Options Sage submits:
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 $200K 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!
Phil commented this week 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 $10K virtual portfolio 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
Instead of placing the short call out-of-the-money in the conventional format, the short call is actually placed in-the-money.
Example 1: 10% in 10 Trading Days
DNDN closed on Friday at $18.05. Since the stock has had a big run up recently, a pullback or consolidation at this point would not come as a big surprise. Rather than chasing the stock (it was at $14 early in the week and $5 the week before), an in-the-money covered call strategy can be employed which will produce a 10% return in 10 trading days should the stock keep rising OR stay flat and it leaves you with a profit even if the stock pulls back 10%.
This trade involves purchasing the stock at $18.05 while simultaneously selling an April $17.50 call which, based on Friday’s close, lowers the cost basis by $2.15. Instead of taking $18.05 out of your pocket, you would only be required to spend $18.05 minus $2.15 or $15.90. That $15.90 becomes 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.
In fact, the trade is setup so that $0.55 is lost on the stock transaction (stock purchase price $18.05 with agreement to sell at $17.50) while the short call credit of $2.15 is paid if the option is assigned i.e. if the stock remains above $17.50. In fact, once an option is $0.05 in-the-money at expiration, an obligation – in this case to sell stock – is automatically assigned.
So, with a risk of $15.90 and an obligation to sell at $17.50, a nice $1.60 profit, equivalent to 10% return on risk, is what is currently being offered for the final 10 trading days through to April expiration…
If the stock remains above the short call strike price at $17.50, the trade generates 10%!
If it drops below that strike price, the trade can still be profitable but must remain above breakeven at $15.90.
The bottom line is the stock can drop from $18.05 to $15.90, an 11.9% drop, before the trade would show a loss. The stock can drop from $18.05 to $17.50, a 3% drop, and still produce a 10% return in 10 trading days. 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 a $10K virtual portfolio, this strategy can be employed regularly on relatively inexpensive stocks; less than $20 per share. And often 100 shares & 1 contract lot trades can produce handsome returns over time.
It's even better when you catch these at the right time and Phil made his call on this play in Friday's Intraday Alerts (and of course during our comment session) as the stock was on the move at 12:46 when he told us to take advantage of the short pullback and buy the stock at $16.40 and sell the May $15s for $4.50 or better. Well the May $15s finished the day at $6.35 but even if you sold them for just $4.50, the trade lowered your basis (your capital at risk) to $11.90 on a stock that is now trading at $18.05. If you get called away on May 18th for $15, your profit will be $3.10 on the investment or 26% in just over a month – that's a very nice low-risk return!
This trade can still be done at today's prices with a net cost of $11.70 (based on the close of the last 2 trades on the stock and the May $15 call). The only difference is you miss the additional spread gained from Phil's very good timing (although Phil did flip to selling the Apr $17.50 after picking up the stock at $16.40 for a best of both worlds trade). Things continue to look good for DNDN and Henry Bee submitted a very nice article on it in SeekingAlpha.
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 $160 as a minuscule amount and dismiss it as not worth considering. But look at the rate of return! 10% in 10 trading days is outstanding!
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 (Phil's original trade), 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.
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.
[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
Before addressing the specifics of LEAPS Calls, let’s briefly revisit last week’s article where we discussed new virtual portfolio margin requirements that came into effect April 2. In that article I commented that I think one of the big winners from the change in regulations will be OptionsXpress (which Phil turned into a very nice trade!).
With an increased wave of sophistication among retail traders toward managing risk through sophisticated hedging strategies in addition to new SEC policy that rewards traders who understand how to manage risk, OptionsXpress seems to be well placed to benefit from increased revenues from exponential increases in interest charges.
Since we know brokers are still working on the necessary programming algorithms and stress-testing their systems before formally rolling out the new offering, the benefits to OptionsXpress are unlikely to be seen in the short-term. However, long-term Jan09 Strike 30 Call options offer a nice entry with the stock much closer to support than resistance levels and, in addition, earnings per share numbers are expected to show attractive year-on-year increases through to the end of 2008.
Phil still favors holding the LCRAF Jan '08 $30s for $1.05 to keep the risk low ahead of earnings, followed by a roll into the Jan '09s, probably the ZCRAF Jan09 $30s, currently at $3.00 (or whatever they end up at). The idea behind this entry is that the stock is unlikely to fall below $22.50, which has held since Nov '05, so the loss per contract is unlikely to exceed .40 while the gain per '08 $30 contract will EXCEED the gain on the '09s we really want without having to commit $3 to the position ahead of earnings, which could go either way.
For a $10K virtual portfolio, a 5 contract lot would be relatively safe, representing an account capital allocation of approximately 5%. This could be scaled up to 10%-20% at most over time and the real 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.
A slight variant on this trade is to engage in a ratio calendar trade. For example, 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.
Example
NYX has had a big move up from recent lows. In fact, it soared to over $100 per share in anticipation of the NYSE/Euronext deal closing. And then, on Wednesday and Thursday last week, as the deal closed, the stock pulled back relatively sharply to its current level of $96.74.
In spite of the pullback, I am still comfortable that the synergies between the two companies can lead to a higher stock price. However, the recent pullback was somewhat surprising so a hedged calendar trade might be in order.
The Trade:
3 long call options at strike $100 for June costing $5.50 & 2 short calls at strike $100 for May, which offer $3.70 of credit.
The combined trade has a risk of $910 which is just 9% of the $10K virtual portfolio. Should the stock decline to a target support level we could certainly close out the short calls at a profit by buying them back and then we would simply hold the long calls during the next uptrend. If the stock flat-lines we know that time-decay erodes the short option faster than the long option, which would generate a handsome profit. Finally, if the stock rallies we have more bullish long options than bearish short options so the trade has the opportunity to profit even more quickly.
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.
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. TSO that Phil has talked extensively about, and on which he has bought put options, is a prime example of a predictive trade. Phil plans on scaling into his put purchases and I have no doubt he will end profitable despite the trend moving against him in the short-term. For a $10K virtual portfolio, this shorter term move can be very detrimental since the ability to scale in is limited by capital constraints so such trades should be entered judiciously. We already took a DD on the VLO puts and Phil has already mentioned that these were too risky for the $10KP.
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.
Have a fantastic week!
Options Sage
