Sharing what we learn: Pay it Forward

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In a recent comment, Mike offered his best advice to Wayne who had described his experience with writing covered calls.

Wayne,

I read thru your covered call example and as I see it you never calculated what the cost basis was for your stock after you sold the call. This would have helped you determine what strike price you should choose for your next covered call if the first had expired. Always keep in mind where your profit and loss zones are each time you place a trade.

Once you stock dropped in price you continued to sell ITM calls (I assume to try to collect the most premium). A better strategy would have been to sell OTM calls knowing what your cost basis is for the underlying and allowing for the stock to recover. The premiums may be smaller but the risk of losing money would be less. You never know when or for what reason the market will change direction in either a positive or negative way. Bookkeeping to me is an important part of a winning strategy. I hope this helps.
I have learned a ton from Mark’s books , blogs and questions he has answered for me. I just hope that I can pay it forward.

Mike

Mike,
I understand the rationale behind your advice. In fact it’s the advice that most traders believe is helpful, intelligent, and the ‘best’ path to follow.

This is one place where I part company with that majority.

1) “This “would have helped you determine what strike price you should choose for your next covered call.”

This seems to be good advice. In fact, it’s terrible advice and leads far too many traders down the path towards decreased earnings. More than that, when these traders earn less than anticipated, there is no logical way for them to discover the error of their ways – because it all seems so logical.

Wolfinger’s Truth: or my trading philosophy

  • Cost basis and other such data are for record keeping only. They must be IGNORED when trading
  • Always choose the best available trade – at the time the trade decision is made
  • Translation: Pretend you are opening a new position. Ignore the fact that it is rolling an existing position
  • NOTHING ELSE matters. It there is no good call to write, then don’t write one. Decide whether to sell or keep the stock
  • This applies to all strategies, not only to covered call writing

2) “Always keep in mind where your profit and loss zones are each time you place a trade”

Wolfinger’s Truth

  • Only think about your profit and loss zones or break-even point when you write your trade plan and decide whether to enter into the trade
  • Once you own the position your goal is to
    • Forget the past
    • Evaluate all positions as they exist today
    • Manage risk based on the current situation
    • Own a portfolio that meets your current portfolio requirements: future profit and loss potential, risk vs. reward, etc.
    • Make money today, tomorrow and into the future
    • It makes NO DIFFERENCE whether you earn $500 nursing a losing trade that gets you back to even or whether you earn $500 with a new, better (more likely to succeed) trade. It’s the same $500
  • Spending time and effort on a losing trade, trying to recover losses is inefficient
  • Spending time and effort on a new position – one that you prefer to own (when compared with that losing trade) – is efficient and offers an improved chance of increasing the value of your account
  • Increasing account value – without increasing risk – MUST be your goal
  • Thinking about break-even points or maintaining profits from older positions – does not do anything of value for you – except that it allows you to believe you are more successful.
  • Avoiding losses makes you feel good. That’s a psychological boost
  • Earning more money makes you feel good. It should make you feel even better and be an even larger psychological boost
  • 3) “A better strategy would have been to sell OTM calls knowing what your cost basis is for the underlying and allowing for the stock to recover.”

    Wolfinger’s Truth:

    • Mike, you can never tell anyone else what would be a better strategy for that person. All you can do is explain what works for you, why it works for you, and then allow the other trader to make his/her own decision
    • ‘Allowing’ the stock to recover is the great bullish myth. Stocks do not always recover Or they take so long to recover that waiting for that to happen represents a huge opportunity cost elsewhere
    • It is far better to earn $1,000 from a new position over the next six months, rather than carefully manage that old position and earn that same $1,000 over a three-year period. Traders who are so pleased with themselves for eliminating the loss from a given trade never recognize the opportunity cost
    • Writing OTM calls is a more bullish than writing ITM calls, and it’s nor right for you to tell anyone to be more bullish than he/she wants to be

    4) “but the risk of losing money would be less”

    Wolfinger’s Truth:

    • When you write OTM calls instead of ATM or ITM calls, the probability of losing money – during the lifetime of the call being written – INCREASES
    • The Truth: It is not the matter of profit vs. loss that determines risk. It’s the size of the profit and loss that is far more important. Writing OTM calls earns a profit less often than writing ITM calls. It also results in larger losses when the stock declines. True it can result i larger profits, but you were writing about less risk of losing money

    and

    Mike: I’m glad you shared your thoughts. Traders have different approaches to trading and adopt different trading philosophies.I know what I preach is best for me and I’m anxious to share it. I know that it makes perfect sense to me. I offer it in this spirit: consider Wolfingr’s Truth and decide whether it makes sense to you. This is the philosophy behind my teaching methods at Options for Rookies Premium.

    920

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2 Responses to Sharing what we learn: Pay it Forward


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