Smart Virtual Portfolio Management III – The $1,000,000 Virtual Portfolio (Members Only)

You can’t lose what you don’t have.

The reverse is true for people with Millions in a stock virtual portfolio.  Phil points out that the reson you don’t run a large hedge fund trying to make 100% gains is that the people who invest in those funds are more interested in what we call "preservation of capital" rather than generating wealth.  Generally, the people who have $1M of investable cash to play the markets have already achieved a great deal of success, often by taking their own risks along the way.  For most of us, $1M is hard to come by and, while we want to put that money to work – we certainly don’t want it wondering off and joining the circus.

As a high net-worth investor, you need to decide how to diversify your assets to suit your long-term goals.  We’re not going to get into that here – let’s just say that if you want to gamble and go for some of our "more exciting" plays, perhaps allocate a portion of the virtual portfolio to those.  Whether that’s 5% or 10% or 30% is up to you but it is good to fence off your risk to a sensible, manageable amount that you really can afford to lose while keeping the bulk of your market allocation well diversified and well-hedged. 

I have my own 5% Rule.  Phil’s famous 5% Rule deals with the predictable movement of stocks in their trading ranges but my 5% Rule, which Phil also agrees with is simply "Do not put more than 5% of your virtual portfolio in the stock of any one company!” This is so much easier said than done for many reasons!!

[1] Transition to Large Numbers

Moving from a 5 or 6 figure account to a 7 figure account has a profound impact on many traders. In fact, our friend Dr. Brett refers to the effect “performance anxiety” can have on a virtual portfolio and notes that one of the causes is the responsibility felt by traders as larger dollar amounts are traded.  Phil advocates a system of "purging" Short-Term Virtual Portfolio gains when they gets too large and shifting money into safer investments in a Long-Term Virtual Portfolio – it is good to have a strategy for balancing out your holdings, not just target goals.

While it might be acceptable to put 15% of your $10,000 virtual portfolio on that long call you just KNOW will make money, it would be a big No-No to consider the same percent allocation to such a trade with a large virtual portfolio. 

Although this might seem very intuitive on the surface, it represents a new rule that must be internalized, one which most traders usually are not compliant with when trading smaller amounts – with good reason – If the dollar amounts traded are small then commissions and bid-ask spread can cannibalize profits.   

The 5% figure is just a guideline and if you believe 6% or 8% is more appropriate then by all means exercise discretion but be very cautious about dedicating more than $100,000 to any position in a $1,000,000 virtual portfolio. It’s one of the reasons Berkshire Hathaway (BRK.A) – closing at $114,000 per share on Friday – has trouble breaking the $150,000 mark.  A sensibly diversified person needs $1M just to buy a single share, over $150,000, they need $2M.  This is why Berkshire capitulated and issued B shares, and then split those B shares 50:1.   

As good a company as Berkshire is, there is surely a Buffett premium that would quickly evaporate (if only in the short-term) should the Maestro trader ever step down or, for any other reason, not remain as figurehead (unless Phil accepts the position – his quote, not mine!). Even a $500,000 virtual portfolio that included a single share of Berkshire could be subject to a sharp account value drop should such a decline occur.

Allocating "just" $50,000 for a position can be frustrating to a person with $1M to play with, especially if you are, as Phil and I advocate, "scaling in" to the position in no more than 25% increments.  The linked article goes into detail on the subject and the main idea is that you begin a $50,000 position with a $12,500 commitment.  If you need to adjust because your stock or options dropped, then it will, logically, require less than $12,500 to double down (if you feel it’s appropriate to press your bet) and then, if that 2nd round fails and you are still undaunted, you can then go as far as doubling down on your position again for less than $25,000 more.

