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Stupid Option Tricks – The Salvage Play

I often talk about stupid options tricks in member chat and I thought it would make for good weekend reading.

Today we’ll look at salvaging bad positions, something that comes up once in a while in any virtual portfolio.  Not everything has to be buy, hold or sell with options – there is always hedging and there is always an option!  Since many of us are short on USO and not happy at the moment, I thought we’d focus on various salvage strategies for positions that go against us but, before we get into that, I did promise we’d discuss scaling, and the two do go hand in hand

Scaling into a position is always a sensible strategy, we can’t be right all the time with our entries so we need to plan ahead for being wrong.  Also, we need to plan for our position going against us tomorrow, next week or next month.  Ideally, you should never be in any position that risks discomfort if you lose it.  If you have a large virtual portfolio, it’s good to keep most of your positions under 2%.  If you have a medium virtual portfolio, 5% and, if you are in the $50,000 range or less, it will be hard to avoid having positions that are 10% of your virtual portfolio and that’s where scaling is even more important so we’re going to focus on the small entries and I’ll assume the big boys can multiply by 2-10 by themselves.

$50,000 is not a small amount of money and we can assume that, if that is your stock virtual portfolio, that you worked hard to make it and you would rather not lose it.  This is all the more reason to take a more conservative stance with your positions.  As I said, you don’t want any position to be more than 10%, or $5,000.  That doesn’t mean it can never happen, but you need to treat anything over 10% as "uncomfortable" and look to reduce it when there is a good opportunity. 

When entering a new position, we want to be ready to be wrong.  Sun Tzu said: "Strategy without tactics is the slowest route to victory. Tactics without strategy is the noise before defeat."  We made a nice profit on Tuesday morning on USO puts we had held over the weekend.  $32 puts we had at .80 from Friday were sold at $1.05 Tuesday morning.   That was a nice, quick 44% profit – TACTICS – we take the money and run!  Our strategy was to reenter if oil spiked back up on the OPEC meeting.  At 11:15 I said: "I’m offering .80 for those same USO $32 puts again but no takers yet.  Early scale, looking to buy more at .60 or roll up."   That is our STRATEGY, to reenter the same position with a nice gain already under our belt.  So what does early scale mean in that context? 

If your maximum allocation for a position is $5,000, you generally want to commit to no more than $1,000 on your first round.  20% is a good rule of thumb for scaling in on any size virtual portfolio and it very much depends on whether or not you can afford to double up your full position in the end.  If you have a $50,000 virtual portfolio and are already allocating $5,000 (10%) to positions YOU CANNOT double up to 20% if you get in trouble.  That is just NOT a good idea – ever.  If, however, you have a $500,000  virtual portfolio and you allocate 2% to each position ($10,000), then if you need to, it is no big deal to move to 4% so you can afford to be a little more cavalier when things don’t go your way (although stop-loss discipline is good for everyone). 

The Actual Book - Well, a reprodcuction of it but very cool!Again Sun Tzu is helpful here as the General said: "In respect of military method, we have, firstly, Measurement; secondly, Estimation of Quantity; thirdly, Calculation; fourthly, Balancing of Chances; fifthly, Victory."  Measurement is the size of our virtual portfolio and our risk tolerance, it is an assessment of our total military strength.  Estimation of Quantity is how much capital we can allocate to each battle (position).  Now we can talk about Calculation:  With a $5,000 position allocation, one thing you need to be acutely aware of is that you have a strict upper limit.  It means that you do not want to lose more than 20% of your full position ($1,000) on the trade and it means you have to allow for being wrong on your entry, having to double up or roll (or get out) on your first 20% loss and then being wrong again and having to double down or roll (or get out) on your second 20% loss.

In a vacuum, think of it as spending $1,000, dropping to $800 (20% loss, $200), then doubling down to $1,600, then losing 20% of that ($320) at which point you have lost 1/2 of your full position’s max loss ($520, 10%) and you are faced with a very serious decision.  You have put in $1,800 and now have $1,280 worth of contracts that are down 20% from your last entry and the position is off about 40% from where you started.  Do you still stick with it?  If you still like your premise and think the run against you will reverse AND you have enough time (be realistic) to be right, MAYBE you commit another $1,280 to double down yet again.  That puts you in for $3,080 and your options are worth $2,560 but you have just $480 left to lose (18.75%) before you MUST pull the plug. 

Notice that this is a self-regulating system.  You intended to put $5,000 into a position but it went against you so you CAN’T put more than $3,080 into it but you have purchased 4 rounds of contracts that you were going to pay $1,000 each for for just $3,080.  You’ve gotten a 25% discount on your entries and you still have 18% left to lose so that’s a 43% buffer built into your initial entry!  Now, starting back at the beginning, if you enter a position and it goes 43% against you – shouldn’t you be pulling the plug by then?  Luckilly, with this system, we have three "brakes" where we are forced to re-evaluate BEFORE things get even that bad.

To recap:  20% loss on $1,000 ($200).  We generally are pleased to get a discount and buy another round unless we entered at a resistance point with a clear stop in which case we take our $200 loss (1% of a full position or 0.1% of the full virtual portfolio) and shut down the trade.  If we bought 2 contracts at $5, we are buying 2 more at $4 so we have 4 at $4.50, 10% less than we were willing to enter at originally.  We are, of course, still down .50 (11%) against our averaged $4.50 entry but we are now resetting our 20% rule to 20% of $4 or $3.20. 

Balancing of Chances: AT THE POINT WHERE YOU CONSIDER MAKING THAT SECOND INVESTMENT ($800), you MUST be willing to see the position drop to 4 contracts at $3.20 ($1,280), down $520 of the $1,800 total that you will have invested.  BEFORE you make that 2nd investment, you should know what you are going to do when you get to that point.  If the answer is "give up," then perhaps it would be smarter to NOT make that second investment, either take your $200 first round loss than and walk away OR take that $200 loss but say "IF it goes to $3.20, THEN I will reenter and IF it goes back to $4.50, I will buy my next round then."  If you hold your 2 20% ($200) losing contracts (and always we are assuming you feel you have a reasonable amount of time and that your target is still valid) then a drop to $3.20 will "only" cost you $360 (36% of the $1,000 but just 7% of a full position and 0.7% of your virtual portfolio).  At that point, you re-evaluate (of course) and, IF you decide it’s worthwhile you can roll (a discussion for another post) or double down yet again. 

Doubling down to 4 contracts by buying 2 more at $3.20 gives you an average entry of $4.10 so you are in for $1,640 and your 4 contracts are worth $1,280 (-$360, down 21% on cash in and down 7.2% against your full $5K).  At this point, need to be looking ahead to your THIRD AND FINAL investment, which would occur 20% lower at $2.50 (rounding off), 50% down from where you started.  When you pay $640 for the next 2 contracts, you should be PLANNING to pay $1,000 for 4 more at $2.50.  Again, here’s where we have a good feedback loop.  If you can’t see yourself having the faith to put in another $1,000 for 4 at $2.50 – WHY THE HELL WOULD YOU BE BUYING 2 AT $3.20? 

Each time you add capital, you need to look at the entry as a brand new position.  Putting money into a position JUST because you are losing money is like coming home to find your house burning and running to the furniture store to buy some new stuff to throw in there to keep your old furniture company or hitting and rolling up a losing position JUST because you are losing money is like having your cruise ship hit an iceberg and, while it is sinking, paying to upgrade yourself to a first-class cabin – you may be the last one to go in the water but you’ll be underwater just the same!  When your ship hits an iceberg you need to rationally evaluate your position – perhaps at this point it’s best to get whatever refund you can on your cabin and purchase a seat on a life-boat?

Victory: We’ve discussed all the ways we can lose and defeat is something we take when we lost that $1,000 but what constitutes victory?  As a rule of thumb, we are always looking to make 20% over the term of our position for non day-trades on options.  If you don’t think you are going to make 20%, since you are risking 20% – the trade is probably not a good idea in the first place as your risk/reward is negative.  EVERY TIME you add money to an existing trade, you MUST see a clear path to a 20% gain or GET OUT – your house is burning and your ship is sinking – TIME TO GO! 

So from our 3 theoretical entries, $5, $4 and $3.20, we have average cost basis(es?) of 2 at $5, 4 at $4.50 or 8 at $3.85.  At point 2 we are down 11% and at point 3 we are down 17%.  Master Sun Tzu says: "He who knows when he can fight and when he cannot will be victorious" and "The general who wins the battle makes many calculations in his temple before the battle is fought. The general who loses makes but few calculations beforehand."  Obviously, setting stops once we hit our +20% is the easy road to victory.  I will point out here that this strategy leads you to many instances where you will make 20% of your first $1,000 ($200) and that is the end of your trade.  Making $200 is 4% of your 10%, $5,000 commitment and it takes just 5 of these "little" victories to bump an entire $50,000 virtual portfolio up 2% for the year.  When we make 20% so fast we didn’t have time to build the position, it is NOT a bad thing – yet many, many people treat it like it is.  See also, our Strategy Section for scaling in on the way up. 

The calculations we make change once we are behind.  Again, see the strategy section for what to do when things are going really well, this is an article about what to do when things are going badly!   Since our overiding goal is to get 5 $200 wins, our main goal on every trade is simply to avoid taking losses.  If we make a poor entry in step 1, we lost $200 and if we kill the trade there, we wipe out one winning trade.  If we decide to press on in step 2 and add $800 more dollars, as I’ve said we are down 11% at (in the above example) on 4 contracts at $4.50 each ($1,800) and we have a new goal – GETTING EVEN.  The minute your trade turns negative on you it means YOU WERE WRONG.  If you go into that house and find the living room on fire, do you go to the kitchen and sit down for lunch or do you get out?  If the boat is sinking and your cabin is underwater, do you upgrade to first class or do you get out?  In both cases you are lucky to escape with your life – why should you not treat escaping with your cash the same way?

The general who advances without coveting fame and retreats without fearing disgrace, whose only thought is to protect his country and do good service for his sovereign, is the jewel of the kingdom – Sun Tzu, 600 BC

Options (not unlike stocks these days) bounce around a lot.  Up and down 20% is no big deal for option contracts and our job is to try to catch more ups than downs.  Note that when I say get out, I don’t mean get out the second you hit your goal.  Generally, I like to set stops (not hard stops, mental stops) at 20% OF THE PROFITS.  Of course, if you have a contract under $1, when you make 20% your stop is $1.15 (assuming no penny increments) and at 40% your stop is $1.30, at 50% $1.40, etc…  You also need to "know" your contracts.   If it’s a wild, bumpy contract like USO (ha, I bet you thought we’d never get back to that!), you may want to give it more leeway.  If it’s a slow grinder like UYG options, you may decide to just get out at $1.20 and not chance a pullback at all (assuming you don’t really think it’s about to break higher).  So this is not a "rule," it always depends on the situation but, going back to our generic example, once you are into your 3rd round commitment, when you already have $1,800 committed on 4 contracts that are now down (at $3.20) 28% ($520), YOUR GOAL IN THE TRADE NEEDS TO SHIFT TO GETTING EVEN. 

At this point, AFTER we had decided at $4 that we wanted to DD because (although we were 20% wrong on our initial entry) we still felt good about the prospect of the trade getting back to $6.  Keep that in mind at $4 BEFORE you double down.  You have only lost $200 and you were already WRONG on the entry.  Now you need a 50% gain just to get to your $6 target.  Is that REALLY still your target?  REALLY?  REALLY???  OK then, so you are gung-ho bullish on the position and you put up another $800 to double down.  This is a very legitimate strategy.  In fact, if you play blackjack properly, they will tell you that you MUST double down WHEN APPROPRIATE in order to win the game over the long haul. 

In blackjack, it is very easy to see when it is appropriate as there are clear rules:  If the dealer is showing 4, 5 or 6, you double down on 9,10 or 11 – that’s the very basic rule.  Why?  Because the dealer must hit on 16 or less and he busts on 22 or more and there is a 6/13 chance he has an 8, 9, 10, Jack, Queen King, all of which would put him in a poor positon as he must take another hit with 12-16 at which point he has a 4/13 chance of drawing a 10, which will bust any of those cards and then various other statistics that boil down to the odds being slightly in your favor that the dealer will bust.  Since you CANNOT LOSE on your next card if your first two total 9,10 or 11 – it is STATISTICALLY RESPONSIBLE to make a bigger bet in this situation.  You will still lose 47% of the time but that 3% is the difference between winning and losing over the long haul.  MOST OF THE TIME, however, you DO NOT double down – keep that in mind as well!

Our option plays are the same way.  We have to place a bet to play the game.  Unlike blackjack, we are allowed to count the deck.  We can watch the "game" (the position we are interested in) play out and, when we think the "cards" (momentum, sector movement, newsflow, pivot points, resistance zones, chicken bones, tea leaves…), are in our favor we take a seat at the table (our initial entry).  Once the cards are dealt, we look at our hand (up or down 20%) and we get to peak at one of the dealer’s cards (reassessing momentum, sector movement, newsflow, pivot points, resistance zones, chicken bones, tea leaves…) and decide if we are going to stick with our original bet ($1,000 in the above example) or, WHEN APPROPRIATE, double down. 

WE DON’T double down with bad cards on the table.  If you could play blackjack and walk away from the table with just a 20% loss whenever YOU were dealt a 13-16, you would own the casino!  That’s because your wins are 100% gains and you will have taken the situations where you have a 53% chance of losing 100% and only lost 20% but you have taken the situations where you have a 53% chance of winning and doubled down so you win 200% while losing only 20% when the bad cards are in your hands.  All you have to do is break even on the "normal" hands (when neither you or the dealer have an obvious advantage) and, over time, you will do very, very well.  Casinos don’t let you do that, of course but stocks and options do!  Unfortunately, there are very few doubles so it takes a lot longer to own the casino but, if you are both patient and disciplined, you can do very, very well here too. 

The man who begins to speculate in stocks with the intention of making a fortune usually goes broke, whereas the man who trades with a view of getting good interest on his money sometimes gets rich. – Charles Dow, 1895

So, we have our 2 contracts at $5 each ($1,000) and we took a 20% loss.  We look at our cards and decide if we are going to fold or if we are going to double down (which would give us 4 contracts at $1,800) or if we are going to wait.  As I said above, the easy "system" here is to wait with 2 contracts for either a rebound to $5 WHERE YOU NEED TO MAKE A FRESH DECISION TO GET OUT EVEN OR PRESS ON or hold the 2 contracts for a test of $3.20, where you would be down $360 on 2 contracts.  Keep in mind these are simplifications as your decision point can also be stock pivots, resistance levels, earnings reports, whatever – the main idea is you take action (or not) based on the new expectations at each level.  Also, you don’t make secondary entries at an exact spot but again, when the momentum seems favorable – the 20% rules are more guidelines to say FOCUS YOUR ATTENTION HERE.

In the case of being down 20% and deciding to wait, perhaps because all momentum is going against us BUT, we think the momentum is wrong and will reverse AND we think we have enough time to recover AND we don’t see a benefit to taking off that first position.  Hmm, it almost sounds like we’re talking about the USO trade now doesn’t it?   Not yet…  By waiting at step 2, we now have our 2 contracts at $1,000 and (if we decide to stick with it), 2 more at $640.  That puts us in 4 for $1,640, averaging $4.10 each with the stock at $3.20.  If we REALLY think it’s a bottom, we could buy 4 more at that point as we’d only be in for $2,280 with 6 contracts ($3.80) and down 20%.  What drives our decision here is our desire TO GET EVEN, not to "win" the trade.  Our plan is to have 6 at $3.80 with the stock at $3.20 because we expect a 20% recovery.  Once again, not to repeat myself but -  If you don’t think you are going to make 20%, why would you be putting more money in at all?

