Vertical Spread

Well, it's been a while since I've posted here.  Hopefully I can be better about that, but let's admit it... I probably won't be. 

Now that we're back from Thanksgiving, Christmas, Hanukkah, New Years, etc, there's so much to talk about.  At the moment, I'm thinking a lot about the rule 'Don't trade Earnings'.  During December, Nike announced earnings, and I had a multi-week diagonal running that I had to close early because of this rule.  It turns out that the stock price barely moved and I would have been fine.  I stood to make $350 for several weeks of rolling.  Instead I forced myself to close the position early to avoid a potential $2,000 max loss.  It's hard to know what the right decision should be.

I'm facing a similar situation this week with MU.  I had a long-term diagonal that was set to expire last Friday.  It was going to expire in the money, and to just close it out would have wiped out all of my profits from the previous weeks rolls.  Instead of closing, I opted to roll it out a few months and narrowed the strike ranges from 22/18 to 21/18 for a small $.10 premium.  They announce earnings after hours today (in about 10 minutes).  They started the day up 3.5%and around 11:00 PST, they started climbing as high as 5.5% to 21.94. 

This sharp rise kind of spooked me.  I started thinking that people are going to buy in, and then if there aren't stellar earnings, they'll bail causing the price to plummet.  All of this questioning caused me to close my position.  I have a $420 profit from this diagonal, and I just closed the 5 contract position for a $.87 debit.  That adds up to a $32 loss (and several weeks of lost opportunity cost) for this play.  I just need to keep telling myself that it's the smart thing to do. 

Why do I avoid earnings?

I had a theory two years ago that I was going to make a killing in the stock market.  Stock prices tend to move on news.  You can make money when stock prices move, so if you could tell when there was going to be news, you could make a trade and profit from the move.  Predicting when there is going to be a news announcement is pretty difficult.  However, earnings announcements are set days and times, so you know exactly when the stock is likely to move.  You just need to place a bet on whether the price is going to go up or it is going to go down.  Sounds pretty simple.  

I started making paper trades and pretty quickly found that even when I picked the beat/miss correctly, the price often moved counter-intuitively. This got to be pretty frustrating.  I would pick that AAPL was going to beat the estimates, they would beat the estimates and then the price would drop.  In one case the price was up 10% after hours, and then promptly dropped 20% the following morning.  

In the options game, sudden large movements are deadly.  What I want is a stock that plods predictably upwards week after week.  When I'm picking spreads, I'm typically leaving a 2-3% cushion between the stock price and my upper strike on a Bull-put spread.  That means I can absorb a 2-3% drop in the stock price and still make a profit that week.  On an earnings day, 10-20% swings are routine.  If you're on the wrong-side of that swing, and you only have a day or two for the price to recover, you're pretty well guaranteed to suffer a max-loss. 

The last couple of weeks I've been letting my rolls expire. In the mean time, I've been researching another way to construct options plays that may make rolling a little easier. In the past, I've been playing with bull put spreads or bear call spreads where both sets of option contracts expire at the same time. You can make money doing this because the premium you get for selling the option closer to the stock price is more than it costs to buy the option further away (for protection).

If you chose wisely, and the stock stays above the strike price of the option you sold (in the case of a bull put spread), then you simply wait for things to expire, and you've made money over all. The difficulty with this comes when the stock looks like it will close below that strike. If the stock closes below the strike of the protection, both sides will exercise, and you lose the cost of the spread. If it finishes in between, you get put the stock, and then, unless you really wanted the stock, you have to figure out how to sell it early in the next week. I allowed this last scenario to happen to me, just to see how it worked. I ended up losing more money than the spread because the stock continued to go down in the next week, and I ended up selling the stock put to me below my protection strike.

If the spread isn't going to finish above the upper strike, you will typically want to roll the option to the next weekly (or monthly) expiration. Depending on where the price of the stock is, it could be difficult to do this without losing money. In most cases, if the stock has fallen below the upper strike, the upper strike option contract starts to become very expensive to buy back because it's worth more than the stock, and there isn't a lot of time-value offsetting it. By the same token, if it's still above the lower strike, and that option looks like it's going to expire worthless, those contracts can't be sold to make up much of the expense of buying back the upper. So usually you have to roll the contracts to another pair of contracts that have a wider spread, thereby increasing the risk of the spread, sometimes significantly. Many times you can't even roll the spread straight out to the same strikes for the following week without taking a loss.

To combat these problems, some of my investing buddies have started playing calendar spreads. These are, in principal, the same kind of spread, but the expiration date of the protection is several weeks or months out. The key here is that you wouldn't have to roll both the upper and lower strikes, only the upper. In practice, it's easier to do this, than have to roll both. Conceptually this still works from the protection perspective. The lower strike option can be exercised at any time up to the expiration, so if the stock dips below it, you can exercise early to protect yourself from the loss. If for some reason you get put the stock (because you didn't roll the upper), you are guaranteed to be able to at least exercise the further-out protection contract if the stock continues to fall.

