Editor's note: This is a special column from the recent winner of TSC's Investment Challenge.
From Feb. 17 through April 7, the
Dow Jones Industrial Average
rose 5.2%, the
was basically flat, up 0.4%, and my portfolio in
TheStreet.com Investment Challenge
soared 526%. So there's just one conclusion you can draw from that, right? I'm just another daytrader who sits in front of his computer for 10 hours a day.
Well, the truth is that I'm a college freshman at
who spends no more than an hour on most days watching or researching the market. But I was an early convert to the markets.
In eighth grade, my math class had a stock market competition. While most kids bought stocks they knew, like
, I searched a newspaper for companies that were far away from their 52-week highs. In my infinite wisdom, I figured they had plenty of room to go up.
Needless to say, I'd bought a bunch of horrible stocks that I'd never heard of, and I didn't do too well. But an interest was sparked.
During my junior year, I entered a team into a nationwide high school investment contest, and a friend of mine introduced me to the idea of options contracts. Over the next few months, I closely watched options prices and came to understand their intricacies. No matter how many articles you read or experts you listen to, there's no substitute for sitting there and seeing the numbers for yourself. We fared quite well, in part because few high school students knew about options. However, in a final attempt to win, we made some bad calls, and we fell substantially.
So all that prepared me for the
Like everyone else, I started out with $500,000 in play money. To make sure one lucky pick wouldn't decide the contest, there were diversification requirements. Contestants couldn't put more than $200,000 in one stock or $50,000 in one options contract. So I decided that with these restrictions I'd have to trade options because stocks aren't volatile enough to generate substantial returns. Daytrading equities could've been a good strategy, but if you start having to follow 15 companies a day as your portfolio grows, it simply wouldn't be worth it. Besides, I had to go to class once in a while!
So here's what I did: I divided the contest into three parts, one for each options expiration that I'd face. My goal for that time period was to try to guess which way the market would move. Through the use of some technical analysis, some intuition and quite a bit of luck, I did a pretty good job of calling the indexes. After picking what direction I thought the market would go in, I would buy either all calls or all puts. (Buying a call is a bet that a stock will rise, while buying a put is a bet that a stock will fall.)
Then I loaded up with companies and their respective options that I thought would follow the market. For the most part, I stuck with tech stocks that moved with the Nasdaq. But there was more to my stock picking than macro issues. Aside from picking the typically volatile stocks, which have the highest options prices, I also tried to choose stocks that I thought would move more than they normally do, and would thus overcome their smaller options prices rather quickly.
For example, a 5% move in
stock price might make me more money in its options than I would make in
options if the underlying equity moved 20%. My portfolio generally consisted of a combination of out-of-the-money options, especially in companies in which I saw extraordinary volatility coming, and in-the-money options for assorted companies, so I could have a little less volatility at times. (In-the-money options aren't as volatile because they already are above their exercise price.)
Hanging in There
The key was sticking with my choices. If I was wrong on the market for a few days, I hung in there and let it turn around. Because of the diversification requirements, I would rarely sell options, especially those that I made a lot of money on. For example, on Feb. 23, I purchased 300
42.5 March calls at $150 each when the stock price was around 40.
In this case, an analyst had come out strong on Dell on a bad day in the market, so the stock didn't catch fire. But pretty soon Dell started flying up, and soon enough I had turned $45,000 into $150,000. Now ordinarily, one would sell on such a great profit, but because I was able to control 30,000 Dell shares, each point the stock went up, I made $30,000. So when the options expired on March 17, Dell was at 56 1/4. My initial $45,000 investment turned into $412,500.
By March 20, I was doing quite well, so I went in for the kill. I went short on the market with about half of my portfolio, but left the other half in cash to make more investments later. By March 26, the Nasdaq had run up about 600 points, and I was dropping quickly. But because I couldn't lose much more, I hung in there. The next two days, the market dropped a little, and I thought that we had seen a temporary top, so on March 28, I put everything I had into highly out-of-the-money puts; I had to make up a lot of ground quickly.
A Big Bet
Then the market started falling, with the Dow and Nasdaq down big intraday on April 4. Unfortunately, I was stuck in a lecture while this was occurring, but when I got back, the market was still down about 200 points. I dropped every single position I had. At this point I figured I'd made enough money to secure first place.
I decided to go with the late-day upward momentum, so on April 4, three days before the contest ended, I put everything I had in calls. Sure enough, the market jumped a few hundred points to end the week, and I made 40% to 50% in those three days alone with 200% gains in
options. My final total was $3,131,438.62.
It may seem that my strategy would apply only to an investment contest using play money, but in reality, you could easily take a
percentage of your portfolio and chase those tremendous returns. The key is leaving some money aside and putting it in only when you have a great feeling about something. Look for good news on a company on a day when the market is doing poorly, or try to call a top or bottom on the market after a large move.
But most importantly, trade the options of stocks you know. If you follow a company long enough, it's much easier to spot trends. If you don't feel comfortable predicting the movement of individual companies, then trade index options. During the competition, big market swings made me upwards of 200% on
or Dow options that I would hold onto for a couple of weeks.