Bernie Madoff got billions of dollars from investors by offering 12% a year. Today I would like to share an investment which should deliver more than triple that return. I doubt if it gets Madoff-like money flowing into it, but maybe some of you will try it along with me. Nothing is 100% guaranteed, but the historical price action for this conservative stock shows that this options spread would make over 40% a whopping 98% of the time.
How to Make 40% With a Single Options Trade on a Blue Chip Stock
Johnson & Johnson (JNJ) is a $70 billion multinational medical devices, pharmaceutical and consumer packaged goods manufacturer founded in 1886. It is truly a “blue chip” stock which pays a 2.7% dividend and raises it almost every year.
JNJ has been a favorite underlying stock for us at Terry’s Tips. Early in November 2015 we started what we call the JNJ Jamboree portfolio with $5000 to trade our 10K Strategy using JNJ as the underlying. JNJ was trading at $102. Nine months later, the stock had climbed to $125, a 22.5% gain. Our JNJ Jamboree portfolio did more than four times better, making 100%. We declared a 2-for-1 portfolio split and removed $5000 from the portfolio so subscribers who were following it could either be fully playing with profits or have double the number of units that they started with.
Terry’s Tips subscribers can either follow our actual portfolios on their own or have trades executed automatically for them through the Auto-Trade service offered by thinkorswim.
This week, with JNJ trading just over $120, we made a trade using JNJ options that would expire on January 19, 2018, a full 15 months from now. This trade would make a guaranteed profit of over 40% if JNJ closed at any price higher than $115 on that date. In order to check what history might tell us about this stock, we took a look at the 10-year graph of JNJ to see how many times the stock fell by more than $5 per share in any 15-month period. Here is that graph:
You can see that that there is one spot on the graph where the stock was lower 15 months later than it was at the beginning, and that was the time period starting just before the crash in August 2008. Over the ten years, you would have theoretically had 120 opportunities to make a similar 15-month bet to the one we are suggesting, and you would have only lost money in 3 of those months. You would have had a winner with 98% of these hypothetical trades.
This week, with JNJ trading at just over $120, we bought the following spread:
Buy to Open 10 JNJ 19Jan18 115 puts (JNJ180119P115)
Sell to Open 10 JNJ 19Jan18 120 puts (JNJ180119P120) for a credit of $1.80 (selling a vertical)
This spread put $1800 in our account ($1775 after commissions) and a maintenance requirement of $5000 would be established (no interest payable on this amount, but it would be cash set aside that could not be used for buying other equities). After deducting the $1775 we received from the $5000, we ended up with a net investment of $3225. This is the maximum loss that would result if the stock ended up below $115 in 15 months.
If the stock were at any price above $120 on January 19, 2018, both options would expire worthless and we would keep the entire $1775, making a 55% profit on our original investment. Annualized, that works out to be 44% a year after commissions, and the historical information says you would earn this 98% of the time. If you make this amount 98 times and lose 100% twice, your average annualized gain would be 41%.
Admittedly, this is a pretty unexciting investment because you have to sit and wait for more than a year for it to be over with. But where else in this world of near-zero interest rates are you going to find something that has a 98% chance of making 44% a year? It seems to me that at least some of your investment portfolio should contain at least a little money that might secure such an extraordinary high return.
We should take a look at the magnitude of these possible gains and compare them with expectations of a traditional investment. To think that you could make 41% a year on your money is truly bizarre. It really sounds too good to be true. But that is what the spread would have earned if you had been able to place it every month for the past 120 months.
We made a similar investment in a Terry’s Tips portfolio early this year. We placed the following trade on JNJ on January 4, 2016. JNJ was trading just over $102 at the time:
Buy to Open 10 JNJ Jan-17 95 puts (JNJ170120P95)
Sell to Open 10 JNJ Jan-17 100 puts (JNJ170120P100) for a credit of $2.13 (selling a vertical)
With this trade we were betting that in one year. JNJ would be trading at some price over $100. If this happened, both put options would expire worthless on January 20, 2017 and we could keep the $2130 we collected from the spread ($2105 after commissions). This trade involved a maintenance requirement of $2895 which if the maximum loss that could result (if JNJ closed below $95 on that date) and also the amount of the money invested. This works out to a 73% gain for the year. With three months to go before these options expire, JNJ is now trading around $120. Our bet looks awfully good right now. We could buy back the spread for $170 which would result in a gain of $1935 after commissions, or 66%.
This spread was quite similar to the one we are suggesting today, but it was a little more risky because it did not allow for the stock to drop at all to make the maximum gain. Taking that extra risk allowed for the maximum profit to be much higher.
Options trading involves risk, just like all investments, and should be only undertaken with money you can truly afford to lose. But sometimes, options investments can offer superior potential gains while involving a lower degree of risk. In the spread we outlined today, the stock can fall by as much as $5 over a 15-month time span, and a 55% gain will still materialize. If you had just bought the stock instead and it went down, you would lose money. Sometimes, option trading gets a bad reputation for being too risky. Hopefully, you can see why it doesn’t necessarily work out that way all of the time.
Tags: Calendar Spreads, Calls, Credit Spreads, diagonal spreads, implied volatility, JNJ, Monthly Options, Portfolio, Profit, Puts, Risk, Stocks vs. Stock Options, Terry's Tips, thinkorswim, Weekly Options