Like Those Stock Buys ? Use Options Instead!

I was called today be a buddy of mine who has a keen eye for stock plays, and is of a conservative bent. We both agree that this stock market is not yet ready to soar, although it has temporarily found a bottom. We both think it's going to rally a bit on recent government interventions, only to falter a few weeks in as the dismal reality of job layoffs and debt problems really sink in. He thinks it's going to go into a long, excruciating slow recovery that may stretch over years. I think it's got another big sharp leg down of around 20% to 25%.

Either way, we both agree that big pharma has taken it on the chin in the last year, and is likely to do well in the eventual recovery. Meanwhile, many of these companies are paying dividends of around 4%. That beats the hell out of bonds while you patiently wait for a recovery.

One of the stocks he likes is LLY. I'm not a gung-ho about that particular stock, but that's beside the point for this exercise.

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What I want to demonstrate, is that a careful application of options will give you a far better risk reward relationship than a pure stock play.

Let's say my friend was happy with the 2.3% return LLY pays around its current price of $139. He himself does not expect the stock to go down much more and he's betting it will be higher in 2 to 3 years. For the purpose of this example, let's say he buys 100 shares, for an outlay of $13,930, or a margin requirement of $3497. Here's the graph of his risk reward profile.

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Now fast forward 9 months. Say he's right and LLY is 10% higher. If he were to liquidate his positions, he'd have a gain of $1390, plus around $240 in dividends, for a total gain of $1630, or an annualized return of 15.61%. If you view it as a percentage of margin required, that's even more, 62.20%.

Conversely, if he's wrong and the stock moves down 10% (less likely, he thinks but definitely possible), he's got a mark to market loss of $1390 less the dividends, so $1150 overall, or 11% annualized in a cash account, or 52.9% annualized based on required margin.

Compare that to a sophisticated calendar play shown below (consisting of selling a lopsisded butterfly expiring in October 2021, and buying a covering lopsided butterfly expiring in January 2022.

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As shown in the graph, although this only requires a $95 outlay, it still requires a margin balance of $4000, similar to the stock only play. In other words, the investor has to maintain at least $4000 in the account, and amount which will not increase over the life of the option trade.

Fast forward 9 months, when the inner options expire, and we would liquidate all positions. On a 10% increase in the stock price, and even using the less favorable assumption that volatility decreases, he would close the trade for a gain of $2000. That's an annualized gains of 66.60% of margin, about 5% better than a stock only play.

Where the play really shines though, is if LLY slumps down. At any price, the maximum loss is only $108, or 0.36% annualized. Given the huge uncertainty in these markets, and the real potential of unanticipated medical or financial events sending markets careening lower, that limited downside risk will feel like manna from heaven.

If stocks move up 20% or down 20%, the option play advantage is even more crass. The only time the stock play is better, is if stocks rally strongly. At around 25%, the stock play starts being more attractive, and it becomes much more attractive starting at a 50% rally, as the option play loses a total of $1108 while the stock position has gained 50%.

But given this investors assumptions, of a stock that will trend higher but with great pains, and may even take a downturn, the option play shown here is clearly the more attractive position. Yes, it's complex. If it were not complex, everyone would be doing it and guess what: it would not be as profitable, because the options prices would be different.

Remember, options trading is complicated. Be sure to read our disclaimer. Consult with a professional before attempting such a trade, or your portfolio will suffer.

How To Play Uncertainty to Goose Your Wallet

As I write this, the corona virus has swept the entire planet, leaving death and economic destruction in its wake.

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Think its all over? Well, your a lot braver than I am, and in a few weeks you'll be a good bit poorer, I fear. I expect a 32% corrective bounce up, than another big leg down, leaving us with a total 50% correction. If you want to start bottom fishing then, you've got my blessing.

But there is one way to play this crisis. "Fortunes are made when blood is in the streets", goes the saying. Well unfortunately, that's the situation now, and I fear it will get much worse before it improves.

Check out the first graph. It shows you that today's levels of uncertainty (red line VIX) spiked higher than at any time in the last 20 years, even more than in 2008 when the financial system was teetering. So it could well be that volatility, reflected in the VIX index, is close to its current peak.

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It's pretty obvious that uncertainty will drop if the market recovers. That's a no-brainer. But I don't expect the market to stop dropping. In fact I expect another huge drop. I could short the market with options, which I've done and described previously, a trade which has rewarded us handsomely thus far.

But there's a safer trade, one that makes money regardless of stocks going higher or much lower. A strange thing happens in market crashes: people get used to the pain. Each and every subsequent drop, while just as harmful to the economy and to investors' portfolios, hurts subjectively just a little bit less, and shocks us less and less as investors.

