The Tycoon Report

Want to Increase Your Odds of Success - Enormously?

Tuesday, February 19, 2008 | Chris Rowe

I recently wrote an article for you about selling naked puts.  It was a big hit because it's perfect for this kind of market.

This strategy holds a bit less risk than just buying a stock as it reduces the cost basis of the stock (on a short-term trade).  We accept that there is a cap on the upside potential in exchange for a strategy that is more likely to end up profitable than the outright stock ownership.

I was talking about the article with a friend of mine Bob Jones (that's really his name), who read it and asked me if there is a way to increase the potential profit vs. loss ratio.  

Bob:  "Chris, on one hand, I like having better odds of success because I know I can profit from naked puts if the stock trades up, sideways or even slightly lower."  (This is true because since we're essentially selling short the naked put option, we profit when the put option loses its value as a result of time passing.)  "But on the other hand, if the stock doubles in price, I will only make the amount that someone has paid me when I sell that put option so the profit is limited.  It seems like selling naked puts is actually risky when you consider the reward."

Me:  "First of all, the risk verses the reward makes sense when you consider the fact that odds of success increase.  And it's not a risky strategy, but maybe it's just not exactly what you're looking for.  Consider the fact that I just heard form a very reliable source that the world’s largest options trader is a guy by the name of Warren Buffett.  In case you've never heard of him, he's been jumping in and out of first place on the Forbes 400 richest people list for decades.  But he certainly isn't a speculator.  He's a value investor, and not a guy who I'd consider a "risky" player.”

Bob: "I know the margin requirement for a put spread is only about 20% (1/5) of the underlying stock position, so I can sell 5 times as many put options so at least I can profit a lot more that way if the stock trades flat or up.  But that opens me up to 5 times the downside risk!  What do you suggest?"

Me: "I suggest that you read the Tycoon Report on Tuesday and I'll write an article about the "vertical put spread" since I can't legally give you individualized investment advice.

Bob: "No, seriously."  

Me: "No... Seriously."


Quick review on selling NAKED puts:

Stock Trader buys 100 shares of OIH (an oil service ETF) at $170.00:

- Requirement: $17,000.00 cash or $8,500.00 on margin

- Maximum upside potential: Infinite

- Downside risk: $17,000.00

- Break-even price: $170


Seller of 1 naked put option (which obligates the trader to buy 100 shares of OIH at the strike price):

OIH is currently at $170.

In this example, we will use the March 170 put option trading at $7.00.  By selling 1, we are saying we are willing to buy 100 shares of OIH at $170.00 upon request before March 22, 2008 when the option expires.  In exchange for the put option contract that we are selling, we get $700.00.

- Requirement:  Strike price X 100 shares - premium received ($17,000.00 - $700.00 = $16,300.00) in a non-margin account.  However this is typically done in a margin account with a 20% requirement.  (0.20 X 16,300 = $3,260 cash outlay.)  

NOTE: Be sure to check with your brokers about their specific margin requirements before doing this or any strategy for the first time.

- Maximum Upside Potential:  There are two possibilities.  The upside if the person who purchased the March 170 put does NOT exercise the put option (because OIH moved much higher making it pointless to exercise) is the 7 point ($700.00) premium received for the put option that we sold. The upside if the person who purchased the March 170 put DOES exercise the put option is infinite (because you'd then actually own 100 shares of OIH).

- Downside risk:  Strike Price X 100 shares - premium received ($17,000.00 - $700.00 = $16,300.)  

- Break-even point:  $163.


BACK TO BOB

Remember, Bob said that he could increase his reward tremendously, but he also brought up the excellent point that he would then be increasing his risk.  

What he is saying, using our OIH example, is the margin requirement is $3,260.00 with a $700.00 upside.  And he's acknowledging that instead of  buying 100 shares of OIH which requires $17,000.00 (or $8,500 on margin), and instead of selling the naked puts which requires $3,260.00, he can take about $16,300.00 and sell 5 times as many put options which will bring in $3,500.00 in premium ($700.00 X 5).  At the same time, he realizes even though his break-even point is still $163.00, he would be losing $500.00 (instead of $100.00) for every point that the stock traded below $163.00.

His concern here is if the stock or ETF that he sold naked puts on trades down by a large amount (e.g.:  if it lost 50% in a day), he would lose 5 times more than he would have lost past his break-even point.  But he likes the concept of the high probability bet so he's tempted to use the high leverage.

Here's my answer to you Bob...

