Do I really need to do the rolls?
Rolling a trade just seems like doubling-down on a loser. Do I really need to do the rolls?
Often when Jim rolls, he changes the spread width from 5 points to 10 points, which means it must be backed up by $1000 instead of $500 in your margin account. Yes, it may seem that widening the spread width between strike prices is doubling-down in order to break even quicker. You’ll be taking on more investment risk in exchange for greater potential investment return.
But this really is part of OFI’s “secret formula.”
Roughly 65% of OFI trades win on the first try. The other 35%, however, need to be rolled to have more time to work out positively. About half of that 35% do ultimately win, and that’s how Jim’s roughly 82% win rate is achieved.
Furthermore, some of OFI’s biggest winners are trades that had to be rolled.
So, skip the rolls if you wish… perhaps because you want simplicity or prefer to deploy your capital elsewhere. But, do realize that you will no longer be following the OFI system, and your win rate and your profits will be lower than other OFI members.
And do not arbitrarily decide to roll some of the trades but not others. That just ensures that you will lock in losses on some trades that would have been winners if rolled and will roll some trades that will incur additional losses. You must be consistent and roll all or roll none to capture the profitability of my trading system.
The silver lining of rolling trades that haven’t worked out yet is that the dollar return when they do work out is tremendous. And, since (with a put credit spread) the stock has declined in price, the probability of success is higher because the stock is cheaper than before and more undervalued, promising an eventual sharp snap-back.
In the context of the stock market, Jim says he’s always viewed the phrase “good money after bad” to be the opposite of “logic.” Rather, it is an illogical investor bias. Evaluating a trade’s future prospects based on past price performance reflects a behavioral-investing bias known as “recency bias,” where one erroneously judges the future prospects of a trade based on some recent past reference point. In most cases, the past reference point is a declining stock price.
http://bucks.blogs.nytimes.com/2012/02/13/tomorrows-market-probably-wont-look-anything-like-today/
The argument to cut losses is based on the erroneous opinion that stock prices are always efficient. In other words, many people think that a stock that declines in price deserves to decline in price and should be sold because the market is “telling” them it is a bad investment. Furthermore, many people believe that a stock price that declines in price is more likely to continue dropping in price than rebound back up. Value investors utterly reject this way of thinking. As Warren Buffett said in his 2011 shareholder letter:
“The logic is simple: If you are going to be a net buyer of stocks in the future, you are hurt when stocks rise. You benefit when stocks swoon. Emotions, however, too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day’s supply.
“Charlie and I don’t expect to win many of you over to our way of thinking – we’ve observed enough human behavior to know the futility of that – but we do want you to be aware of our personal calculus. And here a confession is in order: In my early days I, too, rejoiced when the market rose. Then I read Chapter Eight of Ben Graham’s The Intelligent Investor, the chapter dealing with how investors should view fluctuations in stock prices. Immediately the scales fell from my eyes, and low prices became my friend. Picking up that book was one of the luckiest moments in my life.”
http://berkshirehathaway.com/letters/2011ltr.pdf (page 7)
In a 1990 interview, Buffett said:
“For some reason, people take their cues from price action rather than from values. What doesn’t work is when you start doing things that you don’t understand or because they worked last week for somebody else. The dumbest reason in the world to buy a stock is because it’s going up.
“None of this means, however, that a business or stock is an intelligent purchase simply because it is unpopular; a contrarian approach is just as foolish as a follow-the-crowd strategy. What’s required is thinking rather than polling.”
http://www.scribd.com/doc/158301995/Buffett-Takes-Stock-NYTimes-1990
Thinking requires an evaluation of the company’s competitive positioning, profitability, management quality, and future market opportunity. None of these things have anything to do with short-term price fluctuations, which are nothing more than a snapshot poll of emotional, trigger-happy traders.
So, always focus on a stock’s intrinsic value and the possibility that a stock-price decline is emotional and irrational. Stock prices are often wrong and often do not reflect intrinsic value, thus the best time to invest is when the stock price is lower than intrinsic value. In other words, value investing advocates investing precisely when technical trend followers advocate getting out.
Jim is a value investor who believes that market prices often deviate from intrinsic value but eventually converge with intrinsic value. He is not a slave of short-term price movement. Many of OFI’s most profitable put spreads have initially been losers that ended up big winners after a few rolls precisely because we did not panic and lock in losses, but were patient and confident in our assessment of a stock’s intrinsic value.