysis. A lot of the indicators

used by technicians – momentum, macd, moving averages, etc.

– are really statistical tools. They are helpful to our analysis

but different from technical analysis. Media pundits, for

example, think they are talking technical analysis when they

assert that a 20% decline in the averages triggers a bear market.

But this is a statistical interpretation. A bear market trend in

technical analysis is a series of lower highs and lows… i.e., a

trend.

Support and resistance theory

Edwards and Magee noticed that often when a price trends

upward that a previous high acts as a level of support... so that

the pullbacks often come back just to this last high. They

created a theory to explain this behavior. They argued that

traders who sold at the previous high, realizing they sold to

early, would wait on the bid at that level hoping the stock

would pull back and offer them another chance to stay in.

For more on support and resistance theory,

http://stockcharts.com/school/doku.php?id=chart_school:chart

_analysis:support_and_resistance

http://stockcharts.com/school/doku.php?id=chart_school:chart_analysis:support_and_resistance

http://stockcharts.com/school/doku.php?id=chart_school:chart_analysis:support_and_resistance


80

13.

WHAT ARE TRENDS?

If you’ve seen a stock or asset price graph before it should be

obvious that trends do exist, and no amount of statistical

mumbo jumbo should be able to refute that fact. Yet, the

random walk crowd believes that the move on any given day is

unrelated to the action of the previous day.

The random walk hypothesis is based on the odds of a

stockclosed-end price rising two or more days in a row.. i.e.,

researchers went around flipping a coin and found they could

create the appearance of a price trend even though, day to day,

the odds were just 50/50. However, each new coin toss only

produced two outcomes: up and down; and started from the

point where the last toss ended. If instead you had a computer

generate random numbers then they would be all over the

graph.

Naturally, with only two outcomes, and each new data point

starting from the last, you’re going to have a trend, and it will

be unpredictable.

To be honest, I have no time for random walkers; they have no

idea what they’re talking about. Market trends are easy to

understand.

Imagine throwing a rock into a still pond on a clear day. That

rock is new information. The pond is the marketplace. You will

see the rock’s impact immediately in the form of waves, in a

circle, expanding outward. Information moves through the

market this way.

Regulators would have you think they can make it so that

information spreads through the market instantly and equally.

Regardless, not just information, but ideas move this way

too… perspectives, outlooks, etc.

https://en.wikipedia.org/wiki/Random_walk_hypothesis


81

And if a company continues to grow, its crowd of shareholders

will grow, and at each juncture where the company creates new

wealth, new shareholders may come in, and so on. At the start

of a trend the public’s confidence is low, at the end of a trend

its confidence is high.

We know these things are true from experience and that the

trends to which they relate are not random. They may appear

random if you don’t understand how they form... or lose

enough money to cynicism.

The structure of a price trend is simple.

It consists in either higher highs and higher lows, or lower

highs and lower lows -as in the graph below. Not all trends

have the same slope.

In a normal trend you will notice that the retracements (counter

trend movements) tend to stop at the previous peak for an

uptrend or at the previous trough in a downtrend. Note, for

example, in the uptrend in the graph above that the troughs (T)

will tend to occur about where the previous peaks (P) occurred;

and conversely in the downtrend the peaks (P) will occur where

the previous trough (T) ended. The reason for this was

explained by support and resistance theory previously.


82

The chart above is fabricated but only for illustrative purposes;

it still reflects empirical norms. That is how normal trends tend

to operate.

Important: For whatever reason this is more apparent on a

logarithmic graph than an arithmetic one. Log graphs are

standard practice.

Technicians like to say that a trend is a trend until it’s not.

They say this in order to check their bias; to accept the reality

of the data rather than what they wish to be true. As a rule,

trends, break outs, break downs, and so on, require

confirmation before they are defined. How do we know when

an uptrend reverses, or vice versa?

It would seem rather easy. But not all trends can be defined by

a straight line. The rule is that a trend is defined by the most

recent series of highs or lows. The lows to connect in an

uptrend are the ones that are followed by a new high.

Sometimes it is permissible to ignore a spike low, as in the case

of the graph of the S&P 500 on the right in depicting the more

normal trend.


83

Far too many people will connect lows or highs on two ends of

a chart while missing everything in between. One solution to

this confusion is moving averages. This too is helpful in cases

not amenable to drawing straight lines. However, it is not really

a technical tool; it is statistical, and overlooks important

technical points in defining the trend as above.

For example, when a trend has reversed, it is not simply

because the price has crossed through a straight line in the

graph. There is a rule, however.The rule is that the important

low in an uptrend is the last highest low (or trough) that occurs

before a new high is made. In the case of the S&P 500 above

that would probably be the March 2015 low at 2030

(approximately). You want to draw the trend line starting from

one of those lows backwards, as that is the most important

trend – the most recent slope.

The same goes for the downtrend except it’s the last lowest

high before a new low that counts. So when the S&P 500 fell

through 2030 in August, notice how the decline accelerated.

This is because of a bit of self fulfillment as many traders mark

the same low at the same time as a significant point for a

reversal in the trend, etc.

Traditional technical analysis recognizes four trend categories,

1. Secular

2. Primary

3. Intermediate

4. Short term

Secular bull or bear market trends can last from 7-18 years,

sometimes longer, and may include 3-4 primary cycles (or

more) and numerous intermediate and short term cycles. Wall

Street has had just 3 secular bull markets since the Fed’s

creation: 1915-29, 1942-66, 1983-00.


84

You can see them all here...

From a technical point of view it remains to be seen if the

current post 2009 bull market leg is the start of a new secular

bull market in stocks. From a fundamental point of view we

think not.

A primary trend tends to last from 2 up to roughly 7 years,

depending on if it is a pro- or counter-cyclical move relative to

the secular trend. A primary countertrend, in my experience,

could last up to 3, maybe even up to four years. Likewise, if the

primary leg is aligned with the secular trend, it could push on

for more than 7 years. But the average is 2 and 5. You can see

these trends in the monthly charts, as above, forming the

visible legs that are vacillating around the secular trends. An

intermediate price trend lasts from three months up to 18-24

months, and can be spotted on a daily or weekly chart (but not

so easily in the above monthly chart). A short term trend is

anything less than 3 months generally, and can be as little as a

few days or weeks.

Wikipedia has a helpful entry on the definition trends,

https://en.wikipedia.org/wiki/Market_trend

https://en.wikipedia.org/wiki/Market_trend


85

Important: in any sound chart analysis you want to

make sure to use logarithmic charts; they fix the

proportions of price changes in percentage terms so that

a given pattern has the same implications between $1

and $1.50 as between $6 and $9. If you view them in

arithmetic terms then you will be fooled by bigger

patterns and other distortions just due to high prices,

including trend lines, which tend to be straight on log

charts while going parabolic in arithmetic charts.

