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Smart Portfolio Management I – The $10,000 Virtual Portfolio

Options Sage submits:

“Never risk what you do have and do need on what you don’t have and don’t need”

Smart virtual portfolio management is a world apart from conventional virtual portfolio management.  While conventional virtual portfolio management offers generic guidelines to diversify capital, smart virtual portfolio management is tailored to your personal circumstances.  With that in mind this article has been divided into a three-part series.  The first discusses a $10K virtual portfolio while the second will offer suggestions for a $100K virtual portfolio and the final article will discuss $1M virtual portfolios.

Although this first article in the series addresses prudent strategies for a $10K virtual portfolio, many conservative investors are likely to find  the strategies addressed throughout suitable for their own virtual portfolios – though the % allocations will differ as we will see in the future articles.  No matter what your risk tolerance, a virtual portfolio comprising some relatively conservative trades is always prudent!

$10,000 Virtual Portfolio

Phil once commented that, when trading a $10,000 virtual portfolio, “every $100 counts”! 

Capital should be allocated judiciously in a $10K virtual portfolio.  NEVER allocate a majority of your capital to any single trade.  Dedicating 20% of your virtual portfolio to relatively conservative trades (shown below) is appropriate but exceeding 30% is far too risky when dealing with limited capital.  With a $10K virtual portfolio, it becomes increasingly imperative to be right first time.  Financial constraints limit your ability to scale into trades at different threshold levels and that makes timing critical unless….

Unless you figure out how to trade without requiring perfect timing of the market!  Those of you trading along with Phil’s earnings spreads have already seen some of the ways we take advantage of stock movement, whether they go up, stay flat or even drop to some degree…

Strategy A:  The Covered Call – With a Twist – Making 15% in Just 7 Weeks

Instead of placing the short call out-of-the-money in the conventional format, the short call is actually placed in-the-money.  

C closed on Friday at $4.37.  Since the C has had come down a lot , we're a lot more comfortable establishing a position.  Rather than spending $4.47 a share for the stock and covering it, we can leverage $500 and buy 5 June $3 calls for $1.40 ($700).  C was at $5 two weeks ago and hasn't been lower than $3.15 since July of 2009), an in-the-money bullish call spread can be employed which will produce a 15% return in 7 weeks should the ETF keep rising OR stay flat and it leaves you with a profit even if the stock pulls back 10%

This trade involves purchasing 5 C June $3 calls for $1.40 (paying .03 in premium)while simultaneously selling 5 C June $4 calls for .53 (a .14 premium) which, based on Friday’s close, gives you a net entry of .87 on 5 contracts (100 options per contract) for a net cost of $435.  Instead of taking $435 out of your pocket to buy 100 shares of C and selling 1 June $4 contract to cover for $53 (net $382 with a $18 upside), you are spending $53 more to give yourself an upside of 5 x $13 ($65) instead.  That $435 is the most that is at risk in the trade.  It seems odd trade when you think about your obligation to the caller, which is to sell the stock at a price lower than where the stock is currently trading, lower than where you bought it.

The trade is set up so the stock will be sold at a loss and yet the trade itself can easily end up profitable!  The reason the trade can end profitable is because the short call profit more than makes up for any stock loss down to $3.87 (down 11.4% from Friday's close). 

So, with a risk of .87 per contract and an obligation to sell at $4 for a nice .13 profit - If the stock remains above the short call strike price at $4, the trade generates 15%! 

If it drops below that strike price, the trade can still be profitable but must remain above breakeven at $3.87. 

The bottom line is the stock can drop from $4.37 to $3.87, an 11.4% drop, before the trade would show any loss.  Should the stock pullback more significantly, the short call could be rolled further out in time to offset the correction to a greater degree and this would further lower risk (for example, the Sept $3 calls are $1.48 so we could spend about .10 per contract ($50) to buy ourselves 3 months for C to recover – and to sell more calls!).  We can also simply set a stop if the value of our spreads dips below .57, down $150 on the trade, insuring our $10,000 Virtual Portfolio is not risking more than a 1.5% loss on this trade. 

For a $10K virtual portfolio, this strategy can be employed regularly on relatively inexpensive stocks; less than $20 per share.  At times you may elect to take the stock in a more traditional covered call and at times the bull call spread may work to your advantage.   The key is to manage the risk so that no single trade can wipe out several successes. 

