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Wednesday, June 7, 2023

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Stupid Option Tricks – The Salvage Play

I often talk about stupid options tricks in member chat and I thought it would make for good weekend reading.

Today we'll look at salvaging bad positions, something that comes up once in a while in any virtual portfolio.  Not everything has to be buy, hold or sell with options – there is always hedging and there is always an option!  Since many of us are short on USO and not happy at the moment, I thought we'd focus on various salvage strategies for positions that go against us but, before we get into that, I did promise we'd discuss scaling, and the two do go hand in hand

Scaling into a position is always a sensible strategy, we can't be right all the time with our entries so we need to plan ahead for being wrong.  Also, we need to plan for our position going against us tomorrow, next week or next month.  Ideally, you should never be in any position that risks discomfort if you lose it.  If you have a large virtual portfolio, it's good to keep most of your positions under 2%.  If you have a medium virtual portfolio, 5% and, if you are in the $50,000 range or less, it will be hard to avoid having positions that are 10% of your virtual portfolio and that's where scaling is even more important so we're going to focus on the small entries and I'll assume the big boys can multiply by 2-10 by themselves.

$50,000 is not a small amount of money and we can assume that, if that is your stock virtual portfolio, that you worked hard to make it and you would rather not lose it.  This is all the more reason to take a more conservative stance with your positions.  As I said, you don't want any position to be more than 10%, or $5,000.  That doesn't mean it can never happen, but you need to treat anything over 10% as "uncomfortable" and look to reduce it when there is a good opportunity. 

When entering a new position, we want to be ready to be wrong.  Sun Tzu said: "Strategy without tactics is the slowest route to victory. Tactics without strategy is the noise before defeat."  We made a nice profit on Tuesday morning on USO puts we had held over the weekend.  $32 puts we had at .80 from Friday were sold at $1.05 Tuesday morning.   That was a nice, quick 44% profit – TACTICS – we take the money and run!  Our strategy was to reenter if oil spiked back up on the OPEC meeting.  At 11:15 I said: "I’m offering .80 for those same USO $32 puts again but no takers yet.  Early scale, looking to buy more at .60 or roll up."   That is our STRATEGY, to reenter the same position with a nice gain already under our belt.  So what does early scale mean in that context? 

If your maximum allocation for a position is $5,000, you generally want to commit to no more than $1,000 on your first round.  20% is a good rule of thumb for scaling in on any size virtual portfolio and it very much depends on whether or not you can afford to double up your full position in the end.  If you have a $50,000 virtual portfolio and are already allocating $5,000 (10%) to positions YOU CANNOT double up to 20% if you get in trouble.  That is just NOT a good idea – ever.  If, however, you have a $500,000  virtual portfolio and you allocate 2% to each position ($10,000), then if you need to, it is no big deal to move to 4% so you can afford to be a little more cavalier when things don't go your way (although stop-loss discipline is good for everyone). 

The Actual Book - Well, a reprodcuction of it but very cool!Again Sun Tzu is helpful here as the General said: "In respect of military method, we have, firstly, Measurement; secondly, Estimation of Quantity; thirdly, Calculation; fourthly, Balancing of Chances; fifthly, Victory."  Measurement is the size of our virtual portfolio and our risk tolerance, it is an assessment of our total military strength.  Estimation of Quantity is how much capital we can allocate to each battle (position).  Now we can talk about Calculation:  With a $5,000 position allocation, one thing you need to be acutely aware of is that you have a strict upper limit.  It means that you do not want to lose more than 20% of your full position ($1,000) on the trade and it means you have to allow for being wrong on your entry, having to double up or roll (or get out) on your first 20% loss and then being wrong again and having to double down or roll (or get out) on your second 20% loss.

In a vacuum, think of it as spending $1,000, dropping to $800 (20% loss, $200), then doubling down to $1,600, then losing 20% of that ($320) at which point you have lost 1/2 of your full position's max loss ($520, 10%) and you are faced with a very serious decision.  You have put in $1,800 and now have $1,280 worth of contracts that are down 20% from your last entry and the position is off about 40% from where you started.  Do you still stick with it?  If you still like your premise and think the run against you will reverse AND you have enough time (be realistic) to be right, MAYBE you commit another $1,280 to double down yet again.  That puts you in for $3,080 and your options are worth $2,560 but you have just $480 left to lose (18.75%) before you MUST pull the plug. 

