OPEN: SPY BRCS

We’re opening a small Bear Call Spread (BRCS) on the SPY.   We’re not feeling too confident on the rally and the premium we’re able to get with the SPY calls, being well out of the money, are enticing.  We actually got into this trade yesterday and forgot to post it.  This is not a conservative spread and the entry signal isn’t great.  So We’re keeping our sizing extremely small here.  Take a look at the chart:

We are in a downtrend and possible channel.  The upper channel line we drew in yesterday was violated, but we feel like we are closing weakly and making highs on lower and lower volume.

Here’s our order entry:

We’re bringing in a credit of .37 on a risk of 1.43 for a potential ROI of 26% in three weeks.

The probability on this is 79% for the 154 call expiring out of the money.  Here’s the graph:

We’re using a small percentage with no stop loss.  We will look at adjusting 5 days prior to expiration.

Mojo

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Position Sizing - A free lunch

If there is one thing we’d say has made the most significant difference in our success and stress level as a trader, it would be ”Position Sizing”. What is position sizing? Its determining the maximum number of contracts allowed per trade based against your total portfolio size. Why is this important? Because it determines how many losing trades in a row your portfolio could stand before you lose everything. Professional gamblers call this your “risk of ruin”. Remember your job is not to make money, but to protect your capital and extract the most experience out of every dollar.

Here’s a simplistic example. Let’s say your portfolio is 100K. We will flip a coin 100 times with heads representing a “win” and tails representing a “loss”. This gives you a 50/50 chance for each trade. Here are the results:

WLWLLLWWLLLLLLWWLLWWLWLWLWWWWLLLWLWLWLLLLWWLLLLWWL

LWLWLLWWLWWLLLWLWLLLLLLLLLWWLWLLLWLWWWLLWLWLLWLWLL

Notice that in this random sample there are several consecutive wins (heads) and losses (tails). These streaks are completely normal and expected in a random sample. These streaks are where your position sizing becomes important. In trading there is something called “surviver bias”. Basically its the idea that only the profitable traders survive and only those traders that survive the first three years will be profitable over their entire trading career.

If you are risking 20% on each trade and you have 2 losses in a row your portfolio will be down 40%. Mentally, are you prepared to hold the faith and stick to your trading rules once you’ve wiped out 40% of your account? Most people aren’t (including us!). How would your wife or husband feel about a 40% loss? Would they continue to support your trading? Remember, we are trading to make our lives work for us and for everyone around us.

Since most people’s pain threshold is no more than a 40% loss, let’s look at how many trades it will take to get us to quit trading and end our trading career.

If you are risking 15% per trade it will take 3 losing trades in a row to generate a 45% loss.
If you are risking 10% per trade it will take 4 losing trades in a row to generate a 40% loss.
If you are risking 7.5% per trade it will take 6 losing trades in a row to generate a 42% loss.
If you are risking 5% per trade it will take 8 losing trades in a row to generate a 40% loss.

At this point you might think “That’s impossible, I will never have 8 losing trades in a row!”. Well, look at the random sample (line 2). There’s a losing streak of 9 loses in a row. Ask any trader with sufficient experience and they will tell you that this is not only possible, but even likely to occur.

If you are risking 2% per trade it will take 20 losing trades in a row to generate a 40% loss.
If you are risking 1% per trade it will take 40 losing trades in a row to generate a 40% loss.

Does this make sense? Yes? OK, good. What percentages do we use? We use the following percentages based on the underlying security (stocks vs. industry ETFs vs broad based ETFs) and the type of trade. These are hard fought rules that we’re constantly refining so we’re always open to feedback.

Single Stock (XOM) + Vertical Spread <= 2% [news risk and because we don’t feel that stop losses work well on verts]
Industry ETF (XLE) + Vertical Spread <= 2% [news risk and because we don’t feel that stop losses work well on verts]
Broad Based ETF (SPY) + WOTM Vertical Spread <= 5% [limited news risk, stop loss at 3x initial credit]

Single Stock (XOM) + Put Calendar <= 4% [stocks crash down not up, good salvage value on long puts (50% or better)]
Industry ETF (XLE) + Put Calendar <= 5% [industries crash down not up, good salvage value on long puts (50% or better)]
Broad Based ETF (SPY) + Put Calendar <= 10% [markets crash down not up, good salvage value on long puts (50% or better)]

Single Stock (XOM) + Diagonal <= 2% [use a 20% stop loss so your initial position is up to 10%]
Industry ETF (XLE) + Diagonal <= 2% [use a 20% stop loss so your initial position is up to 10%]
Broad Based ETF (SPY) + Diagonal <= 3% [use a 20% stop loss so your initial position is up to 15%]

Single Stock (XOM) + Iron Condor <= 0% [We don’t do Iron Condors on individual stocks, too much event risk]
Industry ETF (XLE) + Iron Condors <= 2% [use a stop loss of 3x initial credit]
Broad Based ETF (SPY) + Iron Condors <= 5% [use a stop loss of 3x initial credit]

Remember, our goal is to reduce all risk we can and mitigate everything else. Position sizing is one of the “free lunches” we get so take advantage of it.

Mojo

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CLOSE: SPWR +21%, MCD +91%, AAPL +25%, GS +36%, FXI +100%

We’re closing SPWR this morning for a credit of +31.15. This initially cost us a debit of -25.80 giving us a profit of +5.35 over a risk of 25.80 for an ROI of +21% in two weeks.

