At Friday's close Dan asked about why deep in the money calls are for suckers and I thought it would be good to put up a general post regarding the LTP strategy as we have a lot of new members and it is a critical part of what we do here.
We were discussing AMZN '09 $80s but AMZN '09 $80s are not "Deep" in the money. When I say deep in the money I am talking about owning, let's say the '09 $45s, which tie up $47.50 and have $3 in premium vs. owning the $75s, which cost $27.12 and have $13 in premium.
Since you have the expectation of selling at least $3 in premium per month for 12 months you will generate the same $36 in premium sales from $47.50 as you will from $27.12 so there's no fancy math genius involved in this, just the obvious fact that if you can make the same money with less at risk, you should do so and use the other $20 to diversify yourself rather than place a much larget bet on the same exact position.
Again let's remember that I invest with price targets. Most option systems on the market treat the strike prices as random events and their strategies are based on statistical relationships between the contracts which is why so many of you are focused on the greeks but I'm buying AMZN because I am better than 75% confident that by Jan 2009 the stock will be above $100 meaning the premium I am paying for my option is irrelevant and also why I don't mind if my callers make a profit.
With my price target I expect my callers to "make" at least $11 on me over the course of the year otherwise my price tartget is wrong isn't it? Every dollar they make puts my call deeper in the money and reduces my own premium (I am losing $1 per month at the outset on those Amazon $80s) so it's more like me reducing my own premium rather than "losing" money to my callers.
If you think about it, I end up paying $40 over time, not too much less than I would have paid to go "deep in the money" at the outset, but that extra $13 was paid out of the premiums I got from my callers, not out of my pocket. I am a landlord paying off a mortgage by renting to tenants – of course I still have some expenses but, over the long haul, I expect my property to increase in value enough to offset my interim contributions. If there is a storm, I fix the damage and move on or I declare it a disaster and walk away and if there is a sudden spike in the value of my property, I need to consider selling at the top of the market but, otherwise, I simply collect my rents every month until the day I own my property free and clear at which point I either sell it for the cash or continue to rent it for a monthly income.
I am not trying to make money on my leap per se. I am looking to make money off the monthly sale of premiums. If I successfully sell about $3 a month in premiums then my basis on the '09 $75s goes from $27 to $24 to $23 to $20… and by the time we get to August I will own the $75s for free and my next 4 sales are 100% profits and whatever money I collect on Jan 16th, 2009 is a windfall as I already would have made $12 in the 4th quarter for free.
That's why the STP and LTP start going exponential at the later part of the year, my risk on many of these positions is near zero while I continue to collect a full premium every month. This is why I constantly try to get people to watch "The Man Who Planted Trees" – Patience Daniel-san is as important as Balance Daniel-san!
If you plant 1,000 oak trees in your backyard you will break your back all fall and look out over a bunch of dug up piles of dirt all winter. In the spring you will see perhaps half of them sprout and 1/2 will be "failures." In the summer little progress will be made and if you had your heart set on seeing 1,000 oak trees in the fall you will be sorely disappointed, just like many people seem to be when they try a new strategy and aren't rich within 3 months.
You have to follow the strategy, believe in the strategy and reinvest/replant each season (just like we roll the LTP positions that we still believe in to the next year each July) and, after a certain amount of time, you will have a forest of cash, more than you can ever make with haphazard investing. Just like a yard full of saplings, some will thrive on their own and some will require care and some will have to be removed if they get too sick as they take recourses away from the other trees without much long-range chance of return. In ten years you will have a very nice yard and in 20 years it will be most impressive and by the time 30 years have passed, it will be almost impossible for people to believe that you created that forest with your own hands. There is a man who invests this way, his name is Warren Buffett!
It is a game changing/life changing experience to adjust your thinking to the longer-term and get your head above the day to day crash of the waves that pound the market, and your virtual portfolio. They have always been there and they always will be. It is up to you to rise above this and develop a strategy that will work, not just now, but for the rest of your life. Once you have that going smoothly, there is plenty of time to play in the waves – and you all know how much I like to play when the surf is up!
Much like building a beach hose in Malibu, there are tradeoffs between being close to the water and having your living room washed out to sea on a regular basis. When we set up our long-term positions we expect a few storms and, unlike a beach house, it is fairly easy for us to pick up and move to higher ground when we need to. Moving does cost money, in the case of our leaps, we end up paying a bid/ask spread on the leap we sell and the leap we buy within minutes so we don't roll our position every time we get a little wet.
