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.  I enjoy it and continue to learn by writing what I’ve done and leaving it out there for constructive feedback.  Since I’ve starting writing I’ve found that by keeping my investing transparent I can also help others make better decisions in their own investing either by repeating what I’ve done correctly or avoiding my mistakes.  I think all investors should continue learning and this is one of my ways of doing that.

As you will see with my detailed account of how I trade, I try to balance my attempt to beat the market indexes with my risk tolerance.  I tend to beat or match the indexes most years, but like anyone I’ll miss occasionally and call myself out when I do poorly.  You can review my performance in the Historical Perfomance section of the Current Portfolio page.

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 and trading on what works for my risk tolerance and goals.

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 and typically review a chart before a stock’s fundamentals)
– 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
When bullish, I use as much as 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 strong bull market, or if I am well out of the money on a few stocks, I have 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.  When I was with TD Ameritrade this allowed 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.  Now that I’ve moved to Interactive Brokers commissions aren’t as much of a concern.  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.

I started moving away from this higher risk percentage in early 2008, but didn’t diversify enough to save me from losing more than I should have on a few bad picks.  Since the end of 2008 I haven’t been fully invested and have switched to a model that takes a little more of an asset allocation approach where I like to have some cash and bonds in my account along with my stocks and options.  I could see me returning to the model described in the previous paragraph when I get very bullish again, so I’m leaving it here for reference, but don’t think I’ll be as aggressive as I used to be in the upcoming years.

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, but will if I think the stock will recover in the near-term or it’s a dividend paying stock I wouldn’t mind keeping while I sell out of the money covered calls.  My goal is generally 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.

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