Monthly Archives: October 2015

Making Adjustments to Calendar and Diagonal Spreads

If you missed it last week, be sure to check out the short video which explains why I like calendar spreads.  This week I have followed it up with a second video entitled How to Make Adjustments to Calendar and Diagonal Spreads.

I hope you will enjoy both videos.  I also hope you will sign up for a Terry’s Tips insider subscription and start enjoying exceptional investment returns along with us (through the Auto-Trade program at thinkorswim).

Terry

Making Adjustments to Calendar and Diagonal Spreads

When we set up a portfolio using calendar spreads, we create a risk profile graph using the Analyze Tab on the free thinkorswim trading platform.  The most important part of this graph is the break-even range for the stock price for the day when the shortest option series expires.  If the actual stock price fluctuates dangerously close to either end of the break-even range, action is usually required.

The simple explanation of what adjustments need to be made is that if the stock has risen and is threatening to move beyond the upside limit of the break-even range, we need to replace the short calls with calls at a higher strike price.  If the stock falls so that the lower end of the break-even range is threatened to be breached, we need to replace the short calls with calls at a lower strike.

There are several ways in which you can make these adjustments if the stock has moved uncomfortably higher:

1. Sell the lowest-strike calendar spread and buy a new calendar spread at a higher strike price, again checking with the risk profile graph to see if you are comfortable with the new break-even range that will be created.  The calendar spread you are buying will most likely cost more than the calendar spread you are selling, so a small amount of new capital will be required to make this adjustment.
2. Buy a vertical call spread, buying the lowest-strike short call and selling a higher-strike call in the same options series (weekly or monthly).  This will require a much greater additional investment.
3. Sell a diagonal spread, buying the lowest-strike short call and selling a higher-strike call at a further-out option series.  This will require putting in much less new money than buying a vertical spread.
4. If you have a fixed amount of money to work with, as we do in the Terry’s Tips portfolios, you may have to reduce the number of calendar spreads you own in order to come up with the necessary cash to make the required investment to maintain a satisfactory risk profile graph.

There are similar ways in which you can make these adjustments if the stock has moved uncomfortably lower.  However, the adjustment choices are more complicated because if you try to sell calls at a lower strike price than the long positions you hold, a maintenance requirement comes into play.  Here are the options you might consider when the stock has fallen:

1. Sell the highest-strike calendar spread and buy a new calendar spread at a lower strike price, again checking with the risk profile graph to see if you are comfortable with the new break-even range that will be created.  The calendar spread you are buying will most likely cost more than the calendar spread you are selling, so a small amount of new capital will be required to make this adjustment.
2. Sell a vertical call spread, buying the highest-strike short call and selling a lower-strike call in the same options series (weekly or monthly).  This will require a much greater additional investment.  Since the long call is at a higher strike price than the new lower-strike call you sell, there will be a $100 maintenance requirement per contract per dollar of difference between the strike price of the long and short calls.  This requirement is reduced by the amount of cash you collect from selling the vertical spread.
3. Sell a diagonal spread, buying the highest-strike short call and selling a lower-strike call at a further-out option series.  This will require putting in much less new money than selling a vertical spread.

Making 36%

Making 36% – A Duffer's Guide to Breaking Par in the Market Every Year in Good Years and Bad

This book may not improve your golf game, but it might change your financial situation so that you will have more time for the greens and fairways (and sometimes the woods).

Learn why Dr. Allen believes that the 10K Strategy is less risky than owning stocks or mutual funds, and why it is especially appropriate for your IRA.

Order Now

Success Stories

I have been trading the equity markets with many different strategies for over 40 years. Terry Allen's strategies have been the most consistent money makers for me. I used them during the 2008 melt-down, to earn over 50% annualized return, while all my neighbors were crying about their losses.

~ John Collins

Why I Like Calendar Spreads

I have created a short video which explains why I like calendar spreads.  It also shows the exact positions we hold in 3 Terry’s Tips actual portfolios so you can get a better idea of how we use calendar spreads.

 

I hope you will enjoy the video, and I welcome your comments.

 

Terry

 

Why I Like Calendar Spreads

 

The basic reason I like calendar spreads (aka time spreads) is that they allow you to make extraordinary gains compared to owning the stock if you are lucky enough to trade in a stock that stays flat or moves moderately higher.

 

I get a real kick out of making serious gains when the stock just sits there and doesn’t do anything.  Calendar spreads almost always do extremely well when nothing much happens in the market.