Accumulation patterns

For an additional primer on the basic chart patterns visit,

http://stockcharts.com/school/doku.php?id=chart_school:chart

_analysis:introduction_to_chart_patterns

Sometimes prices plateau. They may have found a new level

where demand and supply are roughly in equilibrium for the

moment. This is referred to as a consolidation in prices, and it

can represent a reversal point or a resting place; i.e., either a

reversal or continuation pattern. It is not to be presumed

whether it will lead to a reversal or whether it is just a resting

place ahead of time – until one or the other starts to occur. For

the classical technician, a pattern (i.e., a chart formation) is

only a particular formation once confirmed (i.e., after the price

breaks away from it in the expected direction). Until that

moment it could morph into another formation, and could just

be deceiving the analyst.

Even after a breakout there is still a chance the breakout will

fail and fool the analyst anyway. But the odds improve with the

breakout, which “confirms” what the pattern was… i.e.

whether it was a reversal or continuation pattern.

http://stockcharts.com/school/doku.php?id=chart_school:chart_analysis:introduction_to_chart_patterns

http://stockcharts.com/school/doku.php?id=chart_school:chart_analysis:introduction_to_chart_patterns


86

Various hybrid (technical-statistical) indicators have been

developed to help us judge this ahead of a confirmation (like

the on balance volume indicator, for example). Still,

disciplined technicians and traders avoid trying to anticipate

the formation developing in the chart. It is accepted practice to

wait for the “confirmation” before identifying the pattern. In

my experience, however, I have too often been late to a party

that my sense knew was going to occur before the breakout

occurred… just based on an analysis of the fomenting bias, and

no doubt also my many years of experience looking at

thousands of charts.. each month.

If you have a disciplined trading strategy, confirmation is

perhaps not so important. It may reduce the risk of getting the

pattern wrong, but it is also often guilty of sending a late

signal.

Some of the typical patterns that technicians look for in order

to indicate accumulation include,

1. Double/tripple bottom

2. Head & shoulders bottom

3. Ascending triangle

4. Rounding bottom

All those can be either continuation or reversal patterns, but

either way they tend to indicate there is accumulation in the

shares or commodity. Here is an example of a triple bottom,

http://stockcharts.com/school/doku.php?id=chart_school:technical_indicators:on_balance_volume_obv

http://stockcharts.com/school/doku.php?id=chart_school:chart_analysis:chart_patterns:double_bottom_reversal

http://stockcharts.com/school/doku.php?id=chart_school:chart_analysis:chart_patterns:head_and_shoulders_bottom_reversal

http://stockcharts.com/school/doku.php?id=chart_school:chart_analysis:chart_patterns:ascending_triangle_continuation

http://stockcharts.com/school/doku.php?id=chart_school:chart_analysis:chart_patterns:rounding_bottom_reversal


87

The bottoms have to be pretty much at the same level (as do

the tops). If it is a bottom it is a reversal pattern, but you don’t

know until the “breakout” (marked in the chart above) over the

“neckline.”

If this rectangular formation turns out to be a resting place on

the way to lower lows, the neckline will be the bottom line –

the one connecting the bottoms not the one connecting the tops

as in the graph – and the breakdown would occur when it fell

through the bottom line.

Until the breakout or breakdown occurs the technician tries not

to label it. In the above case it turned out to be a bottom, and a

reversal of the previous trend. You could have two bottoms (or

tops), five, six, as many as you wanted. Another thing that all

of these “formations” have in common is that they provide

technicians with a clue to how far a rally or decline might go.

Remember to use a logarithmic chart for this.

Calculating a target price

Essentially you want to measure the distance between the

bottom and top of the formation in percentage terms.

For example, if the bottoms were at $60 and the tops were

lined up at the $90 level, the distance is either +50% from the

bottom line, or -33% from the top line. You could just measure

it visually and then use that value to estimate a target. But that

will be your foundation for estimating a target price; if it is a

bottom (reversal) then the resulting target price for the

breakout from this hypothetical pattern would be $135 ($90 x

1.5); and if it is a continuation pattern then the target price

would be $40 ($60 x 0.67).

You would be surprised how often those measurements work,

plus or minus a slight margin of error. Another way to measure

the potential of a move following the breakout, especially if it


88

is a continuation pattern (instead of a reversal), is to liken its

potential to the previous leg. Hence in our alternative

calculation we would measure the size of the move that

preceded the pattern. For example, using the graph above

again, if the downtrend began from $135 and bottomed at $60,

followed by a consolidation between $60 and $90, then we

may see that the breakdown doesn’t stop at $40 but instead

continues on to $27 per share (60/135 x 60). This also happens,

usually in the late to middle stages of the larger trend, when

prices really run.

Distribution patterns

Some of the most typical patterns that indicate distribution

include,

1. Double/triple top

2. Head & shoulders top

3. Descending triangle

All of these can represent either continuation or reversal

patterns, but in either situation their characteristics suggest a

partial distribution is under way (click above links for more

info – there are many nuances and variations of these patterns,

this is just a basic introduction). Charts can be deceptive as

well, depending on the market. In some markets any of those

top formations could end up becoming a continuation pattern

within the uptrend, like a bear trap, fooling hasty traders into

shorting the issue too soon (especially before a breakdown

confirmation).

Then the pattern is a fail. But such failures represent good

trading opportunities because they catch the shorts off guard.

The leveraged S&P futures markets are notorious for such

traps.

http://stockcharts.com/school/doku.php?id=chart_school:chart_analysis:chart_patterns:double_top_reversal

http://stockcharts.com/school/doku.php?id=chart_school:chart_analysis:chart_patterns:head_and_shoulders_top_reversal

http://stockcharts.com/school/doku.php?id=chart_school:chart_analysis:chart_patterns:descending_triangle_continuation


89

Example of descending triangle,

The characteristic feature of a descending triangle is a series of

lower price highs (marked by the downward sloping blue line

in graph above) with each decline bottoming out at the same

level horizontally. In a rectangular (neutral) pattern the fight

between the bulls and the bears is even, but in a pattern like

this the bears appear to have an edge. Note in this case that the

descending triangle may also be part of a larger head and

shoulders top.

In any case, the narrowing range is often analogous with a

coiling market ready for a volatility explosion. The bearish

descending triangle and its bullish counterpart (the ascending

triangle) show up a lot in the short and intermediate cycles

while the head and shoulders formations, rounding tops or

bottoms, double or triple tops and bottoms, and the

megaphones, tend to dominate the primary trends. That’s just

this author’s experience. Recall how to judge a potential target

price.

http://www.investopedia.com/terms/b/broadeningformation.asp


90

The move that emanates from an identifiable pattern is often

roughly equivalent to the distance between the pattern’s widest

points. In the case of the above chart that is the distance from

$58 to $66 as per the red vertical line. The implied price

objective of a breakdown from that pattern would be measured

in percentage terms as a proportion of the “neckline”

(horizontal blue line) price. Hence the target price for the

above triangle was $51 (58/66 x 58). You can see that it

overshot and then bounced back to just above $52. We would

say the move is complete at that point.

Another important point about breakouts and breakdowns that

technicians all tend to agree on is that there is always a

retracement (return) to the “neckline” before the move

completes. You can see that tendency in the sample chart

above as well. The neckline is at $58 – representing the

horizontal floor for the pattern – i.e., where the declines kept

stopping just before the breakdown. After the breakdown

above, note how the price pulled back up to that level two

times, the second time from a lower low in October. Some

traders believe gaps must be filled before a trend continues,

which you can see may explain it.

