Army’s Top Advice: Don’t Do THIS
As many of you know, I spent time in the Army — a place where risk management is extremely important. Risks include death, catastrophic injury, and damage to millions of dollars of equipment.
There are formal courses on managing risks in different environments. But grizzled veterans explain risk management by saying “just don’t do anything different or dumb.” I’ve followed that advice in my military and investing careers.
In a nutshell, this advice is basically saying, “Have a process and make sure you have the discipline to follow the process.”
The Army is all about process. And understandably so. If something works, then you shouldn’t change it. You may not understand all the ramifications involved if you do.
My process for selling put options in my premium Income Trader service is detailed in a paper I wrote a few years ago for the Market Technicians Association. (This is the same research I’ve mentioned before that won the 2015 Charles H. Dow Award.)
If you’re curious to learn more, then I encourage you to follow that link and read the whole report. But today, I thought I’d touch on a few points in order to expand on the idea on risk and why it pays to stick to a plan that works…
To put it simply, my process in finding trades for Income Trader is searching for:
– Options that are expiring soon and have a high probability of expiring worthless. Preference is given to the options expiring the soonest.
– A minimum annualized return on investment of at least 10% until expiration.
– A “buy” signal on my Income Trader Volatility (ITV) indicator, which means the indicator is below its 20-week moving average.
The ITV indicator is the key to the success of the system. It shows the ideal time to sell options.
ITV is based on the same concept as the VIX Index. VIX is found with a complex calculation based on options prices. Applying the VIX is relatively simple. High values of the VIX are associated with falling markets. That’s because declines prompt traders to buy put options to protect their portfolios, leading to higher prices in the puts. VIX is designed to capture that behavior.
Because VIX responds so rapidly to market declines, it’s known as the “fear index.” Analysts say that when VIX is rising, fear is rising. As such, they expect fear, and the VIX, to peak near market bottoms.
It’s a useful concept, but I saw some holes in that idea.
It’s useful because options premiums move with fear. Premiums rise as fear, and VIX rises. Premiums will then fall as VIX declines. This is captured by the volatility factor in options pricing models.
Ideally, we would want to sell puts at the absolute bottom in prices. Then, we benefit in two ways — the price rally will drive the value of the put down and we will capture the elevated premium in the option.
The first hole in the concept that I saw is the fact that VIX applies only to the S&P 500. While most stocks will follow the trend in the S&P 500, some will not. I wanted an indicator that would measure the level of fear in individual stocks.
Another problem is knowing when VIX is high enough to signal a bottom. This part of the problem was easy to solve. I just added a moving average to define the direction of the trend. When VIX falls below the moving average, fear is subsiding and the market is most likely bottoming — the ideal time to sell options.
I spent a great deal of time analyzing this problem and came up with ITV. Then I designed a complete process around that indicator.
Sticking To The Process
To avoid doing something dumb, I stick to my process. The process includes trading only when the price is right. For each recommendation, I look at the option’s fair value and I use that to set the upper limit of my recommended “buy” price.
Then I look at where the risk of the trade changes. That information lets me identify the lower limit of my recommended range. I always recommend trading within the range because that limits risk.
This is an important part of my disciplined approach, and it is not the simplest concept to grasp. Many individuals try to trade options like stocks, and there are important differences in the price action.
Let’s say you are a value investor and you like a stock at $20. You are certain it is worth $40 and expect the price to reach that level in three years. You may decide to buy the stock as long as it is below $30, since that provides a 25% gain and that is the minimum price you want. If there’s a market selloff and the stock drops to $10 as the S&P 500 Index drops by 50%, you might buy as much as you can.
Because you have a long-term perspective, the price of the stock isn’t very important. It’s a “buy” anywhere from $1 to $30.
Options are different. They are short-term investments, and large price moves change the risk parameters of the trade.
If I recommend an option at $0.40 to $0.60, and the price moves to $0.80, the amount of risk increased. At higher prices, the market is telling us that the risk of the option being exercised has increased.
This is a different trade than the one I recommended. It’s also a different trade if the price drops to $0.20, since there is now less potential reward. Risks still exist on the trade, but we won’t be properly compensated for accepting the risk.
Trading outside the price range is different than what I analyzed and, to avoid risk, I don’t do that.
Action To Take
Over the long run, my process works. Since February 2013, my Income Trader recommendations resulted in wins 91.3% of the time. That’s seven years of trades with the same disciplined approach… and there have been some significant down moves during that time, like the fourth quarter of 2018 and the summer of 2015.
Discipline means taking trades that pass my screening and avoiding trades that don’t meet my requirements for safety. If there are no trades that fit that criteria, I don’t recommend one to my subscribers. That, as the grizzled veterans from my military career would day, is different and dumb. I don’t do things like that.