So we are adding $640 or $1,280 to our $640 losing position because the $640 losing position has to gain 56% just to get even (pretty hopeless) but, with the contracts at $3.20, 4 contracts at average $4.10 need 28% to get even and 6 contracts averaging $3.80 need an 18.75% move up to get even.  18.75% is just a  33.5% retrace of the loss from our entry – that seems doable!  Notice at no point here are we more than 50% invested and we are dealing with the same $360 (out of $1,000 max) loss AT THIS POINT, no matter how many contracts we add.  Again, Sun Tzu offers mathematical guidance:

It is the rule in war, if ten times the enemy’s strength, surround them; if five times, attack them; if double, divide them; if equal, be able to fight them; if fewer, be able to evade them; if weaker, be able to avoid them. – Sun Tzu

What are we doing in this strategy?  If we are very strong (certain) we add to our position and let the winner run (surround).  If we are fairly strong (confident, but not certain), we add to our positon with caution.  If we are down but willing and able to commit more (double), we divide the losses (divide) among more contracts, reducing their advantage over us and giving us a shorter path to victory.  If we are in trouble or very uncertain but determined to stay engaged (fewer) we may roll our position or simply hold on for the next level (evade), at which point we hope more information will be revealed to us and we can make a better decision and, finally, if our back is against the wall and we are at our loss limit (weaker) then both Sun Tzu and Kenny Rogers tell us, "you have to know when to fold them" (avoid).

Keeping very much in mind then that our goal when we are behind is simply to get even and either reduce or exit our position entirely, let us now discuss THE SALVAGE PLAYS:

In all fighting, the direct method may be used for joining battle, but indirect methods will be needed in order to secure victory. – Sun Tzu

When we left off, many paragraphs ago, we had taken the USO $32 puts for .80 again after coming out .35 ahead off our Friday play.  Our first adjustment came at 2:52, when I said to members: "USO – Gave up on waiting for .60 and took DD on $32 puts at .65. "  It turns out I was impatient, I could have gotten .60 but I had followed my own advice and take a small position earlier so (and bear in mind this is an example based on the $5,000 limit, not my own sizing), from an initial light entry of $480 at .80 (6 contracts), I added 6 more at $390.  We had EXPECTED USO to go higher but the early, small entry was, to one extent, a placemark to watch the trade and to another extent, a consolation prize in case I was wrong and USO tanked – so I wouldn’t have missed the entire move down.  That left us with (in theory!) 12 at .725 into the close.

The next morning, not very surprising, USO moved up ahead of the OPEC meeting and we followed-through with stage two of our plan and my 9:40 comment to members was: "Rolling USO $32 puts to $33 puts for .20 if possible but will also be willing to DD at .50.  XOM has a shareholder meeting to day, that will be interesting…  Oil may keep running into OPEC meeting tomorrow as minsters keep talking up the market but it’s very unlikely they can support $63 a barrel and there is a lot of speculative money in oil looking for them to do just that."  At 12:16, My comment was: "I’ve done a DD at .50 and I’ve got an order to roll up for .20 to the $33 puts so stopping out is not in the plan.  My basis is .61 and .20 more would be .81 in the $33 puts, which are now .75 so I’m not even concerned yet.  This was a scale-in play and would have been disappointed if all I had was the small, initial position."  Keepin up with the math, that’s now 12 more at .50 ($600) for a total of 24 at $1,470 or .6125 per option. 

It is said that if you know your enemies and know yourself, you will not be imperiled in a hundred battles; if you do not know your enemies but do know yourself, you will win one and lose one; if you do not know your enemies nor yourself, you will be imperiled in every single battle. - Sun Tzu

Going back to our lesson, as we were being contrarian in step one (know your enemy, know yourself), we take a half position so 1/2 of our usual $1,000.  Since contracts are in 100 option blocks, 6 for $480 was our closest entry (and, when you have to choose, go lower!).  Step 2 was a given because we intended to fill at a lower average and we ran it down to .725 on 12, which bought us close to our Day 1 goal of $1,000 with $870 committed.  Note that if I had bought 12 contracts at .80 right off the bat, I would have committed $960, a 10% difference on our first day!  Day 2 gave us the opportunity to buy more at .50.  I put in for the roll first but it wouldn’t fill for .20 with and I couldn’t get the .50 round 3.  That gave me 2 critical pieces of information (remember, we always want to see more cards):  1) That there was little interest in selling me $32 puts for .50, so my "value" was firmly $600 on the 12 I had.  That means that I should be happy to get some more at .50 (barring new negative facts on the trade) and  2) That the $33 puts I wanted to roll to did not want to take .70 for their contracts

Since I was already in 24 contracts for .6125 and was planning on paying .20 for a roll to the next level (.81 net) then there was no reason for me not to DD at .50 first and then roll as it lowered my net entry on the $32 puts to .55625 per option, which is what I’d have to pay to buy more anyway and it would lower my net entry (after a .20 roll) on the $33 puts  to .75625, which is what I would have to pay to buy them anyway.  So after having my first 6 contracts drop from .80 to .55 (31%), I was in a position where I had good expectation of having either (as I had both offers working at once) either 48 $32 puts at no more than .05625 (11%) off the mark OR 24 $33 puts at no more than .05625 off the mark OR 48 $33 puts at no more than .05625 off the mark.  The day ended with just the DD at .50, the roll did not fill so, Day 2 = 48 at net .55625, $2,670 committed.  Had I bought 48 at .80, that would have been $3,840 – scaling in gave us a 30% discount and kept us in the game!

As the Wednesday inventory report didn’t bother us (and members know I was checking and rechecking facts and figures for my premise on this one all night, as I often do if a trade moves against me) and the pre-market OPEC comments didn’t phase us, my Thursday 9:38 comment to members was:  "Still loving USO puts here.  The $35 puts are cheap at $1.30 but always scale in with oil as they could get to $65 for no reason at all."  Here I am committing to a new trade on the same track.  I could have just rolled up what I had for .75 per option but that would have been $3,600 more (in the example) and that would put the position over the limit.  This is not impossible to do but starting a new track on the $35 puts opens up a salvage play we’ll discuss further down.  So now we have a new play of 4 contracts at $1.30 ($520) on the $35 puts. 

Before we get too excited, it’s Important here to note what I told Red at 9:50: "USO is the proxy to oil and they are great to short as they lose money over time whether oil goes up or down (high churn rate).  If you want to play along, go with the USO trades I post but always treat them like crap shoots as oil trading is totally fixed and you are at the mercy of manipulators half the time."  It is VERY important to differentiate your risk levels when trading and allocate capital accordingly!  When I talk about "craps" plays, I mean that at no time should you have more money in the play than you are willing to lose on a roll of the dice at a craps table.  We are doing this example as if it were a full, conservative trade for education purposes.

He who is prudent and lies in wait for an enemy who is not, will be victorious. – Sun Tzu

It took until 1:33 but I said to members: "Finally got my roll-up for .20 to USO $33 puts, offering .20 for the roll to the $34 puts next."  So that cost .20 x 4,800 contracts or $960 to move the $2,670 worth of $32 put contracts up to the $33 puts for a total of .75625 per option in a contract that was, tragically, just .50 (down 33%).  My comment at 2:06 was: "Check out the hour chart back to last Mon-Weds on USO and compare that to this Tue-Thurs – pretty much the same so I’m hoping for same tomorrow as last Thursday (gap down) but we need to take that money and run as it didn’t last long.  We can assume they are holding oil up until the 2:30 NYMEX close but if they don’t pull back off $65 after that, I will begin to be concerned…..  "

Where the army is, prices are high; when prices rise the wealth of the people is exhausted. – Sun Tzu

At that point (after 2:30 with no pullback), I made the classic mistake of ignoring my own resistance point with a fairly full ($3,630 out of $5,000) position and I could have gotten out for $2,900 (down $730) and walked away.  This is a classic example of "do as I say, not as I do," advice my parents often gave me but I didn’t understand until I became one.  As the $33 puts were a "dead" trade (no point to additional adjustment other than the roll, which would be another $960 to get to the $34 puts), my concentration turned to my $35 position and I said in our 2:44 Alert:  "As this run-up in the market is just silly, we’re playing (lightly) for a poor GDP report in the morning giving us a bad open but it’s speculation at best.  On oil in particular, I do not think $65 is fundamentally supportable and I would stick with the USO $35 puts over the weekend but our goal is to make 20% and get out and we expect to make that tomorrow morning."  The very sad chart for the $33 puts was this:

Meanwhile, the $35 puts were faring little better, having come down from $1.30 to $1.05 already but that was (as the $33 puts once were) a light entry so it was desirable to DD on those to 8 contracts.  That left an average entry on the $35 puts at $1.175 per option on 8 contracts ($940) so mission accomplished on our new trade.  By the way, is it wrong to have 2 trades on the same position like this?  Generally yes but it depends what your other hedges are and what your exit strategy is.  Don’t forget we have long-standing UNG calls that are doing fantastic as well as our tanker plays so oil puts are not a terrible hedge overall.  Also, keep in mind that in a larger virtual portfolio, we’re talking less than 2% in position A and not even 1% in position B so not anywhere near overexposed – YET!  Still, for the purposes of this example, we will treat this trade as it should be in a more limited virtual portfolio…

On Friday, I put out an alert with adjustments to our OIH and USO trades: "On the USO $35 puts, if they retest $36.50 and you can DD at .75 (where we opened) I like that play as your avg would be $1.03 at .75 and the delta is .35 so a $1 pullback and you’re even."  We missed a fill at .75 and the puts ran up to $1.05 at 1:45 but then came back down as we got the usual pump into the NYMEX close.  That had me give up on .75 and say to members at 2:38: "Short on USO into the weekend (now is the time to DD as the NYMEX just closed but with tight stops on the new 1/2) and MAINLY cash until we see some data."  That is another factor by the way, since we don’t really have many other positions, we can afford to play a little loose with our 10% allocation rule as we’re not crowding out other trades.  So the tally now would be 16 $35 puts at an average entry of .9875 with the contracts trading at .80 so down 19% on $1,580 committed.

One defends when his strength is inadequate, he attacks when it is abundant. – Sun Tzu

We were not too worried about that play because we had an easy cover.  I had said to Smasher at 1:22 (before doubling down): "If you are concerned over the weekend you can put a brake on your exposure by selling 1/2 the $36 puts, now $1.25.  Since they pay you more than the spread, it shouldn’t be a margin issue and since you intend to buy more puts, if they start heading down you just buy more to increase your delta and drop your covers when you are ready.  I’m going to be staying naked on USO puts over the weekend but it’s not something I would recommend for everyone.  The most important thing about scaling in is KNOWING what your next 2 moves will be.  In other words, you are in at $1.20 and if you DD at .80 you will be in for $1 and down 20%.  What do you do next?  At that point I would 1/2 cover with the $36 puts that have a .47 delta and mine is .36 x 2 (although both would be lower at .80) and I would have the putter’s money, which is plenty for me to buy another round of the $35 puts at $1.20 or less when things move my way.  If things go against me, I can sell another 1/2 the $36 puts so I’m fully covered at about $1.10 with my puts at .70 (these are all estimates but this is where it’s good to internalize your greeks) and it costs me about $1 to roll to the July $35 puts so that would be my escape plan which would buy me another month to be right and I can wash, rinse, repeat until oil agrees with my position."

So, clearly I had a plan to salvage the position but what the hell was I talking about? 

Well, Salvage Play #1 is one of the main reasons we roll vertically.  If we roll vertically to keep near the money, in this case to the $35 puts with USO at $36.40, we can, pretty much any time we want, turn it into a vertical (in this case a bull put spread) to stop our own losses as the trade goes against us while taking on very little risk on a reverse.  In the case of the USO $35 puts – they have a delta of .33 at .80, meaning they move .33 for every dollar USO moves.  The $36 puts, now at $1.20, have a .43 delta.  If we were to 1/2 cover with the $35s at $1.20, we would collect .60 per .9875 we had laid out and we will have covered 2/3 of our delta.  Obviously, you can adjust your coverage to suit your move, using the $36s you sell like gas and brakes on a car – the same kind of stopping discipline we use for our own positions applies to the positions we sell.

Another nice thing about moving to a vertical is you can leave it overnight to put yourself into neutral and, if we suppose USO goes up $2 on Monday, then the $36 puts would lose about .85 while our $35 puts would lose .66.  If we had gone for a 1/2 cover, we would be able to (assuming we actually thought $68 was the top finally) buy back the $36 puts for .35 and we would keep 8 contracts x .85 or $680, which would either reduce our basis to $900 on 16 contracts or .5625 per option although presumably, the contracts would be worth just .25.   The good news is we can then roll them up to the $36 puts for about .15 more ($240) and possibly .20 more for the $37 puts ($320) and we’re in 16 $37 puts that are trading right now for $1.70, for net .9125.  Logically, if they can drop .79 in a day, they can come back .79 in a day and we would need far less than that to get ourselves back to even.

If we do not get a violent move, there is another interesting  way to play our position.  Remember those 48 damn $33 puts that we are ignoring as we hope for a pullback?  Well, as I often tell members, hope is not a strategy but butterflies are literally free sometimes.  This is why I like the setup of the $35s after getting blown out of the $33s:

  • We have 48 $33 puts at an average of .7562 ($3,630) and they are $3.40 out of the money at .40 ($1,920).
  • We also have 16 $35 puts at an average of .9875 ($1,580) and they are $1.40 out of the money at .85 ($1,360).
  • The $34 puts are .55 and we can sell 80 of them for $4,400 and their delta is .24. 

That puts $4,400 back in our pockets and USO can go to the moon and we only lose $810.  On expiration, in order for the $33 puts to be worth .50, our $34 puts would be worth $1.50 or $2,400, that would be an additional loss of $1,600 but we have no intention of letting it go that far.  With only $800 at risk to the upside we are now content to let USO run up as far as it likes and, if they hit our $70 upper target and we’re still in the mood, we can do some really cheap roll-ups and start again! 

The final salvage play is buying time.   Essentially, we can take our now rotten $3,280 worth of June puts (down $2,200) and sell 20 June $36 puts for $1.17 ($2,340) and roll ourselves to 20 July $35 puts at $1.52 ($3,040) which buys us another month to get our reversal.  The July $35 puts have a .37 delta while the June $36 puts have a .43 delta so we shouldn’t have too much trouble and the premium on the June puts will, of course, erode about twice as fast as ours (theta).  Mainly we have bought ourselves time and time is what we use to gather more data and, hopefully make better decisions between now and July 17th.  Of course, there are a lot possible adjustments we can make but the key is buying the time to make those adjustments cheaply by doing it sooner, rather than later.  

For now, we have 3 full weeks to go and we’re still playing for that pullback on Monday.  While the new $35 puts are fine, the $33 puts will need to be adjusted quickly if USO heads higher.  As you can see we have multiple ways to salvage these positions and, of course, since we are loaded up on these puts, we can also choose to take a very aggressive bullish play like the 10 July $33 calls for $4.30 that would gain about .75 per $1 USO goes up, giving us $750 per $1 and we are very well protected by our puts until June 19th

 


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  1. Kwan

    Nice book chapter you just wrote there Phil… :)

  2. Phil

    LOL – well you know me, once I get going…. 

