In the last post I showed you the beginning of HUM, an RPM (RadioActive Profit Machine) that I sent out to Subscribers to my Fission’ service last March.
HUM is now Bulletproof, meaning that the cost basis for the stock AND put option is below the strike price of the put. In short, a position with unlimited potential to gain but no longer having the ability to go against.
This sweet situation… and how to GET there… is what I’m documenting with these Anatomy of a RadioActive Profit Machine posts. Past performance is no guarantee of future results.
All righty then… so once we have a stock and long, long term put in place protecting it, this construct is only the beginning point. Now we want to look for an EDGE to ‘put’ into our married put. This edge comes in the form of one or more of the ten so-called ‘Income Methods’… adjustments made to the position to reduce the net cost basis, take a credit, or both.
Today’s adjustment comes courtesy of Probability of Success, as they have asked me to be a guest speaker at an upcoming event July 9. Let’s take a gander at Income Method #6: Selling a Bear Call Spread.
The Money (AHEM) The MARKET Maker’s Edge Against You
Whenever you buy or sell stocks or options, there is only one point contact that everyone eventually runs into. Whether you are a retail trader, broker, whatever… at one point or another you must deal with the Market Maker. His weapon of choice: the Bid/Ask spread.
Let’s talk about the example from last post, HUM:
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%
Hey, ever go to an old-fashioned melodrama? Or maybe something more recent in tradition like The Rocky Horror Picture Show? It’s an audience participation thing. Whenever you hear the hero mentioned it’s “Hooray!” …but when the villain comes on the scene we try to boo him off the stage.
“Castles don’t have phones…” Ahem. Okay, where were we?
Ah yes, HUM married put position. In order to buy this position above, it takes $63.90 to buy the stock. But the Market Maker (boo! hiss!) may only pay $63.85 if you wanted to SELL the stock. The Bid/Ask spread in this instance would be .05 cents, which the Market Maker (boo! hiss!) takes every time he turns over inventory.
Also, the put is $5.80 to buy, sure… but if you were a put SELLER you would end up only getting $5.60 from the Market Maker (boo!) In this case the spread is .20 cents.
SO… Our hero (hooray!) dares to take a position in this crazy market, hoping against hope for the stock to move in the right direction… which in this case is up. But the ‘deck’ is already stacked against him (poor hero!) to the tune of .25 cents on the purchase.
If the stock moves down, he not only loses on the absolute movement of the stock itself… he also loses a little bit extra when he sells to close the position. Who picks up his money? (boo!) That’s right. The Market Maker with his insidious Bid/Ask spread.
Let’s beat the Market Maker (yes! let’s!) and help the hero come out ahead (yayy!)
Let’s try the setup above with 200 shares and 2 put options. Here’s how the graph looks:
- Humana Resources, 200 Shares protected by 2 Put Options
In the above graph and summary it’s easy to see that for an investment of $13,940 our hero (yayy!) has an instrument that has unlimited upside but only $940 AT RISK. That $940 divided by the $13,940 required for the position means that only 6.7% is AT RISK.
Of course, our valiant hero must buy both the stock and the put from the dreaded Market Maker (boo!) and climb his way to the top. He loses .25 cents on the Bid/Ask spread when he buys, and may lose even more when he sells if his position runs against him (boo! boooo!)
But wait! What is that on the horizon? Could it be? Yes! It’s a RadioActive Trading Income Method (ta-daaa!) Income Method #6 to be exact… Selling a Bear Call Spread.
By selling two April $67.50 calls for .95 cents, and buying the April $70 calls for .45 cents, our hero (hooray!) picks up .50 cents credit. Here’s how that looks:
- The Bear Call Spread takes a dollar credit, but may lose four dollars 🙁
Of course, by picking up a dollar (from two spreads at .50 cent credit apiece) our hero (yay!) is RISKING assignment. That means that if HUM happens to go up, he has to deliver on his promise to sell HUM at $67.50, regardless of how high it has gone.
For the Spread to be assigned, Stock has to gain
I'm Kurt Frankenberg, and I have discovered how to truly put the odds on the side on the individual investor.
Hey, just a note: TO more closely see the graphs above, CLICK on the Bear Call Spread, the Married Put position, or the combination of both. It will expand the screen and you can see the numbers more clearly.
HT,
K
Hey Kurt
In the above bear call spread you say to use April Calls – do you mean June ?
If HUM stays flat would this strategy loose money ? An advantage of covered calls is in a flat market can earn a premium.
Overall love the strategy !
Cheers
Paul
Thanks for the Q, Paul, sorry I am tardy replying to it.
If HUM were to stay flat in this example I would keep the $100 worth of premium and be able to do it again. No, I didnt mean June, this had been an April spread. It closed against me but in order to do that, the stock had to increase by more. Kinda sweet deal.
God bless the Market Makers, for without them, you would never have a market to trade with! In other words, don’t bite the hand that feeds you 🙂
Btw, if you noticed the open interest (puny) on the Aug 65s, you would understand the reason for the spread of .20c, but of course you don’t mention OI in your educational set ups. Perhaps something you should do. Put that in the suggestion box.
MM
I hope you ARE blessed, MarketMaker! I have no grudge against you, the service you provide is to keep the stock and/or options liquid. And the bid/ask spread is your compensation for doing so. And even so, being a market maker doesn’t guarantee you a win, does it? Selling at the bid and buying at the ask gives you an edge, but that edge isn’t a guarantee of success. So I am truly thankful for you guys, putting it on the line and in so doing, creating a more tradeable market.
Thanks,
Kurt
Clever way to go. There are some other practicalities. If you only bought 100 shares and you make $.50 you won’t cover the commissions for putting on the spread. I costs money to put on spreads. So you are going further in the hole with commission costs. Probably not a factor with more shares. But then in order to dilute the commission costs, you may have to buy so many shares that your portfolio is not balanced
Yes, this is way less practical with small lots. When you’re looking at 500 shares, 1000 shares then the commissions matter much less. Most of my adjustments only cost one commish through OX even though there are two legs.
Happy Trading,
Kurt
Hi Kurt. I’m new to married calls but I love the downside protection it gives you. Is there any reason not to use this method with leveraged etf’s?
Hiya Henry!
There’s no reason not to use the RPM strategy with an ETF. Actually, with the exception of one play, I’ve ALWAYS made money playing an ETF with the RadioActive Profit Machine. The reason I do it less nowadays is that it’s easier to make good profits on individual stocks.
Kurt:
There is NO such thing as costing you “only” one commission. I happen to work with OX and they explicitly deny anything less then charging TWO commissions for spread trading. Are you sure you are not confused by seeing one cost even though it is in reality made up of two fees?
MM