Regardless, the important insight is sometimes it is better to

wait for the confirmation, then act after the retracement. The

reverse is true for an ascending triangle in the case of a bottom.

Consider our bitcoin example,


91

See the ascending triangle? – i.e., with higher lows and a

horizontal line of bearish defense. Traders may reinforce a cap

(neckline) if they notice the stock or asset repeatedly reverses

at a specific price. In the bitcoin case above, the sellers

eventually ran out of bitcoin to sell at the $300 neckline. But

note how the retracement came back to the neckline – the

previous high – confirming the break out and depicting a fairly

normal trend.

Can you calculate the target price?

>> answer = roughly $600 (i.e., 300/150 x 300).

Notice the explosive break out (I have omitted the volume bars

for simplicity sake but volumes were properly declining

throughout the consolidation), and the full retracement.

Retracements can be anywhere from ⅓ to 80-90%, as you saw

in the prior example. Just watching how the pull back itself

trades can be a tell about how strong or weak the market is.

In the former bearish case of Dupont’s chart above, the

neckline successfully held off the bulls twice, and if you saw

that happening in real time you could interpret the failure of

bulls to recover ground above the neckline as further

confirmation and another opportunity to sell. Tests like that are

part of the determination of tone.

Recall how the trader tested a market he was tipped off on by

selling into it before concluding whether it was strong and that

the rumor must have therefore been good. In the same way you

can judge a market’s handling of key support and resistance

levels at trend lines, congestion areas, and so on, i.e., in order

to get a sense of which side is stronger: the bulls or the bears.

In the same way it pays to monitor how a market reacts to

news and fundamental events for clues as to whether the bulls

or the bears have the edge at any given moment in time.


92

Neutral patterns (of consolidation)

The following continuation or reversal patterns have no visible

bias,

1. Rectangle

2. Symmetrical triangles

3. Diamonds

The characteristic geometric feature of these patterns is that

they are all symmetrical, indicating a relatively equal force

between the bulls and bears (in their fight over valuation and

price points). Consider the example of a symmetrical triangle

formation in the graph above.

Note that the lows are getting higher AND that the highs are

getting lower, which also indicates a coiling in this fight, which

then breaks in one direction or another; but the bias is neutral,

so unless we get a tip off from another indicator one should

http://stockcharts.com/school/doku.php?id=chart_school:chart_analysis:chart_patterns:rectangle_continuation

http://stockcharts.com/school/doku.php?id=chart_school:chart_analysis:chart_patterns:symmetrical_triangle_continuation

http://chart-patterns.netfirms.com/diamond.htm


93

wait for a confirmation break out. Note the declining volume

during the consolidation in the triangle. What is similar in all

patterns – whether accumulation or distribution – is the

behavior of volumes.

In the vast majority of cases you want to see volume declining

within a formation, and then rising on the break out.

On the upside breakouts it is especially preferable to see an

increase in volume. It doesn’t have to surpass the previous

peaks, it just has to turn up as confirmation that the buying is

material. The same doesn’t tend to hold true for breakdowns…

they can occur on light volume.


94

14.

FUNDAMENTALS VERSUS TECHNICALS

I use technical analysis as a timing and trading tool, especially

when it comes to trading stock or commodity ETFs, or options

in particular. An analysis of support and resistance helps me

determine my stop loss points in a trade, for example.

Moreover, minor fundamental changes are quickly factored

into a liquid or widely watched market; and since there is a lot

of noise that drives fluctuations in the short term, technical

analysis can be more valuable to a trader than a fundamental

analysis.

The fundamentals get greater weight in our long term portfolio

and investment strategy. Here the primary objective is to

identify value. Even then, however, technical analysis is useful.

I still try to time investment decisions so that they generate

positive returns within a year. [If that does not happen it is not

on purpose.]

As a general rule, my opinion about technicals vis a vis

fundamentals is this: in new and emerging markets where there

is not very much liquidity in the trading of the security the

fundamentals are more important; but in a liquid market where

the underlying company is well established the market is likely

to be efficient, and the chart is valuable.

Statistical analysis

I don’t mind if people lump this stuff all in together and call it

technical analysis. I like to make a distinction for academic

purposes. The analysis of moving averages and momentum,

bollinger bands, on balance volume, ppo, and so on, all offer

some unique information, but the technical analysis by

Edwards and Magee includes an attempt to be scientific about

their observation of thousands of chart patterns. Without even


95

realizing it they adopted one of the Austrian School’s basic

tenets: methodological individualism, i.e., the principle that all

economic phenomenon ultimately finds its "origin and

measure in the economically acting human and his economic

deliberations.” They didn’t simply settle on patterns or trends

as being the cause of anything, or in assuming that charts could

tell the future; they tried to explain what the patterns meant in

terms of individual human action.

But they only tried to do this with price and volume

relationships, not statistical ones, not to deride the value of the

statistical indicators. In the bitcoin chart below we have

generated four indicators along with the price and volume data:

i.e., on balance volume, accumulation / distribution, rate of

change, and bollinger bands.

In this mode we are typically either looking for divergences

between the trends in these indicators and the price and

volume trend, or to gauge extremes if we are looking at the

asset from a contrarian point of view.

For example, note how strong the accumulation / distribution

trend was before the recent breakout in the price of bitcoin

(below). The OBV line turned up too just before the breakout.

The two are calculated differently but are both meant to judge

the same undercurrents. These are all useful tools in assessing

the physical mechanics of the underlying instrument.

For more indicators see:

http://stockcharts.com/school/doku.php?id=chart_school:techn

ical_indicators

https://mises.org/library/human-action-0/html/pp/643

http://stockcharts.com/school/doku.php?id=chart_school:technical_indicators:accumulation_distribution_line

http://stockcharts.com/school/doku.php?id=chart_school:technical_indicators:on_balance_volume_obv

http://stockcharts.com/school/doku.php?id=chart_school:technical_indicators

http://stockcharts.com/school/doku.php?id=chart_school:technical_indicators


96


97

15.

CONTRARIAN INVESTING

Wikipedia says,

“Contrarian Investing is an investment strategy that is

characterized by purchasing and selling in contrast to

the prevailing sentiment of the time. A contrarian

believes that certain crowd behavior among investors

can lead to exploitable mispricings in securities

markets.”

Every value investor is also somewhat of a contrarian as he or

she is trying to identify value that the rest of the market has

overlooked.

Contrarian investing does not mean taking the opposite

position just for the sake of it. It means always questioning the

crowd and consensus.

Scenario building

Scenario building is a bit like what a chess player does: thinks

ahead; and tries to anticipate the opponent’s moves.

In order to do this, the player must first consider all the

possible moves available to an opponent – in reaction to their

move – rejecting the least feasible along the way, and then

must calculate the odds on the most likely moves.

And this must be done several moves ahead just so that the

player can make the right move under present circumstances.

I do this on every trade, probably every action, on some level.

I’m sure everyone must, even if they aren’t aware of it. For

most situations is pretty simple. Athletes do it when they


98

visualize, or at least I did in my youth. I used to visualize

moves I’d make on the ice the night before an important game.