This is how you preserve capital and manage risk.  If I buy $50,000 worth of GE at $17.50 a share, I have about 2,800 shares and perhaps I sell the June $17 calls for $1.25 to collect $3,500 over 5 weeks (isn’t it great to have money!).  If I am called away, I make net $2,800 and I have $3,500 of downside protection on my long-term position at no cost.  If GE drops $3.50 (20%), like it did last week, and finishes the month at $14, then my 2,800 shares have lost net $6,300.  Fortunately, $6,300 will not break a $1M virtual portfolio but everything dropped last week at once – that would, in the least, be uncomfortable. 

The problem then becomes – How do you get the money back?  With a 2,800 share commitment to GE at net $16.25 ($45,500) you have very little money left to adjust.  If you then sell the July $15 calls for $1 (estimate) you lower your basis to $15.25 and you may be called away at a loss.  If GE keeps dropping, and it was $5.58 in March of 2009, then you will keep taking hit.  How does scaling in turn this around? 

If you scale into GE, your initial purchase would be 800 shares at $17.50 a share, selling the same June $17 calls for $1.25 to collect $1,000 for 5 weeks on your net $13,000 position.  Now, you may say what if I get called away?  Well, the answer to that is that if you keep entering GE and you keep getting called away every 5 weeks for net $600 every 5 weeks then you will "only" make $7,200 on that $50,000 allocation of capital (14%) without risking more than 25% of it at any time.  You will also get 2.2% dividends on the stock you do hold.  This is you "worst case" to the upside. 

On the downside, if GE falls 20% to $14 and you are in 800 shares at net $16.25 ($13,000) you can buy another 800 shares for $14 (11,200) and then sell 1,600 July $15 calls for $1, collecting $1,600 in month 2.  Now if you are called away on a bounce, you will get back a total of $24,000 on your net $22,600 investment – a profit of 5.8% in 10 weeks EVEN THOUGH the stock fell 20% and bounced back just 5% during that time. 

Should GE fall an additional 20%, down to $12, you can sell your 1,600 shares for $12 ($19,200) and take a $3,400 loss despite the fact that GE dropped 40% since you bought it.  If you still believe in the company and still want to be in it for the long term, then you can spend an additional $19,200 to buy 1,600 additional shares of GE at $12.  That puts you in 3,200 shares of GE at $41,800, or $13.06 a share.  This is 25% less than you originally intended to enter the position for and now you can sell perhaps 3,200 of the $13 calls for .75 to collect $2,400 for the next month.  $2,400 is close to 5% of $50,000 collected in a single month - not bad for a position you only had to put $41,800 into. 

Keep in mind we have only allocated 4.2% of the virtual portfolio to this very badly performing stock.  Should GE drop another 20% to $9.60, you may decide to buy another 1,100 shares with your remaining $10,600 (the $2,400 you last collected plus cash), which would give you 4,300 shares of GE for $50,000, or $11.63 a share!  As Phil often says to members during chat – "If you don’t REALLY WANT to own 4,300 shares of GE at $11.63 – why would you buy 800 shares for $17.50?"  This is the magic of scaling in, you only end up with large positions in stocks that you are able to buy cheaply.  Stocks that move up too quickly to make rolling your callers practical get called away automatically – it forces a discipline of taking winners off the table, getting back to cash and finding the next bargain stock rather than constantly chasing momentum.

Phil’s "Buy/Write Strategy" is a way of accelerating this process by using the margin from your sidelined cash in order to collecting more money up front in stages 1 and 2.  This is useful in many ways and I strongly suggest all members be familiar with Phil’s "How to Buy a Stock for a 15-20% Discount."

Note that, even at $9.60 (down 45% from initial purchase), the 3,200 shares could have been cashed in for $30,720 and there was $10,600 on the side for $41,320 – a 17.4% loss on the $50,000 allocation.  That should put your relatively "small" gains into context when we tell you that following this discipline can mitigate almost 2/3 of your losses to the downside.  The $8,640 lost would come about because GE dropped 20% a month, 3 months in a row and did not recover and that, using these very basic techniques off 5% allocations and 25% scales, would limit your loss on the position to less than 1% of your $1M virtual portfolio.   