 

Notice that this is a self-regulating system.  You intended to put $5,000 into a position but it went against you so you CAN'T put more than $3,080 into it but you have purchased 4 rounds of contracts that you were going to pay $1,000 each for for just $3,080.  You've gotten a 25% discount on your entries and you still have 18% left to lose so that's a 43% buffer built into your initial entry!  Now, starting back at the beginning, if you enter a position and it goes 43% against you – shouldn't you be pulling the plug by then?  Luckilly, with this system, we have three "brakes" where we are forced to re-evaluate BEFORE things get even that bad.

To recap:  20% loss on $1,000 ($200).  We generally are pleased to get a discount and buy another round unless we entered at a resistance point with a clear stop in which case we take our $200 loss (1% of a full position or 0.1% of the full virtual portfolio) and shut down the trade.  If we bought 2 contracts at $5, we are buying 2 more at $4 so we have 4 at $4.50, 10% less than we were willing to enter at originally.  We are, of course, still down .50 (11%) against our averaged $4.50 entry but we are now resetting our 20% rule to 20% of $4 or $3.20. 

Balancing of Chances: AT THE POINT WHERE YOU CONSIDER MAKING THAT SECOND INVESTMENT ($800), you MUST be willing to see the position drop to 4 contracts at $3.20 ($1,280), down $520 of the $1,800 total that you will have invested.  BEFORE you make that 2nd investment, you should know what you are going to do when you get to that point.  If the answer is "give up," then perhaps it would be smarter to NOT make that second investment, either take your $200 first round loss than and walk away OR take that $200 loss but say "IF it goes to $3.20, THEN I will reenter and IF it goes back to $4.50, I will buy my next round then."  If you hold your 2 20% ($200) losing contracts (and always we are assuming you feel you have a reasonable amount of time and that your target is still valid) then a drop to $3.20 will "only" cost you $360 (36% of the $1,000 but just 7% of a full position and 0.7% of your virtual portfolio).  At that point, you re-evaluate (of course) and, IF you decide it's worthwhile you can roll (a discussion for another post) or double down yet again. 

Doubling down to 4 contracts by buying 2 more at $3.20 gives you an average entry of $4.10 so you are in for $1,640 and your 4 contracts are worth $1,280 (-$360, down 21% on cash in and down 7.2% against your full $5K).  At this point, need to be looking ahead to your THIRD AND FINAL investment, which would occur 20% lower at $2.50 (rounding off), 50% down from where you started.  When you pay $640 for the next 2 contracts, you should be PLANNING to pay $1,000 for 4 more at $2.50.  Again, here's where we have a good feedback loop.  If you can't see yourself having the faith to put in another $1,000 for 4 at $2.50 – WHY THE HELL WOULD YOU BE BUYING 2 AT $3.20? 

Each time you add capital, you need to look at the entry as a brand new position.  Putting money into a position JUST because you are losing money is like coming home to find your house burning and running to the furniture store to buy some new stuff to throw in there to keep your old furniture company or hitting and rolling up a losing position JUST because you are losing money is like having your cruise ship hit an iceberg and, while it is sinking, paying to upgrade yourself to a first-class cabin – you may be the last one to go in the water but you'll be underwater just the same!  When your ship hits an iceberg you need to rationally evaluate your position – perhaps at this point it's best to get whatever refund you can on your cabin and purchase a seat on a life-boat?

Victory: We've discussed all the ways we can lose and defeat is something we take when we lost that $1,000 but what constitutes victory?  As a rule of thumb, we are always looking to make 20% over the term of our position for non day-trades on options.  If you don't think you are going to make 20%, since you are risking 20% – the trade is probably not a good idea in the first place as your risk/reward is negative.  EVERY TIME you add money to an existing trade, you MUST see a clear path to a 20% gain or GET OUT – your house is burning and your ship is sinking – TIME TO GO! 