Another way to protect this play inexpensively is to follow one of Phil's hedging suggestions.  On Tuesday, Phil suggested hedging with the FAZ July $12/16 bull call spread at $1.10, selling the $10 puts for net .40 on the $4 spread.  Even if you have an IRA and have to put down a full $1,000 in margin for the naked put sale, the bottom line is you are spending $40 in cash for a spread that is $224 in the money already and can grow to $400 if the financials keep selling off.  If the financials go up and up and you do get assigned the ETF at 20% below Friday's close, then you have a long-term hedge against other bullish financial plays to balance your virtual portfolio (and you can sell calls against them too!).  You can use one cover like this to offset almost half of the potential losses of 2 $435 plays like C and it's entirely possible, if the financials stay in this range, that you can collect on both sides of this hedge while it is extremely unlikely that you can lose on both sides.

Hedging does not have to be only for people with $1M to put into Phil's hedge fund, at PSW and Market Tamer we can teach any level of investor how to hedge like a professional.

Controlling Greed

The trap most traders fall victim to when trading smaller amounts of capital is greed!  Looking at the return on this trade, a trader could easily view the capital return of $80 as a minuscule amount and dismiss it as not worth considering.  But look at the rate of return!  15% in 7 weeks is outstanding!  Of course a discount broker will charge $5-10 for the spread (assuming it expires in the money and requires no further adjustments) but net $55 profits on $435 is still 12.6%, almost 2% a week.

Focus on the percentage return because, if you know how to generate even 3-4% per month on small amounts consistently, your capital will grow exponentially and soon you could be generating 3-4% per month on larger amounts of capital producing larger returns for you. 

In fact, for a trader who wants to be more conservative, the lower strike short calls, can often be used to offer greater stock protection at the tradeoff of a lower % return.  This is ideal for the investor who is not in a position to lose a substantial percentage of their capital.  For example, you can buy C stock for $4.37 and sell the 2012 $2.50 calls for $2.30, which lowers your basis to $2.07, called away at $2.50 (42% below Friday's close) for a 20.7% net profit in 2 years.  So you have 42% downside protection on your 20% upside play!  There are many investors who would consider that a great rate of return and it not only outperfoms bonds (other than greek ones) but it's a long-term capital gain. 

Watch Out For…

[1]  A cautionary note for highly conservative traders… Commissions can consume a large fraction of your returns if the dollar return is less than $100 so make sure that you keep a close eye on the how big a percentage impact your commissions are having on your overall return and make sure you find a broker who is appropriate for your style of trading.

On The Risks of Not Taking Risks[2]  Earnings!  As earnings season approaches, volatility inevitably picks up.  For stocks that have a history of extreme volatility, this strategy may not be prudent since the short call only protects the stock to a limited degree and earnings volatility could threaten profits.

Phil likes to sell options into earnings, letting others pay the high premiums while we collect our fees but it is still a dangerous game if you can't consistently guess the outcome of earnings and perhaps not suitable for more than one trade at a time in our $10K Virtual Portfolio.  Incorporating 2-4 covered call trades in your virtual portfolio and dedicating no more than 20% to any single position will set your account up with relative safety early on and should produce some handsome returns quite quickly.  This allows you to take the occasional chance on the "more interesting" plays without putting too much of your capital directly at risk.

Another smart trade for a $10K virtual portfolio is…

Strategy B:  LEAPS Calls

Phil favors buying the SYMC (an old Buy List pick) Jan $17.50 calls for $1.65 to keep the risk low ahead of earnings, followed by a roll into the Jan '12s, probably the 2012 $17.50s, currently at $2.70 (or whatever they end up at).  The idea behind this entry is that the stock is unlikely to fall below $16, which has held since October, so the loss per contract is unlikely to exceed .40 while the gain per Jan contract (delta .50) will be about the same as the gain on the 2012s (delta .55) that we really want without having to commit $2.70 to the position ahead of earnings, which could go either way.  Buying 4 of the Jan $17.50 calls for $1.65 ($660) and selling 2 of the May $17 calls for .70 ($140) for protection give us a net entry of $520 ($1.30 per contract) ahead of the May 5th release.

For a $10K virtual portfolio, our planned position of a 4 contract lot of the 2012s would be relatively safe, representing an account capital allocation of approximately 10%.   The incentive to entering a trade like this is that you can sell call options against your LEAP call at regular intervals when the stock has approached resistance levels and is due for a pullback.  This approach will continually reduce risk in the overall trade and magnify returns without relying as heavily on bullish stock movement.  For more conservative traders, delaying the entry entirely until after earnings might be more attractive.  A pullback is possible and might offer an improved entry point or an opportunity to enter additional contracts.  Obviously the flip side is that more aggressive traders jumping in ahead of the announcement may well be rewarded by a positive spike should the company report good numbers and/or offer a rosy outlook.

