Two 2015 Case Studies of Options Portfolios

 

These case studies were actual portfolios carried out during the first nine months of 2015 in separate brokerage accounts at thinkorswim for Terry’s Tips subscribers (many of whom mirrored these trades in their own accounts or had trades executed automatically in their accounts by the (free) Auto-Trade service at that brokerage firm.  The results include commissions on all the trades.

 

The first nine months of 2015 were not good ones for the market.  The S&P 500 fell 6.7%, from 2059 to 1920. 

 

The two individual stocks covered in this report, Costco (COST) and Starbucks (SBUX) outperformed the overall market during this time period.  COST rose from $141.87 to $144.57, a gain of $2.70, or 1.9%.  SBUX soared from $82.05 to $113.68 (pre 2-for-1 split), or 38.5%.

 

As you will soon see, while the gains in COST and SBUX were most impressive compared to the overall market, they did not do nearly as well as our two actual portfolios which traded options on these underlyings.

 

The strategy used in these portfolios is a lot like buying stock and writing calls against the stock.  However, there is a big difference in the options portfolios.  Instead of buying stock, longer-term call options (and sometimes, LEAPS) are used as collateral against which to sell short-term call options.  The return on investment from writing calls against longer-term options that might cost one-tenth the value of the stock is why the options portfolio comes out well ahead of buying stock and writing calls against those shares. 

 

Extreme leverage can be your friend if the stock holds steady or moves higher.  On the other hand, if the underlying stock falls more than moderately, the options portfolio might lose more than you would lose you had bought stock instead.  So it’s important to select a stock you feel comfortable about.  The stock doesn’t have to move higher for this options strategy to prosper, but it can’t fall a lot and still expect to produce extraordinary gains.

 

Case Study #1 – Costco Options Portfolio

 

Costco (COST) started out 2015 trading at $141.87 while the Terry’s Tips portfolio which uses COST as the underlying was worth $6223.  With this amount invested, you could have purchased 43.8 shares of the stock (we’ll round it off and say you could have bought 44 shares).

 

Here is how the price of COST fluctuated during the first nine months of 2015:

 

 

 

 

 

 

 

The stock rose steadily early in the year, but fell from a high of about $153  to as low as $135 in the first week of September. At the end of September, it was trading about $3 higher than where it started out the year. Let’s compare the prices for 44 shares of COST with the value of the actual Terry’s Tips portfolio trading COST options during this same time period:

 

 

 

 

In late January when the stock fell a bit, the portfolio value fell by a greater amount, but when the stock recovered, the portfolio outperformed on the upside as well.  Two other times during the year, the stock took a sudden drop and the portfolio value fell below the equivalent investment in the stock, but when the stock moved higher in July, the portfolio shot by a considerably higher percentage.

 

Over the nine months, an investment in the stock would have gained $1.20 per share from dividends you would have received on 44 shares, or $52.80.  The stock gained $2.70 over these months, so the 44 shares were worth $118.80 more than they were at the beginning, for a net gain of $171.60 including the dividends. This total works out to a 1.2% gain on the stock purchase for the nine months.

 

Over this same period, the actual COST options portfolio (we call it the Rising Tide portfolio) rose from $6223 to $12,900, for a gain of $6667, or 107%.

 

Let’s check the actual positions in this portfolio at the beginning of the year (from our January 3, 2015 Terry’s Tips Saturday Report):

 

			Rising Tide
	Price:		$141.61
	Option		Strike	Symbol	Price	Total	Delta	Gamma	Theta
-3	Jan-15	C	140	COST150117C140	$2.92	($876)
-3	Jan-15	C	143	COST150117C143	$1.23	($368)
-2	Jan-15	C	145	COST150117C145	$0.57	($113)
6	Apr-15	C	135	COST150417C135	$9.25	$5,550
1	Apr-15	C	145	COST150417C145	$3.43	$343
2	Jul-15	C	140	COST150717C140	$7.68	$1,535
					Cash	$152	218	-37	$26
	Total Account Value					$6,223	3.5%
1					Annualized ROI at today’s net Theta:				152%

 

We owned 7 calls which expired in April and 2 which would extend until July, and we had sold a total of 8 Jan-15 calls, 3 of which were at a strike just below the stock price and 5 which were slightly out of the money.  We had one long uncovered call which we could have sold a short-term call against, but we wanted to maintain a higher net delta.  The option positions were the equivalent of owning 218 shares of stock (the net delta figure).  That explains why the portfolio value gains or loses at almost 5 times the rate of owning 44 shares of stock.

 

Now let’s fast forward to what the portfolio looked like at the close of business on September 25, 2015.  Here are the positions that we held:

 

 Rising Tide Positions Oct 2015

 

You can see many differences between these positions and what we held back in January.  First, the long calls are all the way out to 2016 (Jan-16 and Apr-16).  Second, there are some put positions.  In May, when COST was trading about $144, we sold a bullish credit put spread (buying Oct-15 135 puts and selling Oct-15 140 puts).  If COST is at any price above $140 when those puts expire on October 16^th, both puts will expire worthless, and we will have made 51% on the amount we risked when we sold the spread in May. Third, the short calls are in several weekly series rather than in a single (monthly) options series. 

