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February 11, 2004
Trading Scared Money
By John Brasher, CallWriter Publisher
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On occasion a reader will
ask our support staff how to trade money that the
reader simply cannot afford to lose. The money involved
may be a college fund for a child or the reader's
retirement fund. Because this is actually raising
two questions, we decided to devote a newsletter
issue to it. Money management is crucial to trading
success. And if there ever was a place to discuss
money management, this is it. |
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We are always concerned when a reader is trading with money that
he or she cannot afford to lose. This can lead to poor trading decisions
and consequent losses, as embodied in the old Wall Street adage
that "scared money" never wins. The reason is
of course that a person trading scared money frequently will make
bad decisions due to panic or paralysis. Anyone trading money that
cannot be lost must realistically face the prospect that the money,
or at least a good chunk of it, could be lost in trading. Yet many people have no other money available for
trading and feel a strong need or desire to try, despite the risks,
to grow the money in order to better their financial condition.
And it can be done, but only if the trading is approached realistically,
with a focused commitment to manage the money effectively. The question
of whether to trade scared money actually resolves into two questions:
1. Should the money be traded at all? 2. If it is to be traded, how can it
be traded most effectively and safely? It is not our place to tell people to refrain from
trading money they can't afford to lose, but to point out the risks
and to help them trade effectively if they choose to trade. The
purpose of this article is not to teach the strategy discussed below
- space simply does not permit that - but to point out a relatively
safe and productive method for trading money that the trader dare
not lose. Regarding the second question above, based on our
experience we have learned that covered calls can be traded for
consistent profitability and with relative safety. In fact, covered
calls are the one option-related trading strategy that
most brokerages will allow to be done in I.R.A. accounts. The reason
is that covered calls provide a combination of income (like
receiving a monthly dividend check) and downside protection
should the stock drop. Merely owning a stock produces no income
and no downside protection. If you are not familiar with covered calls, they
are simple: you buy shares of stock and sell call options ("calls")
on them, and the price you get for selling the calls (the "premium")
goes into your pocket as income. If the calls you sold are exercised,
you are obligated to sell the stock at the calls' exercise price,
which is known as being "called out" of the stock.
Because you own the stock underlying the calls, the calls are
"covered" and you have them available for delivery
to the buyer if the calls are exercised - - if you didn't own the
stock, the calls would be naked. If you are not called out of the
stock when the calls expire, you either sell the stock or sell more
call options on the stock the next month for more premium income. Every month you do the same thing: buy stock, sell
calls, pocket premium income. It's like collecting a monthly dividend
from your stocks. This strategy can generate a steady monthly income
that averages 3% to 5% a month.
Example: On February 7th Goodyear
Tire & Rubber (GT) shares could be bought for $10
and the February $10 calls could have been sold for a
$0.50 premium. In this case, the return is calculated
by simply dividing the stock price into the premium received.
This trade creates an instant return of 5% for
a 14-day holding period, since the FEB calls expire on February
20th. Upon writing the calls, the $0.50 premium goes into your
account. A call option contract covers 100 shares, so three contracts
would cost $3,000 to buy the stock (300 x $10)
and yield $150 in premium (300 x $150). The premium
received protects you against a drop in the stock price down to
$9.50. The $150 return in our example may not sound like
much, but it is a 5% return on a $10 stock. And if the stock is
not called out (sold), the calls can be written again, month after
month. Or the GT shares could be sold in order to buy another stock
and write covered calls on it. To successfully trade covered calls, it is necessary
to observe certain safety rules. CallWriter
has over the years developed a simple but comprehensive set of rules
for making consistent profits writing covered calls, which we teach
to CallWriter members. It's so unique
to us that we have named it the CallWriter
Method. The key is to focus not on trying to get the highest
returns but on getting the highest combination of return
and stability in order to eliminate those pesky
losing trades that wipe out many successful trades. In other words,
it is not enough to make good returns; successful money management
requires that you also control losses. And the best way to avoid
losses is to avoid situations that historically are likely to cause
losses. Clearly, writing covered calls is one of the more
conservative strategies available, and can be used very effectively
even by people with relatively small trading accounts. But every
trading strategy can lose if executed poorly, even the covered call.
If you are going to trade covered calls with money you'd best not
lose, you should consider the very conservative approach embodied
in these simple trading rules: 1. Stick with household names.
Concentrate in the larger, more stable stocks such as the S&P
100 and the larger Nasdaq 100 stocks in your price range, which
offer the best combination of return and safety. 2. Avoid money losers. Stick with
companies that have positive earnings. There are many exceptions
to this rule, but for safety it is better to avoid the money losers. 3. Avoid pharmaceutical and biotechnology
stocks. These are companies whose drugs or devices are
regulated by the F.D.A. When one of these companies has a critical
product fail to get F.D.A. approval, the stock can tank. They generally
are too dangerous as covered call trades for anyone but experienced
traders. 4. Avoid life or death news. If
an important news event is expected to occur before the calls expire
(resolution of major lawsuit, major contracts are being bid on,
etc.), avoid the stock. The reason is that the stock will almost
certainly drop if the news is adverse, and it may drop even if the
news is good if it has already run up on the expectation of good
news. This news is not usually hard to uncover and you can usually
find it at free sites Yahoo! or CBS Marketwatch. 5. Stick with rising stocks. The
stock ideally will be in an uptrend, meaning that it is making higher
highs and higher lows. 6. Stay in the money. A call is
in the money if its exercise price is lower than the stock's price.
The deeply in-the-money (“DITM”) calls usually offer
lower returns but provide the most protection if the stock drops.
Example: A stock is trading
at $17.80 and the $17.50 call can be sold for $1.75, which would
produce an 8.15% return. The fat premium protects you down to
$16.05 (17.80 - 1.75). However, you are concerned that the stock
is at a high and could pull back. In that case, it might be smarter
to instead sell the $15 call for $3.80, which would produce only
a 5.62% return but provide protection against a price drop all
the way down to $14 (17.80 - 3.80). The more conservative trader
would sell the deep-in-the-money $15 call, because it offers an
acceptable return but confers far more protection. If the stock
should drop before expiration to $15, the writer of the $17.50
covered call position is hurting, but the writer of the $15 call
position is smiling. These rules have come out of observations made
by us at CallWriter in years of
covered call trading and will serve the careful trader well. There
is of course more to consider in covered call trading than the few
points made above. But you might be astonished how well these six
simple rules work for covered calls, month in and month out. But successful covered call writing is not difficult;
it simply requires patience and a bit of knowledge. That's why
is so successful in covered calls and is the world's premier covered
call website. We have the proprietary tools to find the highest-returning
covered call trades, an amazing trade calculator that manages trades
and squeezes the most profit out of them, and we provide a time-tested
analytical method for profitable covered call trading. |
