Portfolio Position Sizing
August 18, 2004
The Smart Profits Report: Issue #136
Wednesday, August 18, 2004
Portfolio Position Sizing: The “10% Rule” for Safe Option Profits
By Karim Rahemtulla
Investment Director, Mt. Vernon Research
Your options positions should find a place in your portfolio next to other higher-risk ventures like gold-mining shares, small caps, technology and the like. This is the high-volatility sector of your portfolio - shares that could make you wealthy or go to zero.
A good rule of thumb is that only 10% of your entire portfolio should be exposed to these kinds of speculative ideas. That way, if everything hits the skids, you are limiting your loss. Within this 10% you must further “portfolio position size” so that you are not concentrated in just one issue or security.
Position Sizing: Trading vs. Investing
For example, if you own 10 positions, each one should be worth no more than 10% of the speculative set-aside - and therefore no more than 1% of your total portfolio. Where most investors go wrong is when they speculate with 90% of their money and invest 10%.
Now, if you only have a $20,000 portfolio, and only 10% or $2,000 is used for speculation, and only 10% of that is in each position ($200), you will not get far quickly with options. Basically, you are on the sidelines until you have grown that portfolio to at least $50,000.
Trust me, with a portfolio that allows only $200 per investment, the commission charges will be enough to keep you out of the game.
Of course, you could play the nickel options market, just like the nickel slots in Vegas. But options don’t reach a price of $0.05 unless they are very unlikely to pay off. With the odds if winning against you to the tune of 80% or more with cheap, short-term options, you are better off enjoying your losses at the craps table in Vegas… where your chance of winning is also better and the nice waitress will gladly bring you a drink.
Trading Options the Smart Way
This may be discouraging news, but it’s not the end of the story. If you are still interested in options you have two choices:
- Stick with ultra-conservative options trades…
- Make enough money to afford an options set-aside…
The rules I just gave you do not apply to all types of options, only those that are held uncovered, or naked. Covered call writing (you own underlying shares of stock as well as an option against the shares) is actually considered by many, including me, as a very conservative strategy for long-term investing.
And if you do have a large portfolio - $50,000 or more in investible assets - then you should explore options further. You may want to stay with the conservative strategies like covered calls, but you can afford some controlled risk, as well.
Just remember, though: Your exposure should be no more than $5,000 on a $50,000 portfolio, and you can definitely set aside less on larger portfolios.
If you have a small portfolio, are new to investing, or you’re just trying to recover from the devastation of the Internet/tech bubble and the flat year we’ve had for stocks in 2004, then you should NOT be involved in the options market.
Wait until you can afford to do so without losing sleep - the wait will be worth it.
Good Trading,
Karim Rahemtulla
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Today’s Smart Profits Cribsheet
- For more on terms like “covered call,” “position sizing” and “LEAPS,” check out our Smart Profits Glossary.
Related Articles:
- Position Sizing - The Most Powerful Investment Concept
- How the Market Makers Lose: Uneven Trades and Open Positions
- Option Position Sizing: How Much to Invest In Each Option Trade
Double Your Money
August 16, 2004
The Smart Profits Report: Issue #135
Monday, August 16, 2004
Double Your Money: The Truth About Making 300% Overnight in Options
By Mt. Vernon Research Team
The people who ask me about getting into options always want to know the truth about doubling their money overnight.
And why not? I can’t blame anyone for wanting to know the secret to making 50% in two days or 148% in three weeks - with an occasional 300% winner - over and over again.
But the truth may not be quite as alluring as the promise. Before you set out to be the next options king, let’s take a dose of reality medicine.
Starting with this: If you’ve bought any “introduction to options” books, throw them away. Don’t let them infect you. Or at least lock them up until next year when you know enough from experience to glean the scant wisdom in the back pages, because the front pages are full of lies, starting with the examples of how much money you can “easily” make.
Options Truths: What Every Book Says Is Dead Wrong
The big lie goes like this: If you buy an $80 call on IBM for $3 and IBM goes up to $85, you are going to make big money. Instead of making a mere 6% by owning IBM stock, your IBM option will go up to $5 or more, a grand 66% return on your $2 investment.
This will usually be accompanied by some mysterious risk profile graph to prove the point.
