Wednesday, June 27, 2007

An Evolving Plan

We had another great discussion on the Yahoo Group. If you're not a member, and enjoy discussing covered calls, then I encourage you to join.

Someone ask how my results were affected by switching from short-term CC's to longer term CC's, so I spent a few hours calculating my results for closed positions established before March 2006 and after March 2006. The results showed that my average holding period and percentage of initial positions established ITM had increased, as expected. The percentage assigned on the first call vs expired stayed about them same, at 70% assigned 30% expired. However, my average annualized return had decreased. So, while I was getting more downside protection with the longer term CC's I was also sacrificing some returns.

After analyzing this data I decide to make another change to my trading plan to incorporate more short-term (1-2 month) positions to try to improve my annualized returns. I spent a few days running various scans with different criteria for short-term positions, most of the stocks I was finding were rated 1-2 stars by Morningstar. Having a margin of safety, by purchasing stocks below the estimated fair value, is a key concept that I learned from Ben Graham, and I just can't bring myself to buy an overvalued stock.

So, I decided to try a simple change to my existing criteria. Rather than require a fixed percentage of downside protection (e.g. 10-12%) I tried using an annualized percentage. I searched for positions that return 24% annualized if called and 24% annualized if not called over a 1-6 month holding period. That equates to about 2% downside protection (DSP) for a front month call and about 12% DSP for a 6 month call. The further out you go the more DSP you need to achieve a 24% annualized return if not called. This resulted in several short-term positions (1-2 months) and about the same amount of long-term positions (3-6 months) as my prior criteria. Downside protection varied based on stock price and days to expiration.

This new scan looks promising and would be a minor change, as far as procedure goes, to my existing trading plan. I was going to wait until after July expiration to implement these changes, but I had 2 positions that achieved over 90% of their potential profit today so I closed them out to free up some cash. I plan to use that cash to open 1 new front month (July) position tomorrow.

I'm also going to post my trading plan history so you can see how my plan has evolved. As I've said before, having a plan is critical to success, but your plan shouldn't be caste in stone. It needs to evolve as you gain experience and knowledge.