Stupid Option Tricks – The Salvage Play

Covered calls/Jofori – I just put a covered call example up on SGR in a comment under the $5KP post but here I was talking about managing your position and scaling in.  I did write a whole article on scaling in HERE (by the way, the rolling strategy outlined there for USO returned a triple) but let’s look at another example:

First of all, lets’s be clear that scaling into a position means, AT MINIMUM, that you are looking at 3 rounds of buys.  In round one, you buy 1x and in round 2 another 1x and round 3, WHICH YOU HOPE NEVER TO GET TO, you buy 2x more.  Allocation-wise, let’s say you are willing to commit 10% of your porfolio to a position, then you start with 2.5%, move up to 5% and, HOPEFULLY, that’s all you ever need.  The times you do commit 10% are saved for big positions where you got a REALLY cheap price that you want to hold for a REALLY long time. 

So, if I buy AAPL at $135 and another round at 20% lower around $110, then my basis is $122.50,  That’s nice but not an amazing price.  If AAPL falls another 20% below $110 to $88, THEN I think (assuming nothing fundamental has changed), I have an amazing price and I am happy to buy 2x more at $88 for a $105.25 average entry (ignoring any calls I hopefully sold). 

Using this entry system properly you are automatically buying more of things that are cheap and less of things that are expensive. 

So 20% is generally our action point.  If a stock or option contract loses 20% we need to decide whether to cut our losses or add to the position.   Again, there is a certain automation to the process that promotes good decision-making as your first 20% loss, if you start with 2.5% of your portfolio, would only be 0.5% of your portfolio.  That should be easy to walk away from right.  If you double down there to 5% (although it’s less because the 2nd 1x is 20% cheaper) and the position drops another 20%, you have lost 20% of 5% (1%) plus the original 0.5% for a 1.5% portfolio loss AFTER taking a 40% hit on your posiiton.  Again, this should be managable and something you can walk away from.  If you add another 2x at that point, ignoring the fact that it got cheaper, you are in for 10% of your portfolio and another 20% drop will cost you 2% plus the 1.5% you already lost is 3.5% lost on the position after it went 60% the wrong way on you.  That is bad but not devastatiing and don’t forget you have to be totally wrong 3 times in a row with no covers for that to happen.

By comparison, what is the upside.  We don’t cap gains so there’s not limit but we do take 20% profits off the table.  If you are in for 1x and it goes straight up 20% so fast that’s all you get, it’s a 0.5% gain in your portfolio.  You need 7 wins like that to cancel out one 4x wipeout, which is why you need to think VERY hard before you ever double down on something.  If you take a 20% hit and get out in step one, it only takes one win to get it back.  The deeper you chase a bad position, the more right you need to be on your winners just to get even.

Let’s look at GE this month.  Say we entered on June 12th at $13.50 and sold the July $14 calls for .60 and the July $13 puts for .60 too.  That would be a net entry of $12.30/12.65, not very good but that’s why we weren’t buying then! 

Anyway, so by June 19th expirations, GE has fallen all the way to $12.10, below our net entry.  This is no reason to do anything!  It’s not 20% off, which would be $10.80 and you need to go into the position with that target and plan.  IE: I am in for net $12.65, if GE drops 20% to $10.80 I will be assigned so I will have X at $12.65 and I will buy 1x more at $10.80 for an average entry of $11.73.  My expectations are that I can sell another $1 of $11 puts and calls to lower my net to below $11, where I will own 4x at $11 if assigned or 2x at $11 if not assigned.  By the way, with an entry on a buy/write you can start with X (2.5%) or 1/2 X (1.25%) but I find it’s better to run more than less positions and put your money into the losers, which are offset by the profits from the winners.  Keep in mind though that EVERY SINGLE time you sell a naked put – you’d better be damn well committed to long-term ownership!

So good discipline should have stopped you from doing anything with GE at $12.10.  If you remember our original buy list, we rode out the entire March market collapse without doing much of anything and came out just fine.  You have to think in terms of years of ownership, not days and you only take action when events strongly dictate it.  

That’s why we have guidelines for taking out calls and puts we sold when they are ahead by 50% with more than 2 weeks to expiration and 75% with one week to expiration and 85% during expiration week.  We also have a guideline to take out off 1/4 of our callers or putters when they gain 25%, not just from where you sold them but from whatever low they hit.  So, in other words, if a caller drops from $1 to .60 with more than 2 weeks left, you don’t wait for it to go to $1.25 before buying back 1/4 of them, you buy 1/4 back if they bounce to .75!  When you are 3/4 covered, you set another 25% stop on 1/3 of the remainder (the 2nd quarter) and, should you trigger and find yourself 1/2 covered, you have once again reaced a decision point.

So on June 19th, the GE $13 puts had hit $1.25 but had spiked to $1.75 earlier in the week.  Had you followed guidelines for stopping out the putters, you would have taken 1/4 off at .75 and 1/4 off at .90 so you would be 1/2 covered at $1.25 or you would have possibly already rolled them down to a full cover at Aug $12 puts.  Today, the $13 puts are $2.25, a great example of how using stops can greatly improve your returns and limit your losses.  Of course, you have to have at least 2 contracts to work with, preferably 4 (if you have 2 you can stop 1/2 out at 33% but you have to be quick to re-cover if it turns). 

The $13 calls, on the other hand, fell to .10, so were up more than 50% with more than 2 weeks left.  You don’t stop them out for no reason, you stop them out because you have a plan of what you are going to do next.  With the gain of .50 on the calls and the loss of .65 on the puts, perhaps the plan would have been to reposition the puts and calls at the July $12s or Aug $12s – somthing where you adjust your target…  The key to that decision would be redoing your cover math and trying to stay even at least.  Obviously (I hope) dropping the put strike from $13 to $12 would knock .50 off the high end of your basis (the strike if put to you) so it would drop from $12.30/12.65 to $12.30/12.15 – assuming it was an even roll. 

