Improved? Conservative Options Strategy

yucca_mtn,

Thanks for describing what you are doing - I think it seems like a reasonable strategy, especially given the facts that you mention in your first post that you look for - obviously you don't just select the stocks and the timing willy-nilly or anything.

I have a couple of quick questions that I would like to ask you - sorry if you might have already mentioned something in a post - I haven't read this entire thread in detail yet.

1. I know you shoot for a certain return, but in net value per spread is there a number you attempt to close at normally? For example, maybe $450, $440, etc. I would think that if you try to get too close to the full $500, then you could risk early exercise because either the call has become way too deep in the money and/or time is draining. Anyway, I guess I wonder if after you buy these you decide on a target price and either put the sell order in or just watch for the price manually.

2. Do you have any hedge against an overall market tank? It seems like if the market did get hit real hard either slowly but surely or if it got hit hard quickly that could really hurt some of these positions (and since you are long all of them, they could all be hurt at once). Do you have any real hedge? Have you tried to estimate for example what would happen if the markets went down x% or anything?

JJacksET4
 
JJacks, As for my yield target I shoot for 35% annual return. That number is adjusted for market conditions which I consider treacherous at the moment. A smaller target may seem more safe but is not in my opinion safer. So to get that return in this dangerous market, I go further out in time to select my positions.

And yes, I will happily exit profitable spreads early as you suggest. As to early expiration I am all too familiar with the hazards associated with that, it was much discussed in my previous threads, however I mentioned these longer spreads will rarely last till expiration. Since early expiration "usually" occurs very near the natural expiration, I am much less concerned now than I used to be about that. Also having a portfolio with a good chunk of cash, percentage-wise, helps too - to cover those unexpected stock purchases.:) And thanks for your post.


Hedging has already been talked about here. Now, if SOMEBODY WHO HAS ACTUALLY LOOKED at the spreads I have will be kind enough to offer intelligent suggestions about how exactly I can improve my portfolio, why, damn, I would be grateful.

Lastly, there is no intention on my part to sway any trader's methods to my way of thinking. If you have been successful in your own right, great job, don't change, and help me do better. I hope some day to affect the thinking of (or maybe even help) some newby who is looking for a path along a dangerous road.
 
I decided to do some maintenance trading today: profit taking, risk reduction, and dealing with some DO positions I want to get rid of. Some of the positions are duplicated in different accounts.

POSITION, BOUGHT, SELL AT, PROFIT, NOTE

Account M:
SOLD 100 EWZ (LONG), 61.05, 69.415, 830, take profit
SOLD 6 GDX JAN11 30/35, 3.57, 4.61, 614, early exit
SOLD 10 GG JAN11 25/30, 3.48, 4.6, 1101, “
SOLD 100 GLD (LONG), 69.76, 119.67, 4989, partial position
SOLD 6 SLV JAN11 10/15, 3.62, 4.65, 613, early exit

Account H:
SOLD 8 AUY JAN11 5/10, 3.5, 3.93, 331, risk mgmt
SOLD 4 FCX JAN11 55/60, 3.56, 3.655, 31, “
SOLD 10 GDX JAN11 30/35, 3.52, 4.665, 1125, early exit
SOLD 5 GG JAN11 25/30, 3.18, 4.6, 704, “
SOLD 50 GLD (LONG), 75.99, 119.55, 2176, partial position
SOLD 5 MLM JAN11 65/70, 3.44, 3.45, 4, risk mgmt
SOLD 6 SLV JAN11 10/15, 3.62, 4.62, 594, early exit

have bad position: 5 DO JAN11 59/64. Decided to leg out since stochastic looks oversold (to me).
Have 5 DO JAN11 59.25 cost 20.43 present value 6.85 (long calls) paper loss -6789
5 DO JAN11 64.25 original 16.73 present value 4.5 (short calls)
Position has paper loss of 680.

BTC 5 DO JAN11 64.25 @ 4.5 (profit on sale 6109)
GTC STC 5 DO JAN11 59.25 @ 7.95 (if sold position will close with 180 loss)
I am at risk for $3425 to gain 550 if GTC sells. So I'll watch it closely. I'll try this same trade on two other accounts today.

