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I have worked in the financial service industry for 40 years. My area of expertise is risk management and complex financial products. I have been a frequent speaker, on behalf of many financial firms, to financial professionals across the country. I have extensive experience in statistics and... More
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  • USO Calendar Spreads ... An Update

    On January 13th I posted an instablog . As I have done in many of my previous articles, I started out with a thesis ... in this instance a thesis on the price of oil. I felt, and still do, that oil was near a bottom and would likely stay there in the short term, eventually recovering in the future. I don't know if the short term is three months, six months or a year, or if the future is one year, two years or more.

    There were many strategies that could be employed to fit this thesis ... one could use inverse oil or energy ETFs, go short, then long, play contango in one against the other, and so on. It all depends upon one's particular knowledge and comfort level.

    I chose to structure a particular series of option plays on the US Oil Fund (NYSEARCA:USO) designed to maximize profits if, in fact, the thesis played out. I happened to pick a strategy that I was comfortable with and incorporated the "dual mandate" of short term bottom and long term rise.

    As is my pattern, it wasn't a theoretical strategy, but one that I was implementing. After all, anyone can try to look smart writing an article about "whatever" ... it's different when they have skin in the game. So .......

    I started selling 100 calls every week at $18 strike and bought 100 LEAP calls spreads at $17/$27 strike with a January 2017 expiry.

    As happens in most articles, comments about "what ifs" came out. Within a week some asked what happens if oil spikes up and the short position goes deeply into the red.

    This question really hit to the core of all my calendar strategies and especially this one.

    A calendar spread represents two different positions ... in the case of a call spread ... a short and a long ... in the case of a put spread ... a long and a short.

    That means it is a balancing act between long and short term price movement. Proper execution is important to avoid getting "out of balance".

    The key to successful calendar spread investing is to make sure you earn your target extrinsic. However, sometimes you must be willing to sacrifice the extrinsic if your strike is "over-run"

    Keeping this in mind, my response to the "what ifs" ... unless there is some fundamental change ... one that causes you to believe that the thesis is no longer valid just stick it out and wait for the thesis to play out. If necessary give up extrinsic but keep selling weekly calls at $18 strike.

    Sure enough, as if prescient, oil started to spike .... and I did go deeply in the red.

    Though it's been only eight weeks, let's look at the results (using 100 USO options).

    USO Strategy Initiated January 13 at $ 17.25
    DatePrice USOStrategy $$$ ResultRunning Gain/Loss
    Jan 1617.45-( 1,778)


    Jan 2317.004,5142,736
    Jan 3017.821,2644,000
    Feb 619.47-(11,757)(7,757)
    Feb 1319.621,041(6,716)
    Feb 2018.659,6302,914
    Feb 2718.107,60410,518

    In addition to the above, the far-dated call has increased in value $3,629.

    But what is important, really important, is that we must look beyond the actual or anticipated results and examine, instead, the reaction to extremely adverse price movement. Even if the thesis is correct and the strategy appropriate, it will fail if not properly executed.

    The first week, the strategy didn't pan out, but shrugging it off was relatively easy. A big part of the loss was the bid/ask spread on the far-dated call. In the fourth week there was a major move against the strategy. Losing $11,000 in one week is never pleasant.

    Now, of course, I had an emotional reaction and was second guessing myself .... everyone does. But, because I was thesis driven, I could find no fundamental factors, besides price action alone, that warranted a change in the thesis. It was a move adverse to the strategy, not adverse to the thesis. So rather than run scared, I stayed with the thesis, stayed with the strategy and, sure enough, back it came. Turning losses into predicted gains.

    One other factor that I had to consider ... certain securities ... commodities (oil, gold, etc.) in particular are not "investments" in the classic sense. They are trading vehicles. They don't "earn" anything, they don't pay dividends they are just "things". So whatever the day-to-day price action it is likely the result of traders not investors. This adds a large speculation component to their price. So they are prone to wild swings, but eventually approach demand value.

    Some stocks also act as trading vehicles ... Herbalife, Tesla and BABA come to mind. This doesn't make them unfit to buy or sell, but it does make them less suitable for calendar spreads ... unless, of course, one can come up with a thesis and a firm handle on the real value.

    Now, the purpose of this article is not "aren't I a genius" ... for certainly not ... I've had more than my fair share of "bads".

    The overwhelming number of comments to my strategies revolve around "what do I do when things go counter". I always stress that calendar spreads are a process not a trade. They are intended to unfold over time. Some weeks you'll hit it well and some weeks you'll be hit.

    But, if the thesis is sound, it will play out ... over time your favor.

    However, never be so rigid as to stick to the thesis, no matter what.

    For instance, my thesis on the market for 2015 is SPX= 2000 to 2200. It's only March and we're getting pretty close to the top end. The market goes up and down and I'm not ready to adjust the thesis.

    Inherent in the thesis would be a pull back and I act accordingly. If SPX pulls back 2%-3%, the thesis is on track. If it doesn't, then I have to seriously think whether or not I underestimated 2015.

