As we enter October it may be wise to watch from a safe distance rather than step into the potential volatility.

After a week of volatility and several costly exits I am wondering if we should watch from the sidelines rather than venture back into the path of what could be a couple weeks of market declines. I am not specifically afraid of volatility because it does increase option premiums. I am cautious because writing naked puts should only be done in a bullish market. I am not expecting a bullish market after Wednesday.

The other option would be to write some calls but the margin required along with the risk makes call writing a less than desirable strategy. Those who have practiced it over the last few months have lost money. I am also not a fan of call spreads although that is a valid strategy in a down market.

If the market is going to decline as fund managers restructure their portfolios then we are left with limited options until that restructure is over. I would like to think that fund managers will quickly dump unwanted positions once into October and quickly position themselves for a Q4 rally. This may be the plan for quite a few but others are locked into the options expiration cycle. They may have sold calls on their equity positions or bought puts that have to be unwound. Depending on the market those positions could be closed early or they can wait for expiration to avoid another transaction fee.

The bottom line is that we don't know what early October will bring. However, I am fairly confident that the last couple weeks of October will produce the start of a new rally, which could run through November or longer.

The rapidly fluctuating dollar is alternately crushing commodities or giving them wings. Oil prices have fallen more than 10% since the $73.50 high on the 17th. The excuse in the press for the decline in prices was the +2.9 million-barrel jump in inventories on Wednesday. As you can see in the chart below that uptick was almost invisible. It was related to futures expiration on Tuesday and dollar bounce on Thursday.

Oil Inventories

Dollar Index Chart

Momentum stocks in the commodity arena are likely to be the hardest sold as fund managers take profits in winners to offset losers elsewhere. Large cap cyclicals should be favored when the volatility starts but only on a temporary basis. Once any October dip is over it will be the small caps and techs that will be favored. I am following several candidates but I don't want to make any entries until expiration week.

One of the pitfalls of the newsletter business is that readers always want a new trade. Rarely do writers have the luxury of waiting on the sidelines for the right setup. I am going to try and avoid that trap in this newsletter. I am not trying to time the market but simply avoid some potentially obvious pitfalls. I hope everyone will be patient as we await the next setup. The object of trading is to produce profits. We should not continually trade just for the thrill of trading.

I am going to scan my charts every day and if I see something that stands out as a potential short-term play then I will send out an email. I will try to update everyone every day over the next couple weeks so you know what I am thinking and not be blindsided but a sudden flurry of trades. Hopefully by October 16th any market weakness will be behind us.

I am still angry about that big loss in Walter last week. I should have raised the stop after the big $5 move higher. I was dealing with those family problems I mentioned last week and not focused on that position. I was as shocked as anyone when I opened my laptop at night and saw the drop. I am back at work now and I won't let that happen again.

Jim Brown



Current Portfolio


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Recommendation History



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Methodology

We do not sell out of the money puts for a few cents and then hope the market does not correct and cost us a fortune to exit. I don't like to risk a dollar to make a quarter.

The concept for Option Writer is to find solid momentum plays with enough volatility to inflate the option premiums. We will sell in the money naked puts ahead of the stock price and let the stock rally to our strike.

Selling in the money puts allows us to capture nearly dollar for dollar the movement in the stock price.

Because we are selling in the money that same dollar for dollar move can go against us as well. For this reason we establish tight stops to take us out of the play for a loss of a few cents rather than let the losers grow and "hope" they rally again. In a typical month we could get stopped out of twice as many plays as we close for a profit but those stops will be minimal and the winners worth the trouble.

If you do not have the ability to sell options you can turn the plays into spreads by buying a lower strike put. This will decrease your margin requirements but it will also decrease your profits.


Margin Requirements:

There are several different formulas for determining margin requirements for naked put writing. These are normally broker specific and some can require larger margin requirements than others.

Here is the most common margin calculation for naked puts.

100% of the option premium + ((20% of the Underlying Market Value) - (OTM Value))

For simplicity of calculation simply use 20% of the underlying stock price and you will always be safe. ($25 stock * 20% = $5 margin)