 

About half-way through 2015, we changed the way we trade this portfolio. We are now short weekly options in several different series.  Each week, some calls expire, and we buy them back (usually on Friday) and sell new ones which expire about 4 weeks later.  We select strikes which will balance out the risk profile for the portfolio.  This allows us to tweak the profile each week rather than making wholesale adjustments at the end of the expiration month.  We believe that the superior performance we have enjoyed over the past few months in all of our stock-based portfolios has been due to this new way of trading which was not possible before the advent of weekly options.

 

Every Friday, we create a risk profile graph to help us decide which strike prices to use when we buy back the expiring weekly options and replace them with further-out new short calls.  Here is the graph we created on October 2, 2015 which shows the expected gain or loss in portfolio value when the short options expire on the next Friday, October 9^th:

 

Rising Tide Risk Profile Graph Oct 2015

 

This graph shows that if the stock is absolutely flat ($143.21) a week from now, the portfolio will gain $735, about 5% of the portfolio value.  If It moves about $3 higher, the portfolio would gain about double that amount.  A gain should result even if the stock falls by about a dollar during the next week.  It can move higher by about $6 before a loss would occur on the upside.  You can see how most weeks, this collection of long and short calls will result in a gain as long as the stock moves only moderately.  (Actually, in most weeks, we end up with positions that allow for the stock to fall by $2 before a loss would be incurred – this week was unusually bullish for us.)

 

To sum it up, over the 9 months of trading, our portfolio gained $6376.  This works out to be 107% of the starting value of $6223.  Someone who had spent the same amount of money buying shares of COST would have picked up about $172, or 1.2%..  Our portfolio outperformed by more than 30 times what the owners of the stock gained.

 

We believe that this experience establishes beyond all doubt that a properly-executed options strategy can out-perform the outright purchase of the shares many times over.  Of course, it is a lot easier just to buy the stock.  Trading options takes time and attention, but surely, isn’t it worth it when you might do about 30 times better?

 

If you don’t want to bother with all the trading, you could open an account at thinkorswim and sign up for their free Auto-Trade service, and not only enjoy their $1.25 (normally $3.90) commission rate for a single option purchase or sale, but all the trades will be automatically made for you in your account.  By the way, this lower commission rate made available to Terry’s Tips subscribers will apply to all your trades, not just those you make through Auto-Trade.  Many subscribers cover their entire subscription cost by their commission cost savings.

 

We recommend setting up a self-directed IRA account for trading options (especially a Roth IRA if you are eligible for one).  Gains from option trading are short-term capital gains taxed pretty much like ordinary income, and you don’t have to itemize individual trades when you file your tax return for an IRA account.

 

By the way, you may wonder about my options-trading experience.  Way back in 1980, I had a seat on the C.B.O.E. and traded as a market maker on the floor.  Ever since then, for 35 years, I have traded options essentially every day the market has been open.  I graduated from the Harvard Business School and earned a Doctorate in Business Administration from the University of Virginia, but my most valuable credentials came from trading options nearly every day for all those years.  My options trading has enabled me to give away over $2 million to charities in my home state of Vermont.  I was especially proud to build a large swimming pool for the Burlington Boys and Girls Club, and give dozens of college  scholarships to single-parent and first-in-family-to-attend-college Vermonters.

 

Case Study #2 – Starbucks (SBUX) Options Portfolio

 

The first nine months of 2015 were pretty good months for owners of Starbucks (SBUX).  The stock started out the year trading at $81.44 and steadily rose to a high of about $98, and then in early April, they had a 2-for-1 stock split.  By the end of September, the stock traded at $57.99 which works out to a pre-split price of $115.98.  There were 3 dividends of $.16 paid, adding another $.48 to the total, making it a total gain of $35.02, or 43% for the 9 months.

 

Our Java Jive  portfolio started out the year with $6032 invested in SBUX.  At $81.44 per share, you could have purchased 74 shares of stock.  Over the nine months, the portfolio gained $11,768 in value, making 195%.

 

Here is a graphic comparison of how a $6032 investment in the options portfolio compared to the purchase of 74 shares of stock:

 

 

 

 

Unfortunately, the actual portfolio did not gain that much because we also had about half the money invested in Keurig Green Mountain (GMCR), a different kind of coffee company.  The GMCR portion of the portfolio lost $8905 over the period as the stock fell from over $130 to the low $50’s.  In August, GMCR was dropped and FB added to the portfolio, and FB about broke even for the next six weeks (we are now trading both SBUX and FB in separate portfolios).  The portfolio started out the year being worth $10,604 and at the end of September, was worth $12.786, up $2182, or 20.5%.  Not a bad gain over a period when the market fell 6.7%, but not quite the 195% it would have made if only SBUX had been traded.

 

We believe that the above two case studies establish beyond all doubt that a properly-executed options strategy can out-perform the outright purchase of the shares many times over.  Of course, it is a lot easier just to buy the stock.  Trading options takes time and attention, but surely, isn’t it worth it when you can make 107% with options rather than 1.2% owning the same stock, (as we did with COST), or 195% with options instead of 43% owning the same stock (as we did with SBUX)?

 

If you don’t want to bother with all the trading, you could open an account at thinkorswim and sign up for their free Auto-Trade service, and not only enjoy their $1.25 commission rate for a single option purchase or sale, but all the trades will be automatically made for you in your account (this same lower Terry’s Tips commission will apply to all your trades, not just those in Auto-Trade).