From a young age, many of us are conditioned to believe that the harder we work, the greater will be our successes. The advice stands up to scrutiny in most respects. Whether studying hard to graduate from school or working hard on the sports fields to ‘make the team’ and ‘beat the competition’, hard work pays off. And then we transition into the professional world and soon discover that promotion and increases in pay follow from going the ‘extra mile’. So, by the time we have amassed a level wealth with which we can trade or invest in the stock market, we our heavily conditioned to believe that hard work means greater success; the habit was formed through a lifetime of practice. The cause (hard work) and effect (greater success) relationship becomes so ingrained that we often consider it indisputable.
Yet, for many new traders and indeed many experienced ones, translating the habit of working hard into stock market trading does not lead to the expected level of reward. The attraction for so many is to confuse working hard with trading actively. Working hard in the stock market is necessary for long-term success. It means conducting due diligence: fundamental, technical, sentimental, and economic. However, trading frequently should not be so easily equated to working hard. While many outstanding traders engage in active, short-term day-trades, a great many others engage in trading excessively because it offers a level of excitement. Indeed, Tony Robbins contends that two of the six primary needs of humans are certainty and uncertainty. As humans, we need to be excited on a regular basis in order for our interest levels to be maintained.
Examining aspects of our lives, we can quickly see that this contention may be very accurate. Why is it that we like to go to see a new movie? Is it not because there is a degree of uncertainty attached to the series of events throughout the movie? And further is not because we have been conditioned by the movie industry to trust that overwhelmingly the final outcome will be positive; we have a certainty that this will be the case. If we are internally wired to NEED uncertainty and excitement, is it not eminently feasible that we create this uncertainty and excitement in our stock market trading also?
If we assume that most traders are unaware of their internal wiring, leading them to trade more actively than might be prudent, then understanding why so many have mediocre results is apparent. In recognizing that we have a desire to trade actively to create excitement, we should also recognize our unique ability to control our instinct and to think and act in a manner that truly is in our best interests.
That leads us to ask the question, what trading strategies can we consider that require little work, but can produce stellar returns over time? One simple, yet very powerful strategy that fits the bill is the 3-4 month near-the-money Covered Call. For example, from mid-April to late May of 2008, Nvidia held its 20-day EMA as a support level in spite of a choppy stock market during the mid-late May period.
By Memorial Day weekend, the stock was trading at $23.11 and a 4-month short call in September at strike 22.50 offered $3.10. So, the cost basis for entering the entire position is calculated as:
Cost Basis = Cost of Stock – Short Call Credit
Cost Basis = $23.11 – $3.10 = $20.01
The obligation associated with the short call option comprises selling the stock at $22.50, the short call strike price. So, by the time September rolls around, if the stock is still above the 22.50 level, the short call will be automatically assigned and the stock sold at $22.50, resulting in a profit of $12%!
Because the short call strike price is slightly below the stock price at trade entry, the stock can even fall $0.61 by September expiration – a loss of 2.6% – and the position would still end up ahead by 12%. In fact, it is only if the stock dropped below the cost basis, $20.01, that the combined position would be at a loss at expiration. This would require a stock drop of 15%.
But what is required to commit to such a trade (and this is but one example of literally thousands of such examples)? Sloth! That’s right, sloth is good! Sloth means entering the trade and doing zippo, nothing, nada, zilch! The trade is about as exciting as watching a pot boil. Day 1, what happens? Probably not much. Day 2, similar to day 1. Day 3, much the same as days 1 and 2. Day 4, well you get the picture. Initially, the trade can be very boring. In fact, it is only after a considerable time period that time-decay starts to really eat away at the option premiums if the stock remains quite stagnant.
So, is it worth it to enter such a boring trade? Well simply look at the return? 12% in 4 months. If historically, your annualized return is greater than 36% per annum, then the trade is not worth it. However, if historically your annualized return is below 36% per annum, maybe this type of trade is worth considering. Obviously, with the market so weak this past week, such covered calls should be applied sparingly. However, when the market turns back up, such positions can prove very lucrative very quickly.
Indeed, when holding this position in an uptrend, one of the most challenging aspects to manage is knowing that if you never held a short call, the stock alone would have produced a greater profit. This kind of thinking can be very destructive because it leads one to consider chasing trends versus remaining content with fixed returns.
Finally, if the worst-case condition materialized where the stock started to drop precipitously soon after trade entry, the 20-day EMA support may be used as a trigger point. Specifically, for every 100 shares of stock owned, 1 long put contract may be purchased to protect the stock during the downtrend. This would result in a conversion from the Covered Call strategy to the Collar Trade.
