18 May 2011 Do As I Say, Not As I Do

Do What I Say Not As I Do!

do as i say

It is interesting that we are discussing this the day after I said my routine has been disruptive. It is also noteworthy that we share this with you after preaching about protecting your down side and managing your risk. Here is a painful example of not having rules, routine, and risk management all under control. As you know, we are in a market correction. Typically you do not want to add new positions or huge expand existing ones unless you have true conviction in that stock. UNLESS, you are doing a contrarian play.

We have pimped several contrarian plays over the last couple of months (since the February 18 peak.). The included GLD, SLV, (Which we added to as we had strong positions to begin with.) JJG and DBA, ETFs in the agricultural commodity sector as we were expecting the spike in inflation (and dollar devaluation) that we are all witnessing now. In March and April, we continued to add to the JJG and DBA positions. They have been very volatile with 1-3% swings each way from day to day. That creates the perfect set up for playing options. Both have weekly call and put options.

the game

Here is the game and some of this might be review for you. When you buy call option (bullish position as the value of the contract goes up exponentially as the share price goes up), which is the right, but not the obligation to buy a stock at a predetermined price at a predetermined date. Each call option controls 100 shares of the stock or ETF or index in question. When you sell a call option, it is the obligation to sell a stock at a predetermined price on a predetermined date. (A bearish position because you want to sell the contract high and buy it back low as the price of the shares go down. Ideally you want the stock to go down enough to where the contract expires worthless and you keep the original sale proceeds.) When you buy a PUT option, it is the right but not the obligation to sell shares of a stock at a predetermined price on a predetermined date. (This is the opposite of a call and is a bearish position because you are betting the stock will go down.) Selling a put option is the obligation to sell a stock at a predetermined price on a predetermined date. (This is a bullish position because you want to sell the stock higher than when you sole the contract.)

Ok with all of that behind us, Sunday night I am looking at my long positions seeing which might lend itself to some pin action with options. Now I won't bore with all of the mechanics, but there are certain set up scenarios you have to look for like high volume, small spreads (the difference between the bid and ask prices as compared to volume) and the premium value of the option. There was JJG iPath DJ-UBS Grains Sub-Index an ETN (Exchange Traded Note, kinda like a cross dressing ETF.) It fit all of the criteria, and I felt very comfortable that the easing in commodities would continue another week. Now if I think the price is going to go down, my alternatives are to sell calls or buy PUTS. I chose to sell calls.

Now we have a sizable position in JJG. It is 10.3% of our non-cash portion of our portfolio. We are heavy in cash at the moment as we are in a correction. (About 40% cash at the moment.) We chose to sell some May 21^st 51 dollar call options for .73 each. Now go back and look at my well worded definitions and tell me what that means? Right for each contract I sold 73.00 (100X.73) I am obligated to sell 100 shares of JJG at $51.00 a share this Friday at 4.00 EST. So the most I can make is $73.00 for each contract I sold. Now what I would tell you is to mitigate your risk by putting in a stop order if the stock goes up or buy an offsetting call option slightly in the money. That what I would tell you, but that is not what I did. As of the close today, JJG is selling for $55.50 a share. It was selling for $50.82 when I sold the calls. As of tonight I am (note I used the word I as I own this all by myself.) 472% down on the option. I do not remember ever being 472% down on anything. Remember as the stock climbs our exposure increases so there really is no end to how bad a pick this could be. If I wanted to buy back this call, it would cost me $4.42 a loss of $369.00 for each contract. I will have to buy back this call by Friday at 4 PM or relinquish my underlying shares. That is the bright side. As of tonight my gains on the long position outweigh the loss on my options position. Currently my net position gain is .7%. For all of this work we are less than 1% ahead of the game.

woulda

In the land of woulda coulda shoulda, we should have stopped out of the call by executing a buy closing the position with say a 30-40% loss. We would be enjoying an 11% gain in the long position. We hope you are learning from our mistakes.