Options Sage submits:
Last week’s article discussed smart virtual portfolio management with respect to a $10,000 virtual portfolio. In this week’s article we will consider a fairly conservative managment strategy, using options to enhance returns in a $100K virtual portfolio as promised last week and next week we will look into a million dollar virtual portfolio.
The Simplicity of Stocks
Making money trading stocks is (or at least, should, in theory be) much simpler than making money trading options! Making money trading stocks simply involves being correct with respect to direction. You also have the luxury of time on your side should the stock fail to move as expected initially – you can always resort to trusting that your fundamental due diligence will trump any short-term technical analysis failings.
Making money with options, on the other hand, requires that you are correct with respect to direction AND TIME. Take the FAZ July $12/16 bull call spread at $1.10 that we mentioned last week as protection – up a healthy 36% in a week. The C spread they were protecting, on the other hand, was net $3.07 and is now net $2.94, which is a .07 loss on the C calls against a .40 gain on the hedges. Using last week's expamle 2:1 ratio, this play is still up .13 per C contract for a $65 gain on $475 cash used for the two positions or 13.6% profit in 5 trading days. That's what a well-hedged position does for us when the trade moves against us and those are the kinds of sensible trades you NEED to be making in a small portflio!
We also have to factor in another risk variable, implied volatility. WYNN traded as high as $96 prior to its earnings report this week and, with a P/E of 145, Phil came up with a couple of bearish plays to take advantage of the run while and reasoned that, if the stock didn’t report stellar numbers and forecasts, a correction was in the offing. Phil liked aggressively selling the naked $95 calls (a play that requires margin) on the assumption that the protection or "hedge" of the play was that the calls could be rolled to higher strikes in longer time-frames. He also liked the fairly aggressive $100/95 bear put spread at $3.20, where the lower puts effectively removed the premium from the $100 puts while limiting the profits to $5 if WYNN expires lower than that strike. WYNN dropped all the way to $76.86 so his combination play at net $1.15 of cash is right on track to make that maximum $5.
Suffice to say that unless you are an incredibly active trader and very sophisticated trading options already, a learning curve exists to get fully proficient in their application and as a result a reasonably large virtual portfolio of say, $100,000 should comprise a blend of both hedged stock positions and option trades.
Hedged stock positions are particularly attractive if you have ever had a problem timing the market! (I think it’s fair to say all of us fall into that category and if you haven’t please do make sure to contact me!!). You have the luxury of time on your side as your trade matures and even if your timing isn’t perfect you won’t be penalized nearly as harshly as if you were trading options at inopportune times. You also have the added bonus of reduced % account fluctuation compared to a virtual portfolio comprised exclusively of directional options plays (unless they were very well hedged!).
The first step in trading any virtual portfolio is to identify what your target goal is. There is little sense targeting a 300% return if your historical average is 8%! While it’s possible and I’ve certainly seen some phenomenal traders achieve those lofty goals, it usually encourages you to force trades which can be particularly detrimental to your results.
In fact, one of the greatest challenges money managers must overcome is the pressure to force trades to generate quick results in order to keep clients happy. This is one of the reasons you hear about the ‘window-dressing’ phenomenon so much as the close of a quarter’s trading approaches; suspicion is rife that money managers conspire to artificially inflate prices to cloak an otherwise mediocre performance.
I default to the general standard of 20% returns as a reasonable target when you start trading. Of course, it’s feasible to do much better and following a well-informed, active trader (like Phil) enhances your chances of excelling beyond such a target.
Sometimes 20% can be dismissed as being inadequate in the context of options trading where 50%+ returns can be generated on any given day. But you will never (or certainly you should never) have all your money in a single trade that might make 50%+ or go bust on any given day! Phil targets a 20% annual return, which is why he is constantly taking winners off the table. In the past 60 days of this year, Phil took off more than 100% the starting balances on trades on both bull and bear sides, the rest of the year becomes playing with profits that way. Leaving 200%+ of the starting cash position in play is just tempting fate – you must learn to accept your successes and move on as much as you must learn to accept your failures.
If you are struggling to accept 20% returns as being a reasonable number, factor in the impact of compounding and you can quickly see that you will be very rich indeed if you simply target 20% per year no matter what trading capital you begin with. In fact, generating 20% per year for 20 years would yield a 38x multiple in a qualified account on your starting cash – which I think most of us would be quite content to have! With $200,000 starting capital, that’s over $7,500,000,which should still be nice chunk of change in spite of inflation.
Now let’s go see how to make the money….
Hedged Stock Trades
The simplest and one of the most powerful hedged stock trades for a $100K virtual portfolio is the at-the-money Covered Call strategy selling LEAPS against your stock positions. It’s easily dismissed as a strategy because it’s really boring but as I like to say:
“Boredom is not a reason to make or not make a trade”
In fact, one of the reasons it’s a relatively boring trade is there is so little work required on your part so if you have a habit of being trigger happy with trades, this one forces discipline to hold-off and use patience to remain in the trade, which are key attributes to consistent success.
Since 20% is our annualized goal and January '11 is just 8 months away, we should target at least a 14% return in 8 months which equates to approximately the same thing on a rate-of-return basis.
CHK has had a nice decline to $20.91 from recent highs at $30. Jan ’11 $20 calls can be sold for $4.30. A quick calculation yields:
Cost Basis: $20.91 – $3 (calls sold) = $16.61
Projected Reward: $20 – $16.61 = $3.39
Projected Return on Risk: $3.39 / $16.61 = 20.4%
Should we consider such a trade, our expectation should be that CHK will not fall below $16.61 by year’s end. We would realized maximum reward of $3.39 should the stock stay at, or rise above, $20 and between $16.62 and $20, we would be making a return between 0% and 20.4%.
