There is a dynamic that has existed among options trading circles for as
long as I have been trading. That dynamic is a perpetual quest for the
"all weather" options strategy. In other words, there seems to be this
irresistible pull toward the notion that we can trade one strategy and
profit in all markets.
All options traders know that it is possible to make money in up
markets, down markets, flat markets, volatile markets, or any other type
of market you can imagine. After you've been around a while you also
come to realize that it is possible to make money with any given options
strategy if it is properly applied in appropriate market conditions.
Covered calls and naked short puts are no different. They work really
well under the right conditions. The trouble is, and this is true of
all options strategies, is that the market will not consistently provide
the right conditions and we won't know whether conditions were suitable
until after the trade is closed. If we could know that before opening
the trade, we would be infallible..
Here is where most of us, including the "professionals,
figure that we can "build a better mouse trap" or develop a bullet
proof, i.e., market proof, strategy that will deliver profits all of the
time. Of course, it's a fool's errand to go down this path but it is
surprising to see how many very smart people go running off on this
errand.
Covered call strategies can be very effective. We get into trouble with
them because we rationalize our way out of applying sound risk
management. We fail to control losses. All stocks go down at some
point, but we often simply assume that if we hold on to them they will
again move higher. Often, the do. Sometimes they do not. You must
have a plan for exiting trades that are not working.
Another area where we get in trouble is with adjustments. The covered
call trade is opened and then the market begins trading lower. The
short call loses most of its value so we roll lower to bring in more
premium, but in the process we also take on the obligation of selling
the stock at a price below our purchase price. The market rallies and
we're called out of the position at a loss.
Personally, I like covered calls and naked puts. I use them as part of
a long-term investment strategy. It's a nice way to effectively "buy
low and sell high," while generating income. Everyone one of those
trades as a stop, though. Once the market stops behaving in the way I
had anticipated when the trade was opened I want to get out even if that
means taking a small loss. It is far better to take a small loss than
to hold onto a trade that ties up capital for months or years.
Whether you trade covered calls or any other variety of options
strategy, the long-term money is made and lost through managing risk.
Until a trader learns how to effectively manage risk, their trading will
be marked with painful equity draw downs.
Christopher Smith
TheOptionClub.
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