Don’t forget we enter these positions because we WANT to own GE at around $12 so this is just fine!  We haven’t had to make a bigger commitment and we knocked .50 off the assignment price and, as of June 19th, the stock was at $12.10 and our assignments were right about there – not a win but not a loss at all. 

Anyway, NOW we are at $10.80 (20% off) and regardless of what puts and calls we sold it’s decision time so do we still like GE and do we want to buy another round or do we want to cut our losses at about 10% or do we want to try to roll our $12 puts and calls, now $1.37 to something more forgiving like the Aug $11 puts and calls at $1.55?  Our original buy-in was way up at $13.50 so less $1.55 is net $11.95/11.48 at August expiration, not a bad entry but depressing with GE at $10.80.  GE was $7 in March though so, just in case, we may want to save our DD firepower for a real bargain.  The premiums on the puts aren’t all that thrilling to sell (.69 for the Sept $10 puts) so, at this point, just 10% down overall, we’re probably best off riding it out. 

If GE heads up we may want to have a buy point since we don’t want to get called away at $11 with our entry point at $11.95 (it only gets cheaper if we are assigned more at $11) but that brings us back to why we should be stopping out 1/4 of our $11 callers, now .66 at .75 and again at .90.  Then we would be 1/2 covered at $11 with putters expiring worthless and we can easilly roll to the Sept $12 or $13 puts and calls and be right back on track.

As you can see, there are always many options at each decision point (illustrations are in the article) but, over the long-term, it’s a very powerful and flexible way to manage your portfolio.

Comment on 5% rule from June 13th:

Futures/Merk – Unless there is serious unrest in Iran (and a few hundred people getting their heads bashed in by Police is just a typical Friday night there) then so what?  Mahmoud wins and he hates us – what else is new?  Kim Jong Il’s a nut case – yeah, so….  They could be an excuse to sell off but not the real reason we sell off.   From a chart perspective (and I’m not a chart guy) it seems to be that a breakout consolidation pattern usually includes more spikes up through the level.  The S&P and Dow have been dead flat under 950 and 8,800 respectively.  The Nasdaq is doing what I would expect a breakout consolidation to look like – going above and below the 1,850 line.  The NYSE also is treating 6,200 like Kryptonite while the Russell is doing a good dance around 525.

So let’s back up and see what the real levels are.   525 on the RUT is 50% off the non-spike low at 350.  That’s a lovely number so let’s use that bul keep in mind it’s 38.5% from the top so over our 40% line (514).  That means that, if anything, the RUT already broke through that fence we talked about last week and is dancing around waiting for the other indexes to catch up so it can fly higher.

The Dow, I guess, bottomed out at 6,500 so 9,750 is 50% up for them.  It’s worse if we say they bottomed out at 7,000 (10,500) so let’s say it would be very bad for the Dow not to make 9,750.  8,800 is "just" a 35% gain off the March lows so the Russell is 15% ahead of this fat kid (but a 50% additional move for the Dow to catch up).  This is why I was loving the RUT back in March as a long-term play. 

S&P 675 was a bottom and that means we’re looking for 1,012 as a 50% move or 1,050 off the rounder 700.  946 is exactly 40% off the top but only 40% off the bottom or 35% off 700, which makes me want to use that mark since it lines up with the Dow.  These are important decisions as they lead to my next round of 5% Rule selections.  When in doubt, I split the baby but if we see convergence and can work backwards without too much forcing, it’s nice to settle on rounder numbers.

NYSE 4,300 seems like a reasonable bottom and that makes 6,160 their 40% up line and 6,132 is the 40% off line so we’re liking that one.

Nas 1,300 is a good one and 40% over is 1,820, which confirms my thought that they are already in a breakout, like the RUT, they are waiting for their fat friends to catch up.  The Nas alread blew through their 40% line at 1,717 which tells us that the poor Nasdaq should have been higher back at the top or that they held out better then their peers at the bottom.  That’s a good sales point for tech leadership as a long-term investment.

SOX 190 is a clear bottom and 275 just so hapens to be the 50% off mark and the 50% off the bottom mark so I’d say that’s rock solid.  You can’t ask for a better directional indicator than the SOX are right now, they are like a compass for the market right now.  I’d say if they can’t break 329 (40% off) then the rest can’t go up and if they fail here, they will lead the way lower. 

TRANQ made a pretty clear bottom at 1,250 so 1,875 is where they need to be to make the 50% up level and 1,868 is their 40% off mark so not as good an indicator as SOX but, obviously, they are our biggest problem.  1,750 is their 40% up mark so failing that will be a doomsday signal for the markets.

Notice in the 5% rule we could not possibly care less about moving averages or any other squiggly line nonsense – it’s math but the "art" of it is being able to identify tops and bottoms on a chart (throwing out "noise") and then identifying conversion points.  Of course, if you look at TRANQ for example, you’ll see how those squiggly lines tend to converge on OUR targets – not vice versa! 

The rest of the 5% rule is very simple and it’s based on what I’ve observed consulting on computer projects and working with traders.  Everyone thinks they are writing a proprietary trading system but there are several factors at work.  The nature of the project is that the traders tell the programmers what they want and the programmers have to code it.  Since, generally, more than one person has input on the project, certain target levels get averaged out.  It is also human nature to pick whole numbers when asked for long-term targets (how many other people said 8,412 for the Dow or 946 for the S&P) and then there’s a whole essay I could write about how random numbers are not random in a computer and, of course, there’s rounding.

