Five Option Strategies, A Diversified Portfolio

Since Sept 2000, I have not held shares of stock following a collapse in the price of AAPL, a stock that I had held from the time Steve Jobs returned as CEO. Back in November, I said I was going to begin buying the SPY, and I did so, a few shares every 15 days until mid April, but that is the exception rather than the rule for me. I still do not hold stock. I don’t do covered calls or collars, I don’t sell puts. This is because I do not like positions that limit my potential profits and/or make my potential loss unlimited. This is why I am an option’s trader: I want unlimited profit potential with defined risk. I only enter a position knowing how much am I likely to lose so that I can allocate a portion of my capital in a balanced manner. This is portfolio as well as position management. I may have a bad year, but I know I can handle my draw downs.

I have been advocating for the use of the PCCRC because I can limit my risk for position to 2% of my account, and placing up to 10% of my portfolio in a trade. This unique approach make it unnecessary for me to own any stock. I can trade between earnings and be prepared for a market collapse. This strategy worked like a charm last year when I had the best period ever in my career as a trader, and the worst single week in Wall Street was by best week ever. However, volatility has been in decline ever since, and my PCCRC strategy has been lacking of candidates only until recently. I had a lot of capital in the sidelines simply because there were no good PCCRC set ups as volatility declined.

Still, there were plenty of opportunities as the markets begun to rise, and early on I advocated the use of biased butterflies, because they lock in the volatility. I used a very simple strategy: located stocks that jumped >10% in a day. Found the reason for the jump, and entered biased butterflies in stocks that reported earnings and raised earnings guidance. The result is that most trades have returned a profit. However, I understand that such a form of trading depends on the stock market itself, and we have had a very good market. This is why I limit my risk on these trades to only 1% of my portfolio. That is a lot to manage, to be sure, but placing such trades requires little attention, as long as you understand that you can lose every penny. The biased butterfly I use has unlimited potential, just like my PCCRC’s.

In addition to this directional trades, which depend on stock volatility, I have recently begun to sell Iron Condors (IC) on the SPY. For years I have been listening to Don Kaufman of Think or Swim and Options Planet about the IC strategy that he uses (you can learn about Don’s strategy by locating one of his presentations and the Trader’s Expo. Simply go to the MoneyShow.com and search for the videos in previous shows. I never played this strategy because based on my Elliott wave analysis, I was expecting a collapse in the markets. This is the same reason why I adapted the PCCRC in my own trading. So I went back and begun to back test the IC as suggested, entering one a week for the whole year 2008. The result was that despite of the two big loser months (October and November), the IC overall gave an excellent return for the year. Then it occurred to me that the creating and entry of this trade week after week, month after month required very little effort, and would certainly pay better than many investments, even in a terribly volatile year like 2008. However, if you put this together with my PCCRC strategy, the losses from my IC could have been absorbed easily. The combination of IC and PCCRC could be quite profitable and generate consistent profits year after year. This year, the PCCRC candidates have been hard to find but the IC would have generated profits repeatedly. A 5-10% of my portfolio could be easily allocated to the IC.

We can also play the decliners: Stocks that fall more then 10% in a day. For this I look for skews in the front vs. back month options and then trade biased calendar spreads. Contrary to the butterflies, the Calendar spreads benefit from increasing volatility and volatility does increase as markets decline. These days this are rare, but markets do change. Again, I would limit my risk on these to 1% per trade, as I might lose all the cash in each trade.

Finally, I can trade long calls and long puts, but these require a systematic approach. One of my favorites is the approach that Price Headly of Big Trends has come up with. Again, these are play money trades, and I have to be willing to lose all the money on each trade, although he does have rules to exit when the trade is not working.

The most important component to my portfolio is the PCCRC. It requires only 1 day a week for me to see what each trade is doing. The IC is the hedge that will generated consistent profits, with the occasional losing month. The remaining forms of trading are high maintenance, but they are good approaches for traders with lots of time in their hands. Despite the fact that this year has been poor for PCCRC candidates, it remains in my mind as the most powerful approach for the traders that have a “real job” as they say. The IC also requires only 5 minutes a week to select the proper trade, and then a few minutes on the week of expiration to exit the shorts that need to be closed.

If you like to learn more about this strategies, consider joining my e-mail group. For more information, just send me an e-mail at paperprofit1@mac.com.