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.

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Sanjeet Parab
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