So there you are, you just read the example and it makes sense. All it takes to make this money is a $5 move in IBM. Why, that’s entirely reasonable, you think. IBM moves $5 all the time. And wham! You’re suckered right in. You’ve opened an account and you’re ready for the world of short-term options trading.
How to Lose Money on Being Right With Options
What actually happens isn’t at all like that example. To get those results, you’d have to hit your target about two minutes after you bought an out-of-the-money option, which is a very risky buy. And even then, IBM would really have to move up to $85.75 to cover the spread and commissions.
Here’s what happens to most unsuspecting traders: While you are waiting for IBM stock to reach $85, your $3 option wastes away to $2, then $1.50, then $0.50, then nothing. Even if you get out sooner with a stop loss - pay attention here - you still have a loss. All you did was stop it from getting worse.
Meanwhile, IBM only climbs to $82.75 and you wish you’d just bought the stock. And in case you aren’t sufficiently humbled and broke yet, the week after your option expires, IBM will shoot up to $86.
But then you’re really hooked. You were right, after all! You would have made huge money if it had happened just a bit sooner. If you’d just taken an August contract instead of a July contract… We’ll get ‘em next time, you think…
If you are trading option contracts with less than four months to expiration, it’s not the direction you’re driving that will kill you… it’s the speed… or rather the lack of speed in the price-action of your chosen stock.
To Heck With Good Stocks - You Want Fast Stocks
To make money speculating in options you have to do better than choosing the right direction and strike price. You also have to buy your option exactly when the stock is moving in decisive bursts. If it doesn’t happen quickly after you execute your trade, the value of your option will drop so fast that you’ll lose money even if your stock is headed the right way.
Contrary to all those examples in the get-rich-quick books, you can hit your target and still lose money with short-term options. It’s not a straight-line depreciation, either. The shorter the contract, the faster time value disappears on options.
Let me explain…
Time Value On Your Options Contracts
If a stock sits still for three weeks, you lose about 25% or so of the value on an option that has three months to run, but you’d lose about 70% of the value on an option with only a month to run.
That’s why, even as a short-term trader, I rarely take an option with just one month to go. The flip side is that if the stock moves nicely, you’d make a much bigger return (at very high risk) on your one-month option compared to the three-month option.
To make winning even harder in this exciting world of short-term trading, while your stock is ambling around, trading in a range, chances are it’s entered a quiet period and its volatility is dropping, too. That will take another chunk out of the price of the option since high-volatility options are worth more than low-volatility options.
That’s the big secret to doubling your money with short-term trading that the books leave out: With options, you might win big on a stock that only moves up a buck, and you might lose on one that moves up $5. It depends on how fast the stock moves… plus whether you choose the best contract, the right strike price, give yourself the right amount of time, and whether volatility changes.
Good Trading,
Mt. Vernon Research
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Today’s Smart Profits Cribsheet
- Check out our Smart Profits Glossary for more on terms like “strike price,” “volatility” and “LEAPS.”
- Looking for more information on Time Value? Check out Smart Profits #110, Time Value: With Options You Need to Be Right on Time.
Related Articles:
- How to Use Puts and Calls: For Systematic Short-Term Profits
- Short-Term Options: Two Ways to Make Them Work
- The Short Squueze: Don’t Get Squeezed When Investors Rush to Sell!
Technical Analysis
August 12, 2004
The Smart Profits Report: Issue #134
Thursday, August 12, 2004
Technical Analysis: Two Simple Tools for Spotting a Technical Trend
by Mt. Vernon Research Team
Traders are supposed to be good market readers and work with, not against, the market direction at all times. This does not mean calling tops and bottoms! That’s an interesting but not critical exercise. And, as Karim Rahemtulla has noted before, two of the most common indicators - the put-call ratio and the VIX - are difficult to read and often give false signals.
Besides that, market turnarounds only happen occasionally, but the market is there every day. Better to learn a skill that’s always useful rather than one that’s sometimes useful, like the basics of technical analysis.
Using the Force to Reach Your Goal
Don’t worry too much about predicting bottoms and tops, especially not as you start out. At first, focus on learning where your stock is going right now and using the force of its trend to reach your goal.