Our short callers provide us protection against all but the worst storms and another reason I don't like to be too deep in the money is that your downside delta is higher than your callers. In other words, If I'm in the Jan '09 $75s and Amazon drops $5, I can expect my leap's value to drop to that of the $80s, which are $2.64 less. Looking at a worse-than-that case, I see that the $85s are $5 less than my $75 leaps. On the upside, I look at the $70s at $30 so I can expect to "make" $3 on a $5 move up in the stock. This means I lose LESS on the way down than I gain on the way up – THAT'S GOOD!
Let's say my target for AMZN through 1/18 is $95 (earnings are 1/30). I'm going to sell the Dec $90s for $1.50 because there's only a week left so that is just "free" premium to collect but I need to be mindful that I have poor downside protection so if AMZN drops more than $2 I will have to shift my strategy quickly, probably rolling to the Jan $90s unless the drop is very steep, in which case I may sell the $85s, now $7.28, which give me almost $15 worth of downside protection on my leaps (the amount it would cost me to roll down to the '09 $60s).
Assuming things go well, I collect my $1.50 next Friday and I don't really care if we finish at $89 or even $92 because I STILL COLLECT THE $1.50! The fact that I give my caller back $2 at $92 does not change the fact that I've collected his premium and the net effect will be that, rather than getting $2.50 for the Jan $95s, as I expect to get at $89-90, I will probably get $4 so I will have collected $5.50 – $2 I gave back = $3.50 vs the $1.50 + $2.50 = $4 I expected to collect in my best-case scenario of a flatline. Meanwhile, the $2 appreciation in price has gone straight to the intrinsic value of my leaps so it has cost me a grand total of .50 of my best-case scenario profits to knock $2 off the premium of my leaps.
It amazes me how many members panic about a caller going into the money and I keep trying to emphasize that this is a win-win situation, not a loss on your part. As long as you budget yourself properly and don't let it get too out of hand and you have adequate time to roll your caller – it is a minor inconvenience at best and if none of your callers make any money, how do you expect your leaps to finish in the money. The problem most members have is that you strongly identify with the short-term callers, as you used to be one, while the very slow-building profits on your leaps seem vague and unreal, which is why we call them "unrealized" profits!
Also remember that you cannot just blindly apply this logic to any old position. There are 9,400 stocks on the market and we have just 38 in the long-term virtual portfolio. With AMZN, I like them long-term but I am mindful of the fact that they are up 150% on the year already. That volatility has made them great for selling short premiums on and I'm making this play now because earnings aren't until the Jan 30th and I can collect enough money by then to cover a $20 drop in the stock from which point (after rolling down to the '09 $55s) I would still likely feel good about working them for the rest of the year looking for a recovery. Frankly, it is the marginal $1.50 that we can collect on the current $90s that made me choose this position on Friday, without that small bonus, I probably would have passed on this trade.
My break-even point on this trade (the point at which I fully pay off my leap on the premiums I expect to sell) is August. From September through December I expect to collect $12 additional dollars, technically about a 44% profit on the $27 I initially placed at risk. That extra $1.50 pushes me over 50% which means I can be half wrong and still make 25% for the year. If I can't be pretty damn sure I'm going to make 25% over the course of a year, then there's no way I'd tie up $27 as I'm sure that, if I exercise a little patience, I will find a better place to put my money.
By creating a diversified virtual portfolio where I expect to make at least 50% on my winners, make 25% on ones that don't go so well and lose no more than 25% on the ones I get wrong, I can have a very reasonable expectation of better than 25% profits over the course of the year. If you reinvest those profits (and they come in monthly) on a regular basis, you'll find they compound quite nicely over time. Since your maximum loss is 100% and your maximum gain is unlimited, you also have the chance of lucking out once in a while and adding, 5, 10 or 15% as a windfall monthly bonus but again, I'm pretty good at picking those spots to leave things uncovered, it's not something I suggest just playing at!
The more ahead you get, the more you can play. You'll find that you will do much better at your short-term trading if you aren't depending on it to make or break your month and, of course, we can "day trade" our callers and putters, which is much less stressful than daytrading naked options ourselves. If AMZN spikes down $5 like it did this week, we could have taken out our $95 caller at a $3 loss for the week, rolled ourselves down from the $80s to the $75s for $2.48 and now sell the Dec $90s for $1.50 – WHAT A GREAT DROP!
Love the rallies, love the dips, love the flat spots and you will learn to love the markets, that what this is all about. Plant enough little money trees and, given enough time, you will harvest a forest full of cash!