    I am trying to get some definitive posts done for things that come up a lot.  Ilene was last in charge of editing the book Sage and I were writing but we got so busy that nothing has happened for months so I’m just going to crank out some pages in these members only posts for now.

  3. merkhava

    Pai an jiao jue jiang xin, Chan Shi !!    ;)
    ( wonderful explaination, Oh praisworthy Master Teacher !!)
    Master Tzu would be proud

  4. Phil

    Ta shi rong you jiao yi zhide xue sheng!

    (It is an honor to teach a worthy student!)

    Probably mutilated the Chinese of course…

  5. cdspdean

    Hello Phil, I’m a Phil as well.
    Got stuck in the 32p’s, I have 30, avg .50 after a DD at .40. What would be my best play at this point?
    Thanks in advance.

  6. japarikh

    Phil,
      What’s the best way to play SVNT w/ a June to August decision range? Staight buy of out-of-the-money calls or a bull call spread (didn’t find any great spreads though).
    This is more of a general question on how to speculate on biotech stocks before FDA decision dates. Thanks

  7. partha

    Phil – New member here – doing my homework …

    The $34 puts are .55 and we can sell 80 of them for $4,400 and their delta is .24. 

    That puts $4,400 back in our pockets and USO can go to the moon and we only lose $810.  On expiration, in order for the $33 puts to be worth .50, our $34 puts would be worth $1.50 or $2,400, that would be an additional loss of $1,600 but we have no intention of letting it go that far.
    How do we only loose $810 on 80 contracts if USO goes from $36.40 – to say $38.  Or $34 puts worth $1.50 or $2400.  I am missing something …
    - Partha

  8. Phil

    On the $34 puts you keep the $4,400, which is what happened at May expiration.  We spent a total of $5,210 on our long puts so the net loss was limited to $810 but we rolled the puts so it was an carry-forward loss anyway.

  9. Phil

    Covered calls/Jofori – I just put a covered call example up on SGR in a comment under the $5KP post but here I was talking about managing your position and scaling in.  I did write a whole article on scaling in HERE (by the way, the rolling strategy outlined there for USO returned a triple) but let’s look at another example:

    First of all, lets’s be clear that scaling into a position means, AT MINIMUM, that you are looking at 3 rounds of buys.  In round one, you buy 1x and in round 2 another 1x and round 3, WHICH YOU HOPE NEVER TO GET TO, you buy 2x more.  Allocation-wise, let’s say you are willing to commit 10% of your porfolio to a position, then you start with 2.5%, move up to 5% and, HOPEFULLY, that’s all you ever need.  The times you do commit 10% are saved for big positions where you got a REALLY cheap price that you want to hold for a REALLY long time. 

    So, if I buy AAPL at $135 and another round at 20% lower around $110, then my basis is $122.50,  That’s nice but not an amazing price.  If AAPL falls another 20% below $110 to $88, THEN I think (assuming nothing fundamental has changed), I have an amazing price and I am happy to buy 2x more at $88 for a $105.25 average entry (ignoring any calls I hopefully sold). 

    Using this entry system properly you are automatically buying more of things that are cheap and less of things that are expensive

    So 20% is generally our action point.  If a stock or option contract loses 20% we need to decide whether to cut our losses or add to the position.   Again, there is a certain automation to the process that promotes good decision-making as your first 20% loss, if you start with 2.5% of your portfolio, would only be 0.5% of your portfolio.  That should be easy to walk away from right.  If you double down there to 5% (although it’s less because the 2nd 1x is 20% cheaper) and the position drops another 20%, you have lost 20% of 5% (1%) plus the original 0.5% for a 1.5% portfolio loss AFTER taking a 40% hit on your posiiton.  Again, this should be managable and something you can walk away from.  If you add another 2x at that point, ignoring the fact that it got cheaper, you are in for 10% of your portfolio and another 20% drop will cost you 2% plus the 1.5% you already lost is 3.5% lost on the position after it went 60% the wrong way on you.  That is bad but not devastatiing and don’t forget you have to be totally wrong 3 times in a row with no covers for that to happen.

    By comparison, what is the upside.  We don’t cap gains so there’s not limit but we do take 20% profits off the table.  If you are in for 1x and it goes straight up 20% so fast that’s all you get, it’s a 0.5% gain in your portfolio.  You need 7 wins like that to cancel out one 4x wipeout, which is why you need to think VERY hard before you ever double down on something.  If you take a 20% hit and get out in step one, it only takes one win to get it back.  The deeper you chase a bad position, the more right you need to be on your winners just to get even.

    Let’s look at GE this month.  Say we entered on June 12th at $13.50 and sold the July $14 calls for .60 and the July $13 puts for .60 too.  That would be a net entry of $12.30/12.65, not very good but that’s why we weren’t buying then! 

    Anyway, so by June 19th expirations, GE has fallen all the way to $12.10, below our net entry.  This is no reason to do anything!  It’s not 20% off, which would be $10.80 and you need to go into the position with that target and plan.  IE: I am in for net $12.65, if GE drops 20% to $10.80 I will be assigned so I will have X at $12.65 and I will buy 1x more at $10.80 for an average entry of $11.73.  My expectations are that I can sell another $1 of $11 puts and calls to lower my net to below $11, where I will own 4x at $11 if assigned or 2x at $11 if not assigned.  By the way, with an entry on a buy/write you can start with X (2.5%) or 1/2 X (1.25%) but I find it’s better to run more than less positions and put your money into the losers, which are offset by the profits from the winners.  Keep in mind though that EVERY SINGLE time you sell a naked put – you’d better be damn well committed to long-term ownership!

    So good discipline should have stopped you from doing anything with GE at $12.10.  If you remember our original buy list, we rode out the entire March market collapse without doing much of anything and came out just fine.  You have to think in terms of years of ownership, not days and you only take action when events strongly dictate it.  

    That’s why we have guidelines for taking out calls and puts we sold when they are ahead by 50% with more than 2 weeks to expiration and 75% with one week to expiration and 85% during expiration week.  We also have a guideline to take out off 1/4 of our callers or putters when they gain 25%, not just from where you sold them but from whatever low they hit.  So, in other words, if a caller drops from $1 to .60 with more than 2 weeks left, you don’t wait for it to go to $1.25 before buying back 1/4 of them, you buy 1/4 back if they bounce to .75!  When you are 3/4 covered, you set another 25% stop on 1/3 of the remainder (the 2nd quarter) and, should you trigger and find yourself 1/2 covered, you have once again reaced a decision point.

    So on June 19th, the GE $13 puts had hit $1.25 but had spiked to $1.75 earlier in the week.  Had you followed guidelines for stopping out the putters, you would have taken 1/4 off at .75 and 1/4 off at .90 so you would be 1/2 covered at $1.25 or you would have possibly already rolled them down to a full cover at Aug $12 puts.  Today, the $13 puts are $2.25, a great example of how using stops can greatly improve your returns and limit your losses.  Of course, you have to have at least 2 contracts to work with, preferably 4 (if you have 2 you can stop 1/2 out at 33% but you have to be quick to re-cover if it turns). 

    The $13 calls, on the other hand, fell to .10, so were up more than 50% with more than 2 weeks left.  You don’t stop them out for no reason, you stop them out because you have a plan of what you are going to do next.  With the gain of .50 on the calls and the loss of .65 on the puts, perhaps the plan would have been to reposition the puts and calls at the July $12s or Aug $12s – somthing where you adjust your target…  The key to that decision would be redoing your cover math and trying to stay even at least.  Obviously (I hope) dropping the put strike from $13 to $12 would knock .50 off the high end of your basis (the strike if put to you) so it would drop from $12.30/12.65 to $12.30/12.15 – assuming it was an even roll. 

    Don’t forget we enter these positions because we WANT to own GE at around $12 so this is just fine!  We haven’t had to make a bigger commitment and we knocked .50 off the assignment price and, as of June 19th, the stock was at $12.10 and our assignments were right about there - not a win but not a loss at all. 

    Anyway, NOW we are at $10.80 (20% off) and regardless of what puts and calls we sold it’s decision time so do we still like GE and do we want to buy another round or do we want to cut our losses at about 10% or do we want to try to roll our $12 puts and calls, now $1.37 to something more forgiving like the Aug $11 puts and calls at $1.55?  Our original buy-in was way up at $13.50 so less $1.55 is net $11.95/11.48 at August expiration, not a bad entry but depressing with GE at $10.80.  GE was $7 in March though so, just in case, we may want to save our DD firepower for a real bargain.  The premiums on the puts aren’t all that thrilling to sell (.69 for the Sept $10 puts) so, at this point, just 10% down overall, we’re probably best off riding it out. 

    If GE heads up we may want to have a buy point since we don’t want to get called away at $11 with our entry point at $11.95 (it only gets cheaper if we are assigned more at $11) but that brings us back to why we should be stopping out 1/4 of our $11 callers, now .66 at .75 and again at .90.  Then we would be 1/2 covered at $11 with putters expiring worthless and we can easilly roll to the Sept $12 or $13 puts and calls and be right back on track.

    As you can see, there are always many options at each decision point (illustrations are in the article) but, over the long-term, it’s a very powerful and flexible way to manage your portfolio.

  10. Phil

    Trading/Celeste – There’s a reason we say, in the New Member’s Guide, that you should read a month of posts and comments before doing anything else.  Few people do but this is exactly the sort of thing that you would find as at least once a month someone has a bad streak of luck and worries about what to do.  Usually, it’s a simple matter of not balancing the portfolio.  You never want to be 100% bullish or 100% bearish.  Usually you want to move from 60/40 bullish to 60/40 bearish with 70/30 in either direction being exreme.  Of course, that doesn’t do you any good unless you are aware of your trades and how they balance each other out.  It’s important to scale into your positions, no single trade should ever cause you serious pain.  Also, and we say this over and over and over again – buying front-month options is for suckers.  Selling front-month options is how professional traders make a living.  Our goal is always to sell premium, not buy it.  All of the trades where we play the front months buying puts and calls are speculative and, as such, should never be a large bet in any portfolio! 

    Sage wrote a couple of articles 2 years ago on "Smart Portfolio Management" and I urge you read those.  Part 2 is here and Part 3 is here.  The first thing you need to do is figure out what style of investing fits your lifestyle.  If you have ANY distractions in your life (and it sounds like you do!) then daytrading is probably NOT a good idea.  It’s not just about having the time to sit at the computer all day but also about having the mindset to stay cool, calm and collected under some very stressful conditions.  It is very easy to panic out of trades or, just as bad, not to panic when you should.  If you don’t go into your trades with a plan for what to do when a trade goes up, down or sideways on you (see my Salvage Plays article under Strategy) then you are probably going to fail the trade.  There’s an old saying that says "If you fail to plan, you plan to fail" – it’s amazingly true.  Almost as true as "practice makes perfect" but, with trading, if you go broke while you practice, it doesn’t matter how good you get at the end when you have nothing left to bet with. 

    Let’s take some time over the weekend to discuss your porfolio in more detail.  We have two active porfolios now and I will be starting the Buy List (and the new plays for that one were summarized in the weekend post), which is probably the best strategy for you to follow as it’s low-touch.  The $100KP is also low touch but the $5KP is not and any of the day-trades I make during chat are absolutely not!  As Craig said, if you set reasonable goals for yourself, you will find you can reach them but if you treat the market like a casino – then you will find it will treat you like a casino too!   Make sure you remind me Saturday morning and we’ll see what we can do with what you have to set up some balanced positions that might work for you with less stress. 

    By the way, on FAS/FAS – the idea was to short both ETFs at $45, that was the right play to make.  If you were unable to short them, then the play was to do 2 bear put spreads (a spread where you take the higher dollar puts and sell lower-strike ones against them to offset your premiums).  Buying $20 puts is exactly the opposite of this concept as you are taking a huge, speculative risk and paying an enourmous premiuem to do it.  I believe you wrote that you bought the Oct $20 puts, which are .75 on FAZ and .90 on FAS.  So you are $25+ out of the money over 3 month and you need the ETFs to fall $25 (more than 50%) before you break even.  This is not an ideal plan, especially since you are also betting against yourself and will only even possibly get paid on one side.  You MUST know why you are making a trade and if you can’t articulate HOW you are going to win and what you are going to do if it goes against you – you shouldn’t be in the trade in the first place.  We’ll work on this stuff in detail on the weekend.

    Also, it would be very good for you to go to the Portfolio Tab and find the original post of the $100KP and then the next and the next and the next and print them out and then sit with charts and see how and why we made 12 weeks worth of moves.  This cannot be something you consider tedious – this is your "job" when you are going to be trading seriously.  Why do you think I’m up at 4am most weekdays?  I need to know what’s happening in Asia, I need to see the EU markets open and see what’s going up and down so hopefully I get a little insight into the US markets for the day.  When I started writing these posts – they were trading notes for myself so that I could go back and see what the hell I was thinking when I entered a position and by going back and reviewing every mistake I was able to make small improvements over time.  Even now, you see me often referring back to my own old posts because I still use them to see what I was thinking at certain points.  Trading is serious work if you want to make a living at it!

  11. Phil

    Comment on 5% rule from June 13th:

    Futures/Merk – Unless there is serious unrest in Iran (and a few hundred people getting their heads bashed in by Police is just a typical Friday night there) then so what?  Mahmoud wins and he hates us – what else is new?  Kim Jong Il’s a nut case – yeah, so….  They could be an excuse to sell off but not the real reason we sell off.   From a chart perspective (and I’m not a chart guy) it seems to be that a breakout consolidation pattern usually includes more spikes up through the level.  The S&P and Dow have been dead flat under 950 and 8,800 respectively.  The Nasdaq is doing what I would expect a breakout consolidation to look like – going above and below the 1,850 line.  The NYSE also is treating 6,200 like Kryptonite while the Russell is doing a good dance around 525.

    So let’s back up and see what the real levels are.   525 on the RUT is 50% off the non-spike low at 350.  That’s a lovely number so let’s use that bul keep in mind it’s 38.5% from the top so over our 40% line (514).  That means that, if anything, the RUT already broke through that fence we talked about last week and is dancing around waiting for the other indexes to catch up so it can fly higher.

    The Dow, I guess, bottomed out at 6,500 so 9,750 is 50% up for them.  It’s worse if we say they bottomed out at 7,000 (10,500) so let’s say it would be very bad for the Dow not to make 9,750.  8,800 is "just" a 35% gain off the March lows so the Russell is 15% ahead of this fat kid (but a 50% additional move for the Dow to catch up).  This is why I was loving the RUT back in March as a long-term play. 

    S&P 675 was a bottom and that means we’re looking for 1,012 as a 50% move or 1,050 off the rounder 700.  946 is exactly 40% off the top but only 40% off the bottom or 35% off 700, which makes me want to use that mark since it lines up with the Dow.  These are important decisions as they lead to my next round of 5% Rule selections.  When in doubt, I split the baby but if we see convergence and can work backwards without too much forcing, it’s nice to settle on rounder numbers.

    NYSE 4,300 seems like a reasonable bottom and that makes 6,160 their 40% up line and 6,132 is the 40% off line so we’re liking that one.