I would be conditioning my instincts to make the right decision

in the heat of the moment. It was an exercise of the mind. And

it worked.

The Wikipedia has a good description for a scenario analysis,

“Scenario analysis is a process of analyzing possible

future events by considering alternative possible

outcomes (sometimes called "alternative worlds").

Thus, the scenario analysis, which is a main method of

projections, does not try to show one exact picture of

the future. Instead, it presents consciously several

alternative future developments. Consequently, a scope

of possible future outcomes is observable. Not only are

the outcomes observable, also the development paths

leading to the outcomes. In contrast to prognoses, the

scenario analysis is not using extrapolation of the past.

It does not rely on historical data and does not expect

past observations to be still valid in the future. Instead,

it tries to consider possible developments and turning

points, which may only be connected to the past. In

short, several scenarios are demonstrated in a scenario

analysis to show possible future outcomes. It is useful to

generate a combination of an optimistic, a pessimistic,

and a most likely scenario.”

The Fed’s stress testing procedure involves a scenario

analysis… what might happen under various scenarios, for

example. They run complex scenarios. It can be as simple or

complex as you want. Mining companies do it when they

publish NAVs for a base AND optimistic case. For the record,

the formality of this process is usually redundant in practice.

Most people do it in their heads, as I do. The only time I write

it out as here is when I am trying to explain it or when financial

https://en.wikipedia.org/wiki/Scenario_analysis


99

modeling. Actually, to be honest, I have to admit that George

Soros had some influence on me through his first book

(alchemy of finance). His reflexivity concept was also an

exercise in scenario analysis. Except, he used flow charts, and

it is more complex than I want to get. Let’s try a simple

example of scenario analysis using gold to elucidate the

process. For example, my money supply based shadow gold

price spits out 4 values using 3 different base years with one

statistic that is the mean value of two of those years (i.e.,

optimistic and base case).

Shadow

Scenario

Target

Value

Conditions Probability Probability-

adjusted

Wishful

(1981)

$3012 QE infinity 25% $753

Optimistic

(1913)

$1804 War breaks

out

20% $361

Fair $1370 Wall street

bull dies

40% $548

Base (1945) $935 USD stays

strong

15% $140

100% $1802

After applying subjective probabilities based on my scenario

analysis I arrive at a probability adjusted gold price forecast of

$1802 this way. The third column might contain some of the

conditions or events that would have to happen in order to

achieve the expected value within whatever timeframe, say,

one year, in our example. The fourth column is your subjective

probability to that outcome after considering what would have

to occur to get there, and the final column is the product of the

expected target value by its probability value (second column x

fourth column). The probabilities should always add up to

https://en.wikipedia.org/wiki/Reflexivity_%28social_theory%29


100

100%. If they don’t make sure they do. In our case, based on

my scenario analysis using a simple set of hypothetical

conditions, the most likely outcome is the optimistic one.

Obviously, this final number is only going to be as good as the

objectivity that went into its computation.

Even then it is not impervious. It is just an exercise to help the

investor try to think through the trade or investment, and to

help with the decision making process… both the entry and

exit.

In my personal view it is the best way to think about the future.

Conclusion

In the last section you learned a little about the different

techniques available to you in making investment decisions.

You learned some basics about valuation, charting, scenario

analysis, and contrarian investing… probably just enough to

make you dangerous. Really, this is just the tip of the iceberg.

Many books have been written about all of these topics. I have

read many, and have developed my own mode of doing things

over the past three decades.


101

16.

THE ABCs OF SHORTING

Many modern stock exchanges allow for the ability to sell

stock short, which allows you to sell stock you haven’t bought

with the intent to buy it back lower and profit from its decline.

Short selling requires a margin account and the ability of the

firm to borrow the stock you are shorting, which generates an

obligation to pay dividends to the owner/lender, as well as

interest on the margin, and the promise of returning the shares.

The risks of shorting are that you lose money if the shares

continue to rise, and even more if you’re employing too much

margin in your short. And margin accounts are typically not

segregated from the brokerage firm’s assets so if your broker

goes down you may be forced to cover, and lose whatever

assets you have in the account. To be eligible as a short, in

North America the shares just need to be optionable. Each of

the exchanges may have minor differences in the trading rules

that apply to short sales, i.e., whether on an uptick or not for

example.

Just remember, when shorting, you are trading.

Like with the example of leveraged exchange traded products,

the costs of shorting can be too high to maintain as a position.

When we are short, we try to limit our time horizon for the

trade to the length of the intermediate cycles.. up to 9 months, a

year at most, depending on what you are shorting.

Naked short selling

“is the practice of short-selling a tradable asset of any

kind without first borrowing the security or ensuring

that the security can be borrowed.”


102

In many instances this is illegal, like debit kiting – i.e., the

practice of using the broker’s capital by maintaining debits in

your cash account. This isn’t what we are recommending.

The basics of trading

According to the Investopedia,

“Investing and trading are two very different methods

of attempting to profit in the financial markets. The

goal of investing is to gradually build wealth over an

extended period of time through the buying and holding

of a portfolio of stocks, baskets of stocks, mutual funds,

bonds and other investment instruments… Investors are

typically more concerned with market fundamentals,

such as price/earnings ratios and management

forecasts… Trading, on the other hand, involves the

more frequent buying and selling of stock, commodities,

currency pairs or other instruments, with the goal of

generating returns that outperform buy-and-hold

investing. While investors may be content with a 10 to

15% annual return, traders might seek a 10% return

each month… Where buy-and-hold investors wait out

less profitable positions, traders must make profits (or

take losses) within a specified period of time, and often

use a protective stop loss order to automatically close

out losing positions at a predetermined price level.

Traders often employ technical analysis tools, such as

moving averages and stochastic oscillators, to find

high-probability trading setups.”

The differences are a bit pedantic to be sure. Most attempts to

differentiate the practices center on the time horizon and

frequency of turnover in the portfolio, but there is no agreed

upon quantities there. From the government’s point of view the

difference amounts to whether you are paying income taxes or

http://www.investopedia.com/ask/answers/12/difference-investing-trading.asp


103

capital gains taxes. The difference for most governments is

typically based on how long the security has been held, the

type of security, and the business of the investor.

However, I like the contrast between styles as another way to

differentiate trading from investing: the trader tends to put

more weight on non fundamental technical factors

(charts/statistics) while investing in the post Graham and Dodd

world is basically value investing and position holding.

In order to compensate for this traders follow a few rules:

First, every trade has a predetermined exit plan, preferably a

simple one. It involves calculating an expected profit and

target, and taking action to exit then, or calculating the

maximum loss and making sure to exit if that loss is apparent

regardless.

The idea is to be as disciplined with this as possible, but at the

same time I believe in some flexibility. Part of this process may

involve jotting down a stop loss price, but my advice is not to

enter it formally in the market. Keep it mentally, but try to stick

to it. If the market moves in your favor you may want to

tighten the stop, which means adjust it upwards (or down if

shorting).

Second, stay eternally vigilant with your trades. While

investing should involve diversification that is not really

helpful for trading (hedging may be though). It is better to

concentrate your trades and to stay vigilant.

