Today we will continue our discussion of both SVXY and the actual portfolio we are carrying out with only two positions. Every Friday, we will make a trade in this portfolio and tell you about it here.
Our goal is to earn an average gain of 3% a week in this portfolio after commissions. So far, we are well ahead of this goal.
I hope you find this ongoing demonstration to be a simple way to learn a whole lot about trading options. We will also discuss another Greek measure today – gamma.
Ongoing SVXY Spread Strategy – Week 6
Near the open today, SVXY was trading about $89.00. We want to sell a put that is about $1 in the money (i.e., at a strike one dollar higher than the current stock price). Our maximum gain each week will come if we are right, and the stock ends the week very close to the strike of our short put.
Here is the trade we placed today:
Buy to Close 1 SVXY Sep-14 86.5 put (SVXY140920P86.5)
Sell to Open 1 SVXY) Sep4-14 90 put (SVXY140926P90 for a credit limit of $2.70 (selling a diagonal)
Each week, we try to sell a weekly put which is at a strike about $1 in the money (i.e., the strike price is about a dollar higher than the stock price) as long as selling a diagonal (or calendar) spread can be done for a credit.
When we entered this order, the natural price (buying at the ask price and selling at the bid price) was $2.50 and the mid-point price was $2.75. We placed a limit order at $2.70, a number which was $.05 below the mid-point price. (It executed at $2.70).
If it hadn’t executed after half an hour, we would have reduced the credit amount by $.10 (and continue doing this each half hour until we got an execution).
Each week, we will make a trade that puts cash in our account (in other words, each trade will be for a credit). Our goal is to accumulate enough cash in the portfolio between now and January 17, 2015 when our long put expires so that we have much more than the $1500 we started with. Our Jan-15 may still have some remaining value as well.
This is the 6th week of carrying out our little options portfolio using SVXY as the underlying. SVXY is constructed to move up or down in the opposite directions as changes in volatility of stock option prices (using VIX, the measure of option volatility for the S&P 500 tracking stock, SPY). SVXY is a derivative of a derivative of a derivative, so it is really, really complex. Right now, option prices are trading at historic lows, and lots of people believe that they will move higher. If they are right, SVXY will fall in value, but if option prices (i.e., volatility) don’t rise, SVXY will increase in value. In our demonstration portfolio, we are assuming that option prices will not rise dramatically and that SVXY will move higher, on average, about a dollar a week.
In this simple portfolio, we own an SVXY Jan-15 90 put. We will use this as collateral for selling a put each week in the weekly series that expires a week later than the current short put that we sold a week ago. Today’s value of our long put is about $14 ($1200) and decay of this put (theta) is $4 (this means that if SVXY remains unchanged, the put will fall in value by $4 each day). The decay of our short put is $13 (and will increase every day until next Friday). This means that all other things being equal, we should gain $9 in portfolio value every day at the beginning of the week and about double that amount later in the week.
Last week we spoke a little about delta. As you may recall, delta is the equivalent number of shares your option represents. If an option has a delta of 70, it should gain $70 in value if the stock goes up by one dollar. Today we will briefly introduce another options “Greek” called gamma. Gamma is simply the amount that delta will change if the underlying stock goes up by one dollar.
If your option has a delta of 70 and a gamma of 5, if the underlying stock goes up by a dollar, your option would then have a delta of 75. Gamma becomes more important for out-of-the-money options because delta tends to increase or decrease at faster rates when the stock moves in the direction of an out-of-the-money option.
To repeat what we covered last week, since we are dealing in puts rather than calls, the delta calculation is a little complicated. I hope you won’t give up. Delta for our Jan-15 90 put is minus 50. This means that if the stock goes up a dollar, our long put option will lose about $.50 ($50) in value. The weekly option that we have sold to someone else has a delta value of about 75 (since we sold it, it is a positive number). If the stock goes up by a dollar, this option will go down by about $.75 ($75) which will be a gain for us because we sold that to someone else.
Our net delta value in the portfolio is +25. If the stock goes up by a dollar, the portfolio should go up about $25 in value because of delta. (Unfortunately, this gets more confusing when you understand that delta values will be quite different once the stock has moved in either direction, but we will discuss that issue later).
If the stock behaves as we hope, and it goes up by about a dollar in a week, we will gain about $25 from the positive delta value, and about $100 from net theta (the difference between the slower-decaying option we own and the faster-decaying weekly option that we have sold to someone else.
Our goal is to generate some cash in our portfolio each week. This should be possible as long as the stock remains below $90. We will discuss what we need to do later if the stock moves higher than $90.
To update our progress to date, the balance in our account is now $1870 which shows a $370 gain over the 5 weeks we have held the positions. This is well more than the $45 average weekly gain we are shooting for to make our goal of 3% a week. We now have $1009 in cash in the portfolio.