When in Doubt: Get out.

On many levels, its been a great year for me personally. I’ve accomplished a bunch of cool personal things, the wife and I have gone on a couple excellent vacations, I’ve met amazing people from all walks of life, and I’ve been working with some really inspiring and driven individuals at StockTwits.

One area though that has suffered has been my trading. Yes, I actively trade, but my responsibilities during market hours with StockTwits make it tough for me to put in the kind of zen-like focus and effort that I’d prefer to.

So to address this deficiency, I’ve recently made some changes and have brainstormed some ideas that I’d like to share with you and get some feedback on.

Reading this post by Brian Lund (@bclund on StockTwits) opened my eyes to the fact that perhaps my ego is getting in the way. I’ve always prided myself on being a do-it-yourself trader, preferring to learn things the hard way (I must enjoy pain). In his post, Brian makes the case for putting your macho aside and subscribing to a trading service – something I’ve always scoffed. But this got me thinking… the biggest problem for me is I can’t seem to find the time or energy necessary to dig through hundreds of charts each day to find trading opportunities that make sense for me. The good news is, there are several Traders out there who do, and they provide these ideas for a nominal fee. And even better, some of the Traders who are doing this are people I have the highest respect for – earned by watching them share ideas consistently every day on StockTwits.

So last month I shut up my inner ego, took the leap of faith and joined a couple subscription services to help me with idea generation, and so far I’m pleased with the results.

Another idea I’ve been bouncing around is finding a better, more capital-efficient, and less scary way to ride big trends in the biggest market winners.

Last week I had the privilege of spending face time in San Diego with two investors/traders who I have enormous respect for – Howard Lindzon (my boss & CEO at StockTwits) and Ivan Hoff (the evil genius behind the StockTwits 50). I’ve always admired Howard’s ability to jump aboard a trend and ride it out for huge gains. And I’ve been in awe of Ivan’s ability to surface great trading ideas that could turn into the next big trend via StockTwits 50 for quite some time now.

Fundamentally, riding big trends makes sense to me. I understand the math behind it and the fact that the win/loss ratio is very unfavorable but it only takes one huge winner to make up for many, many small losses. The problem I have is that I tend to get shaken out of the big trends before the big move materializes – either from lack of patience or due to a scary but short-lived pullback. This is where Howard’s iron stomach and force of conviction vastly outstrips my mere mortal abilities.

So to minimize my weaknesses as a Trader and to exploit my preference for options, I’ve been exploring the idea of playing potential long-term winners via long-term options (LEAPS, in some cases). When I identify a stock that has potential for large gains (a good place to start is with stocks making new all-time highs), I look to open a position in at-the-money call options in the furthest out month that is available for trading. I choose the furthest month available because the big trends need time to play out.

But it doesn’t stop there, position management is the key to making this work. It isn’t just buy and then close my eyes. For starters, I will attempt to size the position so that the purchase price is no more than 1% of my available cash. Right off the bat, this puts me in the favorable position of knowing that this stock could collapse all the way to zero, yet the risk to my portfolio is no more that 1%.

The next step is to continuously roll the options up as the stock achieves each successive strike price. For instance, if I purchased the $XYZ January 2014 30-strike call option for $4.00 when $XYZ stock was trading at $29.75, I’d then roll up to the January 2014 35-strike when the stock trades to/through $35. And I’d likely be able to do so for a $2.50 credit on the roll. In doing so, I’ve now reduced my total risk in this position down to $1.50 (or about .3% risk to my entire portfolio).

As you can see, with each successive roll I will be taking risk out of the position – eventually locking in profits. And then this puts me in a much stronger position to ride out the inevitable pullbacks. Yet, the position will still be on if/when the stock resumes it’s course of making continuously new all-time highs.

I realize that owning 100 shares of stock outright versus owning 1 call option and rolling it will make much more money in a big trend, but the balance of value-at-risk to my portfolio makes it much more attractive to me. Also, it can become a numbers game as the capital requirements in owning call options allows me to build many more positions than outright stock ownership, thus giving me better odds at capturing the one or two big trends that more than make up for the 10’s or hundred’s of breakouts that ultimately don’t result in “the next big one.”

This week I started two positions to test this out:

I bought November 25 call options in $DDD for $4.20 when the stock was nearing an all-time high on Monday April 16. November is currently the furthest month out that is available for trading. If/when it trades to $30 (the next higher strike price), I will look to sell my $25 call and purchase the $30 call with the procedes, leaving cash left over thus reducing my risk.

I bought November 24 calls in recent IPO $YELP for $3.70 on Friday April 20, and will follow the same plan listed above. Several Traders I respect on StockTwits are bullish on Yelp, and I liked the idea of getting in on a pullback.

I’m interested in hearing any thoughts you may have on this idea. Help me punch holes in it.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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