Investors Observer Article Archives

The InvestorsObserver articles are provided by Fresh Brewed Media/VHS, LLC (“FBM Content”). The FBM Content, including any strategies discussed therein, is provided for general informational and educational purposes only and is not to be construed as investment advice or as an endorsement, recommendation or solicitation to buy or sell securities. In order to simplify the computations, commissions, fees and taxes have not been included in the strategy examples used in the FBM Content. These costs will impact the outcome of all stock and options transactions and must be considered prior to entering into any transactions. Investors should consult their tax advisor about any potential tax consequences.Use of the FBM Content is subject to the Terms and Conditions of the CBOE Website.

Back to Article Archives

Julian Close's Insights

InvestorsObserver
Financial Writer
Julian Close
Author Bio


February 25, 2013 - Our Experts Share "The Perfect Trade" Strategy

Strategy

Most investors consider options trading risky, and to those who don't know what they're doing, it is. What experts in options trading know, however, is that options are not inherently risky, and in fact, one of the primary uses of options is to reduce the risk in certain stock trades. Using options in combination, it is possible to finesse risk and reward on each trade in order to optimize long-term profitability. To that end, we offer the MarketSmart Perfect Trade portfolio, which was created to showcase what our analysts think is the perfect style of trading.

This portfolio tends to be one of our more actively traded offerings. By using trades with shorter holding periods, we seek to maximize the annual return rate. We have designed the portfolio using numerous bull-put credit spreads which are designed to be profitable whether the market is rising, going nowhere, or even declining modestly.

To create a bull-put credit spread, our analysts sell a put that is well out of the money while buying another put - on the same stock, expiring in the same month - that is even further out of the money. The closer the put is to the money, the more it is worth, so the put we sell costs more than the put we buy, resulting in an immediate credit. This credit is our profit from the trade. Our risk comes from the difference in the price between the bought put and the sold put. If the price of the stock falls beneath the higher, sold put, we will begin to lose money. If the price falls below the lower, bought put, we will lose the money ventured on the trade. For this reason, the price of the sold put will usually be at least 10% out of the money. This is another reason why we use numerous, short trades: all that has to happen for us to keep the earned credit is for the options to expire without the stock price dropping approximately 10%.

In a persistent bear market, we may substitute bear-call spreads for bull-put spreads. This is exactly the same strategy, in that we receive an upfront credit, but in this case, the risk is that the stock will rise 10% or more.

Practice

If you are investigating this portfolio for the first time, you are probably asking yourself one very reasonable question right now: does this really work? It does, but take a look at the history and methodology of the portfolio so you can see not only that it works, but how it works.

From InvestorsObserver.com, select "Portfolios/Portfolio Performance History." Under "Performance Data," select the "MarketSmart Perfect Trade" tab. Here you will see a list of trade months, beginning with the current month. For each month, the amount invested, targeted return in dollars, and targeted return by percent are listed. The asterisk beside February 2013* in the example below indicates that the trades initiated in February of 2013 have not yet closed.


Trade
Month
Amount
Invested
Targeted
Return ($)
Targeted
Return (%)
Feb 2013* $13,050 $1,450 11.11%
Jan 2013 $11,910 $2,090 17.55%
Dec 2012 $14,300 $1,700 11.90%
Nov 2012 $11,000 $1,500 13.60%
Oct 2012 $12,950 $2,050 15.8%
Sep 2012 $13,750 -$750 -5.5%

Results are listed for each month, going back as far as Feb of 2008. The percentage returns in the last column are not annualized, but since the trades in this portfolio last approximately 2 months, you can determine an approximate annualized return (for comparison purposes only) by multiplying by six.

Let's examine the trades in the January 2013 trade month, the most recent month in which all trades have closed. Elite members can view all portfolio trades that our options experts initiated each month, and what happened to close the position.


Date Summary
1/2/13 Buy NFLX 2/16/13 $70 put and sell NFLX 2/16/13 $75 put for a $0.89 credit or better.
2/16/13 NFLX puts expire worthless.
1/2/13 Buy EXPE 1/2/13 $50 put and sell EXPE 1/2/13 $55 put for a $0.75 credit or better.
2/16/13 EXPE puts expire worthless
1/2/13 Buy URI 2/16/13 $39 put and sell URI 2/16/13 $41 put for a $0.25 credit or better.
2/16/13 URI puts expire worthless
1/2/13 Buy BZH 2/16/13 $13 put and sell BZH2/16/13 $15 put for a $0.20 credit or better.
2/16/13 BZH puts expire worthless
2/16/13 This portfolio is closed for a full profit of $2,090

As you can see, the first trade listed is a bull-put spread on NFLX, with the buy at $70 and the sell at $75. On the next line, you can see that the puts expired worthless, which is the optimal result.

