Members Only – Setting Up A Hedged Virtual Portfolio Part 1 – Financials

There were a couple of member questions that came in today and both I thought would be good to address:

1020 asked: "What’s the best way to get started using your site?"  That one is easy to answer and hard to do.  We have a "New Member’s Guide" which pretty much lays things out with these standard assignments:

• If you are new to options, read Sage’s Book
• Read 1 full month of my posts and all comments, you will get a good feel for the site, the kind of trades we do and also get to know a bit about the people in chat.  Knowing people’s various expertises and understanding their market philosophy and position makes the next live comment they make much more informative…
• Read Option Sage’s articles under his tab, many were co-authored by me that highlight various option stratgies with real-world examples.
• Watch The Man Who Planted Trees, a short video about investing that characterizes a solid investing philosophy.

AFTER you do those things, then we are ready to talk about setting up a virtual portfolio, which brings us to Pstas’s question of what would be a good model virtual portfolio for $100,000.

In this traing environment I would first and foremost concentrate on the Buy List (under our Virtual Portfolio Tab) and trades like the DNDN (which is riskier) and ZION (which I hope is not risky) that I highlighted just yesterday.  Typically, you can categorize the buy/write plays as fairly low risk.  The idea is we’re buying stocks at discounts to the current trading price and scaling into the positions over time.

Setting realistic expectations is key too, the biggest mistake you can make with $100,000 is to jump right in and spend it.  I’m going to put down a minimum for each play and an allocation

So let’s look at a quick set of trades we can set up:

UYG is my first choice.  Why?  Because it’s not as volatile as XLF, which just jumped out of our $5-$7.50 range and we don’t feel confident enough to chase it at the moment.  UYG is a crap investment by itself but, for the same reason, is great to sell calls and puts against.

500 UYG at $3.48, selling 5 May $3 calls for .72 and 5 May $3 puts for .28, net $2.48/2.74

This play puts you in for $1,240 and you make $260 if called away (20%).  If UYG is assigned to you, you will have 1,000 shares for $2,740.  With any trade, you MUST have a next step plan (preferably two steps). UYG bottomed out at $1.36 in March but generally held $2 at the lows.  Since it will be put to me at $2.74 (notice I always plan for the worst case to happen), I’ll assume I’m at $2.  Since the June $3 puts and calls are $1.28, I will assume I can get .74 for the June $2s after I’m assigned or, at worst, July or Aug $2s.  That would lower my basis to $2/2 and, since there are $1, $2 and $3 strikes to sell through 2011 and the 2011 $6s ($3 out of the money) are fetching $1, I’m thinking even if I get that second round assigned to me at $2 and end up with 2,000 shares at $2 ($4,000).

The premise of this trade is that UYG will not go to zero and there will always be calls to sell that will get me at least .05 per month.  Since .05 x 12 is .60 and I’ll have 2,000 shares at $2, my ROI should be 30% on $4,000.  Since I can live with that "worst case" scenario, this is not a trade I feel the need to cover.  So $4,000 committed, no cover necessary. 

I think you can see why I don’t go into this kind of detail usually – we’d be lucky to get one trade a day done but, for this, it’s a good exercise…  From a notes stand point, going through this logic, you should be looking at the trade like this:

500 UYG at $3.48, selling 5 May $3 calls for .72 and 5 May $3 puts for .28, net $2.48/2.74

• Commitment $1,240/$2,470/$4,000
• May profit goal $260
• Stop/Loss Target: None (I’m willing to live with it)
• Downside coverage required: None (I’m willing to live with it)

FAS is another play I always like but they got away from me as of today for a new entry.  The $7.50 puts are .45 though  and the May $5 puts are .45 so there’s no reason I can’t pick up $90 selling 2 Apr $45 puts as I wouldn’t mind having FAS ultimately put to me for net $4.55 in May.  Since it’s a small entry and I can always double down and adjust, I have no reason to overthink it so my trade plan is:

Selling 2 FAS $7.50 puts for .45 naked

• Commitment -$90 ($660 in margin)
• April profit goal $90
• Stop/Loss Target: Roll to May $5 puts (now .45) or July $4 puts (now .65) even.
• Downside coverage required: None (I’m willing to live with it)

Note for all trades:  Obviously we try to get a better price and if we don’t get our NET price it’s better to let something go and move on, chasing is very bad.  Very, very bad..

C is another bank that’s probably not going under and still way down in price.  The advantage of stocks this cheap is we don’t have much downside concern and that saves us on covers. 