    Nas 1,300 is a good one and 40% over is 1,820, which confirms my thought that they are already in a breakout, like the RUT, they are waiting for their fat friends to catch up.  The Nas alread blew through their 40% line at 1,717 which tells us that the poor Nasdaq should have been higher back at the top or that they held out better then their peers at the bottom.  That’s a good sales point for tech leadership as a long-term investment.

    SOX 190 is a clear bottom and 275 just so hapens to be the 50% off mark and the 50% off the bottom mark so I’d say that’s rock solid.  You can’t ask for a better directional indicator than the SOX are right now, they are like a compass for the market right now.  I’d say if they can’t break 329 (40% off) then the rest can’t go up and if they fail here, they will lead the way lower. 

    TRANQ made a pretty clear bottom at 1,250 so 1,875 is where they need to be to make the 50% up level and 1,868 is their 40% off mark so not as good an indicator as SOX but, obviously, they are our biggest problem.  1,750 is their 40% up mark so failing that will be a doomsday signal for the markets.

    Notice in the 5% rule we could not possibly care less about moving averages or any other squiggly line nonsense – it’s math but the "art" of it is being able to identify tops and bottoms on a chart (throwing out "noise") and then identifying conversion points.  Of course, if you look at TRANQ for example, you’ll see how those squiggly lines tend to converge on OUR targets – not vice versa! 

    The rest of the 5% rule is very simple and it’s based on what I’ve observed consulting on computer projects and working with traders.  Everyone thinks they are writing a proprietary trading system but there are several factors at work.  The nature of the project is that the traders tell the programmers what they want and the programmers have to code it.  Since, generally, more than one person has input on the project, certain target levels get averaged out.  It is also human nature to pick whole numbers when asked for long-term targets (how many other people said 8,412 for the Dow or 946 for the S&P) and then there’s a whole essay I could write about how random numbers are not random in a computer and, of course, there’s rounding.

    All this mish-mosh of activity ends up causing trading programs to end up with predictable patterns.  Then, if you aggregate that over hundreds of trading programs all set with their own "random" targets, you end up with larget and more pronounced moves that end up obeying certain incrimental rules and those rules are this:

    Stocks and indexes tend to move in 5% incriments.  The more liquid a security is, the more more you can break that down to 2.5%, 1.25%, even .625% if you want to micromanage.  As you reach these points, all these different "proprietary" trading systems starts to converge on certain identifyable points.  The system is self reinforcing in that most traders adjust/tweek their systems when they see convergance points, which is why we look for key consolidation points to make our own adjustments.

    The rule goes up as well so when I  say 10%, 15%, 20%, 25%, 40% or 50% rule (there is not 30% rule as that zone gets screwed up by Fibonacci rules), I’m talking about the same 5% rule and all that is (after we have our targets) is that we expect a 20% retrace off any incrimental move we track.  So at 1.25%, we expect a .25% retrace, at 5% we expect 1%, at 20%, 4%….  Those are bullish retracements if they hold. 

    So, if we look at the S&P chart, we see a bottom at 700 (non-spike) and then a huge move up to 800 (and we do expect psychological points to offer resistance as well), which happened to be 14.5% up so we expect a retrace of 20% of that move back to 780 and that’s still bullish.  Now, here’s the art part because the S&P fell a bit more than that on Expiration Day in March but, looking back now, it’s easy to see it was a spike to be thrown out.  It’s easy to say throw out the spike in retrospect but very tough to trade on the actual day… 

    We than spiked up to 832, shy of the 840 mark and then pulled back to 779.81 on a spike and then tested it again.  THAT IS BULLISH, not bearish.  That is the kind of good and healthy test I keep wanting to see up here.  Anyway, so then in April we try to break the 20% line at 840 and that’s what a bullish breakout consolidation looks like.  850 offered small psychological resistance and we never came close to pulling a retrace so not at all surprising to see 875 (25% rule and small psychological) as the next stopping point.  There was no pullback there (worrying) and the usual craziness in the 30-40% zone in May followed by a move to 946, STILL without a retrace.  

    980 is the 40% up mark for the S&P and you want your upside marks to hold, not your downside marks, which is what 946 is.  Now, to be fancy though, we have a 280-point move off 700 at 980 and that means we expect a 40-point retrace, which makes 940-946 a VERY significant zone for the S&P and look where they are this month – Right where the 5% rule predicted they would be back in March

  12. Phil

    How to manipulate a stock:

    "THEM"/Matt – Don’t forget that "they" only have to nudge a very small portion of the $11Tn in cash that is on the sidelines to greatly influence our $25Tn market.  Back when we had a $40Tn market, there was only $3Tn of cash on the side.  As I mentioned this week, market pricing is not really efficient, especially on low volumes.  IBM went up $5 today and added 40 points to the Dow all by itself (the whole gain) but just 20M shares were traded for $115ish ($2.3Bn). 

    IBM actually has 1.3Bn shares outstanding and they gained $6.5Bn on the move.  If you  assume a fairly even number of buyers and sellers in that 20M share turnover today, then it wouldn’t take much of an imbalance to kick the stock up a few bucks if you really wanted to.  Heck, if you have one of those fancy Goldman trading boxes, you don’t even need anyone else to trade with, you can just buy 100,000 shares at $110.10 and sell 100,000 shares at $110.09, then buy 100,000 shares at $110.20 and sell 100,000 shares at $10.19 – you lose $1,000 every time and it would take you 50 steps to to get to $115, costing you $50,000 to trade the same $12,500,000 (average) 50 times, accounting for 1/4 of the total IBM volume for the day. 

    If it weren’t illegal, I would tell you you could do this yourself with a penny stock.  It’s not magic, pumpers can’t keep the whole $152Bn (now) company at $115 but look how easy (and cheap) it is for them to make it LOOK like IBM gained $6.5Bn in value today.  This is what they do to take what you or I or any rational person may think is negative or ordinary news or earnings and "spin" it to make it look like the investors are loving it. 

    That’s why the Dow is so scary, IBM, all by itself, accounted for 130% of the day’s gains.  AA dropped 2%, AXP down 1%, BA – 1.6%, BAC -2%, CAT -0.5%, DIS -1%, GE – 6%, JNJ flat, KFT -1%, KO -1%, MMM – 0.8%, MRK – 0.7%, MSFT – 0.6%, PFE – 0.7%, TRV – 0.3%, UTX – 0.3%, WMT flat, XOM flat.  18 down or flat. 

    That’s pretty awful right?  Who were the Dow winners that gave them a 32-point gain on the day?  CSCO up 2%, CVX 0.3%, DD 0.5%, HD 1%, HPQ 0.8%, IBM 4.32%, INTC 1.6%, MCD 1%, PG 1.29% and VZ 0.3%.

    That’s how you give the Dow a 0.4% gain on the day.  IBM boosted tech outlook and took CSCO, HPQ and INTC up with it.  PG had no news but is a safety stock and a big weight on the Dow at $50 and, with just 13M shares traded today out of 2.9Bn outstanding, think how easy that one is to manipulate in a pinch!  Perhaps HPQ and MCD were random up moves – there’s bound to be a couple.   Effectively though, all the bulls have to do is jump on good earnings from IBM with a little program trading and they can reliably expect the tech boys to follow and it doesn’t take much else to keep things going.  Don’t forget, someone like GS makes broad market bets and if they can goose IBM up 4% and guarantee a payoff on their longer bets – that’s worth hundreds of millions easily….

    That’s motive, means and opportunity – case closed!

  13. Phil

    Very detailed explanation of calendar butterfly spreads from July 17th:

    RIMM/Drum – OK so you are in for $10 and you sold $6.70.  Your longs are now $6.40 (ouch) and the puts and calls you sold are $7.05 – Ouch!  First of all, what went wrong?  First of all, your play, if it worked perfectly, would have left you in at net $3.30 with a $75 call (and the Aug $75s are $2.49) and a $65 put (the Aug $65s are $1.02) so you only would have had $3.51 if everything went off without a hitch.  The main problem is, by selling calls and puts that were on the money and taking your own positions out of the money, you effectively took on much more premium than your caller and putter. 

    The caller or putter each had an excellent chance of being $5 in the money to you and, even if you gained $1.50 on the other side, you would still owe the caller $3.50.  Since a $5 out of the money call is not worth $3.50 on RIMM, chances are this would not work out.  Conceptually, a butterfly calendar spread is a good thing but not for selliing just one month.  With one month, starting at $70, you sold a $70 call for $3 over 30 days (.10 per day) while you paid $4.50 for 60 days (.075 per day).  BUT BUT BUT you are not taking into account that you also are $5 out of the money.  That means your effective premium is $9.50, not $4.50 and, over 60 days, you are losing .16 per day, 60% more than your caller!  

    That, my friend is a dysfunctional trade!  The put side has the same problem.  The rule you violate here is that you are buying premium, not selling it.  If you are going to take up a neutral stance on a stock for a spread – you damn well better be sure that the premium math is in your favor.  Not every stock is good to do this with, you need to find a stock with lower long-term volatility than short-term and you need to make sure you have a selling plan with an excellent chance of paying off your long position, especially if you are out of the money. 

    RIMM earnings are 9/24 and one trick you should use for positioning is keep your long positions behind the next earnings – that helps you maintain value.  The Dec $65 puts are $6.03 (+$3.72) and the Dec $75 calls are $8.30 (+4.18) but they allow you to sell Sept, Oct and Nov calls and puts, in addition to Aug so the total outlay is $14.33 and you need to collect $3.50 a month in premium to pay off your longs completely while your original $10 worth of puts and calls required you to collect $10 in premium in one month – which you failed to do (because it was impossible).

    Is there a "fix" to this?  Well you can roll back for more money and let time do it’s work.  You can also take out the $65 putter for $1.02 (we have a rule and you already beat him by 72%) and roll yourself back to the Dec $70 puts for net +$5.90 ($5 of which you are using anyway because you are using margin) with an eye on selling the Aug $75 puts, now $5.05 ONLY IF YOU HAVE TO but mainly playing for a pullback.  Since you ended up bearish on that leg, now you need to come up with a good play on the bull side that won’t screw you if RIMM heads north and hurts your puts. 

    You are in the puts for $8.70 ($5.50 original, $5.90 to roll less the $2.70 profit on the puts you sold) and we are confident that we can sell $2.50 a month in premium ($8 + $2 out of position) if we have to so no hurry there.  As we are bearish on RIMM for next week (looking for a pullback off this run and also – if AAPL has great IPhone earnings, that’s not really good for RIMM), you can keep the current spread or roll the caller up to 2x the Aug $75 calls, taking them from $2.50 in premium $2.50 in the money to $2.50 in premium $2.50 out of the money) and you can buy yourself one more set of DEC $80 calls at $6.30.  By keeping the Sept $75 calls, you knock out part of the premium and get better upside delta in case RIMM does take off but if RIMM goes down, the Aug calls completely pay for your Sept calls AND you have the Dec puts protecting you as well, which should gain as much as the Dec $75 calls lose.  Just keep in mind, on the way up, you need to sell Aug puts but you can manage your play by simply covering and uncovering the put side once you are set up. 

    I hope that’s pretty clear.  This is why I stopped doing those butterfly plays last year – much more explanation than the play was worth but it’s a tactic well worth learning.  Of course, if you want to sell premium, nothing beats Google and the Jan $410 calls are $48 but you can sell the Sept $430s for $19.25 so $28.75 for a $20 spread +4 months.  You can pair that with the Jan $450 puts at $47.50 and sell the Sept $430 puts for $19, which is net $28.50 on the $20 spread.  What’s cool about this trade is that you have the $500 calls and the $550 puts so you CAN’T be worth less than net $40 in January and all you paid is $57.25 (risk of $17.25) for the ability to sell about $20 a month in premiums.  Of course GOOG is a crazy stock and could move more than $40, which is your safety zone for September but they’ve only moved $50 since April earnings and, obviously, no one seemed to thrilled with these.

    It’s a really great play if you have the cash to add to and roll the longs when the play goes against you but, at net $3K per spread contract, it’s not for ameteurs.

  14. allen060

    Phil,
    Some basic questions on 5% rule described above:
    - Does it apply to stocks as well as index ETFs?
    - In the daily chart that you publish, why are the 2.5% increments based on the close of 2 days back and not on the close from the previous afternoon?
    - As you described the 20% retracement that you might expect from the various levels reached, does that mean that you recalculate each time that an index reaches a new high or low for the day, week or month?

  15. Phil

    5%/Allen – It applies to anything but the more actively something is traded (more liquid) the better it works.  So XOM, AAPL, GOOG, RIMM will do almost as well as indexes when you track them but they can be much more erratic on their way to levels too. 

    2.5% – They should be yesterday’s close.  I never noticed that we’re picking up 2 day’s back.  Are you sure?

    20% is 20% of the move.  There are several moves.  If you take the Dow right now we were at 6,500 as a low in March but 7,000 could reasonably be called support.  Clearly we made a new support level at 8,800 and we haven’t topped yet so there’s no spike to spike calculation.  8,800 is 33% over 7,000 and 35% above the spike low of 6,500.  We’d be looking for a 20% pullback from 8,800 and that’s 360, back to 8,440, which we kind of did in late June (note the many times we bounced off it as support).  From 6,500 to 8,800 we’d be looking at a 460-point retrace as our "spike" retrace and that would be to 8,340 and that bracketed our dip in early July. 

    The question you have to ask though is "Why did we keep dipping to 8,200?" and that is answered by the much longer-term trendlines that gave us a mid-point target of 8,650, where 8,200 is the 5% rule below that.  So now we have a strong indication that 8,200 is right and if that’s right then 8,650 is the right middle (so we went long last the week of the 6th) and 9,100 is the right top.  9,100 is 30% exactly over the non-spike low of 7,000 and 40% EXACTLY above the spike low of 6,500 so to call that significant would be an understatement!

    From that point we then calculate all potential 20% retraces which are 520 from 6,500 (8,580) 420 from 7,000 (8,680) and 180 from 8,200 (8,920).  Those are our watch levels for retraces and, of course, 8,650 is already a known prime point so that remains our focus for the center until we see the other points hold and give up on seeing it lower. 

    The idea is simply to run multiple studies and look for conversion points and also to throw out outlying data like spikes so our real points to watch are 8,650, 8,920 and 9,100.  Today we finished just under 8,920, which was tested several times today and that would make a good inflection point to short and long the Dow at tomorrow.  Notice that the cool thing about this rule is we could have told you that 8,920 would be the breakout point to 9,100 back in November, when we first established 8,650 as our target for this year’s mid-point and as soon as we saw 7,000 hold as a bottom. 

  16. allen060

    2.5% – They should be yesterday’s close.  I never noticed that we’re picking up 2 day’s back.  Are you sure?
    Thanks Phil.
    If you look at the daily chart at the end of your morning posts, the top line is "Current" which is the close the previous afternoon. Two lines down is "Prev Close" which is the close from 40 hours ago, 2 days back. The 2.5% calculations are based on that latter figure. By the way, they are not updated every day so the figures are usually wrong anyway.

  17. Phil

    Protection/Cwan – (I got your wiki Email by the way but haven’t had a chance to get back)  keep in mind it depends on what you expect out of your hedge for one thing.  In general, you want to spend as little as possible for as much protection as possible.  Our DIA covers are a little different because they are, through the sale of short puts, aiming to tread water while your long side gains so it’s aprropriate to cover more aggressively. 