Account R:
SOLD 4 MLM JAN11 65/70, 3.44, 3.46, 1, risk mgmt
SOLD 6 SLV JAN11 10/15, 3.6, 4.62, 595, early exit

BTC 5 DO JAN11 64.25, 4.6, 6199
GTC STC 5 DO JAN11 59.25, 7.95
If GTC successful, will convert paper loss of -6823 (position loss -624) for a position loss of -124


Account R2:
BTC 5 DO JAN11 64.25, 4.65, 5689
GTC STC 5 DO JAN11 59.25, 7.95
If GTC successful, will convert paper loss of -6336 (position loss -647) for a position loss of -147

SOLD 5 DVN JAN11 55/60 , 3.31, 3.45, 63, risk mgmt
SOLD 5 EWZ SEP10 50/55, 3.73, 4.82, 549, early exit
SOLD 5 FCX NOV10 60/65, 3.3, 3.55, 88, risk mgmt
SOLD 10 GDX JAN11 30/35, 3.4, 4.674, 1274, early exit
SOLD 6 GG JAN11 25/30, 3.15, 4.6, 860, “
SOLD 8 SLV JAN11 10/15, 3.3, 4.62, 1037, “


Account T:
SOLD 6 AUY JAN11 5/10, 3.5, 3.95, 260, risk mgmt
SOLD 100 EWZ (LONG), 61.35, 69.85, 849, take profit
SOLD 5 GDX JAN11 30/35, 3.36, 4.7, 663, early exit
SOLD 6 GG JAN11 25/30, 3.6, 4.6, 535, “
SOLD 5 NEM JAN11 30/35, 3.86, 4.814, 468, “


Note: if the buy price and sell price don't seem to agree with profit, the profit number is correct off my account statement.
There can be small errors in listed buy price, and with commissions, that is the difference.

In my next post (more or less) I will tell any interested party (what my version is of) what you need to know
to learn this kind of trading - as a minimum. Obviously I am not qualified to teach an options course, but I can at least tell you what I think you need to know, as an average guy trying to understand this stuff.
 
This post is for a couple of people who might have an interest in this methodology but don't really understand what is going on. I hope this post helps.

Many option traders use complicated strategies. They are not easy to understand , are not intuitive, and can be difficult to manage. These people as a rule I think are more successful generally than daytraders. They take their craft seriously. They study options theory and the methodology in depth, and work constantly to maximize their yield and improve their profitability. They use every technical tool available to create their edge and consistently are profitable. They are not bored.

Then there are people like me. We want to keep it simple and common sensible, and keep the technical side of trading to a minimum. I'm retired, and the money I lose is not replaceable by a salary and years to accumulate saving. I'm looking for modest yield, and as much safety as possible. During the bull market years I was hitting 50% annual yield doing shorter term DITM bull spreads, but I was too extended and got bit. By that I mean I was investing 70 to 80% of my portfolio to these spreads.

Nowadays, that methodology doesn't work Todays market is very dangerous and I consider 10 to 15% portfolio yield do-able with the increased safety margin I need. So I do longer term spreads of 9 to 18 months. That allows me to set up spreads that I believe are hedged for quick market turns, and overall give me an edge as well. So that is why I only put 30 to 35% of an account into these spreads., in today's market.

So for non-option experts, I want to explain what this thread is about. The vertical bull spread is the simplest and most adaptable option strategy that exist in my opinion. These spreads can be ITM (in the money), ATM (at the money) or OTM (out of the money). Now this is not an options course but a very brief summary to understand this thread.

The vertical bull call spread consists of two call options – one you sell (short) and one you buy (long).
The long call always has a strike price that is lower than the short call. For ITM spreads (for this thread the term “spread” is assumed to be a “ITM vertical bull call spread”) the long call is always more costly than the short call, so you pay up front for the spread. The deal is you always pay less than what the spread will be worth if it is successful, and thats how you make a profit. The spread is successful if the strike price of the of the short call is lower that the price of the stock (the underlying basis of the cost of the spread). If you are interested in this type of trading, you must study enough option theory to understand deep in your soul what the meaning of all this is.

So here is the strategy in a nutshell: You buy a spread that has (much) lower strike prices than the current price of the stock. If the price of the stock is still above your spread strikes at expiration, then you make maximum profit.

After you have spent enough time, and done enough independent research, to understand these couple of paragraphs, then you can look at the example spreads I've shown you in previous posts.