All this mish-mosh of activity ends up causing trading programs to end up with predictable patterns.  Then, if you aggregate that over hundreds of trading programs all set with their own "random" targets, you end up with larget and more pronounced moves that end up obeying certain incrimental rules and those rules are this:

Stocks and indexes tend to move in 5% incriments.  The more liquid a security is, the more more you can break that down to 2.5%, 1.25%, even .625% if you want to micromanage.  As you reach these points, all these different "proprietary" trading systems starts to converge on certain identifyable points.  The system is self reinforcing in that most traders adjust/tweek their systems when they see convergance points, which is why we look for key consolidation points to make our own adjustments.

The rule goes up as well so when I  say 10%, 15%, 20%, 25%, 40% or 50% rule (there is not 30% rule as that zone gets screwed up by Fibonacci rules), I’m talking about the same 5% rule and all that is (after we have our targets) is that we expect a 20% retrace off any incrimental move we track.  So at 1.25%, we expect a .25% retrace, at 5% we expect 1%, at 20%, 4%….  Those are bullish retracements if they hold. 

So, if we look at the S&P chart, we see a bottom at 700 (non-spike) and then a huge move up to 800 (and we do expect psychological points to offer resistance as well), which happened to be 14.5% up so we expect a retrace of 20% of that move back to 780 and that’s still bullish.  Now, here’s the art part because the S&P fell a bit more than that on Expiration Day in March but, looking back now, it’s easy to see it was a spike to be thrown out.  It’s easy to say throw out the spike in retrospect but very tough to trade on the actual day… 

We than spiked up to 832, shy of the 840 mark and then pulled back to 779.81 on a spike and then tested it again.  THAT IS BULLISH, not bearish.  That is the kind of good and healthy test I keep wanting to see up here.  Anyway, so then in April we try to break the 20% line at 840 and that’s what a bullish breakout consolidation looks like.  850 offered small psychological resistance and we never came close to pulling a retrace so not at all surprising to see 875 (25% rule and small psychological) as the next stopping point.  There was no pullback there (worrying) and the usual craziness in the 30-40% zone in May followed by a move to 946, STILL without a retrace.  

980 is the 40% up mark for the S&P and you want your upside marks to hold, not your downside marks, which is what 946 is.  Now, to be fancy though, we have a 280-point move off 700 at 980 and that means we expect a 40-point retrace, which makes 940-946 a VERY significant zone for the S&P and look where they are this month – Right where the 5% rule predicted they would be back in March

Very detailed explanation of calendar butterfly spreads from July 17th:

RIMM/Drum – OK so you are in for $10 and you sold $6.70.  Your longs are now $6.40 (ouch) and the puts and calls you sold are $7.05 – Ouch!  First of all, what went wrong?  First of all, your play, if it worked perfectly, would have left you in at net $3.30 with a $75 call (and the Aug $75s are $2.49) and a $65 put (the Aug $65s are $1.02) so you only would have had $3.51 if everything went off without a hitch.  The main problem is, by selling calls and puts that were on the money and taking your own positions out of the money, you effectively took on much more premium than your caller and putter. 

The caller or putter each had an excellent chance of being $5 in the money to you and, even if you gained $1.50 on the other side, you would still owe the caller $3.50.  Since a $5 out of the money call is not worth $3.50 on RIMM, chances are this would not work out.  Conceptually, a butterfly calendar spread is a good thing but not for selliing just one month.  With one month, starting at $70, you sold a $70 call for $3 over 30 days (.10 per day) while you paid $4.50 for 60 days (.075 per day).  BUT BUT BUT you are not taking into account that you also are $5 out of the money.  That means your effective premium is $9.50, not $4.50 and, over 60 days, you are losing .16 per day, 60% more than your caller!  

That, my friend is a dysfunctional trade!  The put side has the same problem.  The rule you violate here is that you are buying premium, not selling it.  If you are going to take up a neutral stance on a stock for a spread – you damn well better be sure that the premium math is in your favor.  Not every stock is good to do this with, you need to find a stock with lower long-term volatility than short-term and you need to make sure you have a selling plan with an excellent chance of paying off your long position, especially if you are out of the money. 

RIMM earnings are 9/24 and one trick you should use for positioning is keep your long positions behind the next earnings – that helps you maintain value.  The Dec $65 puts are $6.03 (+$3.72) and the Dec $75 calls are $8.30 (+4.18) but they allow you to sell Sept, Oct and Nov calls and puts, in addition to Aug so the total outlay is $14.33 and you need to collect $3.50 a month in premium to pay off your longs completely while your original $10 worth of puts and calls required you to collect $10 in premium in one month – which you failed to do (because it was impossible).

Is there a "fix" to this?  Well you can roll back for more money and let time do it’s work.  You can also take out the $65 putter for $1.02 (we have a rule and you already beat him by 72%) and roll yourself back to the Dec $70 puts for net +$5.90 ($5 of which you are using anyway because you are using margin) with an eye on selling the Aug $75 puts, now $5.05 ONLY IF YOU HAVE TO but mainly playing for a pullback.  Since you ended up bearish on that leg, now you need to come up with a good play on the bull side that won’t screw you if RIMM heads north and hurts your puts. 

You are in the puts for $8.70 ($5.50 original, $5.90 to roll less the $2.70 profit on the puts you sold) and we are confident that we can sell $2.50 a month in premium ($8 + $2 out of position) if we have to so no hurry there.  As we are bearish on RIMM for next week (looking for a pullback off this run and also – if AAPL has great IPhone earnings, that’s not really good for RIMM), you can keep the current spread or roll the caller up to 2x the Aug $75 calls, taking them from $2.50 in premium $2.50 in the money to $2.50 in premium $2.50 out of the money) and you can buy yourself one more set of DEC $80 calls at $6.30.  By keeping the Sept $75 calls, you knock out part of the premium and get better upside delta in case RIMM does take off but if RIMM goes down, the Aug calls completely pay for your Sept calls AND you have the Dec puts protecting you as well, which should gain as much as the Dec $75 calls lose.  Just keep in mind, on the way up, you need to sell Aug puts but you can manage your play by simply covering and uncovering the put side once you are set up. 

