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Smart Virtual Portfolio Management II – The $100,000 Virtual Portfolio (Members Only)

Options Sage submits:

Last week’s article discussed smart virtual portfolio management with respect to a $10,000 virtual portfolio.  In this week’s article we will consider a fairly conservative managment strategy, using options to enhance returns in a $100K virtual portfolio as promised last week and next week we will look into a million dollar virtual portfolio.

The Simplicity of Stocks

Making money trading stocks is (or at least, should, in theory be) much simpler than making money trading options!  Making money trading stocks simply involves being correct with respect to direction.  You also have the luxury of time on your side should the stock fail to move as expected initially – you can always resort to trusting that your fundamental due diligence will trump any short-term technical analysis failings. 

Making money with options, on the other hand, requires that you are correct with respect to direction AND TIME.  Take the FAZ July $12/16 bull call spread at $1.10 that we mentioned last week as protection – up a healthy 36% in a week.  The C spread they were protecting, on the other hand, was net $3.07 and is now net $2.94, which is a .07 loss on the C calls against a .40 gain on the hedges.   Using last week's expamle 2:1 ratio, this play is still up .13 per C contract for a $65 gain on $475 cash used for the two positions or 13.6% profit in 5 trading days.  That's what a well-hedged position does for us when the trade moves against us and those are the kinds of sensible trades you NEED to be making in a small portflio! 

We also have to factor in another risk variable, implied volatility.  WYNN traded as high as $96 prior to its earnings report this week and, with a P/E of 145, Phil came up with a couple of bearish plays to take advantage of the run while and  reasoned that, if the stock didn’t report stellar numbers and forecasts, a correction was in the offing.  Phil liked aggressively selling the naked $95 calls (a play that requires margin) on the assumption that the protection or "hedge" of the play was that the calls could be rolled to higher strikes in longer time-frames.  He also liked the fairly aggressive $100/95 bear put spread at $3.20, where the lower puts effectively removed the premium from the $100 puts while limiting the profits to $5 if WYNN expires lower than that strike.  WYNN dropped all the way to $76.86 so his combination play at net $1.15 of cash is right on track to make that maximum $5.   

This is very profitable - in percentage terms on cash (442% gains) and these are the sort of plays that are possible for larger virtual portfolios that have spare margin – something that you don't have with $10,000 or even $50,000 virtual portfolios generally.  Crushing implied volatility works especially well on earnings plays.  However, on our long-term hedges, it isn’t surprising to see that they didn’t improve as dramatically because overall implied volatility (VIX) has increased substantially this past week, doubling to over 40 from 20 Monday morning.  When that occurs, option sellers must rely solely on stock movement to turn their directional plays profitable because the inflated premiums arising from the uncertainty in the markets make it very difficult to make adjustments.   

Suffice to say that unless you are an incredibly active trader and very sophisticated trading options already, a learning curve exists to get fully proficient in their application and as a result a reasonably large virtual portfolio of say, $100,000 should comprise a blend of both hedged stock positions and option trades.

Hedged stock positions are particularly attractive if you have ever had a problem timing the market!  (I think it’s fair to say all of us fall into that category and if you haven’t please do make sure to contact me!!).  You have the luxury of time on your side as your trade matures and even if your timing isn’t perfect you won’t be penalized nearly as harshly as if you were trading options at inopportune times.  You also have the added bonus of reduced % account fluctuation compared to a virtual portfolio comprised exclusively of directional options plays (unless they were very well hedged!).

Step 1

The first step in trading any virtual portfolio is to identify what your target goal is.  There is little sense targeting a 300% return if your historical average is 8%!  While it’s possible and I’ve certainly seen some phenomenal traders achieve those lofty goals, it usually encourages you to force trades which can be particularly detrimental to your results. 

In fact, one of the greatest challenges money managers must overcome is the pressure to force trades to generate quick results in order to keep clients happy.  This is one of the reasons you hear about the ‘window-dressing’ phenomenon so much as the close of a quarter’s trading approaches; suspicion is rife that money managers conspire to artificially inflate prices to cloak an otherwise mediocre performance. 