So from our 3 theoretical entries, $5, $4 and $3.20, we have average cost basis(es?) of 2 at $5, 4 at $4.50 or 8 at $3.85.  At point 2 we are down 11% and at point 3 we are down 17%.  Master Sun Tzu says: "He who knows when he can fight and when he cannot will be victorious" and "The general who wins the battle makes many calculations in his temple before the battle is fought. The general who loses makes but few calculations beforehand."  Obviously, setting stops once we hit our +20% is the easy road to victory.  I will point out here that this strategy leads you to many instances where you will make 20% of your first $1,000 ($200) and that is the end of your trade.  Making $200 is 4% of your 10%, $5,000 commitment and it takes just 5 of these "little" victories to bump an entire $50,000 virtual portfolio up 2% for the year.  When we make 20% so fast we didn't have time to build the position, it is NOT a bad thing – yet many, many people treat it like it is.  See also, our Strategy Section for scaling in on the way up. 

The calculations we make change once we are behind.  Again, see the strategy section for what to do when things are going really well, this is an article about what to do when things are going badly!   Since our overiding goal is to get 5 $200 wins, our main goal on every trade is simply to avoid taking losses.  If we make a poor entry in step 1, we lost $200 and if we kill the trade there, we wipe out one winning trade.  If we decide to press on in step 2 and add $800 more dollars, as I've said we are down 11% at (in the above example) on 4 contracts at $4.50 each ($1,800) and we have a new goal – GETTING EVEN.  The minute your trade turns negative on you it means YOU WERE WRONG.  If you go into that house and find the living room on fire, do you go to the kitchen and sit down for lunch or do you get out?  If the boat is sinking and your cabin is underwater, do you upgrade to first class or do you get out?  In both cases you are lucky to escape with your life – why should you not treat escaping with your cash the same way?

The general who advances without coveting fame and retreats without fearing disgrace, whose only thought is to protect his country and do good service for his sovereign, is the jewel of the kingdom – Sun Tzu, 600 BC

Options (not unlike stocks these days) bounce around a lot.  Up and down 20% is no big deal for option contracts and our job is to try to catch more ups than downs.  Note that when I say get out, I don't mean get out the second you hit your goal.  Generally, I like to set stops (not hard stops, mental stops) at 20% OF THE PROFITS.  Of course, if you have a contract under $1, when you make 20% your stop is $1.15 (assuming no penny increments) and at 40% your stop is $1.30, at 50% $1.40, etc…  You also need to "know" your contracts.   If it's a wild, bumpy contract like USO (ha, I bet you thought we'd never get back to that!), you may want to give it more leeway.  If it's a slow grinder like UYG options, you may decide to just get out at $1.20 and not chance a pullback at all (assuming you don't really think it's about to break higher).  So this is not a "rule," it always depends on the situation but, going back to our generic example, once you are into your 3rd round commitment, when you already have $1,800 committed on 4 contracts that are now down (at $3.20) 28% ($520), YOUR GOAL IN THE TRADE NEEDS TO SHIFT TO GETTING EVEN. 

At this point, AFTER we had decided at $4 that we wanted to DD because (although we were 20% wrong on our initial entry) we still felt good about the prospect of the trade getting back to $6.  Keep that in mind at $4 BEFORE you double down.  You have only lost $200 and you were already WRONG on the entry.  Now you need a 50% gain just to get to your $6 target.  Is that REALLY still your target?  REALLY?  REALLY???  OK then, so you are gung-ho bullish on the position and you put up another $800 to double down.  This is a very legitimate strategy.  In fact, if you play blackjack properly, they will tell you that you MUST double down WHEN APPROPRIATE in order to win the game over the long haul. 

In blackjack, it is very easy to see when it is appropriate as there are clear rules:  If the dealer is showing 4, 5 or 6, you double down on 9,10 or 11 – that's the very basic rule.  Why?  Because the dealer must hit on 16 or less and he busts on 22 or more and there is a 6/13 chance he has an 8, 9, 10, Jack, Queen King, all of which would put him in a poor positon as he must take another hit with 12-16 at which point he has a 4/13 chance of drawing a 10, which will bust any of those cards and then various other statistics that boil down to the odds being slightly in your favor that the dealer will bust.  Since you CANNOT LOSE on your next card if your first two total 9,10 or 11 – it is STATISTICALLY RESPONSIBLE to make a bigger bet in this situation.  You will still lose 47% of the time but that 3% is the difference between winning and losing over the long haul.  MOST OF THE TIME, however, you DO NOT double down – keep that in mind as well!