That's why you got the following behaviour in 2008:

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Notice how volatility skyrocketed on the first big drop in SPY (S&P ETF)? Volatility rose 280% on a 23% drop in stocks. But what happened afterwards? Stocks continued there drop, losing another 7-10%. But instead of risking, volatility dropped by almost 100%!

If stocks had risen, volatility would have dropped even more! The lesson here, is if you can short volatility without betting the ranch, you've got a dream stock play. That's just what we'll do.

Our wager? That between now and January 2021, the stock market is likely to be much lower. (I actually expect the big drop by September-October, just in time to mess up the elections, but that not germane here.) But we'll have gotten used to the dismal state of affairs, so volatilty will drop down to the 20's or 20's. And if things improve and God-willing we get a handle on this nasty disease, all the better. Volatility will drop even more.

I don't expect it to reach the artificially low levels of 10 or 12 which we had previously, a gift from the free spending FED from its unlimited (imaginary ? ) reserves of money fresh off the printing press. My best guess is it will settle into the 30 to 40 range.

So I'll use a calendar spread, selling UVXY (a volatility driven ETF) put options that expire in January of 2021, and buying covering puts that expire a few months later.

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For this play to lose money, volatility must remain higher than 70, or drop lower than 10 by January of next year. I cannot imagine either scenario occurring in 10 months time. If they do occur, I lose the entire amount spent on the position. For 1 set of each calendar option, this is around $115. The reward is maximized if volatility ends at around 30 points, in which case the position can be closed at a profit of around $750. If it drops back down as low as $20, the gains are around $500, or 4 times what I've spent.

Remember, options trading can be risky. Be sure to consult our disclaimer page.

The Corona Virus May Kill You or Make You Money

The world is being ravaged by the corona virus. As I write this it has spread to 56 countries in two months, sickening more than 90,000 people and causing over 3000 deaths. Though as many people die from influenza, corona has been demonstrated to have about 1000 times the infectiousness. It has already humbled China's economy, forcing 10% of humanity into a quarantine.

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Scientists are racing to find a vaccine, but possible vaccines are about 1 year away. Currently, only a handful of treatments show any sign of allowing doctors to treat the severe pneumonia that results from the disease, though nothing it for sure yet.

The leading candidate for an effective treatment (not a vaccine) is Remdesivir, a product under development by Gilead Sciences. I don't know if Remdesivir will perform well, but early indications are that it will. I prefer to buy the rumor. If I wait for proof, from a stock perspective it will be too late.

Readers may want to refer to the following article (and the comments) on Seeking Alpha for the background on the drug. Gilead: Remdesivir's Potential Most Dependent On COVID-19 Spread I'm focusing here on a bullish play, betting that the stock will rise sharply over the next weeks and months.

I have developed a speculative play using what I call a "lopsided butterfly" option play. This is like a traditionial butterfly, but I stack it in favor of the direction I expect the stock to move. This allows me to benefit from the passage of time, disregard volatility calculations - as it is neutral to volatility fluctuations (always a tricky area with options), and requires little margin.

If properly executed the following option has a defined risk for around $57 per position. If I'm correct in my fibonacci/elliot wave calculations and time projections, the stock should reach $82 by the end of this week or the middle of next week. This option expires worthless if the stock does not move by the 13 th of March. Watch out! That's a Friday for those among you who are superstitious...

So if I'm correct, I could make between $300 and $450. If I'm wrong, I lose $57. I like those odds.

If you believe the mathematical probability statistics (the yellow lines) I've got only about a 10% chance of ending up in the money,and making a profit. Obviously, those are poor odds, if they were correct. But those lines and prices represent GILD's price movements in the past. They know nothing of the unique situation that has evolved since the corona outbreak. I've learned to trust my technical calculations more than the options' software. I think I have better than even chances of being right. Time will tell.

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As always, please read our disclaimer. Options trading is very risky if performed by the inexpert. Consult with a professional before investing, or you could lose everything.

Hedging Your Portfolio Against A Big Market Meltdown

Markets are just recovering from the biggest 1 week drop in market history, as the corona virus sends economies and markets reeling.

Here's what my technical analysis of the SPY (S&P 500 proxy) reveals.

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Given that opinion, here's one way you could create a very effective downside hedge to protect other positions you might have that have presumably already lost a lost of value (12-20 percent) off of their peaks, but which you are unwilling to sell at this time.

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Please note. This should only be done if you have experience trading options. You should only place trades like these after consulting with an experienced financial advisor. Please read our disclaimer. Investing in options is very tricky and can lead to loss of your entire portfolio if improperly performed.