The Options Trading and Investing service provides perspective on high quality setups and option trading strategies. We carefully select these setups due to their quality and profit potential and we report back on results. In the weekend free webinar I review current portfolio performance and I also discuss techniques that I utilize to help reduce risk and, in some instances, lock in profits from previous trades. This week I discuss adding a Ratio Spread to the EEM position and preview a new potential position in RUT. Finally, I update the Apple stock vs. Apple option ‘competition’ to see which strategy is performing best.
Please refer to our education video HERE for more information in the option strategies used in this post.
The entries and cost basis of new positions will appear on our private twitter feed during the coming week.
Current position in EEM is shown (below) after I added a Put Ratio Spread to the position this week. I bought 5 Jul21 EEM 41 puts and sold 15 Jul21 EEM 39 puts for a total cost of $65. As I mentioned in the previous slide the open loss on the position is $832.50. Now that Stan is projecting a turn in this price range for EEM I will get a little more aggressive to the downside. I would have preferred not to add any more upside risk in EEM since that is where my loss is occurring at present but since it is only $65 I allowed it. The potential payoff to the downside is many multiples of the upside risk from that adjustment. In fact, looking at the overall position it is possible to turn that loss into close to a $500 gain by Jul21 with a 5% move lower. Even just a 2% move lower will reduce the current loss by over $300. If EEM doesn’t decline over the next couple of weeks? I will continue to make aggressive downside plays until it does go down while only allowing small losses to the upside from those adjustments. If EEM is still in the same price area or just lightly lower next week I will look to add another short-term downside position that I will establish for a credit so I don’t take on any additional upside risk.
Let’s consider a move lower in the RUT into late summer followed by a move higher into the end of the year. You would have to place 2 trades to cover those moves right? Actually, you can capture both moves with one position. Below is an Unbalanced Broken Wing Butterfly (BWB). If you have seen some of the previous option videos you will recognize this position as one of my frequent positions. Here’s why; the position allows for a 2 sided move while accruing Theta the entire time. In this particular position you can see that the break even price at Dec15 expiry is just 2 points below the current price so I don’t need a big move lower to have a profitable outcome. If RUT does move lower for a few months or even all the way into expiry I will make at least a $4,000 profit if it closes below 1400 at Dec15. A $4,000 profit on a risk of $4,975 is an 80% return on risk for just over 5 months. The maximum potential return is 261% or a $13,000 profit. Do I have to accept a much lower probability of profit in order to make such a good return? Actually, the probability of making a profit on the trade is about 50%. There is approx. a 45% probability of making at least the 80% return on risk or a $4,000 profit on the position by expiry. You can see I am not giving up a high probability of success in order to make a really good return. Are there other positions that have at least a 50% probability of profit that pay really well? Let’s consider the standard at the money (ATM) vertical.
The profitable outcome on the previous slide was about 50%. In the risk profile below, the Put Vertical Debit Spread has almost the identical 50% probability of profit. The max loss is pretty close to the previous position and the max profit if RUT is below 1340 @ Dec15 expiry is considerably better. However, compare the profit a the -5% price slice. In the vertical spread the profit is $6,730. On the Unbalanced BWB, the profit if RUT is 5% lower as of Dec15 is $10,525. So when do I use a vertical spread and when do I use the BWB? That is dependent on Stan and Jack’s time a price targets as well as my other positions in the options portfolio. For instance, if I already have the price area on RUT below 1340 covered well where I will make a good profit from an existing position I might add the BWB to maximize profits from a smaller move lower. If I will already profit from a smaller move I may want to use the vertical to increase profitability on a bigger move. Managing an options portfolio isn’t about just adding a bunch of similar positions on top of each other. I want to cover a broad spectrum of time and price to maximize profitability of the overall portfolio.
Some of you (I hope) may be asking why use a call BWB for a move lower instead of a put BWB. Aren’t puts designed for down moves and calls for up moves? In an efficient market, put spreads and call spreads can be interchanged without costing you any extra. However, keep following along here as I will soon mention one major difference to be aware of. If the bid/ask spread is comparable (as it should be) you can be indifferent as to whether you use the calls or the puts on this RUT position. RUT options are European style which means they can’t be exercised prior to expiry and they are cash settled so you can never end up long or short stock. On equities, such as my current position is AAPL that I will discuss in a minute, any short option can be exercised at any time. In general, you will find that if you are short in-the-money (ITM) call options you are more likely to have them exercised early than puts. Why? Dividends! When a stock is about to go ex-dividend and you are short ITM calls you are at a greater risk of finding yourself short the stock on the morning of the dividend. If that happens, you pay the dividend! That usually only happens if the extrinsic value of the call is less than the dividend. However, that is not guaranteed! A quick shortcut to estimating whether or not you will be assigned on a short call is to look at the price of the put with the same strike and expiry. If that price exceeds the dividend you probably won’t get assigned but again, no guarantees!