Third, be clear on what you are speculating about; write down

the hypothesis that your trade is supposed to test, i.e., what

changes are you looking for and why?

This should not change. You don’t want to be in a position

where you are making rationalizations for staying in. Part of


104

staying vigilant is making sure that you are focused on the

reason for making the trade and still expecting it. If not, then

get out.

Fourth, regardless of whether we are trading or investing, I

never recommend plunging. It is always better to wade in and

out of your positions. When investing this can be a relatively

automatic or passive process, like dollar cost averaging over

time.

In trading the process is a little bit different. With trades, we

like to keep adding to the trade only if the trade is working.

If it is not working, we stop adding to it and leave our initial

capital in until either it does work or the stop loss is triggered.

So whereas with investing it is desirable to dollar cost average

in a down cycle, if you are trading from the long side you don’t

want to do this. You want to chase it higher and add to your

trade only when the stock (or whatever instrument) price is

confirming your hypothesis. Fifth, sentiment is the trader’s

friend. We can measure sentiment in many ways. But the point

as a trader is to be either early in the changing of sentiment if

you want to bet with it or if you want to take the contrarian

position you want to bet when you think it’s extreme.

In defense of traders

Profit seeking traders produce liquidity and stability.

They produce liquidity by narrowing the bid/ask spread on a

given security or whatever is being traded just by their

presence.

Their work is what allows the average investor to get in and out

of a security with a minimum of cost (except that the brokerage

cartels still tend to cooperate on fees and commissions through


105

non profit associations and with the help of the government’s

licensing mandate). Traders produce stability because they

stand ready to counter anything that destabilizes markets and

brings disequilibrium. For them it is just an opportunity. This is

their work, not the central planners! They are not the ones that

manipulate interest rates and prices across the board.

A traders’ manipulations are limited and checked by other

traders in any large liquid market. Remember, it isn’t free

market capitalism that produces the instability; it is the need to

regulate and intervene in it. Sure markets can fluctuate widely

around the fundamentals. But largely this is the work of the

government protected fractional reserve banking monopoly in

the production of money substitutes.

Traders contribute to the volatility only in the sense that they

are emotional humans fighting over an uncertain fair value. It

is a moving goal post, constantly changing, due to actions of

the entity or change in the political environment in which it

operates, but through the forces of supply and demand traders

eventually discover a reasonable price. Without traders there

would be fewer mechanisms to offset the instability caused by

the central bank’s interventions.


106

SECTION 4.

OPTIONS AS NECESSARY TOOLS


107

17.

OPTION PRICING AND VALUATION

In a previous section we defined an option, discussed its utility,

syntax, and basic features. In the next two sections you’ll learn

how an option is valued, and some of the more basic or

common option strategies employed by investors (with

references and links in each section). I use options all the time

in my trading strategies. They offer me flexibility control and

cost-efficiency.

An option is simply the “right” to buy an asset or financial

instrument. Its valuation is more or less independent of the

valuation of the underlying asset. An argument can be made for

some value to be attributed to the expected return for the

underlying asset but mostly their value is based on the

underlying volatility of the security, time to maturity and

distance of strike price. Basically, the value of an option is

equal to its “intrinsic value” plus its “time value.”

https://www.cboe.com/learncenter/glossary_g-l.aspx#intrinsic

https://www.cboe.com/learncenter/glossary_s-z.aspx#timevaluepre


108

Unlike when trying to value a company or asset, in this case

there is an intrinsic value. It is intrinsic because it is

arbitrageable. Recall we said that if you knew the value of the

parts of a business and you had bids for these parts (break up

value), that valuation could be intrinsic.

Intrinsic value

= difference between the stock/asset price and strike

price if the option is in the money (if out of the money

it is has no value)

Recall, from earlier, “When the strike price of a call option is

above the spot or market price the option is said to be “out of

the money.” When it is below the spot price it is “in the

money.””

The opposite is true for a put.

That is, a put option (the right to sell) is “in the money” when

its strike price is above the price of the underlying share or

asset, and it is “out of the money” when its strike is below it.

Time value

Time value is the premium over an option’s intrinsic value.

There is always a time value even if there is no intrinsic value,

as in the case of an ‘out of the money’ option.

This part of an option’s value is complex and incorporates

many factors besides purely the time component.

As hinted at above, it also takes into consideration the expected

return and volatility (implied or historical) of the underlying

asset, and maybe liquidity and other risks. There is terrific

software on the market that allows investors to calculate the

value of an option using various models, the most popular

https://www.cboe.com/learncenter/glossary_m-r.aspx#outofthemoney

https://www.cboe.com/learncenter/glossary_m-r.aspx#outofthemoney

https://www.cboe.com/learncenter/glossary_g-l.aspx#inthemoney

https://www.cboe.com/learncenter/glossary_g-l.aspx#inthemoney


109

being the Black-Scholes Model – developed by one of the

brains behind Long Term Capital Management. For some

discussion about the different models used (and available to

you if you want to trade options seriously) in this calculation,

and of the significance of the “greeks” that are calculated on

options, see:

http://www.hoadley.net/options/bs.htm

The “greeks” (delta, vega, theta, etc.) are statistics generated

from option data. Here is a good article about their value,

http://www.investopedia.com/university/option-greeks/

NYU has a detailed slide show on option valuation if you are

keen (it’s a pdf file),

http://people.stern.nyu.edu/adamodar/pdfiles/option.pdf

While option values may be independent of the value of the

underlying asset, they are often used in pricing or estimating

values for the underlying asset. But that’s not relevant here.

http://www.hoadley.net/options/bs.htm#Black-Scholes

https://en.wikipedia.org/wiki/Myron_Scholes

https://en.wikipedia.org/wiki/Myron_Scholes

http://www.hoadley.net/options/bs.htm#greeks

http://www.hoadley.net/options/bs.htm

http://www.investopedia.com/university/option-greeks/

http://people.stern.nyu.edu/adamodar/pdfiles/option.pdf


110

18.

OPTION STRATEGIES

Options are very versatile.

As you now know they can be used for speculation, risk

management, hedging, extra income on your stock portfolio,

and even as indicators for the underlying asset’s value or its

timing points for trading. There are so many strategies, and I

have not employed all of them simply because of the resources

required to do that work – it can be a full time job if one were

to be constantly scouring the opportunities in options.

The CBOE offers courses on all the main strategies here,

https://www.cboe.com/LearnCenter/ViewCurrAll.aspx

Some you have to pay for, but a lot are free. I would suggest

perusing the website for a while if you want to trade options

seriously. Don’t forget to check the following page for the

software tools that can help you pick or trade the right options

and strategies,

https://www.cboe.com/tradtool/strategy.aspx

Investopedia has a slide show detailing the top 10 strategies

here,

http://www.investopedia.com/slide-show/options-strategies/

Most traders employ less than ten.

The Investopedia slideshow referenced in red, above, covers

the most popular strategies. If you want to learn more the best

way is to do it through the CBOE, I think still one of the largest

https://www.cboe.com/LearnCenter/ViewCurrAll.aspx

https://www.cboe.com/tradtool/strategy.aspx

http://www.investopedia.com/slide-show/options-strategies/


111

and most liquid option exchanges, or you could visit Amazon

and type “option strategies” into the search field.