The reason it's easier to only roll the upper, is that you don't have to buy back the protection. Late in the week, the protection can be nearly worthless, especially if the stock price is still above it. And it may not have a lot of open interest, so buying them back can be difficult, even if you weren't offering much. You can't just roll the upper in a normal spread either, because you'll be left short a cash-covered put. I wish I had enough money to do cash-covered plays on these stocks, but alas, I don't so I would need to buy protection on the roll anyway. If you already have that protection further out, then you don't need to worry about that.

There are a few of side-effects to this:

1) The spreads are generally much wider than a normal weekly spread. This is to try to reduce the amount you are spending on the protection. Since the time-value for the protection is high, you want to buy something fairly far from the stock price, or it might be more expensive than the put you're selling. This has caused me to trade fewer contracts to keep the risk in check.

2) The risk is a little harder to grok. Since it's easier to roll the upper out a week, you might be rolling it to a strike price thats higher or lower, depending on what the stock is doing, and that will change your risk profile. You need to keep this in mind and make sure you're not putting too much into the play, lest your account run out of buying power.

3) The premiums on the plays are generally less, for the same risk. This might be OK, since as you roll the short option week after week, you gain some premium each time, and maybe make that up over time.

Another interesting side effect of this is the rolls themselves. The premiums for options lose a lot of value over a Thursday night, and again over the weekend. So the best time to sell a contract is the Thursday of the previous week, the day that the strikes are announced. This nets you the largest premium for those contracts. Also, by then, the contracts that you are rolling from have lost a lot of their time value (perhaps even more if you do the roll on the Friday), so they can be very cheap to close as part of the roll. Since you'll need to keep the risk balanced, you'll have to buy them back, but the extra premium you take by not waiting until Monday should more than make up for it if the stock is in a good place.

Last week I got caught, unable to trade on Thursday. I was on a plane to the east coast, and had to leave my house before the market opened and arrived at my destination after the market closed. Given the slump in the market on Wednesday, I rolled my NTAP and KORS spreads to this week, rolled my DDD spread to next week (DDD announces weeklies for an entire month), and closed my GME spread early to free up margin for the rolls.

This looked like the best way to get out given the impending doom that was on the horizon, but the market rallied on Friday. All but KORS would have expired worthless. Looking at the numbers: If I had just let everything ride, I would have ended up in about the same place (losing about $100) across all the spreads for the week. The rolls aren't accounted for until the play closes, but the GME close cost me about the difference between all the taken premiums and taking the total loss on the KORS play.

One important lesson here is that you shouldn't play if you know you aren't going to be able to roll on Thursday and Friday. I was lucky that this week was a monthly, so strikes to roll to were present without having to go out too far. Another important lesson is not to panic and roll before Thursday. All of the rolls were down and wider, so that their premiums would make up for the loss of closing the current spread early.

The one bright light was my bear call on the SPY. Even with the rally on Friday, it finished worthless, and left some green on my balance sheet for the week.

Last week, TSLA ran into a bit of trouble where one of their Model S's caught on fire at the end of a freeway offramp.  That, coupled with the looming government shutdown caused TSLA to drop 15% over the course of a couple of days.  

I've thought TSLA was overvalued since they hit 80.  I was hopeful that this drop was the start of a return from orbit, so I bought 5 $145 October Monthly put contracts.  If the stock price continued to drop, the price of the put's would increase and I could sell them back for a profit.

Well as luck would have it, I managed to call the short-term bottom of the stock price.  The price has since rebounded from 168 up to as high as 186.  At this point I'm staring at an $800-ish loss.  I could buy it back and close it out, but max-loss is only an extra $335, and we still have the debt ceiling debacle ahead of us.

Last week finished with everything in the green for me.  I didn't have to roll a single spread.  That doesn't happen too often and feels really good when it happens.  

I picked up a SPY Bear-Call Spread late last week in anticipation of the government shutdown.  I was assuming that the market would react negatively and wanted to have a call spread in place to capitalize on that.  

Monday the market headed lower, but Tuesday, when the market woke up and the government had shutdown, the market was up.  I'm assuming that the market doesn't think the shutdown is too big of a deal, so I'm going to pick up a few plays for the week.  I was planning to sit this week out, but since the shutdown seems to have been taken in stride, I'll try to pick up a few bucks in what remains of the week.

I bought back the NTAP 42.5 puts ahead of close on Friday. The stock had been hanging around 10-20 cents from the strike, and it took a dive towards it. So, just to be sure, I bought back the puts at the upper strike. Getting put the stock if it had finished between the strikes was not something I wanted to deal with. My broker is pretty bad at resolving transactions like that, and I would have had a margin call on my account for most of the next week. Not counting commissions, I made money on the spread. Counting commissions, I lost a little.

