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_____________________________