I hope that’s pretty clear.  This is why I stopped doing those butterfly plays last year – much more explanation than the play was worth but it’s a tactic well worth learning.  Of course, if you want to sell premium, nothing beats Google and the Jan $410 calls are $48 but you can sell the Sept $430s for $19.25 so $28.75 for a $20 spread +4 months.  You can pair that with the Jan $450 puts at $47.50 and sell the Sept $430 puts for $19, which is net $28.50 on the $20 spread.  What’s cool about this trade is that you have the $500 calls and the $550 puts so you CAN’T be worth less than net $40 in January and all you paid is $57.25 (risk of $17.25) for the ability to sell about $20 a month in premiums.  Of course GOOG is a crazy stock and could move more than $40, which is your safety zone for September but they’ve only moved $50 since April earnings and, obviously, no one seemed to thrilled with these.

It’s a really great play if you have the cash to add to and roll the longs when the play goes against you but, at net $3K per spread contract, it’s not for ameteurs.

5%/Allen – It applies to anything but the more actively something is traded (more liquid) the better it works.  So XOM, AAPL, GOOG, RIMM will do almost as well as indexes when you track them but they can be much more erratic on their way to levels too. 

2.5% – They should be yesterday’s close.  I never noticed that we’re picking up 2 day’s back.  Are you sure?

20% is 20% of the move.  There are several moves.  If you take the Dow right now we were at 6,500 as a low in March but 7,000 could reasonably be called support.  Clearly we made a new support level at 8,800 and we haven’t topped yet so there’s no spike to spike calculation.  8,800 is 33% over 7,000 and 35% above the spike low of 6,500.  We’d be looking for a 20% pullback from 8,800 and that’s 360, back to 8,440, which we kind of did in late June (note the many times we bounced off it as support).  From 6,500 to 8,800 we’d be looking at a 460-point retrace as our "spike" retrace and that would be to 8,340 and that bracketed our dip in early July. 

The question you have to ask though is "Why did we keep dipping to 8,200?" and that is answered by the much longer-term trendlines that gave us a mid-point target of 8,650, where 8,200 is the 5% rule below that.  So now we have a strong indication that 8,200 is right and if that’s right then 8,650 is the right middle (so we went long last the week of the 6th) and 9,100 is the right top.  9,100 is 30% exactly over the non-spike low of 7,000 and 40% EXACTLY above the spike low of 6,500 so to call that significant would be an understatement!

From that point we then calculate all potential 20% retraces which are 520 from 6,500 (8,580) 420 from 7,000 (8,680) and 180 from 8,200 (8,920).  Those are our watch levels for retraces and, of course, 8,650 is already a known prime point so that remains our focus for the center until we see the other points hold and give up on seeing it lower. 

The idea is simply to run multiple studies and look for conversion points and also to throw out outlying data like spikes so our real points to watch are 8,650, 8,920 and 9,100.  Today we finished just under 8,920, which was tested several times today and that would make a good inflection point to short and long the Dow at tomorrow.  Notice that the cool thing about this rule is we could have told you that 8,920 would be the breakout point to 9,100 back in November, when we first established 8,650 as our target for this year’s mid-point and as soon as we saw 7,000 hold as a bottom. 

Protection/Cwan – (I got your wiki Email by the way but haven’t had a chance to get back)  keep in mind it depends on what you expect out of your hedge for one thing.  In general, you want to spend as little as possible for as much protection as possible.  Our DIA covers are a little different because they are, through the sale of short puts, aiming to tread water while your long side gains so it’s aprropriate to cover more aggressively. 

In this morning’s ultra covers – you need to assess the potential damage of a down market move to your bullish positions and then decide how much of that damage you want to mitigate.  Ideally, let’s say you have $50K in buy/writes that are covered for a 20% down market move and will make 15% if called away.  So, in a flat to up market, you KNOW you will make 15% of 50% of your portfolio or 7.5%.  In a 20% drop, you will pretty much break even and in a 30% drop you will lose 5% AND have a lot of things put to you.  

If you want to guard against a 30% drop that will cost you 5%, you can go with the SDS play with 5% of your portfolio, which will return 12.5% if the S&P drops by Sept expiration.  If the S&P doesn’t drop, you are assuming you will make your 7.5% and, hopefully, not lose all of your SDS coverage.  If the S&P does drop, you have 12.5% cash to use to make your rolls and double downs on the plays that are put to you.  It also depends on where you are in your scale.  If you have a lot of first round entries, you may HOPE that you get a bunch of new stock put to you for 20% off, especially when you just got a bonus 7.5% cash from the cover play to help you buy round two. 

Unfortunately, like many intelligent strategies – it depends.  I know everyone wants a formula and I often have to say to people "what’s the formula for rising to the top of your profession?"  That probably seems like a silly question to you but that’s what people are asking for here – as if there is a formula or two that can be used in ignorance of all other factors to deliver some kind of miraculous performance.  As with any professional skill – there are guidlines but mostly there is practice and experience that you must work very hard at over time. 

I think the big problem is that so many web sites tell people there’s a magical secret that people kind of expect there to be one and when I say there isn’t it kind of sucks (as the truth often does).   Anyway, this is good stuff because the reason I like these new portfolios is the details of the set-ups bring about a lot of good questions and, while there may not be easy answers, there are often answers and the more you hear them and apply them over time, the more sense they will hopefully make.

DIA/Pstas – Well that’s never good, you need to be aware of your net deltas in the very least.   For example, the June $104 puts are at $6.70 with  delta of .58 and the Feb $106 puts are now $4.90 with a net delta of .85 so you will lose .28 per $1 (100 Dow points) that DIA falls.  Of course, at the 5% rule, in a vaccum, this is the correct posture as we expect a bounce now back up 100 points so you would gain that .28 if things go well.  If we head lower, you want to get at least neutral or better on delta, which means, at the very least, you need to add 1/2 the June $102 putss, which have a delta of .52 (so you will make up .26 of .28 delta differential). 

