The Stock Market: How fast is too fast, how high is too high?

The stock market has been surging lately, with few moves to the downside. I’ve rarely been able to lose money for months, except when selling short.  For now I’m staying long. My simple strategy of buying “at the money” call options anywhere from 45 to 60 days to expiration has been highly profitable, and this scares me – things are just too easy now.  Almost everything I’ve bought for months or have been holding long-term is shooting to the moon, and seeing stocks hit their 52 week highs, or come close, is all too common.

What I’m going:

I’m going to continue following the market’s momentum to the upside, but I’m prepared for a big move to the downside. I’ll close any long call option positions when I either achieve my target profit, or as my gains erode due to time decay, a decreasing stock price, or other factors. For my long-term investments, I’m primarily invested in U.S. domestic equities, ETNs and ETFs. For most of my securities, I own put protection, which I usually finance by selling call options, i.e. I’ve created low cost to zero cost collars, having both covered calls and protective put positions.

To clarify, I’ve sold call options with strike prices above the current market prices of my securities to raise cash, and I’ve used the cash to purchase put options with strike prices below the current market prices of my securities. This allows me to protect profits because owning put options on a security gives me the right (but not the obligation) to sell the security at the strike price of the option  until the expiration date of the option (note: most index options are “European style” as opposed to “American style” and  can only be exercised on the expiration date).

If the market price surges above the strike price of a call option I’ve sold, I could miss out on the additional potential market gains as the  price keeps rising. This is because call options give the buyer of a call option the right (but not the obligation) to exercise the option against me, requiring me to sell them the underlying security at the strike price of the respective option.  I could avoid being exercised against by “buying to close” call option contracts, but will likely create a loss on the option transaction because an increase in price creates a more expensive call option, all other factors being equal.

Note: I like using stop orders, particularly stop-limit orders, but I’m anticipating the potential of a fast move to the downside. With a stop-limit order, if the stop price is hit, a limit order is triggered. However, if the market moves quickly below the limit price before my limit order can be executed, I’ll be stuck with the stock because I’ve specified my minimum sales price with the limit order.  And with a stop order, if an event like the “flash crash” occurs, even if less drastic, the stop price may be hit and a market order might not get filled at a price remotely close to the stop price that triggered the market order, leaving me with a large reduction in market value.

Be careful out there folks!

“If something cannot go on forever, it will stop.”

–Herbert Stein


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