Option Investor
Educational Article

Pick On Someone Your Own Size

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By David Popper

In the movie, "Patriot," there is a scene where the hero's son joins the Colonial Army to fight the British. He hides in an abandoned house and witnesses the Colonial forces marching in European style formation to fight against the more experienced British forces. You see row after row of American soldiers being slaughtered at the hands of their enemies. As the boy watched this scene, he did not notice his father enter the room. After observing the scene, the hero remarked that this battle was over before it started. As the movie goes on, the colonists eventually win, primarily by employing guerrilla tactics. These tactics allowed an overmatched force to defeat the stronger enemy.

As I watched this movie, I could not help but to analogize that scene to the market. Millions of traders stayed in the market "for the long haul" and had their accounts annihilated, when the damage could have been averted by limiting their risk in those uncertain times. Millions of traders lost while others stayed profitable entering short-term trades. Millions of traders lost while others greatly profited by shorting the market. Millions of traders lost because they refused to alter their style, while others did well because they adapted to the changing market conditions. Troubled times are not conducive to the strategy of "staying long and strong."

Other strategies may be helpful to the part time trader if he/she wants to stay in the market. The very best solution may be to stay on the sidelines altogether, but some (like myself) will not take that approach. Below I will discuss one of these strategies. The key, however, with all of these strategies is to recognize that trades can turn south quickly and therefore you must trade with only a small portion of your funds. If you typically take 500 share positions, then trade 200 share positions. If you trade 200 share positions, then trade 100, etc. The idea is to achieve short-term gains and not be over exposed to the market. Like the guerrilla fighter above, you do not meet the market head on, but rather you hit quickly for small gains or establish safer but less profitable positions.

The strategy that I would like discuss is selling covered calls. Sounds boring but it is not boring to be profitable in uncertain times. A dirty little secret to enhance your return is to consider writing calls on severely beaten down tech stocks that now sport a low PE, but still have inflated premiums. For example COMS has a PE under 10, a chart that is basing and a ATM premium of 12%. I bought COMS for $10 on January 10th and sold the February 10 call for $1.38. That is a healthy premium with not near the risk of a BRCM, SEBL or other stocks with three digit PEs. Other examples would include WCOM, T, and DELL. The bad news is priced into these market leaders, and yet the premium is rich.

Another thing to consider when writing these covered calls is to try to accomplish the trade near support. Finally, make sure that the company is an industry leader. By trading a quality company which is temporarily beaten down and is technically at good support, you have greatly increased your odds of a successful play even in a volatile market. If by chance a rally erupts, you can always buy back the calls and participate in the ride. In fact, often the time premium will shrink rapidly during a rally. You will be able to buy the call back after having extracted all of this extrinsic premium and can write a new call at a higher premium. If on the other hand the stock continues to tank, you may be able to repurchase the call very cheaply and rewrite it on a rally. Again, by limiting your selections to the criteria listed above, you have significantly reduced your chances for a poor trade.

As an aside, I recently met a former Nasdaq market maker on an airplane in New York who lost in excess of $4 million last year. He is limiting his trades this year to employing this very same strategy. His reasoning is that the professionals that he witnessed trading in this manner did not suffer severe losses last year. No it is not as exciting as owning BRCM call options, but a steady gain while many around you are losing eventually can become exciting. In my opinion, this strategy provides the part-time trader with the best percentage shot at making a profit on a monthly basis in a rough market. The premium will be somewhere between 5 and 10% and the fact that these good stocks have already suffered a valuation adjustment provides additional safety. You do not have to be fully invested and risk severe damage to make money. You do not have to assume the risk of high volatility and triple digit PEs to make money. These risks may be too big for your account. It is better to pick on someone your own size.


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