How to Make the Right Decisions in the Market

All market analysts depend on their best estimates in making decisions. You cannot time your decisions perfectly or consistently; so you have to depend on a combination of fundamental and technical indicators to provide yourself with an edge. That means you improve your percentages, but not that you will be right every time. Base your strategy on the thorough analysis and well-thought-out selection of stocks. Pick stocks on their fundamental merits as long-term investments and not merely to provide coverage for short option positions.

Also keep in mind your long-term reasons for buying the stock; keep the stock in your portfolio as long as the company's attributes remain strong. Avoid making stock-related decisions as a response to option-specific conditions. Don't take advantage of the chance to earn a short-term profit if exercise of a covered call would contradict your long-term goals.


Example

Broker or More Broke: You bought 300 shares of stock last year as a long-term investment. You have no plans to sell and, as you hoped, the market price has been inching upward consistently. Your broker is encouraging you to write calls against your shares, pointing to the potential for additional profits as well as downside protection. Your broker also observes that if exercised, you will still earn a profit. However, remembering your reasons for buying the stock, you reject the advice. Call writing is contrary to your goal in buying the stock.

Even when writing covered calls is an appropriate strategy, never overlook the need for continued monitoring of the stock. By preparing a price performance chart like the one shown in Figure below, you can track movement by week. A completed chart helps you to time decisions, especially for writing covered calls. If you have access to the Internet, you can also use free sites to produce price and volume charts. Three of the many sites that provide this free benefit were listed in Technical Tests for Reviewing Stocks.

[caption id="attachment_12523" align="aligncenter" width="435"]Stock performance chart. Stock performance chart.[/caption]

Track both the option and the underlying stock. If profits in one are offset by losses in the other, there is no point to a strategy except when you hedge a loss with the use of an option for insurance. By observing changes in the option and the stock, you will be able to spot opportunities and dangers as they emerge.

Example

Programmed Portfolio Losses: You bought 100 shares in each of four companies last year. Within the following months, you wrote covered calls in all four. Today, three of the four have market values below your basis, even though the overall market is higher. You add up the total of call premium, dividends, and paper capital gains and losses, and realize that if you were to close out all of your positions today, you would lose money.

This example demonstrates that stocks were poorly chosen or purchases were poorly timed. While paper losses might have been greater had you not written calls, this situation also raises questions about why a particular mix of stocks was selected. A critical review of your selection criteria might reveal that you are picking stocks based on option premium value rather than on the stock's fundamental and technical indicators. Relatively safe stocks tend to have little options appeal, because time value is minimal in low-volatility stocks. So more volatile stocks are far more likely candidates for premium action. That does not mean they are worthwhile investments; it could mean that option profits will be offset by capital losses in your portfolio.

Perhaps the greatest risk in call writing is the tendency to buy stocks that are overly volatile because they also have higher time value premium in their options. You will do better if you look for moderate volatility as a secondary strategy. Three suggestions worth remembering:
  1. Select stocks with good growth potential and hold them for a while without writing options. Give the stocks a chance to appreciate. This gives you much more flexibility in picking options. The combination of premium, dividends, and capital gains can be built into your strategy with ease, assuming that current market value is higher than your original cost per share.
  2. Time your decision to sell calls on stock you already own, to maximize your potential for gains from the options.
  3. Remember the importance of patience. You might need to wait out a market that seems to be moving too slowly. Your patience will be rewarded if you select stocks properly. Opportunity does come around eventually, but some novice call writers give in to their impatience, anxious to write calls as soon as possible. This is a mistake.

Putting Your Rules Down on Paper

Setting goals helps you to succeed in the options market. This is equally true if you buy stocks and do not write options. By defining your personal rules, you will have a better chance for success. Define several aspects of your investment plan, including:Writing down your rules leads to success because it focuses your efforts. Guidelines can and should be modified as conditions change. Having self-imposed rules to follow provides you with a programmed response to evolving situations, and improves your performance and profits.
By Michael C. Thomsett
Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.

Copyrighted 2016. Content published with author's permission.

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