In an effort to explain how I trade the markets, I have been posting a lot of information about our positions and portfolios. From the feedback and questions I am getting, it appears that I also need to cover a lot of the basics of investing, especially with options, so will try to be as brief as possible and yet cover the subject. I know for some of you, all this is old hat. Just skip over it. If not, maybe a review. To others, this will be a revelation. If you have any comments or questions, just post a reply by clicking the “REPLY” button. You can also reach me by email at Dragonslayer112@Gmail.com.Last post I said we would talk about option basics and the value of time.For our purposes today, options come in two flavors, Puts and Calls. They are actually time specific contracts that can have four sides. If you are long a put or a call, you have the right but not the obligation, to either PUT the underlying (stock, future) TO whoever sold you the long option, or CALL the underlying (stock, future) FROM whoever sold you the long option. If you are short the option, you are on the receiving side of the above and either get the underlying PUT TO you or CALLED AWAY from you, or the options expire worthless and you get to keep the premium.Option pricing is a bit complicated but basically consists of two parts. Intrinsic value and time value. Intrinsic value is the price of the underlying plus or minus the strike price of the option. Since the option is a contract that allows you to capture the strike price, options will never buy or sell for less than intrinsic value. They all have some time value added also. That total number is called the PREMIUM. The price action of the underlying multiplies the price action of the option contract so like all leverage it can come around and bite you. Because of the leverage factor, there are those who speculate on buying Out of the Money options (OTM) in hopes of seeing them double on a very small move in the underlying. These moves can occur in days, hours or sometimes minutes. These people are Gamblers speculating on mostly random action. I much prefer to know the answer to my questions before I ask them and I much prefer to have hedging is place.All of trading involves pitting what you “know” against many, many others and what they “know”. Many of those other traders have great resources to acquire that knowledge, such as the institutions, as well as years of experience. On the surface, it looks almost hopeless doesn’t it? How can we compete with that, especially if we are a new trader?If we view this process as a war, and in certain respects it is, then how does a new trader go up against that sort of an army? Remember a few posts back, we talked about Pareto’s Principle…the 80/20 rule? In our context here, that is where 80% of traders are LOSERS and 20% are WINNERS. Remember also, that we set as one of our Trading Principles that we consciously CHOOSE to be a twenty percenter?So, how do we gain an advantage over the other zillions of traders? I have often said, just give me tomorrow’s Wall Street Journal today, then watchout. The truth of the matter is that I will NEVER see tomorrow’s Journal today. While the possibility of sub-atomic particles moving between dimensions exists in the world of Quantum Physics, for our purposes here, IT WILL NEVER HAPPEN. It can’t happen in this dimension. We will NEVER know tomorrow’s stock or futures prices today. But, in the interest of full disclosure, if I were to invent such a device, I will NOT be telling you about it in these pages. Great fantasy but impossible. We DO NOT know the future price of any stock or future, therefore, any stock or future we buy or sell is a SPECULATION. It may go up. It may go sideways. It may go down. We really just don’t know.Yes, there is news that can move prices. There are fundamentals that can move prices. There are even patterns, tradable patterns, that can be taken advantage of, but it is ALL speculation. In spite of all that, there is one thing we know for sure. We know it with absolute finality. ALL OPTIONS WILL BE WORTH ZERO AT EXPIRATION!Well, in the world of stocks and futures, where everything seems to be made of sand, is that a revelation? Is there a better way and can we create a trading strategy out of that fact? Can anyone else create that same strategy?The answer is yes, yes and yes. To answer the last question first: Others can create the same strategy but most will not. First the 80/20 rule. 80% will blow it off and go on looking for the holy grail of investing, paying all kinds of charlatans and side show operators, newsletters, programs and courses, thousands of dollars for the secret…AND WILL NOT FIND IT. The 20% that look at it seriously will further degrade by 80% because they lack the ability to take action. By the time it is all filtered out, very few will take the action required. If you do, that will put you in the tiny minority.As of now, we know that it is an