I know you like the concept of profiting from time decay (deterioration of the price of an option due to time passing) of the option that you sold.  If your focus is to profit from a security by staying above your break-even point with either little or no downside movement (as opposed to your focus being on trying to actually buying the stock), then you should try selling vertical put spreads.  

With a vertical put spread, you are basically doing the same thing that you would do in a naked put, except you are ALSO buying insurance on the position by purchasing another put with a lower strike price.  The margin requirement is the difference between the two strike prices.

So let's go back to our OIH example using March 170 put options.

When we enter a spread, we enter two "legs" of the trade at the same time (which is technically entering two trades simultaneously).

Here are three examples, because there are a few different ways to profit:


EXAMPLE #1

We sell a vertical put spread for $2.00.  When you enter a spread, you only enter one price: the amount that you intend to pay or receive.  However, to break down the mechanics behind the trade, I'll explain it using two prices separately.  

Just as we did in our example above, we would SELL the March 170 put for $7.00.  (This is "leg 1”.)  We would BUY the March 165 put which is at about $5.00.  (This is "leg 2".)  Keep in mind, you don't have to sell at the bid and buy at the asking price.  You can fish for a better price.  (You can enter the spread for a credit of $2.10 for example.)

Since we received $7.00 and spent $5.00 we have received a total of $2.00.

Here, our break-even point is $168. Anywhere above $168 and you're profitable.  

Our maximum downside risk (as long as you close out the position before expiration day) is $300.00 per contract.  So if we sold one March 170, and bought one March 165, I’d consider that one contract.  If you do that, the risk is $300.00.  So why risk $300.00 to make $200.00?  Because the odds of success increase tremendously when you profit from time passing, and your break-even point is lower than the securities price.

Structuring the spread with two options that have strike prices close to the price of the underlying security's price is what I’d recommend if you are highly confident that the security does what you think it should.  This may be because there is a good risk/reward in the security itself due to it being near some vital support level, like if it corrected back to its uptrend line or is bouncing off of historically potent horizontal support.

Margin requirement:  The potential loss.  This is the difference between the strike prices minus the premium received.  Since the risk here is $300.00, that's your margin requirement.  

Insurance of owning a put with the next lower strike price: When you think about it, what happens if OIH trades all the way down to $10.00?  You sold the March 170 put for $7.00, which obligates you to BUY OIH at $170.00 ($160 points higher than $10.00).  If you simply sold that put naked (uncovered), your loss (if you only sold one put for $700.00) would be $153.00 ($160.00 - $7.00).

However, since this is a vertical spread, you also own the March 165 put, meaning someone else is obligated to buy OIH from you for $165.00.  So, per both contracts (your short March 170 and your long March 165), you would technically have to buy OIH for $170, and then sell it for $165: a $5.00 loss. Since you received $2.00 for the vertical spread, you would only lose $3.00.  (If your broker is half decent, you wouldn't have to put up the cash to actually buy OIH for 170 and sell it at $165.  Be sure to ask.)

So, Bob, if you're interested in leverage with less risk than a naked put (and less reward), instead of selling one naked put on OIH with a requirement of $3,250.00, you can sell the vertical spread X 11 with a requirement of $3,300.00 ($300.00 margin requirement X 13).  In this case, you take in a premium of $2,600.00 instead of the $700.00 that you'd get from a naked put spread.


EXAMPLE #2

If you want a little more downside leeway (you think OIH may fluctuate to as low as $163.50), you might sell the March 165 / March 160 put (instead of the 170/165).

In this case, you're giving up some upside in order to decrease the downside risk of OIH because you have a lower break-even point.

If you sell the March 165 / March 160 put spread, you could receive $1.50.  Again, the risk is the difference between the strike prices minus the premium received (which is $5.00 - $1.50 = $3.50).

At first glance this may not seem smart when you consider the risk is $3.50 to make $1.50.  However the odds of success have increased, as OIH is at $170.00, and your break-even point is now $163.50 (instead of $168 in the previous example).  Also, if you think about the risk of owning OIH, you'll recall that if the stock moved down to $163.50, you would already be down $6.50.  With a vertical spread however, you're profitable if OIH is anywhere above $163.50.


EXAMPLE #3

If you want to receive a larger premium, then you can sell the March 160 / March 150 vertical put spread for $2.00.  Notice the difference in strike prices is now 10 points instead of 5.  This increases the dollar amount that you would risk, but it also increases the odds of success.  The risk vs. reward is now 8-2.