Step 2, after having identified what it takes to get you neutral, is what would you do next.  The Feb $106 puts are at $4.90 and if you are adding the June $102 puts, then we are heading lower.  That means you need to look forward to a 1.5x roll of the $106 puts and the March $101 puts are $3.10 so rolling to them would take care of $4.55 of the $4.90.  That means, if the Dow continues down, you need to commit to adding 1/2 x the June $102 puts, now $4.25 and spending another .35 to roll the Feb puts lower. 

Per yesterday’s post on this subject, you don’t have to do the Feb roll right away because, if we keep falling AFTER you buy the June $102 puts, then you will also be buying some June $100 puts (when we go 200 points lower).  If you buy 1/2 x the June $100 puts for another $5.75 then you’ll have X June $106 puts at (adding the delta x 2) $9 and 1/2 X the June $102 puts at $6.75 and 1/2 x the June $100 puts at $5.75 against X Feb $106 puts at $6.60.

The Feb $106 puts should be able to be rolled down to 2x the March $99 puts at $3.20 and THEN the question is – can you live with that spread on the way down?  At least you are good to 9,800 (because you sold the puts for $2 in the first place) and that puts you WAY in the money on the Junes. 

If you are able to go naked on 1/2 the short puts, then you can just let the June $106 puts stop out naked on a move up once you hit 2x (which would flip you bullish with the callers having a $1.60 delta and yours at about $1.20) and, again, being aware of your net delta helps you manage the position because you know that if you do stop out your June $106 puts on a move up but then it reverses again, you can either add 33% more June puts or buy back 25% of the March puts to get delta neutral (and that is AFTER cashing out your very profitable June $106 puts). 

Anyway, that’s the sort of stuff that goes on in my head whenever you guys ask me a question and that’s why I stick with the DIAs rather than flip around.   I have the DIAs pretty well internalized so I can give the answer in about 1/100th of the time it just took me to write down the logic!

TBT/Phlit – Sept $44/48 is a bull call spread where you buy the $44s for $6.90 and sell the $48s for $4.60 for a net of $2.30 so you can see where, without you guys taking the time to learn the shorthand, I would probably rather just quit making these picks than tediously write them out over and over again.  Another DD – see strategy section on scaling in.  This is how we should be buying everything.  You allocate a portion of your portfolio, which should never be more than 10% of your cash, to a new position.  Once you have determined that amount, you work backwards to your first entry so if you allocate $4,000 to a full position, you EXPECT to buy in at $1,000 (1x), $1,000 (2x TOTAL) and $2,000 (4 x TOTAL) for a $4,000 full position. 

Even if you are a trading genius of the highest magnitude, it is very, very likely that 40% of your entries will go the wrong way on you.  If 60% make 20% and go off the table, you make 12% of a 1/4 position (3%) quickly and you are done.  The 40% that go against you by 20% are doubled down to 2x at -10% and let’s say 40% come back to 20%.  Now you made 20% on 16% of the portfolio in 1/2 positions or 1.6%.  Of the remaining amount, you are 2x committed to 60% that are down 10% (-3%) vs cashed out 4.6% – It’s a self-regulating system, especially if you don’t trade idiotic stocks and ultra ETFs that are likely to move faster than you can make adjustments. 

Of course, to the upside, we’re not taking into account better than 20% gains which is another self-regulating system for non-greedy people.  Let’s say you have DISCIPLINE and never allow more than a 20% loss on a position.  If you take 10 posiitons at 10 each and one gains 50% (+5) and one gains 30% (+3) and 2 gain 20% (+4) and 3 flatline between +10% and -10% and cancel each other and the other 4 lose 20% (-8), you are still up +4 and you only picked 3 winners out of 10!

If you limit your losses to 20% of a full position, to get there 1x has to drop 20% and you DD to 2x (-10% avg) and then that has to drop 20% again (option now 40% lower than your entry) and you have STILL decided to pursue it rather than take the 2x x 30% loss (1.5% of portfolio, assuming a 10% full allocation) so you DD to 4x and now you are in a full position at a 15% avg loss.  At that point, ANY 5% downward movement is a stop out with a 20% loss of a full position (2% of portfolio) so you need to learn to be damned sure you WANT to make that last DD, which is why you usually see me advocating a roll back into a spread, rather than a DD at those points. 

Look back over a few wrap-ups and consider how vastly improved your trading performance would be if you simply cut the losers at 20%.  The first DD is easy, when we enter a straight option position, we expect a 50% chance of it going the wrong way and that’s WHY we scale in in the first place.  I want to buy the TBT Sept $44/48 bull spread $2.30 and I want a full position to be $5,000 so I buy 3 at $6.90 for $2,070 and sell 2 $48s for $4.60 ($920) for a net $1,150 entry.  If TBT head up $2 I have 3 $44s at $8.30 (the price of the $42s now) and 2 $48 callers at $5.70 (the price of the $46s now).  That’s net $1,350, more than 20% up but early in the scale and on track so I DD my calls at $8.30 for an average entry of 6 at $7.60 ($4,560) and I sell 3 more $48 calls for $5.70 ($1,710) plus the original $920 I collected is $2,630 for a net of $1,930 on a 6/5 spread. 

At that point, if my callers drops 20%, to $4.56 I will have to decide if I want to add the 6th cover, which would drop my net to $1,474, back to about a 1/3 commitment or whether to take a chance and look to take out some callers or possibly roll down my calls cheaply or some combination.  It’s kind of like chess, the more moves ahead you look the more possibilities there are and the more difficult it becomes to describe as there are also more moves your opponent (the market) can make, opening up even more possibilities.  Like chess, you need to learn to look one move ahead before you can look 2 moves ahead and learn to look 2 moves before 3 etc.  Also like chess, if you practice and practice and practice, you will get better and better at seeing those moves ahead and more comfortable making that first move, because you already see all the things that can happen for the next move or two. 

