Welcome to the December 26th 2016 edition of Profit Effect’s investment newsletter Profit Talk
where you learn new ways to understand the latest market trends, gain strategy insights, and learn from the experts.My name is Rod Mahnami and I’m grateful that you’ve given me this opportunity to join you on your investment journey.
We know that long term successful investing comes from well informed investors applying sound market strategies. Profit Talk was created to help you gain understanding about the investment strategies that work and how to successfully ignore the so called pundits and your own emotions and instead use the modern tools and market key indicators to make investment choices. Here you turn guesswork and chance investing into powerful and informed decision-making.
In the previous edition of Profit Talk you learned there are just two types of options, Calls & Puts. These two style of contracts are used as the building blocks which make up every option strategy in existence. The qualities they offer provide numerous benefits and can be tailored to fit most trading or investing situations with more efficiency than other available financial products. You just have to invest a little time learning how to use them and once you do, you’ll have skills that will last you a lifetime.
This edition we will build on what was covered last week and put it into practice. You will learn to use both Calls and Puts to implement a strategy. I’m going to share with you the first strategy that I ever used which is still one of my favorites. It’s easy to implement and manage, plus allows you to use many of the option qualities learned in last week’s edition of Profit Talk. If you have not watched last week's edition and are not familiar with the basics of Calls and Puts, please watch before continuing. Let’s quickly review some of the highlights from last week.
The two types of options are Calls and Puts. Just like stocks and futures, options can be bought or sold short. Buying, known as being long an option gives you the attributes associated with that particular option. Selling or what’s called shorting an option gives the opposite characteristics that being long the particular option gives. In terms of the directional association the Call and Put have to the underlying, they are the exact opposite from each other. A long Call option’s value will move up and down in unison with the underlying stock price. The long Put option’s value will move in opposite direction of the stock price. Simply said, long Calls = long stock and long Puts = short stock. Think of buying Calls as buying stock and buying Puts as shorting stock. Calls are stock. Puts are the “un-stock”.
As mentioned, options can also be sold or shorted, this is the opposite of being long and therefore has characteristics opposite of the long version. This means selling a Call option is like being short stock and selling a Put option is like being long stock. Remember, I said Calls are like stock and Puts are like “un-stock”. This makes selling calls equal to selling stock. And in the case of the Puts or the “unstock”, selling puts is equal to buying stock. This is because subtracting a negative makes a positive. Selling the “sell” is the same as a buy.
Another aspect we covered last edition was the differences between in the money and out of the money options and the associated intrinsic and extrinsic value. You learned when buying options, either Puts or Calls, always buy ITM options. This is because they contain intrinsic or “real” value. When buying you want to buy real value.
On other hand, when selling either Puts or Calls, always sell OTM options. OTM options contain only extrinsic or “time value”. The extrinsic value exists because of the possibility the option will have real value in the future. This extrinsic “time value” is gone at expiration. This is a good thing if short the option, short options gain profit from time decay as the expiration comes closer. OTM options expire worthless on expiration.
Let’s implement a strategy to put some of these attributes to work for us in the market.
The strategy we’re going to cover in this edition of Profit Talk is the what I call the “Bull Round Trip”. The Bull Round Trip is a strategy intended to improve the cost basis of an investment or provide cash flow from the ownership of the investment. The strategy involves owning the shares of the underlying company. For this reason, it’s best used on stocks you are okay with owning. It is a bullish to neutral strategy.
The “Bull Round Trip” involves two steps. The first step is to sell a Put option. The practice of Put selling to discount the price paid for a stock is a favorite strategy among savvy investors. One of the most successful investors in the world, Warren Buffett uses this strategy to bring in billions of dollars in cash payments for his company Berkshire Hathaway. We can use the same strategy to create cash flow and reduce the cost of our stock investments.
Remember, selling a Put obligates the seller to buy the shares at the strike price and the Put seller gets paid for providing this service. Selling the Put contract on a company, sector, global region, currency or other commodity that you want to own any way provides a great way to create cash flow from the act of buying the shares. If you are going to buy them anyway, why not get paid for it. Based on your preference, this payment can be withdrawn from the account to supplement your lifestyle. Or, left in the account to lower the cost basis of the investment.
There are typically three rules to follow when selling Puts
First, we only sell options when the IV Percentile is high 60% or higher is preferred, but anything above 50% is acceptable. The second rule when selling options is, always use an expiration that is 60 days or less, 45 days is the sweetspot. The third rule when selling options is always sell the OTM options. In the case of Puts, it’s the strikes that are below current price. As it pertains to this particular “Bull Round Trip” strategy, which is used on markets the trader wants to own, the rule regarding the IVP being above 50% can be ignored. Just know, that relatively speaking, the premium received in low IVP situations will be lower than what is received during high IVP situations. That is the reason for the rule. This fact is vital when selling the Put as a trade only, and without intention of implementing the “round trip” strategy.
