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Saturday, February 24, 2024

Smart Portfolio Management – Part III – $1,000,000

Options Sage submits:

Before we kick-off on part III of our Smart Virtual Portfolio Management trilogy, let’s see why it is even more important than ever to employ intelligent virtual portfolio management:

Bizarro World

Bizarro World has arrived!  Phil summed up Bizarro World with these words “a drop in Asian markets doesn’t bother us and a collapsing US economy doesn’t bother Asia”. 

Is the collapsing US Dollar worrying anybody?!?!  Should we really care that the dollar is so low?

  • 1 Euro buys almost $1.36
  • 1 Pound Sterling buys $2.00
  • 1 Aussie Dollar buys almost $0.84
  • 1 Swiss Franc buys almost $0.83


Perhaps not…at least the Europeans seem happy for the moment…  I knew the dollar was really weak when my European friends decided it was cheaper to fly from Heathrow to JFK, stay for a weekend, shop each day and return home rather than simply get the bus into the city center and buy holiday presents in Euros!

At what point does this become a real concern?  Perhaps when 1 Euro is worth $1.50!  While it might seem from the European perspective that this would mean even cheaper vacations to the US and even cheaper presents to bring back home, European exporters may experience a drawback as they run into a rising wall of resistance as the unattractive currency conversion tightens the belt on demand for their goods. 

Maybe we shouldn’t care at all when we can put our money in Google…I am sure everybody read Phil’s excellent article but for emphasis let’s just highlight the quarter's earnings one more time:  1 BILLION Dollars!  How the stock closed Friday at only $482.48 I just don’t know but any creative hedge fund managers out there who do know are encouraged to drop me a line!

I am still amazed that Google has 3.5 times as much cash as Ebay, has a 60% higher profit margin,  40% higher operating margin, its all important return on equity is 23% (versus Ebay’s 10.7%), has significantly higher EPS growth projections yet trailing and forward P/E numbers are quite comparable!

So with our $1,000,000 virtual portfolio should we put all the capital in the stock of this one great company or employ smart virtual portfolio management?  The answer might be in favor of the one stock investment if trying to win the CNBC Million Dollar Virtual Portfolio Challenge (though even then you’d probably want to find the next Dendreon!) but trading real capital, it’s no contest…  Let’s see how we construct a REAL $1 Million dollar virtual portfolio!

The 5% Rule

The 5% Rule 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 often "purges" the Short-Term virtual portfolio when it gets too large and shifts money into safer investments in the Long-Term Virtual Portfolio and from there into commercial real estate – 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 $109,500 per share on Friday 20th April – is so unattractive to so many cautious retail investors.

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.

Reviewing the spreadsheets for the Short-Term Virtual Portfolio we see just 2 positions that are greater than $35,000 in value (5%) and one is the AMZN June $35 calls which were only $11,250 when we picked them up (now $90,250) and the other is the DIA $124 calls at $128,000, which have doubled and are spread against a larger number of $131 puts that Phil has been using as general virtual portfolio protection.  I know Phil is already uncomfortable with the DIA calls and I'm sure he will be lightening up on AMZN as well next week.

In the Long-Term Virtual Portfolio, only LVS ($45,300 up 271% and fully hedged) and XOM puts ($49,000, down 35% with hedges pending) violate the 5% rule but both of these positions are under 5% of the total of the virtual portfolios.  In both virtual portfolios that's 4 out of 159 positions that are over 5% so it goes without saying that PSW practices this strategy with most positions at 2% or less, giving us ample room to double down or roll positions, still without risking more than 5% of our account.

[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 real 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!  On 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 toward 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, though weak, is still the reference benchmark currency for the rest of the world and geopolitical events can result in a flight to perceived safety of the dollar, which could strengthen it and hence magnify declines in overseas investments should they occur.

Another attractive approach to benefiting from global diversification that we have been following the past few weeks 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 = 0.66
  • Altria Group Beta = 0.71

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 2.5%
  • JNJ Dividend 2.3%
  • PG Dividend 1.5%
  • BA Dividend 1.3%

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

  • KO Jan08 Short Call Strike 55 Premium = 2.6%, Current Stock Price $52.09
  • JNJ Jan08 Short Call Strike 70 Premium = 2.3%, Current Stock Price $65.12
  • PG Jan08 Short Call Strike 65 Premium = 4.8%, Current Stock Price $63.80
  • BA Jan08 Short Call Premium Strike 95 = 7.8%, Current Stock Price $93.29 

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 5.5% in 9 months)
  • JNJ – 12.3% (Requires stock increase of 7.5% in 9 months)
  • PG – 8.5% (Requires stock increase of 1.8% in 9 months)
  • BA – 11.7% (Requires stock increase of 1.8% in 9 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 is not performing well.  Happy Trading’s charts of the Nasdaq exemplify this point!

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 Apple, 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 (see our Long-Term Virtual Portfolio) 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 (see our Short-Term Virtual Portfolio!).  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.

image of juggler with 3 balls: high risk, low risk, and moderate riskFor 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 have discussed these plays in great detail in last week’s article so we encourage you to read that if you haven’t already.  Phil's general ratio is (of the options asset allocation): 75% long-term "hedged" positions and 25% short-term puts and calls (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, last week the May short calls at-the-money for BIDU currently had a value of almost 6% of the value of the stock!  Admittedly these options were particularly high for BIDU 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!  DNDN is another extreme stock that we took advantage of in several of our virtual portfolios.

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.  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)
  • 15% Levered Plays (LEAPS, Call calendars, Ratio Backspreads, Straddles/Strangles, Bear Calls, Bull Puts, Daily Trades Phil Makes,…)

Have a Fantastic Week!

Options Sage



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