Adjusting and Managing Leveraged Investing Option Trades
The purpose of this page is to provide option trading examples, including real life examples of trade adjustments and management.
I've created this page at the request of a number of individuals who purchased The Essential Leveraged Investing Guide and who wanted to see more real life examples of how I select and then manage trades.
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I'm also including it as a free web page as a courtesy for those who are considering the Leveraged Investing approach (using conservative option strategies to acquire high quality at a significant discount and then perpetually lowering the cost basis of those investments thereafter).
In addition to general trade information, I also include extensive notes to explain the background of the trade as well as my motivation and rationale for various decisions and adjustments.
The annualized returns are calculated by taking the amount of the "booked" return, dividing that by the implied capital requirement if I were to be assigned (e.g. 1 naked put at a 70 strike price = $7000 implied capital requirement), and then annualizing that based on the number of days the trade was open.
Short/Naked Puts on Pepsico (PEP)
So here goes - the following is a sequence of trades originally initiated in the fall of 2010 on PEP.
As you'll see, even though the share price seemingly went against me, I not only didn't lose money, but I also actually continued to make very good returns.
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Net Premium Booked
4 PEP JAN 22 2011 65 PUTS
I sold 4 Jan 2011 puts at the 65 strike price @ 2.62/contract.
PEP traded in the range of 65.85-66.52 on 9/13.
Over the next 3 weeks, the intraday share price move a couple bucks higher to the 66.91-67.82 range on 10/5, and I closed out the transaction for a quick profit, buying the puts back for 1.85/contract.
I initially received $1034.99 when I wrote the puts, and paid $752.99 to close them out 22 days later for a booked profit of $282.
4 PEP JAN 22 2011 65 PUTS
2 days following the previous trade, PEP traded lower again, to the 65.85 - 66.52 range on 10/7, and I sold 4 new Jan 2011 65 puts @ 2.44/contract for a total premium amount of $962.99.
This time the stock moved back higher again, and 5 days later on 10/12,the intraday range was 66.91-67.82 and I bought back the 4 puts again at the 1.85/contract level for the 752.99.
The booked profit this time was $210 in 5 days.
1 PEP MAY 21 2011 70 PUT
I had no other open trades on PEP for 6 months until I wrote 1 slightly in the money PEP May 2011 70 put @ 1.42 for a total premium of $131.25 after commissions.
A couple weeks later, on 5/13, with a little more than a week to go until expiration, PEP traded 70.22-71.27.
Although the share price remained above 70 through expiration, I chose to close the position a week early and lock in the profits, buying back the put @ $0.18 for a total cost of $28.74.
I actually wrote 2 new/additional 70 puts for the June expiration cycle in the days before choosing to close this one out (see entry below).
I initially anticipated that the stock would continue to trade higher and didn't want to wait until the May contracts expired before opening June positions.
1 PEP JUN 18 2011 70 PUT
Note: This short PEP June 70 put and the one below it were opened while the May 70 put (see above) was still open.
But after writing these two new puts on 5/9 and 5/13 respectively, I closed the May 70 put a week or so early, locking in the majority of the potential gain for that trade in an abbreviated 15 day holding period.
Re: this position, I wrote this June 70 put on 5/9 for an initial premium of $145.25 (1.56/contract).
On 5/9, the PEP share price traded between 69.48-69.98.
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By 5/23, PEP had climbed back above 70 and traded between 70.78-71.34, and I was a little nervous about the market in general when I decided to close the trade early for a quick profit.
It cost $187.49 to close out both short puts (for this entry and the entry that follows below) @ $0.88/contract. Dividing that amount by two, I recorded the net cost on this single put position at $93.74 for a net premium booking of $51.51 on a 14 day holding period.
1 PEP JUN 18 2011 70 PUT
See trade above.
I opened this second short PEP June 70 put on 5/12 when the share price traded between 69.96 and 71.05.
I initially received a premium payment of $91.25 (1.02/contract less commissions).
When I closed out both 70 short June PEP puts at 0.88 per contract, it cost a total of $187.49 to close out the entire trade. I deducted half that amount and recorded a marginal net loss of $2.50 on this portion of the trade ($91.25 less $93.75).
Taken as a whole, however, the 2 June short puts were profitable at somewhere near an annualized rate of return of around 10% on the 9-14 day holding period.
2 PEP JUNE 18 2011 70 PUTS
I basically re-opened the 2 short PEP June 70 puts on 5/27 that I had closed just four days earlier.
The stock traded between 70.28 and 71.03. I had expected the stock to trade lower but it didn't and I received a total of $154.50 (I wrote the puts at 0.83/contract, or 0.05/contract less than I'd closed the position for 4 days earlier).