    In this morning’s ultra covers – you need to assess the potential damage of a down market move to your bullish positions and then decide how much of that damage you want to mitigate.  Ideally, let’s say you have $50K in buy/writes that are covered for a 20% down market move and will make 15% if called away.  So, in a flat to up market, you KNOW you will make 15% of 50% of your portfolio or 7.5%.  In a 20% drop, you will pretty much break even and in a 30% drop you will lose 5% AND have a lot of things put to you.  

    If you want to guard against a 30% drop that will cost you 5%, you can go with the SDS play with 5% of your portfolio, which will return 12.5% if the S&P drops by Sept expiration.  If the S&P doesn’t drop, you are assuming you will make your 7.5% and, hopefully, not lose all of your SDS coverage.  If the S&P does drop, you have 12.5% cash to use to make your rolls and double downs on the plays that are put to you.  It also depends on where you are in your scale.  If you have a lot of first round entries, you may HOPE that you get a bunch of new stock put to you for 20% off, especially when you just got a bonus 7.5% cash from the cover play to help you buy round two. 

    Unfortunately, like many intelligent strategies – it depends.  I know everyone wants a formula and I often have to say to people "what’s the formula for rising to the top of your profession?"  That probably seems like a silly question to you but that’s what people are asking for here – as if there is a formula or two that can be used in ignorance of all other factors to deliver some kind of miraculous performance.  As with any professional skill – there are guidlines but mostly there is practice and experience that you must work very hard at over time. 

    I think the big problem is that so many web sites tell people there’s a magical secret that people kind of expect there to be one and when I say there isn’t it kind of sucks (as the truth often does).   Anyway, this is good stuff because the reason I like these new portfolios is the details of the set-ups bring about a lot of good questions and, while there may not be easy answers, there are often answers and the more you hear them and apply them over time, the more sense they will hopefully make.

  18. Phil

    Good morning!

    DIA Mattress/Ajay, All - This goes for any time you have a 1/2 cover and get "blown out" with a downside move

    We begin with 10 (this is an EXAMPLE AMOUNT) DIA June $108 puts at $6.80, 1/2 covered with 5 Feb $106 puts at $2.12 on Wednesday.

    On Thursday, the Dow drops 200 points and the Feb $106 puts shoot up to $3.  The June $108 puts jumped up to $7.75 so they are up $950 and the 5 Feb $106 puts are up $500 so this is nothing to panic over anyway. 

    Since we are completing a 2.5% move down and since we expect a bounce off 2.5% we want to SELL INTO THE INITIAL EXCITEMENT (which we ALWAYS try to do) and, CONTRARY TO YOUR INSTINCTS TO FREAK OUT OVER A 50% "LOSS" ON THE SOLD PUTS – we SELL another 1/2 (5) Feb $104 puts at $2, not moving to a full cover of 5 Feb $106 puts AND 5 Feb $104 puts.

    What have we done?  We have collected $1,000 selling 5 Feb puts that are $2 lower than the $106 puts, giving us a $2 better spread between our June puts and the Feb puts we’ve sold than the $106 puts.

    What is our plan?  We are HOPING we do get our bounce.  Keep in mind we have a $1,000 loss on the Feb $106 puts but we did just collect another $1,000 for selling the $104 puts.  If the market goes up, we’ve increased the Feb delta relative to our June longs from .35 (1/2 of .70) to .65 (the average of .53 and .77). 

    By adding 5 more shares we have now flipped our spread to BULLISH as our June delta is .65  so a bounce back will hurt the fully covered callers more than it will us.  Our hope is that we have a retrace that allows us to take out the Feb $106 puts at $2 (even) which would mean we effectively traded the Feb $106 puts for the Feb $104 puts at the same price and widened our spread for free.

    If, on the other hand, we are wrong and we break down from 2.5% then what is our plan?  We collected $2 ($1,000) on our original sale of the 5 Feb $106 puts and they are now at $3 ($1,500).  We collected another $2 ($1,000) from the sale of 5 Feb $104 puts ($1,000). 

    Our next move comes IF the $106 puts rise to $4.  At that point, we have obviously moved lower than we thought (and, since the Delta on the Feb $106 puts is .70, we can be pretty sure that it would be roughly 150 Dow points lower than we are now, so at about Dow 10,250.  By the way, if we are at 10,400 and you believe that 10,250 will not hold – THEN DON’T SELL THE ADDITIONAL 5 $104 PUTS IN THE FIRST PLACE!

    So, at 10,250 (roughly) the DIA 5 Feb $106 puts hit $4 ($2,000) and, at this point (assuming we don’t think 10,250 will hold), we then roll the Feb $106 puts lower, which is to say we buy them back for $2,000 and then sell 5 of whatever puts give us $2, which should be the Feb $102 puts, now $1.45 with a .38 delta so a 150-point move would add 1.5x delta or .57 to the $1.45 so about $2.03 at 10,250.

    What have we done?  On drop in the Dow from 10,700 to 10,250 (just about 5%), we have "rolled" our 1/2 cover of 5 DIA Feb $106 puts at $2 (collecting $1,000) to A) 5 Feb $104 puts at $2 (collecting $1,000) and B) buying back the 5 Feb $106 puts for $4 (paying $2,000) and selling 5 Feb $102 puts at $2 (collecting $1,000).

    We still have the $1,000, which is just about enough money to roll our 10 Feb $108 puts up to the Feb $110 puts and now we have covers of 5 Feb $104 puts and 5 Feb $102 puts, which averages to a $7 spread on what was, orginanally a net $5.75 position. 

    We can anticipate that the 10 June $108 puts, which have a .65 delta, would rise, on an additional 150-point drop, from $7.75 to roughly $8.75 ($8,750) and they would now (at Dow 10,250) be fully covered by 5 Feb $104 puts at about $3 ($1,500) and 5 Feb $102 puts at $2 ($1,000) for a net of $6,250, up from our original net of $5,700 so not much of a gain on paper until the premiums you sold start expiring.

    The key is you now have, at Dow 10,250, $5.50 of intrinsic value and, if the Dow heads lower, you can add 5 more June puts (at a lower strike, probably the $103 puts at $5.80) to increase your downside delta by 50%.  This also sets you up to cash out 5 of the June $108 puts when there finally is a bounce, taking the profitable top of your spread off the table and reducing your long delta by 1/3 or more instantly when the market turns. 

    Roughly every 200 points further the Dow drops, you can add 5 more June puts at a $2 lower strike than you added last time and each time you add 5, you set a stop on the next highest 5 puts you have to lock in the gains.  This is a strategy that can cover you well to a 1,000-point drop (10%) at which point you would have 10 June $108 puts, 5 June $103 puts, 5 June $101 puts and 5 June $99 puts with the Dow at 9,700.  The 10 June $108 puts would be worth at least $11 and you would have a stop on them at $10.50 (a .50 trailing stop), taking $10,500 off the table on a turn, which is close to 2x what you began with. 

    That would still leave you with 15 June puts between $103 and $99 covered with 10 Feb puts at $104 and $102, probably about Delta neutral and you would have a stop on your 5 $103 puts, probably at $7.50 at $7, taking another $3,500 off the table and flipping the spread bullish withe the Dow recovering from a 1,000-point drop.

    Of course, many, many things can happen in between but it’s good to have a plan for the extremes because, hopefully, it keeps these little day-to-day moves in perspective.

  19. Phil

    DIA/Pstas – Well that’s never good, you need to be aware of your net deltas in the very least.   For example, the June $104 puts are at $6.70 with  delta of .58 and the Feb $106 puts are now $4.90 with a net delta of .85 so you will lose .28 per $1 (100 Dow points) that DIA falls.  Of course, at the 5% rule, in a vaccum, this is the correct posture as we expect a bounce now back up 100 points so you would gain that .28 if things go well.  If we head lower, you want to get at least neutral or better on delta, which means, at the very least, you need to add 1/2 the June $102 putss, which have a delta of .52 (so you will make up .26 of .28 delta differential). 

    Step 2, after having identified what it takes to get you neutral, is what would you do next.  The Feb $106 puts are at $4.90 and if you are adding the June $102 puts, then we are heading lower.  That means you need to look forward to a 1.5x roll of the $106 puts and the March $101 puts are $3.10 so rolling to them would take care of $4.55 of the $4.90.  That means, if the Dow continues down, you need to commit to adding 1/2 x the June $102 puts, now $4.25 and spending another .35 to roll the Feb puts lower. 

    Per yesterday’s post on this subject, you don’t have to do the Feb roll right away because, if we keep falling AFTER you buy the June $102 puts, then you will also be buying some June $100 puts (when we go 200 points lower).  If you buy 1/2 x the June $100 puts for another $5.75 then you’ll have X June $106 puts at (adding the delta x 2) $9 and 1/2 X the June $102 puts at $6.75 and 1/2 x the June $100 puts at $5.75 against X Feb $106 puts at $6.60.

    The Feb $106 puts should be able to be rolled down to 2x the March $99 puts at $3.20 and THEN the question is – can you live with that spread on the way down?  At least you are good to 9,800 (because you sold the puts for $2 in the first place) and that puts you WAY in the money on the Junes. 

    If you are able to go naked on 1/2 the short puts, then you can just let the June $106 puts stop out naked on a move up once you hit 2x (which would flip you bullish with the callers having a $1.60 delta and yours at about $1.20) and, again, being aware of your net delta helps you manage the position because you know that if you do stop out your June $106 puts on a move up but then it reverses again, you can either add 33% more June puts or buy back 25% of the March puts to get delta neutral (and that is AFTER cashing out your very profitable June $106 puts). 

    Anyway, that’s the sort of stuff that goes on in my head whenever you guys ask me a question and that’s why I stick with the DIAs rather than flip around.   I have the DIAs pretty well internalized so I can give the answer in about 1/100th of the time it just took me to write down the logic!

  20. Phil

    How to save money on your home loans:

    Victims/Pstas – To me, the average person buying a home, pre 2006, is the couple who need a place to live and have saved up enough money to get a first or bigger home.  Generally, their lives leading up to the purchase are consumed with scraping together a deposit and borrowing deposit money from relatives and, of course, house hunting.  They have been told (and it was true at the time) that real estate was the best way in the world save and grow money and the realtors promoted the idea of "home as an investment" to people who never made an investment in their lives. 

    The math of interest and ammortization is well beyond the understanding of the average home purchaser and I rarely met a home buyer who wasn’t surprised when I pointed out that the interest on a $200,000 loan at 6% over 30 years was $230,000 which means buying a $240,000 home with a $40,000 deposit actually cost them $470,000 so their home had to double for them to break even.  You may live in the world of property flipper and speculators who were certainly guilty of gaming the sytem but about 10M real people per year were simply trying to buy a home in which their family could live and they were sold a bill of goods that sucked up their entire life savings and obligated to a lifetime of debt that may never return a penny. 

    Aside from the many other flaws of public education, why is it we don’t teach the kids anything practical like investing or saving or how to buy a home or a car?  It’s way more likely a student will do those things than need to dissect a frog or remember how far down the crust of the earth extends before it hits the upper mantle or even the capital of Missouri but for some reason it has been decided that our future generations should be completely ignorant of finances other than the endless math problems my kids had to do in 2nd grade to make sure they know how to make change (useful for working at McDonalds). 

    I used to help my employees buy homes and they were generally a bright bunch of people (and we were in the title business so they knew scores more than the average home buyer) yet when I would sit down and do the mortgage math with people and talk about the hidden expenses of home ownerhsip (painting, repairs, lawn care, randome tax increases, road assessments…) it was generally the first time they ever heard of it.  It would break people’s hearts when I would explain to them that buying a home wasn’t the best idea at the time and I will tell you that they are PROGRAMMED to believe that they MUST own a home to be "successful." 

    Also, I would tell my employees things like, if you take that $200,000 mortgage payment ($1,200 a month) and instead pay $1,500 a month, that you will knock $100,000 off the interest over 30 years and will actually pay off half the loan by year 11 vs year 20 without.  So $40,000 in extra payments over 11 years gives them a $100,000 return (150%), which is better than any other form of investment they are likely to make yet NO ONE tells them these things.  Not the realtor, not the mortgage broker, not the schools, not their lawyers – NO ONE.  Instead they are encouraged to put $300 a month into an IRA and play the market at an 8% average return (not counting the recent tragedy of course) while forking over $100,000 in extra interest over 30 years ($277 a month). 

    This isn’t complicated, it’s simple!  Putting money into an IRA rather than paying off the mortgage is STUPID!  Yes NO ONE tells people this.  Of course, with rates over 6%, the magnification of this math is stunning.  Another thing they never tell you is that if you pay your mortgage twice a month (same amount just 1/2 paid 2 times a month) that you can save $60,000 off a $200,000 mortgage without spending a penny and the loan would be paid off in 24 years.  Don’t you think that’s the FIRST thing they should tell you in school or that maybe your realtor or your mortgage broker or your banker or your lawyer should mention this stuff to you?  

    Anyway, this is what I mean when I get pissed about the systemic rip off.  Car loans, Credit Card loans, Payday loans, Mortgages are all ways that they system is used to take advantage of a poorly educated poplulation to charge them far more than reasonable rates of interest all so bankers (and the complicit service people who feed off the crumbs) can fatten their wallets at the expense of the masses and our "elected leaders" do nothing at all to combat this – not even a friggin’ educational pamplet – sickening!

  21. Phil

    TBT/Phlit – Sept $44/48 is a bull call spread where you buy the $44s for $6.90 and sell the $48s for $4.60 for a net of $2.30 so you can see where, without you guys taking the time to learn the shorthand, I would probably rather just quit making these picks than tediously write them out over and over again.  Another DD – see strategy section on scaling in.  This is how we should be buying everything.  You allocate a portion of your portfolio, which should never be more than 10% of your cash, to a new position.  Once you have determined that amount, you work backwards to your first entry so if you allocate $4,000 to a full position, you EXPECT to buy in at $1,000 (1x), $1,000 (2x TOTAL) and $2,000 (4 x TOTAL) for a $4,000 full position. 

    Even if you are a trading genius of the highest magnitude, it is very, very likely that 40% of your entries will go the wrong way on you.  If 60% make 20% and go off the table, you make 12% of a 1/4 position (3%) quickly and you are done.  The 40% that go against you by 20% are doubled down to 2x at -10% and let’s say 40% come back to 20%.  Now you made 20% on 16% of the portfolio in 1/2 positions or 1.6%.  Of the remaining amount, you are 2x committed to 60% that are down 10% (-3%) vs cashed out 4.6% – It’s a self-regulating system, especially if you don’t trade idiotic stocks and ultra ETFs that are likely to move faster than you can make adjustments. 

    Of course, to the upside, we’re not taking into account better than 20% gains which is another self-regulating system for non-greedy people.  Let’s say you have DISCIPLINE and never allow more than a 20% loss on a position.  If you take 10 posiitons at 10 each and one gains 50% (+5) and one gains 30% (+3) and 2 gain 20% (+4) and 3 flatline between +10% and -10% and cancel each other and the other 4 lose 20% (-8), you are still up +4 and you only picked 3 winners out of 10!

    If you limit your losses to 20% of a full position, to get there 1x has to drop 20% and you DD to 2x (-10% avg) and then that has to drop 20% again (option now 40% lower than your entry) and you have STILL decided to pursue it rather than take the 2x x 30% loss (1.5% of portfolio, assuming a 10% full allocation) so you DD to 4x and now you are in a full position at a 15% avg loss.  At that point, ANY 5% downward movement is a stop out with a 20% loss of a full position (2% of portfolio) so you need to learn to be damned sure you WANT to make that last DD, which is why you usually see me advocating a roll back into a spread, rather than a DD at those points. 

