I’m undertaking a 1000-day reinvention project, blogging here daily to track my progress. In Tuesday Book Club, I share an idea from a book.
In her book Thinking in Bets: Making Smarter Decisions When You Don’t Have all the Facts, Annie Duke offers a number of techniques for improving decision-making under uncertainty (that is, pretty much all decisions!) This is relevant to me as I develop my skills as an options trader.
One strategy she suggests is using backcasting instead of forecasting, that is, imagining good and poor outcomes and determining what actions you might take and what might happen out of your control that could result in each. You project yourself into the future and figure out what could have gotten you there. Then consider what you might do to maximize the possibility of a good outcome and minimize the possibility of a bad outcome. Duke sometimes calls this latter approach negative visualization to contrast it with positive visualization:
Despite the popular wisdom that we achieve success through positive visualization, it turns out that incorporating negative visualization makes us more likely to achieve our goals.
In the midst of making a decision to place an options trade, most successful traders envision both good and bad outcomes and may even place automatic trades to manage those outcomes. This is what can make options trading a more reliable approach to earning money than simply buying stocks long based on impulse, intuition, or conventional allocation theory.
For example, my current working exit and management rules for selling puts are:
- Immediately after selling a put, enter a good-til-cancelled buy-to-close at half of the initial cost per share. This means that if the position reaches 50% maximum profit, I close to book that profit.
- If a put reaches 21 days to expiration, roll it out in time (and down in strike price if possible) for a net credit. If I cannot roll for net credit, plan to hold it until expiration, accepting assignment if necessary.
- If the price of the underlying reaches the put’s strike price, roll out (and down if possible) similar to reaching 21 DTE. If I cannot roll for a net credit, plan to hold until expiration, accepting assignment if necessary.
- If I get assigned, begin selling calls to earn premium and eventually exit the position, being careful not to sell calls that, if assigned, would leave me with a net loss on the position considering any put premiums earned during this enactment of the wheel.
This leaves only one really bad situation that I could backcast for. What if I am extremely underwater on an assigned position and I believe the stock will never come back?
How could I even know that was the case? As long as I sell puts on large, established stocks (e.g., those listed in the S&P 500) I should never face this.
In effect, what will happen if I am very underwater on an assigned stock is that this position turns into buy-and-hold (and wait).
In this way, the options wheel actually trains me to ride through short and long-term oscillations in the stock market.