500 C at $3.04, selling May $3 puts and calls for $1.11, net $1.93/2.47

• Commitment $965/$2,470/$4,000 (same logic as UYG)
• May profit goal $535
• Stop/Loss Target: 50 DMA is $2.60, action required if we break that.
• Downside coverage required: BK could wipe out $2,470 – $1,500 would be nice.

So C is different than UYG in that they are more likely (not likely, just more likely) to hit zero than UYG since UYG is an ETF with lots of components.  Also, since C may actually fail I can’t count on there being a steady income at almost any price as I can with UYG so I would feel better having downside coverage and limiting my loss to about $1,000 of my $2,470 commitment if C is put to me LOWER THAN $2.47. 

This is something I think many people don’t get about the buy/write…  C is already covered to $2.47, an 19% drop from where it is now so my coverage doesn’t have to begin (and this is a leap of faith) until the Dow (assuming I’m going to cover with DIA) has dropped at least 5%.  So my goal on covering this entry is to protect myself with a $1,000+ gain if the Dow falls betwen 5 and 10% as it’s very unlikely to me that C will go bust but the Dow will go higher.

So far we’ve committed $8,000, hoping to make about $975 by May 15th (doubling the FAS expectaions as they are April plays).  Always, always be conservative in estimating profits.  It’s always fine to be pleasantly surprised to the upside.

Selling 2 IYF May $36 puts for $2 naked

• Commitment -$400 ($3,200 in margin) Possible $2,000 loss
• May profit goal $400
• Stop/Loss Target: Roll to Aug $29 puts (now .1.92) or Nov $25 puts (now $1.98) even.
• Downside coverage required: $1,000 (IYF has fallen 30% quickly twice so I have to assume I could get hit for $2K)

Selling 2 JPM May $29 puts for $1.95 naked

• Commitment -$390 ($2,510 in margin) Possible $2,000 loss
• May profit goal $390
• Stop/Loss Target: Roll to June $25 puts (now $1.85) or Sept $19 puts (now $1.92) even.
• Downside coverage required: $1,000 (not too different from IYF)

Note on the naked puts I’m assuming something terrible happens and IYF or JPM get cut almost in half and I’m forced to buy 2 shares for $6K and take a 33% loss.  While not likely, it pays to know what can happen in a 9/11-type event. This brings our total commitment up to $12,000 but very little of it is being physically deployed up front.  Now it’s a question of weighting the whole virtual portfolio.  Do we want 20% exposure to financials or are there safer places to go?  Also, how is our risk/reward looking?

With $12,000 at risk, it looks like we’re hoping to make $1,375 by May 15th.  At this point, I look back on my trades and see if any seem too risky or have a poor risk/reward ratio compared to the others.  Some of this is subjective – I think JPM is in very good shape and I can’t see them failing the 50 DMA at $24 before I get a chance to adjust.  IYF has its support at $32 so my worst cases aren’t so bad. 

That means it’s time to look at what coverage will cost me.  If my coverage is good, perhaps I can afford more upside risk….

My favorite financial coverage at the moment continues to be selling naked FAZ puts.  FAZ fell 41% yesterday and murdered our $17.50 puts, now $7.20 but those can still be rolled to 2x the July $10 puts at $3.50.  That adds just $1.25 in margin requirement (was $8.75, now 2 x $5) and puts the putters into 100% premium, raising my buy-in from 100 at $1,750 to 200 at $2,000, less the $350 I collected or $1,650.  Longer term, I can roll the July $10s at $3.50 to 3x the Oct $5 puts, now $1.15 and that would commit me to 600 at $3,000, less the $350 I collected or $2,650.  At that point will love owning them for net $4.41 for the same reason I like owning FAS at $4.41 – it takes very little for it to shoot back up and, meanwhile, we can sell .10 per month in calls for a 25% annual ROI. 

So I love selling my FAZ puts but don’t lose sight of what you are committing to.  In the above example, to get $350 in protection I am committing long-term to owning 600 shares for $2,650.  If I look at my virtual portfolio as needing $3,500 in total downside protection, I’m NOT willing to commit to owing $26,500 worth of financial ultra-shorts!  So FAS is not likely to be my best solution BUT the stats have changed since our last entry so lets see…

Now I can sell May $10 puts for $2.20.  Those can be rolled to 2x the July $6 puts, now $1.02 or 2x the Oct $5 puts at $1.15.  Since $3.85 net (if the Oct $5s are assigned to me) is an entry I want for FAZ and since having at least 1/3 of my virtual portfolio playing the downside is the norm, then I don’t mind being assigned up to $7,000 worth of these.  So that would be 2,000 shares at $3.85 and I can work that backwards (as it’s a 2x roll) to say I don’t mind selling 10 of the May puts.  To play it safe I can sell just 7, leaving good margin for error and still collecting $1,540.  That makes this hedge:

Selling 7 FAZ May $10 puts for $2.20 naked.