unalterable fact that ALL options will expire worthless…100% of the time. What else do we know about options? Options are viewed in relation to the underlying stock or future. Therefore, within that relation, the option STRIKE price is either IN THE MONEY(ITM), AT THE MONEY (ATM), or, OUT OF THE MONEY(OTM). We know that ITM options consist of mostly INTRINSIC value and very little time value. OTM options consist of all time value. ATM options have the most premium.The price of options can be shown as a bell curve, with the price of the underlying slicing vertically through the middle of the bell, ATM being at the top, and ITM and OTM out on the flanges. Obviously, the price of time is greatest ATM. Time values peak ATM. Now that we know where the money is, we know where to buy and sell options.So far, our strategy could be defined as: Buy time ITM or OTM. Sell time ATM. Buy time cheap and sell it dear. We are merchants of time.Next post, we will discuss more about options and insurance.FROM THE LOG:No trades today. In our premium capture FUTURES positions we sold time when it was dear and allowed Miss Theta do her work with time decay so we either buy the options back cheaply or better, capture all the premium. We absolutely know the options will go worthless on expiry day and , if out of the money, we keep ALL the premium.DEC Crude continues to inch forward coming just short of $100 a barrel and threatening our $102-$103 short call position. Yet, with only 6 days to go to expiry(as of Friday) and 3 days to go when we come back Monday, Miss Theta is doing her job on the premium decay front. The premium is rapidly falling off and is still below what we sold the options for when crude was in the 70’s. If the first part of the week for Crude is flat to down we will dodge the bullet and capture all the premium. We have already captured all of the Dec 64 put premium from the put side of the strangle. This demonstrates the advantage of the strangle. BOTH sides cannot be threatened at the same time. You always have at least one winning side. As of today, the mathematical probability that we will win this initial strangle is 80%. Annual yield is 761%. Daily Theta Decay is $378 a day.Otherwise, if we continue to be threatened by the price of crude, we have Plan B available, which is to buy the options back and sell the options further up and out. Always for as much or more premium as the buy back costs. That way, we continually widen the strangle which also widens the area of profit by selling more time value further away from the underlying and without taking a loss. As long as Crude does not spike markedly, we will win and capture the premium eventually, no matter where Crude’s price goes.DEC Gold Strangle has 12 days to go (as of Friday), 9 days when we come back on Monday. Gold’s price is almost right down the middle of the Profit Zone at 1789 and the capture is right on schedule and on course. Its mathematical probability of profit is now at 100%. Annual yield is 978%. Daily Theta Decay is $1,072 a day.Be Blessed
When we left off in Friday’s Journal we were discussing options and some of their characteristics. The purpose, of course, is to explain our strategy and edge…something that will allow us to win on a consistent basis.
I said that, so far at least, we could describe our strategy as: Buy time cheap and sell it dear. We are merchants of time. Let’s talk more about amazing options, or derivatives as they are sometimes called, and how they can limit risk. As you will see in the LOG below, controlling risk is paramount for a trader, and we are obsessive about it, even to giving up some profits.
I have often been asked if it is true that a trader could hedge positions to the point of reducing risk in the stock or futures market to zero. The simple answer is yes.
The more complex answer is that sometimes what looks like a hedge is not, or is not as complete as we would like. There are many old wives tales in the market. Things that have been repeated so often that they are universally believed to be true…but some are not.
Hedging can be considered very much like buying an insurance policy. For a price, you can hedge a position to zero risk. Options are almost perfect for that purpose.
The stories you hear, often from your broker, are that people can get into a lot of trouble with options…and there is some truth to that. For example, selling options naked, theoretically can give you unlimited risk; however, I will say it again…if you are dumb enough to let that happen then you should NOT be in options. I have been selling options naked for many, many years and haven’t lost the house yet. You can also lose money in options if you use them as a tool for gambling…but, then, stocks will do that to you too. Frankly, I love the stories because it scares lots of traders away from my side of the street.
Hedging decreases the risk or defines it in dollar terms. One popular hedging technique is the Covered Call.