So, per the first step of the “Bull Round Trip” strategy. Sell OTM Put(s) contract(s) that have 60 days or less to expire. Each standard contract represents 100 shares. Sell as many contracts as per 100 shares you want to buy. Then wait for expiration to see if you are exercised. If you recall, the obligation to buy the shares is only exercised by the Put buyer if the share price is below the strike price. And, most of the time, exercise only happens if the stock closes below the strike price on the day of expiration. There is no value in exercising while the Put is above the strike price because they’d be obligating you to buy shares lower than they are currently trading for. That would be a deal to good to be true. This means that just because you’ve sold Puts to get into a trade doesn’t necessarily mean you’ll be “Put” the shares. That’s fine, you get paid anyway. The idea behind the “bull round trip” strategy is to continue selling Puts until you wind up with the shares.
When the shares are “Put” to you, meaning the stock price was below the short Put strike price at the time of expiration, and the option was exercised, it’s time to implement step number two in the “Bull Round Trip” strategy.
Step number two is sell a Call option equalling as many Put options you sold to acquire the shares. Remember, the standard contract represents 100 shares of stock when exercised. For every Put contract that was sold and exercised, the account will now have 100 shares. Sell 1 Call contract per 100 shares that are now “long” in the account.
If you recall, the obligation brought on by selling Calls is the promise to provide the Call buyer the shares at the strike price. Since you own the shares in the account, the only obligation is to relinquish your shares at the strike price when exercised. These are what they Call “covered” Calls. The long shares exist to cover the obligation to sell shares. Exercise will happen if the stock price is above the strike price when the contract expires.
Typically, the Call option(s) are sold immediately after receiving the shares from the short Put being exercise. As always, use options that have 60 days or less to expire and are OTM. In this case, that will be above the current price. Ideally, when doing this, use a strike that is higher than the strike price that got you Put the shares. This adds to the profit made on the round trip when the shares get called away.
Again, the obligation is to provide the shares. You get all the appreciation the shares gain up to the strike price of the Call you sell. This profit is added to the premium received from selling both the Put contracts that resulted in the shares being sold to you and the Call contracts which will lead to the shares being “called away” from you. When this happens, the round trip trade is over. This is great news, it means you get to start the whole process over again.
When it comes to using this strategy in practice, follow the “Delta Match” rules which were discussed in a previous issue of Profit Talk. Compare the prospective trade to the portfolio of holdings and consider the beta weighted effect of the trade. Use this consideration as the final decision whether or not to place the trade.
In addition, the “Bull Round Trip” strategy involves taking ownership of the shares. This gives it a “personal skew” factor that goes beyond the “Delta Match” rules. It’s a strategy that works best when used on markets the trader is okay with owning.
Those two things considered, let me demonstrate use of the “Bull Round Trip” strategy using two different example trade candidates. From a technical analysis standpoint, or what the chart rules say, these are not the best bullish set-ups, but they do have a few technical aspects going for them. And the IV Percentile is better than anything else on the market.
The reason why I don’t love them technically is the trend condition. Both of these trade examples are in well established downtrends and as we’ve covered previously, the trend direction determines the trade direction. This means we would typically look to short sell markets in downtrends, not buy them or place bullish trades. But, there are a few exceptions. If you recall, through trend has a very powerful influence on price direction, ultimately, supply & demand determine what price does. Let’s go through each example.
First up is and exchange traded fund which represents the Euro currency. The value of currency are determined by comparison to the other currencies. In particular, when compared to the US dollar. This is because world market prices commodities in US dollars. This makes it the benchmark currency. Since the US election, the US dollar has experienced a phenomenal rally. This US dollar rally has put tremendous pressure on the Euro which has declined significantly. The decline has brought the Euro near a significant, physiological number at $100 per share. This Euro number means parity with the US dollar. Generally speaking, big round numbers, such as 100 bring support for falling prices or resistance for rising pricing. This is the basis for the long trade. In addition, the Euro dollar moves contrary to the US dollar. The US dollar may have gotten a little ahead of itself with this recent rally. Any “giveback” that is experienced will bring a rise in the Euro.
The market: Euro currency ETF
Ticker symbol: FXE
Current share price: $101.43
Beta: .27 (low correlation to US broad market)
The process of placing the trade is simple. First, pick the expiration date. Selling options requires a date of 60 days or less. Let’s go with the contracts that have 56 days to expire as of today, Friday the 23rd. On Monday, they’ll have 53 days. Then, decide how many shares, if any, you are willing to own and sell the appropriate amount of Puts contracts. Remember, each standard contract represents 100 shares. That is your guide to determine the number of contracts to sell. Selling the OTM 100 Put will bring $106 of credit per contract as shown here (Figure 1). The premium amount displayed is for each share of the contract. $1.06 X 100 = $106. The obligation is to take ownership of 100 shares per contract sold if the share price is below 100 on expiration. The $106 per contract is yours no matter what happens. Each Put contract will bring in $106 and will require the purchase of 100 shares at 100 each if the stock is below that price on expiration.
Once the trade is placed there is nothing to do but wait for expiration. If the stock is above $100 per share, the contracts expire worthless. You are then free to sell more Puts for another expiration cycle. Before they expire, if they get cheaper as expiration closes in and or the stock has moved up, you can buy them back and sell the further month for more credit. That’s called rolling. I typically roll them when they get below 25 cents for more premium in a further expiration or closer strike.
