Options versus Stocks — Know when to use ’em.

Options versus Stocks

Team, one thing that I do naturally (as a result of NOT doing it naturally when I began trading) is shift my bias between stocks and options, depending on what the market is doing.

When the market is trending, I want leverage.  When the market is trending nicely and appears to have clear upside (a subjective judgment, based on analysis, experience, etc.), I will pile it on in what appears to be an irresponsible manner — taking outsized positions in just a few stocks that are working (Frankly, it’s the pyramid concept that I discussed a week or so ago).  If a stock is working, I’ll buy more and more calls on the way up (yes, on the way <i>up!</i>, not on the way down).  I’m big on averaging up because I feel that I am playing with the house’s money.  But that only remains correct (i.e., playing with the house’s money) if you are diligent in watching.  You are deliberately taking on a high-maintenance situation where risk is high, and reward is high…and the best way to manage that risk is by additional, uninterrupted, and unwavering vigilance — always talking to yourself, cautioning yourself to avoid being too greedy…and also telling yourself that good traders become very aggressive when they “see” the trade. 

Profitable traders have two main themes in their market approach (irrespective of what that specific approach is).  First, they want to lose less money when the market is falling, and make more money when the market is advancing!  This is the twin pillars of outperformance — lose less when the environment is bad, and make more when the environment is good!

So, when the environment is good, I’ll pile it on with options.  I always track the dollar value of the stocks I am controlling, and it will occasionally rise to 3:1 or even 4:1 (i.e., I’m controlling stock that is 3-4 times the value of my portfolio.)  But when I’m that long, I am also distracted, a bit anti-social, and introspective.  I’m not particularly fun to be around because I am thinking all the time.  I’m not grumpy, that’s for sure.  Why?  Because, by definition, I’m making a lot of money.  That’s why I’m so overleveraged.  I darn sure wouldn’t be that way if I was upside down.  That’s what fools do, and I’m no fool.

So trending markets are actually pretty high maintenance if you are pouncing on them!  They are easy if you’re content to make some money in a strong market without working too hard.

But there is always the other side of any cycle.  Uptrends give way to sideways chop or violent reversals.  Each has its own characteristics…and therein lies the art of trading.

When the market changes and the trend falters…even in some small way…then I’ll start pulling in those horns.  I’ll be selling those call options (Note: I’ve got some LEAPs on AAPL.  Those don’t get sold.  Those are leveraged investments that’ll be sold during the latter part of 2010).  I will scale out slowly…or quickly, depending on what the market is doing.  Am I bearish?  No!  I’m just cutting down on my risk, which was quite high.  I am not requiring the market to continue to do my bidding.  I expect it to change because that’s what markets do! 

So when it changes, I change.  I’ll cut down my options exposure and buy stock.  A 5% move in a stock can cut your option profit by a lot more than 5% — if you’ve traded options, you know this.  You’ve seen a 25% gain transform into a 30% loss overnight.  Example: Google is down around 3.5%.  How many folks with calls that expire on Friday are now having a really, really bad day?  Those $580 calls that looked so good on Friday are crushed today — nearly worthless! 

If you’re long GOOG rather than calls, then you’re down 3.5% — barely enough to get your attention.

I could go on and on, but I won’t.

The point is this: If you insist on trading options through thick and thin, you’d better either know what you’re doing, including spreads, straddles, strangles, naked selling, etc., or have a lot of discretionary money that you’re happy to risk.  Instead, just switch to stocks.  Be comfortable buying stocks you like when they dip.  Embrace the decrease in downside risk…and upside reward.

Stay in the game; stay involved; stay in emotional sync with the market.  You’ll make more money by losing less money.  And you’ll also develop as a “S.M.A.R.T. Trader” — something that I’ll talk about at another time.

Have a great day.

Dan

By the way, we are now a MAC OS company.  When I was in the hotel room with Gary back in D.C., he got the BSOD on his laptop (though he did recover everything) at the same time that my computer was freezing up.  In toto, we probably spent about 3 man hours just dealing with PC/Windows issues.  Yes, if we scrubbed our hard drives and reinstalled Windows and all the programs we use, then we’d each have some nice machines.   But think: Why, in 2010, should I have to do that?  If there is no competition, then you’ve got to do what you’ve got to do.  But that’s not the case here.

So I stopped by the Apple store last night before I even went home.  They are setting both me and Gary up on new Macs, including migrating all of our stuff from our PCs to the Macs.  We have unlimited support, classes if we want ’em, and also a business plan that enables us to get top priority if anything ever goes wrong.

They have had a business transition program (I forget the exact name) for less than a year, and it focuses solely on helping small businesses like SMM transition from PCs to Macs.  I will let you know how the whole process goes (we are right in the middle of it now).  But so far, we are both quite happy with it.  And since Apple only owns 13% of the PC market and has unarguably better hardware and software, it remains a growth story, despite its massive market cap.

(Note: The only thing that doesn’t work on MAC OS is Telechart.  But that’s easily overcome by running Windows parallel with the Mac.  Easy fix).