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Vacation Proofing Your Virtual Portfolio



Save it.  Post-it.  Record it.  Use it.

When driving a car and some object appears on the road ahead do you usually run right over it or do your best to avoid it?  Don’t we all take action in real-life based on the new information we receive that changes the old paradigm?  Take the first two guys in this video:  Who would you rather be, the first or the second guy?  While the second gentleman reacts and looks ridiculous in so doing, he’s the guy that is more likely to survive when real disaster hits because he’s reacting to new information.  In fact he doesn’t even know what’s making everyone else react, he just knows that when 99% are moving one way in panic, it’s best not to fight the crowd or he will be trampled.  It’s no different in the market.  Pride, ego and old theses have no place when new information directly contradicts an existing trade.

When the market is up, we use DIA puts and calls to "react" to quick changes in the market while we wait for better information before making more permanent changes in our positions.  This gave us the benefit of the quick reaction of gentleman #2, the one who went unquestioningly with the crowd, while also giving us the "wisdom" of gentleman #1, who was confident (or oblivious) enough to soldier onward, despite the fact that the world seemed briefly to be against him.

When new information does arrive, one of the first things I look to do is minimize risk - hedging the existing position.  The next step for me is to become more aggressive in reacting to the new information and shifting the bias of the trade in the opposite direction.  In this article, I will outline our basic strategy for protecting your virtual portfolio from a major dip, which can then be used to adjust your risk profile, based on changes in outlook arising from new information. 

The strategy outlined can be applied also when you know that you will be unable to monitor your positions.  Many of you will likely be taking vacations this summer and, with them, a break from actively monitoring your positions.  With that in mind, it’s always prudent to protect your positions from the “just in case” events that can derail your positions in a flash when you are not attending to them.  Those “just in case” events are a reason to remain nimble and flexible when trading the stock market as opposed to becoming emotionally tied to any single position.

We have published this aricle before with many individual strategies but, today, we will focus specifically on the DIA puts, which are the cornerstone of our "mattress plays."  Keep in mind, the point is not to "win" these trades; the idea is to bet against yourself, putting your folder in "neutral" while you head off to the Bahamas for 2 weeks or just off to the Hamptons for the weekend.  You may lose time value on both ends of your trade but often this is less than the cost of jumping in and out of positions.  You paid for your vacation - adding a hedge is just another travel cost that let's you really enjoy it without worrying about your virtual portfolio!

I use the DIA's because the Dow is always in your face, even when you are away, so it's very easy to keep track of in case you need to make an emergency call to your broker - but the logic works for any of the indices.  If you are heavy in technology shares, you can purchase QQQQ puts etc. but I find the DIA puts to be excellent overall virtual portfolio coverage.  When I am more actively trading, I may focus on the index that is likely to snap back the most on a correction which is another great way to insure your positions and often more profitable (assuming you are good at doing your homework).

Remember, this is about buying INSURANCE, protection against a catastrophe.  Much like life insurance, this should be considered the cost of keeping your bullish virtual portfolio alive and healthy, even in a downturn.  Also, much like life insurance, it sucks when you collect!  You need to go into these plays knowing what kind of drop are you worried about.  You need to look at how well covered you are now and (yesterday being a good example as we did drop 300 points) get a handle on the danger you face in a 300 point drop and think about the value of that kind of insurance

As with any spread, it's a relative gain issue.  There is virtually no point to having two contracts at the same strike a month apart as you will have no particular advantage over the short position (putter) on a drop.  Rather than write a book on the subject, let's just take the best current protection at this exact spot, even though I currently do not have DIA puts as I am waiting for 11,800 to put them on.  I was fully covered and too deep in the money yesterday after the run-up so there was no point in the puts, I am now 1/2 covered (we took off callers we were 50% or more ahead on) and may add DIAs today rather than cover up over the weekend as I don't want to get buried in another pop so let's say we end today in the same spot and I took a $20K hit yesterday but now I'm half naked so I'm worried about a $30K hit if we drop 300 more on Monday.

