Tuesday, June 14, 2005

An example long-only option portfolio.

There were some great posts on Niederhoffer's site today. By the time you read this, they will probably no longer be at the top of the site. For the first article search for "Roger Arnold writes of the Sage". It's a great article about Warren Buffet.

The other great article is a basically a backtest of buying QQQQ LEAP calls. Search the site for "Nasdaq Options, by Charles Pennington". If I understand this article correctly, ATM QQQQ Calls 18 months out usually return about 3:1.

I've been asked lately about how a long option premium portfolio would work. (Remember I usually short option premium.) So, I'll use these QQQQ leaps as an example of how a very conservative long-option portfolio could be constructed. Say you have $10000. You could use that money to buy a 10 year Treasury bond yielding almost 4.60%. Today the options in the article mentioned in the paragraph above could be purchased for $460 per contract. (I purchased at that price today.)

So here is how the portfolio could work. You could purchase a 10-year Treasury Bond, and use the interest each year to buy one of these option contracts. If the options on average return 3:1 over 18 months, then that is around 200% return over 12 months, right? So now instead of earning a riskless 4.6% interest you are getting 4.6%*200% = 9.2% return, and the return is still basically riskless since none of your principal is at risk. That's a pretty nice rate of return for almost no risk isn't it? If I was allready wealthy I'd be seriously tempted to put most of my money in a strategy like that. (not exactly like that though.)

Here are some potential problems with this quick and dirty analysis. First of all I'm doing this all in my head, and may have made some very simple math errors that could ruin the whole thing. Secondly I know almost nothing about bonds...I may be missing something important here, especially with regard to the whole mechanics of how bonds work. For example, I'm not sure if treasury bonds actually pay an annual coupon or not, also you would be buying the first option contract a year before you would actually have accrued any interest.

Probably the most important problem with a strategy based on buying exactly those options though, is that there are only 13 independant data points in the sample set. I think my Dad (who happens to be a professional statastition) once told me that as a general rule of thumb you want at least 29 data points if I recall correctly. Based just on the information in that article, there isn't enough information to know if buying those options is a good idea or not. But anyway, this illustrates the general idea of when I talk about building a long-option portfolio. I'd put the bulk of the capital in a safe place (preferably earning decent interest) and use a small percentage..like 10% a year or less, buying options that are well-leveraged to their underlying issue. One of my favorite options books Options as a Strategic Investment by McMillan has a chapter about this type of strategy. Once I get my option database set up I hope to investigate these types of strategies more thouroughly.

Yesterday I bought some more SHLD common for my long term portfolio. I have been watching SHLD closely during this sell-off in the stock. I was hoping to increase my position in this sell-off, by at least 50%. Yesterday I bought half of that (I've held SHLD for a little over a year now.) I wanted to buy at around 130, but I was concerned the sell-off might end before the stock hit that price so I bought some yesterday at around 135 I think, with the plan to buy the rest at around 130. The stock was up 3 bucks today...I wonder if I will ever get a chance to buy more. My gut tells me I won't. One thing that is kind of cool, is the money I spent yesterday buying the stock was basically the house's money, since my profits on the position were more than it cost me to buy what I bought yesterday, even when the stock was down so much.

As I mentioned before, I also bought those options mentioned on the daily-spec list today at $4.60 as another addition to my long-term portfolio. They expire in 18 months. I don't think I've ever actually heald a position for 18 months in my life. Maybe my CMCSA position is getting close to that length of time, but that would be about it.

Other than those 2 trades, I'm just patiently waiting for option expiration. I expect to make a profit this month. I have 2 positions which are problematic. ONXX is trading close to break even, and DY is at a considerable loss. Delta's on both of these are pretty high now. Either one could wipe out my profits for this month in the next 3 days. The rest of the positions I am still carrying, will almost certinately expire worthless, and are all presently trading with no bids. My PnL at this point will largely depend on the fortunes of those 2 stocks. This is the first expiration in a long time where I don't have to be concerned about getting assigned stock, as I am currently only using 65% of my margin capital. This makes it much easier to just relax, hang back and see how expiration goes.

I'm looking at several potential option short sales in the near term. I'm looking at establishing a new position in MO options, off of recent weakness...perhaps sep 65 or 60 puts. I want to wait to see if MO comes in a little more during this expiration week. I'm also looking at EBAY puts. Maybe Oct 32.5's or if ebay drops a little something in the 30 strike.

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