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Monday, February 26, 2024

Smart Virtual Portfolio Management Update – 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 30% in 5 Months

The original trade was 5 June $3/4 bull call spread at net .87 ($435), which finished at $500 for a nice $65 gain (15%) in 7 weeks.  A lot of small virtual portfolio player spend too much time "going for it" with risky trades when there is very good money to be made on sensible ones. – Phil 

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 $4.06.  Since the C has had come down a lot , we’re a lot more comfortable establishing a position.  Rather than spending $4.06 a share for the stock and covering it, we can leverage $500 and buy 5 Jan $2.50 calls for $1.62 ($810).  C was at $5 in April 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 Jan $2.50 calls for $1.62 (paying .06 in premium) while simultaneously selling 5 C Jan $4 calls for .47 (a .41 premium) which, based on Friday’s close, gives you a net entry of $1.15 on 5 contracts (100 options per contract) for a net cost of $575.  Instead of taking $406 out of your pocket to buy 100 shares of C and selling 1 Jan $4 contract to cover for $57 (net $349 with a $51 upside), you are spending $226 more to give yourself an upside of 5 x $35 ($175) instead.  That $575 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 $3.65 (down 12.5% from Friday’s close). 

So, with a risk of $1.15 per contract and an obligation to sell at $4 for a nice .35 profit – If the stock remains above the short call strike price at $4, the trade generates 30%! 

If it drops below that strike price, the trade can still be profitable but must remain above breakeven at $3.55. 

The bottom line is the stock can drop from $4.06 to $3.65, an 10.1% 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 2012 $2.50 calls are $1.86 so we could spend about .24 per contract ($120) to buy ourselves 12 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 .75, down $200 on the trade, insuring our $10,000 Virtual Portfolio is not risking more than a 2% 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. 

In this section, our original FAZ cover was 10 FAZ July $12/16 bull call spread at $1.10 ($1,100), selling the $10 puts for .70 ($700) for net $400 on the spread.  FAZ expired at $15.81, which was net $3.81 on this spread for a $1,905 profit (476%) in less than 3 months.  Note that timing this cover LONGER than the C trade allowed us to have a big win on both. – Phil

Another way to protect this play inexpensively is to follow one of Phil’s hedging suggestions.  Phil suggested hedging with 4 FAZ Jan $10/12 bull call spreads at $1.10 ($440), selling 2 $10 puts for $1.13 ($226) for net .54 on the $2 spread.  Even if you have an IRA and have to put down a full $2,000 in margin for the naked put sale, the bottom line is you are spending $214 in cash for a spread that is $800 in the money already and should hold $800 up to about a 4% rise in XLF (to $15.38).  If the financials go up and up and you do get assigned the ETF at 25% 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 over half of the potential losses of 3 $525 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 the C trade, a trader could easily view the capital return of $225 as a minuscule amount and dismiss it as not worth considering.  But look at the rate of return!  42% in 5 months 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 $225 profits on $525 is still 42.8%, over 8% a month!

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 $4.06 and sell the 2012 $2.50 calls for $1.85, which lowers your basis to $2.21, called away at $2.50 (38% below Friday’s close) for a 13.1% net profit in 18 months.  So you have 38% downside protection on your 13% 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 also 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 with a Ratio Spread

Our original play here was SYMC, which went badly.  4 Jan $17.50 calls at $1.65 ($660) were hedged with just 2 May $17 calls at .70 ($140) for a net $1.30 per contract.  The callers expired worthless but the calls fell more than we thought and the planned roll to the 2012 $17.50s cost .50 per contract ($200) which left the position net $720 for 4 2012 $17.50s ($1.80 each) and they are now .65 for a very nasty $460 loss so far.  SYMC cut outlook and got slammed despite beating earnings (also, IPads don’t need virus protection!).  There is no logic to NOT selling the Jan $15 calls for .40 and spending .70 to roll down to the 2012 $15s (now $1.35) for net $120 more – hopefully not throwing good money after bad… – Phil 

Phil favors buying 4 WFR (an old Buy List pick) 2012 $7.50 calls for $3.70 ($1,480), selling 3 Jan $10 calls for $1.30 ($390).  This gives us a net entry of $1,090 or $2.72 per share, knocking off the majority of the long premium.  It is not impossible for this trade to get away from us as the long calls are $2.50 deeper in the money than the January calls and one of the 4 calls is uncovered, and will get the full benefit of any move above $10.  

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. 

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.

A good example of a simple calendar trade is 4 VLO March $16s at $3.25 ($1,300), selling 4 Sept $18 calls for .86 ($344) for net $956 on the spread.  If VLO goes up, it is anticipated that the trade can be rolled up – currently, the Dec $20 calls are .78, which would leave us with a very comfortable spread and 2 more months to sell after that.  To the downside, the delta differential between the March $16s (.70) and the Sept $18s (.53) is .17 so, in theory, it should take a $2 drop in VLO for us to lose 10% (.34) of the value of the long calls.  That means we are betting VLO will not fall below $16 in the near future.

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, JRW plays TNA and TZA (often in the same day) on bullish momentum.  Even if you knew nothing about the index, the lemming-like behavior of the technical investors often rewards the people who get in AND GET OUT early. 

Predictive trades are slightly more challenging to ‘get right’.  For example, if a stock or an index 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.  For a $10K virtual portfolio, a move the other way can be very detrimental since the ability to scale in or roll is limited by capital constraints so such trades should be entered judiciously.   Phil’s Tuesday trade idea on USO from the morning alert is a good example of how to play a hunch:

USO still makes a good short into inventories but the idea was to take the Aug $37 puts, now $1.15, and hopefully sell the $36 puts for $1 on a nice move down to put you in the $1 spread for about .15.

We had a rough week of it and Phil called the inventories "a very poor demand picture" on the Wednesday report and the USO puts climbed from there, peaking out at $1.50 in yesterday’s action (the $36 puts topped out at .88 so no $1 sale was possible).  0.35 may not seem like much but it’s $35 per contract and a 30% gain on the week.  Of course, not many make a perfect exit but following the basic strategy to set stops to make sure a 20% gain is off the table still makes for a nice week’s trading as that would translate to over 1,000% annually.  If you are ahead of goals in your virtual portfolio, taking a chance on one or two contacts on trades like these is acceptable but, if you don’t use stops – they can be VERY DANGEROUS.

Trades based on ‘Hope’ include purchasing long call or long put options ahead of an earnings announcement or events, like the weekly inventory report.  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.

Another speculative trade idea Phil suggested on Thursday afternoon was a bearish cover for the drop he anticipated coming on Friday morning:

TOS just slowed down on me, that’s often a sell signal!  QQQQ WEEKLY $46 puts are .07 and a fun play on a disaster tomorrow as last Friday support is way down at $45.50 but a throw-away if we have anything but a big sell-off.  The regular Aug $45 puts at .25 are a more sensible way to play and they could double up on a big drop

We did get a big drop on the jobs number and the weekly $46 puts shot up to .17 (up 142%) while the standard Aug $45 puts did not disappoint at .40 (up 60%).  No one can get these trades right all the time but if you play them with standard amounts of, say $200 and stop out at $160 when you are losing, then a single win of even 60% can make up for 3 losing trades.  The goal then is to do better than even in your calls and the math should work itself out for you over time.  

Have a fantastic week!

Options Sage

 Next in our Series was Smart Virtual Portfolio Management II – The $100,000 Virtual Portfolio (Members Only) and we will be updating that next.

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