Over the last week, more than a few illuminating questions hit the TradeSmith Daily inbox. Questions begging a response from the talented folks who make up our network.
I passed those along… and got you some answers.
Normally, this kind of thing is exclusive to our paid-up subscribers. But today, to highlight how well our analysts take care of our readers, we're making an exception.
Here's the first question from Everett H., directed to 25-year options trading veteran and founder of our corporate partner Masters in Trading, Jonathan Rose.
I am going to try to watch all of the sessions with Jonathan Rose as I think they will really help.
One thing that would help me and perhaps many others in covered options would be as follows:
Do we need to own the stock?
Which option do we buy first?
Is it buy to open, buy to close, sell to open or sell to close?
I am still working, now for myself, however I will make as much effort as possible to learn and make the right trades to earn a decent retirement over the next 8-10 years.
- Everett H.
[Quick note before Jonathan's response. Jonathan's doing a series of free daily livestreams at 11 a.m. Eastern, sharing trade ideas and insights from the mind of a 25-year market veteran brought up in the Chicago Board Options Exchange trading pits.
He initially answered this question in the Tuesday, March 26, livestream. The answer below is adapted from that.
Jonathan Rose: Everett, thanks so much for writing in.
What I love most about your question is your willingness to learn. If anyone's willing to learn, I'm here to teach.
There are lots of different covered options strategies. The one I tend to recommend is selling a covered call option on stock you own.
With this strategy, the result would either be the option expires worthless and you keep all that premium and your stock, or the option is exercised on favorable terms for you – in this case, selling the shares for higher than your entry price, and even higher than the current price when accounting for the premium earned for selling the option.
For selling covered call options, yes, you need to own at least 100 shares of an underlying stock. That's because options trade in lots of 100 shares. So if you're going to have any kind of option exposure that would result in potentially calling your shares away, you need to hold the underlying stock to the same amount. Otherwise it's an uncovered position, which is a separate – and very risky – strategy.
Once you have you have your 100 shares, you can then sell to open (aka write) one call option on those 100 shares of stock.
When you're selling the call, think about it like getting paid to put your stock up for sale at a price you decide. Here's an example with some hypothetical numbers.
If you buy 100 shares of a stock at $100 per share, you can decide to offer that stock at $125 per share by selling to open a call option at the $125 strike price.
When you do so, let's say you collect $1 in premium, multiplied by the 100 shares your option covers. So you walk away with $100 in income in exchange for giving someone the right to buy your stock at $125 by the expiration date. And since you've collected that premium, your initial cost on the stock is effectively $99 per share, since you just got $100 in premium right back to you.
Now, either the stock never reaches $125 and the option expires worthless, or it does and you sell it at that level. Either way, you keep your premium, so you're ahead no matter what happens.
I hope that clears some things up, and I look forward to sharing more ideas with you in the Masters in Trading: Live daily videos. It sounds like you're already signed up, but for anyone reading this who isn't, you can fix that with one click right here.
On to the next question, here's one for Jason Bodner on his Big Money Index...
Hi Jason Bodner,
I have been following your work on Big Money moves the market. In it you've mentioned that the market is overbought since Dec. 14, 2023, and we should prepare for a pull back when it goes back under 80.
Since then I have been sitting on the sidelines waiting for that pull back that has not materialized and as a result left a lot of money on the table. Am I correct in thinking that this pullback is imminent, or should I get back in the market?
Your thoughts?
Henry
Jason Bodner: Hi Henry, thank you for writing in.
First things first, I have to tell you that I'm not allowed to give independent financial advice. I am not a registered investment advisor, nor do I provide financial advice to individuals. With that out of the way, let me get to your question.
I did indeed mention that the market was overbought on Dec. 14 to my Quantum Edge Pro subscribers. We knew that thanks to my Big Money Index, a rolling calculation of overbought and oversold conditions guided by the moves of Wall Street institutions. (My colleague Lucas Downey covered it here in TradeSmith Daily a few weeks later, in January.)
But I also said it's essential to understand that what matters is not necessarily when the market goes overbought, what matters is when it falls from overbought. That happened in early February:
As that was happening, I was taking some profits in some of our services, notably in Super Micro Computer, which is now a risk-free position with 66% of our chips off the table and a 225% gain.
But I've also been saying along the way that we need to look out for elevated selling. We never saw that.
What we saw was a ton of buying in December that slowly rolled out of the calculation for the Big Money Index. We then saw still more buying than selling, just substantially less buying than what we saw from December's extreme levels. And the market has continued to rise during that time.