March calls @ .75 – If you don’t have the memory (or sticky-note capacity) to remember to sell the March $50s when they cross .75 then yes, put in a STOP order to sell them there but that is a FALL BACK sell.  In other words, we expect it to go higher from here and we don’t WANT to cover but we also aren’t going to be idiots and not cover if we break levels.  If you put in a hard sell at .75, you may as well sell them now for .88 as any quick spike down will trigger you anyway so why not take the .13.  WHEN IN DOUBT, SELL HALF is Rule #2 (and there only are 2 Rules, so it’s probably important) so you can put a hard order in to sell a few and let that be your alert when it drops (as in, say, what are those couple of short March $50s at .75 doing in my portfolio – oh yes, I remember…) so you can watch them more closely and decide if it’s really time to cover. 

I REALLY hope it’s obvious that, if we go up $1 and the March $51s, now .60, go over .75, that THEY become our new sell-stop and if that doesn’t trigger, then the $52s, now .45, when they cross .75 are the ones we will sell.  Each time your underlying stock moves 2.5%, it’s time to take a very hard look at what you think it will do next and adjust accordingly. 

DD Roll – Either up or the following month or 3 months down the line, whatever makes sense based on the move that happens.  If you have sold a 1/2 position (10, for example) of $50s at $1 and they go to $1.75 and you look to roll and the $52s are $1.25 – do you NEED to do a 2x roll?  No, you have a $1,750 obligation you’d like to see all in premium so you can roll it to 14 $52s even – you don’t NEED to do a 2x roll.  I can’t write a 5-page essay for every single trade, of course, which is why these discussions are good sometimes because you need to focus on the GOALS we have (selling premium, staying flexible) and, once you internalize that, a lot of these adjustments seem more obvious.

TBT/Hanna – 21% is a lot for a single position, especially if you have calls, which expire and leave you potentially with nothing.  It is possible, if we do have another financial meltdown or a 9/11-type crisis that TBT could go right back to the $30s as the Fed does another round of emergency liquidity.  If that just happens to cross the time-frame where your calls expire – what is your plan?  I would ask you the same question if 20% of your portfolio was SPY or QQQQ or AAPL or whatever – 20% is a lot of money to put on one horse…

As to playing TBT, I favor in-the-money verticals becasue it gives you all the joys of ownership without as much risk so I can have a $100,000 portfolio and allocate $10,000 to the Sept $44/50 bull call spread at $3.20 ($6,400), so let’s say 20 contracts and then sell 10 Apr $51 calls for .65 ($650) so I’m in for net $5,750.  If TBT goes lower, I will look to roll down for about .65 per $1 and if TBT drops $2, I would cover another 1/2 for another .65 and put a tight stop on the $51s, which should be down to about .40 by then.  To the upside, I can roll my Apr $51 callers to 2x the June $65s and TBT has not moved up more than $10 in two months even during the craziness so I can assume I will have time between $48 and $65 to add more long positions to cover. 

That’s a trading plan for a position.  I intend to collect at least .30 per long for 6 months, knocking $1.80 off my basis so my target break-even is $45.80.  I have $4,250 on the side for adjustments and it’s a position I’d be willing to stick with and I know I can roll to the 2012 $40/50 spread, now $5 for about $2 so I’ll keep my eye on that if things head south as I do feel strongly about my premise that rates can’t stay low forever (but they have in Japan) and, in the very least – if they do I would have a clear path to selling enough premium to cover myself in 2012.

So a adequate cash to make adjustments, a plan to reduce my baisis significantly over time and a 100% upside means I’m allocating 10% of my cash to this position, I will leave apx. $5,000 on the side and, if all goes well, I will get $10,000 back at $50, which is a 50% gain on cash over 6 months.  If all goes badly, I am willing to go a little more than 10% to push this play out a year but that is my EMERGENCY fallback position, not my starting position. 

This goes back to the whole idea of gambling vs. investing.  If you cannot be happy with a 50% return in 6 months, then you are a chronic gambler and you are bound to eventually get yourself in trouble with the risks you take.  Making 50% on 10% of your portfolio twice a year is a 10% return on your whole portfolio and that outperforms virtually any place you could possibly put your money.  If you have a DIVERSIFIED portfolio with many high-probablitly posiitons that aim to make 20-50% over 6 months and you allocate 50% of your cash overall – then you can make $15-25,000 in 6 months if all goes well. 

That is HUGE money!  The flip side is, if you mix those positions so you have some that profit from a major downturn and some that do well in a good economy but both do well in a flatline – then hopefully your worst case will be losing about 25% of your 50% commitment (12.5%) which is realtively easy to recover from.  That only works if you don’t have ANY positiion that can cost you 20% of your porfolio. 

Most people who go broke in the markets go broke betting on "sure" things – don’t be one of them.

tchayipov – May 15th, 2010 at 12:07 pm |

do you reccomend for 50% conservative buy/write without sell puts? to reduce volatility of portfolio?

50%/Tcah – I think for an established portfolio, yes.  The idea is to work your way into those positions over time and, frankly, from my perspective, it’s more than 50% because, as you wear down the basis over time, you can end up with many almost free positions that do nothing but produce an income for you. 

In other words, let’s say you have the WFR buy/write, which was selling the 2012 $12.50s for $6.70 against the stock at $12.14 for a net $5.44/8.97 entry.  So you allocate $50K to the trade and you work that backwards to being willing to allocated $25,000 to own it at $8.97 (a 2x assignment).  That’s 2,800 shares so you buy 1,400 shares at $12.14 ($16,996) and write 14 contracts for $6.70 ($9,380) for a net cash outlay of $7,616 and about $4,500 in margin. 

