Options Sage submits:
Last week’s article discussed smart virtual portfolio management with respect to a $10K virtual portfolio. In this week’s article we will consider a fairly conservative managment strategy, using options to enhance returns in a $200K 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 LCRAF Jan ‘08 $30s for $1.05 OptionsXpress calls for example that we mentioned last week – up a healthy 38% since the 4/6 close for the week before earnings! If the stock had stayed flat for many months those calls would have suffered from time-decay continually eating away at the $1.05 of premium. So much so, in fact, that even if the stock did move bullish close to expiration, a much more substantial move would have been required to overcome the effects of time-decay erosion on the option premium and turn a profit.
We also have to factor in another risk variable, implied volatility. Research in Motion traded as high as $148 prior to its earnings report this week and, with a P/E of 59, Phil reasoned that if the stock didn’t report stellar numbers and forecasts, a correction was in the offing. Phil accumulated long put options at $130 for less than $1. As the stock dropped all the way to the low $130s in after hours trading following the report, it would have been easy to presume that those long puts would be making tons of ‘moolah’!
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, $200,000 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 virtual portfolio's starting balance, 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 the dollar’s seemingly never-ending decline.
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 $200K 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 '08 is just 9 months away, we should target at least a 15% return in 9 months which equates to approximately the same thing on a rate-of-return basis.
AAPL has had a nice decline to $90.24 from recent highs at $96. Jan ’08 $90 calls can be sold for $12.30. A quick calculation yields:
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Cost Basis: $90.24 – $12.30 (calls sold) = $77.94
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Projected Reward: $90 – $77.94 = $12.06
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Projected Return on Risk: $12.06 / $77.94 = 15.4%
Should we consider such a trade, our expectation should be that Apple will not fall below $77.94 by year’s end. We would realized maximum reward of $12.06 should the stock stay at, or rise above, $90 and between $77.94 and $90, we would be making a return between 0% and 15.4%.
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 $102 i.e. $12 above the short call strike. However, we don’t require that the stock rises $12 in order to generate our return. This philosophy of profiting without requiring significant stock movement is a particularly attractive feature of this trade.
Dedicating 10% of trading capital to a single trade like this would not be inappropriate at all. In fact, a 300 share/3 contract lot trade for AAPL would require just over $23,000 of trading capital, which is relatively prudent risk management for a single hedged stock trade like this on a $200K virtual portfolio.
In fact, you could spread your risk among 7-10 stocks in this manner and dedicate up to 80% 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 Apple to highlight the point. The May $90 calls at $4.10 carry a $3.86 premium over a 34 day timeframe. On a per day basis, that equates to about $0.11 per day. Contrast that with the longer term LEAPS in the previous example. They offered $12.30 over 279 days, equivalent to approximately a $0.04 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 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.
Smart LEAPS
With approximately 10%-15% 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 calls.
For example, this week, Phil found a perfect example of an appropriate LEAPS call option. In comments on Friday he mentioned that he was picking up LEAPS 09 strike 65 calls for Johnson & Johnson.
“JNJ – no way would I short at this price. They are another great exporter and they are beaten down on the same news that BSX is recovering from. I’m not sure I would want to risk them pre earnings but he May $65s are a fun bet at .22. Had I realized they were bouncing off $60 a couple of weeks ago I would have made a leap play there. This is a globally diversified $180Bn company that makes every disposable thing you use in your bathroom – talk about a defensive stock! They pay 2.4% dividend and make $11Bn a year (which used to sound like a lot pre-XOM) with $4Bn in the bank and no real debt. They also bought back $36Bn worth of stock last year (20%) yet they are trading flat to January and their EPS is projected to go up just 6% on a 20% increase in sales (Gillette aquisition costs are expected to be high).
OK – you’ve convinced me, I’m going to add some Jan ‘09 $65s for $4.75!”
With the last 5%-10% 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 5 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 5% returns your bank likely offers!
Have a fantastic week!
Options Sage