This popular strategy though as a hedge is flawed. Many brokers recommend covered calls as a way to produce additional income on your stocks. Remember, a covered call is where you buy the stock and sell, or write, an OUT OF THE MONEY call, for which you receive a premium. If during the life of the call, it does not go IN THE MONEY, and expires worthless, you get to keep the premium. If, however, the price of the underlying stock exceeds the strike price of the call, the stock will be called away from you and you will be paid the strike price of the option. You get to keep the premium too.
Sounds good doesn’t it. It is good, under those two conditions…the stock goes up or the stock goes nowhere. Either way we make money. Where we get into trouble, is when the stock goes down. If the stock declines 20% and we received 5% in premium, we still lose 15%. To make matters slightly worse, if the stock goes up we miss the upside.
Covered calls can be used safely if we combine them with another strategy. More on that later.
Is there a strategy that will absolutely define the downside to the penny, allow any upside to accrue to our position, allow dividends to be captured, boring to the point of not even having to constantly monitor the markets, and allow us to sleep at night, no matter what the markets are doing?
Happily, the answer to that one is a resounding yes. Enter the MARRIED PUT.
Married Puts insure against loss and maintain total upside potential. They also allow us to use other hedge strategies that produce income and simultaneously further reduce our defined risk, even to the point of zero, or better, to a guaranteed profit, even if the stock itself goes to zero.
Buy 100 shares of XYZ @ 29.05 $29.13 $2913.00
Buy 1 Jan 2013 30 option 2.50 250.00
Total Investment 31.63 $3163.00
Total Guaranteed Purchase 30.00 $3000.00
Total Maximum Risk 1.63 $ 1.63.00
Total Risk Percentage 5.59%
We now have approximately 13 months to initiate other income enhancement strategies, and dividends, which will further reduce the Maximum risk to zero, or into the guaranteed profit zone. Any appreciation on the stock is also ours to keep.
Tomorrow, more on this strategy.
FROM THE LOG:
Today we further reduced risk by covering two Futures spreads:
Bought to Close 102 and 103 Calls @ .10 and .06. Closed the 64 puts also @ .01 Remember futures are expressed in points. This is $100, $60, and $10 per contract.
Originally Sold and received $10,199. Earned almost all the premium, except the small amount paid to purchase back the options.
Bought to close DEC 2000 Calls @ .30
Bought to close DEC 1400 Puts @ .10
Total Net Capture per 5 lot, $4,099.00
We are now flat in the commodities markets.
With just about anything ready to spook the crude and gold markets, it is likely prudent to set up only puts at this time. Tried to sell the Crude JAN 75 Put at .42, when the bid/Ask was .40/.44, but the MM quickly made our offer the new offer, and we did not get a fill.
Yesterday, Monday, we talked about a married put strategy to put an absolute floor under our stock and provide a platform for additional transactions to enhance the income and reduce the overall risk to zero or less.
Once we set up a trade, buy a highly liquid stock with good prospects of going up, and buy an IN THE MONEY put, out a ways, maybe a year or more, at a strike above the current underlying price, we have a married put. A lot of things can happen in a year, but one thing that will NOT happen is that we will NOT lose money beyond what we have set as our risk threshold.
Now that we have the contract set up and in place, we can sell covered calls without all of the downside, calendar spreads, a collar, or various other spreads to eliminate the downside entirely and produce income. We can get about our business of making money by manipulating time, not the price of securities.
Short commentary today. More tomorrow.
For Tuesday. GOLD. Sold JAN 1510 Puts @ 4.00, or $400 per contract. A 5 put lot gives us a premium of $2,000. When setting a spread, sometimes it is better to go in carefully. Whether we do a 10 lot all at once, or a 10 lot over multiple transactions, commissions are the same.
This is the opening transaction of a gold spread that has its outer wings set at the second standard deviation where the probability of finishing below the put or call target is just 2.8%. Once both outer wings are set, we will receive a premium of around $4,000. Then we will look for an opportunity to set intermediate wings closer to the underlying, depending on market conditions (and geopolitical conditions), probably at about the first standard deviation, to produce more premium…much more premium, of around $10,000. Margin required will be around $40,000.
Implied Volatility is rising and is at a moderate high of 30%. Remember, our objective is to sell time, or volatility, when it is expensive and cover when it is cheap.
