Economists usually apply the phrase “animal spirits” to an emotional stirring that leads to a buying frenzy like the Internet craze of 1999, but it might also apply to the gloom that sets in during a market panic. Animal spirits overwhelm the facts on hand and drive prices far above or below expected values.
Of late, animal spirits set in whenever our dear leader’s gut gets an idea that finds its way to a Tweet, that short and least subtle communique that excites or disgusts, and provides no detail. A Tweet is pure animal spirit, and we scratch our heads as the market moves in apparent reaction.
What happens next? Will rates go down? Will a trade war kill off sales? Is employment up? Will we go to war with Iran? Will a new technology take off? Will we alienate our allies? Will the trade war suddenly abate? Will we be buried by debt? These questions invoke our animal spirits.
One might also think of the market in terms of music theory. The piece begins with a chord; dissonance and syncopation engage the ear; the key moves up; the time slows down; the dissonance resolves to a final, pleasing, resounding major chord — or dissolves into an ominous, minor, sad denouement. Many attractive or alarming voices emerge, but the theorist hears an over-arching trend.
Today that trend is the application of powerful, cheap, and universal technologies to the reinvention of our lives: massive digital storage, clever pattern recognition, faster communication, and insightful analytics. We see it already in the way we buy goods and entertain ourselves: Amazon fills our orders and Netflix fills our time.
If you had the resources you would tap every source in the digital world to measure the sentiment of animal spirits and optimize your investments in trends. You would score all the negative and positive words written or spoken about a particular stock, and you would combine that with a general fear or ebullience market score. You would see how similar scores affected price movements historically, and you would have some idea of how animal spirits might move prices in the near term. With your teams of data scientists and petabytes of data, you would quickly get more sophisticated, which is how the best fund managers pay themselves a billion dollars a year.
You and I, though, are in the data desert. We may see trends, but we have a murky window on the broader sentiments that can crash a stock or the market — and we cannot react as quickly as the data elite when an event blows up the trend. One way to optimize a trend while limiting one’s downside is by buying call options.
A call option is the right to buy a stock at a certain strike price for a certain period of time. The closer the strike price to today’s actual stock price, the higher the cost of the option. For instance, if today’s stock price is $10, there is a higher likelihood that it will hit $11 than $15. Let’s say that you think the stock is going to $25, and you decide to buy a call option at $15. You are buying the option from someone who owns the stock, and that person might think, “This stock has never hit $15, and I don’t think it will go up 50 percent in the next six months, so I will gladly sell you the option for $3, and pocket that money.”
Let’s say you are right: the stock hits $25. Your option is worth at least $10 — the difference between your $15 strike price and the $25 current price — and it could be worth more depending on how quickly the price accelerated toward $25 and the time left on your option. If the stock is rocketing upward, the value of the option tends to surge higher. If a lot of time is left before the option expires, the stock has more time to perform, and the option value tends to be higher.
Let’s say you have a small premium on your option, so now it’s worth $12. You invested $3 and have made $9, or 300 percent. Had you bought a share of the stock, you would have invested $10 and made $15, or 150 percent.
Options are traded in lots of 100, so your $3 option costs $300. Also, if your option expires at less than the strike price, the option expires worthless. People like to say that “80 percent of options expire worthless,” but the truth is that about 10 percent of options are exercised to buy or sell the stock, about 60 percent are closed prior to expiration, and 30 percent expire worthless. Still, even if your options expire worthless, it is interesting to note that the loss of the entire option can be less than the loss that you might have sustained if you owned the stock in a market crash. For instance, let’s say the price of the stock in our example declines by 50 percent: instead of losing $300 for your options, you are down $500 on your stock.
Here are three real-world examples:
On January 23, I profiled Universal Display (OLED). It was worth $97 a share, and, since then, is one of 12 stocks that have doubled in 2019. Like Qualcomm (QCOM), OLED is a patent-licensing company that effectively controls an important technology. In February QCOM had a market cap of $62 billion, and OLED had a market cap of $5 billion. It seemed to me that OLED could climb much higher in the next two years, so I bought the January, 2021, call options at a strike price of $140 when the stock price was $110. Since the strike price was out of the money, the option price was only $25. As the stock price climbed to $211, the option price rose to $91, a 260 percent gain — as compared to the 90 percent gain in the stock that, at $110 a share, would have tied up significantly more cash.
My Skechers options have not worked out as well: also in February, I bought Skechers (SKX) January, 2021, options at a $45 strike price. In July SKX stock climbed to $39, and the option was up 45 percent. The stock is back down to $31 now, and the option is down 45 percent. However, I still have another 16 months to see if SKX succeeds. I don’t understand the shoe business, but I observe that shoes magically appear in our house. The hallways and closets fill with them. People buy lots of shoes, and the entrepreneur behind SKX has founded two major shoe companies.
Alteryx (AYX) is a data analytics company whose sales rose from $131 million in 2017 to $253 million in 2018. It also turned its first profit of $29.8 million. I bought AYX $140 June, 2021, options at $36. So far, I am up 10 percent, and I could have an outstanding return. If the country crashes for any of the reasons mentioned above, my loss is limited and probably less than the loss I would have sustained had I bought the actual stock at $140.
These investments could also grow in the next two years.
NICE (NICE, $153). A profitable Israeli company that is consolidating the contact center software market. Its $4.1 billion market cap would make it a good acquisition target for Salesforce, Microsoft or another company in sales software.
Trade Desk (TTD; $247). Digital advertising with astonishing growth in revenue and profits, and a $10.2 billion market cap. This seems like a natural acquisition for any of the big digital companies.
Immersion Technology (IMMR; $8.47). Like QCOM and OLED, IMMR is a patent-licensing company with 3,500 patents for haptic technology. IMMR is burning cash, and down about 6 percent since I recommended it here. However, IMMR is focused on an important technology and has a market cap of only $272 million. If its scientists succeed in developing new haptic applications and patents, it is a likely candidate for outsized returns.
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