Thursday, June 16, 2005

A Strategy Adjustment

ONXX was up today. I covered my puts at $0.10 for a profit of $0.59. They'll probably expire worthless tomorrow but this stock is volatile and I don't want to risk a major portion of my profits for the month to make another 10 cents. DY was up nicely today and yesterday too. DY seemed to make an intra-day reversal yesterday. I was tempted then at the low of the day to close DY and ONXX both, so I could be done watching the markets for the week and lock in a profitable month. I'm glad I was patient in this case. DY has recovered a little and I think it may continue to do so. This stock could still cost me significant profits this month, but I decided to hang onto my DY position for another day since the premium was still around ~20+ cents above parity, and because of my hope that DY will continue to recover some of its losses. It's price is close to my break-even price at expiration. I'll probably end up letting myself be assigned DY shares tomorrow, and unload them on Monday if the options don't trade to within 5 cents of parity on the offer tomorrow.

I am in good spirits. Now that I am out of ONXX it looks like most likely I will have a decent ROI for June. I've felt confident that I would come out with a gain the entire month after taking significant profits in MOVI and NVDA early. For the past few weeks though, it has looked like ONXX and DY would cost me significant profits, yielding a low return for the month which would have left me in low spirits after last month's negative return.

I sold short PLMO Nov 20 puts @ $0.85 today. PLMO was up 90 cents selling around 28 bucks. PLMO's implied volatility has been ramping up ahead of earnings which come out at the end of June according to finance.yahoo.com. I'm apprehensive about this play. It seems like the market expects a tumultuous earnings report so I wanted to sell options very far out of the money to give myself a wide margin of error on this trade.

This position represents a small change in strategy. I am trying to move into selling options with longer expiration dates instead of primarily front and second month option contracts as I have mostly done in the past.

One of the surest ways to increase your profits in the markets is to reduce your transaction cots. Interactive brokers commissions are low and these are not the transaction costs I'm primarily talking about. I'm talking about the bid/ask spread which is a minimum of 5 bucks a contract each way. By trading options with longer expirations I will be reducing my transaction costs in two ways. First of all Options with longer times to expiration have larger premiums. Thus that 5 cents will be a smaller percentage of the premium collected. Secondly, I'll probably end up trading less frequently since my capital will be tied up for longer periods of time which will reduce my opportunities to pay transaction costs.

Another advantage of trading options with expirations further out is that my break-even level will be lowered, giving me a larger absolute margin of safety. However, there is a price to pay for selling longer dated options. You just can't get as high a return, assuming the positions are heald to expiratoin. I like to sell options that yield a minimum of a 10 percent annualized yield on unmargined capital. Selling this far out, it's often hard to find that.

I believe though that my yield may actually end up being higher than initially expected selling options farther out in time. If the stock moves in my favor sometimes I can exit the position very early and take most of the profits over a shorter period of time. For an example of this I have my recent NVDA trade. Earnings came out shortly after entering the position and the puts became next to worhtless very quickly. This was not only do to the favorable price-movement. The position also benefitted from the volatility collapse after the news event. I think I only heald that position for like 4 days instead of the 30+ that were left on the expiration. This gave me a much higher yield on the capital risked in that position than was originally expected. (Yield is profit divided by time)

For PLMO the only July puts today worth selling seemed to be the 22.5's. They could be sold for $0.30, and represent really high theoretical odds as well aa very nice yield on an annualized basis. Selling those short would be a break-even level of $22.2. With the stock trading north of $28.00, that's pretty far out of the money, but these PLMO options remind me of last months NVDA, MOVI, ONXX, and DY trades. There's a reason they look so attractive. They are probably riskier than they seem even though they are almost 6 bucks out of the money.

By selling the Nov. 20's@ 0.85 insted of the July 22.5's @ 0.30, I'm giving myself room for the stock to move almost 9 points against me instead of just 6. If the PLMO earnings are bad it will probably drop quite a bit and just sit until the next big bad event. The unfavorable price movement will increase the value of my options which will be bad, but hopefully they won't be in the money and that will allow me to sit tight and wait a few months for time-decay to work in my favor since there probably won't be as much movement after the earnings related movement settles down. Hopefully I'll get my expected 10% return assuming I've given my self enough of a safety margin. Furthermore I'll get some help from the post-event volatility drop. If PLMO rallies or stays the same, the options will lose a lot of their value right away due to this drop in volatility, and I will probably be able to cover them sooner than November, and earn a return better than 10%, assuming I am able to redeploy the capital elsewhere between now and then.

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