Writing Naked Calls using Warren Buffett's Philosophy

In my previous post- Signs of Wave 2- Consumer Confidence Slides- I mentioned that the US equity markets are in wave 2 of the wave cycle. CLICK HERE to see my complete analysis of DJIA.

You must know that writing covered calls is one options strategy that consistently makes money with limited risk exposure. We are ignoring the chance of loss on plumetting value of the underlying asset. The assumption is that the intrinsic value of the underlying asset is greater than the market value and the covered call writer will continue to hold the stock because the market will not recognize the intrinsic value until the option's expiration. In essence, the covered call writer holds a fundamentally strong asset which reduces his risk.

Now assume that the same writer writes naked calls on the same asset. If the strategy turns against him, then he'll have to pay the difference between the strike and market price of the asset. Because there is no upper limit to price, the loss can be substantial. Intuitively you would assume that his risk is largely increased because the possibility of loss is greater. But is the person's risk increased? In today's market? Let's see what Warren Buffett would say.

Conventional academic practitioners and financial analysts will discount future cash flows by a higher discount rate if the risk is high. However, Warren Buffett would discount the same cash flows with the treasury/risk-free rate even though the risk is high. He says, "I put a heavy weight on certainty. If you do that, the whole idea of a risk factor doesn't make sense to me. Risk comes from not knowing what you're doing."

So how does this relate to Writing Naked Calls using Warren Buffett's Philosophy? It has to do with the current market being in Wave 2. Wave 2 is a corrective wave. Writing naked calls in a declining market is much less risky than writing them in a rallying market. So if you've correctly identified a retracing market, then the idea of risk should not factor in. However, one needs to be careful and identify whether the corrective formation is a zigzag or a flat.

If the corrective wave is of the zigzag family, then writing naked calls can be a lucrative venture. However, if the corrective wave is a running or expanded flat, then writing naked calls may result in exercise if the writer sets the strike price close to the start of wave A. This is because wave B often terminates beyond the start of wave A.

In summary, writing naked calls in the current market may not be as risky as it appears because the market is in the corrective mode. If the corrective pattern is not a zigzag in wave 2, then writers with a low risk tolerance should wait for wave 4 to write naked calls because, according to the theory of alternation, if wave 2 is a complex formation such as a flat, triangle, or a double or triple three, then wave 4 will be a simple formation.

Don't forget to visit my website at http://www.technicalanalysisbase.com/ and my other blog at http://technicalanalysisbase.blogspot.com/

Sanjeet Parab
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Signs of Wave 2- Consumer Confidence Slides

It appears as though the US equity markets have been correcting since June 11, 2009 after recording a 30% rally over 3 months. If someone had bought DIA with $200,000 at the bottom, he or she would have made $60,000 in 3 months. Let's say a person only caught 20% of the rally. Then the person made $40,000. That's one good news. And the other one is that you can still make money as the DJIA retraces in the second wave.

I outlined the wave personality of each wave in the wave cycle on technicalanalysisbase.blogspot.com. CLICK HERE to go directly to the post.

Second waves- Second waves often retrace so much of wave one that most of the profits gained up to that time are eroded away by the time it ends. This is especially true of call option purchases, as premiums sink dramatically in the environment of fear during second waves. At this point, investors are thoroughly convinced that the bear market is back to stay. Second waves often produce downside non-confirmations and Down Theory “buy spots,” when low volume and volatility indicate a drying up of selling pressure.

Just look at the recent economic news and you'll know wave 2 is here.

Today, consumer confidence unexpectedly declined and delinquencies on the least-risky mortgages more than doubled. I'm staring at 'unexpectedly' right now. First we see a huge 30% rally propelled by better than expected earnings. 'Better than expected' ... or better yet, "Unexpectedly better than expected": analyst were so pessimistic about corporate profits/performance that their expectations were a lot lower than normal. Earnings kept beating expectations and the market continued to rally. Seeing that, consumers felt more confident. Even economic reports started releasing positive news indicating improving fundamentals. Everything happened as if we didn't go through the worst recession since the Great Depression.