This, by the way, is one of the subtle differences between thinking as an investor and thinking as a speculator. Sometimes, going with the market as a trader will mean going against your judgment as an investor.
Let me give you a concrete example…
As an investor, for instance, I’m keeping my eye on Avid Technologies because its earnings and profitability are growing. (Don’t take this as a recommendation, just a good example.)
Eventually, this company is going to be a winner if it continues the progress it’s made in the last couple of years. But as a trader, I wouldn’t buy any calls on Avid right now simply because it “should go up.”
The fact is, it’s not going up.
The market trend is against Avid. The sector trend is against it. The stock’s own trend is very much against it. Yet not so long ago, in April, I made 136% in three weeks with an Avid call. The company’s the same. The trend changed.
Today, though, I still like the company enough to think about going long as an investor - as a trader I’d go short.
“A Simple Approach to Technical Analysis”
How do you know whether you have a good trend? This is where technical analysis comes in.
On the rough level, you can look at a chart and see whether the price is tracking up or down. But learning to draw trend lines is a simple task that takes it a step farther.
Though trend lines can get complex, as can all technical analysis, I’ll explain the simplest approach. It will be more than adequate to get you started, and may be all you ever need.
Technical Analysis For A Rising Stock
Here are some simple technical analysis steps for tracking a rising stock (pull up any good one-year stock price chart from Yahoo! Finance and print it out for this revealing little exercise)…
- Find the lowest point on the chart and put your ruler under it.
- Now connect it to the next-lowest point (there may be some lows between these that don’t touch the ruler).
- Draw a line all the way out to the end of the chart. What you have is a line under the stock prices. Support.
If the stock is really bullish, you will be connecting a series of higher lows. A stock that is staying above that line is “respecting” the bull support trend. It remains bullish as long as prices are above that line. Every time the stock drops toward that line, bullish buyers tend to snatch it up and the price tends to rise again.
By the way, in the rare cases where you can’t get a very good fit - for instance, if two extreme lows create a line that is far away from the rest of the prices, choose a shorter, more recent section of the chart and connect the lows in that segment.
Technical Analysis For A Falling Stock:
For a bearish stock, one whose price line is going down, do almost the same. This time you are interested in finding the line that is keeping prices down, overhead resistance.
- Find the highest peak on the chart and put your ruler on top of it.
- Connect that peak to the next-highest peak and draw your line.
You should have a line that is slanting down, with successive tops getting lower. As long as the stock price stays below this “bearish resistance” line you’ve just drawn, it’s still on its bear trend. Every time the price rises toward the bearish resistance line, investors tend to sell off to take profits and the stock resumes falling.
Trend lines tend to stay in place for months at a time, even years, which is why they are so worth your time.
Better than a Trend Line: the ADX Indicator
A more sophisticated tool that I rely on within my own technical analysis is the ADX line, also known as Wilder’s DMI. It’s not as well known as relative strength, momentum and some other indicators, but it is ALWAYS the first technical indicator I look for. Always.
That’s because the most important thing to know about a stock you want to trade is whether it is trending and how strong the trend is.
The ADX line will tell you that and also whether the trend is getting stronger or weaker. I do trade stocks that aren’t trending, but that takes special skills and more complicated analysis. As a new trader, you should stay with stocks that are trending. The ADX is your friend.
The way you read the ADX is simple. First, you want to know if there is a valid trend or not. The number will tell you. ADX goes from 0 to 60, or higher, although you never see a zero and rarely a 70.
The key number is 20. When the ADX is below 20, there is no trend in the stock. It is ranging. It may go up and down, but not enough to make trading it easy. When the ADX goes over 20, you have a trend in place. (For Nasdaq stocks, I like to see it over 22 because they are more volatile and more likely to suffer a trend reversal.)
The Trend Is Your Friend In Technical Analysis
Once you know that you have a trend, look at the direction the ADX line is traveling. If it is rising, the trend is getting stronger. If it’s falling, the trend is getting weaker. This applies to bullish and bearish trends alike.
If the number was very high, say over 40, I don’t worry too much if the ADX is dipping a bit. The reason is logical: Even if the trend is tapering off, it’s still in the “strong” range.
But when the ADX drops from a good number to under 20, look out! Your trend is drying up and you should probably shut down your trade the minute it stops working for you.