As you can see, I added a new feature to the blog that allows you to follow along each week as we make our trades.  We'll try to keep the Tickers and Strikes up to date each week so that you can see what we have in play.  

I wanted to split my plays 50/50 between Puts and Calls, but it didn't seem to work out that way in the end.  I'm a little afraid of the looming government shutdown and what that's going to do to the markets.  I did manage to get an SPY Call, so that should help a little in the event there's really bad news later this week.  

Speaking of SPY Bear-Call spreads, I saw that I had a blinking light on the answering machine that I never check, so I decided to clear off some of the old messages that had surely been piling up.  One of the messages was from my brokerage letting me know that SPY was going to go Ex-Div last Friday, and that if I got exercised early I would owe the Dividend which amounted to $800 and change.  I'm glad that I didn't get exercised early, but I'm also glad that I didn't check my messages.  I surely would have closed the position early and probably for a loss.  Sometimes ignorance is bliss, but I don't want to make it a habit.

As an aside, when left to my own devices, I've been pretty good at picking stocks to buy where the company ends up filing for bankruptcy. Earlier in the year, I emotionally purchased a few shares of EK, hoping that the company would garner enough support to stay afloat. We all know how that turned out...

This last monday ECTY filed for bankruptcy. I didn't lose much on this stock, but this will be the second of the six different stocks that I hold/held shares of that has gone under.

In general, I’ve been suspicious of the market for individual investors. Buying stocks and hoping they go up has always seemed a bit of a gamble to me. Stock prices can move on seemingly unrelated information, and the large banks and investment firms appear to have the game rigged in their favor. So until this year, the majority of my investments have been in my 401k or a savings account. I’ve had a few stocks that really worked out for me, like Isilon, but most of my other stock pics have ended up like EK. Mostly though, I haven’t been willing to put in enough money to have it matter in the grand scheme of things, so stocks trading above $30 or so seemed too expensive.

When my coworkers started talking about options, it started to sound like a rather interesting proposition. By playing spreads you can limit the losses on any particular play, you get feedback on how you are doing every week, and if things are going badly you can push your bet out a little ways to allow the market to recover. Best of all, you don’t have to actually buy the stock.

Time to tally up the results from this week.  As I said earlier, 6 of my 7 plays for the week expired worthless. 

I made $659.80,  which is a 9.77% ROI (including all of my future rolls, 11.04% if you exclude them).  That's 2.62% on the account in a week.

It looks like all of my plays this week are going to expire worthless (except for the HD play that I rolled yesterday).  SPY turned around and headed back down below my lower strike at 172.5, and assuming it stays there, I'll be in good shape.

Since things look promising, I'll go shopping for some plays for next week.  

                                       I have a 5 contract HD 80/77.5 bull-put spread that expires this week that I've rolled for a few months.  It's currently ITM as HD is trading at 77.85.  It looks like rolling it straight out to Oct '13 will produce a $.44 debit.  Not really ideal, although I do have a total of $.89 worth of credit at this point to work with.  

The other option is to expand the risk from $1,250.00 to $2,500 by rolling to 80/75.  The probability of breaking even on an this expanded roll is currently 48%.  This would provide a $0.33 credit.  

Well after some hemming and hawing, I decided to roll it straight out for a debit.  I figure it's probably safer to cut my profit than to expand my risk.  I'm trying to avoid getting greedy, but it's hard.

I first started investing in one way or another in 2004 with around $5,000.  Over the next several years, I probably invested a total of $8,000 and by 2011 had grown that to $24,000 at which point I hit a wall.  My account hadn't moved much from the $24,000 mark over the course of the following year.  Isilon had been puchased by EMC, Steve Jobs had died, and my two high fliers essentially stopped producing gains. 

During the 2011/2012 year, I made a series of mediocre investments along with some really dumb ones (EK) and didn't move the needle much in the grand scheme of things. 

In October 2012, I overheard some of my co-workers talking about options and how they were going to try it out.  As they explained the world of options trading to me, I grew both seriously confused and mildly intrigued.  I figured that the only way to get my head wrapped around how this all worked was to dip my toes in the water and try it out.  I had a pot of money to play with that wasn't doing much else so what could possibly go wrong.

I have been making weekly trades now for close to a year.  Some weeks have gone really well, and others have gone horribly wrong.  I've made a handful of mistakes along the way, developed a lot of rules for myself, and hopefully continue to get better and better at this as I go.

I wanted to start this blog to chronicle my ups and downs on this adventure.  I'm hoping to lay out my reasons each week for why I chose the trades that I did, and how they turned out at the end of each week.  I want to write a bit about the lesson's that I've learned, and the rules that I've created, and struggle to follow.  My goal is to remain transparent through all of this to show the good times and the bad.