So what we have is a bull market continuing without the red flags of a correction. Historically speaking, when markets go overbought, we do expect near-term volatility. But what we have learned over time is that we need to see some actual evidence of selling as a potential catalyst for a broader correction.
That just hasn't come yet. It may or may not. But at this point, the BMI has leveled off and has been in a tight range between 71 and 74 or so since around Valentine's Day. As that happened, and selling did not increase, there was no need to sound alarm bells.
My advice is to continue following my work closely. Things change on a dime in markets, and we never know when. But if selling does pick up, and it does come time to de-risk from the markets, you'll soon hear about it.
Also, keep this in mind: While I do use powerful indicators to help with market timing, my personal goal is not to time the market. I have been 100% invested in stocks since 2014 and even earlier than that. That means that I have ridden through some of the deepest corrections in history, including COVID.
My defense against avoiding losses is simply being in the best quality stocks over time. That does not mean I dodge all volatility, but it does mean when the rubber band invariably snaps back, I am in the best stocks to own according to my metrics. Now granted, that method is not for everyone and requires certain resolve that I have developed in my 25-plus years of investing.
I'll leave you with one last pearl of wisdom: I used to have a client who founded and managed a $9 billion hedge fund. He would give me orders to buy stocks and options.
Often his levels were nowhere near where the market was trading. The end of the day would come and I would have 5 or 10 orders that just never got executed. So finally one day I asked him, "John, why do you even bother with these orders when they're so far away from where the market is trading?"
His response stuck with me and became a cornerstone to how I view investing in the stock market. Not necessarily in terms of execution prices and getting the best fills on orders, but more in terms of the bigger picture.
He simply said: "Patience and process."
Moving right along, here's an excerpt from a recent Trade Cycles issue where William McCanless addressed feedback from a few readers concerning recent positions:
Ken C. writes, regarding William's stop loss policy for options trades:
Do you recommend stops for getting out? What about a stop loss or maybe triggers based on the stock's trading value?
William McCanless: I don't ever recommend using stop losses with options for a few reasons I've covered before. The main reason is that, over the years, I've found that setting stops led me to both take on too large a position, and to lock in losses at just about the worst possible time to do so.
Options are so volatile that they can and do easily turn around on a dime. Not always from a loss into a profit, but at least from a big loss into a smaller one.
In Trade Cycles, I recommend letting your position size act as your stop loss, and instead set a firm profit target where you'll sell no matter what.
I recommend the total cost of the option (or the maximum risk of the option) should not exceed more than 2% to 5% of your account size. So, if losing 100% of an option's value is no more than 2% to 5% of your account, then you're good to go.
In other words – your position sizing is your stop loss. However, I should note we will very rarely – if ever – hold on to an option position for a 100% loss.
And another two readers – Jerry S. and John K. – wrote in about Predictive Alpha signaling a buy on NVDA while William recommended a net short trade.
Some background – William recently recommended what's called a "spread trade" between Apple (AAPL) and Nvidia (NVDA). It was designed to mitigate risk by making money as the gap between the two stocks close. Now, here's William's response.
It's important to keep in mind that our spread trade between NVDA and AAPL isn't a true "long" or a true "short": It's a relative value trade.
Remember, they can both rise, and we make money. They can both fall, and we can break even. Or NVDA can fall and AAPL can rise, and we can make a larger profit.
It's really a trade on the big discrepancy between what essentially are two stocks that are correlated as far as sentiment and sector are concerned. In that situation, I want to buy the cheap one and sell the expensive one. So, this was not an outright directional trade.
That'll do it for this rare peek behind the curtains to see how TradeSmith's top minds are helping our readers navigate this market.
For more in this same vein, check in this Tuesday for a brand-new video from Lucas Downey where he'll walk you through a few stocks our readers asked to hear coverage on – some landmines and some goldmines.
To your health and wealth,
Michael Salvatore Editor, TradeSmith Daily
P.S. If you missed last year's big A.I. trade, don't worry.
To be clear, this trade is still early days. It's mega volatile.
And that's why Luke and his team aren't recommending a buy-and-hold strategy.
Instead, they designed a quantitative trading system to score quick singles and doubles on these stocks in a matter of weeks, if not days, before internal breakthroughs become headline news.
TradeSmith is not registered as an investment adviser and operates under the publishers' exemption of the Investment Advisers Act of 1940. The investments and strategies discussed in TradeSmith's content do not constitute personalized investment advice. Any trading or investment decisions you take are in reliance on your own analysis and judgment and not in reliance on TradeSmith. There are risks inherent in investing and past investment performance is not indicative of future results.
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