Notice that when the market is weak and falling, the premium in the puts increases. When the market is strong and rising, the premium in the calls increases. Obviously then, if we are legging into a spread, we sell into that trend.
Here is how it looks so far:
-5 JAN 1510 Puts @ 4.00 $ 2000
Time to Expiration: 43 Days
BreakEven 1506 15% away from the underlying
Margin Required 7,000
Probability of Profit 97%
Theta (Daily premium decay) 108.53
Annual Yield to Expiration 128%
CRUDE: It is interesting to note that we covered our Crude DEC 102 and 103 Calls on the 14th, when crude was below 100, trending weakly, and before today’s big push. Theta (Daily decay) had decimated the premium with only two days to go to expiry. We were not necessarily seeing into the future, just adhering to our rules. The profits were sweet.
The rule that saved the day is our policy to cover positions to reduce risk and take profits when we have captured 80% of the premium, provided one side or the other is being threatened.
IRON CONDORS: Remember, way back on October 18th, when we initiated an Iron Condor on TLT –Shares Barclays 20+ yr Treasury Bond ETF? It has incubated all these 29, or so, days and loo it is two days (Friday) from expiration. The harvest awaits.
Our short wings are set at the 125 Call and the 104 Put and Miss Theta has done her work and premium decay has picked the pocket of some hapless trader who speculated in long TLT calls to the tune of about 90% of his/her premium, so far. But, you say, according to your rules, you close out any spread when you have earned 80% of the premium. What gives here?
Commissions are larger on Condors and, more importantly, none of the wings are being threatened and we have a very short time to expiry. Today the underlying is at 118.42. Unlikely that the underlying will gain 6 ½ points by Friday to seriously threaten our 125 call. In fact, mathematical Probability says we have a 100% chance of profit and I always trade based on probability.
Maximum profit is .53, or $530 per 10 lot at expiration, before commissions (I reported $463, as max profit earlier in error). If all we have traded is a 10 lot, $530 by itself doesn’t seem like much. Margin required is about $5,000. Too much like watching grass grow you think?
Consider this question though: What is a consistent strategy with a high annual yield and a very high mathematical probability of profit worth? What if we did one of these spreads each week? One spread per week with a 6 week average holding period means about six spreads to fill up the pipeline. That would produce around $2,000 per month, requiring about $30,000 in margin. That is about an 80% annual return. Probability of Profit for each spread runs from 80% to 95% when initiated.
Scale that up by doubling lot size to 20, or initiate two separate spreads of a 10 lot per week. This brings in about $4000 per month. I can hear the question: So, are you claiming 100% of spreads come in? No, not always, but most do and by exiting a trade that is not going our way, under a comprehensive set of rules, limits losses to small, and allows us to replace that spread with one that is more to our liking.
With these kinds of numbers we even get excited about watching grass grow.
To see how many Condors do or do not work out, watch these pages. I will report them as they occur.
Remember, we stay out of prophesying where stock prices are going to go and are not interested in the little up and down squiggles on charts. Too much like reading tea leaves, and about as profitable. We are not interested in being wrong most of the time (or even 50% for that matter).
We are instead, merchants of time. We buy time cheaply and sell it dear.
The Iron Condor is but one of the strategies to do so. More tomorrow.
No Transactions today, November 16th.
COMMENTARY –Wednesday, November 17, 2011
We maintain a constant flow of worldwide intelligence coming into our trading room which is constantly displayed and updated on several of our 12 large screens. Some sources are public, but the majority comes from private and covert intelligence sources. We feel information is essential for making money in these fast moving and treacherous markets.
All of the geopolitical stuff is important because it affects markets so drastically. While all markets are affected, commodities and currencies are very prone to these events and we need to stay on top of them. If we understand some of the dynamics behind these moves, our trading accounts will benefit.
It has been my position for some time now that we are in a deflationary depression. Without going into a long writing on this, I submit as partial proof, housing. Prices continue to fall, with no end in sight. That is deflation. Bank assets continue to crumble, or deflate. Coupled with a REAL unemployment rate of almost 20% and a lying, corrupt government that cannot be believed...that and a lot else, makes for a depression.