    Look back over a few wrap-ups and consider how vastly improved your trading performance would be if you simply cut the losers at 20%.  The first DD is easy, when we enter a straight option position, we expect a 50% chance of it going the wrong way and that’s WHY we scale in in the first place.  I want to buy the TBT Sept $44/48 bull spread $2.30 and I want a full position to be $5,000 so I buy 3 at $6.90 for $2,070 and sell 2 $48s for $4.60 ($920) for a net $1,150 entry.  If TBT head up $2 I have 3 $44s at $8.30 (the price of the $42s now) and 2 $48 callers at $5.70 (the price of the $46s now).  That’s net $1,350, more than 20% up but early in the scale and on track so I DD my calls at $8.30 for an average entry of 6 at $7.60 ($4,560) and I sell 3 more $48 calls for $5.70 ($1,710) plus the original $920 I collected is $2,630 for a net of $1,930 on a 6/5 spread. 

    At that point, if my callers drops 20%, to $4.56 I will have to decide if I want to add the 6th cover, which would drop my net to $1,474, back to about a 1/3 commitment or whether to take a chance and look to take out some callers or possibly roll down my calls cheaply or some combination.  It’s kind of like chess, the more moves ahead you look the more possibilities there are and the more difficult it becomes to describe as there are also more moves your opponent (the market) can make, opening up even more possibilities.  Like chess, you need to learn to look one move ahead before you can look 2 moves ahead and learn to look 2 moves before 3 etc.  Also like chess, if you practice and practice and practice, you will get better and better at seeing those moves ahead and more comfortable making that first move, because you already see all the things that can happen for the next move or two. 

    March calls @ .75 – If you don’t have the memory (or sticky-note capacity) to remember to sell the March $50s when they cross .75 then yes, put in a STOP order to sell them there but that is a FALL BACK sell.  In other words, we expect it to go higher from here and we don’t WANT to cover but we also aren’t going to be idiots and not cover if we break levels.  If you put in a hard sell at .75, you may as well sell them now for .88 as any quick spike down will trigger you anyway so why not take the .13.  WHEN IN DOUBT, SELL HALF is Rule #2 (and there only are 2 Rules, so it’s probably important) so you can put a hard order in to sell a few and let that be your alert when it drops (as in, say, what are those couple of short March $50s at .75 doing in my portfolio – oh yes, I remember…) so you can watch them more closely and decide if it’s really time to cover. 

    I REALLY hope it’s obvious that, if we go up $1 and the March $51s, now .60, go over .75, that THEY become our new sell-stop and if that doesn’t trigger, then the $52s, now .45, when they cross .75 are the ones we will sell.  Each time your underlying stock moves 2.5%, it’s time to take a very hard look at what you think it will do next and adjust accordingly. 

    DD Roll – Either up or the following month or 3 months down the line, whatever makes sense based on the move that happens.  If you have sold a 1/2 position (10, for example) of $50s at $1 and they go to $1.75 and you look to roll and the $52s are $1.25 – do you NEED to do a 2x roll?  No, you have a $1,750 obligation you’d like to see all in premium so you can roll it to 14 $52s even – you don’t NEED to do a 2x roll.  I can’t write a 5-page essay for every single trade, of course, which is why these discussions are good sometimes because you need to focus on the GOALS we have (selling premium, staying flexible) and, once you internalize that, a lot of these adjustments seem more obvious.

  22. Phil

    Originally: February 16th, 2010 at 2:16 am | (Unlocked) Permalink  edit  lock  



    STD/Yodi – Those are all buy/writes.  Sorry if I wasn’t more clear but they are dividend plays so of course we are buying the stock (otherwise, no dividends).  In the buy/writes (and this is, of course in the original articles on the subject) the two prices are the net price, $9.36 and the second price, /10.93 on STD, is the average cost of your 200 shares of stock if STD finishes below $12.50 and is put to you.  You have your original 100 shares at net $9.36 plus the 100 shares that are put to you at $12.50 and you average them out. 

    This is all part of scaling in.  If I am willing to buy $10,000 of STD overall (my allocation) then I’m going to allocate about $2,500 on this first round.  Since I worked our a net of $9.36 for my entry, I take $2,500 and divide by $936 so I go for 300 shares of stock and sell 3 $12.50 puts and calls.  TOS tells me the net margin for selling 3 naked $12.50 puts is $636 so not a big consideration there but, in my mind, I’ve tied up 6 x $1,093, which is my put to price so $6,558 is commited through September.

    If STD gets called away at $12.50,  I make $3.14 on 300 shares or $942 on my $6,558 commitment, which is 14% in 7 months plus whatever dividend.   As long as STD stays over $10.93, we’re at least even plus the dividend and we can either roll forward or quit.  If STD drops all the way back to $7, which was it’s non-spike lows during the crash, we’re going to have 600 shares put to us at $10.93 and we will be down (assuming we don’t roll out of it) $2,358 or 23% of our full allocation. 

    Hopefully, we would have done something before then but, even if we didn’t, we still have $3,442 available and that’s close enough to DD (assuming we wanted to stick it out) at $7, which would reduce the average basis to $8.96 and, if we could sell long $7.50 calls for $1.50, we’d drop our net to $7.46 with an even call away (and we’d still be collecting dividends unless that’s why they dropped) and we’d have 1,200 shares at $7.50 avg for $9,000, which is $6,792 cheaper than it is now (about 50%). 

    So if you want 1,200 shares of STD at $7.50, there’s no reason not to do a 300 share buy/write now, is there?  If you don’t WANT to follow through with those steps and you are going to consider a $1 or $2 drop in the price some reason to squeal like a pig and panic and start "cutting your losses" – then DON’T get into the stock at $13.16.  This is the kind of thought that should go into every entry you make.  That’s what makes Warren Buffett successful, he only buys companies he really WANTS to own so, when other people are selling, he’s buying more. 

    I’m not saying we blindly buy STD or whoever when they go down but, assuming our outlook and valuation doesn’t change – what do we care what the rest of the market thinks?  The rest of the market was selling AAPL for $85 and IBM for $67 and GE for $5.61 last year – at some point you have to realize the market is an idiot.  The way you buy low and sell high is to have an actual value range that you yourself place on the stock.   This is why pure TA is so dangerous to investors because it assumes the market "knows something."

    I KNOW BAC, for example, is worth between $15 and $22.50 at the year’s end.  So, when BAC is below $15, I get interested and when it’s above $22.50, I happily sell it.  Now, the year’s end is a tricky concept.  If I buy it today at $15 and I expect to get $22.50 by Jan then I expect to gain about .75 per month between now and then.  That means if I’m at $15.75 in March, I’m not too excited and if I’m at $16.25 I’m a month ahead of schedule and if I’m at $17, I’m going to be looking to sell because it’s TOO early and I do not have expectations of gaining another $2 per month for the rest of the year.   That means I’m looking at diminishing returns after the initial run which leads us to Rule #1:  ALWAYS sell into the initial excitement.

    Because I KNOW I want BAC at $15, it doesn’t bother me when it goes to $12.50 the same way it doesn’t bother me when a pair of Levis is marked down 20% at the store.  I don’t change my mind about the jeans because they are on sale do I?  Why then, would you change your mind about a stock?  If the jeans are ripped or discolored – that is new information and they are no longer the jeans I intended to buy.   I may look at the flaws and say "I can live with that for 20% off" or I may decide to move on and see what else is on sale.  It’s the same with stocks.  WHY did it go on sale and is it enough reson to change your buying premise?  If not, then buy!

    For some reason people will hold onto a $40,000 car when it loses value and a $100,000 painting when it loses value, and jewelry when it loses value and homes when they lose value and even their own businesess as their value fluctuates up and down but if a stock they own drops on them – they act like it’s cancer and try to get rid of it asap.  That’s something you need to consider in your own trading and outlook.

    Go into a trade prepared for your next 2 moves in any situation (up, down or flat) and allocate your cash properly and you’ll find trading can be fun and relaxing and, even better, very profitable over the long haul.  Just ask Warren!

  23. Phil

    TBT/Hanna – 21% is a lot for a single position, especially if you have calls, which expire and leave you potentially with nothing.  It is possible, if we do have another financial meltdown or a 9/11-type crisis that TBT could go right back to the $30s as the Fed does another round of emergency liquidity.  If that just happens to cross the time-frame where your calls expire – what is your plan?  I would ask you the same question if 20% of your portfolio was SPY or QQQQ or AAPL or whatever – 20% is a lot of money to put on one horse…

    As to playing TBT, I favor in-the-money verticals becasue it gives you all the joys of ownership without as much risk so I can have a $100,000 portfolio and allocate $10,000 to the Sept $44/50 bull call spread at $3.20 ($6,400), so let’s say 20 contracts and then sell 10 Apr $51 calls for .65 ($650) so I’m in for net $5,750.  If TBT goes lower, I will look to roll down for about .65 per $1 and if TBT drops $2, I would cover another 1/2 for another .65 and put a tight stop on the $51s, which should be down to about .40 by then.  To the upside, I can roll my Apr $51 callers to 2x the June $65s and TBT has not moved up more than $10 in two months even during the craziness so I can assume I will have time between $48 and $65 to add more long positions to cover. 

    That’s a trading plan for a position.  I intend to collect at least .30 per long for 6 months, knocking $1.80 off my basis so my target break-even is $45.80.  I have $4,250 on the side for adjustments and it’s a position I’d be willing to stick with and I know I can roll to the 2012 $40/50 spread, now $5 for about $2 so I’ll keep my eye on that if things head south as I do feel strongly about my premise that rates can’t stay low forever (but they have in Japan) and, in the very least – if they do I would have a clear path to selling enough premium to cover myself in 2012.

    So a adequate cash to make adjustments, a plan to reduce my baisis significantly over time and a 100% upside means I’m allocating 10% of my cash to this position, I will leave apx. $5,000 on the side and, if all goes well, I will get $10,000 back at $50, which is a 50% gain on cash over 6 months.  If all goes badly, I am willing to go a little more than 10% to push this play out a year but that is my EMERGENCY fallback position, not my starting position. 

    This goes back to the whole idea of gambling vs. investing.  If you cannot be happy with a 50% return in 6 months, then you are a chronic gambler and you are bound to eventually get yourself in trouble with the risks you take.  Making 50% on 10% of your portfolio twice a year is a 10% return on your whole portfolio and that outperforms virtually any place you could possibly put your money.  If you have a DIVERSIFIED portfolio with many high-probablitly posiitons that aim to make 20-50% over 6 months and you allocate 50% of your cash overall – then you can make $15-25,000 in 6 months if all goes well. 

    That is HUGE money!  The flip side is, if you mix those positions so you have some that profit from a major downturn and some that do well in a good economy but both do well in a flatline – then hopefully your worst case will be losing about 25% of your 50% commitment (12.5%) which is realtively easy to recover from.  That only works if you don’t have ANY positiion that can cost you 20% of your porfolio. 

    Most people who go broke in the markets go broke betting on "sure" things – don’t be one of them.

  24. Phil

    DIA Mattress Plays/Gucci – It’s important to know WHY you are in the trade.  The idea of the mattress play is to give yourself something that you reasonably believe will double if the market falls 500 points in some big event.  That means you should always have a clear path to a double if something bad should happen overnight.  Let’s say I have the June $105 puts at $5.10 and I sell 1/2 the March $103s at $1.40.  That means I’m in the June $105s at net $4.40 and they have a delta of .56.  If the Dow drops 500 points to 9,850 I should gain about $3 on the longs ($8.10) and my $103 putters will jump to $4.50.  I’m not worried about this because the May $100 puts are $2.40 now so I can be fairly certain I can roll my 1/2 March $103 putters to 2x the May $98 puts for about even and that puts me in a $7 spread clean, which would be a 59% gain ($2.60) so close enough as it’s not likely to happen all at once. 

    Once you are comfortable with your downside goal (because the whole point is to make this 10% of your portfolio which will double on a move down) then the whole trick is to realize this is an INSURANCE play and your main goal – outside of adjusting in the event of an actual disaster – is to tread water and try to stay in the trade without losing much money.  Since you are in a June spread for $4.40 net, your goal is to sell $1.10 per month in premium.  That means, if you can scalp a quarter 5 times during the month – you have accomplished your mission towards paying off your long put.

    We always want to roll up our long put to the next $1 strike whenever we have the opportunity to do so for .50 or less.  That guarantees we always have at least a .50 downside delta and, each time we make 2 rolls up, it is generally time to sell another set of puts.  Since the delta of the March $103 puts is .44, 2 rolls up on the longs should mean that the March $103s have lost .88 and that’s .44 per long in the bank – paying for 1/2 of your roll up.  Then you sell whatever put has the most premium – in this case the $104 puts and you either take out the lower putter immediately or you set tight stops on them – depending on your short-term outlook. 

    MAINLY, you are letting time decay do your work.  If you have a sensible portfolio like our buy/writes, your expectation is to make 20% at least if the market goes up or is flat.  Let’s say 80% of your portfolio is like that and you make 16% between now and June and you have 20% in the DIA – it’s fine if you are down 1/3 on them as that’s 7% and you are up net 9% in 4 months in a well-hedged portfolio.   If the market drops past your 15% safety net on the buy/writes – perhaphs your 80% loses 10% (8%) but your 20% doubles and you have tons of cash to roll and adjust your long positions.  That’s what this strategy is all about – it’s insurance that pays you off in a disaster…

  25. Phil
    • Running/Gil – I often say I would rather make 10% 10 times than 100% once because there is far less stress making 10% and you can often make 10% 20 times while waiting to make 100%.  I often talk about how there are 289 people in the Baseball Hall of Fame and only about 1/4 of them are home run hitters and even the home run hitters aren’t in there unless they can hit for average as well (think Dave Kingman).  Batting average is far more important to a team (and your portfolio is a team) than the occasional home run.  Everyone wants to be Babe Ruth but they forget he had a lifetime batting average of .342, not too far behind Ty Cobb’s .366.   And that’s another point about baseball – notice two of the best hitters of all time "lost" their at bats 2 out of 3 times. 

      As a trader, you need to learn to appreciate a win – small or big.  Imagine if every time you got a single in baseball (25% gain) you insisted on going for a double (50% gain) and then, even if you ran all the way to second base on your infield hit, that didn’t satisfy you either and you always ran for third (75%) - even if the shortstop was standing there with the ball in his hand.  What would that do to your batting average?  You don’t get credit for a double if they put you out going for third do you? 

      Only 27 people in the history of baseball batted .333 or better for their careers.  Don’t get caught up on letting your winners run, worry about cutting your losses before they wipe out your winners and, every once in a while, some of your winners will run.  Even Ty Cobb accidentally led the league in home runs once (9) and won the triple crown but not one of those home runs went over the fence (all inside the park home runs).  Another thing about Ty Cobb – in 1910, he had the lead in batting average going into the last game of the season so, to make sure he won, he DIDN’T play!  Even a guy batting .400 knew that there was a chance of going 0 for 4 so, since he wasn’t sure that his investment would pay off – he sat on the sidelines that day.  That’s a VERY important investing lesson!

