Selling Premiums vs Buying for Gains

In my last post I mentioned a bit about sector rotation, among other things, and it got me to thinking some more about relative sector performance among themselves and against the market in general.

Sticking with the S&P 500 as the index and the ten basic sectors.

Trading ETFs or stocks to take advantage of outperforming sectors was where I was headed with the Bullish Percent Index charts... trying to determine when to get into a sector security and when to switch. The trouble came in when I realized that I was splitting my efforts between two conflicting ways of thinking about making money in the market.

Selling premiums and buying for gains are pretty much opposing in there ideology. This goes against my plan to specialize and get to know one method and to be able to execute that method very well. This has been my greatest downfall over the last two years as I see potential in one system only to see potential in an alternative idea... skipping about until something felt right.

Enough already.

Selling premiums is where I am at and I will not lose sight of that plan now.

So, back to topic at hand, sector performance vs market performance.

Two plans, two methods of study

First, a basic premise. The market can do one of three things in varying degrees of amplitude.

1) the market can go up

2) the market can go down

3) the market can go sideways

All three are subject to duration and amplitude or volatility.

Buying for gains requires a sector to outperform the market toward the bias of the trade, up for long and down for short. In order for a plan to also outperform that market money needs to be in play on that sector or group of sectors for most of the period of out performance. Of the three basic premises one must be chosen and be relatively correct to beat the market. This does not necessarily mean it is profitable, just better than the underlying index.

Of all of the factors direction, duration and amplitude, there are 12 possible combinations. For buying, getting 1 in three of the major ones right is necessary. Profitability is determined by amplitude and duration which, if the first premise is correct, still have a huge affect.

Exit strategies are important as well as stop loss protection. While trading ETFs the whole trade is at stake but it is unlikely to be all lost in one trade. Capital needed may be large as some ETFs are expensive.

Trading options can skew the results in my favour and reduce cost and exposure as a down move may not be as damaging to the account. Even so, options become more sensitive to the duration even with the correct direction.

Choosing one of the three possibilities when only two can produce gains without range trading, which is pernickity.

Selling for premiums does not require any particular sector to outperform the market. This saves making the first selection the most important one. Amplitude is a factor but can be mitigated by a decent exit plan.

Unlike typical buying, selling can be right for two of the three basic premises and even all three if the amplitude is small. Duration is not really a factor if time to option expiry is kept short. The only case that can be wrong is if the amplitude is large and faster than the term of the trade and even then profit can be managed later into the trade. I would have to be really wrong and right off the bat by a large margin to lose a lot of quickly.

Of the 12 combinations any with duration are eliminated due to the short time to expiry, basically the trades are short enough that duration does not affect the profitability. This cuts it down to 3 major premises, up down and sideways and one other factor, amplitude. Choosing a correct combination is made much easier as only 1 of the remaining 6 combinations will work against the trade. Wrong direction with a large amplitude.

It boils down to comparing two basic methods

1) Making a buying decision where being correct is a 2 in 6 and profitability and complexity are issues. Exit strategies are often more important than entry strategies.

2) Making a selling decision where being correct is 5 in 6, profitability is known beforehand and complexity is no longer an issue. Also, being wrong that 1 in 6 time does not necessarily mean a loss unless the amplitude of the move occurs very early in the trade and the exit strategy is to just let the trade expire normally...easy as pie.

While this is an overly simplistic way to look at the issue and there are other factors that can affect trading plans of any style, this covers the major ones.

Keeping it simple is the best plan in any case.

Jeff.