Good Trading,
Mt. Vernon Research Team
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Today’s Smart Profits Crib Sheet
- The essential tool for technical analysis is both powerful and easy-to-understand. So where do you get access to the ADX? Expensive charting software always has this choice, but you can find it for free at www.stockcharts.com.
- Also, check out the Smart Profits Report Glossary for more definitions of options terms used above like “volume” and “resistance.”
Related Articles:
- Technical Indicators: How to Overcome the “Evil Twins of Trading”
- The VIX Index: Instant Access to the World’s ‘Best Contrarian Indicator’
- Fundamental Analysis: Three Screens For Technical Traders
Trailing Stops
August 10, 2004
The Smart Profits Report: Issue #133
Tuesday, August 10, 2004
Trailing Stops: How to Give Your Options Room to Grow
By Karim Rahemtulla
Investment Director, Mt. Vernon Research
In my 20-plus years of trading, I’ve found that most investors face two problems when it comes to trading… They don’t know when to pull the trigger on the buy side or on the sell side. When shares move down, the normal reaction is to freeze… and acts like this can’t be happening. When shares move up, the euphoria of an early retirement seems to take over.
Of the two problems, though, the one that causes the most alarm is deciding when to sell your investments when they’re headed down. One way to take the pain out of such decisions is to use a system of trailing stops from day one.
Here’s how it would work…
Trailing Stops: Choose the Risk That’s Right for You
Let’s assume that your tolerance for risk is low, and you set a 10% trailing stop. If you bought an option for $1, you would sell if the price fell to $0.9. Simple, right?
You’d also make a daily adjustment to your stop price, based on the where the shares close. So if the options moved up to $1.20, then your new stop would be $1.08. You would consistently take 10% off the closing price, and use that as your guide, as long as the price is increasing.
Of course, this can be a bit of a pain. Your broker won’t do this for you, and unless you are glued to the computer screen, you won’t be able to do this either. You’d have to use a “mental stop” and keep your trigger price in mind… either that or you’d have to continue entering new limit orders and running up huge commission costs, which is impractical.
Nonetheless, here’s one real-world solution…
How to Give Your Trailing Stops Room to Grow
A couple of weeks ago I recommended that my LEAPS service members take advantage of the falling Nasdaq index by buying puts on the Nasdaq QQQQs. Our timing was good. We made about 40% on the trade in two weeks as the Nasdaq fell almost 6%.
But I didn’t know for certain in advance that it would turn out so well. Even the smartest trades can turn the wrong way, so I planned ahead for potential trouble. When I recommended the puts, they were at $1.75 and I set a stop-loss at $0.80 from the start.
Why such a big trailing stop?
With options (much more than with stocks) you don’t want to set such a narrow stop loss that you get stopped out without having the chance to make a profit. Options can move 10% in a day, in either direction. Sometimes that happens without anything changing to the underlying stock.
And with Long-Term options like LEAPS, you have many months, even years, to make money. So setting a fretfully tight stop loss defeats the purpose of using the time available and going with the stock’s longer-term trend.
And, with LEAPS, the spread between the bid and offer is often quite large (5% to 15% in some cases), so that a tight stop would cause an almost immediate loss.
So what’s the solution?
Start Loose, Then Lock ‘Em Up
So here’s what we did with our profitable QQQQ trade. As the option increased in value, I moved the stop loss higher along with it. Each time our option made a significant move, we increased our sell stop.
For instance, when the option hit $2, we moved our stop from $0.80 to $1.50.
Why such a jump? The answer is protecting profits. At that point the trend was moving in our direction. You want to follow your profits upward, but you must also realize that once a trend slows down and brakes, it usually means a new, opposite trend may be forming. So as you begin to make money it makes sense to use narrower stop losses to protect your profits.
With such a good trade, we moved up our sell stop to preserve our capital several times. When the option moved up to $2.50, we moved our stop up to $2.20, locking in a nice profit in case the trend turned. When the option then moved to $3 - definitely confirming the trend - we stayed with it, but moved our stop up to $2.40, locking in a 40% profit. The next day the market turned and the Nasdaq rallied. We were ready and I issued a sell, getting out a little higher than our sell stop.