I default to the general standard of 20% returns as a reasonable target when you start trading.  Of course, it’s feasible to do much better and following a well-informed, active trader (like Phil) enhances your chances of excelling beyond such a target. 

Sometimes 20% can be dismissed as being inadequate in the context of options trading where 50%+ returns can be generated on any given day.  But you will never (or certainly you should never) have all your money in a single trade that might make 50%+ or go bust on any given day!  Phil targets a 20% annual return, which is why he is constantly taking winners off the table.  In the past 60 days of this year, Phil took off more than 100% the starting balances on trades on both bull and bear sides, the rest of the year becomes playing with profits that way.  Leaving 200%+ of the starting cash position in play is just tempting fate – you must learn to accept your successes and move on as much as you must learn to accept your failures.

If you are struggling to accept 20% returns as being a reasonable number, factor in the impact of compounding and you can quickly see that you will be very rich indeed if you simply target 20% per year no matter what trading capital you begin with.  In fact, generating 20% per year for 20 years would yield a 38x multiple in a qualified account on your starting cash – which I think most of us would be quite content to have!   With $200,000 starting capital, that’s over $7,500,000,which should still be nice chunk of change in spite of inflation.

Now let’s go see how to make the money….

Hedged Stock Trades

The simplest and one of the most powerful hedged stock trades for a $100K virtual portfolio is the at-the-money Covered Call strategy selling LEAPS against your stock positions.  It’s easily dismissed as a strategy because it’s really boring but as I like to say:

“Boredom is not a reason to make or not make a trade”

In fact, one of the reasons it’s a relatively boring trade is there is so little work required on your part so if you have a habit of being trigger happy with trades, this one forces discipline to hold-off and use patience to remain in the trade, which are key attributes to consistent success.

Example 1

Since 20% is our annualized goal and January '11 is just 8 months away, we should target at least a 14% return in 8 months which equates to approximately the same thing on a rate-of-return basis. 

CHK has had a nice decline to $20.91 from recent highs at $30. Jan ’11 $20 calls can be sold for $4.30.  A quick calculation yields:

  • Cost Basis: $20.91 – $3 (calls sold) = $16.61
  • Projected Reward: $20 – $16.61 = $3.39
  • Projected Return on Risk: $3.39 / $16.61 = 20.4%

Should we consider such a trade, our expectation should be that CHK will not fall below $16.61 by year’s end.  We would realized maximum reward of $3.39 should the stock stay at, or rise above, $20 and between $16.62 and $20, we would be making a return between 0% and 20.4%.

Note that you can do this same trade, selling the $22.50 calls instead for $3 and your net return would jump up to 25% but you require a 10% better price on the stock at expiration to make that 25%.  Phil often talks about "the bird in the hand" when making decisions and, if this is not play money, it really is not worth the risk you take to chase another 5% in the bush – so to speak. 

The really attractive aspect of this trade is that we are no worse off for shorting the call option, even if the stock rises to $25 i.e. $5 above the short call strike.  However, we don’t require that the stock rises 15% in order to generate our return.  This philosophy of profiting without requiring significant stock movement is a particularly attractive feature of this trade.  The other VERY attractive part of this trade is that it's self-hedging.  CHK can drop all the way to $16.61 (down 25%) before you begin to lose money.  While we hate to be in a trade for 8 months and not show a profit – we all know how great it is just to be even if the market drops 25%. 

Dedicating 10% of trading capital to a single trade like this would not be inappropriate at all.  In fact, a 600 share/6 contract lot trade for CHK would require just over $9,966 of trading capital, which is relatively prudent risk management for a single hedged stock trade like this on a $100K virtual portfolio.

In fact, you could spread your risk among 8-12 stocks in this manner and dedicate up to 70% of your trading capital to such relatively conservative trades.  However, to achieve greater returns we will have to employ another hedged stock trade.


