Saturday, July 25, 2009

Picking Strategies

In both my books, "Trade Your Way to Wealth" and "Smart Investors Money Machine", I have emphasized what I consider to be the importance of having a business and trading plan. In "Trade Your Way to Wealth" I cover how to go about creating such a plan and discuss elements that I believe are important to include in your own personal plan. In "Smart Investors Money Machine", I illustrate considerations people at varying stages of life may want to incorporate into their investment strategies in order to produce added streams of income no matter what their stage in life and no matter what their time constraints. Overall, one significant consideration is what strategy or strategies may be best for you.

Many, if not most, investors use only one strategy; they buy a stock with an aim to sell it some time in the future, hopefully at some higher price. Some have exit strategies, some don't. What few seem to realize is that buying a stock with the intent to sell it in the future and without some exit plan is one of the riskiest things we can do in the markets. When we buy a stock, our whole investment is at risk. My guess is that few "buy and forget" investors ever give serious consideration to that risk when buying the stock, but only become concerned if or when the stock price begins to fall. Please don't misunderstand what I am saying. I do not mean to suggest that one should never buy a stock. I do mean that when that is the strategy to be employed the stock buyer should be aware of the risk.

Some say selling a naked put is very risky, but is it as risky as just buying a stock? When we sell a naked put we are undertaking an obligation to buy a stock at a specific pre-determined price (the strike price) if it is assigned to us and for undertaking that obligation, we are paid a premium. Let's take a look at a present day example of the risk in selling a naked put versus just buying a stock. What follows is definitely not meant to be a recommendation, only an example of a scenario taken from real prices at the time I am writing this article on July 21, 2009. Suppose we like GE stock. As I write, the last trade was for $11.41 a share. At the same time, I could sell the August $11 naked put for 34 cents a share. That means that someone was willing to pay me 34 cents a share if I were willing to buy GE stock at $11 a share (41 cents less than it was currently trading) anytime between the time I entered the contract and the third Friday in August (31 days from the time I am writing). Now, what are the relative risks? First, if I just bought the stock, my risk (however unlikely) would be that the stock would go to zero and I would lose the $11.41 a share I paid for the stock. On the other hand, if I sold the Aug 11 put for 34 cents, I would have 34 cents a share coming into my account the following day. Though I would have money on hold in my account, I would have invested nothing. Would there be any danger of having the stock assigned to me at $11 if the market price stayed above $11 a share? No, since the stock could be sold on the open market at a higher price, why would anyone want to force me to buy it at $11 when they could get more elsewhere? Suppose, though, that GE fell below $11 and the stock was assigned to me for $11 a share. What would my risk then be? It would be $11 a share less what the market paid me to sell the put or $10.66 a share. Obviously, the lesser risk would have arisen from selling the naked put and having the stock assigned to me than having bought the stock at $11.41. In fact, the risk would be 75 cents a share less.

That example is only one of many considerations that are available in choosing a strategy. In the example, the naked put portion of the play is over in no more than 31 days. I either just get to keep the 34 cents at expiration or I have to buy the stock at $11 but still keep the 34 cents that went to help me buy the stock. Other factors that an investor might consider in choosing a strategy besides risk might be the time required to monitor the position or the likelihood that it might require adjustments (that could be good or bad), and the amount of capital that may be required. In "Trade Your Way to Wealth", I discuss a number of strategies and for each, look at potential risk, reward, initial capital required, the projected time frame, what protection may be available, the level of monitoring required, and the market direction for which each is suitable. In "Smart Investors Money Machine", I explore various types of investments including stock, options, MLPs, bonds, annuities, and others with an emphasis on what types and what strategies may work for investors ranging from novice to relatively expert and showing how much or how little time may be required in establishing and maintaining regular added income from each.

Each of us is able to structure a plan that fits within our personal parameters, whatever those parameters may be in terms of available capital, risk tolerance, time we can afford, and knowledge we have or can gain, and personal financial needs and goals. First, though, it is important to engage in a bit of introspection to see what it is that we want and then find the strategy (or strategies) that best enables us to achieve that end.

by Bill Kraft, Editor
Copyright 2009, Makin' Hay, Inc.
All Rights Reserved

P.S. Save $50 PER MONTH on my subscription trading newsletters!
SAVE on my Under $10 Stock Trader Service!
SAVE on my Option Trader Service!
SAVE on my Trend Trader Service!

Technorati tags:

To comment on Bill's article click on the "comments" link below.


Anonymous said...

I have no recommendation or opinion on Value cost averaging of an index ETF or Mutual fund.

Anonymous said...

Hello Mr Kraft

I sent you an email to about the formatting of your newsletter and improving the readability. I included an example of how I might format it. I hope you will read it. Let me know if I can be of assistance in reformatting (and making corrections, if nec )your newsletters or this blog in the future. Helen

Anonymous said...

Naked put is the only game I play. If the option is exercised, I immediately do covered call. When this strategy is only played with "value and dividend paying stocks" like BP, INTC and VZ, the probability of winning is very high. I also pick the time when the stock is at its lower resistance point. So far, I have 80% accuracy and beat S&P for the last 5 years -- I only traded for 5 years.

Bill Kraft, said...

Helen, thank you for writing. I am simply an editor and author of the Newsletter. The publisher has well-trained professionals who format and handle the technical information. I am sure they will review your suggestions.
Bill Kraft

Bill Kraft, said...

Anonymous, sounds like you are doing very well with the naked put strategy, even in the bearish times. Congratulations. Generally, naked puts are reserved for bullish situations but it sounds like you have created a good plan for yourself no matter what the market conditions. Here's to your good trades!
Bill Kraft