The Options Miracle System:
How to Generate 30%
Annualized Returns in a
Stagnant Market With Limited
Risk
Jim Fink
The Wealth Summit
May 2014
Jim Fink
Chief Investment Strategist,
Jim Fink’s Options for Income
Stocks are Significantly Overvalued
• Yale economics professor James Tobin
• Q ratio: market price of stock divided by asset
replacement cost
– Similar to book value, but better because market values, not
accounting values
• Andrew Smithers (U.K.) maintains Q ratio:
www.smithers.co.uk
• Stock market is overvalued whenever Q ratio is above its
long-term average.
• Right now, stock market is 75% overvalued, right near
the overvaluation peak prior to previous bear markets.
• Robert Shiller’s cyclically-adjusted 10-year P/E ratio is
currently 28.4 vs. 15.7 long-term average: 81%
overvalued.
Market Cap of Stock Market >
GDP
• Warren Buffett:
– The percentage of total market cap relative to the US
GDP is “probably the best single measure of where
valuations stand at any given moment.”
• US GDP is $16.8 trillion and total market cap of U.S. stocks is
$19.8 trillion
• Since 1970, only three times that market cap has equaled GDP:
– 1999-2000 (148%) – Nasdaq lost 78%
– 2007 (111%) – S&P 500 lost 56%
– 2014 (118%) -- ????
• Economics Ph.D. John Hussman: “ since the 1940’s, the ratio of
equity market value to GDP has demonstrated a 90% correlation
with subsequent 10-year total returns on the S&P 500. Present level
is associated with projected annual total returns on the S&P 500 of
just over 1.8% annually.”
Other Warning Signs
• High-flying momentum stocks in the Internet (e.g., GOOG, FB,
PCLN, NFLX) and biotechnology (e.g., ALXN, REGN, CELG,
GILD) sectors have already begun to crack with steep corrections.
• Nasdaq/NSYE relative strength dropped decisively below its 10week moving average for the first time since late September 2012.
• University of Michigan finance professor Nejat Seyhun: insider
selling is “as pessimistic as I’ve ever seen over the last 25 years.”
More pessimistic than in 2007 (before 37% bear market in 2008)
and more pessimistic than in 2011 (before 20% market correction).
• The Investor Intelligence bull/bear ratio has been above 3 for most
of the past five months, which is longer than any time since the
1980s.
• But the S&P 500 remains comfortably above its uptrending 10month moving average, so the Ivy Portfolio market-timing
system continues to flash a “fully invested” signal.
Loss/Gain Asymmetry
Loss (%)
Gain (%)
Needed to
Break Even
10%
11%
15%
18%
20%
25%
25%
33%
30%
43%
40%
67%
50%
100%
60%
150%
70%
233%
80%
400%
90%
900%
Options
General Strategy
1.
Sell Low-Probability Fear
–
2.
Out-of-the-money put options
Buy High-Probability Growth
–
3.
In-the-money call options
Sell Low Probability Greed
–
Out-of-the-money call options
OFI’s 10-Year Stock Seasonality
Navigator
•
“Seasonality” refers to particular time frames during the calendar year when a
company’s stock price is influenced by recurring forces that produce a consistent price
direction – either bullish or bearish. Some stocks tend to go up consistently at certain
times in the year.
•
For example, consumer-related stocks (e.g., food, drugs, beer, leisure, utilities, media,
and retail) outperform the overall market between May 1st and October 31st and
manufacturing and production stocks (e.g., consumer durables, chemicals,
construction, mining, steel) outperform between November 1st and April 30th.
•
Seasonal tendencies can be based on weather events (temperature, precipitation,
planting cycle), spending surges (holiday and back-to-school shopping, end of
government fiscal years, tax refunds), new-product announcements at industry
conferences, or financial events (quarterly earnings reports, dividend hikes, and
regulatory approvals.).
10-Year Stock Seasonality
Navigator
Frequency
Strength
10-Year Stock Seasonality
Navigator
Easy Strategy:
Buy Long-Term Calls
(LEAPS)
Stock Replacement
Options
LEAP Call Strategy
1.