• Commitment -$1,540/-2,000/$7,700 ($1,960/3,860 in margin) 
• May profit goal $1,540
• Stop/Loss Target: Roll to 2x July $6 puts (now $1.05) or Oct $5 puts (now $1.15) even.
• Upside coverage required: None  (I’m willing to live with it)

On the commitment side I’m guessing that I would roll to 20 July $6 puts, which will bring in $600 more in cash (maybe it would be the $5 puts) and take up $6,000 in margin less the $1,540 I’ve collected plus the new $600 so about $3,860 in margin at that point.  As I said above, if I am forced to roll those down to the Oct $5s, at that point I would take the assignment (unless there was a good out of course) and then the margin is gone in exchange for $7,700 committed.

This pretty much ties up all the money ($20K) we would want to commit to one sector but the nice thing about selling the puts is you can win that one even as you win the upside.  We are, however $1,000 short on our desired $2,500 in coverage and now we can afford to have some fun. 

FAZ Oct $12.50 calls are $4.40 but they were $5 in the money on Wednesday and selling for $10.  So a one-day reversal on FAZ can give us a double on these calls.  If you look up at the Oct $25 calls, you’ll see that those are still $2.95 so we can assume even a devastating loss in FAS would still leave you with $3 out of $4.40.  That becomes our "at risk" capital, not the $4.40 itself and, since we expect to make $1,300 a month if FAZ goes down at all (as all of our upside plays only requre the financials NOT to go down, we can pretty safely assume that buying 5 of these and risking $725 in losses will be OK. 

Actually, it would be doubly OK as the rise in FAZ also assures us of a win on the May puts we sold and those are $1,540 right there.  Keep in mind the problem with any hedged strategy is violent swings blowing you out one side or the other as we are generally playing for something within 10% on either side.  Since I’m buying 5 Oct $12.50 calls for $2,200 and I only needed $1,000 in additional upside coverage, I can hedge these by selling the May $21 calls for $1.05.  If the May $21 calls go in the money, I would still be $8.50 in the money to my caller vs. the net entry of $3.35.  This means I’m very well covered to the downside and I’m setting up my Oct calls to be good long-term protection as I’m working the cost off month by month while I wait for that disaster.  So, the last play is:

5 FAZ Oct $12.50 calls for $4.40, selling 5 May $21s for $1.05, net $3.35.

• Commitment $1,675
• May profit goal – None (hoping to stay even and keep protection)
• Stop/Loss Target: Will roll down .20 per $1 so offering $1 to roll to $7.50s right away (now $5.60)
• Upside coverage required: None  (I’m willing to live with it)

Since FAZ has such violent moves, it’s very possible we get that roll, which suits us fine as we knock out the caller, who pays for the roll and we’re left in great shape to sell the next one. 

So that’s our starter with about $20K committed to the Financials in a fairly well-hedged group.  As things move up or down we have plenty of cash on the side to make adjustments.   For your own virtual portfolio, you probably don’t want so many positions as just 1/5th of your holdings.  Ideally 20 positions is as many as you want to be looking at and many people have trouble with 10 but there’s a big difference between being diversified and being hedged, as this market has taught us.  You could have been amazingly diversified and still lost 50% on this drop as no sector was spared.  That’s why we want to move into a virtual portfolio slowly and put more cash into what’s working as things move forward. 

The put positions we sell are easy, if the stock moves up, the puts expire worthless and you keep the cash.  Not too much concentration required, which is why I like them.  They are all optional or you can do more naked FAS sales and forget the specific ones (as any specific stock is more likely to hurt you than an ETF).  The less positions you will have in a sector, the more attactive an ETF is to protect you from single-company events messing up your virtual portfolio.  The same goes with the buy/writes.  You can do just UYG or just IYF and forget C as it’s more of a gamble. 

I know it sounds lame to go for $1,375 in profits against $20,000 worth of your virtual portfolio but this is just the month of May and we’re mostly in cash, waiting to commit more as things play out.  Even if the hedges cost us 1/2 the gains then we’re looking at $7,000 a year in profits on $20K – that’s good!  When we start making money, THEN we can put some more at risk but, starting out, there’s a reason that Warren Buffett’s Rule #1 is "Don’t lose money."

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This entry was posted on Friday, April 10th, 2009 at 3:14 pm and is filed under Education, Virtual Portfolio Review. You can leave a response, or trackback from your own site.