Rule number one in selecting an index put is have at least 45 days because you want to be somewhat insulated by the time of the spread and, most importantly, you want to be able to sell front-month puts (short) against your position.  We could take September but, at this point I'd rather see October.  Generally, our rule with an index put is that we will roll up to the next $1 strike (higher for a put) for .40, as we are buying $1 in position for 40 cents.  Since it's 11 weeks away, rather than look for rolls at .40, I'm going to look to roll up $1 for .50 so, logically, the position I choose is the first position that can NOT be rolled up for .50 or less, that would be the Oct $117 puts at $6.38 as the $116 puts are $5.85 (-.53) and the $118 puts are $6.97 (+.59).  More importantly the $119 puts are $7.60 (+$1.22), the $120 puts are $8.23 (+$1.85) and the $121 puts are $8.93 (+$2.55) so a 400 point drop will net me $2.55 profit and a 300 point drop will net me $1.85 off the Oct $117s.

Assuming roughly a $2 gain, if I want to cover 1/2 of my projected $30,000 loss of a 300-point drop, then I need 75 contracts but let's say we are a little more nervous and take 100 for for $63,800.  On the downside, a 300-point gain will drop me to (approximately) the level of the Oct $114 puts and they are $4.88 (down $1.50) so I will lose $15,000 on a run up.  Since I lost $20,000 on the way down I can assume I'll make $20,000 on the way back up (probably better as I am now 1/2 uncovered but let's be conservative) so getting my virtual portfolio back to even on a 300-point run up will cost me $15,000.  Just like life insurance, you don't want to be over or under-covered

Now I can look to offset that $15,000 loss by covering my long puts with current puts.  Question 1:  How low do I think the Dow can go?  Let's say I'm pretty sure 10,800 will hold (500 points down).  My main goal of protection is my worry about a drop to 11,000 even and the Aug $111 puts just so happen to be $1.44, which is almost exactly what I would lose on my longs if we head up 300 points!  Also, since my Oct $117 puts have $3 in premium with 3 months left (about) this $1.44 will more than cover my premium loss for the month so also perfect! 

If the Dow goes up 300, I get my $20,000+ back on my main positions and remain neutral with my puts.  As my the value of the August puts I sold decreases, I "invest" that money into rolling myself up to higher stikes on the long puts following the rule of spending .50 to gain $1 in position.  This will require some additional investment in the October puts as the front-month puts will only lose about .30 per 100-point move against them.  Still, that nets out to me spending .20 per $1 of protection on the way up.  Once my short putter is not returning .30 per 100 point Dow gain, it is time to roll him to a higher strike (following the same rule of thumb – what kind of drop do I fear from the new Dow level?).

So, ideally, if the Dow were to gain 300 points next week to 11,650, I will have spent $1.50 to roll my Oct $117 puts to the Oct $120 puts and would have moved my putter up to the $115 puts for another .70.  That means I have now collected $2.14 by selling puts against my now $7.88 position in the October DIA $120 puts.  Now the Dow can drop 500 full points before I owe my putter a penny and my virtual portfolio is now protected by October puts that are $3.50 in the money that I spent a net of $5.74 on, not bad!  Of course as time goes on this gets more complex and that's why we teach it month after month but, for a vacation of less than a month, it's not too much of an issue…

If the Dow goes down 300, my puts gain $20,000, offsetting 2/3 of my probable losses AND it's still not enough to put my putter in the money (and he can be rolled down to the Sept $106 puts even anyway, which is why it's nice to have an extra month between you).  The more the Dow goes down, the more my long puts gain per 100 points and, since I can roll the August puts to September (and even, ultimately, to October to create a vertical bear put spread) I can state with fair certaintly that my spread can be managed through an 800-point drop, although preferably not on one day! 

A lot of our older members have learned this technique as we practiced it over the years and through several harsh market corrections.  Having long puts in place as protection allows us to leverage our puts into mattress plays, which can actually turn a nice profit during a severe dip.  It was nice to see the generally calm attitude of our group during member chat yesterday as we were well covered and able to watch the drop making minor adjustments, rather than screaming for the exits

Market dips should be buying opportunities, not gut-wrenching tragedies and balancing your virtual portfolio is a good idea any time.  Learning to use these techniques will allow you to shift your virtual portfolio from bullish to bearish to neutral almost at will.  We will be establishing DIA puts, usually held in the Short-Term Virtual Portfolio, directly in our Long-Term Virtual Portfolio and will be spending more time on this technique this year as the tremendous volatility of the market makes it more important than ever for us to manage our risk appropriately.

Trade safely,

- Phil


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    Sign up today for an exclusive discount along with our 30-day GUARANTEE — Love us or leave, with your money back! Click here to become a part of our growing community and learn how to stop gambling with your investments. We will teach you to BE THE HOUSE — Not the Gambler!

    Click here to see some testimonials from our members!

  1. Great article Phil – This baby gets a permalink.  Thanks…