The passive investor
The passive investor makes long-term investments: for example, he will buy a stock or a fund and will hold it for years, as part of a buy and hold strategy. For decades, this strategy of buying for the long term had many advocates, because average annual stock market indices had risen since World War II. However, with the events of the past few years, this strategy has lost some of its lustre.
Chart 1 illustrates the monthly performance of an exchange-traded fund (ETF) with the ticker symbol XIU. This fund replicates the performance of the S&P/TSX 60 Canadian index, which is composed of the 60 biggest stocks on the Toronto Stock Exchange. An investor who purchased this ETF at $12 per share in early 2004 would have made profits until 2008, when XIU rose above $22, and would have kept his position to profit from a further increase in price. However, shortly thereafter, this ETF tumbled back to $12.
On the U.S. market, the strategy of buying for the long term has produced even more disappointing results. Chart 2 shows the Dow Jones Industrial Average, which is composed of 30 large cap U.S. stocks. An investment made in 1996, when the Dow was at around 6,000, would have lost, 13 years later, in 2009, all the gains made, because the Dow, after hitting 14,000 a few months earlier, quickly plunged to around 6,000.
In the case of the Dow Jones, one could argue that the index was at 1,000 in 1977 and that at the time of writing this article, it is at 12,000, which represents a considerable gain. However, it took 34 years to do so – which is too long – and one must also take into account inflation, which over those decades has reduced the purchasing power of the dollar to less than one sixth of what it was in 1977.
The active investor
Active investing requires a high level of knowledge and experience. Novice investors would therefore opt for less complex strategies than advanced investors.
The novice active investor
Novice active investors can stick to exchange-traded funds (ETFs). As we saw above, a traditional ETF like XIU simply mimics the overall performance of the Canadian stock market by replicating the S&P/TSX 60 Index. This index is composed of the top 60 Canadian companies in terms of capitalization, soundness and earnings continuity.
When is the best time to buy or sell this index? One of the many technical analysis tools available is the EMA or Exponential Moving Average, which is practical and simple.Chart 3 illustrates this technique. The blue line represents the 27-day average and the yellow line, the seven-day averagefootnote 1.
When the yellow line crosses above the blue line, we have a buy signal. In Chart 3, the last such crossover occurred in late August 2010, at around $17.25. A sell signal is given when the yellow line crosses below the blue line. However, since August 2010, the two averages have not crossed. On the far right of the chart, we see that on March 10, 2011, XIU was trading at $19.75.
With this method, an investor holding XIU at that point will have made a profit of two dollars if he had bought at $17.25, which represents a return of about 12% in seven months, or 21% on an annual basis.
When the yellow line crosses below the blue line, the investor will sell the ETF and wait for a new buy signal. If the investor’s type of account allows it, he can, at the same time as he closes out his long position, sell short the ETF to profit from a decline. He will subsequently close out his short position by buying back the shares at the same time as he buys XIU to profit from the next upswing.
The two averages technique, like most technical analysis tools, only signals the beginning of a trend, without indicating how long the trend will last. So it's simply a matter of acting on all the signals.
An investor who uses this strategy doesn't have much to do other than wait for the signals, which often come at long intervals, as we can see in Chart 3.
The intermediate-level active investor
If an intermediate-level active investor wants to be even more active, he can trade stocks – because the choice is greater – and use technical analysis tools that give more frequent signals, in order to profit from a series of lows on the market.
The big question is how to choose the stocks to add to one's portfolio. The investor will have to consider the financial ratios of the companies that interest him (this is called quantitative analysis) and know how these companies are managed on a day-to-day basis (this is called qualitative analysis). However, most investors are not interested in this type of analysis, because it is a highly specialized exercise and too time-consuming.
A quick and simple way to identify a number of quality stocks is to get a list of the companies that belong to conservative indices, like the S&P/TSX 60 in Canada, and the Dow Jones and S&P 500 indices in the United States. In other words, the active investor will choose from among the stocks that specialized financial institutions have already analyzed and selected because of their soundness, their reputation, and their high trading volume.
The fact that a stock does not belong to one of these indices does not mean that it should be excluded, but it will take more time and effort for the investor to evaluate it himself.
From a technical analysis standpoint, this type of investor can use the Exponential Moving Average (EMA) method described above and apply it to many stocks, or use the MACD (Moving Average Converge Divergence). This tool can signal turning points in the market before EMAs do, in addition to identifying minor moves within a major trend.
The lower part of Chart 4 illustrates the MACD. The signals are as follows: when the blue line crosses below the red line, we have a sell signal, and when the blue line crosses above the red line, we have a buy signal.
In the upper part, we have a bar chart of AGU with Exponential Moving Averages (EMAs) of seven days and 27 days. Note that the signals given by the MACD are more frequent than those given by EMA crossovers, because this method also signals minor moves, which EMAs cannot do. In addition, MACD signals are given earlier than the same signals given by EMAs. For example, the MACD sell signal in late October preceded the EMA sell signal in mid-November, which was given at a lower price.
The advanced active investor
An advanced active investor will apply the above-mentioned techniques and add options to his portfolio as well. The most common strategy is covered call option writing.
The strategy is as follows: after buying, for example, 1,000 shares of Agrium (AGU) at $86 ($86,000), the investor writes ten call options with an April expiration at a price of $4 per share. This exercise produces an inflow of funds – a credit in the account – of $4,000 ($4 per share X 100 shares per option)footnote 2. If, at the expiration of the options (the third Friday in April),the stock is still at $86, the value of the options is zero. By buying them back now when they have no value after having previously sold them for $4, the profit on the 1,000 shares of AGU will be $4,000. A tidy sum.
If the stock drops, the premium of $4 per share acts like a “cushion”: the price can drop to $82 before the investor starts to lose any money. In other words, writing covered calls lowers the breakeven point on the stock from $86 to $82.
If the stock rises to $90 or more, the maximum profit is $4 per share, because the investor must sell the shares at $90. In this case, as in the case where the stock remained at $86, the profit is consistent, considering the short time elapsed between the date on which the options were written and the third Friday in Aprilfootnote 3.
It should be noted that an investor who uses this strategy believes that there is a low likelihood of a sharp rise in the price of underlying stock. This is why they are willing to renounce any gains above $90.
This strategy can be used for any stock on which options are traded. It can generate a nice profit, especially if this strategy is employed using technical analysis.
- The numbers 7 and 27 were chosen for illustration purposes only. Investors can change these parameters if they think it will produce a better result.
- The prices indicated are those of March 10, 2011. The premium of $4 per share translates into a credit of $400 per option, because option contracts are for 100 shares. The investor cannot pocket the amount credited if the option position is open.
- If at expiration the shares are trading at $90 or more, the investor will be obliged to sell the shares at $90, because the option will be automatically exercised. The investor will have purchased the shares at $86 and will be forced to sell them at $90. He will thus have made a profit of 4.65% in a little more than five weeks (or 48% on annual basis).