All this is characteristic of the first wave when people believe that the worst is behind us. In reality, the worst is actually behind us but all is not over. Wave 2 is when fear creeps in again. Its a good shorting opportunity and also a time to prepare for wave 3. Write calls or covered calls. Writing calls in wave 2 season is far less risky. Even a person with a low risk tolerance can risk writing naked calls. But only after careful consideration. For more on this topic, refer to Writing Naked Calls using Warren Buffett's Philosophy.

Wave 3- one of the wonders of the long investor's world only if it is extended, which it usually is. I'm glad we're in wave 2. It'll give me some time to gear up for wave 3 and lock in some huge returns. BUY LEAPS!

Don't forget to visit my website at http://www.technicalanalysisbase.com/ and my other blog at http://technicalanalysisbase.blogspot.com/

Sanjeet Parab_____________________________

Improve Writing Skills

Lastly, I think writing blogs will improve my writing skills. I passed the English AP exam in high school. I only had to take 1 literature course in college because I passed all exams that waived my english requirements. I even got a 6 on the GMAT writing section.

But if you ask me to write a poem or an essay, there is no way I can make my writing be anywhere close to creative. What you can expect from me is bullet points and short sentences. Nah. Look I don't know because the last time I did some creative writing exercise was 4.5 years ago. After that, it has all been business communication. American business communication where the sole objective is to communicate as opposed to exhibit your rhetorical skills.

Wow, this is pretty nice. I didn't know I would enjoy writing so much. Especially after being grilled by Professor Gary Grudnitski in my MBA Culminating Experience class. Now that professor is one of the sharpest people I've ever come across. Amazing man.

Okay, enough of this writing. Am going to move on to something more productive.

Don't forget to visit my website at http://www.technicalanalysisbase.com/ and my other blog at http://technicalanalysisbase.blogspot.com/

Sanjeet Parab
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First Post- June 30, 2009

It's quite evident that I am Sanjeet Parab. That's the advantage of having a unique name. In the 22 years of my life, I've not come across a single Sanjeet. That is why I've always gotten the email IDs I wanted.

Yes. One more blog on the web. Let's see how long it will take me to be the first one listed on every search engine. I don't mean my blog, but Sanjeet Parab in general. There you go..there's my first attempt. Perhaps google will pick the 'Sanjeet Parab' and display it in search results if I'm searched for.

By the way, here are two of my other sites:

http://technicalanalysisbase.blogspot.com/
http://www.technicalanalysisbase.com/

Be sure to check out my latest analysis on where the DJIA is headed (DJIA June 29, 2009).

Back to the topic I started with. Its not that my sole ambition is to have my blog appear in search results. But am tired of seeing facebook, myspace, hi5, bigulo, linkedin profiles show up first before anything else. I mean, I'm not even active on those sites. I don't even know what bigulo is but they seem to have my data. Clearly, I don't have an identity yet. But it won't be long before I make one for myself.

Well I've never been a fan of blogs. But just writing this first post makes me feel like I'm talking to myself. Similar to the diary we were supposed to keep in 4th grade. Feels good though. Contemplation. But I won't be doing this sort of contemplation too much. It's quite..um..ridiculous..and worthless. What will I do?

I read somewhere that having a blog increases your chances of getting hired by some 20-30%. Here's my attempt at increasing my chances of getting hired. Yes, I just graduated with an MBA in, as Jay bhai told me, one of the worst job markets.

ATTN: Recruiters

I suck at blog writing. But I'm pretty good at FP&A, Capital Budgeting, Enterprise Valuation, Statistical Analysis for Businesses, GAAP, financial statement preparation, Fundamental Analysis, Performance Analysis, Liquidity Analysis, Efficiency Analysis, Technical Analysis, Elliott Wave Principle, Fibonacci Studies, and a number of other things.

So, I'll be posting random stuff on this blog. Things like my reflection/analysis on articles, current events, and anything that requires me to think and flex my mental muscles.

Hope to have some followers in some time. Let's see.

Don't forget to visit my website at http://www.technicalanalysisbase.com/ and my other blog at http://technicalanalysisbase.blogspot.com/

Sanjeet Parab
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