This should come up,

http://www.amazon.com/s/ref=nb_sb_noss_1?url=search-

alias%3Dstripbooks&field-keywords=option+strategies

I learned options from several books in my formative years but

none of them stood out as anything special. Most of what I

learned came after in trading and advising in them. If you’re

buying a book just make sure to read the reviews.

But I’d recommend the CBOE courses.

I’m going to cover the few strategies I’m most familiar with,

excluding the straightforward buying or selling of puts and

calls as that has been covered in previous sections already.

http://www.amazon.com/s/ref=nb_sb_noss_1?url=search-alias%3Dstripbooks&field-keywords=option+strategies

http://www.amazon.com/s/ref=nb_sb_noss_1?url=search-alias%3Dstripbooks&field-keywords=option+strategies


112

Profit/loss analysis

First, let us describe a method of visually graphing the profit

and loss potential of any given option strategy. If you are

proficient with spreadsheets (like Excel) this should be easy for

you.

In this “payoff diagram” or “profit graph,” as it is commonly

called, dollars of profit or loss are graphed on the vertical axis,

and various stock prices are graphed on the horizontal axis.

It’s basically a scenario analysis for an option strategy.

In this example we have plotted a simple P/L graph for the

January 16, 2016 $30 call on the Direxion Gold Miner’s 3x

leveraged ETF (NUGT). The price of the call was $2.75 and

with a $25 commission the total cost of 1 contract is $300.

Recall that when you are simply buying or selling options the

most you can lose is the cost. As long as the price of the NUGT

etf remains below $30 the call is worthless intrinsically. The

blue line in the above graph indicates the maximum this

strategy can lose and plots it against the amount it can gain –

starting at the break-even point, which is $33 in this example.

We’ll create simple graphs like this for each strategy but it is

important to understand that we are only graphing the profit

and loss at expiry, and relative to the option’s intrinsic value.

In reality recall that there is also a time value component to

option prices. You can download spreadsheets or access online

options calculators that plot this value (profit and loss) using

estimates for time value calculated using the aforementioned

models – i.e., the most commonly used is Black-Scholes. In the

example in the chart above the option is out of the money so its

price is entirely time value. But this value (the blue line) should

start to increase on the approach toward the $30 strike price at

a rate predicted by the model. Most option calculators will spit

out a curved line instead of the one above.


113

However, you can still create the simple graphs in order to

visualize and understand the strategy: its maximum risk and

reward, and basic parameters. For purposes of simplicity we’ll

illustrate the option strategies below using a simple profit

graph.

1) Straddles and combinations

A straddle is the simultaneous purchase or sale of an equal

number of puts as calls with both having the same terms, i.e.,

the same underlying instrument, strike price, and expiry date.

A combination is almost the same, except the terms will vary

between the call and the put. Strictly speaking it is “any

position involving both put and call options that is not a

straddle.”

Investors go long these strategies when they believe there is

going to be a significant move in the underlying asset but are

not sure in which direction. That is, they are betting on

volatility, or insuring against it. When they want to bet against

volatility they can short (or write) these strategies, i.e., if they


114

are right the markets will be calm they can earn an income this

way.

Example

At the time of writing Freeport McMoran (FCX) is trading at

$7.83 (US) and we think there’s going to be a $2 move in one

direction or the other this month but not sure which. One way

to “straddle” this would be to buy the Dec 18 $8 call and the

Dec 18 $ put. The $8 call is offered at 39 cents and the put is

offered at 56 cents. In this example the $8 strike price is the

nearest one to the market price that we could find. Ideally, for

the perfect straddle, the market price will be equal to the strike

and both options would be “at-the-money.”

In this case the call is out of the money and the put is in the

money by 17 cents (if you subtract 17 cents from 56 cents you

get 39 cents – basically the time value of both options). As a

small distraction the fact that they have equal time values

suggests sentiment between the bulls and bears is about equal.

Put/call ratios are typically calculated in terms of trading

volumes (or values) of one side (puts) versus the other (calls)

but premiums are also telling.

Back to our example: by buying an equal amount of puts &

calls at the $8 strike price (and the Dec 18 maturity) we are

purchasing a straddle on Freeport. Now let’s graph this trade.


115

If the stock is at $8 at expiry both options expire worthless and

we lose $145 assuming we bought 1 put and 1 call contract on

a 100 share board lot, and paid $25 in commissions for each

contract (100 x .39 + 100 x .56 + 50 = $145).

Remember, we can’t lose more than we put in when purchasing

options (unless we use leverage or borrow to purchase them

also). The breakeven value on this trade is a move of at least

$1.45 per share in either direction, and you can see that the

profit is symmetrical on either side of the strike price after that.

If you were writing the straddle your profit and loss situation

would be the reverse. That is, your maximum profit would be

the sum of the premiums minus commissions, or approx: $45

in this case for each contract straddle. If the stock flat lined you

would earn that income, but if the the straddle purchaser was

right and the stock moved the short seller (or writer) could lose

an infinite amount of money in theory if they were unable to

cover or exit.

An example of a combination would be buying an out of the

money call and in the money put, or out of the money call and

out of the money put, or in the money call and out of the

money put or in the money call and in the money put… i.e., the

puts and calls have varying strikes. In the Freeport example,

also betting on volatility, we could instead have bought the Jan

15 2016 $10 call for 17 cents and the Dec 24 2015 $7 put for

23 cents. Almost any variation of the terms qualifies as a

“combination.” In this example the maximum downside would

be $304 per contract.

Both options are out of the money and therefore cheap. The

call is more out of the money but it also has a longer fuse (date

to expiry) in our trade. If the underlying stock falls to $6 before

Christmas then you would have made $10 after commissions

(100 - 23 - 17 - 50) and still have the opportunity to make

money if the stock rebounds and closes above $10 before the

call expires on Jan 15 in the new year. A combination is


116

versatile and you can customize it for almost any situation. But

remember the market can be pretty efficient in pricing future

volatility and risk.

You really have to work hard to find those tradable anomalies.

Investors can also short or sell combinations like straddles to

earn an income but like straddles they are vulnerable to infinite

losses if they can’t cover or deliver the securities.

2) Bull/bear spread (vertical)

A bull spread involves buying & selling a call –simultaneously.

The expiration date is usually the same but the call being

purchased would have a lower strike price than the one sold.

A bear spread can be implemented with either puts or calls.

Whether using puts or calls, in a bear spread, the option with a

higher strike price is bought while one with a lower strike price

is sold, both typically having the same expiration date.


117

In a spread trade the profit and risk both have a maximum

value (i.e., they are limited). The most profit that can be made

is the difference between the higher and lower strike less the

cost of the trade. For example, let’s say you were bullish on the

NASDAQ 100 ETF in the chart above (QQQ) through

February, but you don’t think it’ll be a big move. You could

buy a call flat out as we did in an earlier example of a

straightforward bullish position. The February 19, 2016 $115

‘at the money’ call is offered at $3.44. If you bought this call

your maximum risk would be $3.44 per share and your upside

would be unlimited (theoretically). If, on the other hand, you

thought the market wouldn’t go up that much a bull call spread

may make more sense because the selling of the call at a higher

strike price would reduce the acquisition cost by the value of

the premium.

