Some Profitable Risks In This Stock Market

Published on 2 Nov 2008 at 1:05 pm. No Comments.
Filed under Investing,Poker.

First off I don’t claim to be any kind of Investment Guru or have any kind real knowledge on the matter whatsoever. However for those that know me, what you know is that I am is a risk taker, but a calculated risk taker. I don’t think I have to tell anyone that the stock market can be very risky. However I think this market provides some return opportunities that haven’t existed in recent history and will continue to diminish as the market volatility levels off.

When poker was booming and it was still legal and easy for everyone to get money into their poker accounts it was VERY EASY to make money. At the peak I averaged 8-10K profit PER MONTH playing poker. That’s right, I would sit down at the table for 3-6 hours per day and walk away at the end of the month with a nice profit. It wasn’t all good times and took a lot of discipline. Some days I would lose 5K and then the next day I might win 10K, it took a long term perspective but I knew by keeping to my game I would win in the long run. My best month ever was around 12K and during those few years while poker was going strong I NEVER had a losing month in 3 years. THANK YOU MATH! (and self discipline). After 2-3 years of this fun the government outlawed funding of poker accounts in October 2006 (my black October) making it very difficult for “Joe Six pack” to pop down his credit card on a Friday night after having a few drinks and spend $50 on “entertainment”. The bottom of the poker pyramid consisted of a huge amount of people who lost anywhere from $25-$100 per month as a form of entertainment, above them were a huge amount of people who broke even in the long run, then came a small percent who made a living wage, and an even smaller percent who made a lot of money. In this 4 level pyramid I would have placed myself somewhere between the second and third level (yes in the poker world 10K/month is not considered a lot of money) many of the people who played in the same games I played made 500K+ a year).

So what does poker have to do with the stock market? Both are games of information and risk. You try to get your money in based on the information provided to you and it is the risk that provides the opportunity for reward. This current stock market we find ourselves in has provided huge opportunities for people who have both the analytical abilities to search out good bets and the stomach to take a chance on them. This takes some time to research and execute but at the valuation stocks are currently trading and the high value of the vix (volatility index) there are some very simple plays to be made. Let me give you one example.

My favorite stock to trade is AAPL (Apple). This is because not only is it a very solid company, which does high volume, but also because I believe in this company, their products and their long term survivability. I have recently switched from Micro$oft operating systems to Apple, I have an iPhone and I just generally believe their products are better. So find yourself a stock you believe in, that has solid financials and high trading volume (make sure the options volume is good too).

I do the following strategy with a number of different stocks over different time frames so there is always something to do, however you can easily just pick one stock and do this over and over again. I generally have 30-50% of my portfolio in some kind of AAPL play, which is more than most would suggest you should have in one equity, but at the current prices I feel very safe in holding AAPL as I have no problem holding it for the long term.

This play is most profitable in a very volatile market (because the options give higher premiums) like we have now and that is why I am writing about it now. This can be done with options anywhere from 1-3 months out, 3 months give you the best premiums but 1 month plays allow you to realize profits sooner.

Jim Cramer from Mad Money (who I originally found very annoying but has grown on me due to his excellent insights, despite the fact that he keeps telling people to buy stock in the EVIL Wallmart) has said that the days of buying and holding stocks is over. What he means by this is that if you bought stock in the 90’s and held them till now, they would now be worth the same as when you bought them. Not a great 10+ year investment. However ironically I never hear him talk about plays like I am about to describe. He just talks about valuating stocks and dividends, which are both great things to look at when looking for a stock to make these plays on, in case you get stuck holding it longer than you expected.

Let me also preface this by saying that I am not looking to get rich in the stock market. I am always in search of new ways to add to my residual monthly income that keeps me from a 9-5 job. I am very happy averaging a couple hundred dollars per day overall. This is pennies when compared with what most traders are trying to make, which makes it that much easier. It’s easy as long as you aren’t greedy. Also the more capital you have to play with the easier it is to make 3-6K per month without leaving the comfort of your home office chair.

The Trade
This is an example of a trade I made just this last Friday. I am long on both AAPL and Jan AAPL calls.

On top of my long holdings I also made this short term play on AAPL:

On Friday 10/31/08 I bought 200 AAPL at $107 (which was about $2 higher than the day low, but no one is going to buy the exact low or sell the exact high).

Shortly after getting in at $107 I sold two Nov $110 calls for $5.60. For those of you that don’t know how options work a “call” option is a contract that means the person who bought the contract from me has a right to buy 100 shares of AAPL at $110 per share anytime before expiration date, so the price is $5.60×100 = $560. In this case the expiration is November 21st (always the third Friday of the month). When I sell these calls the money is immediately deposited into my account. So on Friday my account was approx $1110 richer (after fees).

