Howdy Tackle Traders,

While Bob is out embracing his inner golf spirit this week he has asked me (Matt Justice) to be the guest writer for this weeks version of Environmental Hedging.  Bob will be back next week for more adventures from around the world.  The philosophy of EH is very simple and straight forward, it is to give money (invest) in companies that the investor believes in so the company can expand their business to accomplish things that would have a net benefit to society as a whole.  While this investing philosophy is not original and has been around since the beginning of investing it is unique in how it can be allied to something that Bob and I strongly believe in and that is our environment.  It is also something that regardless of political philosophy all can support as it does not break it down into political identity of regulations but on the simple belief of the individual supporting companies that have a proven track record of being environmentally conscious that can be selected by the individual.  In this case Bob prefers to focus on the following stocks: TSLA, WFM, SPWR, and FSLR.  He invests in these companies by trading Tackle Trading cash flow systems such as Personal Gold, Tackle 25, and Cash Flow Condors to use gains to compound into what he refers to as Targeted stocks.  Once he acquires the Targeted stocks he uses them to cash flow through the covered call.  The Target stocks win through Bob investing money used through cash flow on the stocks and ETFs such as X, USO, FCX, GDX, AMD and other stocks from the Tackle 25 or stocks he personally chooses.  Bob wins through more cash flow, freedom of time, and travels the world documenting all of this from random locations.

To review Bob’s philosophy:

1: Via the usage of Tackle Trading systems we are going to take money away from corporations that are a net-negative on our social and natural environments.

2: With said profits we will then compound the gains into companies which are a net-positive on our social and natural environments. We do so such that these companies can expand their business operations, thus expanding their overall positive impact.

3: We will then cash-flow from these long term positions, of which, we will use the profits cleaved to better the human / environmental landscape on a personal level. What this entails is either the consumption of their products, i.e. solar panels and so on, or the extension of charitable donations directly to individuals or non-profit organizations.

4: Authentic Travel. If time and money were not an issue 9/10 people would undoubtedly use their time and money to travel. The richest of human experiences come from this activity. Saint Augustine, the father of modern Christianity, said “the world is a book and those who do not travel have only read one page.” George Moore said ” a man travels the world over to find out what he needs, then returns home to find it.” And Mark Twain stated: “Travel is fatal to prejudice, bigotry, and narrow-mindedness.” I want the reader to consider the last and final step of this system as the first step in becoming fully human, and the first step in truly giving back.

As you can read, the philosophy of the system is fairly straight forward, however, the application of cash flow systems can be somewhat complicated.  Let’s focus on one aspect (most important) and that is the investing in companies to eventually cash flow on through the covered call.  Here is an article on the Tackle 25 including a video and the basic philosophy and rules for the covered call.  We also detailed the creation of the Tackle 25 in a recent edition of the Trading Justice Podcast episode 234 found here www.tradingjustice.com

Tackle 25: Covered Calls

One aspect I want to focus on in this edition of the EH blog is one of the critical areas of all things investing and that is the concept of timing.  Regarding the covered call this includes the timing on purchasing more shares and the timing of when to sell a call against the stock to cover risk and cash flow which is the true power of the covered call.  Let’s take one of the stocks that Bob enjoys trading but I enjoy investing in and that is United States Steel (X).  As you can see in the figure below X is in a nice bullish uptrend.  An uptrend is defined by higher levels of resistance (ceilings) and higher levels of support (floors).  In the figure, X is obviously closer to the highs than the lows.  This is the perfect timing on renting your stock out through the covered call as the expectation is that the stock will retrace back into the low of support.  What makes this obvious to the trader is because of the signs we see from a technical perspective. 

1. The stock has reached the top end of the channel as you can see from the two boxes.  While visually these are fairly similar in length it is a very simple calculation,
2. simply average the two price movements as traders will not hold past average probabilities.  Since the stock is at the top end of the of the channel the expectation is for X to head south to support.
3. The candlestick is very telling as well.  While there are more types of candles than anyone cares to really evaluate or need, there are two basic ones that will help new traders tremendously and that is big and small candles.  Big candles mean increasing momentum which has a tendency to continue to move in the direction of the candle, while small candles are reversal candles due to decreasing momentum.  Think jumping on a trampoline, at some point you slow down and head south.  If you have jumped on a trampoline in your life then you understand big and small candles.

Now that the trader has determined that the stocks most probable destination is back to support the trader can make a decision to continue to hold the stock which is perfectly fine as it is a nice bullish uptrend overall, the trader can also determine that the best way to monetize the asset overall is to hedge the downside movement by selling a call against the stock to create cash flow that will offset the movement to support as well as receive cash flow to reinvest.  At this moment I decided to write the call as the system rules indicate.  At this point I sold the 28 call option (.40 delta) for 1.05 with 32 days left till expiration with the stock price at about 27.25.  What this means is the buyer of the call option has the right to buy my stock at 28 which would allow me to maximize my growth with a side of cash flow.  If the stocks stays neutral or goes back down to the support level as expected the option will decay in value thus allowing me to eventually buy the option back for a cheaper value at support.

 

As the market the following week starts its decent back to support the value of the call option starts to decrease thru both delta (direction) and theta (time decay).  Now watch this work…for every dollar the stock drops the value of my option loses value by .40 cents.  As X moves from 27.25 to 26.25 the option moves from 1.05 to .65 and as it took 4 days for that to occur the theta decayed another .02 per day for a total value decrease of .08 for a net value of .47 cents.  Two days later it moves another .28 cents due to gamma decreasing the rate of delta by .12 for a net value of the option .19 minus the 2 days of time decay for a net value of .04 thus the option value is now .15 cents based on the original value sold of 1.05.  If all of that math drives you up the wall and it certainly does me, realize this is all done automatically through the algorithm of the Black Scholes model which Tyler Craig did an amazing job of explaining in a recent version of Options Theory found here:

Options Theory: The Whiz-Bang Option Pricing Machine

What to do now?  I have 26 days left on the option contract with the max I can make from this point of .15 cents per contract.  At this point I have a few options:

1. Let it ride: This potentially means I would give up the .90 cents on the option I just made as the stock goes back up and let the option either expire worthless (under 28 stock value) and pocket the entire 1.05.
2. Buy back the option and sell another full value contract: This would mean I pocket the .90 cents, receive another full value contract.  However, if the stock goes back up this time I will sell the stock at 27 instead of 28 thus giving up my growth.
3. Buy it back and wait:  This would mean the position simply goes back to being a longer term investment based on growth.

 

What to do?  Takes me less than 1 sec to buy back the option thus increasing my cash flow by .90 cents ($90 per contract) in 6 days on a stock that was 27.25.  That also means I can also compound that $90 back into the stock to create for velocity to money in time.  Put that into perspective, that is a 3.3% ROI in 6 days and now I have a stock sitting at support in a good bullish uptrend ready to bounce off the trampoline again and when it goes back up to resistance reload on the selling of the .40 delta strike call option and rinse and repeat.  Cash Flow King!!!!

When learning a trading system it is all about rules.  What expiration date you select as a buyer or seller depends on your theta rules for time decay.  What strike price to buy or sell is based on delta rules.  It takes mastering trading to create rules that can be repeatable but it does not take any amount of expertise on the application of the trading rule.  However, management of any trading system is the most difficult thing to master as a trader and it can take years of experience to get to the point where you can act unconscious.  My hope in writing for Environmental Hedging this week you take an inside look into one example for a technique that you can use in the future.

In next weeks edition of EH, Bob Shannon is back, somewhere in the world, doing whatever he wants to do because as a trader life is simply enjoying the journey.