Wednesday, September 20, 2006

I had a dream

Last night I had a dream, but I need to tell you a story before: At the beginning I was day trading very aggressively, leveraging with a lot of margin and short term options to invest in technology companies. That is as aggressive as it gets. When I did research on companies like AMD, Intel, Dell, Apple, Pacific Ethanol, Archer Daniels Midland, Sandisk, Google, Rackable, nVidia I felt as preparing for a hunting trip, it was an extraordinary game.

It seemed sohhhh bohhhriiiing (very boring) to do the normal stock market investment game of returns of 10% per year that I looked to long term investors with contempt, as prey to benefit from by controlling their shares with options.

I was making nice money, but as in everything that involves good luck, it has to end. I was also becoming exhausted of tracking so many details about companies to do trading, and wanted to invest in a more conventional way. It was then when I made the nearly disastrous move of shifting almost all my money to AMD positions; which then I saw reduced to a third, even taking into account that I unloaded most of my call options and wrote many many calls since April (yes!, it was *that* much my margin leverage), but that is another story.

The thing is that I self - imposed a "trade embargo" in which I prohibited myself to do more than one trade per month (or two trades that correspond to a complex trade such selling short and covering when appropriate), and began to seriously study the subject of (simple) investment. And I discovered on my own how superior investing is compared to trading, even though I made a lot of money trading and lost even more investing in what I thought was the best prospect, AMD.

By the way, the days before the last AMD conference call I was down more than a year's worth of wages, but I am not concerned. In my philosophy, investing in the stock market you can lose and you can win, but you must absolutely have a good reason for every trade you do. If the reason proved wrong, there is learning. If the reason was right, although it made you lose money, so be it, eventually good decisions impose over the wims of the market. I studied a lot, which was the key to make use of the opportunities that were showing up little by little. Remember the common saying "Success is when opportunity meets preparation"?. I am recovering all of that money faster with every new research project I succeed completing, and then it will be gains and more net gains.

The thing is that the money pump relies on a "Hippodrome" use of options: You are "the house", who sells the calls so that others may gamble, and pretty much no matter what, the house wins a bit. It is still possible that some very keen gambler may consistently win with the "gambling tickets" you sell, just like very hardcore horse racing fans may win, but that is rather exceptional. While I was in that mood, almost ashamed of my recent wins, recently Ron gave us a lecture in the message board about how options are not just a non-constructive game, but a rather destructive one, which set my concious and unconscious mind to work.

Thus I had this dream, when I remembered my days of a trading privateer raiding the bountiful unsuspecting investing public in my dutch sloop-o-war. If I thought a company was overvalued, I felt as taking the candy off the nilvestor purse. If it was an undervalued company, I felt that I was beating the Wall Street pros at their own game. Those were days of strong winds, looking for hurricanes and storms in which to ambush the ships; weeks of persecution of the bounty (research) followed by a feast of trading to capture it, and then the return home trip unloading the positions and accounting for the gains.

But ever since I started to put into practice the money pump, with its rather modest monthly returns, I began to feel like the captain of one of the Galleons full of treasures that I used to raid, but it feels so relaxed!, I can forget about the market not for an hour but for weeks at a time!. I can use my knowledge of piracy to steer my ship to avoid turbulences and navigate in tranquil waters...

But success is again leading to nasty greed. My Galleon is a perfectly fine vessel, but I overloaded it! I am once again at over 120% margin leverage, I already received a margin call (although actually making a bit of money, paradoxically), and have been very very close to another one...

For me, the interest rates of the FED are like coral reeves, I can naufrage with a rate hike that will crash the shares as well as the defensive puts while appreciating the written calls! speak of a triple-play!

But this time the captain knew his route across the reeves... so he was spared, but not of the scare!


Anonymous said...

I still see that you need to do frequent gear shifting in the "money pump" so you're still in day trading mode, it doesn't take care of itself as hydraulic ram.

What is the decision criteria that you follow to either close your written calls or allow your shares to be called away?

If the stock is going up, trying to close your covered calls will be more expensive than the initial premium that you received when you sold your calls.

I think that your water pump article can be substantially simplified, is unnecessarily complex, for instance you need to provide more real life examples.

Eddie said...

About the money pump, I am not required to do frequent adjustments. I do them because I am speculating. In general, the money pump works best whenever the written calls are the fastest depreciating, which almost always are those that have a larger premium, but you don't have to readjust every time the stock oscillates; you can define a sensible policy regarding rebalancing and stick to it.

Speaking of "sticking to it", I have this strategy, and it is flexible, so that I can fold it any moment to day trade.

Regarding the policy of whether to allow the shares to be called away, I don't allow it at all. In fact, I buy shares if they go up a lot, let me explain: I have about 2.5x margin leverage, that is, my positions are about 250% of my equity. If the shares go up a 5%, my extra purchasing power allows not only to close short calls, but also to ratchet up the gains buying more shares and protective puts.

Then, if the price slides down, I can choose how to get out of the margin call, whether rolling down puts or selling shares, but this stuff is sub-optimal, everything works best when you can simply do counter-momentum trades.