So your maximum risk is $800.00 for each contract (if you sell just 1 March 160 and buy 1 March 150).  This is because your risk is 10 point strike price difference, minus the $2.00 received for selling the spread.

Your breakeven point is $158.00.

Your margin requirement is $800.00 per.


IMPORTANT NOTES:

1) When people who will benefit from you doing these trades in larger quantity or trading more frequently, such as brokers, talk to you about this, they might only focus on the fact that in our last example, you are only committing $800.00 to make $200.00: a 25% gain in a month.  That sounds quite appealing.  But make no mistake; you are risking $800.00 to make $200.00 as compared to owning OIH, where the risk of the required cash balance (margin) is less.  Although the odds of success increase tremendously with a vertical put spread, we are using leverage.  Don't let anyone convince you otherwise.  

2) Because of the leverage factor, I prefer to use options on an ETF or index for vertical put spreads.  This is because individual stocks are MUCH more likely to lose 50% in a day than an index or ETF as indices and ETFs are diversified.  In short, I prefer the diversified trading vehicle because it moves slower, and I have more time to realize when my position is going the wrong way.

3) You can unwind your spread at any time (whether it's working in your favor or not).  You don't have to (and absolutely shouldn't) let the spread expire even if it's only worth 5 cents.  If it's that cheap, then it's even more of a reason to get out as you can only profit by another 5 cents, but you could still lose your max risk.  Try to always be out of options positions at least 10 calendar days before expiration.



“Profit from the Trend”

Chris Rowe
Chief Investment Officer
The Trend Rider


Mark Your Economic Calendar: What's ahead for the week of February 19, 2008
Economic Calendar for the Week of February 18 - February 22

Wednesday, February 20

8:30 AM - CPI: Consumer Price Index

Release Details

Importance (A-F): This release merits a B .
Source: Bureau of Labor statistics, U.S. Department of Labor.
Release Time: 8:30 ET, about the 13th of each month for the prior month.
Raw Data Available At: http://stats.bls.gov/news.release/cpi.toc.htm.

The Consumer Price Index is a measure of the price level of a fixed market basket of goods and services purchased by consumers. CPI is the most widely cited inflation indicator, and it is used to calculate cost of living adjustments for government programs and it is the basis of COLAs for many private labor agreements as well. It has been criticized for overstating inflation, because it does not adjust for substitution effects and because the fixed basket does not reflect price changes in new technology goods which are often declining in price. Despite these criticisms, it remains the benchmark inflation index.

CPI can be greatly influenced in any given month by a movement in volatile food and energy prices. Therefore, it is important to look at CPI excluding food and energy, commonly called the "core rate" of inflation. Within the core rate, some of the more volatile and closely watched components are apparel, tobacco, airfares, and new cars. In addition to tracking the month/month changes in core CPI, the year/year change in core CPI is seen by most economists as the best measure of the underlying inflation rate.


Highlights

Briefing.com Forecast:   0.3%, 0.2% core
Market Consensus:    0.3%, 0.2% core

Key Factors

Pretty tame growth expected.  Energy prices will provide a larger kick than food.
Core CPI is expected to show the same 0.2% gain seen in six of the last seven months.
The 0.3% CPI gain leaves a slight lift to 4.2% annual growth -- more than double the 2% yoy gain in August before energy prices surged.
Core expected to hold at 2.4% annual growth, up from the 2.1% yoy two year low in September.
Core commodity prices are up just 0.1% from a year ago, energy (17% yoy) as services (3.3% yoy) provide the core pressure.
Core hot spots:   the services of medical care (5.9% yoy) and education (5.6% yoy).  Owners equivalent rent has softened to 2.8% yoy from 4.1% at the start of 2007.

Big Picture

The core rate of consumer inflation reached a decade high of 2.9% yoy in September 2006 and has eased off only slightly to 2.4% yoy.  The stickier prices for shelter and medical care and tuition will continue to hold firm as yoy core commodity prices are flat from a year ago.  Energy prices provide the monthly swing and the largest underlying pressure.  In the big picture its aggregate demand which provides the price direction as sub-potential growth (below 3%) is easing the core inflation pressures over time.  The Fed more closely watches core PCE prices as an inflation guide which stands at 2.2% yoy -- back above Fed expectations and its 'comfort zone'.  Overall CPI reached a 14 year high of 4.7% yoy in Sept '05 as energy prices have provided the recent lift to the current 4.1% yoy.