Note that you can do this same trade, selling the $22.50 calls instead for $3 and your net return would jump up to 25% but you require a 10% better price on the stock at expiration to make that 25%. Phil often talks about "the bird in the hand" when making decisions and, if this is not play money, it really is not worth the risk you take to chase another 5% in the bush – so to speak.
The really attractive aspect of this trade is that we are no worse off for shorting the call option, even if the stock rises to $25 i.e. $5 above the short call strike. However, we don’t require that the stock rises 15% in order to generate our return. This philosophy of profiting without requiring significant stock movement is a particularly attractive feature of this trade. The other VERY attractive part of this trade is that it's self-hedging. CHK can drop all the way to $16.61 (down 25%) before you begin to lose money. While we hate to be in a trade for 8 months and not show a profit – we all know how great it is just to be even if the market drops 25%.
Dedicating 10% of trading capital to a single trade like this would not be inappropriate at all. In fact, a 600 share/6 contract lot trade for CHK would require just over $9,966 of trading capital, which is relatively prudent risk management for a single hedged stock trade like this on a $100K virtual portfolio.
In fact, you could spread your risk among 8-12 stocks in this manner and dedicate up to 70% of your trading capital to such relatively conservative trades. However, to achieve greater returns we will have to employ another hedged stock trade.
Higher returns can be achieved by accepting higher risk through at-the-money or slightly out-of-the-money short-term short calls applied regularly against stock positions.
Although the trade looks very similar to the original trade discussed, the returns can be considerably higher. This is due to the fact that the cumulative return of short-term short call premiums over time exceeds that which you can receive on longer-term short calls.
Let’s stick with CHK to highlight the point. The June $22 calls at $1.31 carry a $1.40 premium over a 45 day timeframe. On a per day basis, that equates to about .03 per day. Contrast that with the longer term LEAPS in the previous example. They offered $3 over about 240 days, equivalent to approximately a .0125 return per day. If each and every month we were to short options at-the-money or slightly out-of-the-money, our returns would be much higher than if we were to stick solely with the first LEAPS Covered Call strategy discussed.
This strategy does require us to be more active in our accounts. It also requires a higher capital commitment to start the trade. And during earnings season which we are currently in, the trade can suffer more should negative numbers or poor outlook cause a sell-off.
A virtual portfolio comprising a combination of the above strategies and applied in a manner that suits your own risk tolerance would be a tremendous improvement over a simple buy-and-hold strategy. If your virtual portfolio has approximately 8-12 stocks applied in this manner, you will be relatively well diversified in terms of risk and yet, you don’t have too many stocks whereby you cannot follow them. In fact, for most people, 8-12 stocks is about as many as can be actively followed with respect to reading headlines, keeping up with quarterly reports, staying on top of charts and so forth.
One of the great advantages of being in a trading community like PSW is that we have more "eyes on the market," much like a large fund or trading shop, with various members tracking their favorite sectors and bringing ideas to the virtual conference room. This is what Phil set out to build from the beginning and it's amazing to see how well it functions as the membership rarely misses hot stocks and big market moves and, more often than not, are far ahead of the game!
With approximately 15%-20% or so of virtual portfolio capital, it’s often very prudent to wait during the year for the big sell-offs. Inevitably they do occur, it’s just a matter of when! When the carnage ends, it’s often a great idea to scout around for LEAPS and other more aggressive plays.
For example, this week, Phil found a perfect example of an appropriate option combo on RIG. Because there is still uncertainty, the stock is too dangerous but some of that risk can be offset by taking a long bull call spread (the "buy") and Phil likes to write puts against those positions to maximize (if all goes well) the gains on cash:
RIG Jan $60/75 bull call spread at $7.20, selling $50 puts for $3.30 is net $3.90 on $15 spread and worst case is you own RIG at net $53.30. I think their liablility is not that great on spill and much work is ahead for them.
The trades of this play breaks down like this with a $2,810 commitment:
- Buy 1 RIG Jan $60 call, now $14.10
- Sell 1 RIG Jan $75 call, now $6.90 (net $7.20)
- Sell 1 RIG Jan 50 put, now $4.10 (net $3.10 cash and $2,500 margin if 50% margin required)
This trade begins losing money at $63.10 but the loss is capped at $3.10 (5% of what you could lose if you bought the stock) all the way down to $46.90, which is 31% below today's price of $68.10. The spread is currently $800 in the money, which is a gain of 28.5% on cash and margin we finish here in 8 months. If, as Phil suggests, your options virtual portfolio is no more than 25% of your stock virtual portfolio and you have at least 25% cash in your stocks virtual portfolio, then margin should never be a real issue in your option portfilio – which is why Phil generally concentrates on gains on cash, which, in this case, would be an impressive 384% if RIG retakes $75 at January expiration.
Even looking at it as a gain on a non-PM account where this margin prevents you from making other plays, it's still a potential gain of $1,190 or 42.5% of $2,810 over 8 months with your risk of owning 100 shares of Transocean at a net cost of $53.10, 22% below the current price. As Phil often says: As long as you REALLY want to own the stock, it's one of the best strategies out there!
With the last 10% of your virtual portfolio capital, you can enjoy the speculative plays that Phil discusses during the day. You’ll still have sufficient capital to partake in many of the plays, perhaps not in scaled 10 contract lots but maybe a few contracts at a time and you’ll still have the opportunity to profit handsomely from shorter-term plays!
Combine the strategies altogether and you should have your risk well-managed while still offering the potential for tremendous returns that significantly beat the 3.5% returns you'll get on a Treasury Bill…
Have a fantastic week!