Look a bit further down on the table and you will see that a bull-put spread was also placed on BZH. Let's examine this trade more closely. The trade was initiated on January 2. Our options traders bought a put with a strike price of 13 and sold a put with a strike price of 15, both of which had an expiration date of 2/16. These options expired worthless as well, which, again, is optimal, but let's consider what might have happened if things hadn't gone smoothly.

As the table indicates, we received a credit of $0.20. We always trade in 1000 share increments (we trade blocks of 10 option contracts, and each contract covers 100 shares of stock.) 1000 shares times a $0.20 credit per share is $200, which was our initial credit on this trade, as well as our highest possible profit.

Those who are new to options trading often ask the following question: if $200 is our reward, what is our risk? On this trade, consider the meaning of the options trades we have made. If BZX goes below $15, we will still have the obligation to buy shares at $15, because that is where we sold a put. Fortunately, if BZX goes below $13, we still have the right to sell shares at $13, because that is where we bought a put. Because BZX did not fall to these levels, it was not an issue, but let's consider, for the moment, an extremely unlikely scenario: suppose that during this trade, BZX was hit with such calamitous unforeseen liabilities that the company had to declare bankruptcy and their stock was declared worthless. Our $15 put would certainly be assigned, forcing us, in effect, to buy worthless stock for $15 per share. However, we could also exercise our $13 put, allowing us to sell our worthless stock for $13 per share. In this scenario, we lose $2 per share. Note that we lose $2 dollars per share if the stock falls to any price under $13, so for us, it makes no difference whether the stock falls to zero or not.

Our loss in this worst case scenario is further mitigated by the fact that we initially received a credit of $0.20 per share. Combine the 20 cent credit with the $2 loss, and you will see that our maximum net loss of this trade was $1.80 per share. As you might expect, the money we risk losing in a trade, $1.80 per share in this case, must be held in our options account during the trade. Our profit of $0.20 per share, therefore, was on an investment of $1.80 per share, an 11% return.

So what was our risk? In a worst case scenario (if the stock had fallen below $13) we would have lost 100% of our investment. If the stock had fallen to a level below $15, but not as low as $13, we would have lost a percentage of our investment roughly equal to the percentage of the distance between $15 and $13 that the stock actually fell.

It is natural to be a bit disconcerted by the fact that the potential loss in these trades is so much greater than the potential gain. If you have ever gambled money on a roulette table or slot machine, or even bought a lottery ticket, you know that the gambler typically risks a small amount and has the potential to win a large amount, which seems logically preferable and is certainly more emotionally appealing. But this 'logic' is entirely spurious. The gambler's chance of making money is so low that it undoes the perceived advantage. In fact, the longer he gambles, the more certain it becomes that he will lose money; he is in a fool's paradise. For the options trading expert, the chance of profiting on any given trade is so high that it undoes the perceived risk/reward disadvantage. Furthermore, our traders initiate many trades each month, so if a trade goes wrong, there are usually many that go right.

And of course, as you can see from the historical performance table, there have been months when the portfolio traded at a loss. In 2008, we were beaten up with the rest. In 2011, we had a patch of bad luck. We are happy to show you the losses as well as the gains for two reasons. First, we want you to understand that there will be volatility in this portfolio, and second, we want you to see the results of laying all our wins and losses end to end. The Portfolio has a lifetime return rate of 24.3% on the maximum capital invested and a lifetime return of 42.4% on the average capital invested.

Today's Bull-Put Spread

Here is a Bull-Put Spread that our experts have identified for Thursday, February 21, 2013. If you aren't comfortable with the portfolio yet, or if you aren't sure you have a firm handle on Bull-Put Spreads, here is one more trade you can watch. If, however, you are ready to begin, there is no better way than with a stock we have already looked at and successfully traded in the portfolio.

We believe that though the stock price is lower, the fundamentals on BZH are sound, as they were in January when we last placed a profitable bull-put spread on the stock. You can profit from a stable or rising BZH share price with a April 12/14 bull-put spread for a 25-cent credit. You will make a 14.3% return in 2 months on this trade, if nothing goes wrong, and nothing will go wrong, unless the stock falls 10.3% or more. That's a 86%% annualized return (for comparison purposes only). As with all bull-put spread trades, we suggest this trade for investors with diverse holdings who can tolerate some risk in their portfolios.

Articles and other Content

  VIX Snapshot

*Third Party Advertisement