In the family charitable trust I set up many years ago, I trade options to maximize the amounts I can give away each year.  In this portfolio, I prefer not to actively trade short-term options, but each year, I make selected bets on companies I feel good about and I expect they won’t tank in price over the long run.  Last week, I made such a bet on FaceBook (FB) that I would like to tell you about today.  The spread will make over 40% in the next 8 months even if the stock were to fall $5 over that time.Terry

Check Out a Long-Term Bet on FaceBook (FB)

When most people think about trading options, they are thinking short-term.  If they are buying calls in hopes that the stock will skyrocket, they usually by the cheapest call they can find.  These are the ones which return the greatest percentage gain if you are right and the stock manages to make a big upward move.  The cheapest calls are the shortest term ones, maybe with only a week of remaining life.  Of course, about 80% of the time, these options expire worthless and you lose your entire bet, but hopes of a windfall gain keep people playing the short-term option-buying game.

Other people (including me) prefer to sell these short-term options, using longer-term options as collateral.  Instead of buying stock and writing calls against it, longer-term options require far less capital and allow for a potentially higher return on investment if the stock stays flat or moves higher.  This kind of trading requires short-term thinking, and action, as well.  When the short-term options expire, they must be replaced by further-out short options, and if they are in the money, they must be bought back before they expire, allowing you to sell new ones in their place.

Most of the strategies we advocate at Terry’s Tips involve this kind of short-term thinking (and adjusting each week or month when options expire).  For this reason, many subscribers sign up for Auto-Trade at thinkorswim (it’s free) and have trades executed automatically for them, following one or more of our 10 actual portfolios.

Some portfolios make longer-term bets, and since they do not require active trading, they are not offered through Auto-Trade.  With these bets, you place the trade once and then just wait for time to expire.  If you are right, and the stock falls a little, stays flat, or goes up by any amount, the options you started with all expire worthless, and you end up with a nice gain without making a single extra trade.

In one of our Terry’s Tips demonstration portfolios, in January of this year, we placed long-term bets that AAPL, SPY, and GOOG would move higher during 2015, and when the January 2016 options expired, we would make a nice gain.  In fact, we knew precisely that we would make 91% on our investment for that one-year period.  At this point in time, all three of these stocks have done well and are ahead of where they need to be for us to make our 91% gain for the year.  We could close out these positions right now and take a 44% gain for the 3 months we have owned these options.  Many subscribers have done just that.

Let’s look at FaceBook and the long-term trade I just made in it.  I like the company (even though I don’t use their product).  They seem to have figured out how to monetize the extraordinary traffic they enjoy.  I looked at the chart for their 3 years of existence:

Note that while there have been times when the stock tanked temporarily, if you look at any eight-month period, there was never a stretch when it was lower at the end of 8 months than at the beginning.  Making a bet on the longer-term trend is often a much safer bet, especially when you pick a company you feel good about.

With the stock trading about $80, in my charitable trust, I made a bet that in 8 months, it would be trading at some price which was $75 or higher on the third Friday of December, 2015.  I make most of my donations in December, so like to be in cash at that time.

This is the trade I placed:

Buy to open FB Dec-15 70 puts (FB151219P70)
Sell to open FB Dec-15 75 puts (FB151219P75) for a credit of $1.52  (selling a vertical)

For every contract I sold, I collected $152 which immediately went into my account.  The puts I sold were at a higher strike than the puts I bought, so they commanded a higher price.  The broker placed a maintenance requirement on me of $5 ($500 per contract) which would be reduced by the $152 I collected.  This left me with a net investment of $348.  This would be my maximum loss if FB ended up below $70 on December 19, 2015.

A maintenance requirement is not like a margin loan.  No interest is charged.  It just means that I must leave $348 in cash in the account until the puts expire (or I close out the positions).  I can’t use this money to buy other options or stock.

If the stock ended up at $74 in December, I would have to buy back the 75 put I had sold for $1.  This would reduce my profit to $52 (less commissions of $3.75 – 3 commissions of $1.25  on the initial trades as well as the closing one).

If the stock ends up at any price above $75 (which I feel confident that it will), all my puts will expire worthless, the $348 maintenance requirement will disappear, and I get to keep the $152 (less $2.50 commission).  That works out to a 43% gain for the 8 months.

Where else can you find a return like this when the stock can fall by $5 and you still make the gain?  It is a bet that I don’t expect to lose any sleep over.

One of the great mysteries in the investment world (at least to me, an admitted options nut) is why anyone would buy stock in a company they really like when they could dramatically increase their expected returns with a simple stock options strategy instead.  Of course, buying options is a little more complicated and takes a little extra work, but if you could make two or three times (or more) on your investment, wouldn’t that little extra effort be more than worth it?  Apparently not, since most people take the lazy way out and just buy the stock.Today I will try to persuade you to give stock options a try.  I will show you exactly what I am doing in one of my Terry’s Tips portfolios while trading one of my favorite stocks.

Terry

Why Calendar Spreads Are So Much Better Than Buying Stock

I like just about everything about Costco.  I like to shop there.  I buy wine by the case, paying far less than my local wine store (I am not alone – Costco is the largest retailer of wine in the world, selling several billions of dollars’ worth every year).  I like Costco because they treat their employees well, paying them about double what Walmart pays its people.  I like shopping at Costco because I know I am never paying more than I should for anything I buy.  It seems to me that the other customers like it, too.  Everyone seems to be happy while roaming the aisles and enjoying the free samples they offer (I have a skinflint friend who shops at Costco once a week just for the samples – they are his lunch that day).

But most of all, I like the stock (COST).  It has been very nice to me over the years, and I have consistently made a far greater return using options than I would have if I had just gone out and bought the stock.