Below is the current position in AAPL. It is a long-term Stock Replacement Strategy that deserves a place in any of my option portfolios. Why do I call it a stock replacement strategy? What advantages does it have over simply buying the stock? As you can see below, the position is profitable as long as AAPL’s price is below $158.34. There is no risk to the downside. That feature is not available if you purchase the stock. This position doesn’t benefit from a large, immediate move higher like owning the stock does. That has been the big advantage to owning the stock over the past year. Will that continue? Stan doesn’t project that to continue in the Big Five Chart Service view of AAPL. If you are not a subscriber consider the 30 day free trial to see where he and Jack think AAPL (as well as NFLX, AMZN, FB, TSLA) is headed over the next year.
On June 11th I began keeping an updated comparison of how this strategy has performed in comparison with owning the stock so we can all see how it is working. As of the close on Friday 6/23/2017: The option position I established used up $5,000 of margin. For that amount of margin, I could have instead bought 72 shares of AAPL stock at $139.79 on 3/1/2017. On 6/30/2017, AAPL closed at $144.02/share. If I had bought the stock my profit would be $304.56. The option position currently has a gain of $265.00. That means that the option position has under-performed the stock purchase by $39.56.
This was the question I asked on the June 11 webinar when the stock position was out performing the option position by $918.68: If I was allowed to switch positions and take the stock position and the open profit but I had to hold whatever position I owned through Jan2018 expiry, would I make the switch? My answer? Not a chance! As we get closer to Jan2018 it will become obvious if I made the right decision.
What if the price of AAPL on Jan19, 2018 is the same as the current price ($144.02/share), what will the stock and options positions be worth then? The stock will still maintain it’s current $304.56 gain plus accrue $136.08 in dividends for a total stock profit of $440.64. The option position will have a total option profit of $2,732. The option position will out-perform the stock position by $2,291.36 by Jan 19, 2018 if AAPL’s share price is the same as the current price.
Consider the AAPL position I just discussed. I established the position when AAPL was trading at $139.79 on 3/1/2017. To be profitable, AAPL could trade higher or lower or unchanged but the area where the position would lose at expiry was above $158.34. The area where the trade would be unprofitable immediately after the position was established was any price higher. In other words, the position was short-term bearish and long-term neutral to bullish. So what happened after I established the position? Of course the stock moved against the position and traded as high as $156.65 on 5/15/2017. Any bearish to neutral short-term (less than 60 days) strategy gets blown up and takes a loss as it expires. With this position I was able to ride out the storm and keep the position which has now turned profitable.
So what about the short-term traders? You can still be a short-term option trader and utilize longer-term option positions. Let’s look at the week of 6/12 – 6/16 in AAPL with the Jan2018 position that I own in the portfolio. Let’s say I felt AAPL was going to have a bad week and I wanted to take advantage of that. What if I didn’t already own my current position and I initiated it just before the close on Friday, 6/9/2017. So the stock drops by 4.5% but the option position would have had a $600 profit in one week which is a 12% profit on $5,000 margin requirement. If I was a short-term trader I could have closed the position 6/16 and booked the $600 profit. Now, if I knew that AAPL was going lower that week I could certainly have used a much more profitable short-term strategy instead but the problem is nobody knew what the price of AAPL was going to do last week. Stan estimates that good chart patterns play out about 70% of the time which is a huge advantage in trading however no one should take that to mean 100% certainty! Art of Chart option trading is about maximizing the range of profitability that you can get with longer-term positions while incorporating Stan and Jack’s price and time targets to reduce the cost basis of entering the positions. This method will produce slower profits but fewer losses and, over time, more consistent profitability with lower trading costs.
That is all for this week. If you have questions or comments you can post them here on the blog or if you are an Art of Chart subscriber you can post it on the private Twitter feed. If you are not a subscriber you can sign up for a 30 day Free Trial to try out the service. What have you got to lose, it’s free!