Response to (ANOTHER!) Challenge

Sigh…

Okay, Traders! Here we go again. Yet another gunslinger has challenged me to a duel and as always, I AM GAME. In this issue, I’ll first explain the principle that our trades are based on. THEN I’ll go ahead and answer the latest gunslinger with his own proposition. You can decide for yourself which is a better way to go…

First, let’s make this fact perfectly clear: I have never claimed that the RadioActive Trading Method would guarantee higher returns than other methods. With a perfect knowledge of the future, one would never do what I do (manage losses like a BOSS) because there are ways to leverage oneself and get a better return. But who DOES have a perfect knowledge of the future? Not you or me.

The claim of RadioActive Trading is simply that one might participate in MORE great returns… because one has the freakin’ capital left over to catch them when they come around. This is because we address RISK first so that if we are wrong, it only stings a tiny bit. But when we are right, we’re positioned for great gains.

In other words, RadioActive Trading is designed to take advantage of when winners run… but cut losers very, VERY short. I’ve had returns in the double digit zone: 20+, 30+, 40+%… and had returns reported to me by others of even higher amounts. One of my favorites to recant is that of a former skeptic, Mike C., who pulled in 59.8% in one of his trades last year.

See, the high level returns are few and far between… and they are a product of LUCK… but the privilege of enjoying high level returns is only allowed if they are not devastated by losses. This is the principle that RadioActive Trading handles so nicely: management of losses beforehand as well as afterwards. Managing one’s account before and after the big wins is every bit as important (I would say MORE important) as the wins themselves.

See, strangely enough… that 59.8% gain that Mike (my former skeptic friend) had last year would NOT come with bragging rights if he had endured a loss of only 38% before or after it.

Let’s do the math: $10,000 X 38% loss = $6,200.
$6,200 X 59.8% gain = $9907.60.

Going the other way: $10,000 X 59.8% gain = $15,980
$15,980 X 38% loss = $9907.60

HMMMM… so if Mike had only ONE loss of 38% it would have wiped out his 59.8% gain, PLUS some of his original capital.

Good thing Mike dials down his losses to single digit percents or less. In the case of the 59.8% winning trade I am referring to, Mike began with an only 7% possible amount AT RISK. Starting from 7% possible loss, Mike removed even THAT risk after the first month! By doing a RadioActive Trading Income Method he reduced the cost basis of his stock and the put option protecting it.

Mike made himself what we call “Bulletproof”. That what happens when the cost basis for both the stock and the put option covering the stock… is about equal to or less than the strike price of that put.

On to that gunslinger’s challenge. Here is what a poster with the handle “MarketMaker” sent to me recently, along with my response. Right beneath it I’ll share an actual trade I did that illustrates why he is playing with fire. Read MarketMaker’s challenge:

MARKET MAKER: Whew, if it was only that easy, we can all be winners and pay the commission rates that probably is somewhat less for you than the new kids on the block. But make no mistake sports fans, this is a bullish strategy and if you want to make money with a whole lot less work (and commissions), why not buy a deep in the money call and be in the money vs. out of the money with buying a costly put? <==(Emphasis supplied)

I challenge Kurt to a dual (sic). Give me a stock you show profit on recently, and I’ll do a “combination” trade and we will see who has the greater returns. And with a lot less money invested in the trade.

Game?

MY REPLY:

I propose a BETTER game. Because it’s easy to look at a winning play and in hindsight say, “Oh, but you could have done this much better if you had only…” That doesn’t, or at least SHOULDN’T impress anybody.

Here’s a duel that more closely approximates what reality looks like. I’ll choose and play ten stocks MY way, you put on a virtual trade YOUR way… only we commit ourselves to the record BEFORE they are winners or… (gulp) LOSERS.

Then we may compare results fairly. I’ll betcha dimes to donuts that your winners win more, but that your losers lose a LOT more. We’ll tally it all up and see who’s still grinnin’.

Shucks, I’ll even go the other way ’round. YOU pick the stocks and buy an ITM long call. I’ll play the same guys my way.

Then let’s compare results after the sh$t hits the fan… or not.

Wow, you’ve given me a great idea for another blog post 😉

Did you see the built-in assumption in MarketMaker’s challenge? “Give me a stock you show profit on recently, and I’ll do a “combination” trade and we will see who has the greater returns.” Well, of COURSE MarketMaker’s highly leveraged In The Money Long Call, played in hindsight, would always perform better than my winning Married Puts. That’s because he’s taking something that I’ve already done the spade work on… and then saying, “Oh, but I could have played it this way and made so much more.”

Shoot, I can look at any of my winning trades (and so can you) and say, “Golly, had I only played that winning one with more leverage it would have won more.” Buying an In The Money Call, buying the stock on margin, buying a hundred out of the money calls and putting all of one’s capital into one trade… all of these are examples of things that would work PERFECTLY in hindsight. But not knowing the future they are suicide.

My counter challenge was a game he really SHOULD NOT play with me. Because chances are he will lose over time. My counter was that he should play his long In The Money Call options, while I play the RadioActive Trading setup on Married Puts. But we do it in real time. If MarketMaker wins on an individual trade, he WILL win bigger. But when he loses… he will lose in a (literally) exponentially worse way.

