The Importance of Long Term Investing

Whether you’re a net buyer of options dreaming of triple digit returns in a matter of days or weeks (and sometimes realizing those dreams), or whether you’re a net seller of options writing credit spreads and striving to produce a viable and lucrative monthly cash flow business, once you’ve experienced options, it’s hard to ever go back to straight buying and selling shares of stock.

Passive investing, be it through mutual funds, index funds, ETFs, or even some long forgotten buy and hold stock you’ve owned for years in an ignored account somewhere, is as incomprehensible to the options trader as obsessively analyzing a stock’s price chart to determine short term areas of support and resistance is to the long term investor.

And yet, the options trader can learn a thing or two from the long term investor. It may seem odd, even counterintuitive, to suggest that short term instruments such as stock options be associated in any way with a long term horizon, but there are a number of powerful advantages to investing for the long haul, advantages that anyone interested in creating wealth would do well do consider:

1. Long term investing makes it easier to focus on only high quality companies. How many times have we gotten ourselves in a predicament over the options of a stock whose shares we would never consider owning ourselves unless we were forced to do so at gun point? When our criteria for selecting an options trade primarily involves amounts of premium and current chart technicals, we can easily find ourselves trafficking in mediocre securities. And mediocre securities, we learn through painful experience, are not always as predictable or as well-behaved as their charts suggest. [for additional insights, see the related article, "Quality Investing."]

2. Long term investing gives you time to recover if your position moves against you in the short term. Successful option trading requires not only that you be right about what a particular stock will do, but that you also be right on the timing. That's quite a combination. The long term investor, however, only has to be right on the first part. By excluding near term timing requirements, the long term investor has the luxury of being protected against short term volatility or market irrationality.

3. The long term bias of the stock market is higher. Long term, the outlook for most solid investments is relatively certain. Invest in quality companies at reasonable prices and then wait. In almost every case, you’ll have good returns and a substantially higher net worth than if you’d just squirreled your money away in a money market account. And yet we option traders are invariably drawn to place trades in the short term where, no matter what our charts tell us, the outlook is far less certain. Yes, you can make a lot of money real fast in the options markets, but let’s be honest. For most people, it's difficult to do so consistently. And you can also lose a lot of money just as fast.

4. Long term investing (eventually) leads to automatic outsized returns. Ultimately, this is the most powerful lesson that long term investing teaches us. It's the classic tale of the tortoise and the hare. The tortoise's formula for success is virtually guaranteed: consistent and reasonably good rates of return + the power of compounding + a long term time horizon = sustainable (and self-sustaining) wealth. [for a powerful illustration, see related site article, "High Dividend Stocks and Option Trading."]

Scenario 1 - Assume you make a $10,000 investment in a safe and stable stock paying a 3% dividend. And assume two other things — that the dividend grows by just 5% a year and that you spend the dividends rather than reinvest them.

After 30 years, your original investment would be generating a 12.35% annual dividend. And, thanks to the power of compounding, assuming the dividend continued growing 5% yearly, the dividend rate based on your original investment would be accelerating. Wait another five years and the rate jumps from 12.35% to 15.76%.

Double digit income with below average risk and no effort on your part. Isn't that pretty much every option trader's dream? Granted, you'd have to sit around and find something to do for three decades waiting for all this easy money to start coming in, but keep in mind that Scenario 1 is based upon some very conservative numbers and assumptions.

First, we didn't reinvest the dividend (in which case our returns would really benefit from the power of compounding). Second, we assumed a very conservative 5% dividend growth rate. Third, we started with a fairly low dividend base of just 3%. And, if we were willing to wait 30 years or more while doing absolutely nothing, we still came out pretty good.

Scenario 2 - Assume you make the same $10,000 investment in the same safe and stable stock paying a 3% dividend. And, as in Scenario 1, the dividend still grows at 5% a year and you spend those dividends instead of reinvest them.

But instead of passively waiting for the decades to roll by, you choose to employ some relatively basic and safe Leveraged Investing option trading strategies from The Essential Leveraged Investing Guideto help you and time out a bit.

The result is, that in addition to the dividend payout, you use options to generate additional modest amounts of income.

It's important to note that dividend income is income from the company's underlying business. It's part of the profits and profits are why you invested in the first place. Option income, however, is income from your efforts. And the net effect of option income produced by a stock position you hold is that it reduces your original cost basis.

So let's assume — very conservatively — that through the use of options, you generate an additional 2% of income per year based on your original investment. That works out to be just $200 a year. Even on a low volatility (and therefore low premium) stock, that's still a very low bar. The net effect is that the option income lowers your original cost basis by $200 a year.

Let's assume further that you continue lowering your cost basis by just $200 a year. As the current value of your stock position grows over time, that $200 becomes easier and easier to attain because the option pricing is based on current stock prices, not the price at which you originally invested (a $1 movement on a $5 stock represents a 20% move while a $1 movement on a $100 stock represents only a 1% move).

At the end of 30 years, your dividend rate alone wouldn't be 12.35%, but 29.40%. And after 35 years? The traditional long term investing tortoise would be collecting an impressive 15.76%, but you, the hybrid tortoise-hare, would be banking an astounding 49.25% dividend rate.

It's important to note that the dividend amount received in dollar terms is the same in both scenarios. The Scenario 2 investor receives the same dividends as the Scenario 1 investor. The difference is that the Scenario 2 investor is constantly lowering his cost basis. He is, in effect, receiving rebates every year that—unlike the dividend—he must reinvest in order for this scenario to be viable. He may reinvest those rebates in additional shares of that stock or in some other investment which, in turn, produces additional income and, presumably, additional rebates that lower the cost basis on that investment. It's in this way that the returns of Scenario 2 completely blow away the returns of Scenario 1.

Finally, keep in mind, that the original assumptions of these examples are very conservative. Using options to lower your cost basis by 2% is not particularly difficult. And you can find numerous quality stocks with a dividend yield higher than 3% and with a dividend growth rate of more than 5%. Increase any of these numbers by even a small amount and you'll still have to wait for your guaranteed double-digit returns, but you definitely won't be waiting three decades.

[For additional information and specific examples of this approach to investing, see related site article, "Adjusted Cost Basis with Options."]