Take this example, of a position that was successfully closed for a profit:
SOLD 5 GDX JAN11 30/35 3.36 4.7 663 early exit

At some time in the past, when I thought that GDX was at a cheap price, I bought this position. I bought 5 call options of GDX with a Jan 2011 expiration and a strike price of $30. At the same time (using a spread option trading platform provided by my broker) I sold 5 call options with the same Jan 2011 expiration but a strike price of $35. I don't know or really care what the original prices of those options were (of course I have a record of the details). What matters to me is that I paid $336 for each of these spreads. Now if the price of the stock stays above 35, the spread will eventually sell for a maximum price of $500 dollars, so I expected to make $164 profit. Now to understand why I selected those strike prices and that expiration date, you need to look at a chart of the GDX prices for the past year or two. And you need to see that GDX is an ETF or an index of gold related stocks. It is therefore more stable than any individual stock might be, which is a factor in selecting strikes. Now if you figure the yield of the investment (164/336) it is 49% over about a year duration. That is a high yield in todays market, but I used stochastics and a minimum of technical analysis to buy in when the ETF was at a low price (near support), and as it happens sometimes, the ETF did well. Look at the example again, see that I exited the position (sold the spreads) in August 2010, well ahead of the Jan 2011 expiration. I sold the spreads for $470 each and made $663 on the sale of the 5 spreads. It was not wise to hold the spreads for an extra five months to collect another $30 per spread. I also freed up $2350 that I can probably reinvest for a better yield than $30X5 over 5 months. Hopefully you will discern from the charts that this spread was indeed DITM, and why that correlates directly with safety.

You must learn some new skills, but when you balance what you can accomplish in the future against the relatively easy to learn skills you must have, it's kind of a no brainer. A few hours or 200 hours, what does it matter?

This is what I think you have to do know to be able to invest in spreads like these:

Enough option theory to understand this one particular option strategy (out of dozens available) really well. I mean really well. It's all about risk vs. rewards, safety vs. greed. These spreads can be structured anyway you like.

Enough technical analysis to come reasonably close to picking lows in prices, this is not so hard as you might think. That is because spreads that are 9 to 18 months away from expiration, and are Deep ITM, have very low deltas, which means the price of the spreads are not very sensitive to price changes in the stock. If a stock shows support at 40 and resistance at 55, if you buy the spreads when the underlying is between 40 and 43 (for example), the spread price will still be viable for the position.

You need a broker with low commissions, and a combination option platform, and paper trading for practice and for learning their trading platform. There is nothing quite so memorable as buying 15 spreads or 50 spreads when you wanted to buy 5, because you were careless with the keyboard.

You need to develop a method for selecting stocks. You want good sectors, you need not invest in bad sectors simply for the sake of a diversified portfolio. You need stocks that have a lot of option strike choices, open interest, enough volatility to provide profit and safety. There are many other factors, it is totally up to you to do stock selection. There is no guru. No single source of wisdom. It takes time and hard work.

You also must think about money management. What percent of your portfolio for spreads, for long positions or covered call positions, or cash or whatever. You skill level and experience might determine your investments.

You need to have as good an understanding of general market conditions as possible.

There is no such thing as too much knowledge, but we also have to be practical when we don't have unlimited time. Do the best you can, start slow, be super conservative, like any trader. Gain experience for at least a year before you will begin to feel comfortable.

Now a quick word on hedging before I close this post. Hedging is simply protecting yourself against the inevitable ups and downs of the market. A perfectly hedged portfolio is neutral and cannot make a profit. What people do to protect their portfolio is to limit investment exposure. The nature of the kind of spreads I propose here (and practice here) have built in hedges by virtue if being DITM, by being long term, by using TA for market timing (as I've said there are only several opportunities a year to optimally open positions), by limiting the percentage of portfolio that I invest, and by using experience and whatever acquired skill I have is managing positions and risk. That is enough of a hedge for me.
 
I couple of days ago I successfully legged out of several unfavorable DO positions. Since the market tanked today, I thought it might be a good idea to try that trade again on two remaining DO positions in other accounts. Same exact trade, hoping for the same outcome......

BTC 5 DO JAN11 64.25 @ 4.1 for a gain of 6007
GTC STC 5 DO JAN11 59.24 for 7.5 (now at 6.35 so I have 3175 at risk)
Paper loss on these long calls is -6681, if the GTC hits I'll save 575 of that loss.

BTC 5 DO JAN11 64.25 @ 4.1 for a gain of 5859
GTC STC 5 DO JAN11 59.24 for 7.5 (now at 6.35 so I have 3175 at risk)
Paper loss on these long calls is -6531, if the GTC hits I'll save 575 of that loss.