Higher returns can be achieved by accepting higher risk through at-the-money or slightly out-of-the-money short-term short calls applied regularly against stock positions.

Although the trade looks very similar to the original trade discussed, the returns can be considerably higher.  This is due to the fact that the cumulative return of short-term short call premiums over time exceeds that which you can receive on longer-term short calls.

Example 2

Let’s stick with CHK to highlight the point.  The June $22 calls at $1.31 carry a $1.40 premium over a 45 day timeframe.  On a per day basis, that equates to about .03 per day.  Contrast that with the longer term LEAPS in the previous example.  They offered $3 over about 240 days, equivalent to approximately a .0125 return per day.  If each and every month we were to short options at-the-money or slightly out-of-the-money, our returns would be much higher than if we were to stick solely with the first LEAPS Covered Call strategy discussed.

This strategy does require us to be more active in our accounts.  It also requires a higher capital commitment to start the trade.  And during earnings season which we are currently in, the trade can suffer more should negative numbers or poor outlook cause a sell-off.

A virtual portfolio comprising a combination of the above strategies and applied in a manner that suits your own risk tolerance would be a tremendous improvement over a simple buy-and-hold strategy.  If your virtual portfolio has approximately 8-12 stocks applied in this manner, you will be relatively well diversified in terms of risk and yet, you don’t have too many stocks whereby you cannot follow them.  In fact, for most people, 8-12 stocks is about as many as can be actively followed with respect to reading headlines, keeping up with quarterly reports, staying on top of charts and so forth.

One of the great advantages of being in a trading community like PSW is that we have more "eyes on the market," much like a large fund or trading shop, with various members tracking their favorite sectors and bringing ideas to the virtual conference room.  This is what Phil set out to build from the beginning and it's amazing to see how well it functions as the membership rarely misses hot stocks and big market moves and, more often than not, are far ahead of the game!

"Artificial" Buy/Writes 

With approximately 15%-20% or so of virtual portfolio capital, it’s often very prudent to wait during the year for the big sell-offs.  Inevitably they do occur, it’s just a matter of when!  When the carnage ends, it’s often a great idea to scout around for LEAPS and other more aggressive plays.

For example, this week, Phil found a perfect example of an appropriate option combo on RIG.  Because there is still uncertainty, the stock is too dangerous but some of that risk can be offset by taking a long bull call spread (the "buy") and Phil likes to write puts against those positions to maximize (if all goes well) the gains on cash:

RIG Jan $60/75 bull call spread at $7.20, selling $50 puts for $3.30 is net $3.90 on $15 spread and worst case is you own RIG at net $53.30.  I think their liablility is not that great on spill and much work is ahead for them.

The trades of this play breaks down like this with a $2,810 commitment:

  • Buy 1 RIG Jan $60 call, now $14.10
  • Sell 1 RIG Jan $75 call, now $6.90 (net $7.20)
  • Sell 1 RIG Jan 50 put, now $4.10 (net $3.10 cash and $2,500 margin if 50% margin required)

This trade begins losing money at $63.10 but the loss is capped at $3.10 (5% of what you could lose if you bought the stock) all the way down to $46.90, which is 31% below today's price of $68.10.  The spread is currently $800 in the money, which is a gain of 28.5% on cash and margin we finish here in 8 months.  If, as Phil suggests, your options virtual portfolio is no more than 25% of your stock virtual portfolio and you have at least 25% cash in your stocks virtual portfolio, then margin should never be a real issue in your option portfilio – which is why Phil generally concentrates on gains on cash, which, in this case, would be an impressive 384% if RIG retakes $75 at January expiration

Even looking at it as a gain on a non-PM account where this margin prevents you from making other plays, it's still a potential gain of $1,190 or 42.5% of $2,810 over 8 months with your risk of owning 100 shares of Transocean at a net cost of $53.10, 22% below the current price.   As Phil often says:  As long as you REALLY want to own the stock, it's one of the best strategies out there!

