Greetings, Traders!
In this post I want to begin a series called Anatomy of a RadioActive Profit Machine. We’ll chronicle the history of an RPM from beginning to end:
- First the setup which limits risk but not potential upside.
- Second, the application of an Income Method to reduce risk
- Third, the concept of zero-risk credit spreads
- Fourth, a zero-risk debit spread
- Fifth, “Double dipping” or taking extra premium WHILE stock moves up
I think you’ll really dig it.
This information is spelled out in greater detail real-time for subscribers of FUSION… but I’ll present a scaled down version of it here for the common rabble 😉
Oh, and if you’re into it… Come to a special webinar presentation on July 9 to get all the pieces I’ve described above, PLUS. See you there!
Okay, so Part One – The Setup:
March 11. 2011 Humana RPM (RadioActive Profit Machine)
HUM shares $63.90
Aug 2011 $65 put +$ 5.80
Total Invested $69.70
Guaranteed Exit -$65.00
Total Amount AT RISK $ 4.70
…or 6.7%
Now, I know a lot of folks would say at this point “Kurt, why not just buy a long call? Isn’t that the SAME THING as a married put trade?”
IN a word… no.
There are a few misinformed souls that will argue this point to death… but the plain cold fact is that a married put and a long call are not identical. Their risk/reward graph looks nearly the same but that is where the similarity ends. Here’s why…
On the same day at the same time on March 11 2011 instead of a married put, you might have picked up an August $65 call option. That call option’s pricing would be a dime, maybe fifteen cents more than the AT RISK amount described above.
This is because all the pricing models (plus the market!) take into account that you DO have capital on hand to buy the stock, but instead you elect to buy a call option and deposit the rest at interest.
Why would one want to buy a call instead of a married put? “Why, in order to DO THE SAME THING only with less capital!”
Hmm. Okay, so the married put trade above requires $6970 for 100 shares and one $65 put option. That means you NEED to have $7K to even do the trade.
On the other hand, if you only had a thousand bucks to trade, you could put on the ‘identical’ position for $480, using up only half of your capital. Or you could use almost all of your capital and get in two contracts for $960.
Enter the Mathematics of Position Sizing
In the first scenario (the RadioActive Profit Machine), we used almost $7K to get into a position that risks only 6.7% of capital, but enjoys unlimited upside potential. In the second scenario (buying a call at the same strike and expiration but with less capital) we still have unlimited upside potential, and used only $480 of our $1K to buy one, or nearly EVERYTHING to buy two contracts.
Then disaster strikes. Bad earnings announcement. Huge lawsuit. Corporate structure upheaval. Overseas markets wobble, or terror strikes within the U.S. You name it, but something happens to seriously rock the market and HUM is now trading at $40 a share. Don’t laugh… I’ve seen it happen.
In the case of our RPM, RadioActive Profit Machine, only 6.7% of capital can possibly be lost, leaving $6530 or 93.3% of our original $7000 to play with.
But the guy that did the “same thing with less capital” is decimated. One contract costing $480 is gone, leaving only 52% or $520 to play with. I’m being generous and leaving commissions out of the picture, but you know they make it even worse than I’m saying. Oh, and if he picked up TWO contracts… well. That fella leaves the table with almost nothing.
The first and most important benefit of RadioActive Trading is F.I.S.T. — Force Ideal Size Trades.
This feature enables the user to only take trades that cannot hurt too badly in the case he is wrong. ‘Automatic Position Sizing’ occurs when the RadioActive Trading principles are followed, sparing the trader from debilitating losses and… hey, this is IMPORTANT… allowing him the opportunity to get into OTHER potential winners with a low risk as well.
IN the case of the RadioActive Profit Machine, losses are limited from the get-go to only a single digit percent risk… FORCING us into a position that can truly “cut losers short and let winners run.”
While the risk is limited, the profitability potential is not. I’ve ‘put’ together trades like this that only risked 5,6,7 percent but then ended up returning 30,40,50 percent. My friend Mike had an RPM last year return 59.8% in five months. He had 7% AT RISK the first month, made an adjustment that made him “Bulletproof” the second month, and went on to high double-digit returns. Doesn’t ALWAYS happen… but then again, sometimes it DOES.