If the stock is below $100 per share, you will be “Put” the shares. This is great news, now turnaround and sell an equal amount of OTM Call options. This action will bring in more premium. The amount of premium will depend on the strike distance away from the current share price and the amount time until expiration. Your only obligation will be to relinquish your shares. Keep selling the Calls until the shares are called away. Then start the whole “Bull Round Trip” cycle over again.
Those who like to establish and hold positions for longer periods of time, may choose to sell fewer Calls per shares held. This allows the trader to hold on to some of the shares for the possibility of further appreciation, while bringing in cash flow from the Calls they do sell and locking in profit for at least part of the position.
The second example trade pick is another play off of the US dollar. The price of gold is heavily influenced by the US dollar outlook. Just like the Euro, gold tends to move opposite of the US dollar. The significant rally in the dollar has crushed the price gold. The implied volatility in gold itself is low as it’s IV tends to rise when gold is in demand and fall when it’s being sold off. However, the companies that make their money from gold, such as gold miners, are experiencing elevated levels of volatility. Again, when selling options as a strategy, the higher volatility situations bring in the most premium and therefore the biggest chance for success.
The market of interest is another exchange traded fund. This one representing the smaller companies in the gold & silver mining business. The junior miner ETF ticker GDXJ
The market: Junior Gold Miners
Ticker symbol: GDXJ
Current share price: $28.38
Beta: .15 (low correlation to US market)
The process of entering the trade is simply sell an OTM Put contract for every 100 shares you are okay with owning. Currently, the shares are trading for $28.38 each. (Figure 2) Again, using the 56 days to expiration options we see the prices of the OTM Puts below the current price of GDXJ. The 27 Puts, give a little breathing room for price movement and still bring in a nice premium of $1.40 per share, or $140 per Put contract sold which is paid to the seller. (Figure 3)
Decide how many shares, if any, you are willing to own and sell the appropriate amount of contracts. 100 shares are represented by each contract sold. Then, simply wait to see where price ends up at expiration. If “Put” or assigned the shares, go two step number two in the process and sell OTM Calls for the number of shares you want to relinquish.
That is the “Bull Round Trip” in action. Of course there are variations to the process that can performed. One in particular is, if the share price rallies, and or as expiration gets closer, the Puts you sold will drop in price because the chance of being ITM becomes lower. This means the Puts profit (your profit in the position) will rise. If a trader wishes to be more active with this strategy, they could buy back the Puts at a profit when this happens and wait for a price pull back to sell more. And/or, sell Puts at a different strike and/or further expiration.
The main takeaways when implementing the Bull Round Trip are:
First, always use proper delta match. Meaning, confirm your portfolio does not already have enough exposure to the particular sector. And make sure it’s a market you are okay with owing.
Second, sell OTM Puts to enter the trade and once you’re “put” the shares, sell Calls against them until they are called away.
Third, depending on your desired activity level, if the contracts you’ve sold become “cheap” (cheap is relative of course), buy them back and sell the further out and/or closer in, more expensive contracts. This is called rolling.
Taking a look at the market I have to say it is a bit like watching paint dry. No volume and not much price movement in the broader markets. There has been a bit of weakness in the S&P 500 which did bring price into the moving average zone that was mentioned in the previous edition of Profit Talk. (Figure 4) Technically speaking, entering a bullish position when price briefly traded in the zone is a valid trend trade, but a pretty tough one to take at these prices and with less than a handful of trading days left in the year. As mentioned, the horizontal demand zone a bit lower is more interesting to me, personally speaking. (Figure 5)
Looking at the Dow Jones industrial average. (Figure 6)Previously, I mentioned that this market was hanging around it’s all time high and just underneath the big round 20,000 point number. These big round numbers have a physiological effect that can act like a magnet, drawing price to them before it retreats to build momentum for a break above.
The Dow has formed what’s called a pennant. (Figure 7) See the shape here. This is a consolidation pattern. These patterns build energy like winding a spring. When they break out of the pattern they tend to move in the particular direction with some force. Typically, they are a continuation type pattern, meaning they’ll break to the side of the prevailing trend which “continues” the current price direction. Let’s keep an eye out and see what, if anything, the coming week brings.
As far as the economic reports due out next week. The high impact reports include the consumer confidence report on Tuesday. Wednesday, the Pending Home Sales report comes out and on Thursday, we’ll see the unemployment claims and crude oil inventory releases. Any surprises have the potential to move the market.
Looking ahead to the next edition of Profit Talk, we’ll dive into the subject of sector ETFs. I’ll share a few cool tools and techniques that can be used to help trade a variety of markets that include, individual sector and sub-sectors of the US economy. Also, global regions, currencies, precious metals and other commodities.
I hope this has been helpful for you. If you have any questions or comments, please leave them below or reach out on social media. You can also email me directly with any questions or comments at firstname.lastname@example.org.
Thank you so much for being a Profit Talk subscriber. I look forward to joining you for next week’s edition of Profit Talk. Until next time keep trading and investing the Profit Effect way proven, consistent and stress free, just the way trading is supposed to be.