Thursday, June 02, 2005

What it means to be a "contrarian" changes as the markets change.

Last Friday I purchased some in the money QQQQ puts right before the close, because the market is overbought and sentiment had been very bullish for sometime. All weekend I felt like the trade was a mistake. The market felt (and still feels) like one of those markets where the market goes overbought and stays that way for a long time. When there is strong momentum, I don't think selling strong bullish sentiment works anymore. You just don't run out of buyers like you do in a down or range-bound market. The rising stock prices begin to attract new money, and stocks just keep going up. Shorting these markets too early can be suicidal. This is why I felt uncomfortable with the trade over the weekend. However on Tuesday, the market was down a little when I woke up. I resolved to stay in the trade. Then I read some article from Cramer on where he said he expected strength into the close. That was enough for me, and I exited the position at a small profit of $3.00/contract. By the end of the day as the market sold off into the close I felt stupid for listening to Cramer. I didn't feel dumb when I woke up on Wednesday to a really strong up market. I would have easily lost a minimum of 40 to 50 bucks a contract if I had still been in those puts.

Remember a while back when I said I was tempted to buy DNA LEAP CALLS? Remember how I congratulated myself for having the strength to resist my temptation to buy those calls? I would have made out like a bandit on those calls. They have almost doubled since then. I'm noting this, so that maybe I'll remember this next time I feel trepedation about buying premium. That pick would have made my long premium portfolio. PBG and NITE have been losers so far, but with the profits I could have made from DNA, would have more than made up for that. Remember the idea for being long out of the money puts and calls is to expect to lose money on most of your positions, and have one or two winners that are up so hugely that they make up for many small losses.

Part of the problem with a stock like DNA is the options I wanted to buy were so expensive on an absolute basis (they were cheap according to the Black Scholes Model however). At the time the call contract I wanted was around $280. When buying far out of the money options, I expect that more than likely I will have a complete loss on any individual position. Now losing 280 would not be a huge drawdown in capital for me. Over the timeframe of 6 to 9 months, I would barely even notice a loss that size. The problem is that a drawdown that size would be noticeable in terms of monthly profit/loss for my short premium portfolio in whatever month I took it. Right now I am focusing on learning to sell premium and being consistantly profitable every month. Psychologically the prospect of hurting my results in whatever month I potentially took a 280 loss was too much for me. I have found this year that even losing as little as 100 dollars on a trade here and there really adds up to hurt my performance over the long term. As I become more capitalized, I will be able to experiment more with trades like the DNA trade, because the loss from trading just 1 contract will become insignificant, since I will still be trading in the same size when I experiment.

The bottom line right now though is that I don't have enough capital to have a good expiremental long premium portfolio, as well as my primary short-premium portfolio. For a portfolio consisting of long puts and calls positions, I would want/need to be even more diversified than I am in my short-premium portfolio. I don't even have enough money right now to have a sufficiently diversified short premium portfolio. (I can be less diversified when short premium for a period of time because more than likely most of my trades will be profitable, so over any period of time my likelyhood of one position hurting me is small.) I should have 30 positions, all equal sized in my short premium portfolio. Right now I have like 9, and the position sizes vary more than is ideal. I would want at least 30 in a long premium portfolio to make sure my net was cast wide, since all of my profits would be coming from maybe as few as a couple of my positions in a year.

I sold short DNA JULY 75 puts today, with DNA around 82.85. Yes I'm chasing this stock up. Sometimes to be a contrarian I believe you have to chase stocks. Sometimes in markets "the crowd" is waiting for a pull-back to jump in. In such markets to be a contrarian you need to jump in early, since the crowd won't get their pull-back, and money will be made by the few who did jump in. Eventually the crowds will capitulate and buy, because their greed over the lost profits will be to much to bear, and the stock stops going up. Of course the chalenge is to know when we are in that accumulation rather than that capitulation stage. I guess we'll see.

