A couple of weeks ago, I put $1500 into a separate brokerage account to trade put options on an Exchange Traded Product (ETP) called SVXY. I placed positions that were betting that SVXY would not fall by more than $6 in a week (it had not fallen by that amount in all of 2014 until that date). My timing was perfectly awful. In the next 10 days, the stock fell from $87 to $72, an unprecedented drop of $15.
Bottom line, my account balance fell from $1500 to $1233, I lost $267 in two short weeks when just about the worst possible thing happened to my stock. Now I want to put $267 back in and start over again with $1500, and make it possible for you to follow if you wish.
This will be an actual portfolio designed to demonstrate one way how you can trade options and hopefully outperform anything you could expect to do in the stock market. Our goal in this portfolio is to make an average gain of 3% every week between now and when the Jan-15 options expire on January 15, 2015 (22 weeks from now).
That works out to 150% a year annualized. I think we can do it. We will start with one trade which we will make today.
I hope you find this ongoing demonstration to be a simple way to learn a whole lot about trading options.
Ongoing Spread SVXY Strategy For You to Follow if You Wish
Our underlying “stock” is an ETP called SVXY. It is a complex volatility-related instrument that has some interesting characteristics:
1. It is highly likely to move steadily higher over time. This is true because it is adjusted each day by buying futures on VIX and selling the spot (current) price of VIX. Since over 90% of the time, the futures are higher than the spot price (a condition called contango), this adjustment almost always results in a gain. SVXY gained about 100% in both 2012 and 2013 and is up about 30% this year.
2. SVXY is extremely volatile. Last Friday, for example, it rose $2 in the morning, fell $6 mid-day, and then reversed direction once again and ended up absolutely flat (+$.02) for the day. This volatility causes an extremely high implied volatility (IV) number for the options (and very high option prices). IV for SVXY is about 65 compared to the market (SPY) which is about 13.
3. While it is destined to move higher over the long run, SVXY will fall sharply when there is a market correction or crash which results in VIX (market volatility) to increase. Two weeks ago, we started this demonstration portfolio when SVXY was trading at $87, and it fell to $72 before recovering to its current $83.
4. Put option prices are generally higher than call option prices. For this reason, we deal entirely in puts.
5. There is a large spread between the bid and ask option prices. This means that every order we place must be at a limit. We will never place a market order. We will choose a price which is $.05 worse for us than the mid-point between the bid and ask prices, and adjust this number (if necessary) if it doesn’t execute in a few minutes.
This is the strategy we will employ:
1. We will own a Jan-15 90 put. It cost us $15.02 ($1502) to buy (plus $2.50 commission for the spread). Theta is $4 for this option. That means that if the stock is flat, the option will fall in value by $4 each day ($28 per week).
This is the trade we made today to get this demonstration portfolio established:
Buy To Open 1 SVXY Jan-15 90 put (SVXY150117P90)
Sell To Open 1 SVXY Aug4-14 87 put (SVXY140822P87) for a debit limit of $12.20 (buying a diagonal)
This executed at this price (90 put bought for $15.02, 87 put sold for $2.82 at a time when SVXY was trading at $85.70.
2. Each week, we will sell a short-term weekly put (using the Jan-15 90 put for collateral). We will collect as much time premium as we can while selling a slightly in-the-money put. That means selling a weekly put at the strike which is slightly higher than the stock price. We hope to collect about $2 ($200) in time premium by selling this put. Theta will start out at about $20 for the first day and increase each day throughout the week. If the stock stays flat, we would get to keep the entire $200 and make a net gain of $172 for the week because our long put would fall in value by $28. This is the best-case scenario. It only has to happen 6 times out of 22 weeks to recover our initial $1200 investment.
3. Each Friday we will need to make a decision, and often a trade. If the put we have sold is in the money (i.e., the stock is trading at a lower price than the strike price), we will have to buy it back to avoid it being exercised. At the same time, we will sell a new put for the next weekly series. We will choose the strike price which is closest to $1 in the money. Our goal is to take some money off the table each and every week. If it is not possible to buy back an expiring weekly put and replace it with the next-week put at the $1 in-the-money strike at a credit we will select the highest-strike option we can sell as long as the spread is made at a credit. We eventually have to cover the $1220 original spread cost, and collecting about $200 as we will some weeks would recover that amount quite quickly – we have 22 weeks to collect a credit, so we only need an average of about $45 each week (after commissions).
4. On Friday, if the stock is higher than the strike price, we will not do anything, and let the short put expire worthless. On the following Monday, we will sell the next-week put at the at-the-money strike price, hopefully collecting another $200.
5. We are starting off by selling a weekly put which has a lower strike price than the long Jan-15 put we own. In the event that down the line (when the stock price rises as we expect it will), we may want to sell a weekly put at a higher strike price than the 90 put we own. In that event, we will incur a maintenance requirement of $100 for each dollar of difference between the two numbers. There is no interest charged on this amount, but we just can’t use it for buying other stocks. For now, we don’t have to worry about a maintenance requirement because our short put is at a lower strike than our long put. If that changes down the line, we will discuss that in more detail.
This strategy should make a gain every week that the stock moves less than $3 on the downside or $4 on the upside. Since we are selling a put at a strike which is slightly higher than the stock price, our upside break-even price range is greater. This is appropriate because based solely on contango, the stock should gain about $1.00 each week that VIX remains flat.
I think you will learn a lot by following this portfolio as it unfolds over time. You might find it to be terribly confusing at first. Over time, it will end up seeming simple. Doing it yourself in an actual account will make it more interesting for you, and will insure that you pay close attention. The learning experience should be valuable, and we just might make some money along the way as well.