For example, a 120 call on the QQQ expiring on February 19

2016 is bid at $1.11. As a result, your acquisition cost (per

share and excluding commissions) would be $3.44 - $1.11, or

$2.33; however, your profit would be capped at the difference

between strikes less purchase cost.


118

Here is the trade graphed, above, on a profit and loss graph. In

this case the maximum profit on one contract is $500 less the

acquisition cost of $233, or $267; and your break even point

would by about $17.33 – again this is a simplified model based

on ultimate intrinsic values. In the real world the profit could

vary more before expiry. But the dynamics of the trade (bull or

bear spread) are nevertheless as described – both profit and loss

are capped. There are many kinds of spreads. The bull and bear

spreads in the example above are “vertical” spreads, but there

is also the butterfly spread (involving combinations of bull and

bear spreads and three strike prices), box spread, credit spread,

calendar spreads, delta or ratio spread, and diagonal spread.

By capitalizing on opportunities in this way investors are

arbitraging the market – i.e., this is how the free market system

calibrates and equilibrates any deviations from normal. The

existence of the opportunity is like a call out to traders and

speculators to eliminate it and return the market to equilibrium

ratios. Derivatives are not a destabilizing factor as lore has it.

3) Covered call

Writing or selling a covered call offers investors a way to earn

income (time value premiums) while long and waiting. The

word “covered” means that the investor either already owns the

underlying asset or is buying the asset and writing the call

simultaneously. A call option is sold or written against long

stock on a share-for-share basis (i.e., or board lot for contract

basis). This strategy could be likened to a bull call-spread

where you don’t bother buying the call option, as you already

own the stock, but you still sell the call option with a higher

strike price.

Let’s say we own Freeport McMoran shares as in the earlier

example, and it is still trading at around the $8 level.We want

to hold the shares for the long run but there is a chance that

they may go lower in the short run or nowhere at best.

https://www.cboe.com/learncenter/glossary.aspx#calendarspread

https://www.cboe.com/learncenter/glossary_m-r.aspx#ratiospread


119

We have several options here.

1. Sell the stock and hope to buy it back lower (risk: you

have to buy it back higher)

2. Buy a put as insurance (risk: the cost of the premium

may reduce your return a bit)

3. Sell a call to capture time value (risk: lose your position

and buy back higher)

There are other options but these are the basic three. Number

three is a softer version of #1 because at least you earned a

premium to offset the cost of having to buy it back higher.

Effectively, when you sell or write a call option you are at risk

of having to deliver securities. If you don’t already own them it

is called “naked” writing. If you write a call on a security that

you don’t own and it expires in the money then you must

secure it, typically by buying it in the market. So, for example,

if we sold a February 19, 2016 $7 call on Freeport shares at

$1.35 (last bid), then we can keep that if the stock falls below

$7. But if it is above $7 by the time the option expires then we

would have to buy it in the market in order to satisfy the

contract. If it trades up to $10 then we are obligated to deliver

the stock at $7 anyway.


120

Unless we hedged it another way we’re going to have to buy

the stock at $10. So we lose $3 ($10 - $7) less the $1.35

premium we earned, or $1.65 per share… plus whatever the

cost of buying back a new position assuming we still want to

hold it long term.

That is still better than if we sold the stock at $7 thinking it

would go lower and then end up buying back at $10.

On the other hand, if the stock sinks to $6 from the current

$7.85 then at least we earn a premium that helps offset our

losses.

At $6 the option expires worthless and we still own the shares.

But instead of being down $1.85 we are only down 50 cents.

Basically, your downside is exposed the same as it would be if

you owned the shares but this strategy involves giving up most

of your upside in exchange for a downside buffer in the short

term. It allows investors to outperform the stock if it is not

rising but if the stock is rising this strategy will underperform.

We offered these basic examples as an introduction to option

strategies. As already mentioned there are many books written

on this subject and they are all pretty much the same. The links

provided earlier in this section should help give you some

direction. Option strategies can be used for stocks, bonds,

currencies, commodities, futures or ETFs – all these assets and

financial instruments have standardized options available to

you.


121

SECTION 5.

RISK AND REWARD, CONCLUSION


122

19.

OPTION RISK

The risks in buying options are as follows,

1. limited time and time premium can eat returns

2. options expiring out of the money are worthless

3. on some exchanges there is no secondary market for

options

4. even where there is a secondary market it may be

illiquid

5. regulators may halt trading or interfere with profit

realization

6. if brokerage firm defaults you may lose your trading

capital

The additional risks inherent in writing options are as follows,

1. if they are ‘in the money’ they may be exercised at any

time

2. covered call writers limit their upside if stock rises

3. naked call writers expose themselves to unlimited

losses

4. naked put writers expose themselves to unlimited losses

5. option writers run margin risks, and pay interest costs

6. leverage cuts both ways

There are also risks of compounding errors if your option

strategy is complex, and the terms of trading options may

change at any time. In general, option writers have the

advantage. An option buyer not only has to be correct on the

direction or change in the price of the underlying claim, but it

has to be correct within a specific time frame, and the change

has to be big enough to beat the time premium.

The writers tend to be the smarter money and consist of the

specialists on the floor. They are privy to the order flows and


123

have other valuable information that retail option buyers cannot

have. As a consequence, option pricing is relatively efficient –

it prices in most movements very well. It is only the outlier that

is missed, where the risks are higher.

So, although the writer takes on more risks, the odds favor him.


124

20.

STOCK RISK

Risks related to stocks are numerous,

1. operating risks (costs, competition, changing demand)

2. geopolitical (changing regulatory/legal climate or war

risks)

3. financial (balance sheet, leverage, etc.)

4. imperfect knowledge (and general uncertainty)

5. volatility and the business cycle (systemic risk)

All these factors, and more, essentially mean that when people

invest in stocks their returns are not guaranteed and they may

lose money. What I’ve found is, most people overrate stock

investment (and options trading) as a means to becoming

wealthy. They come into it with their expectations inflated

because of some movie they watched, or because of some

friend they know who became a millionaire overnight. If you

are young and have a high income and your savings are easily

replaceable then you may be able to afford taking risks, but for

most people who may have savings that took them years – or

decades – to accumulate, such risk taking should be restricted

in their portfolio.

We are not advisors per se and our allocation recommendations

are very general. You should decide on how much risk you

want to take. We will highlight opportunities in all the risk

categories but our suggestion is to diversify and keep most of

your savings invested prudently – as per the recommended

weightings in our newsletter. The goal of investing in our

framework is the maximization of returns but with a view to

the preservation of capital over the long term. We aim to

protect wealth from inflation and the boom-bust cycle.


125

The US Securities and Exchange Commission puts together a

nice little summary of things that investors should consider

before investing,

https://www.sec.gov/investor/pubs/tenthingstoconsider.htm

And for the micro caps we may feature there may be additional

risks,

https://www.sec.gov/investor/pubs/microcapstock.htm

https://www.sec.gov/investor/pubs/tenthingstoconsider.htm

https://www.sec.gov/investor/pubs/microcapstock.htm


126

21.