Our option plays are the same way.  We have to place a bet to play the game.  Unlike blackjack, we are allowed to count the deck.  We can watch the "game" (the position we are interested in) play out and, when we think the "cards" (momentum, sector movement, newsflow, pivot points, resistance zones, chicken bones, tea leaves…), are in our favor we take a seat at the table (our initial entry).  Once the cards are dealt, we look at our hand (up or down 20%) and we get to peak at one of the dealer's cards (reassessing momentum, sector movement, newsflow, pivot points, resistance zones, chicken bones, tea leaves…) and decide if we are going to stick with our original bet ($1,000 in the above example) or, WHEN APPROPRIATE, double down. 

WE DON'T double down with bad cards on the table.  If you could play blackjack and walk away from the table with just a 20% loss whenever YOU were dealt a 13-16, you would own the casino!  That's because your wins are 100% gains and you will have taken the situations where you have a 53% chance of losing 100% and only lost 20% but you have taken the situations where you have a 53% chance of winning and doubled down so you win 200% while losing only 20% when the bad cards are in your hands.  All you have to do is break even on the "normal" hands (when neither you or the dealer have an obvious advantage) and, over time, you will do very, very well.  Casinos don't let you do that, of course but stocks and options do!  Unfortunately, there are very few doubles so it takes a lot longer to own the casino but, if you are both patient and disciplined, you can do very, very well here too. 

The man who begins to speculate in stocks with the intention of making a fortune usually goes broke, whereas the man who trades with a view of getting good interest on his money sometimes gets rich. – Charles Dow, 1895

So, we have our 2 contracts at $5 each ($1,000) and we took a 20% loss.  We look at our cards and decide if we are going to fold or if we are going to double down (which would give us 4 contracts at $1,800) or if we are going to wait.  As I said above, the easy "system" here is to wait with 2 contracts for either a rebound to $5 WHERE YOU NEED TO MAKE A FRESH DECISION TO GET OUT EVEN OR PRESS ON or hold the 2 contracts for a test of $3.20, where you would be down $360 on 2 contracts.  Keep in mind these are simplifications as your decision point can also be stock pivots, resistance levels, earnings reports, whatever – the main idea is you take action (or not) based on the new expectations at each level.  Also, you don't make secondary entries at an exact spot but again, when the momentum seems favorable – the 20% rules are more guidelines to say FOCUS YOUR ATTENTION HERE.

In the case of being down 20% and deciding to wait, perhaps because all momentum is going against us BUT, we think the momentum is wrong and will reverse AND we think we have enough time to recover AND we don't see a benefit to taking off that first position.  Hmm, it almost sounds like we're talking about the USO trade now doesn't it?   Not yet…  By waiting at step 2, we now have our 2 contracts at $1,000 and (if we decide to stick with it), 2 more at $640.  That puts us in 4 for $1,640, averaging $4.10 each with the stock at $3.20.  If we REALLY think it's a bottom, we could buy 4 more at that point as we'd only be in for $2,280 with 6 contracts ($3.80) and down 20%.  What drives our decision here is our desire TO GET EVEN, not to "win" the trade.  Our plan is to have 6 at $3.80 with the stock at $3.20 because we expect a 20% recovery.  Once again, not to repeat myself but –  If you don’t think you are going to make 20%, why would you be putting more money in at all?

So we are adding $640 or $1,280 to our $640 losing position because the $640 losing position has to gain 56% just to get even (pretty hopeless) but, with the contracts at $3.20, 4 contracts at average $4.10 need 28% to get even and 6 contracts averaging $3.80 need an 18.75% move up to get even.  18.75% is just a  33.5% retrace of the loss from our entry – that seems doable!  Notice at no point here are we more than 50% invested and we are dealing with the same $360 (out of $1,000 max) loss AT THIS POINT, no matter how many contracts we add.  Again, Sun Tzu offers mathematical guidance:

It is the rule in war, if ten times the enemy's strength, surround them; if five times, attack them; if double, divide them; if equal, be able to fight them; if fewer, be able to evade them; if weaker, be able to avoid them. – Sun Tzu

