NEW YORK (TheStreet) -- I'm not a very well-read person but one book that I couldn't resist reading was The Psychology of The Simpsons.
It was actually a gift given by a psychologist who knew that "The Simpsons" was one of my few passions. That psychologist also introduced my wife and I to one another, so I should have, perhaps, been somewhat wary of new gifts.These days, really all I care about is trading and right now my thoughts are focused on modifying my trading in a covered option strategy, as there is indication of a transition in market sentiment and most importantly, in market volatility.
My least favorite situation is to have uncovered positions. Lately that is an increasing occurrence.Back during the 2008-2009 financial crisis, volatility was high and option premiums were substantially higher while the market was falling. it was actually very easy to stay ahead of the market, if you channeled Homer Simpson: Just say "D'oh."
For my purposes, "D'oh" is an acronym for "Digging out of a hole." The way it is practiced should be the antithesis to the exasperation in which it is usually uttered.
In March 2009, it will be the fifth anniversary of market lows that saw a market that went from all-time highs to having lost more than 50% of its value.I don't want to draw parallels between this market, which is barely down 4% in the first month of the year, and the situation in 2008. But I do want to dust off some of the trading strategies that were incredibly useful in outperforming during a terrible market.
The first thing to understand is that the primary objective during a down market is to not go down as much as the overall market. It doesn't take too much thought to realize that it's easier to fall from $100 to $80 than it is to rise that same $20 going from $80 to $100. Mountains are much harder to climb than they are to fall off from.
By virtue of selling options and collecting premiums you are already at an advantage in a declining or sideways moving market, but the real advantage comes from continually being able to sell those calls even when your positions are far below their cost basis. For those that have now been doing this for a while you have seen how accumulating premiums really can add up, but they have to be given the chance to accumulate.
There are differences between now and 2008.
The first is that there were only monthly and longer options available back then. Additionally, there were fewer and more widely spaced strike levels. Finally, volatility was already high, while it is just now showing some evidence of growing.
Why are those three items important?
First the basic "D'oh Strategy.
Digging out of a hole implies that there is action and not simply passivity awaiting a fallen stock to rise higher, especially in a downward moving market.
The idea is to start delivering option income from a non-performing asset that is no longer expected to be carried, along with what was once a higher moving market.
During a higher-moving market, option premiums tend to be low, sometimes very low. That means it's difficult to get an acceptable premium on shares that are well under their cost basis, if you use the cost basis as your strike level.
So instead, you let your asset sit and do nothing while waiting for it to pop higher. That expectation is more realistic during a bull market than it is during a bearish phase. During a bull phase, you would feel like an idiot if you traded your shares for pennies, so you let actions take second place to passivity in many cases.During a bear phase, as option premiums start to rise along with volatility, there come instances when you will see premiums starting to get more attractive even for strike prices that are a level or two above the current price. Now, however, instead of a level or two representing unobtainable or unrealistic price objectives (as in 2008, and therefore, bringing very low premiums), the range of strike levels now offers many more realistic prices and more appealing premiums.
The idea is to capitalize on those higher premiums, but to reduce the risk of assignment by using higher strike levels. During a bear phase, the expectation of a pop higher in price is lessened, although it can still occur. While you may feel like an idiot in a bull phase for taking pennies, during a bear phase you may feel like a genius for finding some additional income. You will especially feel like a genius if you can ride your shares higher and still collect those premiums.If and when a pop in price does occur, you simply evaluate the relative benefit of rolling over the existing option, preferably to an even higher strike price. Doing so will reduce the net premium, but may even result in a trading loss on the option in the event of a sudden price rise. The idea with rolling over and hopefully to a higher strike, is that you continue to want to be in the game and have an opportunity to get more premiums and eventually exit your position intact, rather than at a loss.
Back in 2008-2009 when only monthly options were available, you would find yourself getting locked in for longer than you might prefer. With weekly options, you can be more nimble and responsive to changing share prices. However, as forward month volatility further increases, there may be opportunity to use a longer time period and a further out strike price to guarantee a greater premium and minimize the need to aggressively monitor and trade the position.
As a recent example, some of you may own shares of Anadarko (APC). If you do you know all too well of the swift plunge shares took when a judge ruled on an old case regarding a firm that Anadarko bought and calling for a $14 billion settlement.
Dropping from $88 per share to $78, there was no opportunity to get a decent premium to make call sales worthwhile, even if owning unusually large positions.
While the market was still in its 2013 bullish phase, I did buy additional shares using my "Having a Child to Save a Life" strategy to offset some of the paper losses. As the market started to weaken, I'm less excited about committing more money to a specific position in order to underwrite some of the losses.
However, volatility for this company increased when the company announced that it was going to appeal the decision and believed that damages were in the $3 billion neighborhood. Shares then spiked $80.80 per share. At that point, a weekly $82.50 contract had a $0.31 premium.The next week, as the previous options expired, an $83 per share call was sold for $0.30 when shares were about $81. However, for a brief time (following word of an activist investor taking a large position), it looked as if the $83 strike would be exceeded, so I was prepared to buy back the options and then roll them to a higher strike level.
Instead, following the rest of a weakening market, shares retreated and those contracts were rolled over to a new weekly $84 contract for an additional $0.41 net premium at a time that shares were trading at about $81. While the share price was the same as it was just a week earlier the premium was growing nicely having gone from $0.30 to $0.47.
The story is still one in progress and continues until an acceptable endpoint, but at least you go out fighting.
At the time of publication the author had a position in Anadarko.
This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.