Monday, March 05, 2007

Risk Awareness in the Stock Market

Following publication of my Article on calls and writing covered calls, I received a thoughtful and helpful letter from a subscriber. After thanking me for the article, the subscriber suggested that I may not have emphasized the risks associated with the covered call strategy strongly enough. He suggested that the inexperienced trader could "put the cart before the horse" and just look for calls with high premiums so he could then buy the stock and write the high priced calls.

My subscriber noted that my article did point out that buying stocks is always risky and was concerned for the neophyte that the idea of buying a stock just because the call premiums were high could prove disastrous. He then, quite correctly, noted that the risk graph for writing covered calls was the same as for selling naked puts. He suggested that no one would ever suggest a novice sell naked puts. As an aside, I should note that brokerages apparently see a risk distinction between writing covered calls and selling naked puts since they will let almost any client write covered calls, but require the trader be level 4 and have a defined minimum account balance before selling naked puts. Does that make sense when, as my subscriber pointed out, the risk graphs for the two strategies are exactly the same?

Finally, my subscriber suggested that the strategy of writing covered calls "...applies only to writing calls on investment grade stocks that the reader already owns..." I believe all of his points are worthy of discussion, but I don't necessarily agree that covered call writing be reserved for only "investment grade stocks" already in the portfolio.

Truth is, I thought I had made the point that stock buying is risky. It seemed obvious to me that writing a covered call involved buying a stock so the strategy is risky. Of course, it is less risky to buy the stock and write the call than it is to buy the stock alone. If we buy the stock alone without taking in a premium, our risk is the price we paid for the stock. If we write the covered call, our risk is the price of the stock less the amount we took in for writing the call. The real point the subscriber makes is that writing covered calls can be risky and that traders shouldn't just go out and buy stocks to write covered calls simply because the calls have a high premium. There is usually a reason for the high premium --- and it's usually high risk. That's a valid point. The strategy is bullish so we usually don't want to buy a falling stock just to write a call. I write calls on stocks that are flat to uptrending. Of course, the largest premiums are often found on the falling stocks. That is the danger about which my subscriber is rightly concerned.

I don't agree that calls should *only* be written on stocks that are considered to be "investment grade" since a stock is only "investment grade" in hindsight once the profit is realized. For example, was Cisco an "investment grade" immediately before it dropped 90% over 2-1/2 years; is it today? Or GE that dropped 65% in 2 years? Or Qualcomm that was down 88% in 2-1/2 years? Or Amazon when it was down 95% in less than 2 years? That list goes on and on.

I often buy stocks that are nowhere near what one would think of as "investment grade" (even though that is a suspect category, see above) and sell calls against them. If the stock is bullish in a bullish sector in a bullish market and has a good return on its call premium, why not? If it turns, I can generally undo the play for what is normally only a slight loss. Knowledge makes a big difference in what strategy to use and how to use it. Anyone who trades is taking on risk. In my opinion, common sense dictates that anyone entering any trade has an obligation to himself or herself to understand that trade completely before they ever even consider putting real money at risk.

The fact is, I do teach novice traders how to trade naked puts as a strategy and, as I have repeatedly said in my Articles, I encourage them to paper trade the strategy (as any strategy) before ever putting real money at risk.

I really don't expect people to go out and utilize strategies I mention in my Articles without doing the other things I repeatedly mention including creation of a personal business plan, formulation and use of a money management strategy, paper trading each strategy until they can trade it successfully before putting real money at risk, and continuing their education. Trading is a business. If one were going to open a computer technician business or a greeting card store, they would have a business plan wouldn't they? Well, it is every bit as important, if not more so, to have a business plan for trading. As part of that plan, it is critical that the trader develop a money management plan. As I have discussed in earlier articles, without a proper money management plan the trader is likely doomed from the beginning. So, too, I believe it is foolish to trade a strategy that one does not understand completely. In order to understand a trade completely, one must not only study it, one must also practice it. The initial practice needs to be done without using real money, without putting real money at risk. The would-be trader needs to paper trade the strategy until he can successfully repeat it over and over. Only then should he even consider putting his toe in the water.

This business of trading is just plain risky. It is not get rich quick! It requires study, patience, practice and EFFORT. It can pay off handsomely, but like any other successful business it requires understanding of the business, understanding of the risks, knowledge of what one is doing, proper management of money and continuing education. Only then does the trader begin to give himself a chance.

Bill Kraft, Editor
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