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Rookie Blog: Speculation Anyone?

June 10, 2021

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Good day all, In this week’s blog I want to talk about something that I have held off talking about for as long as I could. For anyone who knows me, you would know that I tend to err on the side of being conservative when it comes to investing and trading. I prefer to “stay in my lane” when it comes to putting my hard-earned to work. This is probably why I was given the “Old Money” moniker. I am constantly asked about penny stocks and my canned response is that they typically carry way too much risk and they are very vulnerable to manipulation due to lack of liquidity and potential price issues. I am also asked quite frequently about things like bitcoin and I also approach that with great caution as well due to its extreme volatility. As you can see there is a bit of a pattern here, I tend to stick to things I have some knowledge and familiarity with and this has done me a great service for most of my trading life. This is not to say that I haven’t missed out on some major trends but I believe I have also missed out on just as many disasters as I have opportunities. This brings us to this week’s topic, I can’t believe I am going to say this…but here goes… this week we are talking about MEME stocks in the rookie blog.

For the uninitiated MEME stocks have been all the rage lately. By lately I mean for the last six months or so these stocks that are shall we say…fundamentally challenged have been driven to new heights. The first of these stocks that popped up on the radar was GME (Gamestop). This stock and for that matter business was left for dead. The business was not making money and for all intents and purposes was bankrupt but yet the stock went from a low of $3.77 to as high as $483. The price of the stock at this writing is around $300 and yet fundamentally speaking the company hasn’t changed. This activity has been classified as a short squeeze. For those who do not know what a short squeeze is, here is a very brief explanation. Essentially there were large bets on the short side or downside of the stock and yet buyers stepped up and started driving the price upwards until the “shorts” get forced out of their positions and then they, in turn, become buyers, and the stock skyrockets. This euphoria becomes a self-fulfilling prophecy and a vicious circle until the price gets so high that the buyers become exhausted and then the stock has no more fuel to rise and comes back down to earth. This has occurred with a number of stocks, not just a bankrupt gaming company, but a bankrupt car rental company, a near-bankrupt retailer among others.

The latest of these companies has been a movie theater company that has had challenges due the current pandemic conditions. The reason I am bringing up these stocks after being a strong opponent against having anything to do with them is because I believe there are responsible ways to speculate and it can be on a MEME stock or really anything one chooses and it ultimately comes down to controlling the risk. So if you want to speculate do it with control and you may live to speculate another day metaphorically speaking.

Here are three ways to control risk when speculating,

  1. Choose to not play the game. This one is very self-explanatory. You should never speculate with money that you are not willing to lose outright. Don’t bet the rent money or the kid’s college fund and you should be fine. This is sage advice for those who are new to speculation as this game is not for the faint of heart.
  2. Use a fixed risk instrument. This is the ultimate in risk control. Using straight options to speculate ensures that one can only lose whatever the cost of the options happens to be. The problem with straight options is you have to be absolutely right on direction and magnitude to cash in. There is also another massive problem that can sneak up on the folks who do not really understand the options they may be using and that is the problem of volatility. Options can get more expensive or cheaper depending on what implied volatility is doing. The real big problem is that options can get so expensive that even if one is right on direction and magnitude that money will still be lost because the options prices have become too saturated. This is a scenario that a lot of folks have never experienced and are seldom prepared for as it requires a thorough understanding of how options work.
  3. Use Spreads. This technique can fix risk and offset some of the damage of volatility due to the fact that this involves both buying and selling options so even if prices are extreme one is using both sides of the system so “there” can be a small negating effect. Ratio spreads can take advantage of volatility swings very well but must be constructed in such a way as to fix the risk to the upside and downside. This takes a solid skill level and understanding of options spreads but can prove to be effective in certain cases.

After reading this list I hope you can see that speculating with control is the right way to go. Everyone wants to make lots of money and catching the ride of one of these MEME stocks has the potential to do that very thing but there is also an inherent danger as well. For example, GME went to $483 as a high which means someone bought that stock at that price and as of today’s price if they have not already sold it at a bigger loss then they are underwater by approximately $181 per share. This has a way of crippling even the most hardened traders.

So be safe and speculate responsibly.

Coach “Old Money” Holmes

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