What are we doing in this strategy?  If we are very strong (certain) we add to our position and let the winner run (surround).  If we are fairly strong (confident, but not certain), we add to our positon with caution.  If we are down but willing and able to commit more (double), we divide the losses (divide) among more contracts, reducing their advantage over us and giving us a shorter path to victory.  If we are in trouble or very uncertain but determined to stay engaged (fewer) we may roll our position or simply hold on for the next level (evade), at which point we hope more information will be revealed to us and we can make a better decision and, finally, if our back is against the wall and we are at our loss limit (weaker) then both Sun Tzu and Kenny Rogers tell us, "you have to know when to fold them" (avoid).

Keeping very much in mind then that our goal when we are behind is simply to get even and either reduce or exit our position entirely, let us now discuss THE SALVAGE PLAYS:

In all fighting, the direct method may be used for joining battle, but indirect methods will be needed in order to secure victory. – Sun Tzu

When we left off, many paragraphs ago, we had taken the USO $32 puts for .80 again after coming out .35 ahead off our Friday play.  Our first adjustment came at 2:52, when I said to members: "USO – Gave up on waiting for .60 and took DD on $32 puts at .65. "  It turns out I was impatient, I could have gotten .60 but I had followed my own advice and take a small position earlier so (and bear in mind this is an example based on the $5,000 limit, not my own sizing), from an initial light entry of $480 at .80 (6 contracts), I added 6 more at $390.  We had EXPECTED USO to go higher but the early, small entry was, to one extent, a placemark to watch the trade and to another extent, a consolation prize in case I was wrong and USO tanked – so I wouldn't have missed the entire move down.  That left us with (in theory!) 12 at .725 into the close.

The next morning, not very surprising, USO moved up ahead of the OPEC meeting and we followed-through with stage two of our plan and my 9:40 comment to members was: "Rolling USO $32 puts to $33 puts for .20 if possible but will also be willing to DD at .50.  XOM has a shareholder meeting to day, that will be interesting…  Oil may keep running into OPEC meeting tomorrow as minsters keep talking up the market but it’s very unlikely they can support $63 a barrel and there is a lot of speculative money in oil looking for them to do just that."  At 12:16, My comment was: "I’ve done a DD at .50 and I’ve got an order to roll up for .20 to the $33 puts so stopping out is not in the plan.  My basis is .61 and .20 more would be .81 in the $33 puts, which are now .75 so I’m not even concerned yet.  This was a scale-in play and would have been disappointed if all I had was the small, initial position."  Keepin up with the math, that's now 12 more at .50 ($600) for a total of 24 at $1,470 or .6125 per option. 

It is said that if you know your enemies and know yourself, you will not be imperiled in a hundred battles; if you do not know your enemies but do know yourself, you will win one and lose one; if you do not know your enemies nor yourself, you will be imperiled in every single battle. – Sun Tzu

Going back to our lesson, as we were being contrarian in step one (know your enemy, know yourself), we take a half position so 1/2 of our usual $1,000.  Since contracts are in 100 option blocks, 6 for $480 was our closest entry (and, when you have to choose, go lower!).  Step 2 was a given because we intended to fill at a lower average and we ran it down to .725 on 12, which bought us close to our Day 1 goal of $1,000 with $870 committed.  Note that if I had bought 12 contracts at .80 right off the bat, I would have committed $960, a 10% difference on our first day!  Day 2 gave us the opportunity to buy more at .50.  I put in for the roll first but it wouldn't fill for .20 with and I couldn't get the .50 round 3.  That gave me 2 critical pieces of information (remember, we always want to see more cards):  1) That there was little interest in selling me $32 puts for .50, so my "value" was firmly $600 on the 12 I had.  That means that I should be happy to get some more at .50 (barring new negative facts on the trade) and  2) That the $33 puts I wanted to roll to did not want to take .70 for their contracts

