Buy, Right?

So I’m breezing through some Dorsey Wright newsletter that found it’s way into my email, and lo and behold I see a blurb about buy-writes. They love the idea here. I don’t. Which does lead me to thinking, since among other things, they’re brilliant, and I’m not. So what am I missing?

I guess there’s just so many variables, either answer could be correct.

Let me try to ‘splain.

I don’t think walking in right now and slapping on buy-writes, or their Evil Twin, naked short puts, is a bad idea. I don’t think it’s the best idea right now either, but I mean it all depends on what you are trying to accomplish. You’re locking in fat volatility sales, but the flip side is there have been a whole lot of sales that looked very fat not all that long ago. You’re also at worst, buying stock at prices even lower than these, of course that too sometimes seems dubious when the stock actually gets there.

The best way of looking at it imho is that you want to get long, but not aggressively. And despite the open-ended downside nature of they play, it’s certainly less aggressive than buying stock. The flip side of course is you don’t get the upside, but that hasn’t been an issue lately.

What IS a horrible idea though is over-writing fat calls against a stock position you’ve ridden down, or are riding down, or just own and are getting ill with. The relatively small money you took in vs. the stock will barely ease the bleeding, and will only annoy you to now end if/when it ever turns. I would way rather do the exact opposite and sell the loser stock out and replace it with calls. The premium you paid will drive you nuts when you pay it, but the plus side is you’ve now defined your downside and will still participate if it ever turns.

Anyway, going to close with a thought from Nick (Ocho Cinco) Perry over at Schaeffer’s regarding the pros and cons of premium sales in this environment.

Now, I know that one of the characteristics of volatility is that is it supposed to be mean reverting. In that scenario it seems logical to assume that volatility will decrease and therefore take option premiums with them. If that is the case, then yes, selling premium here is a potentially “easy” trade. But that is built on the premise that volatility, and the wild swings, starts to recede here.. My response to that would be – have you followed the market this week? There is nothing rational or logical going on here. Prices are swinging wildly. Maybe that lasts for a couple of days, maybe a couple of weeks.

The issue with premium selling is the you have limited upside and can be subject to some big risks. That is a fine strategy if you understand that risk and have the capital to ride through a potential blow-up. However, for most of us, I think it best to keep this quote, attributed to John Maynard Keynes, in mind…

“Markets can remain irrational longer than you can remain solvent “