That’s all you do in the first 18 months of your $50K allocation, which is why, when people tell me they have large portfolios and no margin room I get deeply concerned because, if you are playing 1/2 your portfolio conservatively like this, you should ALWAYS have huge amounts of spare maragin. 

So the only way we own 2,800 shares of WFR is if we get them for net $8.97 in Jan 2012 and that’s still just $25K laid out to the position.  TLAB is a $8.87 stock so let’s use those contracts to look at what we expect for round two in WFR.  TLAB 2012 $7.50 puts and calls can be sold for $3.50 so let’s say we can (assuming we want to keep accumulating) 28 WFR 2014 $7.50 puts and calls for $3.50 against our 2,800 shares at $8.97.  Notice it doesn’t really matter whether the shares are $8.97 (down 25%) or $6.97 (down 45%) because the put/call combo would be about the same.  The sale of the 28 leaps would bring our new net down to $5.47/6.49 and our new "worst-case" outcome is that we own 5,600 shares of WFR at net $6.49 ($36,344) so even at a "full" commitment, I still have $13,656 cash left over from my $50,000 allocation.

If our 5,600 shares end up being called away at $7.50, we make $2.03 per share or $5,648 on our 2,800 shares, which is 22% of $25,116 or about 11% a year – not a bad escape for a stock that dropped 40% since we bought it.  Meanwhile, since we never triggered the rest, we had tons of spare margin to play our shorter term, margin-intensive plays that tend to do quite well.

If we do end up with 5,600 share being assigned to us at net $6.49, then we are in for $36,344 and we can (if we LOVE WFR the way I loved CROX or TASR when they were down) keep going by selling (using ENER 2012s as ENER is currently $6.38) 56 2016 $5 puts and calls for $3.90 and that drops our net to $2.59/3.80 with the possibility of owning 11,200 shares of WFR for $42,560.  Isn’t that strange, it almost would seem silly NOT to DD the number of shares from 5,800 for $36,344 since it costs so relatively little)…

So now it’s 2016 and we either get our 5,600 shares called away for $5, which is a 93% profit on the $15,022 we had left on the table or we end up with 11,200 shares at $3.80, tying up $42,560 long-term but then, if we can sell just .10 per month of calls at $5 or higher, that’s a monthly income of $1,120, which works out to $13,440 (31.5%) and in 3 years you have a free position on WFR.

If, at any given time you are working a dozen of these positions in various stages, ideally you will be building a portfolio of very cheap stocks over time.  In this example you may have just 6 positions like WFR that mature over 6 years (and the rest get called away or killed) and perhaps about $250,000 committed that are generating $80,000 in revenues, which is 8% on $1M locked in before you even begin play around with the other $750,000. 

Of course, since you are locked down and no longer need to sell puts at that point, your mature positions add to margin, rather than subtract from it and you have EVEN MORE buying power along with your very safe 8% income generators. 

So, to get back to the original question about committing 50% to these, realistically, over time, it is hoped that your $1M starting portfolio should end up with $4M of these positions and you are still working the $1M the same way you started.  If you maintain this discipline over 20 year, you are sensibly reducing your risk exposure year after year while managing your $1M portfolio every year, transitioning your winners to simple long-term income producers that are no longer part of your active portfolios other than the monthly (or quarterly) call selling. 

I know it’s very hard to think in terms of 5 and 10-year plans but notice how our very conservative plan to make 8% a year can "accidentally" end up making you millions over time.  As Sage noted – watch "The Man Who Planted Trees" –  watch it until you belive in it!  It is unfortunate that we usually talk about short-term (2012) time-frames and don’t spend enough time on the big picture.  Perhaps that’s one of the things that make some people so impatient.  It’s fun and exciting to play for big money but that should be for the money you can afford to lose.

What does "afford to lose mean?"  If I have $1M of mature long-term positions that are generating $300,000 a year on option sales and I only need $200,000 to live on then I have $100,000 that I can afford to lose.  That then determines the high-risk portion of my remaining portfolio so even if I have $2M in cash and short-term posiitons, I should only be allocating $1M to Sage’s mix above and the other $1M should remain in cash or something ultra-safe.

If, on the other hand, I didn’t need any of the $300,000 to live on because I’m still producing another income then I can afford to lose the whole $300,000 in any one year and I can put $300K into levered plays and $1.7M into the rest.  Obviously, if you do lose $300K, you need to re-allocate to something much safer with the remaining $1.7M but all you need to do is wait a year for the safe $300K to come back and then you can be off to the races again. 

So your penalty for taking a hit in a well-managed portfolio is a forced "time-out" from trading. 

exec (premium)
September 4th, 2010 at 1:19 pm | Permalink 

Phil
I’m in the middle of a lake attempting to type on a cell phone so please excuse any typos. 

I was studying you comment from yesterday and previous postings regarding covered call and buy write strategies and I have a few questions. 

First off it occurred to me that I don’t fully understand your buy write strategy.  Is there anywhere on the site that explains the concept? 

The covered call strategy is pretty straightforward, you buy a security and sell calls.  If the stock is taken away, you profit from the premium plus or minus the intrinsic value, or the option expires and you keep the stock and make the premium.

Now, your post yesterday indicated the it’s rare that everything goes perfect. I thought the worst case scenario would be that the security tanked, and your stuck holding a stock that is worth less than your basis, and you could potentially have it called away for a negative net profit if you sell another round of calls.  Is there any other downside risk that you are aware of?  Having not sold covered calls before, is it common to have the worst case scenario play out when implementing this strategy?

Getting to your buy write strategy, from what I can decipher, you buy less stock than you would if using the CC strategy, then sell calls and naked puts. The questions are:   What percentage of the security would you buy?  I’m assuming half. So then you sell the calls and sell puts. Again, I’m assuming that you would sell enough puts that it would double your position if the security was put to you. So is this the general premise of the call write strategy?  If so, then the best case scenario would have both options expire worthless and the worst case would have the market dropping and being stuck with double the security. Correct?

