Lowering Your Risk – Advanced Option Management Strategies
OptionSage submits:
Recently I attended an event where Jim Rogers was due to speak. He was introduced as a man who delivered a 4200% return in a 10-year period. I was curious as much about the mindset of the man as about his returns. So I started to mingle with those who knew him back when he was delivering stellar returns and each person I spoke with mentioned the same thing: “When Jim knew he was right, he wouldn’t budge….he took big risks and made a great fortune by sticking with his convictions”. Many of them expressed that they themselves could not have withstood the pressure of remaining in some of the trades and to see them through to profitability. For each of us, a pain threshold exists at which point we simply fail to do the “right thing”. We panic, we exit, we lose. Knowing where that point lies inside you is to have a HUGE advantage over the amateur who repeats the same emotional buy/sell pattern without success.
The reason it is such a huge advantage is that once you know the point where you do the wrong thing, you can then construct your virtual portfolio to never breach that threshold. The simplest way to achieve that is by protecting your positions and hedging your virtual portfolio.
One of the best ways to think about hedging is the analogy Phil likes to use “It’s not that we’re fighting the tide, it’s more like we’re going with the flow but making sure our life jacket is fully inflated at all times”. The challenge most of us have in adding hedging to our existing positions is that, almost by definition, we are recognizing that at least one of our positions is NOT going to make money. This is so hard for most traders to come to terms with that it’s worth emphasizing and it’s worth you taking some time out to ask yourself whether you really can tolerate a losing position in your account (even if it’s part of another hedged trade that may make even more money!) without scolding yourself too much. You must learn to view the hedged position as a combination trade rather than two exclusive directional positions otherwise it will drain your emotional capital which usually leads to a drain of financial capital!
For example, placing long puts on the indexes (like our DIA "mattress plays") against existing bullish positions almost by definition means that those puts are going to be losing value as the other positions appreciate in value – and that’s okay…they are serving their purpose. On corrections they are there to cushion the rest of your virtual portfolio’s fall when the inevitable dip comes, which gives you a chance to calmly assess the stiuation when everybody else is panicking!
Phil mentioned with great regularity his policy of adding put protection on indexes as the market was rising and on June 6 at 3.21PM, he commented on DIA puts “That gives me 150 (contracts of the strike) $137s, 100 of the $136s and 150 of the $135s”. This was the follow-up position to his earlier comment in the day “Only a steep drop in oil prices is likely to save our markets in the short run but that drop will itself exert downward pressure on the markets so let’s make sure that we have our mattress plays (i.e. index puts!) ready – it may finally be time to go to level 2 on our DIA puts!”.
But this is Phil and he has a habit of making lots of money and if you’re having trouble keeping up with his volume of trades (I know I often do!) then the question is what modification can you make to your virtual portfolio when the markets move against you – if you don’t already have your positions well hedged?
Modifications to Stock Positions
If you are holding stocks and the markets is going down and you are concerned it will continue dropping then PROTECT your stock - don’t tell yourself the market might come back the next day and, when it doesn’t, repeat that comment to yourself like a doomed mantra! You WILL be inundated by media messages giving you a whole host of reasons to take no action. For example, Phil mentioned on June 8 that Federal Reserve President Michael Moskow was on CNBC encouraging viewers to keep “a longer term perspective” about this last week’s dip. As Phil points out this is good advice but “don’t let the past cloud future judgment”
How do you protect yourself? You can hedge your stock holdings through the purchase of long puts in addition to the sale of short calls. If you are already holding short calls against your stocks (and few financial reasons exist why you shouldn’t already be doing so to produce regular income) then consider rolling those short calls out in time and potentially even down in strike price. This will offset the stock decline much more so than simply maintaining a cheap short call out-of-the-money front month. You could certainly roll those short calls out anywhere from a few months in time all the way to a few years (LEAPS options) to minimize cost basis to the greatest extent.
This strategy was described in detail in our February 20th article "KMP – We’ve Got You Covered" where we chose to own the stock as a dividend producer at $50.50 and to protect it with the Jan ’09 $50 puts at $4. Safe though that may be and as good of a timing call as Phil thought KMP was at the time (and boy was he right!), we never assume our stocks will go up forever. As we were very bullish on the stock, we initially sold the March $52.50s for .35 so let’s follow through with that trade to date:
With a basis of $50.15 per share (less the .35 collected for the March calls), the stock rose to $51.66 on expiration day (March 16th). As there is always a run-up of KMG into the dividend we don’t sell the April calls (dividend date is 4/26) as we are already getting .83 for the month and we don’t want to get called away (and we have our downside protection). Our protection was the ’09 $50 puts (at $3.20 on March 19th) , which had lost very little ground. The best play at the time, to continue to protect our gain, was to move that protection to the Jan ’08 $55 puts at $4.20 for an additional $1. We traded 1 year of time protection for $5 of improved insurance position.