As for relying on your broker to maintain a trailing stop for you… hardly any will do it… unless he or she has a number of clients trading the same options.
Good Trading,
Karim Rahemtulla
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Today’s Smart Profits Cribsheet
- For more on option terms like “trailing stops,” “put options” or “LEAPS,” see the Smart Profits Glossary.
Related Articles:
- Time Stops Strategy: Your 10-Day Profit Test
- Exit Strategies: Prenuptial Agreements for Options
- Using LEAPS: These Options Are Set to Run Full Tilt
The VIX Index
August 5, 2004
The Smart Profits Report: Issue #132
Thursday, August 05, 2004
The VIX Index: Instant Access to the World’s ‘Best Contrarian Indicator’
By Karim Rahemtulla
Investment Director, Mt. Vernon Research
You may have heard of the VIX Index. The term is bandied around often by financial analysts, pundits and those trying to impress at cocktail parties.
The VIX is formally known as the CBOE Volatility Index. (The symbol for it is ^VIX.) The VIX is an index that was created to track how “jumpy” the market is:
- A high VIX number implies extreme fearfulness on the part of investors, and means prices are bounding up and down a lot. Every time a stock falls a bit, a flood of investors will sell, causing a bigger drop. Then the minute something does well, a horde will come chasing the latest hot idea and push prices upward.
- A low VIX number implies complacency - generally, it means that people are happy to believe the market always goes up. They will ignore bad news and warnings. They’ll overlook high valuations and hold overoptimistic expectations.
The index is calculated based on prices for S&P 500 index options. Because option prices incorporate a premium for volatility, the VIX gives an instant reading on how volatile investors expect the market to be over the next 30 days. But its most common and important use is to measure investor sentiment.
In fact, you can use the VIX, just like the savviest pros do, to increase your chances of making good decisions with your stock and option trades. While it won’t be the only indicator a smart investor uses, the VIX does provide a nifty addition to the toolbox. Let me explain…
Worry When Others Don’t, Using The VIX
Essentially, the VIX just tells us whether investors are fearful (and overly pessimistic) or complacent (and too optimistic).
An extremely low volatility reading tends to occur when the market is about to peak, and extremely high readings hit right before it is about to take off.
For instance, in July 2002, after the market had been bearish for more than two years, the VIX hit a high of 48.46, indicating extreme fear and pessimism. At that point, the market was approaching its bottom. It would have been the time to buy.
Last week, the VIX closed at 15.32 - indicating relatively bullish sentiment and complacency. Is it time to sell?
A Quick Guide To The VIX Index
Here’s a guide - just a guide, mind you:
- When the VIX is high, in the 40s, it’s time to go long - fear is becoming overdone.
- If the VIX is low, under 20, it’s time to hedge or pare down your stock holdings.
The implications are pretty clear: It may be time to scale back your stock and option exposure…
Of course there are other factors involved in how you handle your portfolio - but the VIX has always been the professional’s best contrarian indicator.
Finally, do take VIX readings as a warning… but don’t take them as oracular truth.
Every low reading will not successfully predict an immediate rise in the market; nor will every high reading mean the market is about to fall. Instead, you should use the VIX as a weathervane and be prepared for market changes when it is at extremes.
Good Trading,
Karim Rahemtulla
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Today’s Smart Profits Cribsheet
- Until recently, the VIX was calculated on the volatility of S&P 100 options. If that’s what you want, it has a new symbol, ^VXO. (It is also called the “Old VIX.”) There is also a volatility index called the ^VXN, which may give you a better reading of the tech sector as it is calculated on a basket of Nasdaq options. (the ^ symbol can be found over the number 6.)
- For more information on such option terms as “The Vix” or “volatility” look no further than our free Smart Profits Glossary.
Related Articles:
- Fast and Furious Volatility is Back in a Big Way: How To Profit Using Leg Spreads & The VIX
- Market Volatility: How to Pay $27 for a $50 Stock
- Understanding Options Risk: How to Beat the “Volatility Premium” on Options
Put/Call Ratio
August 2, 2004
The Smart Profits Report: Issue #131
Monday, August 2, 2004
Put/Call Ratio: When this Number Jumps, It’s Time to Trade
By Karim Rahemtulla
Investment Director, Mt. Vernon Research
Options traders are always trying to figure out which way the market is headed next.
