The Goldilocks Entry

I was speaking to someone last night about setting up a fund and he asked me what the optimum amount was to set up a virtual portfolio and I told him you have to first come up with a strategy and work your way backwards from there.

Let’s take a look at my strategy and what my own logic is for portioning a trade:

It is very important to have realistic expectations going into this.  The returns we have gotten over the past couple of months have been astounding but that is luck – thinking otherwise can get us into big trouble!  The short-term virtual portfolio, which we mainly track, is meant to be the fun one, that is meant to be played with a small percentage of a sensible virtual portfolio.  For larger investments the long-term plays, where we buy leaps and sell puts and calls against them, are the way to go.

Diversification is also very important.  I make a lot of picks because not all picks are right for all people but what is important is that you have a diversified mixture of sectors and no less than 25% (no matter how bullish/bearish the market is) in puts or calls.  Jim Cramer’s game "Am I Diversified" is, I think, his greatest contribution to novice investors.  No more than 20% in a single sector!!!

It’s actually more complicated than that as I will take into account that a DOW call is like an oil put, as they both work off the same underlying factor (the price of oil and gas) so DOW calls do noting to protect my oil puts – they are actually the same bet!  So, if I have enough money for just 10 trades, at least 3 of them will be either puts or calls and no more than 2 of them will be in the same sector.

While it’s fun to imagine you can double your entire virtual portfolio in a month by throwing caution to the wind, you also risk losing it and any action that takes a lifetime’s worth of work (because that’s how long it took you to get the money you now have) and risk it all on a single month is not a good plan!  As I just wrote in my weekend post, Babe Ruth wasn’t great because he hit a lot of home runs, Babe Ruth was great because he batted .341 AND hit a lot of home runs!

The long-term virtual portfolio is my batting average.  I have a high expectation of success for those trades and my goal there is to do a bit better than even on the leaps while generating a monthly income.  This is just month 3 as I scrapped that virtual portfolio at the end of October so we could all be on the same page.  I don’t expect much out of this virtual portfolio yet as we are just trying to wear down the basis – effectively trying to get our money out so we can put it to better use and start making real profits on the remaining positions.

Patience is the key here.  I wrote an article on this subject back on October 8th and, rather than make a book of this, it would be a good idea for you to look at each of these trades when you have the time.  It is important to note that this is not a strategy that works well with every stock, this is a strategy that works with maybe 50 out of 5,000 stocks a month that are in the right position for this kind of set-up!

As I wrote in the article’s title, this is my bread and butter trade – 75% of your options capital (not 401K stock money or IRA stocks) should be in a long-term type virtual portfolio.  Also note that stocks of any type are very risky and I much prefer commercial real estate as an investment vehicle!  The amount you place in a long-term virtual portfolio can actually determined by your short play goals. 

25% of your options virtual portfolio (which should all be considered high-risk capital) can be in the short-term virtual portfolio.  Generally I like to be no less than 25% cash and usually 50% cash at any given time (there should always be enough to double down or move any position at any time).

So, at minimum, 12.5% of your cash would be needed to cover the number of open positions you intend to maintain with an average contract price of $1.50.  I usually enter $500 or $1,000 units with 10 units being a full position, some positions, like Apple or Google, can cost over $1,000 for a single contract (100 options) but for arguments sake let’s say you could get by with $500 per unit.

I usually don’t go further than 50% (5 units) into an uncovered position as that leaves me with at least enough cash to double down twice and roll it (although I would have to LOVE a position to keep after it that long).  See the strategy section for entry and exit rules – I’m sure you can see that we will have no end of things to talk about in our book!

Using this formula, even if I am WIPED OUT of a sector (no more than 20%) of all full 50% entries (that I, for some reason, didn’t cover), since that represents 50% (I stay half cash) of 25% of my option virtual portfolio, my worst-case scenario is losing 1.25%.  If I go totally nuts and I’m using 75% of my cash (for that sector) to double down my positions and I ride the whole thing to a total wipeout – I will lose 3.5%.  Of course this also means that if I have a great run on full positions and make 100%, it’s usually just a around a 10% profit on the total options account but if we can average just 2% on a monthly basis, it’s an amazingly good compound return.

You need to set realistic expectations for yourself when playing with options.  If your goal is to beat the S&P, beat the best hedge funds by a factor of 5-10 (what a double would be) then you will, by necessity, be taking a 5-10 times greater risk.  You must have patience!

Since we have new readers on the site. I will again steer my members to the short film "The Man Who Planted Trees" and urge you to watch it AND think about it as both an investment and life strategy.

You can learn more about investing and planning for the future watching this film than by reading all 12 of Cramer’s books so please take 20 minutes to watch this, especially if you are the kind of person who doesn’t think they have 20 minutes to watch a cartoon!

Just as a quick real-life example we can go over two of yesterday’s day trades.  I always tell people, I’m not a day trader, but I’m not averse to taking profits during the day. 

Yesterday we took two quick trades, MO $90s into earnings on news of the Kraft spin-off and MER 95s on the Fed news that sent the brokerages higher.  The MER was a pure momentum play and we entered at .75 and got out as soon as it lost momentum at .95 while the MO trade was based on a short-term oversold bottom we caught for a cheap entry (at the time, AHEAD of earnings) and sold half as soon as we got the bounce we expected.

One thing I want to point out about position sizing is, in these examples, if you started trading smaller amounts (2-3 contracts, $250 per entry) the $25 (avg) fees would eat you alive as a percentage of your trade! 

These were just quick in out trades and I left half the MOs on the table as I had the basis down to .25 but you can see I made money so fast on both of these that I took them off the table before I had a chance to build up the position as I feel it is foolish to make 40% and 22% in an hour and hold it overnight because you think you can do better.  Who the heck does better than 30% a day?  Greed is what does most people in.

I took the MER trade, as I do any trade, hoping to make 20% on a full position but I made 20% on my initial entry.  If I add to it at that point I’m betting against myself and now I need the stock to go up 40% from my original position in order to get a 20% return on the new position….  The logical thing to do is to sell, not to buy more, but you’d be surprised how many people this never occurs to because "it’s too little."

So anyway, the point is, the gain on the MER is net of a $25 fee and the fee is fairly constant so entering with a smaller position ($200 units) would cause that same "accidental" gain to be just $44, which would be wiped out by fees and would cause me to make a different, poorer decision to hold it, even though it was up 22% in one hour and I felt it was risky to hold overnight.

Effectively, if you start with the wrong amount of resources for your strategy, your plan is doomed before you start (see Iraq for a good example).  If you are going to pursue a strategy for investing, you need to find an entry and exit strategy that is "just right" for your virtual portfolio and work your way up from there!

I want to be very, very clear that I am totally against putting more than 20% of assets into options of any kind and, of them, I would want 75% in the safer, long-term and covered plays.