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Tuesday, May 21, 2019

Beware of Evidence Based on False Investment Assumptions

I have seen/read several "experts" or "pros" who quote
stats supporting the widespread use of  selling covered calls as a source of regular income who
keep quoting stats in a way that grinds me wrong.

When it comes to the stock market, pretty  much NOTHING is guaranteed.  Risk is something that can be "managed" but usually not entirely protected  against.

If you have an interest in options trading you may find this post  compelling.......if not you may want to skip ahead to another post.... Just sayin' ")

So, I just wanted to mention that when you look at a quote of a covered call premium that would potentially be paid to you if you sold a covered call at precisely that moment and had your bid honored and accepted and the order filled by your broker.... let's  call that "Premium X"

So....what I see happening is that "experts" who are hyping the advantages of selling covered calls for generating income are taking a brief premium quote and then blindly multiplying that to cover one year span of time, based on the FALSE assumption that this same scenario will exist identically on  a weekly or monthly basis ALL YEAR LONG. Then they face you with a toothpaste smile and say "See how high of a return you can earn just be repeating that pattern for one full year?" They try to entice you by showing you how, based on that one brief quote of "PremiumX" how you can double your money in 18-24months. But I want to ask you. Is that a fair assumption? Can you really take a random call option quote and multiply that by how many trading weeks/months are in the year and use that as a baseline income assumption?

Those kind of false assumptions do not take into account any kind of risk or volatility!!!

If you actually fall for that line of reasoning you are setting yourself up for huge potential losses.
Taking one random quote CAN NOT and SHOULD NOT be used a fair gauge of income generation from a covered call writing strategy. Covered Call writing can and may indeed bring in to your accounts a legitimate cash flow. But it depends on a multitude of very crucial factors.

Permit me to express some of these crucial factors:
1/ what is the current market climate for the underlying equity that you are attempting to write the covered call on ? Does that equity have an "up" season and a "down" season?
2/ Is there a consistent demand for options on that equity, or is the demand hard to predict?
3/ Companies sometimes go through extended years of negative  returns, which harshly impact any kind of positive uptrend in share pricing. How will your covered call writing be affected by a tanking stock price that  lasts more than a year?
4/ If the market for options dries up for a certain equity, are you willing to pivot and change your income strategy? Do you have enough funds to re-position and try options trading again, but with a new position on a different equity?
5/ Do you have an exit strategy if/when a trade takes an unexpected turn?
6/ What is the P/E ratio for the equity that you are writing covered calls on?
7/ Do you really understand the risks of trading options on really volatile equities with "unknown" fundamentals?
8/ Do you have other sources of income if/when you make an error of judgement? Even seasoned traders occasionally make a clerical error that can cause a loss in income. Seasoned traders know too well when their emotions have gotten the best of them and they know when it is time to walk away from trading for the rest of the day and start again on a new day.
9/ Do you have the wisdom to manage your positions on a regular basis? Selling options for consistent income requires managing your positions. One should not just "set it and forget it" if you want to protect your investments.

Markets ebb and flow. Prices of equities flow up and down and sideways. Sometimes they go bust.
Sometimes options prices are so volatile that even regular traders have a hard time following their movement and timing their trades in a consistently profitable pattern.

That  is why, it is not prudent or logical to  say that writing covered calls is Always a great idea based on the numbers gleaned from one random option premium plucked from one potential trade on one possible trading day.

There are a million different things that can affect your ability to get the price you want to collect for a covered call premium. There are also a million different  things that can happen to the underlying equity that you are writing your covered call on.

In some parts of life, blind optimism can be a great asset. Not so with financial matters. It always pays to be prepared for every possible scenario that can unfold in the markets and to be able to be flexible enough to adjust your strategy to take advantage of up markets, down markets, and sideways markets.

When something, especially in the financial world sounds too good to be true.....it just may be too good to be true. Don't just question the statistics that "experts" quote. Question how and when the statistics were collected. You can't just measure potential options trades based on one random happy sunny trading day. One also needs to prepare for those days when the clouds roll in and the profits are harder to find.

 Just take a closer look at what happened to most equity prices in the 2008 recession.  Big dips happen. Prices can take as many as 4 years or more to bounce back from a big dip. I am not trying to depress you. I am simply trying to suggest that we all need to prepare for the rainy seasons as well as for the days filled with sunshine.

In peaceful productivity,
.
C.