Since I was already in 24 contracts for .6125 and was planning on paying .20 for a roll to the next level (.81 net) then there was no reason for me not to DD at .50 first and then roll as it lowered my net entry on the $32 puts to .55625 per option, which is what I'd have to pay to buy more anyway and it would lower my net entry (after a .20 roll) on the $33 puts  to .75625, which is what I would have to pay to buy them anyway.  So after having my first 6 contracts drop from .80 to .55 (31%), I was in a position where I had good expectation of having either (as I had both offers working at once) either 48 $32 puts at no more than .05625 (11%) off the mark OR 24 $33 puts at no more than .05625 off the mark OR 48 $33 puts at no more than .05625 off the mark.  The day ended with just the DD at .50, the roll did not fill so, Day 2 = 48 at net .55625, $2,670 committed.  Had I bought 48 at .80, that would have been $3,840 – scaling in gave us a 30% discount and kept us in the game!

As the Wednesday inventory report didn't bother us (and members know I was checking and rechecking facts and figures for my premise on this one all night, as I often do if a trade moves against me) and the pre-market OPEC comments didn't phase us, my Thursday 9:38 comment to members was:  "Still loving USO puts here.  The $35 puts are cheap at $1.30 but always scale in with oil as they could get to $65 for no reason at all."  Here I am committing to a new trade on the same track.  I could have just rolled up what I had for .75 per option but that would have been $3,600 more (in the example) and that would put the position over the limit.  This is not impossible to do but starting a new track on the $35 puts opens up a salvage play we'll discuss further down.  So now we have a new play of 4 contracts at $1.30 ($520) on the $35 puts. 

Before we get too excited, it's Important here to note what I told Red at 9:50: "USO is the proxy to oil and they are great to short as they lose money over time whether oil goes up or down (high churn rate).  If you want to play along, go with the USO trades I post but always treat them like crap shoots as oil trading is totally fixed and you are at the mercy of manipulators half the time."  It is VERY important to differentiate your risk levels when trading and allocate capital accordingly!  When I talk about "craps" plays, I mean that at no time should you have more money in the play than you are willing to lose on a roll of the dice at a craps table.  We are doing this example as if it were a full, conservative trade for education purposes.

He who is prudent and lies in wait for an enemy who is not, will be victorious. – Sun Tzu

It took until 1:33 but I said to members: "Finally got my roll-up for .20 to USO $33 puts, offering .20 for the roll to the $34 puts next."  So that cost .20 x 4,800 contracts or $960 to move the $2,670 worth of $32 put contracts up to the $33 puts for a total of .75625 per option in a contract that was, tragically, just .50 (down 33%).  My comment at 2:06 was: "Check out the hour chart back to last Mon-Weds on USO and compare that to this Tue-Thurs – pretty much the same so I’m hoping for same tomorrow as last Thursday (gap down) but we need to take that money and run as it didn’t last long.  We can assume they are holding oil up until the 2:30 NYMEX close but if they don’t pull back off $65 after that, I will begin to be concerned…..  "

Where the army is, prices are high; when prices rise the wealth of the people is exhausted. – Sun Tzu

At that point (after 2:30 with no pullback), I made the classic mistake of ignoring my own resistance point with a fairly full ($3,630 out of $5,000) position and I could have gotten out for $2,900 (down $730) and walked away.  This is a classic example of "do as I say, not as I do," advice my parents often gave me but I didn't understand until I became one.  As the $33 puts were a "dead" trade (no point to additional adjustment other than the roll, which would be another $960 to get to the $34 puts), my concentration turned to my $35 position and I said in our 2:44 Alert:  "As this run-up in the market is just silly, we’re playing (lightly) for a poor GDP report in the morning giving us a bad open but it’s speculation at best.  On oil in particular, I do not think $65 is fundamentally supportable and I would stick with the USO $35 puts over the weekend but our goal is to make 20% and get out and we expect to make that tomorrow morning."  The very sad chart for the $33 puts was this:

Meanwhile, the $35 puts were faring little better, having come down from $1.30 to $1.05 already but that was (as the $33 puts once were) a light entry so it was desirable to DD on those to 8 contracts.  That left an average entry on the $35 puts at $1.175 per option on 8 contracts ($940) so mission accomplished on our new trade.  By the way, is it wrong to have 2 trades on the same position like this?  Generally yes but it depends what your other hedges are and what your exit strategy is.  Don't forget we have long-standing UNG calls that are doing fantastic as well as our tanker plays so oil puts are not a terrible hedge overall.  Also, keep in mind that in a larger virtual portfolio, we're talking less than 2% in position A and not even 1% in position B so not anywhere near overexposed – YET!  Still, for the purposes of this example, we will treat this trade as it should be in a more limited virtual portfolio…

