(Published on August 31, 2014 in the prestigious website GURUFOCUS.COM)

The day was May 24th, 2014. It all started with the harmless expiration day Bear Call Spread (BCS) ($1950/$1930) for the expiration day June 21, 2014, as the SPX was trending sideways, slightly bullish at $1888 a share. I was double dipping for cash because I also had a Bull Put Spread ($1700/$1670) going for the June 21, 2014 expiration. The credit collected for the Bear Call Spread ($1.66 per share) was 7.5 times that of Bull Put Spread (BPS, $0.22 per share), probably because the short strike for the Bear Call Spread was only 83% OTM compared to the Bull Put Spread which was more than 96% OTM. Or is it because of implied volatility? I was more concerned about the downside risk. (Aside: Kelly Criterion suggests 26% bankroll bet on the BCS, see at the end).

Now, I was on to July 19, 2014, $1940/$1920 Bear Call Spread. I knew that Mr. Market who was irrationally exuberant would soon become unjustifiably pessimistic and I would have my chance of getting out alive. Mr. Market, relentless, went amuck and continued his exuberance. Again, I found my self having a Hobson’s choice of rolling forward. Still, I was betting Mr. Market would be down and out, but did not know when. So, on July 14th, 2014 I rolled forward and up the BCS to Sep 20, 2014 from 3 contracts to 4 contracts from $1940/$1920 to $1945/$1925 on a custom even trade.

 

 

On July 31st, 2014 Mr. Market, bi-polar that he is, gave in and plunged from $1965 to $1930, 1.78% drop. On August 1st, 2014 the stock slipped further down and closed near $1925. SPX had punched through the 50-day moving average with no sweat and heading towards 100-day MA at $1910. Closing the BCS at the stock price of $1930 with my strike prices straddling it, still costed $11.50 per share, which was twice the cost of getting out at 70% OTM. So I gave it some thought. SPX could punch through 100-day moving average with ease and the next support at the 150-day MA was $1888. I could have waited. Here, my instinct suggested to accept this as the bottom and buy back the short position $1925 which was still in the money and let the long strike $1945 to run as a winner. I fully knew what the risk was and what the reward was at this moment. On Aug 1st, 2014, I pulled the trigger and bought back all my 4 contracts at $40 a share ($16,000) and let the long position $1945 call, loose for the unlimited profit, with the maximum potential risk of $16,000. From a risk averse bear call spread I shifted to risk appetite long call for the unlimited reward to risk ratio which is high. Even though theta, the time decay was against me, the delta, the ratio of the price movement to that of the underlying stock/index, will more than take care of it. At this point of time I was fully aware that I was controlling $778,000 worth of underlying SPX. Wow! This is the power of Options!

Reading the SPX candlestick chart correctly for the next couple of days, the fight between the bulls and the bears was obvious. On August 8th, 2014 the bulls ran over the bears when SPX closed up from $1910 to $1931. There was the bounce I expected off the 100-day SMA.

On August 15th, 2014, I was $10 deep in the money when SPX closed at $1955 with my long position at $1945, 4 contracts controlling $778,000 worth of underlying. I could feel the twin-turbo effect of the underlying stock power! The Russian-Ukraine crisis put a damper on an otherwise of-to-the races situation. Over the weekend the crisis cooled off and I was ready with my delta roll, a vertical roll at the same expiration of Sep 20, 2014, to lock-in my profits, i.e., to sell $1945 ITM call (0.55 delta) and buy $1985 OTM call (0.28 delta) on August 18th, 2014. SPX moved from $1958 to $ 1971.

On August 19th, 2014, SPX closed even higher at $1981. At this point I erased all my would-have-been losses, including my RUT 3 BCS contracts which had to be closed at a loss and in to my unlimited green zone. So, without being greedy I closed 3 contacts of my $1985 long position and let one OTM contract at $1985 run its course which was really almost on the house then.

On August 21, 2014, SPX hit 52 week high at $1992 and now my 1 contract of $1985 long call was deep in the money with a delta of 0.57 (came up from 0.28 delta) and with the underlying stock power of $198,500 (Option was at $24 per share). SPX is sure to hit $2000 and beyond when the Russian-Ukraine crisis cools-off once again and I will be deep in GREEN before my expiration Sep 20, 2014. I am getting emotional, I should say that the probability is high and I am not done yet. (On August 30, 2014, SPX closed at $2003).

Please see the attached SPX Chart and the Spreadsheet showing RUT and SPX BCS trades to understand what I have narrated so far.
Betting Size – Kelly Criterion

Probability of Success (p) = 0.83 (OTM of the short strike $1930)
Probability of Failure (q) = 1 – p = 0.17
Net profit per share = $1.66 (net credit from BCS)
Potential loss per share = $5.40 (if I had to get out at 70% OTM before expiration)
Odds (b) = $1.66/$5.40 = 0.3

Edge = p.b – q = 0.83*0.3 – 0.17 = 0.079

Kelly betting % = Edge / Odds = 0.079/0.3 = 0.26

26% of the bank roll can be bet.

I was betting 8% to 16% which is much below what Kelly would want.
End Result: My portfolio reclaimed the ROI (return on investment) for the past year to match that of the Gurus!
Conclusion:

Know the technicals and the fundamentals of options trading well.
Know the technicals and the fundamentals of the underlying stock/ index well.
Control the emotions, fear and greed.
Be aware of all the biases, hind-sight bias, self-confirmatory bias, sunken-cost bias, etc.
Follow-up with a journal, stay on top and manage the situation.
Options are like laser saber and it can cut both ways.

Bottom line:

You can turn a bad trade to a good one if you know what you are doing!
Have fun with it!
Be funny and make money!

Every adversity carries with it an equivalent or a great seed of benefit.
– Napoleon Hill.

Smooth seas do not make skillful sailors.
African Proverb.

Through changes various, through all vicissitudes we make our way.
– Benjamin Graham’s favorite quote

Thanks.

Dr. Ram K. Ganesh
Independent Investor.