We’re closing the remaining shares of the MCD bullish diagaonal for a credit of +6.50. Our running cost basis in this trade was a debit of -3.40 giving us a profit of +3.10 for an ROI of +91% in two weeks.

We’re closing the agressive, ATM BLPS we placed on AAPL for a debit of -1800 (-1.20 * 15 contracts). Adding up all of the credit over the initial position plus the roll we brought in +2,930 on 15 contracts at 5 dollar spread. With our cost to exit at -1800 we bought in a total credit of +1,130 on a risk of 4,570. This gives us an ROI of +25% over two months.

We’re closing GS this morning for a credit of +35.70. Our cost basis was a debit of -26.20. This gives us a profit of +9.50 on a risk of -26.20 for an ROI of +36% in two weeks.

We’re closing FXI, this for a credit of +7.70. Our cost basis was a debit of -3.85. This gives us a profit of +3.85 on a risk of -3.85 for an ROI of +100% in two weeks.

There is no technical reason for closing this trade. December is our busiest time at work so we’re closing the trade early to concentrate on the day job.

We will calculate out our returns for November, but we expect to see that this month will be record for returns.

Mojo

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OPEN: XLE Put Calendar

We’ve been waiting on an entry for a put calendar on XLE for the past few weeks. XLE is the energy sector ETF. Even though oil prices continue to be high, the profits from the companies involved in the energy sector are declining (albeit from historic highs). Here’s the chart:

This is a 9:50am chart and we wanted to use the gap down to get in. We suspect that there will be a rebound and bounce off of the $70 support line where the stock will channel between 70 & 75.

We decided to use a put calendar because its less directional (meaning its almost perfectly neutral), we get to sell a lot of time value because fear (and the price of puts) is high, and the salvage rate for put calendars is also high (meaning if XLE moves against us, we still have good potential recovery).

We bought the March 08 70 puts for -5.10 and sold the Dec 07 70 puts for +2.41 giving us a cost basis of -2.69. By buying the March and selling the Decembers we have 5 time periods to sell against reducing our cost basis (Dec, Dec quarterlies, Jan, Feb, Mar). Also, with fear so high we were able to cut our cost basis on those long March 70 puts by almost 50% in one month.

We usually limit our exposure in a single trade to 2% of our portfolio with exceptions for indices and ETFs. On this trade, we limited our risk to 5% because its an ETF and we’re using a put calendar (high salvage value). How do you calculate this?

If you have a 100K portfolio you would multiple 100K * 5% = 5K. Since each spread is costing you a debit of -2.69 take $5K and divide by 2.69 per spread = 1,859 potential spreads (shares). Since there are 100 spreads / shares per contract take that number 1,859 and divide by 100 = 18 contracts.

Assuming 100% loss of your entire debit (not likely considering the salvage value of a put calendar) you could only do 18 contracts on a 100K portfolio.

Mojo

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UPDATE: FXI bounce off of 170

On Monday we took advantage of the down day and sold the Dec 175s for +13.50 credit bringing our cost basis down on Feb 175s puts down to -3.85.

At the time our concern was a possible bounce up from 170. Sure enough we got it yesterday.

If you look closely you can see that FXI was up 4.6% just yesterday! Add in some high volume and the beginning of a possible channel and I’m very happy with our trade.

You want to know what’s crazy?? With this large move up, our put calendar actually gained value!!

The short Dec 175 went from a sold price of +13.50 down to 10.60 giving us more than enough profit to overcome the reduction in our Feb 175s.

Right now, we are long the Feb 175s at a cost basis of -3.85. As we write this we are showing those Feb 175s to be worth a little more than $17.00!! SWEET!

Mojo

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ADJUST: FXI Nov 175 expired for +1.6%, Sell Dec 175

OK, we entered this Put Calendar on FXI on Friday (you can see the original entry here) and sold the Nov 175 put for +.30. We wouldn’t normally sell such a put for such a small amount of money but +.30 for a few hours of time seemed like too good to pass up.

FXI expired worthless at the close on Friday giving us a profit of +.30 over a risk of 17.65 for an ROI of +1.6%. Not a lot of money but at 10 contracts that’s $300 for a few hours.

OK, FXI moved down this morning at the open. Take a look at this chart:

The Dec 175 puts are now selling for 13.40×13.60. With possible support approaching at 170, the stock being hard to borrow (meaning that there are lots of short sellers and if there are short sellers and the stock moves up they will begin to cover their shorts causing a violent short rally), and the fact that I’m heading off to the Zoo and to visit my Grandmother this afternoon, we’re going to go ahead and sell the Dec 175s.

We’re going to hold out for +13.50 (the mid) credit. If the stock moves against us, we’ll take the natural to get filled.

Getting this +13.50 credit and adding it to our cost basis gives us a new cost basis of -3.85 for our Long Feb 08 175s. We still have the opportunity to sell January and then February 175 puts. This is turning into a very profitable trade!

Mojo

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Heading to KS

I’m heading to KS for the week of Thanksgiving with my family. Traveling through Chicago on United and then to Wichita. We are staying at my Dad’s and hopefully will get a chance to see everyone. We are also having a family reunion on my Mother’s side so that should be a lot of fun as well. My wife and I are looking forward to it!

Have a great holiday and give thanks. There’s a lot to be thankful for.

Mojo

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