Are You Making This Profit-Killing Mistake?
I study a number of great investors because I believe success leaves clues. Every buy and sell decision Warren Buffett makes tells us more about his process, and those insights can help us create our own success.
While you’re obviously familiar with Buffett, you might not be familiar with Lynn Tilton. She is CEO of the $8 billion private equity firm Patriarch Partners and one of the more obscure investors I follow.
Tilton has a number of critics and has seen her share of controversy. I am not in any way expressing an opinion about that controversy or the charges recently filed against her by the SEC. But many of her investments have been uncontroversial and successful, and we can learn a great deal from those.
Tilton is known for her ability to turn around struggling companies in basic industries and is credited with saving 700,000 jobs at the roughly 75 companies Patriarch invests in, including MD Helicopters, Stila Cosmetics and Gorham Paper and Tissue.
One of Tilton’s favorite jokes plays off of the work she does bringing these companies back to life. It’s about the three “universal lies” people tell. The first is, “Margins are weak, but we’ll make it up on volume.” The second is, “The check is in the mail.” And the third… well, the third would probably get me fired if I included it here.
Margins are the amount of profits a company reports expressed as a percentage of sales. Weak margins indicate a company is only earning a small amount of profit on each sale.
Now, if you’re a big-box retailer like Wal-Mart (NYSE: WMT) that has giant sales volume, weak margins aren’t such a big deal; you’ll still report a large profit in dollar terms. But that’s not the case in all industries. Many manufacturers cannot become profitable by increasing sales unless profits margins improve. This is because operating capacity is often limited.
If you own a factory, the floor space only allows room for so many machines, and each machine has a finite production capacity. When you operate at full capacity, the only way to increase profits is to increase the price you charge for your output or decrease operating costs.
Option sellers face the same problem as manufacturers. If we have weak margins — in our case, the amount of profit we keep after trading costs — we will have limited success.
Note: If you’re unfamiliar with selling options to generate income, I urge you to check out this free eight-minute tutorial. It is a step-by-step guide to selling put options, a strategy I have used to close 85 straight winning trades with an average annualized gain of 53%. Click here to access it.
As option sellers, we can try to increase our profits by increasing our volume, but just like manufacturers, we have limited ability to do this. Each trade we make requires the use of capital, which is a limited resource for all of us. Since our money is limited, we cannot create great wealth with weak margins.
So, how does an option trader improve margins?
In our “business model,” a primary cost we have some control over is the commissions we pay on each trade.
High commissions can limit our opportunities in hundreds of stocks. For instance, some people use brokers that charge $30 commissions to place an order. Because of the way options are priced, finding trades that will still be profitable means eliminating many stocks that trade for less than $35 a share.
Now, selling options on lower-priced stocks doesn’t mean we’re settling for low income. Low prices on options means we can look at low-risk trades in high-quality stocks selling at low prices.
Even with lower premiums, we can maintain high income because these trades require lower margin deposits. You can also increase your income by trading more contracts of a lower priced stock than a higher priced stock for a comparable level of risk in dollar terms.
I reviewed what discount brokers charge for options trading using the Online Broker Review and have included a list of several that provide great service at extremely low costs in the table below.
Brokers change commissions and fees from time to time, so please fully research any brokerage firm and confirm its fee structure before opening an account.
In addition to commissions, some brokers charge exchange fees and other fees. It’s extremely important that you fully research a broker to understand all costs. While I cannot recommend a specific broker, this can serve as a starting point for your own research.
Using the Online Broker Review, I also calculated the cost of commissions for trading 10 contracts at a time.
Notice there is a relatively small increase in commissions for each additional contract. This means if you can find trading opportunities that require smaller margin deposits, you could trade more contracts and generate additional income.
(To personalize this information, you can use the Online Broker Review to calculate the costs for any number of contracts. The site also shows the cost of exercising options, which should be considered.)
I recommended put selling trades each week in my Income Trader service. If you’re interested in collecting anywhere from $45 to $1,300 this week, you can learn more here.