CONCLUSION: PROMISE OF PRECIOUS METALS

In this book we have covered business cycles, instruments,

investment fundamentals and industry facilitators such as

brokers. We’ve also suggested that if you understand these

elements, you will be in a better position to comprehend what’s

coming next. In this conclusion, we’ll provide an example of

how an expanded knowledge base that applies business cycle

analysis to economics provides you with valuable conclusions.

You may or may not want to act on what you decide but even

the process of making the determination is useful. Let’s walk

through it.

We’ve determined that the mainstream presentation of

recession and recovery isn’t really valid. What the mainstream

calls a recovery is merely money printing that swells various

asset bubbles. In late 2015, these asset bubbles began to deflate

much as they did in 2008 and 2001. It is very likely, as we’ve

seen, that the US and the West have been fighting recessionary

trends since the turn of the century some 15 years ago.

If central banks had simply let the recession have its way there

would have been bank collapses and industrial bankruptcies but

the damage would have taken place in a concentrated time, and

more importantly, a true recovery may have taken hold. The

economy could have improved and a longer boom time cycle

could have been generated similar to the one that began in the

early 1980s.

Instead, central banks have showered the world with debt and

created literally hundreds of trillions in new currency.

Now this miscalculation is coming due.


127

The “money stock” that has been created by central banks

around the world is going to begin to leave asset markets. Most

of this is in dollar denominated debt and this means, most

likely, that over time the dollar will weaken and become

subject to increasing price inflation.

Remember, the monetary inflation has already taken place and

inevitably, sooner or later, this leads to price inflation. Within

this environment, central banks have begun to do something

rather surprising: Many have started to become net purchasers

of gold. While the Asian central banks, of course, have been

net gold purchasers for years, the Western central banks

haven’t been nearly as positive about buying gold.

In fact, anyone who observes the relationship between central

banks and precious metals is well aware that the anti-gold

attitude of central bankers filters down throughout the larger

financial industry. For the most, Wall Street is bearish on gold

and silver. Brokers, if you ask them, won’t for the most part

recommend precious metals as part of a portfolio allocation.

Gold and silver are in fact seen as a challenge to the fiat money

printing of central banks. It is easy to print paper but hard to

dig precious metals out of the ground. There is a limited about

gold and silver but central banks can print virtually unlimited

amounts of paper currency. And often they do, especially the

US. All that is changing now. The US – central banks in

general – have been printing non-stop for 15 years in the face

of a sluggish and failing global economy. With no real

recovery in sight, the massive amounts of currency flooding the

world have galvanized the financial sector and provided the

mainstream media with the spectacle of a recovery that doesn’t

really exist.

What has “recovered” are financial assets but this sort of

recovery inevitably leads to asset bubbles and serial collapses.


128

That’s what has been happening in early 2016. The reason for

these collapses has to do with the realization that traditional

central bank monetary stimulation is at an end. It may continue

but central bankers are going to have much less control over

the outcome.

Janet Yellen had hoped to retain control over the money supply

by raising rates but this hasn’t worked out. The world’s

financial situation is too fragile to tolerate a sustained series of

rate hikes, or so it seems as of this writing, that normalized

interest rates seem like an eternity away. Instead, Yellen and

other central bankers are now faced with a steady leakage of

dollars into the world’s economy. Too many countries hold too

many dollars and the dollar, increasingly, will not be seen as a

valuable commodity to buy and hold.

Part of this, as we’ve discussed, is simply the normal outcome

of overprinting. When there is too much of something it

inevitably makes its way into the larger market place, affecting

prices as it goes. But another reason that this is taking place is

because central bankers the shadowy forces that control central

banking actually want it to happen.

As strange and disturbing as it seems, the powers-that-be

continue to pursue their dream of a world currency and a world

central bank. In order to get there, the world’s economy must

be destabilized and that’s what is taking place now.

The world is apparently going to be subject to a continual

series of financial disasters based on what has already been

prepared. Fifteen years of dollar printing in a recessionary

environment have created a kind of perfect storm of monetary

inflation, currency debasement and the inevitability of

continued weak economic performance. Best case is a return to

what took place in the 1970s: stagflation in which currencies

depreciated while economies stagnated.


129

But then as now, one bright spot became noticeable: precious

metals. As economic conditions continued to be shaky in the

1970s and currencies lost their luster, the flow of investments

in gold and silver expanded and became a torrent.

It was a self-reinforcing trend that affected first the physical

metal and then its paper offshoots, most noticeably mining

stocks. Mining stocks always begin to catch fire toward the end

of a business cycle, when people have grown afraid of what

else is happening. This is another reason why we know we

remain in a long-term recession. We can trace the debasement

of dollar against the value of gold and silver throughout this

new century.

Focus not on the dollar’s price action against gold and silver

but on the larger trend and there is a cohesiveness that clearly

indicates we remain in a “golden bull.”

In other words, the paper bull ended around the turn of the

century and only now are we beginning to see the culmination

of the golden bull as precious metals become increasingly

sought after.

This is indeed a “golden” opportunity for investors if they

understand what is taking place and can see past media

obfuscation to the reality of current business cycles and their

outcome.

As the dollar and other currencies lose value against precious

metals, all sorts of explanations will be floated but the reality is

simple enough: We are finally coming to the end of this

elongated golden bull and at the end of every cyclical financial

trend a blow off occurs. It occurred in the 1970s when gold

reached $800 and silver reached $50 and it will occur again

today, sooner or later.


130

It’s not clear how high gold and silver will go but they could

go high indeed against the dollar.

At the same time, mining stocks may provide an extraordinary

opportunity because inevitably the leverage inherent in

securities far exceeds the potential of physical prices.

If you understand what I’m explaining in this final chapter,

then you will be doing yourself a favor if you keep a close eye

on precious metals.

It could be that central banks fight back against the coming tide

of dollar debasement and price inflation but it is just as likely

that they cannot now full control what is about to occur. In fact,

given the central bank buying of gold and silver it may be that

the bankers have decided to welcome the occurrence as it

increases economic chaos and creates conditions that will usher

in a more centralized financial system.

In closing, I would urge you to pay attention to the larger

business cycle that we are experiencing and keep up-to-date

with developments by reading our TDV newsletter. Our

“defensive” strategies are developed with your best interest in

mind and to help make sure you can profit on what is

occurring.

Use the information in this book to plot your strategy going

forward. If you decide to speculate in equities or in precious

metals in particular, please take into account the strategies and

instruments we’ve presented in these pages. Or follow our

ideas in the TDV newsletter.

Remember, the point is to invest “defensively” if you wish to

invest at all. Use your powers of observation and apply

business cycle analysis to the positioning of your portfolio

whether you are working on your own or with someone else.


131

Again, if you have questions or problems, please don’t hesitate

to contact us. To the degree that we are able, we’ll be

responsive to you. You’re a valued member of our extended

family, and we want you to succeed. When you succeed, we

do, too.

Good luck!

defensive investing - the dollar vigilante · investments. you’ll want to keep this kind of...

Documents