One tool at their fingertips is the “put/call ratio.” It’s used to measure the current sentiment - and try to foretell when the market is about to peak or bottom.
The put/call ratio measures how many put options are bought versus call options.
Bulls vs. Bears
The formula is simple: puts divided by calls. If there are 5,000 puts sold and 10,000 calls, the ratio is .5, a neutral number. Traders are interested in the extreme numbers - below .3 and above .8. The low reading means that not many people are interested in puts… everybody wants calls. They’re feeling very bullish - and that’s bearish.
The higher numbers mean people are buying a lot of puts and likely feeling bearish at the moment… and that may be bullish for the future.
You see, the put/call ratio is one of the so-called contrarian indicators. That is, you can read an extreme position as a warning of change to come…
The idea here is that if a wide majority believes one direction is a sure thing, then they pile on. By the time that happens, the market is usually ready to turn the other way. The thundering herd is hardly ever right. So the smart money almost always bets against this ratio.
But there is one problem with this theory… The put/call ratio does not give you the most important clue - time! People can stay bullish too long.
How to Get the Most From Put/Call Ratio Extreme Numbers
The best use of the put/call ratio is to watch for extremes and be ready for a change in market direction. Don’t take it as gospel. Take it as a warning. Here are a couple of problems to watch out for, though:
- Not everyone who buys a put is really bearish. Many institutions use protective puts as insurance to hedge against losses in their large holdings. For this reason, the put/call ratio on indexes is of little use when predicting the market direction, because so many index puts on the S&P 500 or Nasdaq are merely hedges against big portfolio losses. It is the put/call ratio for individual equities that tells the most.
- The put/call ratio jumps from one extreme to the other quickly, so it’s best to look at a moving average. The average over 10 days is a popular number, and many professionals use a 21-day moving average.
You can follow the put/call ratio by linking to the Chicago Board Options Exchange at: http://www.cboe.com/MktData/default.asp. About halfway down the page you’ll see the columns that provide you the numbers of put and calls. But don’t jump yet… There’s a bit more art involved in understanding the put/call ratio.
How Low Can You Go? Better Question - How Long Can You Go Low?
In March 2000, the put/call ratio was at one of the lowest points in the past 30 years - many more calls were being bought versus puts… We all remember what happened the following year as the Nasdaq 100 lost more than two-thirds of its value, with the S&P and Dow suffering losses as well.
Of course, nobody knew that this would prove to be the lowest historical ratio of puts to calls until after the damage was done. In fact, the put/call ratio had already been extremely low the previous October, but the market continued to rise for another five months.
On the upside for the ratio, in May 2002, the put/call ratio based on a 10-day moving average recorded .81 and .83 on successive readings. Extremely high.
That meant that more than eight out of 10 options traded were puts - a very glum sentiment. And the market soon followed with one of the most explosive bull market rallies in history, just as the contrarians would have expected.
So the ratio does have good use… just be careful not to trust it infallibly.
No doubt, keep an eye on the ratio - and be ready to adjust your risk tolerance accordingly. Here are some numbers to guide you:
- A ratio of .8 is extremely bullish. If you see the ratio approaching that number again, it would be a good idea to begin going long on strong ideas.
- As the ratio falls below .5, the market is beginning to be too optimistic, and you should begin to think about paring your long positions. The market is perennially skewed toward the bulls. People are more interested in finding stocks going up - and therefore calls - than they are in looking for losers. So as soon the calls begin to outnumber puts by less than 2 to 1 (a ratio of .5) something’s afoot. When it reaches .3 or goes even lower, it’s time for some serious unloading as the market may be so bullish it is about to peak. The lowest readings on record were right around .10 - a sign of extreme bullishness.
Good Trading,
Karim Rahemtulla
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Today’s Smart Profits Cribsheet
- For detailed explanations of options-trading terms such as “put/call ratio” and “strike price,” check out our Smart Profits Report Glossary.
Related Articles:
- Three “Fundamental” Screens - For Technical Traders
- “Trade” E-Minis With Less Risk - Using These ETFs
- How to Use Delta to Maximize Your Options Leverage
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