I recently set up an actual brokerage account to trade COST options for the educational benefit of Terry’s Tips paying subscribers.  I put $5000 in the account.  Today, it is worth $6800.  I started out buying calendar spreads, some at at-the-money strike prices and others at higher strike prices (using calls).  I currently own October 2015 calls at the 145 and 150 strike prices (the stock is trading about $146.50), and I am short (having sold to someone else) May-15 calls at the 145, 147, and 150 strike prices.  These calls will expire in 23 days, on May 15, 2015.  (Technically, the 147 calls I am short are with a diagonal spread rather than a calendar spread because the long side is at the 145 strike.  With calendar spreads, the long and short sides are at the same strike price.)

Here is the risk profile graph for my positions.  It shows how much money I will make (or lose) at the various possible prices where COST might be on May 15th when the short options expire:

In the lower right-hand corner, the P/L Day number shows the expected gain or loss if the stock stays flat ($148.54), or is $3 higher, or lower, than the current price.  If the stock stays absolutely flat, I should make about $976, or about 14% on the $6800 I have invested.

I could have bought 46 shares of the stock with $6800 instead of owning these options.   If the stock doesn’t go up any in the next 23 days, I would not gain a penny.  But the options will make a profit of about $976.

If the stock falls $2 by May 15, I would lose $92 with my stock investment, and my options would make a gain of $19. I am still better off owning the options.  Only if the stock falls more than $2 ½ dollars over those three weeks would I be worse off with the options positions.  But I like this stock.  I think it is headed higher.  That’s why I bought COST in the first place.

If I am right, and the stock goes up by $3, I would make $138 if I owned 46 shares of the stock, or I would make $1,700 with my options positions.  That’s more than 10 times as much as I would make by owning the stock.

Can you understand why I am confused why anyone would buy stock rather than trading the options when they find a stock they really like?  It just doesn’t make any sense to me.

Of course, when the options I have sold are set to expire in 23 days, I need to do something.  I will need to buy back the options that are in the money (at a strike which is lower than the stock price), and sell new options (collecting even more money) in a further-out month, presumably June.  The lazy guys who just bought the stock instead of owning stock are lucky in this regard – they don’t have to do anything.  But if the stock had stayed flat or risen moderately over those three weeks, I know that I am way ahead of the stock-owners every time.

While stock owners sit around and do nothing, my job on May 15 will be to roll over the short calls to the next month (and use the cash that is generated to buy new spreads to increase future returns even more).  I show my subscribers exactly what and how to make those trades each month (in both the COST portfolio and 9 other portfolios which use different underlying stocks).  Hopefully, eventually, they won’t need me any longer, but they will have discovered how to use stock options to dramatically increase their investment returns on their own.

About a month ago I sent out a strategy we were using to capitalize on the price of oil falling further (as many analysts, including those at Goldman, Citi, and Barclays, were predicting).  We set up a small demonstration portfolio which had $2910 to start, and bought calendar spreads at the 18, 17, and 16 strikes when USO was trading at $18.45.When the price of oil did retreat further, USO fell to about $17, and we sold our calendar spreads at the 17 and 18 strikes and replaced them with calendar spreads at the 15 and 14 strikes.  Since the strike prices of calendar spreads is what determines whether you are bullish or bearish on the stock, when we had all our calendar spreads at strikes below the stock price, we were extremely bearish.

Then the stock turned around and headed higher, taking away the gains we had made, and we were right back to where we started.  Today we made a new start, and I would like to share our thinking at this time.

Terry

Update on Oil Play Designed to Make 25% in One Month

USO is an Exchange Traded Product (ETP) which is highly correlated to the price of oil (West Texas Intermediate). But there is another component that is not as easy to contend with, and that is the speculative element.  Oil prices are less than half of what they were a year ago, and in spite of most of the big investment banks warning that even lower prices are coming, there seems to be some people out there who are betting that oil prices will eventually recover, and this may be a good time to get on board.  For example, Robert Shiller, Nobel laureate and Yale University economist  made a strong pitch to “buy oil” this week.  Consequently, over the past few days, USO has inched up a bit in spite of these recent developments:

• The supply of oil is at an 80-year high, and grew at more than 4 million barrels last week in spite of expectations far less than that.
• The rate of oil rigs closing down has fallen drastically (and it appears that the rigs that have been closed down so far were the lowest-producing ones so the supply of oil gets higher each week)
• There appears to be an accord with Iran which could flood the market with new oil from Iran if sanctions are removed.

We are siding with the investment banks’ predictions instead of Mr. Shiller’s (who is likely to be thinking longer-term). While we believe the short-term price of USO is headed lower (for the above reasons and the headwinds caused by contango), we hedged our bet a little, and established new positions in our demonstration portfolio.  We own puts expiring in Jan-16 and we have sold Apr-4 15 puts which expire in 3 weeks (on April 24th).  We have 8 calendar spreads at the 15 strike, 8 at the 16 strike, and 5 at the 17 strike at a time when the stock is trading at $17.45.  Our portfolio is worth $2910 today.

This is the risk profile graph for these calendar spread positions for April 24th:

The graph shows that if USO doesn’t change one cent in value for the next three weeks, we will make about 20% with our positions.  If it falls by about a dollar (or more) as we expect, we could make double that amount.  If we are wrong, and it goes higher by a dollar in three weeks, we will break even.

We like our chances with these positions, and they demonstrate how you can make extraordinary gains with options, even if you are not quite right in guessing which way a stock price is headed.  I always like the feeling that if the stock doesn’t change at all (which is so often the case), I will still make a nice gain when the short options expire.