8:30 AM - Housing Starts and Building Permits

Release Details

Importance (A-F): This release merits a B-.
Source: The Census Bureau of the Department of Commerce
Release Time: 8:30 ET around the 16th of the month (data for one month prior).
Raw Data Available At: http://www.census.gov/const/www/newresconstindex.html.

Housing Starts are a measure of the number of residential units on which construction is begun each month. A start in construction is defined as the beginning of excavation of the foundation for the building and is comprised primarily of residential housing. Building permits are permits taken out in order to allow excavation. An increase in building permits and starts usually occurs a few months after a reduction in mortgage rates. Permits lead starts, but permits are not required in all regions of the country, and the level of permits therefore tends to be less than the level of starts over time.

The monthly national report is broken down by region: Northeast, Midwest, South, and West. Briefing recommends analyzing the regional data because they are subject to a high degree of volatility. The high volatility can be attributed to weather changes and/or natural disasters. For example, an unexpectedly high level of rain in South could delay housing starts for the region.


Highlights

Briefing.com Forecast:   Housing starts 1020K, permits 1005K
Market Consensus:  Starts 1000K, permits 1035K

Key Factors

A modest gain is expected after the -21% Nov/Dec plunge to a 17 year low.  Down -55% from the January 2006 peak.
The downward trend in new home sales hasn't slowed yet and argues for a long wait for stability in construction.
Moreover, a new high in new home inventories makes clear the oversupply.
Tighter mortgage lending is also lengthening the wait for an upturn in housing starts.
Harsher Winter weather conditions and the heavy seasonal adjustments provide added volatility over the coming months.
Permits to build reached a 15 year low in December with a lower 16 year low expected for January. 

Big Picture

Housing starts reached a 17 year low in December with no sign of the fundamentals (housing demand) needed to turn the direction over the intermediate term.  The plunge has been a large drag on economic growth as further risk surrounds the defaults/foreclosures coming from sub-prime and other mortgage borrowers.  The upturn could be a long way off in early 2009.   The correction for the inflated housing market was expected (and needed) but with a more moderate decline as the poor quality mortgage lending has added strongly to the downturn.  Stability will have to wait for new home sales to tick higher and unsold inventory to significantly thin.  Continued lending to low risk mortgage borrowers is needed just to get the declines to decelerate.  Housing starts have fallen 56% since the January 2006 peak.


Thursday, February 21

10:00 AM - Philadelphia Fed Index

Release Details

Importance (A-F): The Philadelphia Fed Index merits a B.
Source: The Philadelphia Federal Reserve bank.
Release Time: Third Thursday of the month at 12 ET for the current month.
Raw Data Available At: http://www.phil.frb.org/

In Brief

There are many regional manufacturing surveys, and they tend to be ranked in order of timeliness and the importance of the region. The Philadelphia Fed's survey is first each month, actually coming out during the third week of the month for which it is reporting. Several smaller surveys are then released before the Chicago purchasing managers' report on the last day of each month. A few, such as the Atlanta and Richmond Fed surveys, are released after the NAPM and are of little value. The purchasing managers' reports are measured like the national NAPM - 50% marks the breakeven line between an expanding and contracting manufacturing sector. For the Philadelphia and Atlanta Fed indexes, 0 is the breakeven mark.

These surveys can be of some help in forecasting the national NAPM - particularly the Philadelphia and Chicago surveys which are more closely watched due to their timeliness and the fact that these regions represent a reasonable cross section of national manufacturing activities.


Highlights

Philadelphia Fed's manufacturing index plunged to -20.9.

Key Factors

Lowest reading since 911 terrorist attack  (Oct 2001) during the recession.
A level below 0 reflects contraction.  The decline started with the revised -1.6 level in December.
New orders plunged 27 pts to -15.2.   Shipments (sales) fell 17 pts to -2.3.
All components except prices were in decline -- a truly ugly report for the region.
Prices paid and recieved rose, but there is only weak pricing power in manufacturing -- no inflation concern.
Index is independent of the components -- is extremely volatile and can provide a misleading read.

Big Picture

The regional manufacturing index is volatile but reasonably tracks the direction of national orders and production.  The January 2008 plunge leaves the lowest level since the last recession in 2001.  Risk is tied to another stall in business capital investment given economic growth concerns and financing rates which leaves the manufacturing sector with fewer orders.  The Philly index is independent of its components so can provide a misleading read and is especially volatile given the small region covered (mid and east PA, southern NJ and Delaware).  The manufacturing sector moves in mini-cycles compared to the overall economy and the regional measures move in even shorter cycles with far more month to month volatility.  A level of 0 is the break between growth and contraction.