We do not advocate mindlessly adding to every positions that falls but, hopefully, this example illustrates the power of scaling over the long-term.  Phil tells all new members to watch "The Man Who Planted Trees" and I urge you to do the same as you ponder this system of wealth building in the context of your long-term goals.  Think of your positions as dozens of little acorns that you plant.  Some will take root and become mainstays of your virtual portfolio for many years and some will need to be helped along to maturity while others will need pruning.  Having a long-term perspective and a good risk-management strategy helps you make better decisions (under less pressure) along the way..

[2] Emotion

Long-term success is dependent on adhering to the set of rules that have worked consistently for you. Whatever they may be, stick with them, even if it means placing a post-it on the top of your computer that reminds you of such a rule. 

You’ve certainly heard Phil’s statement “ALWAYS Sell into the initial excitement” or one of my favorites “With greater uncertainty should come greater hedging,” and Phil’s corollary "When in doubt, sell half.". These rules have arisen from our experiences and we would hope that you too can adopt them and internalize them without experience having to teach you the lessons!  This is why Phil often uses the "I told you so" method of teaching by example – when your money is at stake, it’s better to learn from the mistakes of others than to insist on making your own!

[3] Due Diligence

Since smaller account sizes often mean fewer open positions, less due diligence is required to effectively manage each position than is required to manage larger accounts. As the virtual portfolio grows and the number of positions increases in order to still adhere to the 5% rule, the amount of due diligence increases accordingly.  If you don’t have time to at least check the news headlines on your positions once every 48 hours – you simply have too many positions!  One of the great things about having a collaborative trading community like ours is that we are looking out for each other’s positions and often breaking news hits our daily comment section well before it makes it to CNBC or Bloomberg.

Even some of the greatest of money managers have fallen victim to violating the 5% rule - don’t join them! As Cramer points out “Diversification is the only free lunch in the stock market!”

Global Investments

Although we refer to the dollar declines in a facetious manner at times, it really does have a profound impact on spending power, particularly when taking trips to the United Kingdom, European countries that have adopted Euros and even Australia which has seen its currency strengthen significantly over the past few years relative to the US dollar.   

As your capital base increases, you are likely to be visiting these places more frequently so it’s often worthwhile having some exposure to different world markets. With the inception of Exchange-Traded funds this becomes even easier to achieve. The following is a list of ETFs that might be of interest to you.

• Australia – EWA (Australia iShares)

• Brazil – EWZ (Brazil iShares)

• China – FXI (iShares FTSE/Xinhua China 25 Index Fund)

• Emerging Markets – EEM (iShares MCSI Emerging Markets)

• Europe – IEV (Europe 350 iShares)

• India – INP (iPath MSCP India ETN)

• Latin America – ILF (Latin America 40 Index iShares) 

As the ETFs trade back towards their all-time highs and media coverage about them increases keep in mind that while some exposure is prudent, investments greater than 10%-15% would be on the higher end of what might be deemed appropriate. The primary reason for this is that the dollar is still the reference benchmark currency for the rest of the world and geopolitical events result in a flight to perceived safety of the dollar, which strengthens it and hence magnifies declines in overseas investments when the dollar is on a run.  However, when the dollar is high, as it is now, taking some US profits off the table and investing in some foreign stocks can be prudent.

Another attractive approach to benefiting from global diversification that we often follow is to purchase stocks of US companies that have global exposure such as:

• Altria Group (MO)

• Boeing (BA)

• Cameco Corp (CCJ)

• Caterpillar (CAT)

• Coca Cola (KO)

• EBAY

• IBM

• McDonald’s Corp (MCD)

Account Volatility

An additional feature of established companies such as KO and MO over and above their global reach is their relative lack of volatility. In fact, the beta coefficients of Coca Cola and Altria are less than 1.0

[Beta is a measure of the volatility of a security or a virtual portfolio in comparison to the market as a whole. A beta of 1.0 indicates that the security’s price will move with the market]

• Coca Cola Beta = 0.59

• Altria Group Beta = 0.38

For those of you looking to sleep well at night without much concern that your stock is going to spike 10% in one direction or another, stocks such as KO, JNJ, PG, BA are all established companies offering dividends. 