Sell Low-Probability Fear
–
Out-of-the-money put options
2. Buy High-Probability Growth
– In-the-money call options
3.
Sell Low Probability Greed
–
Out-of-the-money call options
Long-Term Calls (LEAPS)
Specific Trade Example (April 29th)
Stock: Occidental Petroleum (NYSE: OXY) at $97.45
Call Option: January 2016 $90 Call at $12.90 (expires in 625 days).
Upside Breakeven: $90.00 + $12.90 = $102.90, which is a 5.6% premium
($5.45 more) to current stock price of $97.45.
Cost Advantage: $1,290 vs. $9,745, or 87% less! If stock drops 30% to
$68.22, max. option loss is only $1,290 (13.2%). Stock loss is $2,923
(9,745-6,822), or 127% (more than double)!
Delta: 70%, so call option increases $0.70 per $1.00 move in stock. Delta
increases towards 100% by expiration.
Profit if Stock Rises to $110 at Expiration: $20/$12.90 - 1 = 55.0%, which
is 42.1 percentage points higher than stock return (12.9%)!
Long-Term Calls (LEAPS)
Portfolio Construction
•
$200,000 Equity Portfolio. Reasonable diversification requires 20
holdings of $10,000 each
•
102 shares of OXY costs $9,940 ($102 * $97.45)
•
One OXY $90 LEAP call for $1,290 gives virtually same profit
potential of 102 shares for 87% less cost than $9,940.
•
If all 20 stock holdings of 100-share positions could mimicked by
$1,290 cost, then total equity option investment would be only
$25,800, leaving $174,200 in cash.
•
Maximum dollar loss of LEAP call positions is $25,800 or 13% of
portfolio. Same stock upside with built-in 13% stop loss. Much
less than 100% potential loss with all-stock portfolio. Stocks must
rise to make money in both call option and stock scenarios.
Medium Strategy:
Put Credit Spreads
Selling Irrational Fear
Options
Put Credit Spread Strategy
1. Sell Low-Probability Fear
– Out-of-the-money put options
2.
Buy High-Probability Growth
–
3.
In-the-money call options
Sell Low Probability Greed
–
Out-of-the-money call options
Put Credit Spreads
Generates Income With Less Risk than
Owning Stock
Put Sellers: Obligation to buy stock at a strike price
Selling Options
•
Receive fixed amount of instant cash
•
Risk limited to width of put strikes.
Stock Price Does not Need to Rise
•
Maximum profit occurs if the stock does not rise or even falls a little
bit.
Put Write ETF (HVPW) vs.
Buy/Write ETF (PBP)
12-20-07 to 3-9-09 (Bear Market)
• SPY: -52.3%
• PBP: -39.3%
• ^PUT: -35.9%
•
•
•
•
4-28-13 to 4-28-14 (Bull Market)
SPY: 19.7%
PBP: 9.2%
^PUT: 10.1%
Put-Write ETF (HVPW): 0.8%
(started trading 2-28-13)
Put Credit Spreads
Specific Trade Example (May 2nd)
Stock: Reynolds American (NYSE: RAI) at $56.50 (Apr. 29th)
•
•
Second-largest U.S. cigarette manufacturer (Camel, Pall Mall, Kool)
10-Year Positive seasonality into August expiration of 90%, with
single loss in 2011 of only -2.7%.
Put Spread:
•
•
•
•
•
•
Sell August $55 Put at $2.35 (expires in 105 days)
Buy August $50 Put at $1.00 (expires in 105 days)
Net Credit = $1.35
Potential Rate of Return = $1.35/$3.65 = 37.0 Percent
Breakeven = $53.65 ($55-$1.35)
Breakeven Discount to Current Stock Price = 8.3 Percent
Put Credit Spreads
Short Put Options Can Be Exercised Early
•
Although early exercise is rare, it does happen
•
Usually able to buy back put and sell longer-dated put if not
ready to buy the stock (i.e., Vertical Roll)
•
Buying stock at a discount from the current market price is a
good thing! Can easily sell assigned stock and re-initiate new put
spread.