Since the "guaranteed" dividend return is only $2.52 over 12 months and the move cost us $1, we traded $2.52 of speculative money plus $1 in cash for $5 of guaranteed stock appreciation – not a bad trade!
We had already gained $1.51 from our basis and had a .83 dividend coming to us on 4/26, locking in a $55 strike price on Jan 18th assured us of the following gains: $4.85 from the original adjusted basis, plus the .83 April 1st dividend, plus the .83 July dividend plus the .83 October dividend for a minimum return of $7.34 as of late October less the dimished value of the remaining Jan $55 puts. If we assume the stock to still be at $55 it would be reasonable to assume 90-day puts would be worth, at worst, $1.50, a loss of $2.70 for a net return (at the end of October) of about 9% in 8 months.
The risks are that the dividend would not be paid or that the call would be worth less than expected but the roll already assured us that we could not lose money on the position. We gave up $1 of our profits to lock in a very likely 12% annualized return with 0 downside (and unlimited upside should the company get bought). Of course we still have the option to sell calls each month and selling the May or June $57.50s was a winning play that would have added another .60 each month. The stock is back at $53.18 now and gives us an opportunity for a similar play to the one we started with but this is just an example, these are the kinds of plays smart traders can learn to make every day – you just need to learn where to look for them and how to take advantage of them when you find them!
As Phil always says, his member site follows the philosophy of “Give a man a fish; you have fed him for today. Teach a man to fish; and you have fed him for a lifetime." We hope that through examples like these you will be able to draw your own game plan, for KMP or any other stocks out there. With KMP, the logical move (assuming you want to keep milking this cow) is to roll your put back to Jan ’09, perhaps the $60 puts, on a spike up, locking in the next level of gains and 4 more dividend checks, but the market is fluid and we maximize our profits by making new decisions every day as new information becomes available to us.
For genereal virtual portfolio protection, long puts can be kept relatively short-term (1-4 months is plenty) since bearish corrections tend not to last nearly as long as bullish trends (with the obvious exception of bearish markets, recessions etc). If you are really bearish or, as with KMP, looking to lock in gains, you can even consider purchasing those long puts in-the-money.
The really attractive aspect of this trade (the collar trade) is that the short call premium can in fact pay for most, if not all, of the put insurance. As the stock finds a bottom and starts to trend back up again you can always close out the put and call positions and ride the stock back up again.
If you are really reluctant to modify your initial position, ask yourself - WHY? By not adding protection you are risking further account value declines whereas by adding protection, the worst that can happen is you miss out on some gains. It is much better to miss out some short-term gains than it is to suffer losses. Never forget the first rule of trading “Don’t lose money!”
Modifications to Option Positions
When the tide changes the first stage is to ride through the inflection point and uncertainty without losing capital. The second stage is that of making money as direction changes.
In order to successfully pass through the first stage when holding long call options you want to achieve a neutral position that doesn’t impact account value detrimentally as the volatile stock is deciding its future direction. This is achieved by adding long puts to existing long call positions; thereby creating a straddle or strangle play.
(Straddles comprise long calls and long puts at the same strike price while strangles comprise long calls and long puts at different strike prices. If the expiration month of the long call options is different to that of the long put then the trade is considered to be either a calendar straddle or a calendar strangle).
When you have greater certainty as to the future direction of the stock, you can move from a neutral stance to being more directional again. For example if the stock keeps falling you could sell call options against your existing long call positions while adding further puts to the original trade. Conversely, should the stock rise you could add short puts to the existing long put positions and create all sorts of interesting plays (bull puts, calendar bull puts, put calendar plays etc.).
The same technique can be applied to existing put plays. You will often see Phil comment that he is adding short puts to offset some long put losses he may incurring in the short-term. It’s a way of getting paid to wait for your original trade to come good as expected. If you believe that the market does cycle up and down then few reasons exist to abandon your original trade if the premise has not changed and few reasons exist why you shouldn’t pay yourself to wait!
Trade Safely!
OptionSage
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