Improved? Conservative Options Strategy

Five years ago I decided that the best approach to investing was to utilize DITM (Deep In The Money) Vertical Bull Spreads. Now, I still firmly believe in that approach. In the past couple of years, I and every other surviving self investor have learned a few things. This thread will document the things I've learned (or at least my current thoughts), and am still learning. The lessons rise out of the ashes of the market from late 2007 through early 2009. Mostly, my accounts have recovered, most are ahead of their peaks in 2007, a couple have not yet recovered.

Earlier I started two threads on ET, “Methodology of the DITM Vertical Bull Call Spread” (posted 2/04/07) and “Conservative Options Strategy” (posted 5/12/08). They may not be around anymore. The threads sparked some good debate and also pointed out every single flaw of my methodology (mostly the lack of a working exit strategy, but there were other deficiencies as well). I've worked hard to reduce the deficiencies, improve the methodology, and hope to document some progress here.

I am still an options novice. I am not an options expert. I am not a teacher. Below are methods that have helped me invest my money and my family's money successfully enough that nobody is yet gunning for me.

GENERAL PRINCIPLES (considering present economic conditions)

Enter the market when it is oversold. There are only a few times a year when the opportunity to enter spreads is optimal. Chasing a bull market works fine for some types of trading, but not long term option spreads. Enter these positions when slow stochastics and volume indicate that a significant correction has occurred and the market is starting to come out of it. The more confident you feel in the timing, the more spreads you enter. This all requires patience, doesn't work for everybody.

I keep 25 to 40 percent of the portfolio in cash (40% while waiting for a correction, 25% after buying spreads). Maybe 25 to 35% in long positions (if I can find something, cash if I can't, - gold and silver ETFs now). I average 30 to 45% of the portfolio in my DITM spreads.

I look for spreads that yield 25% to 35% annualized yield.
I want as deep ITM spreads as I can humanly get, given my yield target.
I want spreads that are well under major support levels that have held up for months. If I can buy the spreads when prices are at these support levels, that's just perfect, and I can get even deeper ITM.
I want spreads that “feel” as safe at CD's. As I said above, market timing helps me “feel” safe.
I want spreads in major corporations from sectors I like for the extended future. This is one of the most import criteria. I want low P/Es if I have a choice, but I think price action trumps P/E.
I want high open interest, decently high volatility. (JNJ, GE, Wallmart doesn't cut it.)

n order to get all the characteristics I want, considering todays economy, I look for the following spreads specifically: I look for verticals that are 9 to 18 months till expiration, in order to get lots of time value helping my yield, while still diving deep ITM for safety.

I love certain characteristics of these long-term option spreads:
They weather short term fluctuations well. If the nature of a company changes quickly, the spread value doesn't take as huge a hit as short term spreads would.
They frequently allow you to close out a successful position months early for 60 to 80% of max yield.
They allow you lots of time to weather the lows of stochastic charts, or to decide to exit the position when you no longer consider it a good spread. Frequently if the price of a stock drops, enough time has passed that time value gains equal the loss of intrinsic value, and the position can be exited at little or no loss. I constantly evaluate my portfolios to reduce overall risk and sell unfavorable positions to raise cash for future opportunities. Also with such long term spreads, risk of unexpected early execution is very low

So, if 35% of my portfolio can yield 35% annual return, the overall portfolio earns about 12%.
If you consider that too conservative, you may think I have major “trust” issues. You are correct. I still have unhealed burn marks on my butt from 2008.


I am listing several of the positions I presently hold as examples, purchased at various times:

AEM JAN11 35/40 (bto jan11 35 call & sto jan11 40 call) @ 3.2 (cost of spread is X100), 56% (max yield, not annualized)

GLD JAN11 95/100 @ 3.8 , 31%

EWZ JAN11 45/50 @ 3.6, 38%

FCX JAN11 50/55 @ 3.25, 53%

GDX JAN11 30/35 @ 3.57, 40%

SLB JAN12 42.5/47.5 @ 3.1, 61%

DO JAN12 45/50 @ 3.58, 40%

FCX JAN12 40/45 @ 3.2, 56%

RIG JAN12 35/40 @ 2.75, 82%

My intention in this thread is to post approximately weekly, or as new thoughts hit. This is not a daily journal, but I'll try to answer questions.

 

I think what you might be overlooking and this happens a lot with people who find a strategy that appears to work so well is that you fail to take into account market conditions and how the strategy performs.

DITM Vertical Spreads will perform awesome in a bull market. It makes sense, the market moves up and your position makes money as it is long/bullish. An analogy would be to say that buying tech stocks from 94-99 is a great strategy. 5 years ago, or 2005 up until about 2007 we had a nice bull market so it goes without saying that DITM Vertical Call Spreads worked well.