With the last 10% of your virtual portfolio capital, you can enjoy the speculative plays that Phil discusses during the day.  You’ll still have sufficient capital to partake in many of the plays, perhaps not in scaled 10 contract lots but maybe a few contracts at a time and you’ll still have the opportunity to profit handsomely from shorter-term plays!

Combine the strategies altogether and you should have your risk well-managed while still offering the potential for tremendous returns that significantly beat the 3.5% returns you'll get on a Treasury Bill…

Have a fantastic week!

Options Sage

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  1. Nice work &   very informative. Only problem is CHK went from $20.91 on May 6  to $23 in 2 days.

  2. Time for a beginner’s question. With the CHK example 1, what happens if the stock tanks to $12 prior to expiration? How do you stop your loss on the way down when you have sold the Jan ’11 $20 call? My luck is that I sell the stock before expiration only to see it rise again to $25 and I still need to cover the call. Sorry in advance for a simple question.

  3. Another beginner’s question. I waited until the close of the market to ask.
    Last Thursday when the market did its thing the TBT fell and I bought 1500 shares for an average cost of $40.47. Today I am looking at doing a collar to protect my gains. The price as I was doing this analysis was $42.96. First I considered buying the 43 Jun 10 puts for $1.65 and selling the 45 Jun 10 calls for $0.90. According to my math this would give me a minimum gain of $1.78 and a maximum gain of $3.78. Basis=$41.22
    I then looked at buying the 47 Jun 10 puts for $4.50 and selling the 49 Jun 10 calls for $0.30. According to my math this would give me a minimum gain of $2.33 and a maximum gain of $4.33. Basis=$44.67
    I discovered that as I went further out of the money the greater my gains and lower my risk. I also realized that this would require more capital, but since the cash required for the additional capital is only getting 1.5% it doesn’t seem to matter.
    So with that I looked at buying the 53 Jun 10 puts for $10.20 and selling the 55 Jun 10 calls for $0.12. According to my math this would give me a minimum gain of $2.45 and a maximum gain of $4.45. Basis=$50.55
    This is when I realized that the proceeds from the sale of the calls was close to nothing, so I looked at just buying the 53 Jun puts for $10.20. It looks like I would have locked in a minimum gain of $2.33 and no limit on the maximum. However, to get a $4.33 gain the TBT would need to reach $55. Basis=$50.67
    Where as, with the 47/49 collar the TBT only needs to reach $49 to hit the $4.33 gain.
    If I were to simply sell the shares at $42.96 there would be a gain of $2.49.
    What factors should I be considering when trying to pick which collar to use?
    Thanks for your time.

  4. Much thanks for putting these together, Phil & Sage. I guess it was my inability to find the originals that gave the impetus to redo this, for which I’m grateful since I assume the times have changed. Could you do a favor for those of us who do a lot of trading within the confines of IRAs, and put an addendum explaining how this all works when you can’t sell naked options? It may be something as simple as "Do only the long arm of any play", but it would be good to know.

  5. CHK/Dflam – Well you can see why they were our top pick on that dip!  8-)

    Stopping loss/Trust – You always have a net price for the spread.  If you have a sophisticated system like TOS, you can set an alert if the overall spread price goes below a target you set (not hard stops, that would flush you out of most positions on a day like Thursday).  Your question mixes up trading with investing.  If we are investing, we don’t care if the stock’s price drops – we only care if the value of the company changes – Thursday again was a great example of that.   Is a stock worth whatever the ticker tells you or do they have some sort of real value?   What if your home had a ticker on it that went up and down 20% a week?  Would you move in and move out every couple of weeks?  At some point you need to pick a price you are willing to live with and make a stand…

    So there is no "luck" – you INVEST in a diversified portfolio and you allocate some money for disaster protection and you begin to build positions.  When the market goes up, your insurance expires worthless and you get called away or roll your winners.  When the market goes down, your disaster hedges give you cash that you can apply to dollar cost averaging the stocks you want to keep. 