I also bought:
5 DO JAN12 39.25/44.25 @ 3.61
5 RIG JAN12 35/40 @ 3.46
DO still near support. RIG is a little higher than support, but I did it anyway - cost of spread was near previous costs for same spread.
 
Some more trading today, mostly maintenance.

Account E:
SOLD 5 AEM JAN11 35/40, cost 3.2, sold at 4.762, profit 766
SOLD 8 GLD JAN11 95/100, cost 3.2,sold at 4.65, profit 1137
BUY 4 DO JAN12 39.25/44.25 @ 3.6
BUY 3 NE JAN12 20/25 @ 3.5
BUY 4 CNQ JAN12 20/25 @ 3.68
BUY 5 CNQ JAN12 20/25 @ 3.48

Account G1:
SOLD 8 GDX JAN11 30/35, cost 3.32, sold at 4.595, profit 1014
SOLD 8 GLD DEC 95/100, cost 3.3, sold at 4.754, profit 1157
SOLD 6 SLV JAN11 10/15, cost 3.6, sold at 4.6, profit 583
BUY 5 CNQ JAN12 20/25 @ 3.67
BUY 5 CNX JAN12 20/25 @ 3.49

Account G:
SOLD 5 EWZ JAN11 45/50, cost 3.6, sold at 4.56, profit 476
SOLD 5 GDX JAN11 30/35, cost 3.56, sold at 4.71, profit 566
SOLD 6 GLD JAN11 90/95, cost 3.46, sold at 4.75, profit 765
SOLD 4 POT JAN11 70/75, cost 3.6, sold at 4.86, profit 502
BUY 5 CNQ JAN12 20/25 @ 3.68
BUY 5 CNX JAN12 20/25 @ 3.49

Before I started trading today I made a list of 10 prospects that looked promising from charts and opening prices, but only 4 worked out. I have a list of about 90 stocks and etfs I monitor, but about 70 are those are in sectors I don't like right now. Maybe if the expected big crash occurs later this year I'll look at them again.

Most of the JAN12 positions I'm entering now have strikes that should survive even if the lows of March 2009 are revisited. Not that I would still be holding them! We could still go lower than that, but the V shaped lows of the very worst days only lasted one month (mid Feb – mid Mar), and my spreads are relatively long.
 
I apologize if you already answered this, I didn't see it in the posts.
Why are you using DITM debit spreads instead of OTM credit spreads?
The risk reward is the same profile and the OTM has a tighter bid ask spread. Ex. IBM Jan 12 100/105 call spread at 3.68 mid or Jan 12 105/100 put spread at 1.42 credit. You have a better profit on the put side and you can let it expire if you want without having to pay commissions to get out.
 
Dolemite (rock-hound?)

I'm aware of the synthetic equivalence. And I understand most option traders use the credit vertical bull spreads. So I don't have a strong reason to persuade others to do debit spreads, however I have my reasons.

The debit spreads are more intuitively correct for my mind set, that is they are very simple and I don't have to reverse my brain to scan a lot of positions and see exactly where I stand and what I need to do. I am used to them!

I prefer credit spreads to debit spreads because I pay in advance and I always know how much cash I have available in any portfolio. It is more complex, in my opinion especially when you are dealing with multiple accounts, to see that you have long debit positions and short credit positions and maybe it creates some margin confusion to see exactly where you stand and what your risk is. The last reason is that the few dollars I (may) be loosing by paying too much for equivalent spreads are not worth screwing up the first two reasons I gave you. The nature of the spreads I put on are not seriously affected by the nickle per spread I (may) loose on the front end, and I don't worry about the relatively small commission (typically 1.5 per contract maybe 7.5 for 5 spreads) to end a position early if I can collect a $500 profit five or six months ahead of expiration. Same deal with puts, do you wait an extra 5 or 6 months for expiration,when you can take an early profit by paying a couple of bucks in commissions?

The most dangerous aspect of debit spreads, in my opinion, is early execution, and possibly not having the cash or margin required to handle the unexpected transaction. But that is offset by the danger of the credit put spread getting in trouble and creating unexpected margin problems of equal severity. Anyway the risk of early execution is minimal since I would very rarely hold a spread till expiration.

It boils down to the old saying: There's an ass for every saddle.
 
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