 

While I call them calendar spreads, if you look at the actual positions that we hold in our portfolios, you will see that the long calls we own are not always at the same strike prices as the short calls we have sold to someone else.  That makes them diagonal spreads rather than calendar spreads, but they operate exactly the same as calendar spreads.

 

With both calendar and diagonal spreads, the long calls you own decay at a slower rate than the short calls that you have sold to someone else, and you benefit from the differences in decay rates.  Both spreads do best when the stock ends up precisely at the strike price of an expiring option.  At that point, the short options expire worthless and new options can be sold at a further-out time series at the maximum time premium of any option in that series.

 

If you have sold short options at a variety of strike prices you can make gains over a wider range of possible stock prices.  We use the analyze tab on the free thinkorswim software to select calendar and diagonal spreads which create a risk profile graph which provides a break-even range that lets us sleep at night and will yield a profit if the stock ends up within that range.  I encourage you to try that software and create your own risk profile for your favorite stock, and create a break-even range which you are comfortable with.

Making 36%

Making 36% – A Duffer's Guide to Breaking Par in the Market Every Year in Good Years and Bad

This book may not improve your golf game, but it might change your financial situation so that you will have more time for the greens and fairways (and sometimes the woods).

Learn why Dr. Allen believes that the 10K Strategy is less risky than owning stocks or mutual funds, and why it is especially appropriate for your IRA.

Order Now

Success Stories

I have been trading the equity markets with many different strategies for over 40 years. Terry Allen's strategies have been the most consistent money makers for me. I used them during the 2008 melt-down, to earn over 50% annualized return, while all my neighbors were crying about their losses.

~ John Collins

Two 2015 Case Studies of Options Portfolios

Got an extra five minutes of time to change your thinking about investing forever?  I invite you to read the following report and see why.  You could get a clear understanding of how an options strategy can be used to dramatically improve your investment results for any stock you feel good about (good enough to buy shares in that company).   For two companies we picked at the beginning of 2015, we have made over 100% on our money in the first nine months, and you could have done it as well, even if you knew absolutely nothing about options (read on and see how).

 

These case studies were actual portfolios carried out during the first nine months of 2015 in separate brokerage accounts at thinkorswim for Terry’s Tips subscribers (many of whom mirrored these trades in their own accounts or had trades executed automatically in their accounts by the (free) Auto-Trade service at that brokerage firm.  The results include commissions on all the trades.

 

The first nine months of 2015 were not good ones for the market.  The S&P 500 fell 6.7%, from 2059 to 1920. 

 

The two individual stocks covered in this report, Costco (COST) and Starbucks (SBUX) outperformed the overall market during this time period.  COST rose from $141.87 to $144.57, a gain of $2.70, or 1.9%.  SBUX soared from $82.05 to $113.68 (pre 2-for-1 split), or 38.5%.

 

As you will soon see, while the gains in COST and SBUX were most impressive compared to the overall market, they did not do nearly as well as our two actual portfolios which traded options on these underlyings.

 

The strategy used in these portfolios is a lot like buying stock and writing calls against the stock.  However, there is a big difference in the options portfolios.  Instead of buying stock, longer-term call options (and sometimes, LEAPS) are used as collateral against which to sell short-term call options.  The return on investment from writing calls against longer-term options that might cost one-tenth the value of the stock is why the options portfolio comes out well ahead of buying stock and writing calls against those shares. 

 

Extreme leverage can be your friend if the stock holds steady or moves higher.  On the other hand, if the underlying stock falls more than moderately, the options portfolio might lose more than you would lose you had bought stock instead.  So it’s important to select a stock you feel comfortable about.  The stock doesn’t have to move higher for this options strategy to prosper, but it can’t fall a lot and still expect to produce extraordinary gains.

 

Case Study #1 – Costco Options Portfolio

 

Costco (COST) started out 2015 trading at $141.87 while the Terry’s Tips portfolio which uses COST as the underlying was worth $6223.  With this amount invested, you could have purchased 43.8 shares of the stock (we’ll round it off and say you could have bought 44 shares).

 

Here is how the price of COST fluctuated during the first nine months of 2015:

 2015 Stock Price Of COST

2015 Stock Price Of COST

 

 

 

 

 

 

The stock rose steadily early in the year, but fell from a high of about $153  to as low as $135 in the first week of September. At the end of September, it was trading about $3 higher than where it started out the year. Let’s compare the prices for 44 shares of COST with the value of the actual Terry’s Tips portfolio trading COST options during this same time period:

COST Stock vs Portfolio 2015 

COST Stock vs Portfolio 2015

 

 

 

In late January when the stock fell a bit, the portfolio value fell by a greater amount, but when the stock recovered, the portfolio outperformed on the upside as well.  Two other times during the year, the stock took a sudden drop and the portfolio value fell below the equivalent investment in the stock, but when the stock moved higher in July, the portfolio shot by a considerably higher percentage.