• KO Dividend 3.3%

• MO Dividend 6.5%

• JNJ Dividend 3.3%

• PG Dividend 3.1%

• BA Dividend 2.3%

Covered Call strategies can augment any income received from dividends too.

• KO Jan Short Call Strike 55 Premium = 5.2%, Current Stock Price $53.34

• MO Jan Short Call Strike 22.5 Premium = 3.7% Current Stock Price $21.61

• JNJ Jan Short Call Strike 65 Premium = 4.8%, Current Stock Price $63.97

• PG Jan Short Call Strike 62.50 Premium = 6.2%, Current Stock Price $62.54

• BA Jan Short Call Premium Strike 70 = 11.8%, Current Stock Price $69.82 

These returns assume no stock price appreciation at all. Factoring in token increases in stock prices and resulting short call option assignments at expirations, the returns on risk including dividends and short call premiums would be:

• KO – 10.9% (Requires stock increase of 3.1% in 7 months)

• MO – 10.2% (Requires stock increase of 8.9% in 7 months)

• JNJ – 6.4% (Requires stock increase of 1.6% in 7 months)

• PG – 6.2% (Requires stock increase of 0% in 7 months)

• BA – 11.8% (Requires stock increase of 0% in 7 months) 

Although these returns are less than stellar they can be thought of simply as a cushion against excessive account volatility while producing a reasonable return on invested cash (certainly better than your bank!).  Also, there may be tax advantages to employing a "buy and hold" strategy using the leaps to hedge against a downturn.

For example, if you dedicated 20%-30% of your account to relatively conservative plays such as these, the more volatile plays that may comprise the remaining 70%-80% will obviously have a lesser impact on your overall account volatility than if you accepted higher levels of volatility throughout your entire virtual portfolio. 

Industry Spread 

From Yahoo Finance’s Industry Index,  you can quickly see the breadth of areas in which you can invest. 

• Basic Materials

• Consumer Goods

• Financial

• HealthCare

• Industrial Goods

• Services

• Technology

• Utilities

Choosing one stock from each of the areas (while not violating the 5% rule) would be a reasonable approach to mitigating virtual portfolio risk from economic declines affecting a specific industry.  Many people fall into a pattern of trading one area, such as technology and falling victim to virtual portfolio woes simply because one industry or sector is not performing well.

BIG Money

“You only have to get rich once” 

Since this article is concerned with a million dollar virtual portfolio, keep in mind your job is to make reasonable returns and stay rich!

If you have $9,000,000 or $10,000,000 does it really make a difference to your lifestyle? Since the answer is probably not much at all, this article is all about espousing principles that ensure you maintain the level of wealth you have, grow it at a reasonable pace and no matter what, don’t lose it! So many people are working so hard to attain riches that, when they finally have millions of dollars, they often forget to protect them!    

The 4 concepts discussed so far (and listed below) are all designed to protect your capital while ensuring you can still generate reasonable returns.

1. 5% Rule

2. Global Diversification

3. Reducing Account Volatility Through Investing in Blue-Chip Companies

4. Spreading Risk Across Industries

In order to make BIG money, a ‘play-to-win’ mindset is needed! 

This means be more aggressive, shoot for the winners and if they don’t work out you at least know you have the risk mitigation and virtual portfolio protection aspects well covered so you can easily return to more conservative approaches should they become necessary.

A starting point for playing to win includes finding stocks such as GE, NYSE Euronext and so forth that have reasonable growth projections, catalysts to future growth, appear undervalued, tend to be relatively volatile and most importantly offer attractive option premiums! 

Then take advantage of those option premiums through short call options. It’s free money so take it!  When your outlook is more bullish, it’s a good idea to keep those short calls out-of-the-money so that you can benefit from the premiums plus the stock price appreciation. And when stocks are falling from resistance levels, your outlook is bearish or you are uncertain as to its outcome you can be more aggressive with the short calls by placing them at-the-money or even in-the-money as a way of protecting the stock.