This trade can basically go 3 ways for me:

Outcome 1: AAPL is at or under $110 on November 21st
In this case the options I sold are worthless, and thus I keep the $1110 I made when selling the option. I am then left holding 200 shares of AAPL. I love AAPL so holding 200 shares doesn’t bother me one bit, that’s why you choose good long term stocks for this play. Now I am ready to do another 1-3 month play on these shares or just hold them.

Outcome 1 Result: Profit $1110 + Holding 200 shares of AAPL

Outcome 2: AAPL is over $110 on November 21st by enough for someone to execute the option
In this case the buyer of the option will “execute” them. Essentially forcing me to sell them the 200 AAPL I bought at $107 for $110. These were “covered” calls which means I held the underlying stock. So when they execute the option I make $600 ($110×200 – $107×200) on the sale of the stock and I keep the initial $1110 premium I got for the options contract.

Outcome 2 Result: Profit $1110 from contract + $600 from stock sale = $1710 profit

So the cost of this investment was $20,700 and on the low end it made 5.3% return in one month (while still holding the underlying stock) and on the high end it made 8.2%. So both results return more than most CDs. SO IF YOU PICK SOLID STOCKS (this is the key) the WORST CASE outcome in this beat down market is that you are left holding an under valued stock and you have a 5%+ return in your pocket from the sale of the contract. The volatility in this market is what’s setting the time premium on these options. You can find plays like this returning much more than 5%. There was a time around Oct 17, 2008 when you could buy CHK in the $17 range and sell a $22.50 Jan call for nearly $4. On the low end this play returned $23% ($400 profit on $1700 investment) and around 55% if your call was executed! Due to the $400 premium of the call you basically bought the stock at $13. Your upside is limited to $950, but hey that’s fine with me on a $1700 investment.

What if the stock goes to 0??
This is why you pick solid stocks with strong balance sheets, the odds of AAPL going to 0, well I would say are close to 0. Now if you were making these plays on AAPL just a few months ago you could have been in real trouble. But at this point I would guess the floor for AAPL is around $85 and my guess is that within a year it will be in the $150 range. That is why I said these plays work best in this current under-valued market situation.

What if the stock goes to $150??
Well in the scenario I provided you would just have to take your $1710 profit and move on to the next trade. However this is why I have multiple hedged bets going at once. In reality on a stock as strong as AAPL I would only hedge half of my holdings, I would also do it not just for November but also December and Jan. The december $110 calls were selling for $9.65 and Jan for $12.35 giving you much larger time premiums.

Trading As You Go
You may notice I said the trade could go 3 ways but only listed 2 outcomes. This is because most of the time my options never make it to expiration. This is option 3. All stocks have their ups and downs throughout time. You can’t be short and long the same call option but you can be short November calls (when you sell the call option as I state above you are essentially “short” this option) and at the same time be long Jan calls. I generally have a mix of being short and long calls on AAPL with different expiration dates, while always holding the underlying stock at a price that is protected by my shorts. What this does is give me wiggle room in the interim to make profitable trades on a day by day basis without having to wait for expiration.

Let me clarify a bit what I mean by “wiggle room”. If after I short those calls at $107 the stock drops to $103, the cost of that call I sold will go down with the stock price, the amount will vary based on how close we are to the expiration date. As we get closer to the expiration date the option has less and less time premium and only includes the intrinsic value of the option. For example sake lets say the same day that I sold the option for $5.60 the stock dropped to $103 and the option dropped to $3.60. If I feel this is just a temporary dip at this point I can go ahead buy that contract back, make a quick $200 (before fees) and then get ready to re-sell it again when the stock price goes up a bit. This is why I like to have different hedges on the same symbol, allowing me to hopefully make a little bit on moves in both directions. If I feel AAPL is trading in a range and $105 is the low end I might even buy a call option before the next rip.

Now at the poker table I would NEVER bet 10K to make $200, however in the market with these covered calls I think it does make sense for me to make these bets and turn $100-$200 profit per day as long as the underlying stock I’m holding is one I believe in fully. If I can make $100-$200 per day that’s 3k-6k / month without ever putting a shirt on.

If what I have posted here interests you I encourage you to research more some of these plays that can pay off particularly in a volatile market like we have now. I suggest reading about Straddles, Collars, and Covered Calls (what I just described here). All can be used to limit downside and make a little money while (hopefully) limiting the risk.

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