    However, I'll do my best to resist changing just because of price action. I need to see some of the headwinds alleviated.

    But as long as I keep earning my target extrinsic .... what I stand to lose is oversized returns. For instance, if SPX ends up 30%, I'll be lucky to realize 1/2 that. On the other hand, if it ends just modestly up (6%-8%) I'll double the return.

    One thing I do keep in mind from the recent price action is my opinion that in a bull market every high will be revisited after a pull back. That means the current high of SPX=2017 will be revisited. So, if there is a pull-back, I'll augment the calendar spreads by selling naked puts until SPX 2017 is achieved.

    Mar 03 7:38 AM | Link | 16 Comments
  • USO: A "Double Play" On Oil

    Though there are many divergent opinions on the future of oil, most people can agree that recent developments have been interesting. It seems that almost daily there are multiple articles on SA on the future of oil and Energy and they run the full gambit. A "selective reader" can find support for almost any position they want to believe.

    Now, I have to say, right off the bat, that I'm no expert on oil and certainly know less than the "experts" but probably more than the casually informed.

    So, for those that are interested, here's how I see it and how I'm positioning to make money. After all, for many people the hardest part of investing is implementing an effective strategy once they've reached a "viable premise."

    First comes the "viable premise" .... and here's mine ....

    In the near term any geo-political warfare and the "glut" point to a downtrend in oil's price ... or at least stabilization at these prices. At some point, this is likely to reverse and prices will head up. How high? ... I just don't know and won't hazard a guess. When ? ... again I don't know .... but I am willing to say, probably within the next few years.

    So, given the "viable premise" that current prices are flat to down but likely to change course sometime in the future ... can I develop a strategy that fits this premise? But most importantly (at least to me) can I hedge my investment ... just in case I'm totally wrong. I'm always willing to take risk but also mindful of the need to limit the risk, just in case I've got it wrong.

    First, one could just short oil through any number of ETFs. But this is "unidirectional" ... and offers no protection if wrong. It also means that I'll have to decide when to cover and go long. That brings "timing" into the forefront and we all know how that usually turns out.

    Second, one could just wait for the perceived bottom and go long. Once again, that requires timing and doesn't take advantage of any further decline in oil's price.

    Neither of these two really appeal to me. Probably because the "action" seems NOW.

    There is, however, a strategy that fits perfectly with the "viable premise". A strategy that makes money in flat and down markets ... goes long in the future and .... hedges the reverse course.

    It is the Option Calendar Spread. Here's what I've done and how it works.

    First, since the "viable premise" calls for a rebound at some point within, say, two years, I've purchased a Bull Call Spread on USO.

    Now, USO is one of many ETFs that offer exposure to oil, but I use it because it has the necessary option flexibility I require.

    So, with USO trading at $17.42, I bought the January 2017 (two years away) call at a strike of $17. That cost me $3.90. To hedge the cost I sold the January $27 call for $1.00 ... making it a 17/27 Bull Call Spread at a net debit of $2.90.

    A little explanation on why the $27 upper (OTM) leg. Straight up it represents $10 increase in USO which is about 60%. Assuming (really...assuming!) it tracks oil precisely, it equates to an oil price around $80. But, since it degrades (has a negative tracking error) compared to actual oil PPB, it probably equates to oil getting back near $100. Quite frankly, if my premise plays out, that's fine by me.

    Now, some might just sit on the bull call spread, waiting for it to go back up, but I take it a little further, entering the "calendar" part of the strategy.

    I sell the slightly OTM $18 weekly call on USO. This week it credited me 43 cents.

    So, if USO closes January 17th at or below $18, I pocket the 43 cents. If USO rebounds above $18.43 I start to lose on the weekly call, but the Bull Call Spread gains. Depending on how high USO goes, I stand to gain or lose a little.

    Now, each successive week I simply sell another call on USO. I can adjust it up (OTM) or down (ATM or ITM) depending upon how I see things. But, let's say I sell it each week and counting my winners and losers, I average a net gain of, just for illustration, 15 cents. I would average much greater (closer to 43 cents) if USO continues to go down or flat, but I'm expecting some weeks where it would be very volatile and jump up for a loss.

    Well, if the Bull Call Spread was a debit of $2.90, and I net 15 cents per week on the weekly call write .... in 20 weeks (less than six months) the Bull Call Spread is fully paid for. Now I can continue to sell weekly calls Deep out of the money (DOTM) and profit a little more, or just sit back and wait for my "viable premise" to conclude and cash in on the Bull Call Spread.

    Conclusion: Options aren't for everyone. But, for that matter neither is speculating on the price/direction of oil.

    So, if one wants to speculate and is reluctant to place a "firm bet" on flat to down short term oil prices (less than 2 years) with an eventual rebound, I see no better method.

    Tags: commodities
    Jan 14 6:04 PM | Link | 23 Comments
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