Beyond that, our response should be: Be prepared, be praying, be out of debt, be ready to help. Forewarned is forearmed.
The following information and statistics come from the Telegraph's international business editor.
"NEW RECESSION THREATENS the GLOBE"
-Ambrose Evans-Pritchard (Nov 10).
The OECD's index of leading indicators for China, India, Brazil, Canada, Britain and the eurozone have all tipped below the warning line of 100, with the pace of the decline in Europe exceeding the onset of the Great Contraction in early 2008.
Professor Simon Johnson, a former chief economist at the IMF, rattled nerves earlier this week by warning the world is "looking straight into the face of a great depression".
The grim data is coming thick and fast. Japan's machinery orders fell 8.2% in September as the post-Fukushima rebound lost steam and the delayed effects of the super-strong yen began to bite. Export orders have been declining for eight months. "Outright contraction is possible in the quarters ahead," said Mark Cliffe, from ING.
Exports in the Philippines dropped 27% in September, the sharpest fall in two years. Korea's exports have showed sharply, caused by a 20% slide in shipments to Europe. Manufacturing has been contracting for the past three months.
Christine Lagarde, the IMF's chief, warned in Asia that "there are dark clouds gathering in the global economy. Countries need to prepare for any storm that might reach their shores". She said, "adverse feedback loops" are at work as financial stress and economic woes feed on each other.
China's carefully managed soft landing has turned uncomfortably hard, with ripple effects through the commodity markets. Spot iron-ore prices have dropped 30pc since July to $126 a tonne. Copper prices have fallen 20% since August.
Barclays Capital said the risks of contagion to China has become serious. The bank is monitoring the country's "key high frequency data" for early warning signs of the sort of sudden crash in metals demand seen during the Lehman crisis...
"The credit spigot has been turned off in the US," said Chris Whelan from Institutional Risk Analytics...
Fiscal and monetary stimulus has disguised the underlying sickness in the debt-laden economies of the West over the past two years. This heavy make-up has at last faded away, exposing the awful visage beneath.
It is a delicate moment. The risk of a synchronized slump in Europe, the US and East Asia is bad enough. What is chilling is to face such a possibility with the monetary pedal already pushed to the floor in the US, UK and Japan.
Worse yet is to do so with Europe spiraling into institutional self-destruction...
This past week or so, we have discussed the Married Put Strategy of precisely defining Maximum Risk with each of our positions and have touched on producing income from those positions. We have also discussed the Iron Condor Strategy and the production of steady but EXTREMELY boring income. We made a case that boring is good… and it is.
Tomorrow, Geo-political events willing, we will discuss another method of producing income to fatten our trading accounts.
Hedged our short 1510 puts by buying: +5 JAN 1515 Puts @ 5.50, or $3500.
When coupled with our short 1510 Puts, this sets up a Put spread with a maximum risk of $1100, capping the risk on our formerly naked short puts. This is also a good example of what can go wrong when we leg into a spread. On Monday, the 14th, we got a fill of the puts but missed on the calls. The market immediately began to fall. The end result is we have no call premium anchor which gives us an unbalanced strangle. Had we gotten a fill on the calls, those options would have been losing premium very quickly in this market (profitable to us), offsetting the increasing premium of the short puts (not profitable to us). Instead, we have had to employ a hedge.
It is also a good example of what active management of positions does for you. There is no need to take large losses. If, or should I say when, the Gold market turns around, we will sell short OTM call premium to balance the spread, then sell off the bought (long) put to recover some or all of the $3500. An unintended positive consequence of the hedge is that it reduced margin down to $1100.
When the market turns around, we will proceed with our plan to sell more puts and calls to enhance the premium generation and ultimately, the harvest.
From the Dividend Machine Portfolio: Sold Payex stock @ 28.621, for a profit of .34p/sh. Sold the married puts for 8.10ea. Paid $7.60 on Oct 27th. This gives us a profit of $ .50 ea. on the puts, or .84 p/sh total.