Strategy C:  Hedged Calendar Trades

As I said above, these are the plays Phil favors ahead of earnings.  More often than not calendar trades comprise the purchase of longer term long options (usually calls though puts can be employed as well) and the simultaneous sale of a similar number of shorter term short options at the same strike price.  This trade primarily takes advantage of the rampant effects of time decay on the shorter-term option which erodes quickly, particularly during the last 2-3 weeks before expiration.  Usually we are not expecting much volatility in the underlying stock (or at least not as much as our caller!) when entering this position.

The above variant on this trade is called a ratio calendar trade.  If the expectation is that a stock will remain relatively flat but we have some concern that the stock might make a charge higher (potentially because the stock is hovering closer to support than resistance or perhaps because an event such as earnings is imminent and could prove to be a catalyst to a gap up) then we might wish to purchase more options than we sell..   

Strategy D:  Speculative Trades

Speculative trades can fall into a number of categories including:

  • Momentum “Everybody else is buying so I should too!”
  • Predictive “I can see the future!”
  • Hope “It’s just gotta move higher…right?!”

No matter which category we consider choosing above, we should restrict speculative trades to not much more than 10% of our trading capital on a $10K virtual portfolio. 

Momentum trades are likely the easiest of the speculative trades to profit on.  For example, this last week DNDN offered numerous opportunities to jump on board the bullish momentum.  Even if you knew nothing about the company, the lemming-like behavior of speculators was so evident that a whole handful of entry points were available and Phil posted multiple trade ideas on DNDN for members on Monday and we still had good entries, even on Friday morning, after the announcement. 

Predictive trades are slightly more challenging to ‘get right’.  For example, if a stock has had a big run or even more so, if it has had a big run but you don’t like the fundamentals, it’s hard to pick the exact top.  BWLD which Phil has talked extensively about, and on which we took a put play last Thursday, is a prime example of a predictive trade and those $1.70 $50 puts closed Friday at $13.50 – up 694%!  For a $10K virtual portfolio, a move the other way can be very detrimental ($50 calls are down to .10) since the ability to scale in or roll is limited by capital constraints so such trades should be entered judiciously but a single $170 contract here (risking 1.7% of the virtual portfolio) is now worth $1,350 (13.5%) a week later…

Trades based on ‘Hope’ include purchasing long call or long put options ahead of an earnings announcement.  As much as any of us can know the fundamentals of a company, a risk always exists at earnings that a company surprises us with poor forward-looking guidance or the analysts latch onto a particularly poor number in a generally positive report (or vice versa).  These trades are ‘all-or-nothing’ because options are usually inflated right before earnings announcements building in the expectation of a big move and, if the move fails to materialize in the expected direction, the options suffer from implied volatility crush and rapidly become worthless.  In the speculative category I would place these ‘Hope’ trades last on my list of preferred trades.

That is why Phil suggested a more conservative play was to hedge bet with the sale of the Dec $40 puts for $2, which are now $4.80.  That lowered the cash basis on the trade to -.30 with the risk of, as Phil would say, REALLY owning BWLD at net $39.70 in December.  Since Phil loves BWLD but expected a rough quarter, this play was the best of both worlds and the .30 credit spread can be closed out for net $870 which, added to the .30 we collected up front is $900 in our pockets on a well-hedged trade.  Margin on the sale of the Dec $40 put contract should be less than $2,000 so even if you have a small virtual portfolio – as long as it was in our recommended "mainly cash" position, this is the kind of short-term hedged play you can make. 

Have a fantastic week!

Options Sage

 Next in our Series – see Smart Virtual Portfolio Management II – The $100,000 Virtual Portfolio (Members Only)

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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!

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  1. Fantastic article, Sage.  Thanks for putting it together.

  2.  Thnakyou very much for posting this!

  3. Great work as usual, thanks Sage!

  4. Thanks very much, Phil & Sage. Keep going, now.

  5. I’d like to see more on going examples of trades for A, B, C in this 10k portfolio.
    Understanding portfolio management is one thing, but picking/finding the trades that fit the bill is another.
    I appreciate your hard efforts to teach.