Do you always use leaps with this strategy?

What is the next step in this strategy after the security is put to you?

Please explain what your talking about when you refer to having to roll.  I see a lot of comments on the member chat about rolling but don’t understand the concept. 

Finally if you could lay out a typical buy write example using one of your dividend recommendations with the current option prices, I’ll try and developed a spreadsheet that makes it easy to follow the strategy and track the profitability of the trades. 

I just read you morning post and it raised another question:  I’m tired of day trading and sitting cash at the moment. I’m ready to start building a long term, relatively maintenance friendly portfolio. What is the foundation of your portfolio, buy/writes? 

I’m sure you’re tired of these newbie questions but any information would be appreciated. 

Buy/writes/Exec – Hopefully you read the linked post and that helped.  More than anything else, a buy/write enforces a discipline of commitment to the position.  As I pointed out in the numbers in the earlier comment, no, there is no particular danger to selling a covered call and it is infinitely better to sell them, on the average, than not to – I was merely attempting to point out the disadavantage of the covered call to the buy/write.  Of course it’s rare that everything goes perfectly – I would hope that is a given… 

As to the percentatges, see the Strategy Section notes on scaling in.  The trick is to allocate a percentage of your portfolio to a postion and then work your way backwards to an entry.  Of course, you may be more confident with some than others like if my allocations are $20,000 each, I may choose to commit $2,500 or less to HOV, which is inherently risky but $10,000 to PFE because I want to get my dividend and I don’t mind A) ending up with $20,000 at a 20% discount or B) ending up with $40,000 at a 40% discount if push comes to shove. 

The most important thing about a buy/write strategy is (if you stick to blue chips that follow the S&P) that you KNOW how much you will make at what index strike (obviously with minor variations).  This makes it VERY easy to hedge and, more importantly, not to over-hedge.  Since we hit our buy/writes at about 1,045, 9,600 with 20% entry discounts we KNOW we make 20% at about those levels and we KNOW we don’t lose money until 836, 7,680 (20% lower) so we don’t really even have to worry about any major hedging until we are halfway down and just a light Disaster Hedge when we fear going below those lines is sufficient to cover us. 

Don’t foget, NOT LOSING MONEY when the whole market goes down 20% is as good as winning in the long haul.  If I buy $10,000 worth of PFE at $16.50 (600 shares) and sell the 2012 $15 puts and calls for $4.70 then I’m in for net $11.80/13.40 with a 27% gain if called away at $15 (10% down) or I end up with 1,200 shares at an average of $13.40 ($16.080).  So my commitment is to own 1,200 shares of PFE in Jan 2012 IF they drop 10%, below $15 but I don’t LOSE anything until fall below $13.40, which is 18.5% below the current price. 

So, if the market drops back to 836, 7,680 and PFE falls 20% along with the rest of the stocks (and we’re ignoring the dividend) and let’s say it’s at $13, which is around where it bottomed in ’09, other than the spike down, then I’m down 1,200 x .40 or $480 – EVEN WITHOUT A HEDGE (and ignoring the dividend).  While it sucks not to have made any money for 17 months, what’s the reality?  I still have 1,200 shares of PFE which I can sell for $13 and that’s $15,600 cash when EVERYTHING is on sale for 20% off.  Maybe I stick with PFE or maybe I flip to AAPL at $85 – who knows but if you can keep a portfolio EVERY YEAR that can withstand a 20% market drop without losing money – you will be beating the markets over time.

Keep in mind the big difference with a buy/write, aside from the fact that you don’t need to mess around with it, it that you make 20% EVEN IF THE STOCK IS FLAT.  How HUGE of an advantage is that in your investing?  While that is also the case with covered calls, you are simply not as well protected to the downside on a month to month basis and you do not lock in the 20% gain if the stock jumps 10% in a certain month and stays higher or gyrates up and down outside of your covered range.

Answering other questions in the multi-part essay:  No, we don’t always use leaps, sometimes we feel we are adeqately covered with shorter-term play.  With PFE, perhaps I would sell the Jan $16 puts and calls for $2.20 because I REALLY don’t mind owning 2x PFE at net $14.26/15.13 in 5 months or making a quick 10% if called away.  It’s riskier but I would say that, if put to me at net $15.13 THEN I would sell the 2012 $15s for maybe $3.50 to drop me to a potential 4x entry at net $11.63/13.32. 

So that anwsers both the next step and the rolling question.  The next step is deciding what you want to do if the stock is put to you.  You won’t know the answer to that until you know the actual price of the stock at the time it’s put to you although having a plan with expectations means you have an early warning system when you are "off track" so far in advance that you shouldn’t get caught in a poor outcome too often.   Rolling is just shorthand for taking one option you sold and cancelling it and replacing it with another, usually longer-dated contract.  Rather than saying "If PFE is at $15.50 we would owe the $15 caller .50 and the $15 putter would expire worthless so we would then buy back the $15 caller for .50 and then sell the 2012 puts and calls for $3.50" it is much easier to say "If PFE is at $15.50 we can roll the caller to the 2012 $15 puts and calls for net +$3."  Like any profession, option trading has some "lingo" that experienced trades can use to communicate concepts efficiently. 

Yes the foundation of a portflio is buy/writes.  Look at the market and imagine that every year for the past 10 years you had simply allocated 50% of your portfolio to trades that made 20% if the market was flat or up and you compounded that every year.  That’s why if you look back at our Buy Lists in the Portfolio section, you’ll see them dominated with this strategy.  Since the strategy forces you to hold a good deal of cash, there is plenty of money to day trade when you WANT to but you don’t NEED to because half your money is working for you every single day, driving towards a conservative, obtainable goal.  

That takes a lot of pressure off!