    An example I often use is buying a pair of jeans.  I wear Levis 501 jeans.  I know I like them, I know I want a pair and I know they cost $40.  I’ve seen them as high at $49 and as low as $39.  I see them every time I go shopping but mainly ignore them as they trade in their range.  When they get down to $39, I might become more interested – especially if there’s a place in my closet (portfolio) for them. 

    Do I worry when they get to $39 that they are no longer desirable because they are on sale?  No, that would be asinine wouldn’t it?  They are the same damn jeans they were last week – just on sale.  I KNOW I like them, they are not defective – just on sale for whatever reason.  So at $39, maybe I buy a pair and then I will wear them until I am done with them – until they give me good value which, in the case of stocks, means they either appreciate or allow me to sell calls against them over time.  

    If I have my new pair of Levis at $39 and a month later the store has a 2:1 sale on jeans – do I run home and return the Levis I bought for $39 a month ago for $19.50?   Would that be rational?  Did the jeans change?  Did they become defective?  If the fundamentals of my jeans haven’t changed and I intend to get use out of them, then how does a short-term change in price affect my closet?  More sensibly, I may simply go back to the store and buy 2 more pair for $39 – then I have 3 pair for $78 or $26 each, not too far from the $19.50 sale price and much lower than the usual $29 price and I can expect to get many years of good use out of them but I’m also "full" from a jeans perspective and it would be silly to buy more so I’m not even going to be looking in a jeans store again for a while – perhaps it’s time to check out some Clarks?

    Read the Strategy Section, including the linked article on Salvaging Plays and Scaling In - especially the commentary below, which gets updated from time to time.  Portfolios are built over time.  If you have 100 stocks that you watch, in any given month one or two will go on sale.  If you then drill down on the ones on sale and recheck your buying premise and decide the fundamentals are still sound, you can then initiate a small position and give yourself an additional 20% discount using the buy/writes. 

    Let’s say my stock is CHK and they ranged from $15 to $30 last year but I think they are worth at least $20.  I put them on my watch list HOPING they fall to $20.  So the only time I’m going to buy them is when nobody else wants them, right?  When they go to $20 (last week) I say "why did they go to $20?"  I can see nat gas at lows that I don’t think will last and I don’t see any detrimental changes in their operations.  This is the same company that traded in the $30s and $40s a couple of years ago so, as a LONG-TERM investor, I figure there’s an excellent chance that, at some point in the next 10 years, natural gas will be back around $10 and CHK will hit $40 again.

    That makes $20 a pretty good price.  I see they went as low as $9.63 when the market tanked and I KNOW RIGHT NOW – BEFORE I BUY MY FIRST SHARE – that I intend to buy more if they drop that low.  So I allocate 5% of my portfolio to CHK – let’s say $5,000 and I spend net $1,661 on 100 shares and the sale of the Jan $20s.  If it works out, I get back $2,000 in Jan and my $5,000 originial allocation becomes $5,339 a gain of 6.8% in 8 months. 

    That is not a big winner but scaling into a position means we WANT it to go lower.  We would be HAPPIER if it did fall to $12 because then we could double down at $12 and then we’d have spent net $2,861 on 200 shares and, when they eventually get to $40, they’ll be worth $8,000.  As Sage points out, with conservative plays like this one, you can go up to 10% on your portfolio so you could easily allocate $4,983 to 300 shares in round one and, if called away, you have $6,017 cash in Jan – a gain of 20% on your $5K allocation in 8 months. 

    If you run 15 trades like that ($75,000 ish) and keep $25K in cash, you can afford to DD $50,000 worth of the positons that drop to half and, hopefully, you have 5 winners that don’t need to be scaled into.  If every trade you enter pays 20% on a flatline and you only buy stocks at the bottom of a channel that you feel are undervalued (not JUST because they are low in a channel), then you have a pretty good chance of being 33% successful.  The $25,000 that do work out would return $30,000 in cash and that gives you $55,000 in cash to adjust the other $50,000 worth of trades.  