Shoot, I’ll even refute MM’s argument USING a hindsight play. Ready? Check out the following actual RadioActive Profit Machine I opened April 22, 2009 on GMCR:

Buy shares of GMCR at         $54.20
BTO September $65 puts at +$16.70
Total Amount Invested            $70.90
Exit guaranteed by put:         -$65.00
Total Amount AT RISK           $  5.90 or 8.3%

BTW, you might ask why I am using a 2009 trade. It’s one of very, very few RPMs in recent years that I could show with zero adjustments.

Okay, so I did the above actual trade with 200 shares and 2 put options, and my buddy Mike did it with 100 shares and 1 put option. We both had the same %AT RISK, though it was different dollar amounts invested for each of us.

Say that MarketMaker had gotten in to the same trade with us, only using his ITM Long Call as the setup instead of a RadioActive Trading Married Put. My trade of 200 shares and two put options would be mirrored on the same day with two long, ITM calls:

Buy to open two September $40 calls at $16.20
Total Amount invested:                           $3240

On April 30, GMCR had a earnings announcement and its stock BLEW UP.  She was priced at $72.31 by the end of the day. MarketMaker could have sold his long September $40 calls at $30.70 apiece!! Look at the profit as a dollar amount and as a percent:

Sell two September $40 call contracts at $30.70 =  $6140
Buy two September $40 call contracts at $16.20 = -$3240
Total PROFIT                                                       $2900, or 47.23%

That IS a tidy profit. Now, let’s look at what I did in the same timeframe. I sold to close both the stock and the put, which is analogous to MarketMaker selling the long calls:

Sell to Close two September $65 puts $9.70 = $  1940
Sell 200 shares GMCR at $72.18 =               +$14,436
Total of sale                                                  $16,376
Minus original investment of $70.90 X 200=     -$14,180
Total roundtrip profit                                       $  2,196 or 15.48%

So on this trip MarketMaker would have profited $2900 whereas I would only have profited $2196. That does show MM making more doesn’t it?

But MarketMaker will point out to you that not only was there a higher dollar amount profit, but a greater PERCENT as well. He got 47.23% on his invested capital, whereas my return was a piddly 15.48%.

Oh, MarketMaker… you shouldn’t have gone there 😉 mwa hahahah ahhaha (diabolical laughter)

Here’s the dealio: GMCR may have had an overnight gap because of good news. BUT..! Any issue that can have an overnight gap of about 33%… can gap DOWN by 33% too, right?

In the case of MIKE’s and MY setup, we could only possibly lose a maximum of 8.3% of our total investment. That would be a dollar amount of $590 in Mike’s case with 100 shares, and $1080 in my case with 200 shares. The amount that we had to trade determined how big of a position we could take.

So how would Mike’s and my 8.3% maximum loss compare with MarketMaker’s? Heh heh hehhh… Well, with a 33% drop in the stock from $54ish, the stock would be valued at $36 a share or so.

It’s hard to imagine those $40 calls of MarketMaker’s being worth more than $5.00, being out of the money by four bucks. But let’s be generous and say that they would be worth $6.20. With MM paying $16.20 apiece for two contracts that’s a $2000 dollar amount lost (nearly TWICE the maximum $1080 that I would be out..) but a 61.7% loss of capital!! To come back from such a devastating loss of capital, Market Maker would have to have subsequent wins totalling over 250% and still wouldn’t have bragging rights… because he would only be where he started.

Oh, and a little follow-on. Stocks can and do dive 30% or more in an opening gap…That actually happened to me TWICE in 2009, the year I’m showing the GMCR trade. Of course, because I was protected it was not that big a deal.

Once when I was playing RIMM and once with DRIV, the stock PLUMMETED by over 30%, overnight… but my bacon was saved by the RadioActive Trading Setup. In the case of RIMM I lost only 3.6% of my invested capital. DRIV cost me 5.7%. Anyone that says, “Oh, I would be out way before because my stop order would have protected me…” Really? Both of these stocks gapped before the open with no way to make an adjustment, so the ‘stop’ order becomes a ‘stop HERE and take a BATH’ order.

So for those of you that want to ‘accomplish the SAME thing, but using less capital’… If we’re going to include big winners like GMCR it’s only fair to consider the losers as well, isn’t it?

That’s where MarketMaker’s argument absolutely disintegrates… because hindsight allows for his method to beat mine… but reality does not.

Consider the power of limiting risk to dingle digit percents: In the case of RIMM I lost 3.6% and in the case of DRIV I lost 5.7%, even though both stocks made over 30% drops. Say that these two, plus my GMCR trade were the only trades I made that year. What would my net return look like? Even with a dismal stock-picking record of 67% losers and 33% winners, and the losing stocks gapping by 30% or more… I would have:

$10,000 X 3.6% loss = $9,640
$9,640 X 5.7% loss   = $9090
$9090 X 15.4% gain  = $10489

…or a net, 4.89% gain! That’s with two trades losing out of three.

THERE’s the power of managing losses.

Okay Traders, ready to hear your feedback. Post away!

Happy Trading,

Kurt