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How Some of the World’s Best Investors Use the Stock Market

The difference between amateur and professional traders

As part of my involvement with Robert Kiyosaki’s book Unfair Advantage, he asked me to discuss the difference between amateur and professional investors. The difference is huge.

With their lack of understanding, amateurs generally try to buy low and sell high. They try to time the market with very little training and experience. Amateur investors believe they are diversifying their stock portfolios by acquiring stocks from different sectors of the market, and hoping the overall market continues to go up during the next twenty or thirty years until they retire. But when the entire market drops, it takes all stocks with it. That’s the reality of the stock market we now have.

Yet the typical amateur investor doesn’t foresee that these days the market moves in cycles with regular crashes. These crashes can be catastrophic to an investor’s account. It usually takes many years for an amateur’s account to recover from a big market crash, just in time for the next one. The type of dollar cost averaging made popular by Wall Street and consumer investing publications only benefits the investment companies who manage these accounts. When the crash occurs, it’s the investor who is left with the painful losses.

When we look at how professional investors exploit the stock market to earn profits, we see a variety of behaviors. With their solid understanding of how the market really works, and the knowledge that they can’t control where the market heads, they typically use investing methods with a built-in safety net. The most commonly-used strategy for them is to use the stock market in conjunction with the options market. Stocks become their main investment, while options are like the insurance they buy for that investment. It’s very similar to real estate – you buy the property as the main investment, and then you purchase insurance to protect it. That’s why top stock market investors know how to do the same thing with stocks and options. It’s not difficult at all, but it takes a basic understanding of how it works and how to use it for yourself.

Warren Buffett is widely regarded as the greatest investor of all time. Virtually everything he touches turns to gold, helping him become one of the richest men to ever walk the earth. When you read his name in the newspaper, it’s usually about a new business that his company has acquired. That’s an important part of his strategy. But what most people don’t know is that Buffett is a very skilled stock and option player. He uses them together to ensure that he profits no matter what direction the market heads. And he protects himself so that his losses are minimal compared to the size of his investment.

What I love about Buffett’s approach is that it can also work for any investor, even if you have a very small account. His approach is smart because you can sell options to create income for yourself. It’s very simple to set it up in such a way for you to actually get paid to buy stock. That’s my type of investing!

In a nutshell, here’s how professional investors use options to create income: When they find a stock they want to buy, they set up options trades to lock in the price they want to buy it for. These options also create income for them until they actually buy the stock. As an added bonus, the options also protect their risk exposure just like insurance. If the stock price moves the wrong way, they will still get paid.

As a summary to the difference between amateur and professional investors, in general we can see:

* Amateurs seek to earn their money in stocks from capital gains (buying low and selling high), and to manage their risk by diversification.

* Professionals seek to earn their money with cash-flow strategies, and to manage their risk by using contracts – they sell options for income and they buy options for protection.