I got very lucky on timing my trades the previous October (see the first two entries above), but clearly I would've been better off not closing the 2 June 70 puts early.
And on 6/13, with about 4 trading days remaining until the puts expired, and the stock trading between 68.62 and 69.32, I rolled the 2 June 70 puts to July.
The way I calculate "booked" returns is that I subtract the cost of rolling from the new premium received for a net premium received designation (see trade below).
So that means even though this trade was in the money and it cost more to close than I received when I initiated the trade, I consider it "booked" income of $154.49 over a 17 day holding period, which converts to a 23.69% annualized rate.
2 PEP JUL 16 2011 70 PUTS
On 6/13, with PEP trading between 68.62 and 69.32, I rolled my 2 short PEP June 70 puts to July 70 puts.
I bought back the June 70 puts @ 1.06/contract and sold the July 70 puts @ 1.66/ contract for a net premium credit of $107 (-$213.50 + 320.50).
2 PEP AUG 20 2011 70 PUTS
This was another roll on my 2 short 70 puts, this time from the July cycle to the August cycle.
Short/Naked Puts on Pepsico (PEP)
With PEP trading between 68.92 and 69.48 on 7/11, I rolled for a net credit of $137 (bought 2 July 70 puts @ $1.03/contract and sold 2 Aug 70 puts @ 1.78/contract).
4 PEP AUG 20 2011 62.50 LONG PUTS
This is where it might start to get a little confusing.
These 4 long puts were actually part of a bull put spread I opened on 7/18:
I sold 4 Aug 2011 65 puts @ 0.54/ contract and bought these 4 Aug 2011 62.50 puts @ 0.26/ contract for a net premium of $96.00.
On 7/18, the PEP share price fluctuated between 67.38 and 68.61. One week later, on 7/25, the PEP share price had fallen, and was trading on that day between 64.27 and 65.38.
The net result was that these long 62.50 puts had increased in price to 0.40/ contract.
I chose to sell the long puts and booked a small gain of $40 ($107 initial cost + $147 final sell price). Buying back the 4 long puts then changed the remaining short 65 puts from a bull put spread to regular naked puts (see trade entry below).
The artificially high annualized rate of return is based on calculating the $40 return on the $107 initial cost of the long puts held for just 7 days.
4 PEP AUG 20 2011 65 PUTS
See trade entry above - this position of 4 short PEP Aug puts at the 65 strike price was originally part of a 65-62.50 bull put spread, but when the underlying stock fell, I sold the 4 long 62.50 puts for a small gain.
And as an additional trade off, selling the 4 long puts eliminated any further downside protection, but it also increased the potential gain from the short portion of the trade should the stock rebound.
Originally, the maximum gain was $96 ($203 premium received less the $107 paid for the long puts).
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With the long puts removed, the net premium received here returns to $203, which is what I recorded as "booked" income on 8/11 when PEP traded in a volatile daily range of 60.41 - 63.59 and I rolled these short Aug 65 puts to short Sept 65 puts (see two trades below).
2 PEP SEP 17 2011 70 PUTS
One more roll on the 2 short 70 puts.
On 8/10, with PEP trading all the way down to the 60.10 - 62.89 range, I was pleasantly surprised that I could actually do a straight roll out one month to the same strike price and still generate a decent net premium.
This coincided with some pretty volatile 500+ point intraday swings in the DJIA so that premium levels were extremely elevated.
I bought back the 2 Aug 70 puts @ 8.93/ contract for a total cost of $1787.50 and wrote 2 new Sept 70 puts @ 9.45/contract for a premium amount of $1878.47, or a new net credit of $90.97.
On 9/6 with PEP still essentially trading in the low 60s (61.52-62.58 on this day), I made another important trade adjustment in order to lower the strike price on these 2 short puts from the 70 strike price to 67.50 (see two trade entries below).
3 PEP SEP 17 2011 65 PUTS
Options are always about trade offs.
This position was the result of a roll, but with a twist that I used to lower my overall risk.
Instead of simply rolling my in the money short PEP Aug 65 puts to Sept 65 puts, I actually used the time decay advantage to reduce the number of short puts from 4 to 3.
Here's what it looked like: I bought back 4 short Aug 65 puts for a total cost of $1084.99 (3 @ 2.66 + 1 @ 2.74) and then rewrote 3 Sept short 65 puts for a $1088.73 credit (3 @ 3.67).
If I would have rolled all 4 short puts, I would've generated something short of an additional $400 net premium credit (4 contracts @ a net credit of 1.01/ contract less commissions).
