Option Investor
Educational Article

A Strategy That Can Work

HAVING TROUBLE PRINTING?
Printer friendly version

By David Popper

Boy this is hard. The market looks like a bottom is forming and a trap door springs. Many friends of mine gain confidence when the market has a rally and despair the very next day when the market resumes its downward trend. There are a lot of technical and fundamental reasons why the market is behaving like this. There are all sorts of books that would teach you how to play a bear market rally such as Stan Weinstein's book, "Secrets for Profiting in Bull and Bear Markets." The bottom line for part time traders is that these fine strategies take too much time and require a lot of practice before a trader begins to be profitable. There are principles and safeguards that can be employed, however, which can help a trader in this environment as long as the trader is realistic about the amount of profit which can be achieved.

In case you have not noticed, this market is completely counter- intuitive. Just when it "seems" safe to jump in, the market falls. Just when fear is in the air, the market rises. Simply put, feelings and hunches are completely unreliable and are usually totally out of sync with the market. It may be best to stay out at this point. If you must play, however, there is a strategy which can work in this type of market. Keep in mind that this is not the strategy that you would want to play in a bull market, nor is it a strategy that you would want to play in an overvalued market. Instead, this strategy is designed for busy people, who want to be involved in the market, stay in sync with the market, hedge their position and be profitable. Below I will discuss aspects of this strategy.

1. ONLY TRADE THE TOP STOCKS OR INDEXES: Institutions have certain favorites which are well established companies and are gorillas in their field. Because these companies are quite large, and their stock is quite liquid, institutional money tends to flow toward them when the market trend reverses. Indexes such as the NASDAQ 100 share these same characteristics, but actually provide even more safety because no one warning will make the index fall out of bed. The NASDAQ 100 is my trading vehicle of choice.

2. BUILD A POSITION: Purchase a position in one or more stocks or indexes with 1/4 of your funds and write either current month deep in-the-money(ITM) calls or alternatively write at-the-money(ATM) calls four to six months out. The advantage of the deep ITM calls is that the extrinsic portion of the call premium depreciates rapidly. The advantage to the longer ATM call is that you secure much more premium due to the high amount of time premium associated with a lengthy expiration date and the fact that ATM calls have the most extrinsic premium built into them. Writing longer term calls does not keep you necessarily in the play for four to six months because if the stock really roars up or down and then settles, the extrinsic portion of the call premium will depreciate rapidly. At that point, you would be able to buy the call back and begin a new play.

3. COVER OR CLOSE YOUR POSITION: If the stock or index, moves up rapidly you would have the option of closing your option position, as discussed above, or simply buying a put for a small amount of money. Once the put is in place, my downside is protected. The profit I make will be the difference between the call and put premium if they are at the same strike price. For example, if I were to sell the $50 call on the QQQ (NASDAQ:QQQ) for $10 and later buy the put for $4, my profit would be $6 and my downside is protected. On top of that, I will be able to profit on a market downturn because my the call that I sold will depreciate in value, while the put that I own will increase in value. On a dip, you would be able to buy back the call cheap and resell it on a rebound.

Likewise you could sell the put when the market is severely oversold and repurchase the put on a rally. The beauty of this strategy is that you are in sync with the market. When the market rallies and everyone is buying, you are selling calls for a high premium and establishing downside protection. When the market is dropping and everyone else is panic selling or buying puts for high premiums, you are buying back calls cheap and selling the "cheap" puts for a profit. You are actually buying low and selling high. True, even this strategy will take some practice, but the moves are slower and it is easier for a part time trader to stay on top of the trade.

4. WAIT 30 TO 60 DAYS BEORE YOU DEPLOY AN ADDITIONAL 1/4 OF YOUR TRADING ACCOUNT: Sometimes during the frenzy of an unproven bear market rally, I have found myself jumping the gun and deploying too much capital at once. This can be unproductive. Currently, the market swings are violent. Each thirty to sixty days finds the market trading in a new range. It can be helpful to start an entirely new position, even if with the same security, because the position will be established at an entirely new strike price and with covered calls established on different expiration dates. These modifications are an additional way to diversify your positions. Further, after this system has been employed for a period of 6 months, you will notice that expiration dates will be approaching every month or every other month, so you will have the opportunity to establish new positions often.

In essence, by using this strategy, you will be able to collect premium every 30 to 60 days which will provide substantial cash flow. The employment of a portion of your funds on a systematic basis gives you some of the protection of dollar cost averaging, while the use of puts protects your downside and allows you to profit in bull or bear markets. Obviously, skill at reading charts will aid in a trader's ability to establish positions that are potentially safer and more profitable. This strategy, however, affords much more margin for error.

www.OptionInvestor.com

Options 101 Archives