 

Over the nine months, an investment in the stock would have gained $1.20 per share from dividends you would have received on 44 shares, or $52.80.  The stock gained $2.70 over these months, so the 44 shares were worth $118.80 more than they were at the beginning, for a net gain of $171.60 including the dividends. This total works out to a 1.2% gain on the stock purchase for the nine months.

 

Over this same period, the actual COST options portfolio (we call it the Rising Tide portfolio) rose from $6223 to $12,900, for a gain of $6667, or 107%.

 

Let’s check the actual positions in this portfolio at the beginning of the year (from our January 3, 2015 Terry’s Tips Saturday Report):

 

  

Rising Tide

     Price:

$141.61

     

 

 

 Option

Strike

Symbol

Price

    Total

Delta

Gamma

 Theta

-3

Jan-15

C

140

COST150117C140

$2.92

($876)

-3

Jan-15

C

143

COST150117C143

$1.23

($368)

-2

Jan-15

C

145

COST150117C145

$0.57

($113)

6

Apr-15

C

135

COST150417C135

$9.25

$5,550

1

Apr-15

C

145

COST150417C145

$3.43

$343

2

Jul-15

C

140

COST150717C140

$7.68

$1,535

 

Cash

$152

218

-37

$26

    Total Account Value

$6,223

3.5%

1

Annualized ROI at today’s net Theta:

152%

 

We owned 7 calls which expired in April and 2 which would extend until July, and we had sold a total of 8 Jan-15 calls, 3 of which were at a strike just below the stock price and 5 which were slightly out of the money.  We had one long uncovered call which we could have sold a short-term call against, but we wanted to maintain a higher net delta.  The option positions were the equivalent of owning 218 shares of stock (the net delta figure).  That explains why the portfolio value gains or loses at almost 5 times the rate of owning 44 shares of stock.

 

Now let’s fast forward to what the portfolio looked like at the close of business on September 25, 2015.  Here are the positions that we held:

 Rising Tide Positions Oct 2015

 Rising Tide Positions Oct 2015

 

You can see many differences between these positions and what we held back in January.  First, the long calls are all the way out to 2016 (Jan-16 and Apr-16).  Second, there are some put positions.  In May, when COST was trading about $144, we sold a bullish credit put spread (buying Oct-15 135 puts and selling Oct-15 140 puts).  If COST is at any price above $140 when those puts expire on October 16th, both puts will expire worthless, and we will have made 51% on the amount we risked when we sold the spread in May. Third, the short calls are in several weekly series rather than in a single (monthly) options series. 

 

About half-way through 2015, we changed the way we trade this portfolio. We are now short weekly options in several different series.  Each week, some calls expire, and we buy them back (usually on Friday) and sell new ones which expire about 4 weeks later.  We select strikes which will balance out the risk profile for the portfolio.  This allows us to tweak the profile each week rather than making wholesale adjustments at the end of the expiration month.  We believe that the superior performance we have enjoyed over the past few months in all of our stock-based portfolios has been due to this new way of trading which was not possible before the advent of weekly options.

 

Every Friday, we create a risk profile graph to help us decide which strike prices to use when we buy back the expiring weekly options and replace them with further-out new short calls.  Here is the graph we created on October 2, 2015 which shows the expected gain or loss in portfolio value when the short options expire on the next Friday, October 9th:

Rising Tide Risk Profile Graph Oct 2015 

Rising Tide Risk Profile Graph Oct 2015

 

This graph shows that if the stock is absolutely flat ($143.21) a week from now, the portfolio will gain $735, about 5% of the portfolio value.  If It moves about $3 higher, the portfolio would gain about double that amount.  A gain should result even if the stock falls by about a dollar during the next week.  It can move higher by about $6 before a loss would occur on the upside.  You can see how most weeks, this collection of long and short calls will result in a gain as long as the stock moves only moderately.  (Actually, in most weeks, we end up with positions that allow for the stock to fall by $2 before a loss would be incurred – this week was unusually bullish for us.)

 

To sum it up, over the 9 months of trading, our portfolio gained $6376.  This works out to be 107% of the starting value of $6223.  Someone who had spent the same amount of money buying shares of COST would have picked up about $172, or 1.2%..  Our portfolio outperformed by more than 30 times what the owners of the stock gained.