But because I also had 2 additional short 70 PEP puts open, I felt it was more prudent to begin lowering my risk rather than trying to maximize my income (which was basically in the category of loose change on this particular trade adjustment).
On 9/6 with PEP still essentially trading in the low 60s (61.52-62.58 on this day), I made another important trade adjustment and combined a roll on these as well as my other position of 2 short 70 puts.
Basically, I bought back the 2 puts at the 70 strike and these 3 puts at the 65 strike, and rewrote 5 short October puts at the 67.50 strike for a total net credit of $304.45 (see trade entry below)
5 PEP OCT 22 2011 67.50 PUTS
More trade offs - here I rolled 2 Sept 70 short puts and 3 Sept 65 short puts into 5 Oct 67.50 short puts for a net credit of $304.45.
Trade off here is that I lowered the strike price on the 70 puts to 67.50, but in order to do so, I raised the strike price on the 65 puts to 67.50 as well.
But I also generated an additional $300 in net premium (although this was actually achieved by the overall/average increase in strike price - 2 came down, 3 went up).
On day of roll (9/6/2011) PEP traded in the range of $61.10-$61.49.
8 PEP NOV 19 2011 65 PUTS
When you're managing an in the money naked put position, there are only two ways to reduce risk via rolling - either by reducing the number of outstanding puts or by lowering the strike price on those puts.
In this case, after getting all my outstanding short puts at the 67.50 strike price, I chose to do what was necessary to lower those further to the 65 strike price and still generate a net credit on the roll.
The trade off?
In order to achieve this, I increased the number of naked puts in the position from 5 all the way to 8.
On the surface, you could argue that I significantly increased my risk because whereas before I had potentially been on the hook for $33,750 worth of stock (500 shares @ $67.50), this trade increased my potential liability to $52,000 (800 shares @ $65).
Still, I believe this was a good move, and that lowering the strike price a full notch from 67.50 to 65 was a very good adjustment.
Much of my confidence stemmed from the quality nature of the underlying business. PEP is a world class business and while it was definitely out of favor during these last several months, the business model is still sound and it's a company that I'm confident will continue to generate consistent and growing profits for decades.
If I didn't have such long term confidence in the company, there's no way I would be adding short puts or, in effect, "doubling down" on the trade (and hopefully, I wouldn't have initiated any kind of trade on such a company to begin with).
On the day of the roll/adjustment (11/10/11), PEP traded in a range of $62.29-$63.26.
7 PEP DEC 17 2011 65 PUTS
After lowering the strike price on my outstanding naked PEP puts from 67.50 to 65 (and increasing the number from 5 to 8) on the last roll, I rolled again on 11/10/2011 (PEP traded in a range of $62.29-$63.26 that day).
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This was about a week prior to the November expiration.
Because the share price had finally started to rise, I found that I was able to roll to December, decrease the number of outstanding puts from 8 to 7, and still maintain a net credit. It basically cost me $2096.10 to close out the 8 Nov 65 puts and I collected $2329.62 for writing the 7 Dec 65 puts.
UPDATE: PEP closed at the November expiration @ $63.89.
In hindsight, I would have been dramatically better off if I had held off doing this roll until the final day of the expiration cycle instead of doing it a week earlier as I did.
This really illustrates the power of the accelerating time decay at the end of an option's lifespan.
I could have rolled to December 65, stayed essentially flat on the premium, and actually reduced the number of naked puts from 8 all the way down to 4.
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Or I could have even lowered all 8 of the November naked puts from the 65 strke to the 62.50 strike in December while basically remaining flat on the new net premium.
Obviously, I wish I had waited now, but the rationale for my decision a week or so earlier was that was the first opportunity I saw to reduce the number of outstanding short puts.
The U.S. markets have been very volatile over the last several months and in the short term I could see the PEP share price just as easily decline as rise. I didn't want to find myself in a situation at the end of the Nov cycle where PEP was trading at or below $60/share with me sitting on a bunch of short puts at the 65 strke.
5 PEP JAN 21 2012 65 PUTS
This time around, I held on to the previous position (December 2011) much longer before rolling.
Although for the December 2011 cycle PEP finished @ $64.85/share, the stock actually closed @ $65.19/share one week earlier as well as topping the $65 level on an intraday basis in 3 of the final 5 trading days of the December expiration cycle.