Okay! That’s it for today. Principle One: “Don’t pick STOCKS… pick STOPS”. That is, get a contract on your stock that locks in the greatest possible loss at 5-7% at worst. Next post we’ll see how RadioActive Trading Principle Two works: “Don’t time trades… TRADE TIME.”
Happy Trading,
Kurt
P.S. Hey, did ya ‘like’ this post? (hint, hint) 😉 Share it with a friend. IN a recent webinar, one of my poll questions was “If you could keep your winnings from last year, but your losses were reduced from whatever they were to just 6%, would you have had a better year?” EVERY SINGLE RESPONDENT said, “Yes.” Think about it.
P.P.S. To read more about RadioActive Trading, try the following links:
http://blog.radioactivetrading.com
I'm Kurt Frankenberg, and I have discovered how to truly put the odds on the side on the individual investor.
Okay, sure, percentagewise the guy who buys a single call loses more. But in absolute dollar terms, the loss is nearly the same. Rather than buying the stock and one put, how about buying one call and put what you would have spent on the stock in a CD or a “high yield” savings account (both are kind of laughable these days of course). You get the same FIST effect. Why isn’t that just as good?
Ahhhh… NOW we are getting somewhere. That is, now we’re being mathematically honest. The long call PLUS a corresponding deposit is finally a position at parity. And it IS just as good in terms of position sizing. However, there are still just a few advantages to the married put versus a long call plus deposit.
These advantages have little to do with mathematics now; they are based on how governments and (“make-you”) brokers treat options and stock versus cash…
For example, say your trading clearance allows selling covered calls and buying long calls and puts. If you own stock, your broker won’t ALLOW you to sell a call against a call. He won’t let you sell a bear call spread, or sell a ratio call spread AGAINST a call. But he will allow you to do a collar position and also buy a long call… effectively the SAME as selling a bear call spread in the context of a married put. This leaves upside open while taking premium and is way SAFER than a simple covered call so your make-you-broker will allow it. Unless you have a high trading clearance, you can’t do a calendar spread or a bear call spread against a long call.
Here’s another one: you already own stock and it’s up quite a bit from where you bought it. I had a client that couldn’t AFFORD to sell his stock because of the tax bill it was going to bring on him… but he DID want to “bulletproof” it, did NOT want to pay for ‘insurance’, wanted to keep receiving dividends, and get this… he on top of all this, he wanted to leave the upside open for growth. The RadioActive Trading solution? 1) Buy a far-out put at a strike that was lower than the stock’s present price, but higher than his cost basis; 2) sell a near term bear call spread to finance the purchase of the far-out put; 3) be prepared to ‘manage’ the bear call spread in the event that it went against him.
The result was that he took in enough credit to BULLETPROOF his stock, be positioned to receive current income not only from dividends but also from other bear call spreads, and MOST importantly… he didn’t have to sell his stock for cash and get hit with capital gains on a tax bill. BTW, you can see a detailed account of the solution that we gave this client HERE.
The point is that sometimes companies and governments make it advatageous to use a married put instead of a long call plus cash. But you are right; with a high enough trading clearance and in the absence of policies and laws that change the landscape, a long call PLUS (and don’t forget the plus..!) a corresponding cash deposit very nearly approaches parity with a married put with respect to the position itself and how you may adjust it.
HT,
K
Put another way: can you please compare and contrast “stock + put” to “cd + call”.
Same stock purchase using options only:
Bought the Jan 2012 40 strike at 24.10 or $2,410.00 for 100 shs (effective break-even on the stock=64.10 (you add the 40 strike to the 24.10 to get the effective break-even) or .20c higher than your purchase of stock.
Sold the April 2011 65 strike for 2.10 (effective break-even on the stock=62.00 (the 64.10 from the above break-even less the 2.10 premium received)and the cost of the trade=$2,200.00
At April expiration, the options were assigned which=3.00 profit X 100=$300.00
Invested capital: $2,200.00
Return on capital=13.64% (300/2200)
NOTE: I bought the Apl 65s to be VERY conservative which put the trade at 1.72% under the sold strike price, but could have easily went for the Apl 67.5s which would have brought in a whopping return or 19.31%
Yeah, I get it. You are playing with nickels and I like to play with dimes. So be it.