•
No margin call for involuntary early assignment because brokers
know that your risk is limited to width of put spread. “Same-day
substitution” rule.
Put Credit Spreads
Proper Use of Options Leverage
Two Ways to Use Option Leverage – One Bad, One Good
1.
Bad: Buy more stock for same amount of cash
a) 100 shares of Reynolds American for $5,650
b) Since one RAI Aug. $55/50 put spread can be sold for $1.35
per share and risk of $365 per contract, one could sell 15
put spreads for similar $5,475 of risk (15 times share
exposure)
2.
Good: Buy same stock for less cash
a) Sell one RAI put spread for $365 of risk (93.5 Percent Less
Risk than 100-share purchase of $5,650)
b) 15 different put-spreads for same price as one stock
position! Using options optimizes portfolio diversification.
Put Credit Spreads
Portfolio Construction
•
$135,000 Equity Portfolio. Reasonable diversification requires 20
holdings of $6,750 each. Expected portfolio return = 10%, or $13,500.
•
50 separate positions of two-contract put credit spreads at per-contract
income of $135 and per-contract cost of $365 would yield same $13,500
income, but the total investment risk would be only $36,500 (50*2*$365),
leaving $98,500 in cash.
•
Maximum dollar loss of put-spread positions is $36,500 or 27.0% of
portfolio. Much better than 100% potential loss on stocks. But chance of
suffering maximum loss on all 50 put-spread positions is infinitesimal,
whereas chance of losing 27% on stock portfolio is definitely possible.
•
Probability of making $13,500 income with put spreads is much higher
than buy-and-hold stocks because put spreads do not require stocks to
rise.
Advanced Strategy:
Iron Condors
Selling Irrational Fear and
Irrational Greed
Options
Iron Condor Strategy
1. Sell Low-Probability Fear
– Out-of-the-money put options
3. Sell Low Probability Greed
– Out-of-the-money call options
Autozone (NYSE: AZO)
May 2nd–to-June Seasonality
Year
Stock Return %
2013
1.1
2012
-2.8
2011
3.7
2010
5.6
2009
-4.0
2008
-7.2
2007
3.5
2006
0.5
2005
12.1
2004
1.4
Autozone (NYSE: AZO)
May 2nd–to-June Seasonality
• Frequency of up or down is not important for
neutral iron-condor trades.
• Magnitude of yearly moves is what counts.
• Only one year out of 10 had a price move in
double-digits (12.1% in 2005).
• All the nine other years saw price moves of 7.2%
or less in magnitude.
• Conclusion: Choose short strikes 8% out-of-themoney both up and down from current stock
price.
Autozone 3-Year Chart
Iron Condor
Specific Trade Example (April 28th)
Stock: Autozone (NYSE: AZO) at $531.00
Iron Condor:
•
•
•
•
•
•
•
•
Sell June $480 Put at $3.00 (expires in 50 days)
Buy June $470 Put at $2.20 (expires in 50 days)
Sell June $570 Call at $3.00 (expires in 50 days)
Buy June $580 Call at $2.00 (expires in 50 days)
Net Credit = $1.80
Potential Rate of Return = $1.80/$8.20 = 22.0 Percent
Breakeven = $478.20 downside (9.9%), $571.80 upside (7.7%)
Maximum Profit Range = $90 wide ($480 to $570)
Iron Condor
Pros and Cons
Pros:
•
•
•
•
Double credit and yet single margin requirement
Can’t lose on both credit spreads; guaranteed to win on at least
one of them
June $480/$470put spread has $0.80 credit and $920 margin
requirement; June $570/$580 call spread has $1.00 credit and $900
margin requirement
If trades done separately, two margin requirements totaling $1,820,
but iron condor margin requirement only $920.
Cons:
• Need to worry about two short option strikes, not just one. Vulnerable
to strong move in either bullish or bearish direction. (2 bad scenarios,
1 good scenario).
• Four option legs, so commission cost is heavy both initial and if roll.
Trade Summary
Easy, Medium, Advanced
Trade Examples
Long-Term Call: Buy Occidental Petroluem (NYSE: OXY) January 2016
$90 call for a debit of $12.90 or less.
