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.
ExampleBroker 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.
[caption id="attachment_12523" align="aligncenter" width="435"] 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.
ExampleProgrammed 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.
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:
- 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.
- Time your decision to sell calls on stock you already own, to maximize your potential for gains from the options.
- 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 PaperSetting 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:
- Long-term goals for your entire portfolio.
- Strategies you believe will help you reach those goals.
- Percentages of your portfolio that are to be placed in each type of investment.
- Definitions of risk in its many forms, and the degree of risk you are willing to assume.
- Purchase and sale levels you are willing and able to commit.
- Guidelines for review and possible modification of your goals.