My Trading Model

Background
My model for investing/trading has proven good for me which does not guarantee it will work for you. I’ve read numerous books by writers who also claimed they knew the road to millions and it always made me wonder if they could make so much investing then why are they wasting their time writing. I always doubted the validity of their claims, especially since most had no documentation of what they did in real life examples. A lot of ideas are great in theory, but until you document what you’ve done, not just back test, then the theory is not worth much.  That still left the question of why should I write about trading if I’m so good at trading.  The answer is simple.  If I want to make enough money to replace my current income, I need a higher balance in my account to work with.

As you will see with my detailed account of how I trade, I beat the market indexes consistently.  That is not to say my word is golden.  Disclaimer: Do your own research.  Under no circumstances does the information in this blog represent a recommendation to buy or sell specific stocks or options.  I’m only detailing what I’m thinking.

The Details
All trades I enter into start by selling naked puts.  Depending on what I think of the stock I might sell well out of the money (OTM), at the money (ATM) or even deep in the money (ITM).  The time horizon for my puts is typically between one and two months being that the last month is when time value really starts to sink faster for options.
These are the criteria I try to check before making a trade:
·          I only consider stocks that trade options, so that’s generally my first check
·          If the stock is optionable I move to the fundamentals and charts:
·          Trailing P/E, forward P/E  and PEG
·          Growth, quarter and yearly
·          Cash and Debt on Balance Sheet (although I don’t have any hard rules I stick to on this one)
·          Charting - (I like to find support on one or both of these)
           - Trend lines (Increasingly so I have been relying on trend lines to help make decisions)
           - Moving averages
·          When earnings are due (this might affect option pricing)
·          Any news that is troubling (rumor mills can do wonders for volatility)
·          Short Ratio (too high and maybe the shorts know something)
·          If available, I try to read the free analyst reports in Ameritrade’s “Reports and Ratings” section under the stock’s Overview tab to make sure I’m not missing something obvious in my own research. 
·          I also track what industries my underlying stocks are in.  I’ve been burned by having all of my eggs in one basket when I was positive I was right about the industry, but know I’ve learned.  I don’t make extremely hard rules about percentages in each industry.  I just try not to go overweight in any one direction. 

Evaluating a Trade
I use half of the underlying value of the stock at the strike price as what I must keep in reserves for the stock.  Most stocks I trade allow for 30% in cash to support owning them in full.  By using 50% as my own limit I feel safer about an unexpected downturn that ends up with all of my options being assigned to me.  In a bull market or if I am well out of the money on a few stocks, I might let this buffer range go as low as 40%, but no lower.  At 40-50%, I am bringing in a very nice return without taking the chance that a short term dip will sink my account.  What it means to me is that if my account liquidation value is $50,000 I am trading as if I have $100,000.  This allows me to trade in larger lots thereby decreasing the impact of commissions on my trades and at the same time it allows me to further diversify.  Since my goal is to not keep the actual underlying stocks in my account and just keep the premiums rolling in like an insurance company, I rarely have to use any margin.

An exit strategy is built in to this model.  When an option expires I have exited the position.  That doesn’t mean that I can’t get back in to it if I still like it, but it requires me to do my full due diligence again.  A common mistake I made before was not continuing the “homework” that Jim Cramer always states is mandatory.  This forces me into it, although I have gotten better about regularly doing checks on what I own prior to expiration.
If an option is assigned to me, my new exit strategy is planned.  I write the covered call ITM, OTM or ATM based on what my belief in the stock’s next one or two look like. 

I try not to take ownership of stocks themselves.  My goal is just to take the profit and move on.  I like to think of the way I trade as the way insurance companies receive premiums for insurance (basically that’s what a put is, insurance for someone who owns the stock) and I realize that I’ll have some claims against the insurance I’m selling and hope that I’ve planned well enough to get through the rough times and hope not to have many Katrina type losses.Although I’m fully invested, I still have an account that is predominately in cash most of the time and I do not have to rely on using margin.  This gives me more flexibility and greater opportunity for larger gains.  While each trade has a limited upside, the downside risk has a reduced probability of occurring. The entire foundation of my model of investing is not to pay full price for a stock.  Selling puts allows me to buy at a discount, if I do indeed get pushed into buying the stock rather than just taking profit and moving on when the option expires.  Ideally I’m just the insurance company that sits back and takes in premiums and doesn’t have to pay out any large claims.

If you this trading model sounds interesting to you, I encourage you to subscribe to my RSS feed to see it in action.