Temptation to Select Most Volatile Stocks

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When your conservative portfolio does not perform as you expect, what can you do? Some investors are tempted to sell lackluster stocks and go with more exciting, more volatile issues. The idea is that you can experience profits more rapidly, make up for past losses, and outperform the market. In fact, though, this approach is an abandonment of conservative principles. You need to continue to carefully select value stocks and then protect their equity value. That is the truly conservative strategy.

Investors who like the idea of using options also face danger if and when they pick stocks inappropriate for the conservative risk profile. If you shop option premiums with the idea of buying stock and then discounting your purchase price with covered calls, you are taking the wrong approach. A conservative application of options requires that you first select stocks based on fundamental analysis and comparison; that you pick stocks with lower-than-average volatility and potential for price appreciation; and that the capital structure, revenue and earnings, PE ratio, dividend history, and other indicators of your stocks are a good fit for your conservative standards. Then you use various conservative options strategies to protect equity and enhance current income. Remember, using conservative options strategies on risky, volatile stocks contradicts your standards. The first rule is to pick your stocks carefully and then identify methods for protecting their value.

Creating a List of Potential Investments

There is no shortage of high-quality stocks. By applying conservative principles, you can easily identify at least 10-20 stocks you would like to own. You might not be able to afford to buy shares of all of them, but that is not the point. Once you develop your list of potential quality-growth investments, you can buy shares in several of those companies; if a covered call strategy ends up with stock called away, that is not a complete loss. The transaction frees up capital that can be reinvested in the stock of another company on your list. As long as you continually maintain that list of strong candidates based on sound fundamentals, you should never have a shortage of good value investments that you can buy and hold, buy and cover, or apply in contingent-purchase strategies. It is a mistake to believe that only a limited number of "good" stocks are available at any given time; more likely, there will be far more issues than you can afford to own, which gives you great flexibility in moving capital from one stock to another if you need to. A long-term buy-and-hold strategy makes sense as long as fundamentals remain strong, but it does not mandate that you avoid selling stock under any circumstances. The proper selection of conservative options strategies may result in shares being called away, but as long as you experience a higher-than-average current annualized return, it is a successful transaction. In fact, application of conservative strategies can produce consistent annualized double-digit returns, as demonstrated by the many strategies explored in preceding chapters.

You gain further flexibility in options trading when you own more than 100 shares of stock. This gives you the chance to vary the use of options, to cover partial holdings, and to change the mix of short options against long stock when you roll forward and up. You can also write covered calls with a mix of expiration and strike prices, or make combinations and short straddles more flexible and interesting with a similar mix.

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