Balancing Act

You must have balance Daniel-san!

Some things stick with you your whole life and that line, or concept, from the Karate Kid was one of those things for me.  As Mr. Miyagi says to Daniel: "Lesson not just karate only. Lesson for whole life. Whole life have a balance. Everything be better. Understand?  Better learn balance. Balance is key. Balance good, karate good. Everything good. Balance bad, better pack up, go home."

In life we need balance.  Work and family need to be balanced (and you type-A workaholics should rent the movie "Click" and think about your lives!) and our virtual portfolios need to be balanced as well.  If we are going to keep capital in the markets, we need a strategy that keeps the bulk of our positions market-neutral so that we can play on the fringes, spending our time looking for market opportunities rather than trying to preserve our capital.  On Survivor a couple of weeks ago there was a game where one team tries to throw water into a boat while the person in the boat tries to either paddle to avoid the water that is coming in or bail it out (with their hands).  Of course this is a hopeless choice as either you are bailing water and a sitting duck for more water attacks or you are a moving target that is taking on water but not doing anything to bail it out.  The winner was the team that sank last but, inevitably, there is no strategy that can keep you from sinking eventually.  The winners were the ones that achieved a good balance of time between avoiding the other team AND bailing water out.

Bad virtual portfolio management is like that.  When we are unbalanced in our virtual portfolios and the market shifts against us, we have to spend all of our time bailing out of losing positions, leaving us less time to steer ourselves to safer waters.  If we choose to concentrate on changing our investment direction then we don't have the time (or capital) we need to salvage our misdirected choices.

As I often say, for me, being 100% bullish means 70% of my virtual portfolio is bullish and 30% bearish and when I'm 100% bearish then 70% of my virtual portfolio is bearish and 30% is bullish.  This is why on Thursday and Friday, while our bearish-biased virtual portfolio was raking it in, I was looking to add discounted '09 positions on GOOG, AAPL, AIG, TXN, GS, C, ISRG, AXP, FDX, BA…  They were not the bulk of my virtual portfolio but, while the market was tanking, I was happy to go from a very successful 30% bullish to take a chance at 35% bullish, knowing that on day (and it doesn't seem soon after Friday's close!) I will want to get my bullish side back to 70% and these positions are a great place to start.

So we're not predicting any great turnaround while I'm buying these positions but we are SCALING into them, which means for example, that I take BA Jan '09 $100s for $13.85.  Assuming I want a $50K position there I buy 10 contracts to start at $13,850.  I'm buying them because, obviously, I think BA will go to $100 (now $95) in the near future and I will be able to sell $100 calls for the same price as the $95 calls (Dec $95s are $3.25) are selling for now.  Next week, we will see what happens.  If BA goes up, I will be thrilled to sell the $100 calls (now $1.30) for $2.50 or so as I am not greedy and $3.25 is the most I can reasonably expect from a $5 run.

If BA does not go up and flatlines, I may wait and will probably add 10 more contracts and sell 10 of the Dec $100s for $1.30 before they go stale.  If BA goes down, I will sell the Dec $95 calls against my existing 10 for hopefully no less than $2.50 and use that $2.50 to fund a roll down to the '09 $95s (now $2.40).  Rather than buy more, I would then wait a bit essentially follow the same plan I started with, just focusing on the $95s instead.  Let's say I buy round 2 and pick up 10 more '09 $95s, now the same $11.45 I bought the $100s for (assuming BA is at $90).  Following the same strategy for 3 more $5 dips I would end up owning 40 BA Jan '09 $80s for $45,800 and I would have sold $80 calls for $2.50 against 30 of them.  The current price of the '09 $80 calls is $22.60 so the deal would be picking up $90,400 worth of calls for $45,800 just because BA, one of the greatest corporations in the history of the universe, falls back to around last year's high. 

Let's say that takes 3 months to play out.  It might amuse you to know that I can then roll back the entire set to 2010 for another $6 per contract (while selling the front month contract for $3!) while I wait for the market to regain it's senses.

This is what we SHOULD be doing in a down market.  In order to concentrate on that aspect of our trading lives it is important to have balance in our existing virtual portfolios.  Finding the proper balance is a tricky business, our short call and put sales are, of course, natural balances to our more aggressive long positions since they perfectly offset a downside move in that position but, of course, the protection is limited to their value and how fast they lose it.  That's why it's important to, not just cover, but  to cover adequately.  We learn this by observing how our positions act under stress (a 100-point plus market move) and, if we regularly make adjustments, we can achieve a balance that can withstand a 200, even a 300-point drop which, unfortunately, we were able to see this week!

While avoiding tremendous losses, the downside of balance means we don't make tremendous gains either, even when the market moves our way, it means that, no matter what the market direction, we live to trade another day.  As long as we are smart enough and not too greedy, we can take a little bit of profit every day – no matter what the market brings, mainly from those fringe plays and a little profit every day can really add up over the long haul!

On Friday morning I posted up the Short-Term Virtual Portfolio and, as an example, I reran it as is so we could analyze the effect of a 223-point plunge.  On Thursday afternoon, having made too much money on the two-day drop, I mentioned I wanted to protect against a bounce and go neutral.  As you can see, if you compare the updated positions below from this morning's STP Update, you can see that they held up very well.  Even if I hadn't changed a thing, those positions would have gained 5% on the day!  Having that kind of balance in our virtual portfolios let's us pick and choose where to make our adjustments – that is what it takes to change you from one of the sheep, that panics with the herd, into the wolf that spots an opportunity and takes advantage of the situation.

We did, of course, make lots of changes, but they were the changes we WANTED to make (at the time we wanted to make them) not the changes that were "forced" upon us by the market.  If every position in your virtual portfolio is one you would happily put more money into (by a roll or a DD), then a move against you becomes an opportunity to get a good deal on something you really want.  If your virtual portfolio is full of positions that you only hope will come back, then it is much too easy to go from hope to hopelessness when things don't go your way!

I didn't work up every sheet but the $10KP, if left untouched from this morning, would have gained $600, the $25KP would have lost $7K (and pretty much did as it was far less hedged!) and the LTP would have, and did, have a fabulous day, gaining about $50K (5%) even if it was left alone, as our poor callers were decimated.  Of course our longer positions lost a lot of value this week as well but they have time to heal (and we can always adjust them) our poor callers do not!

Here's how the same exact STP positions we had this morning, would have finished the day if we had done nothing.  Following our simple rules though (roll to a better position for 35% of the bracket's cost, stop out your callers under the same 20% of the profit rules we stop ourselves out once they reach 50%) we actually did much better but it's too messy to get an exact number as we added some and sold some so the comparison isn't there but this is a nice way to take a pure look at what balance does for you – hopefully we can all work on getting better at it for the balance of the year!