On Friday, I put out an alert with adjustments to our OIH and USO trades: "On the USO $35 puts, if they retest $36.50 and you can DD at .75 (where we opened) I like that play as your avg would be $1.03 at .75 and the delta is .35 so a $1 pullback and you’re even."  We missed a fill at .75 and the puts ran up to $1.05 at 1:45 but then came back down as we got the usual pump into the NYMEX close.  That had me give up on .75 and say to members at 2:38: "Short on USO into the weekend (now is the time to DD as the NYMEX just closed but with tight stops on the new 1/2) and MAINLY cash until we see some data."  That is another factor by the way, since we don't really have many other positions, we can afford to play a little loose with our 10% allocation rule as we're not crowding out other trades.  So the tally now would be 16 $35 puts at an average entry of .9875 with the contracts trading at .80 so down 19% on $1,580 committed.

One defends when his strength is inadequate, he attacks when it is abundant. – Sun Tzu

We were not too worried about that play because we had an easy cover.  I had said to Smasher at 1:22 (before doubling down): "If you are concerned over the weekend you can put a brake on your exposure by selling 1/2 the $36 puts, now $1.25.  Since they pay you more than the spread, it shouldn’t be a margin issue and since you intend to buy more puts, if they start heading down you just buy more to increase your delta and drop your covers when you are ready.  I’m going to be staying naked on USO puts over the weekend but it’s not something I would recommend for everyone.  The most important thing about scaling in is KNOWING what your next 2 moves will be.  In other words, you are in at $1.20 and if you DD at .80 you will be in for $1 and down 20%.  What do you do next?  At that point I would 1/2 cover with the $36 puts that have a .47 delta and mine is .36 x 2 (although both would be lower at .80) and I would have the putter’s money, which is plenty for me to buy another round of the $35 puts at $1.20 or less when things move my way.  If things go against me, I can sell another 1/2 the $36 puts so I’m fully covered at about $1.10 with my puts at .70 (these are all estimates but this is where it’s good to internalize your greeks) and it costs me about $1 to roll to the July $35 puts so that would be my escape plan which would buy me another month to be right and I can wash, rinse, repeat until oil agrees with my position."

So, clearly I had a plan to salvage the position but what the hell was I talking about? 

Well, Salvage Play #1 is one of the main reasons we roll vertically.  If we roll vertically to keep near the money, in this case to the $35 puts with USO at $36.40, we can, pretty much any time we want, turn it into a vertical (in this case a bull put spread) to stop our own losses as the trade goes against us while taking on very little risk on a reverse.  In the case of the USO $35 puts – they have a delta of .33 at .80, meaning they move .33 for every dollar USO moves.  The $36 puts, now at $1.20, have a .43 delta.  If we were to 1/2 cover with the $35s at $1.20, we would collect .60 per .9875 we had laid out and we will have covered 2/3 of our delta.  Obviously, you can adjust your coverage to suit your move, using the $36s you sell like gas and brakes on a car – the same kind of stopping discipline we use for our own positions applies to the positions we sell.

Another nice thing about moving to a vertical is you can leave it overnight to put yourself into neutral and, if we suppose USO goes up $2 on Monday, then the $36 puts would lose about .85 while our $35 puts would lose .66.  If we had gone for a 1/2 cover, we would be able to (assuming we actually thought $68 was the top finally) buy back the $36 puts for .35 and we would keep 8 contracts x .85 or $680, which would either reduce our basis to $900 on 16 contracts or .5625 per option although presumably, the contracts would be worth just .25.   The good news is we can then roll them up to the $36 puts for about .15 more ($240) and possibly .20 more for the $37 puts ($320) and we're in 16 $37 puts that are trading right now for $1.70, for net .9125.  Logically, if they can drop .79 in a day, they can come back .79 in a day and we would need far less than that to get ourselves back to even.

