A Lesson from the S&P 500 — Don’t be Afraid to Trade

If you’re still a “crock pot” investor — one who buys a stock and forgets about it — here’s a lesson from Standard & Poor’s that should make you think twice about that outmoded way of investing.

For starters, Standard & Poor’s is the firm behind the widely followed S&P 500 stock index. Even though major media still focuses on the Dow Jones Industrial Average when discussing the day’s market action, the investment community relies on the broader measure of the market found in the S&P 500. How much broader is the S&P 500 than the Dow Jones Industrial Average? As the name implies, the S&P 500 is comprised of 500 stocks. The Dow Jones Industrial Average, however, is made up of only 30 stocks. That’s one of the reasons why the S&P 500 is probably the most popular benchmark against which stock market investors measure themselves — and so should you.

One less obvious attribute is that the S&P 500 is not static, and its holdings are not at all the same as they were when it was first conceived. That’s right, the S&P 500 has experienced a fair amount of turnover — since 1980, more than 320 companies have been deleted from the S&P 500. That’s almost 10 a year, each year, during the last 34 years!

There are a number of reasons why companies may be removed from the index. They were acquired at a premium to their current price; they merged with other companies in the index; they reincorporated outside the United States; or they may have had a “business problem.”

Though this may seem to be a surprising amount of turnover at first, it makes sense that it would have changed so much, if you think about it.

As subscribers to my investment newsletter PowerTrend Profits know very well, the competitive playing field for companies is fraught with many pitfalls. These include changing competitive dynamics, disruptive technologies that have industry-shaking repercussions, supply chain dynamics, regulatory mandates, demographic drivers and much, much more. If a company’s management isn’t paying careful attention and preparing to adjust to meet changing conditions actively, the results can be disastrous. And if you’ve invested in a company run by such a management team, you know the pain to your portfolio firsthand.

I see the adding and subtracting of companies in the S&P 500 as “creative destruction,” or a process that changes the composition of the portfolio by exiting certain positions and replacing them with new ones that reshape the portfolio. In just the last few months, here’s how the index has changed:

  • December: Added Royal Caribbean Cruises Ltd (RCL), removed Bemis (BMS);
  • November: Added Level 3 Communications (LVLT), removed Jabil Circuit (JBL);
  • September: Added United Rentals (URI) and Universal Health Services (UHS), removed Peabody Energy (BTU) and Graham Holdings (GHC).

There are two lessons to be learned here. The first is that many think investing in the S&P 500 through an index fund or exchange traded-fund (ETF) designed to mimic the index is passive investing. As we’ve just discussed, “passive” is a bit of a mischaracterization, as the index is much more active than not. Second, just as the S&P 500 is creatively destroying its holdings, you, too, should be on the lookout for new holdings that offer better risk-to-reward positions compared to ones that you’ve been holding, particularly if their business model is becoming challenged.

Timing is Everything When Choosing an Option’s Expiration Date

One of the best ways to invest from a risk-to-reward perspective is using options, and during the last two weeks, I’ve pulled back the covers on trading options. First, I shared with you that more than 70,000 investors made their very first options trade in the last 12 months. Next I shared with you more details on what a strike price is when it comes to picking options, as well as the difference between in-the-money and out-of-the-money calls. This week, I’m going to talk about the importance of strike prices.

While the mechanics of buying and selling options are similar to trading stocks, there are a few differences — and one of the biggest, if not the biggest, is that each option contract has an expiration date. Usually, the expiration date for an option dated for a given month is the third Friday of that month. In my example from last week, the expiration month on the LifeLock (LOCK) February 2015 $17 calls is February of 2015, and the third Friday of that month is Feb. 20.

Identifying and picking the right expiration date can lead to a very successful trade — or it can be a disaster if you simply pick one out of the blue. For each options contract recommendation I make in my PowerOptions Trader service, I not only use PowerTrend investing to identify the right underlying security, but I also look for catalysts during the coming weeks and months that should drive both the shares and the options contract higher.

A great example of this was the United Parcel Service (UPS) January 2015 $100 calls that I recommended back in August of this year. The shift toward online shopping is part of my Always On, Always Connected PowerTrend, and while that trend has been growing each and every year, all the data was pointing toward an even bigger acceleration this year. In the world of online shopping, each package has to be delivered to its recipient somehow. I picked the January 2015 expiration date in order to capture shopping ahead of the holiday season as well as after. As the favorable online shopping data kept rolling in, I recommended my PowerOptions Trader subscribers sell half the position in early November for a 230% gain and then exit the rest of the position a week later, booking a 269% return on the remaining position. All told, PowerOptions Trader subscribers had the opportunity to book an average 248% profit on that one options contract.

As you can see, picking the right expiration date can make all the difference. As I said last week, once you understand the lingo associated with trading options, it’s as easy as buying and selling stocks. If you trade wisely, you can reap big rewards with far less capital at risk. (I’ll prove this to you, once you decide to give PowerOptions Trader a 3-month “test drive” for just $99. But do hurry — this end-of-year special savings is good only until midnight on December 31, 2014. Click here to take advantage.)

In case you missed it, I encourage you to read my e-letter column from last week about the Sony crisis and the increasing demand for cybersecurity. I also invite you to comment in the space provided below my Eagle Daily Investor commentary.