On Thursday 12/15/2011, the day before the last trading day of the cycle and with the stock trading in a range between $63.94 and $65.10, I was able to roll from the December 2011 65 strike to the January 2012 65 strike, reduce the number of outstanding naked PEP puts from 7 to 5, and still generate a new net premium of $400.85 (which, projected out across the full 37 day holding period until January expiration, equated to a 12.17% annualized rate of return based on the assumed capital at risk of $32,500, or 500 shares of PEP at the $65 strike).
Including commissions, it cost me a total of $225.33 to close out the 7 December puts and I received $626.18 in new premium by writing the 5 January PEP 65 puts.
Could I have done a little better on the timing?
Sure - the ideal time to roll probably would've been Friday morning when the stock opened @ $65.28 and traded as high as $65.40 before pulling back and closing at $64.71. This is a great example of how the closer to your strike price that a stock ends the expiration cycle at, the more lucrative and flexible future rolls become.
UPDATE: On 12/30/2011, the last trading day of the year (with PEP trading in a range between $66.24-$66.69), I closed out this trade "early" (an ironic descripton to be sure considering how long I've been rolling and adjusting).
I closed out the trade for a couple of reasons.
The primary reason was to find a way to wrap up this example at a nice chronological stopping point (i.e. the end of the year).
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And I was alos willing to close the trade nearly three weeks early, because the final net premium income that I ended up booking resulted in a slightly higher annualized rate (14.38%) than holding it for the whole period would have produced.
And secondly, this has been a tough and long trade, especially when you consider that I originally had 2 short puts at the $70 strike.
Although, I've been able to maintain net premium credits month after month even as I've worked to lower the strike prices on the rolls (which sometimes required I expand the total number of short puts), it's still nice from a psychological standpoint to step back, claim victory, and know that I finally have zero exposure on the trade .
. . and that I also booked $2344.73 in the process.
And finally, this last trade demonstrates just how quickly an "underwater" trade can reverse itself if/when the share price finally trades near the strike price. Once the puts are at the money or close to it (whether the stock rebounds or you have to lower the strike price on rolls yourself) the trade really begins to works in your favor.
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In this example, I was able to generate substantially higher returns while simultaneously reducing overall risk (i.e. reducing the number of short puts in the trade).
Summary of PEP option trades
The above option trading examples are a terrific illustration of how option trading, when used conservatively, methodically, in conjunction with high quality businesses, and all without panicking when things seem to go the wrong way, can still generate lucrative returns even as the trade seemingly goes against you (and even as I failed to always make the best adjustments in hindsight).
By the end of 2011, the trade was in much better shape than it was over the previous several months. But throughout these series of trades, and despite the challenges and technically being "underwater" much of the time, I was still able to generate $2344.73 of booked income in the roughly 8 month trading period detailed in the table above (from the first trade to the last was around 15 months, but recall that I had no PEP option postions open at all from mid-September 2010 until the very end of April 2011).
Compare my results since September of 2010 to the hypothetical investor who purchased shares at that time. At the end of 2011, the share price was essentially flat. The only income he or she would have seen would have been in the form of dividends.
In contrast, the $2344.73 of booked income I received would translate into approximately 36 free shares of PEP (assuming a $65/share price) should I choose to purchase shares at this time. At the current dividend payout that would equate to $74.16 in annual dividends.
Big deal, right?
Don't look at the small number - look at the huge implications behind that small number.
That $74.16 in annual dividends would have a zero cost basis - they would have cost absolutely nothing. In effect, it would be income manufactured out of thin air.
And what happens when you multiply the above over a full portfolio and over a full lifetime of investing? Do you see now why I am so optimistic about the future?
These PEP Trades Going Forward
Although I closed the final roll from this sequence of trades early at the end of 2011, in 2012, I continue to write new puts on PEP and I continue to book additional premium income.
Regardless of the zigs here and the zags there, I remain confident that I will always be able to meet one of either two objectives - continue to generate additional booked premium income, or if the options trade in the money, continue to lower the strike price on future rolling trades until the short puts eventually expire worthless, at which point I can then write new trades at a more advantageous strike price and subsequently generate much higher levels of premium income.
No matter what, I expect to come out ahead of those investors who simply bought on the open market.
And the premium income I've received (and will continue to receive in the future) affords me many advantageous choices - from buying X amount of free shares (matching the net premium received to date) to allowing me to define the exact amount of a discount on X mumber of shares I choose to purchase to even retaining the total premium amount as personal income.
Finally, please remember that the above is what I consider a worst case example of Leveraged Investing. What other system or approach allows you to generate these kind of returns even when you're wrong?
That's because when you focus on only the highest quality companies, in my opinion, the downside is significantly limited because even in volatile and declining markets, the share price on high quality companies declines less and rebounds more quickly than most of the market's other average choices.