In our June 19th blog we wrote "The bottom line is the flush is upon us. What is a flush you may ask? It is the final collapse of the indexes that pushes all the weak holders to their absolute limits and just beyond. It causes the courageous to become meek. Conviction is eroded and faith in the markets is destroyed. It is painful for many. It should not be painful for you, our members, because (we) warned of this correction and we stated we would stand aside from it. And we will swoop in with more aggression when it is done. We have already started to build longer term positions as evidenced by recent Trade Alerts. In the short-term the pain may last a little longer. If it does appear, it will be very painful for most. But it will be necessary before the long awaited uptrend finally appears. Fasten your seatbelts, it’s a rollercoaster ride, but the fun times are not far away now."
On June 20th, we viewed the flush that had just occurred with optimism but stated it was not a ‘Royal Flush’ and concluded "As of right now, the reward to risk ratios are not overwhelmingly positive, so we remain with our fingers on the trigger ready to jump in with greater abandon but are holding off until we have greater certainty."
Well, the best way of describing our feeling after Friday’s big declines is "PHEW!" It was oh so tempting to believe the bottom was in Thursday and we certainly believed it might have been possible, however discipline demanded we hold off until the markets presented us with greater clarity over future direction.
But that’s all in the past, the real question is how do we trade the market in front of us now?
Well, our preference is to return to what we call the The Backup Plan. When the going gets tough, confusion is rife, turbulence is prevalent and the stench of panic in the air, it’s time to go back to the basics. We thought it might prove helpful sharing our step-by-step process in finding a trade during such challenging times.
The first step is recognizing the climate is tough and that it’s okay to target lower returns while the markets are turbulent.
Next, we evaluate our watchlist of fundamentally solid sompanies; these are companies that will be around for a looooong time. Think McDonald’s, Walmart, Home Depot etc. Companies with strong fundamentals which are much closer to support levels than to resistance levels are generally preferred.
Once a company is chosen, we scan options chains to verify attractive premium exists. And what is that strategy?
Well, it comprises purchasing stock and selling short calls slightly in-the-money with approximately 3-4 months of time value. This strategy protects the stock holding to a greater extent that would be the case had an out-of-the-money short call been sold.
Next, a bull put is considered for the same timeframe but at a lower strike price. If the stock remains flat, rises or even dips slightly but stays above the short put strike price, the bull put expires and enhances the overall return. If the stock drops, resulting in assignment of the short put, an additional stock purchase is made, albeit at a lower price. Hence, we effectively get paid to scale into a solid stock over time.
The most important aspect of this strategy is money management. We must ensure that only half the capital we apportion to the overall position is deployed via the initial stock purchase, so that the remaining capital may be used to fund the subsequent stock purchase should it become necessary.
Finally, the goal in this strategy is to make approximately 8%-12% in a 3-4 month timeframe. For emphasis, we will highlight that independently Phil and Stock and Option Trades both referred to very similar strategies this weekend. So, if you weren’t sure about these strategies before, hopefully the dual emphasis resonates strongly and you take a closer look at them!