For more conservative traders you may even wish on certain occasions, such as just prior to earnings announcements, to protect stocks with long put options and short calls thereby creating a collar trade. Or if you are leaning more bullish but still want to maintain protection you could simply place the long put against the stock and employ a protective put strategy. This would leave the upside potential open in contrast to a situation where the placement of short calls would obligate you to sell your stock at a specific point strike price.

The cumulative returns from these premiums can be astronomical and it really is a mindset issue deciding that you are going to shoot for a large number of small returns consistently over time rather than a huge return from the next shooting star stock. It all boils down to probability and while it makes sense intellectually to make money consistently each and every month and ultimately become very rich, it is much harder to control the greed devil within, which wants to find the next stock shooting for the moon.

For moderately aggressive investors, allocating up to 50% of a virtual portfolio to these income producers should produce handsome returns over time with acceptable levels of risk.  We discuss dozens of these plays in every week and we encourage you to read about our various strategies in the Education Archives if you haven’t already.  Phil’s general ratio is (of the options asset allocation): 75% long-term "hedged" positions and 25% short-term, aggressive positions (but even those he often hedges).

Conservative Speculation

In order to make superior returns from such covered call strategies, it’s usually necessary to commit to stocks with much more volatility. Although this seems might seem somewhat counterintuitive, studies have shown and indeed Buffett has commented that there is “no correlation between beta and risk”.  The reason these volatile stocks can be so attractive is they can return 40%+ per year –  not necessarily because the stock is going to appreciate hugely but because the option premiums reflect the expectations for underlying stock volatility.

Since the underlying stocks might be somewhat speculative, the options can be applied in a highly conservative manner such as at-the-money covered calls that were discussed extensively in last week’s article.   For example, the June short calls at-the-money for MON currently have a value of almost 5% of the value of the stock!  Admittedly these options were particularly high for MON because earnings were imminent and implied volatilities had increased, but each and every month you will see returns as high as 4%.  4% monthly compounds to a 60% return at the end of the year!  WFR is another extreme stock that we took advantage of this week as Phil set up a buy/write that makes "a LOVELY 129% profit if called away in 18 months."

These stocks require investors to have a high degree of risk tolerance since on any given day the stock may be up or down $2, $3, $4 or more! However, the short calls at-the-money offer a relatively conservative hedge to these more volatile stocks and can produce handsome returns over time or, in the case with WFR, the willingness to commit to doubling down by entering the buy/write, gives you spectacular returns on the cash outlay.  Depending on risk tolerance, it would be appropriate to shoot for up to 20% of the virtual portfolio in these positions.

Sample Million Dollar Virtual Portfolio Breakdown: 

• No Stock Comprises More Than 5% of Entire Virtual Portfolio

• 15% International Exposure (ETFs, US Stocks with global reach, International Equities..)

• 50% Fundamentally Strong Stocks (LEAPS options on these stocks should produce at least 20% annualized returns. Cumulative returns from shorter term options should produce higher annualized returns)

• 20% Conservative Speculation (Volatile stocks that offer high short call premiums)

• 10% Levered Plays (LEAPS, Call calendars, Ratio Backspreads, Straddles/Strangles, Bear Calls, Bull Puts, Daily Trades Phil Makes,…)

• 5% Disaster Hedges (see Phil’s "5 Plays that Make 500% if the Market Falls")

Have a Fantastic Week!

Options Sage

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Tags: BA, BRK.A, BRK.B, CAT, CCJ, EBAY, EEM, EWA, EWZ, FXI, GE, Hedging, IBM, IEV, ILF, INP, JNJ, KFT, KO, MCD, MO, MON, Option Strategies, PG, SPWRA, WFR

This entry was posted on Saturday, May 15th, 2010 at 6:35 am and is filed under Uncategorized, Virtual Portfolio Review. You can leave a response, or trackback from your own site.