I hope I am not jumping into this stock just because I feel bad for not pulling the trigger on that DNA LEAP call purchase last month. I don't think I am. I like the stock's prospects near term, and selling these options short has good theoretical odds and a high probability of profit according to the BS model. But really it's hard to know when bad emotions slip into trading decisions.

The June portfolio remains in good shape despite serius sell-offs in DY, GS, and ONXX. GS is still far above my break-even (around 10%). ONXX has sold off but seems like it wants to stay above the strike. DY is now in the money and below my break-even, but not hurting me badly yet. It's going to be awhile before I have to worry about being assigned. Since it is a small position and I have allready taken profits on some June positions, I will probably be ok if I'm assigned. Usually where I have to worry about assignment is when I'm transitioning into later month options, when at the same time I still have lots of front month options which I am waiting to expire. I often have to use most of my margin in such cases.

It's usually only for a few days that I am so highly margined...but unfortunately this is usually the few days when my danger of being assigned is highest. In such cases I get very nervous as an assignment would surely result in a margin call. I've never gotten a margin call so I'm not really sure how bad that would be. If my broker liquidated me out of really illiquid option positions that would really suck. I would lose significantly on the bid-ask spread. Interactive brokers doesn't actually give traditional margin calls...their computers just immediately liquidate your positions...I'm not exactly sure how that works since it has never happened to me. I think there is some way to set priorities for what gets liquidated first. I probably should do that...but I know I won't ever really worry about it until it hurts me. Sometimes lessons have to be learned the hard way. Maybe I'll get the opportunity to learn this one some day.


At 1:17 AM, Blogger Alien Shaman said...

What is the minimum capital investment it would take to be able to maintain a short portfolio of 30 positions given your strategy?

What kind of capital for your long portfolio?

Is a goal of yours to extract profit from your short portfolio to finance an ever growing long portfolio? i.e. Walk away from the table with your winnings and put it some place safe(r)?

At 4:36 PM, Blogger Quant Trader said...

To answer this here is what I do. Typically the most expensive stocks I sell options on are around 100 dollars. So, say I want to be able to have 30 equal dollar sized positions on stocks trading between 10 and 100 dollars. The minimal unmargined position I can enter on a 100 dollar strike would be 1 contract which is $10000 per position. (In practice, for a 100 stock I'd actually probably be selling a 90 or 95 strike contract, not a 100 strike.) I like to use 2:1 margin (I'm allowed aproximately a maximum of around 4:1 margin selling options short), so divide that $10000 by 2 to get the margin capital. That gives $5000 per position. I want all positions to be relatively equal sized so that means 5000*30 = $150,000, is how much it would cost to carry 30 EQUAL-SIZED positions using 2:1 margin, and being able to sell strikes up to $100 .

Right now I do not keep my positions equal sized. I value diversity more than keeping all positions sizes equal. Obviously most of the strikes I sell are not $100 strikes. Most are 20 to 50, so without keeping all positions equal sized, I believe a 30 stock portfolio could be achieved with considerably less than 150k. I'd guess anywhere between 30 and 50k would be the absolute minimum.

It's hard to say how much capital would be required for a diversified long option portfolio. You'd want to carry more positions, but the capital for each position would be much much smaller. I'd guess the options I'd want to carry would cost 200 dollars max per contract. (In general probably a lot less) But lets say 200 dollars. That means to carry 30 positions a year it would cost $6000. You would want only 10% of the portfolio to be at risk in a given year so 6000*10=$60000. Again, in practice this could be done with a lot less. Maybe 10000 to experiment with.

No my goal is to consistantly make profits with small drawdowns by whatever means works best. Right now I feel most comfortable shorting put options. I'd like to become comfortable with a variety of strategies, so that I can pick whichever one(s) have a risk/reward profile that is best for me.

Remember that "safety" is a very complicated thing to determine. Safety is a function of many dimensions. A portfolio of long options is not necessarily "safer".


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