I exchange emails with readers on a fairly regular basis and occasionally try to move the conversation to a blog post. One of the newer readers and commenters, Josh, sent me a few good questions that made me think. So, I figured I’d try to answer the best I could in front of everyone since others might be wondering the same questions and have more they can add to the discussion.
- If the stock you purchase trades against you is there an adjustment strategy you utilize to lessen the shock of capital drawdown?
A month ago I might have answered differently, so keep in mind the foundation for my answer is flexibilty. If I’ve been assigned a stock from a naked put or look like I’m about to I first have to decide if the stock is worth keeping. If it is, I sell a covered call to try to keep a profit. If it continues to drop, I have to reconsider and might sell an other call, although this one would NOT be covered, it would be a naked call and therefore a lot more risky. I sold a naked call on AA a few months ago and wrote about it here. It worked for me then as the stock came back above the naked put strike and stayed below the naked call strike. That gave me a profit on both sides. If it stayed down I would have reduced my cost per share by the amount of the call on top of the original reduction from the put.
- I read your article regarding exits with great interest today and I think you are absolutely right. The exit decision should be predicated on decisions other than getting back to breakeven. I was wondering if you also wouldn’t mind elaborating a bit on the approach you take when assigned stock that goes far against you.
If a stock moves against me farther than I can sell options on to recover to a profit I’ve made a mistake (just happened on MOT, GM and DOX this month) and I have to deal with it. I can take it from a “start from scratch” point of view based on what I have now or dump it for a loss (as I did with GM and DOX).
- Do you have any conditional entry techniques that help you avoid getting caught in a stock like C? Even though I have written puts and now selling calls on stock assigned, I am still underwater.
I try to avoid the obvious bad sectors and don’t try to time the bottom. I’d probably have dumped C once all the bad news started coming out. It’s hard to admit when you are wrong, but C is another example that just keeps getting worse every day. Eventually it will find footing, probably, but for me it’s not worth guessing when I can find a better opportunity to trade elsewhere. That’s the same reason I just dumped GM for a loss. I made a bad trade and it cost me so I cut my losses and moved on. If it goes up after I exit, then so be it. I exited FWLT twice for a loss before getting in a third time for a profit. The risk of a downturn wasn’t worth it for me to hang on the first two times, although the stock tripled when I wasn’t invested. All I cared about was the premium, so up $1 or up $100 didn’t really matter. My profits were limited by selling the option and I dealt with the loss by using my money elsewhere.
- The year you ended with a loss, even though it came on the heels of a 40%+ year, any lessons learned from the trading experience?
I was too new to investing in options then and got overextended before I understood the risks. I set a rule for myself not to have less than 50% of the underlying stock available in cash (ie 2x cash). I only let myself break that rule when I’m very far out of the money on a few positions and even then no less than 40% ever. I try to stay away from stocks with very high p/e ratios and I try to diversify. I updated my current portfolio page this morning to show how much I’m diversified right now. That year I lost, I was overweight in tech stocks and when they fell I was slow to react.
Keep a trader’s journal to allow yourself to look back on your successes and mistakes to learn from both. I also try to sell naked puts farther out of the money if I’m not extremely confident on a trade or see an opportunity to just be a little safer on a high flier like AAPL or FWLT.
I think keeping your pride and greed in check are probably the two most imporant generalizations I can make on what I’ve learned so far. Too much greed and you overextend beyond a reasonable level. Too much pride and you don’t accept losses when you can. Without losses I’d return better than 45% on a regular basis, but that’s not possible. I’m going to make mistakes and need to accept that to really try to keep my returns above 20% for each year. I have been running around a 35% return for the past 12 months trailing most of this year, but with this recent pullback I’m back down to 21% for the past 12 months. I’m still beating the indexes, but now with a more sustainable level that includes more than one bad month.
- If you were going to target lower returns, with accompanied low volatility, how would you do it?
I don’t necessarily target lower volatility, I target stocks that are on the lower end of their trading channels and off their highs usually, sometimes these are still very volatile stocks. Then again, if I see a stock breaking out to new highs I’m willing to sell puts on it too. I also don’t like to sell stocks with high p/e ratios. That was part of my problem in my losing year. I did well with most of my picks, but the few bad ones sank me. Along that same thought, I have learned cut losses before they sink me.