      A lot of people read all about trading ideas and techniques but they neglect to study trading psychology, which is equally important.  As you know I like to refer to the options we sell as being sold to a "caller" or a "putter" – that’s my way of personifying they game as I like to think of options as a chess match between me and an opponent.  That means I’m taking into account what my next few moves will be as well as what their likely reactions will be. 

      To me the VIX, the fundamentals of the stock, the news flow, the TA… are all just psychological components that make up what my "opponent" is willing to pay for the options I’m selling and, by always looking ahead, I keep from being surprised by the next move.  Also, by being "aware of the board" I can spot a good opening when it presents itself and avoid traps as they form.  Like chess, there is no magic formula to say "this is how you win" – there are basic fundamentals and certain "smart plays" but, from there – it’s practice, practice, practice.  They say it takes 10,000 hours of practice to become an expert at something – there are many, many tombstones with the names of people who didn’t think they needed to put in the time..

      I often forget to tell new members to take a weekend and read Dr. Brett’s great articles on Trader Psychology.

    • DIA/Salvum – It’s not about crying uncle.  The DIA spread was just to take the sting out of the bearish plays we’re sticking with on the way up so you set it up and try to take quick day’s profits off the table and re-load next time the markets are moving against your bearish positions.  When we take those spreads we hope they DON’T work becasue they are covering our larger, bearish positions and the profits we make from the bull side can be used to re-position the bear plays as it’s always better to improve yourself with other people’s money. 

      If I have, for example, 100 short TZA $7.50 puts at .95 ($9,500) and I’m worried about a move over 11,000 on the Dow and 690 on the RUT, then I look ahead to what I need to do when I do "cry uncle" on the TZA putter.  So I figure that 700 on the RUT will put TZA down to $5.75 and my putter is worth $1.25 and my escape is to either pay them .30 out of pocket or roll them to Oct $6 puts, now .90, for hopefully less. 

      So the bottom line is I need about .30 to offset this loss but I’m willing to take a small hit so .15 would help.  That means I need to make $1,500 on a move up so I buy $1,500 of the DIA $109/110 bull call that will double at 11,000 and now I know I’ve offset my roll on TZA.  If the Dow falls, I could care less because, by the time I lose $750 on the DIA spread – I’ll be up $3,000+ on my TZAs. 

      That’s hedging.  The key is learing to manage your portfolio and balancing your risk appropriately.  Keep your eye on the ball, as they say.  In the inteview with Ty Cobb I linked above he says that he found 25 years of baseball exhausting because he would study and prepare and plan and practice every single day for 25 years – never once coasting or sitting back.  That’s why I’m up at 4am watching the markets and reading everything I can get my hands on.  As Stephen King once said: "Talent is cheaper than table salt. What separates the talented individual from the successful one is a lot of hard work."

  26. Phil

    BP/Dflam – I don’t like paying off callers or putters who are all in premium unless I think there is a real threat but there are more than 3 weeks to go and you did spent $1.75 to roll the putters down $5 and the callers up $2.50 so if that’s the value of comfort, that’s fine but the money would have been better spent improving your own position or JUST rolling the puts down to lower the risk as you have no "risk" to the upside.  Just be aware that if you make a similar decision 10 times a year then it costs you $17.50 and if you do it 100 times a year, that’s $175 per option and, at 15 contracts, it was a $262,500 decision so I hope it made you EXTREMELY comfortable! 

    This is the kind of thing I’d like to do a seminar about because it’s a lot to discuss but let’s just say that your job is to sell premium – kind of like an insurance company.  You assess the risk you are willing to take, set a price and find a buyer.  What do insurance companies do?  Do they buy back their policies because a storm is coming?  I bet they could (actually, this could be a cool business – go to Florida and buy out insurance policies ahead of a big hurricane…) but they don’t because they solld the premiums and they are putting the money to good use elsewhere and they know that, barring any "black swan" events, their pool of risk premiums sold plus their investments (VERY conservative ones) will provide them a reasonable rate of return. 

    BEFORE you sell any contracts, you need a plan for what you will do if the stock goes up 20%, down 20% or is flat.  If the plan is "I will freak out and buy back what I sold and curl up into a ball and cry" then you probably need another plan.   You have a BP Oct $49/60 bull call spread at $7.93 and you sold the Oct $55 puts for $2.48 for net $5.45 on the $11 spread so your best case, Up 20%, is a double and presumably the plan is to be called away.  If BP drops 20% to $48, you own BP at net $60.45 so the plan may be to do that (yuch!) or to roll down to the 2012 $50 puts for an extra couple of bucks.  If you are comfortable waiting until 2012 to get your money back and don’t mind the $6K of margin then that’s fine too.  On a flatline (more or less) the plan would be to either cash out or roll but you won’t do all that well unless they’re over $55. 

    If that all seemed like a good plan when you started but perhaps you are off plan now – THAT’S GREAT!  It’s great because, by virtue of having a plan, you can immediately see where you deviated from the plan and THEN make adjustments to get you back to a plan that you can be excited about.  Are you really now excited about the fact that you spent $1.75 ($262,500) to raise your break-even on the spread to $56.20?  Sure your upside is now $62.50 but it cost you $1.75 of your $2.50 possible additional gain to get there. 

    How should I put this?  I think every time you look at your trades you should try to look at them, not as the trade you WERE in, but saying to yourself "Knowing the new information I know now about this stock and having had time to observe it’s movement and the changing relationships in my spread as the stock moved.  If I had this much cash, is this what I would be doing with it with this stock right now?"  If the answer is yes – then great, stick with it.  If the answer is no – then try to get yourself to a yes. 

    This is just an overlay to the Microwave Oven Theory, which is a very important theory to study as it’s a trap few traders can avoid.  The $55 puts could have been rolled down to the Jan $50s for +.60, which would have lowered your margin reqirement by more than it cost you to roll.  The Oct $49 calls were a bit too deep in the money anyway but you could have rolled the $60 caller to the Jan $60s for +$1 and you could have rolled to the Jan $50s  for +40, which would have dropped your basis on the $10 spread to by $2 to $3.45 with a $53.45 break-even and 3 more months for BP to go up and put you in the money.  If BP breaks down from there you can target a roll down to the Jan $45s for $3 and then you’d have a $15 spread with a $6.45 basis and a break-even at $51.45.  Improve, improve, improve and DON’T speand money on premiums…

  27. Phil

    tchayipov -

    do you reccomend for 50% conservative buy/write without sell puts? to reduce volatility of portfolio?

    50%/Tcah – I think for an established portfolio, yes.  The idea is to work your way into those positions over time and, frankly, from my perspective, it’s more than 50% because, as you wear down the basis over time, you can end up with many almost free positions that do nothing but produce an income for you. 

    In other words, let’s say you have the WFR buy/write, which was selling the 2012 $12.50s for $6.70 against the stock at $12.14 for a net $5.44/8.97 entry.  So you allocate $50K to the trade and you work that backwards to being willing to allocated $25,000 to own it at $8.97 (a 2x assignment).  That’s 2,800 shares so you buy 1,400 shares at $12.14 ($16,996) and write 14 contracts for $6.70 ($9,380) for a net cash outlay of $7,616 and about $4,500 in margin. 

    That’s all you do in the first 18 months of your $50K allocation, which is why, when people tell me they have large portfolios and no margin room I get deeply concerned because, if you are playing 1/2 your portfolio conservatively like this, you should ALWAYS have huge amounts of spare maragin. 

    So the only way we own 2,800 shares of WFR is if we get them for net $8.97 in Jan 2012 and that’s still just $25K laid out to the position.  TLAB is a $8.87 stock so let’s use those contracts to look at what we expect for round two in WFR.  TLAB 2012 $7.50 puts and calls can be sold for $3.50 so let’s say we can (assuming we want to keep accumulating) 28 WFR 2014 $7.50 puts and calls for $3.50 against our 2,800 shares at $8.97.  Notice it doesn’t really matter whether the shares are $8.97 (down 25%) or $6.97 (down 45%) because the put/call combo would be about the same.  The sale of the 28 leaps would bring our new net down to $5.47/6.49 and our new "worst-case" outcome is that we own 5,600 shares of WFR at net $6.49 ($36,344) so even at a "full" commitment, I still have $13,656 cash left over from my $50,000 allocation.

    If our 5,600 shares end up being called away at $7.50, we make $2.03 per share or $5,648 on our 2,800 shares, which is 22% of $25,116 or about 11% a year – not a bad escape for a stock that dropped 40% since we bought it.  Meanwhile, since we never triggered the rest, we had tons of spare margin to play our shorter term, margin-intensive plays that tend to do quite well.

    If we do end up with 5,600 share being assigned to us at net $6.49, then we are in for $36,344 and we can (if we LOVE WFR the way I loved CROX or TASR when they were down) keep going by selling (using ENER 2012s as ENER is currently $6.38) 56 2016 $5 puts and calls for $3.90 and that drops our net to $2.59/3.80 with the possibility of owning 11,200 shares of WFR for $42,560.  Isn’t that strange, it almost would seem silly NOT to DD the number of shares from 5,800 for $36,344 since it costs so relatively little)…

    So now it’s 2016 and we either get our 5,600 shares called away for $5, which is a 93% profit on the $15,022 we had left on the table or we end up with 11,200 shares at $3.80, tying up $42,560 long-term but then, if we can sell just .10 per month of calls at $5 or higher, that’s a monthly income of $1,120, which works out to $13,440 (31.5%) and in 3 years you have a free position on WFR.

    If, at any given time you are working a dozen of these positions in various stages, ideally you will be building a portfolio of very cheap stocks over time.  In this example you may have just 6 positions like WFR that mature over 6 years (and the rest get called away or killed) and perhaps about $250,000 committed that are generating $80,000 in revenues, which is 8% on $1M locked in before you even begin play around with the other $750,000

    Of course, since you are locked down and no longer need to sell puts at that point, your mature positions add to margin, rather than subtract from it and you have EVEN MORE buying power along with your very safe 8% income generators. 

    So, to get back to the original question about committing 50% to these, realistically, over time, it is hoped that your $1M starting portfolio should end up with $4M of these positions and you are still working the $1M the same way you started.  If you maintain this discipline over 20 year, you are sensibly reducing your risk exposure year after year while managing your $1M portfolio every year, transitioning your winners to simple long-term income producers that are no longer part of your active portfolios other than the monthly (or quarterly) call selling. 

    I know it’s very hard to think in terms of 5 and 10-year plans but notice how our very conservative plan to make 8% a year can "accidentally" end up making you millions over time.  As Sage noted – watch "The Man Who Planted Trees" -  watch it until you belive in it!  It is unfortunate that we usually talk about short-term (2012) time-frames and don’t spend enough time on the big picture.  Perhaps that’s one of the things that make some people so impatient.  It’s fun and exciting to play for big money but that should be for the money you can afford to lose.

    What does "afford to lose mean?"  If I have $1M of mature long-term positions that are generating $300,000 a year on option sales and I only need $200,000 to live on then I have $100,000 that I can afford to lose.  That then determines the high-risk portion of my remaining portfolio so even if I have $2M in cash and short-term posiitons, I should only be allocating $1M to Sage’s mix above and the other $1M should remain in cash or something ultra-safe.

    If, on the other hand, I didn’t need any of the $300,000 to live on because I’m still producing another income then I can afford to lose the whole $300,000 in any one year and I can put $300K into levered plays and $1.7M into the rest.  Obviously, if you do lose $300K, you need to re-allocate to something much safer with the remaining $1.7M but all you need to do is wait a year for the safe $300K to come back and then you can be off to the races again. 

    So your penalty for taking a hit in a well-managed portfolio is a forced "time-out" from trading

  28. Phil

    Protection/Amatta – Well I had hoped you would be more specific about what it is you are protecting but let’s talk about what is generally a good idea for the benefit of all.

    Right now, ideally, we are 65-70% in cash.  Cash includes short-term trading but no more than 10% of a conservative portfolio should be allocated to that anyway and you should follow the same rules with short-term trades as we do with long-term trades, which is to scale in in no more than 25% rounds of commitment.

    So if you have a $100K portfolio, then $10,000 is OK for short-term trading and no trade should be more than 10% ($1,000), which means you want to keep initial entries around $250.  For one thing, that mean, out of hand, you don’t even want to consider entering a position that is expensive. 

    Once you enter, you follow the rules in the Strategy section (and all Members should read the main article, the attached article and the comments because we discuss all kinds of fun stuff there).  The most important rule, and this goes for anything is to stop out with a 20% loss.  That would be 20% of a full position so, for short-term trades, it’s fine to (assuming you feel strongly about it) watch a $250 position drop to $100 and then decide to Double Down but – if you do, then you’d better be right because if that drops in half, you’ve lost $200, which is 20% of $1,000 and you should get the hell out

    Ideally, each 20% move should be an inflection point where you make a decision on the trade.  So, if you are buying a call for $1 at 1x (which would be $200 since you would buy 2 contracts) and it drops to .80, you already need to make a decision as to what you plan to do.  If you are excited about it still, you want to look to DD but ONLY when you are sure it’s done going down – you don’t just mindlessly DD at .80.  If you think it may go down only a bit further, then you can offer .70 and see if it fills.  If it doesn’t fill, and the trade jumps up – then great, you didn’t lose any money!  If it does fill, then you are in 2x (4 contracts) at an average of .85 ($1 + .70) for $340 and the current value is .70 ($280) and you are down 17%, even though the position is down 30% from where you started. 

    Any time you double down or roll, at the point where you get back to even, you need to look to take 1/2 back off the table to reduce your commitment.  That means at .85, you really want to cash out 1/2 because that will leave you back at 1x (2 contracts) at .85, which is 15% less than your original entry.  Now, you can survive a pullback all the way to .55 and DD again for an average of .70 on 2x (4 contracts).  That puts you in a very comfortable $280 for 4 contracts and you can afford to let that ride since it is now hard to lose your 20%.

    Keep in mind that you don’t stop out the moment you get even if you are fairly certain things are going your way after a slight pullback but your mindset needs to be that A) You were already wrong about the stock’s direction and B) You are very lucky to get even so don’t blow it if it doesn’t look strong.  Really, if you bought it for $1 originally and you DD’d at .70 and now it’s having trouble getting back over .85 – you may want to consider ditching the position entirely! 

    There are a LOT of factors of course like how long you have left, whether or not you have a way to cover, do you have a plan to turn it into a longer position, etc.   That’s why my favorite short-term trades are ones where the exit strategy is to be in the position long-term.  So selling naked puts is fun because my worst case is I have a stock I want cheap.  Also, calender spreads or diagonal spreads can end up being long-term positions but buying a front-month call or buying a put is a very limited bet that will either be right or wrong and so you have to be very disciplined with your stops. 

    So that’s the play money.  The idea of taking profits at 20% and taking losses at 20% is, if you have good discipline, you will never lose more than 20% but, if you have a $1 position that you DD at .70 and then DD again at .50, putting you in 8x at .60 for a $480 entry, once in a while that will run up 100% or more for you.  If you do 10 trades a week and you end up even on 9 and have a single 100% winner of $500, that’s going to boost a $100K portfolio by 6% a year and is a 60% return on the $10K you are playing with!  You don’t have to take big chances to make big returns

    There is also scaling to the upside, of course.  If you have 2 $1 contracts and it runs up 10% or 20% and you feel strongly that you want to be in 4 contracts, then if you DD you will be up 5% or 10% and, very simply, as long as you stop out 1/2 even, you can’t be harmed by the DD (other than being a bonehead and losing the 20% you had because you were greedy!).  Again, you always have to try to be realistic and think of the time you have left and what a realistic goal for the stock is etc. 