Short Put Spread: Sell Reynolds American (NYSE: RAI) August
$55/August $50 put spread for a net credit of $1.35 or higher.
Short Iron Condor: Sell Autozone (NYSE: AZO) June $480/$470 put
spread and sell June $570/$580 call spread for a net credit of $1.80
or more.
Downside Protection Hedges
• Bear call credit spreads on stocks (neg. delta)
• Directional (OTM) calendar put spreads on stocks (neg.
delta and pos. vega)
• VIX put credit spreads (pos. vega but contango roll risk)
• VXST options (NEW!)
• VIX ETNs (pos. vega), but don’t work well.
How To Calculate Number of SPY
Puts for Portfolio Hedge
• Divide Dollar Value of Portfolio By Index
Value * 100 Multiplier
• Portfolio worth $100,000
• SPY = $188
• $100,000/($188*100) = 5.3 SPY puts
Adjust SPY Hedge By Portfolio
Beta
• Beta = Correlation and magnitude of portfolio
movement with S&P 500.
– Perfect correlation = 1.0
• Portfolio Beta =
– (Stock A % amount * stock A beta) + (Stock B %
amount * stock B beta)
• If portfolio Beta = 0.8, adjust SPY puts from 5
down to 4 (0.8*5)
• If portfolio beta = 1.8, adjust SPY puts from 5 up
to 9 (1.8*5)
VIX Calls vs. SPY Puts
• VIX calls can replace SPY puts in a ratio of between 1.5
and 2.5, depending on current volatility of VIX futures vs.
SPY.
• Conversion formula:
(SPY volatility (VIX) * SPY price)/
(VIX futures volatility (VVIX) * VIX futures price)
• Right now, correct ratio is near upper end at 2.5, so 5
SPY puts = 12 VIX calls
CBOE Short-Term Volatility Index
(VXST)
•
Uses weekly SPX options to calculate 9-day expected
volatility – compared to the VIX’s 30-day expected
volatility.
•
VXST futures started trading on Feb. 13, 2014.
•
VXST options started trading on Apr. 10, 2014.
•
Less contango means better performance
VXST vs. VIX vs. VXX
(April 2011 to April 2014)
Second-Generation Volatility ETFs
• XVIX – UBS Daily Long-Short VIX ETN
– Benefits from contango
– 100% long VIX mid-term futures index (VXV)
– 50% short VIX short-term futures index
• XVZ – Barclays iPath Dynamic VIX ETN
– Also long/short VIX futures, but changes percentages based on current
term structure
– Ranges from -30% short short-term VIX/70% long mid-term VIX if steep
contango to 50% long short-term VIX/50% long mid-term VIX if inverted
(backwardation)
• VIXH – First Trust VIX Tail Hedge ETF
– Long S&P 500 index and buys one-month 30-delta (i.e., OTM) VIX call
options
– 1% allocation to VIX calls if VIX is between 15% and 30%
– ½% if VIX between 30% and 50%
– 0% if VIX under 15% or over 50%
Second-Generation Volatility ETFs
(Page 2)
• VQT – Barclays S&P 500 Dynamic VEQTOR ETN (SPX + VIX
Futures)
Performance Comparison of VIX ETNs
Year
SPY
XVIX
XVZ
VIXH
VQT
Outperform
SPY?
2008
-36.8%
16.4%
132.3%
-19.3%
21.3%
All 4 VIX
ETNs
2009
26.4%
24.2%
0.7%
16.0%
24.5%
None, but all
positive
2010
15.1%
55.4%
20.7%
21.1%
1.7%
3 of 4 VIX
ETNs
2011
1.9%
-13.6%
8.8%
5.9%
16.2%
3 of 4 VIX
ETNs
2012
16.0%
-11.1%
-18.6%
3.6%
2.6%
None, but 2
of 4 positive
2013
32.3%
-9.4%
-26.7%
19.0%
13.0%
None, but 2
of 4 positive
2014
(thru
Apr.
28)
1.6%
-6.2%
-9.3%
-0.5%
-1.5%
None