If we do not get a violent move, there is another interesting  way to play our position.  Remember those 48 damn $33 puts that we are ignoring as we hope for a pullback?  Well, as I often tell members, hope is not a strategy but butterflies are literally free sometimes.  This is why I like the setup of the $35s after getting blown out of the $33s:

  • We have 48 $33 puts at an average of .7562 ($3,630) and they are $3.40 out of the money at .40 ($1,920).
  • We also have 16 $35 puts at an average of .9875 ($1,580) and they are $1.40 out of the money at .85 ($1,360).
  • The $34 puts are .55 and we can sell 80 of them for $4,400 and their delta is .24. 

That puts $4,400 back in our pockets and USO can go to the moon and we only lose $810.  On expiration, in order for the $33 puts to be worth .50, our $34 puts would be worth $1.50 or $2,400, that would be an additional loss of $1,600 but we have no intention of letting it go that far.  With only $800 at risk to the upside we are now content to let USO run up as far as it likes and, if they hit our $70 upper target and we're still in the mood, we can do some really cheap roll-ups and start again! 

The final salvage play is buying time.   Essentially, we can take our now rotten $3,280 worth of June puts (down $2,200) and sell 20 June $36 puts for $1.17 ($2,340) and roll ourselves to 20 July $35 puts at $1.52 ($3,040) which buys us another month to get our reversal.  The July $35 puts have a .37 delta while the June $36 puts have a .43 delta so we shouldn't have too much trouble and the premium on the June puts will, of course, erode about twice as fast as ours (theta).  Mainly we have bought ourselves time and time is what we use to gather more data and, hopefully make better decisions between now and July 17th.  Of course, there are a lot possible adjustments we can make but the key is buying the time to make those adjustments cheaply by doing it sooner, rather than later.  

For now, we have 3 full weeks to go and we're still playing for that pullback on Monday.  While the new $35 puts are fine, the $33 puts will need to be adjusted quickly if USO heads higher.  As you can see we have multiple ways to salvage these positions and, of course, since we are loaded up on these puts, we can also choose to take a very aggressive bullish play like the 10 July $33 calls for $4.30 that would gain about .75 per $1 USO goes up, giving us $750 per $1 and we are very well protected by our puts until June 19th

 

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Nice book chapter you just wrote there Phil… 🙂

Pai an jiao jue jiang xin, Chan Shi !!    ðŸ˜‰
( wonderful explaination, Oh praisworthy Master Teacher !!)
Master Tzu would be proud

Hello Phil, I’m a Phil as well.
Got stuck in the 32p’s, I have 30, avg .50 after a DD at .40. What would be my best play at this point?
Thanks in advance.

Phil,
  What’s the best way to play SVNT w/ a June to August decision range? Staight buy of out-of-the-money calls or a bull call spread (didn’t find any great spreads though).
This is more of a general question on how to speculate on biotech stocks before FDA decision dates. Thanks

Phil – New member here – doing my homework …

The $34 puts are .55 and we can sell 80 of them for $4,400 and their delta is .24. 

That puts $4,400 back in our pockets and USO can go to the moon and we only lose $810.  On expiration, in order for the $33 puts to be worth .50, our $34 puts would be worth $1.50 or $2,400, that would be an additional loss of $1,600 but we have no intention of letting it go that far.
How do we only loose $810 on 80 contracts if USO goes from $36.40 – to say $38.  Or $34 puts worth $1.50 or $2400.  I am missing something …
– Partha

Phil,
Some basic questions on 5% rule described above:
– Does it apply to stocks as well as index ETFs?
– In the daily chart that you publish, why are the 2.5% increments based on the close of 2 days back and not on the close from the previous afternoon?
– As you described the 20% retracement that you might expect from the various levels reached, does that mean that you recalculate each time that an index reaches a new high or low for the day, week or month?

2.5% – They should be yesterday’s close.  I never noticed that we’re picking up 2 day’s back.  Are you sure?
Thanks Phil.
If you look at the daily chart at the end of your morning posts, the top line is "Current" which is the close the previous afternoon. Two lines down is "Prev Close" which is the close from 40 hours ago, 2 days back. The 2.5% calculations are based on that latter figure. By the way, they are not updated every day so the figures are usually wrong anyway.

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