    Keep in mind that you have 20% downside protection built in so the 10 positions that lose (66% – you really suck at picking stocks!) have to drop at least 20% just for you not to get your money back.  If they drop 10% further ($50,000), you would be even in the overall portflio (because you gained $5,000 on $25,000 worth of winners) and if they drop 10% further than that (now down 40% from your purchase price), you will have $40,000 worth of positions and $55,000 in cash and (and here you have to trust my experience) the VIX will be nice and high and you’ll have great option prices to sell so you can knock 20% off the prices again (down to 60% less than your entry) with another round of Leap sales, which drops your basis on 10 stocks (assuming you want to stick with all 10) to $32,000 and you take another $32,000 and double down the positions so you now have $64,000 of stocks that will make 20% if they don’t fall lower than 40% below your original purchase and are protected down to 60% off your original price and you still have $23,000 in cash to make adjustments. 

    If your $64,000 worth of stocks flatline or recover, you will get back $76,800 plus your $23,000 in cash and, after 2 years, you’ll be even, which isn’t bad for surviving a 40% dip in the market.  If you manage to suck less than that in picking or if you had hedged for a disaster – it’s a much happier outcome…

    Diversification, patience, hedging and scaling into positions are all very important things but so is having a plan and if you don’t know what your end-game is for up 30%, down 30% or flat for the next two years, then you have not put enough though into your positions!

  6. TBT/New – $60,000 worth of TBT is a heck of an initial entry!  I am not a collar fan at all, I hate betting against myself although, with the high VIX and TBT’s crazy moves, you can do an effective collar with the Jan $43 puts at $4.35 and selling the $47 calls for $4.35 to pay for it.  That way you risk $1.28 to possibly make another $3.72.  Hang on, that’s such an exciting way to tie up $60,000 I have to try to contain myself… (end extreme sarcasm font). 

    Come on New – don’t be a wimp!  Collars are for people who read option books!   How about cash in the whole thing at $43.28 for $64,920 and take the $4,000 you made and buy 40 Jan $41/43 bull call spread for $1 and those will give you a $4K profit if TBT holds $43 and you can do something more useful with your other $60,920 besides collar it to death….

    Do not be the sucker that I sell options to!!! 

    Also, don’t buy ultra stocks, they tend to lose money over time regardless of what the underlying does, which makes them bad investments.  You’ll notice all our TBT plays involve bull call spreads or selling puts to suckers.  If I wanted ot make $4.33 x $1,500 ($6,495)  on TBT with $60,000 (10%) in 8 months, I’d go for 30 Jan $37/42 bull call spread at $3 ($9,000) and sell a short strangle of the Jan $63 calls for $1 and Jan $34 puts for $1 (net margin $26,000) so you are in the $5 spread for $1 cash ($3,000) and $26,000 in margin and your upside is $12,000 profit at $42. 

    Personally, I’m more bullish on TBT and would sell $2 puts and no calls but, statistically, this play is safer and you STILL have $30,000 left to play with.  Of course, you can also do the trade with 15 contracts and that’s just 1/4 of your $60,000 put to work to make $6,000 and only $1,500 at risk other than the outside chance of the caller or putter being hit but you can stop them out with a .50 loss and that’s $750 added to your basis (on 15 contracts) at worst.

    You’re welcome Snow, it was due for a refresh anyway…  On IRA’s, my understanding is you can sell covered calls and even naked puts but the naked puts cost you 100% margin so the answer is that the buy/writes are fine (per the above CHK example) as long as you are willing to commit to a 2nd round but want to stick with some cash (and you need to shop brokers because requirements seem to vary) or yes, you can do only the long arms but absolutely you should be able to sell covered calls and I am fairly sure that TOS and others let you use verticals, which is a great way to enhance your buying power (per the TBT above).