The effort to try and perfect it is overlooking the obvious that the strategy is suited for a bull market. When Gold went from $400 to $1000, I am sure gold funds and long fold traders thought they found the holy grail for trading.

What went wrong with your strategy is that from 2007 - 2009 the market sank hard and most DITM Vertical Spreads you did when you thought the market was oversold lost money as the market kept falling. This has little to do with the strategy and skill, rather the market condition changed the nature of the beast.

So there is nothing really to perfect except maybe stock selection which this is really based on since you are in effect going long the stock in a limited risk position. If the market is up the strat will do well and if the market is bearish, you will lose money. In between it will take your own stock selection skills to find the winners.

So always remember to consider the market conditions before praising or "improving" a strategy.

 

With respect to Mike, and thanks for his comments-
This thread is ALL about market conditions. It is all too obvious that bull strategies work in bull markets, and same for bear strategies. My biggest failure while investing in 2007-09 was underestimating the power and speed that bear markets can exhibit. And no, I wasn't the only one to do that.

The points I was trying to make in the first post, refer to improving my trading rules with the goals of avoiding investing in bull spreads during bear markets, identifying and using the end of bear markets (and/or corrections) as position entry points, and to mitigate the speed and power of the bear markets by “perfecting” or improving the trading rules to add more safety to the positions I open. I hope to continue along that path in this thread.

Before the Gulf spill, I was happily over-invested in one of my favorite sectors – the oil service companies, like SLB, DO, RIG. Look at their charts and P/E ratios prior to April. Do you fault my being in them? So that sector got creamed by a bear market of “unexpected” speed and power. (revisiting 2008 markets?) Well all the positions I had is those stocks took a hit. Keep in mind this happened in April/May and I am sitting on Jan2011 spreads. Because I was implementing the “rules” as described in my first post, I sailed through that disaster with minimal losses. I scaled down my positions as the risk became more and more apparent. The remainder of the positions were successfully legged out of by buying back the short calls when the stochastics indicated a recovery was imminent or as support levels became evident, then using GTC orders to sell the long calls as the expected partial recovery eventually occurred. (This worked on all positions except one DO spread that I misjudged and cost that account an extra$800 instead of reducing losses as I hoped.)

This mostly successful save only occurred because of methods I recently learned and am trying to pass along here.

None of this has much to do with stock selection, except as stated in post one.

 

does this strategy works when there is flash crash like one we had in april/may period?

 

50% of the time it works ALL THE TIME.

Seriously though, how could it work? You're long delta, short vega, gamma and speed (of gamma). Worst possible scenario. Here's where we'll hear that it worked at expiration. I am tired of people (not Yucca) making excuses that crashes are unpredictable and therefore unavoidable. Options are perfect hedging vehicles.

 

so whats the difference between buying a call and doing a bull call spread besides reduced cost and bull spread limiting upside profit.?

How does volatility effect a bull spread as opposed to an outright long call?

 

Vertical vs. single: It depends on the delta position, as vega is bimodal on locale. Also skew plays a role.

 

The flash crash was a one day event in which the market recovered pretty quickly. These spreads go out almost a year.

How could it "work" or "not work" with respect to a one day event? I do no think there is an answer to the question regarding a one day unexpected event.

Beside the market was in a bearish trend before the flash crash occurred anyway.

 

but how does it impact ones position if its on margin account?

 

Levitation: In layman's term (all I got), a call and a spread are not even the same animals. Selection process, goals, outcome are all different. Simplistically I consider buying a call a purely speculative play based on technical greeks or price expectation, and I consider a spread as a carefully structured investment vehicle tailored to meet specific risk tolerance (ranging from outrageous to wimpy – I go for wimpy), time in force, overall outlook, etc. Experts will tear these comments apart, but I hope you get the point.

Take one of my example spreads: FCX JAN12 40/45 @ 3.2, 56%
This spread will give me maximum yield 56% if on January expiration in 2012 the price of the stock is above $45.00 per share. Today the stock closed at 74.07. This is a 34 billion $ company with P/E today at 9.86. To judge the quality of my decision you have to look a a price chart. Look at the 1, 2, 5 year charts on yahoo. Form an opinion of the likelihood of the stock being below $45 after another 18 months in this economy. Look at analyst estimates of $90 next year (yes they are notoriously wrong). I invested $320 per spread in hopes of making $180 profit in 18 months. I looked at this and decided I'll take that risk. I have 18 months to change my mind.

Gobar: This is a debit spread. There is essentially no impact on margin. A credit spread does impact margin.
My total risk in the example in the paragraph above is the $320 per spread, and I paid cash for that up front.

Dear atticus: Keep an eye on me, but I'm not taking you on.