Okay MarketMaker… but!
You are only showing a single example of a single trade that would have worked out. In my industry this is known as cherry-picking… and why I insist on showing every trade, including the ones that did NOT work out.
But let me humor you. IN this example, HUM was trading at $63.90, so your $40 call is waaay in the money and costs $24.10. Only .20 cents is time value, and you sold the April $65 for $2.10. Total cost: $2200.
On expiration Friday, April 15 HUM was at $70.78, a $6.88 increase or 10.9% gain from $63.90. And wow… your “options only” trade returns a total of $300 or 13.64% of the $2200 you had invested. Okay, gotta give you that.
NOW. Since you have the benefit of hindsight… which I did NOT… you are saying, “I would have done better with my options-only setup than you would have with yours.” Mmmm-kay. Shall we see?
ON Expiration Friday April 15, the HUM August $65 puts were trading at $2.30 X $2.50. With HUM at $70.78, I add the put’s bid and close the whole bugger for $7308. Minus the $6970 to get in, that’s $338… a greater dollar amount than you have earned at $300.
Of further interest: ALL you can make is the $300, right? I mean, if HUM had gone to $100 a share, you’d still have the $300 gain. My married put, on the other hand would be sittin’ in tall cotton 😉
But I understand… you wanna talk PERCENTS of return, not dollar amounts. Fair enough, you asked for it. Because if we’re going to invoke “I have better percent gains on winners” you MUST consider your percent losses on losers.
If yer gonna be intellectually honest.
SO I’m puttin another nail in the coffin, MM. Any stock that can go UP by 10.9%… can FALL by 10.9%, agreed? 10.9% off of HUM’s price of $63.09 leaves us with $56.21 a share.
Let us say that your .20 cents of time value on the August $40 call is totally intact. Even though time has passed. An assumption in your favor. So the $40 call is $16.21 in the money, plus that .20 cents leaves your net value at $16.41 ($1,641) You no longer have a short call to unwind, and may now sell for a $559 loss, or 25.4% loss from your original $2200 investment.
Scorecard: HUM done my way risks an absolute maximum of $470, leaves the upside completely open.
Your way, it risks… well, the whole $2200 to be honest. But with only a 10.9% dip in the stock it would lose $559 or 25.4%.
Oh, and the most your way CAN possibly make by April is $300.
Sorry, MarketMaker… the math doesn’t make a good argument for your options-only play. $470 risked for unlimited potential vs. $2200 risked for $300 uncertain bucks. Not a compelling idea at all.
Bring it on again MM? 😉
Happy Trading,
Kurt
I’m ready for the challenge. Are you?
MM
Kurt,
Not sure how to get this question to you on your blog but this seems like an appropriate place. With the recent volatility and the wide trading ranges we’re experiencing, I’ve noticed something that does appear to be adding a drag to the techniques. Now mind you I don’t use them all, but in the simple approach of establishing a married put on a new position, the percent risk has moved from the 4 to 5 range to the 8 to 10 percent range. Also I’ve noticed that when I get a run up in price close to my put, the call at the next price level over the put price (when price approximates the put) is a very small percent unless I move out 60 to 90 days. I had this recently happen to me with WMT. I would just like to get your take on what we’re seeing in the options prices given the recent volatility and do we need to use spreads more in this environment. Thanks
Hi Chuck: True, volatility has increased over the last 90 days. That fear in the market has increased all option prices. Luckily, we are not deciding which put options to buy based on pricing or volatility criteria. We buy the put based on a range in-the-money and the ultimate max. risk that the time premium portion of the option price can guarantee. So there may be fewer new married put (RPMs) that the market is showing us now, but there are certainly still married put trades that meet the basic criteria that are set out in The Blueprint for RadioActive Trading. If volatility increases too high in any given married put combination, then it gets naturally selected out of contention because it’s risk characteristics will be too high for comfort. If the general max. risks that the market makes available are too high for your comfort, you certainly don’t have to put a new trade on. Remember, making a decision to sit on the sidelines for a play or two is totally acceptable.