    So that’s your 10% of the cash for short-term trading.  We also allocate 35% to long-term trades.  Ideally, in this market environment, they should all be hedged positions, either buy/writes or covered calls or short puts – things that have built-in protection. I won’t get into the Buy/write strategy, that’s done to death in the Portflio section but let’s say you have $35,000 worth of positions that have 20% built-in protection so your commitment is to DD on them at about $28,000.  That means you have committed $63,000 out of $100,000 to being in 2x your long positions (or 1x on sold puts) if the market drops 20% or more.  

    If the market drops "just" 20% (S&P 820) then you are in $68,000 worth of positions that are worth $68,000 – THIS IS NOT A PROBLEM!  What you would do then is look over your positions, decide which ones you like best and toss out the rest or maybe – since we are down 20% and forming a bottom – you may want to add more to your favorites or maybe they are all great and we keep them all (we did that in March of last year and it went great!). 

    This is why I get excited about market drops.  I WANT to DD at 20% off, making 20% on 35,000 is not as much fun as making 20% on $68,000.  Trust me, I’ve checked!  So it’s all fun, fun, fun on the way down UNLESS we cross below the 20% mark and now I’m committing to buy $68,000 worth of positions that are worth just $50,000.  That is not good!

    So we hedge.  The hedge should match the time-frame of the trade.  So if you sold 2012 buy/writes, you don’t give a damn if the market goes up and down 30% between now and then 5 times, you only care about where it finishes on Jan 20th, 2012.  So we’re worried about a 40% drop in the S&P that costs us 20% of our $68,000 ($13,600).  To the extent that you are REALLY worried that the S&P will be at 614 in 2012, that’s the percentage of coverage you should take.  Also, you are not really going to sit there like a dumb bunny while the market drops 20% and you do have $65,000 in cash so it’s not too crazy to imagine you may take a few downside bets somewhere betwen a 10% and 40% drop that also mitigate your losses.  Also, if you REALLY think the S&P is going to drop 40% in 18 months – why are you buying stocks at all? 

    Let’s say we have decided that losses would be intolerable and we want to hedge for a $15,000 loss.  We will now look for something that gives us a good pay-off if the S&P falls below 820.  TZA is currently at $8.36 and a 20% drop in the indexes should (other than normal ultra-ETF decay) take is up 60% to $13.30.  We can commit to buying $8,000 worth of the ETF by selling 20 2012 $4 puts for $1.05 ($2,100) and we can buy 20 2012 $5/12 bull call spreads for $1.30 ($2,600).  So we are using $400 of cash and (according to TOS) $3,000 in margin to get $14,000 of upside.  Don’t forget that a 20% drop is only the begining of where we need protection.  If the market falls further, then it’s much more likely that our TZA will be well in the money. 

    What is our downside?  Well if TZA falls further than 50% (about a 17% rise) we will be forced to buy TZA for $4 ($8,000).  To whatever extent TZA is LOWER than $4, we will take a $2,000 per $1 loss.   We know for a fact that if the market is up 17% (as long as our positions follow the market) we will be collecting 20% of our $38,000 or $7,600 so our worst case is TZA is zero and we have our stock and our profits pay for TZA.  This is why hedge funds don’t like strong up moves or strong down moves – when you are hedged, you are playing for the middle! 

    This is why I caution against over-hedging.  You must make a decision.  Do you REALLY think you need to protect against a 40% drop?  Maybe mitigating 1/2 your potential losses will be fine.  Of course, the nice thing about this kind of play is, if we do flatline (between down 20% and up 20%),  we can actually make a payoff on both ends of the trade and, right down the middle, we can get a double!  Another thing to consider is that, with the Russel up 17% and you are back in cash (because all your longs would be called away), having $8,000 worth of ultra-short hedges in your $108,000 portfolio means you can buy your next round of buy/writes without the need for an additional hedge.

    Again, there is also the dumb bunny factor – you are not going to sit there and watch the Russell go up 20% and not buy anyting else or not add to some of your longs.  We were saying last time that if the Dow got over 11,200, we would go for another round of longs.  It didn’t happen so we stayed in cash (actually we took a ton of shorts 2 weeks ago).  So you don’t need to hedge 100% of your potential loss if you aren’t walking away for 2 years and coming back only to see how you did

    The more committed we are, the more we hedge but, when you have 65% cash on the sides, then you don’t need to cover ALL of your downside losses.  What’s my worst case? 

    • 500 shares of XOM at $56.61 = $28,305.
    • Sell 5 2012 $52.50 calls for $10.10 = $5,050 (net $20,255)
    • Sell 5 2012 $52.50 pus for $7.75 = $3,875 (net $16,380, margin $8,000)

    So my net entry on XOM is now $38.76/45.63 which is a $6,870 profit if called away (41%) and a 19% discount if put to us.  By the way, people sometimes say, why don’t you count the margin?  If you buy the stock, you only use 1/2 the margin so, technically, the net margin requirement on this trade is $14,153 + $8,000 less the $8,925 collected, which is a net margin requirement of $13,228 to make $6,870 (51%) but who’s going to sit there and calculate that every time?  So I just count the profits against cash committed. 

    Now, what if I don’t hedge at all and XOM falls 40% to $33.97?  I have a committment to own 1,000 shares at $45.63 and I can assume I can do another 20% disount spread to take my entry down to (apx) $28/34 for 2014 so, without hedging at all, my damages are that I’ll own 2,000 shares of XOM at $34 in 2014.  If I can live with that I DON’T NEED TO HEDGE AT ALL!  Again, if you are at your first stage of scaling in, you are hugely flexible and should have plenty of cash so your need to protect against phantom damages is not so great. 

    And again, we’re making the dumb bunny assumption that you sit there for 18 months while XOM goes down and down and down and you do nothing to hedge it and you don’t stop out and you are essentially a helpless victim of the markets with no abilty to intervene.  Not what we try to teach here….  

    So, if you are confident in your momentum trades, you have little need to hedge other than a disaster hedge for an unexpected 1,000-point overnight drop but a long-term disaster hedge doesn’t really help you with that, that’s what the short-term ones are for.  If you have 10 positions, you may decide (as above) that XOM doesn’t need a hedge at all and you’d also be happy to own lots of KO, MCD, INTC, AA and MMM so you’re not even going to hedge them but PFE, WFR, HPQ and CHK all concern you that if they are falling 40%, there may be something seriously wrong with them and you may not REALLY want to own them for the rest of your life so you calculate JUST THE ONES YOU ARE WORRIED ABOUT and protect them

    So not really that complicated but, like all things in life, it takes practice and experience to get good at hedging and, unfortunately, these positions take time to play out so the learning curve is slow as well.  That’s why it’s good to practice with at least some 2011 plays – just to at least get the experience of running these plays out to expiration more than once every 18 months so you can get more confident. 

  29. Phil

    exec (premium)

    Phil
    I’m in the middle of a lake attempting to type on a cell phone so please excuse any typos. 

    I was studying you comment from yesterday and previous postings regarding covered call and buy write strategies and I have a few questions. 

    First off it occurred to me that I don’t fully understand your buy write strategy.  Is there anywhere on the site that explains the concept? 

    The covered call strategy is pretty straightforward, you buy a security and sell calls.  If the stock is taken away, you profit from the premium plus or minus the intrinsic value, or the option expires and you keep the stock and make the premium.

    Now, your post yesterday indicated the it’s rare that everything goes perfect. I thought the worst case scenario would be that the security tanked, and your stuck holding a stock that is worth less than your basis, and you could potentially have it called away for a negative net profit if you sell another round of calls.  Is there any other downside risk that you are aware of?  Having not sold covered calls before, is it common to have the worst case scenario play out when implementing this strategy?

    Getting to your buy write strategy, from what I can decipher, you buy less stock than you would if using the CC strategy, then sell calls and naked puts. The questions are:   What percentage of the security would you buy?  I’m assuming half. So then you sell the calls and sell puts. Again, I’m assuming that you would sell enough puts that it would double your position if the security was put to you. So is this the general premise of the call write strategy?  If so, then the best case scenario would have both options expire worthless and the worst case would have the market dropping and being stuck with double the security. Correct?

    Do you always use leaps with this strategy?

    What is the next step in this strategy after the security is put to you?

    Please explain what your talking about when you refer to having to roll.  I see a lot of comments on the member chat about rolling but don’t understand the concept. 

    Finally if you could lay out a typical buy write example using one of your dividend recommendations with the current option prices, I’ll try and developed a spreadsheet that makes it easy to follow the strategy and track the profitability of the trades. 

    I just read you morning post and it raised another question:  I’m tired of day trading and sitting cash at the moment. I’m ready to start building a long term, relatively maintenance friendly portfolio. What is the foundation of your portfolio, buy/writes? 

    I’m sure you’re tired of these newbie questions but any information would be appreciated. 

     

     

     

    Buy/writes/Exec – Hopefully you read the linked post and that helped.  More than anything else, a buy/write enforces a discipline of commitment to the position.  As I pointed out in the numbers in the earlier comment, no, there is no particular danger to selling a covered call and it is infinitely better to sell them, on the average, than not to – I was merely attempting to point out the disadavantage of the covered call to the buy/write.  Of course it’s rare that everything goes perfectly – I would hope that is a given… 

    As to the percentatges, see the Strategy Section notes on scaling in.  The trick is to allocate a percentage of your portfolio to a postion and then work your way backwards to an entry.  Of course, you may be more confident with some than others like if my allocations are $20,000 each, I may choose to commit $2,500 or less to HOV, which is inherently risky but $10,000 to PFE because I want to get my dividend and I don’t mind A) ending up with $20,000 at a 20% discount or B) ending up with $40,000 at a 40% discount if push comes to shove. 

    The most important thing about a buy/write strategy is (if you stick to blue chips that follow the S&P) that you KNOW how much you will make at what index strike (obviously with minor variations).  This makes it VERY easy to hedge and, more importantly, not to over-hedge.  Since we hit our buy/writes at about 1,045, 9,600 with 20% entry discounts we KNOW we make 20% at about those levels and we KNOW we don’t lose money until 836, 7,680 (20% lower) so we don’t really even have to worry about any major hedging until we are halfway down and just a light Disaster Hedge when we fear going below those lines is sufficient to cover us. 

    Don’t foget, NOT LOSING MONEY when the whole market goes down 20% is as good as winning in the long haul.  If I buy $10,000 worth of PFE at $16.50 (600 shares) and sell the 2012 $15 puts and calls for $4.70 then I’m in for net $11.80/13.40 with a 27% gain if called away at $15 (10% down) or I end up with 1,200 shares at an average of $13.40 ($16.080).  So my commitment is to own 1,200 shares of PFE in Jan 2012 IF they drop 10%, below $15 but I don’t LOSE anything until fall below $13.40, which is 18.5% below the current price. 

    So, if the market drops back to 836, 7,680 and PFE falls 20% along with the rest of the stocks (and we’re ignoring the dividend) and let’s say it’s at $13, which is around where it bottomed in ’09, other than the spike down, then I’m down 1,200 x .40 or $480 – EVEN WITHOUT A HEDGE (and ignoring the dividend).  While it sucks not to have made any money for 17 months, what’s the reality?  I still have 1,200 shares of PFE which I can sell for $13 and that’s $15,600 cash when EVERYTHING is on sale for 20% off.  Maybe I stick with PFE or maybe I flip to AAPL at $85 – who knows but if you can keep a portfolio EVERY YEAR that can withstand a 20% market drop without losing money – you will be beating the markets over time.

    Keep in mind the big difference with a buy/write, aside from the fact that you don’t need to mess around with it, it that you make 20% EVEN IF THE STOCK IS FLAT.  How HUGE of an advantage is that in your investing?  While that is also the case with covered calls, you are simply not as well protected to the downside on a month to month basis and you do not lock in the 20% gain if the stock jumps 10% in a certain month and stays higher or gyrates up and down outside of your covered range.

    Answering other questions in the multi-part essay:  No, we don’t always use leaps, sometimes we feel we are adeqately covered with shorter-term play.  With PFE, perhaps I would sell the Jan $16 puts and calls for $2.20 because I REALLY don’t mind owning 2x PFE at net $14.26/15.13 in 5 months or making a quick 10% if called away.  It’s riskier but I would say that, if put to me at net $15.13 THEN I would sell the 2012 $15s for maybe $3.50 to drop me to a potential 4x entry at net $11.63/13.32. 

    So that anwsers both the next step and the rolling question.  The next step is deciding what you want to do if the stock is put to you.  You won’t know the answer to that until you know the actual price of the stock at the time it’s put to you although having a plan with expectations means you have an early warning system when you are "off track" so far in advance that you shouldn’t get caught in a poor outcome too often.   Rolling is just shorthand for taking one option you sold and cancelling it and replacing it with another, usually longer-dated contract.  Rather than saying "If PFE is at $15.50 we would owe the $15 caller .50 and the $15 putter would expire worthless so we would then buy back the $15 caller for .50 and then sell the 2012 puts and calls for $3.50" it is much easier to say "If PFE is at $15.50 we can roll the caller to the 2012 $15 puts and calls for net +$3."  Like any profession, option trading has some "lingo" that experienced trades can use to communicate concepts efficiently. 

    Yes the foundation of a portflio is buy/writes.  Look at the market and imagine that every year for the past 10 years you had simply allocated 50% of your portfolio to trades that made 20% if the market was flat or up and you compounded that every year.  That’s why if you look back at our Buy Lists in the Portfolio section, you’ll see them dominated with this strategy.  Since the strategy forces you to hold a good deal of cash, there is plenty of money to day trade when you WANT to but you don’t NEED to because half your money is working for you every single day, driving towards a conservative, obtainable goal.  

    That takes a lot of pressure off!

  30. Phil
    Well that was super fun!  
    Up about 2% on the day not bad to start the week.  Tomorrow is little news day so maybe they keep going but then it’s the 5% rule all over again and we’re back to testing this level anyway, most likely…
     
    At the close: Dow +1.5% to 12037. S&P +1.49% to 1298. Nasdaq +1.83% to 2692.
    Treasurys: 30-year -0.31%. 10-yr -0.41%. 5-yr -0.34%.
    Commodities: Crude +1.06% to $102.93. Gold +0.02% to $1426.70.
    Currencies: Euro +0.27% vs. dollar. Yen -0.1%. Pound +0.47%.
    Great timing: On the day housing numbers show a sharp dropboth in price and sales, the Treasury’s move to start unloading its portfolio of mortgage debt likely will add one more pressure point to a housing market hardly in a position for more stress. "They’re going to have a hard time unloading this without moving rates higher," Peter Cardillo says. 
     
    Investors pump record amounts of money into Japanese ETFs and equity mutual funds. Joe Weisenthal’s take: "Investors remain of the mindset that every dip – even something as epic as an earthquake and possible existential crisis (the nuke plant) – is a buying opportunity… While this is incredibly bullish for now, it would seem to raise the prospect of a huge air pocket if things go wrong." 
     
    And then they all went to court!  Microsoft (MSFT) says it is suing Barnes & Noble (BKS), Foxconn and Inventec for patent infringement related to the bookseller’s Android-based (GOOG) e-reader and tablet devices. The patents at issue cover functions that allow speedier Web surfing and interacting with e-books.   

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