 

We believe that this experience establishes beyond all doubt that a properly-executed options strategy can out-perform the outright purchase of the shares many times over.  Of course, it is a lot easier just to buy the stock.  Trading options takes time and attention, but surely, isn’t it worth it when you might do about 30 times better?

 

If you don’t want to bother with all the trading, you could open an account at thinkorswim and sign up for their free Auto-Trade service, and not only enjoy their $1.25 (normally $3.90) commission rate for a single option purchase or sale, but all the trades will be automatically made for you in your account.  By the way, this lower commission rate made available to Terry’s Tips subscribers will apply to all your trades, not just those you make through Auto-Trade.  Many subscribers cover their entire subscription cost by their commission cost savings.

 

We recommend setting up a self-directed IRA account for trading options (especially a Roth IRA if you are eligible for one).  Gains from option trading are short-term capital gains taxed pretty much like ordinary income, and you don’t have to itemize individual trades when you file your tax return for an IRA account.

 

By the way, you may wonder about my options-trading experience.  Way back in 1980, I had a seat on the C.B.O.E. and traded as a market maker on the floor.  Ever since then, for 35 years, I have traded options essentially every day the market has been open.  I graduated from the Harvard Business School and earned a Doctorate in Business Administration from the University of Virginia, but my most valuable credentials came from trading options nearly every day for all those years.  My options trading has enabled me to give away over $2 million to charities in my home state of Vermont.  I was especially proud to build a large swimming pool for the Burlington Boys and Girls Club, and give dozens of college  scholarships to single-parent and first-in-family-to-attend-college Vermonters.

 

Case Study #2 – Starbucks (SBUX) Options Portfolio

 

The first nine months of 2015 were pretty good months for owners of Starbucks (SBUX).  The stock started out the year trading at $81.44 and steadily rose to a high of about $98, and then in early April, they had a 2-for-1 stock split.  By the end of September, the stock traded at $57.99 which works out to a pre-split price of $115.98.  There were 3 dividends of $.16 paid, adding another $.48 to the total, making it a total gain of $35.02, or 43% for the 9 months.

 

Our Java Jive  portfolio started out the year with $6032 invested in SBUX.  At $81.44 per share, you could have purchased 74 shares of stock.  Over the nine months, the portfolio gained $11,768 in value, making 195%.

 

Here is a graphic comparison of how a $6032 investment in the options portfolio compared to the purchase of 74 shares of stock:

 SBUX Stock vs Portfolio 2015

SBUX Stock vs Portfolio 2015

 

 

 

Unfortunately, the actual portfolio did not gain that much because we also had about half the money invested in Keurig Green Mountain (GMCR), a different kind of coffee company.  The GMCR portion of the portfolio lost $8905 over the period as the stock fell from over $130 to the low $50’s.  In August, GMCR was dropped and FB added to the portfolio, and FB about broke even for the next six weeks (we are now trading both SBUX and FB in separate portfolios).  The portfolio started out the year being worth $10,604 and at the end of September, was worth $12.786, up $2182, or 20.5%.  Not a bad gain over a period when the market fell 6.7%, but not quite the 195% it would have made if only SBUX had been traded.

 

We believe that the above two case studies establish beyond all doubt that a properly-executed options strategy can out-perform the outright purchase of the shares many times over.  Of course, it is a lot easier just to buy the stock.  Trading options takes time and attention, but surely, isn’t it worth it when you can make 107% with options rather than 1.2% owning the same stock, (as we did with COST), or 195% with options instead of 43% owning the same stock (as we did with SBUX)?

 

If you don’t want to bother with all the trading, you could open an account at thinkorswim and sign up for their free Auto-Trade service, and not only enjoy their $1.25 commission rate for a single option purchase or sale, but all the trades will be automatically made for you in your account (this same lower Terry’s Tips commission will apply to all your trades, not just those in Auto-Trade).

Making 36%

Making 36% – A Duffer's Guide to Breaking Par in the Market Every Year in Good Years and Bad

This book may not improve your golf game, but it might change your financial situation so that you will have more time for the greens and fairways (and sometimes the woods).

Learn why Dr. Allen believes that the 10K Strategy is less risky than owning stocks or mutual funds, and why it is especially appropriate for your IRA.

Order Now

Success Stories

I have been trading the equity markets with many different strategies for over 40 years. Terry Allen's strategies have been the most consistent money makers for me. I used them during the 2008 melt-down, to earn over 50% annualized return, while all my neighbors were crying about their losses.

~ John Collins