Profit In Your Spare Time

June 25, 2007

325

Option Sage submits:

Recently I saw an infomercial from Fisher Investments where Ken Fisher mentioned 3 attributes that he believes are keys to successful investing which can be crudely summarized as follows:

[1] Focus on long-term investing

[2] Expect surprises

[3] Stay ahead of the crowd by knowing what others don’t

The first point is certainly critical and weeds out the greedy ‘get-rich-quick’ traders from the patient traders. Our policy here is that of ‘play-to-win’. We like to be aggressive in seeking profits with short-term plays but we also recognize that if those trades don’t work out that we can still rely on longer term plays to end up profitable in the end.

The second point regarding expecting surprises asks the trader the question “Are you managing risk well and do you have contingency plans in mind each time you enter a trade?” While the second part of the sentence is important, the first is paramount! No matter what you do, never violate risk management rules which we have discussed here in the past.

The third point is a luxury in my view. Of course, it would be nice to know what others don’t but it’s not critical. By definition only a small number can have information that the rest of the crowd does not have so if you are not trading full-time you have to find another way of making money without relying on staying ahead of the crowd.

As I was scanning for trades over the weekend, I came across one trade which might in fact fall into the category of offering relatively attractive profits by relying on options rather than additional information. In fact, I know many of our members find it hard to focus on the daily trades and would like to construct virtual portfolios with the longer-term in mind. As Phil mentioned in his "James Bond Investing" post, playing short-term positions requires constant vigilance and you need to ready to turn on a dime with small windows of opportunity and this kind of trading is not for everyone. Even Phil has a rule of thumb that 75% of his virtual portfolio is in longer calendar spreads, which generate lower returns but are easier to manage and have a wider margin for error.

So, I set out with the goal in mind of finding a trade that could produce a 25% return in an 18 month period, noting that this would lead to more than a doubling of virtual portfolio size every 5 years or so. I also wanted to find an opportunity that I believed was very conservative. This meant finding a stock that had relatively strong fundamentals, minimal risk of suffering from some anomalous ‘gotcha’, and a company that had been around for a long-time and would likely be around for a long time to come. I also added the stipulation that it should be much closer to recent support levels than resistance levels so a margin of safety was built-in.

The stock that jumped out at me was NYSE Euronext. We are hoping to initiate a trade on this one at $70 but we'll be watching to see how it handles $75 and may begin scaling in first. Phil has been watching it for a short-term play once he feels it has bottomed so this play will have the added benefit of having two sets of eyes on it as we move forward. As I mentioned above however, this is a play that we can make that will require little of your attention to make a fair return. What interested me in this trade was the very low premiums that are being asked for the Jan '09 $90 puts, now $20.80. If you own the stock, now $75.37, these puts give you the right to sell it for $90 between now and Jan 2009.

Even if you don't make a well-timed entry, your entry price today would be $96.37, meaning you are paying just 7% over 18 months to guarantee that you will get $90 back at the end of this trade .

Now, there are several ways to work this trade;

Do nothing and hope that, over the next 18 months, the NYSE retakes its November high of $112.
Lock in getting your $6.37 premium back by selling the Jan '08 $80 calls for $7.35
- there is some danger to this as the stock could run up on you and you may get called away for $87.35 and your long puts may no longer be worth $9.
Our preferred method: Sell the Aug $80 calls, now $2.62 checking in now and then to see if it's appropriate to roll.

Since you own the stock, we can anticipate that every month you will be able to find an appropriate strike price and, if we can pick up an average of $1.30 in premium each month, then we would be looking at a return on investment of $23.40 plus any amount over $96.37 that we are able to get in Jan 2009. The least we can get for our stock portion is $90 so, assuming the $23.40 holds true, we are looking at an 18-month return of $17.03 or 18% as an expected minimum. This does require you to pay attention to sudden moves in the stock, which may require you to buy back or roll your caller should the stock start to take off. More aggressive player could pick up a little money selling closer puts against our leap but, again, this does increase your risks.

The really attractive aspect of this trade is that it requires no work from either you or the stock! If the stock remains flat or rises, the trade profits. If the stock drops, the trader is protected. You are "even" as soon as you collect $6.37 in premiums from expired calls!

Another way to play this stock with even less involvement on your part is to buy the stock for $75.37 and sell the Jan '09 $80 call for $14.20, rather than buy the long put for protection. This does have the element of risk if the stock should suddenly fly below $61.17 (your net investment) and does cap your gains at $80 but that's a 30% retrurn in just 18 months on a trade you may never have to touch again.

Now this is a highly conservative application of this trade. You will often see our preference is to sell call options when we approach resistance levels to profit from short-term pullbacks. But those plays require us to be active in the market and constantly spending time on our due diligence. This type of play is targeted to the working Joe who just doesn’t have time to juggle the career, family and investments but still needs to grow his wealth without dedicating all his time to the markets.

Now, if you scan hard enough you will find other plays which produce a higher percentage return (e.g. AAPL near-the-money 09 options), however few meet the margin of safety requirement stipulated earlier because in this market most stocks I scan have already had big movements up!

Hopefully, a nice trade to consider for those of you looking to build wealth at an attractive pace while remaining relatively inactive so you can spend more time with your family and less time with your virtual portfolio. Even our more active traders should consider having some of these trades in play as they provide a nice backdrop of slow, steady growth against the more volatile parts of your virtual portfolios.